About Asset-Backed Securities

Mortgage-Backed Securities

Mortgage-Backed Securities are financial instruments that are collateralized by one or multiple real estate mortgages, and they include securities such as:

• GNMAs

• FNMAs

• FHLMCs - mortgage-backed pass through certificates (also known as participation certificates)

• Adjustable Rate Mortgages (ARM's)

• Collateralized Mortgage Obligations (CMOs) including Real Estate Mortgage Conduits (REMICs)

• Z tranches

• Jump Z's

• PAC tranches (Planned Amortization Class)

• TAC tranches (Target Amortization Class)

• Interest Only and Principal Only (IO, PO)

• Partial Stripped Bonds (STRIPs)

• Mortgage-backed bonds

Types of MBS Securities

This section describes several types of mortgage-backed securities:

Mortgage-Backed Securities

Mortgage-backed securities were created in the U.S. Market during the 1970's, as a means of transforming non-liquid assets (mortgages) into liquid assets (securities) that could be sold on the secondary market. Mortgage-backed securities are distinctive as an investment type, possessing many of the characteristics associated with mortgage payments. An investor receives monthly return (normally) of a portion of principal; in general, the outstanding principal reduces over time as does the monthly interest due. An MBS asset may be expired earlier than the expected maturity date, due to increased refinancing by the underlying mortgages. An MBS can also increase in principal and interest if the mortgagee does not make a payment that covers the interest on their mortgage.

The sources of assets are leasing companies, commercial banks, savings and loans, and other financing institutions. Such companies sell these assets to underwriters, who restructure the assets (typically by "pooling" like financial instruments) and then sell them in the financial markets. By selling the original assets to underwriters, the lending institutions do not have to absorb the risk of potential delinquencies, and at the same time they immediately receive the present value of the associated future cash flows. Mortgage-backed loans are typically pooled into securities by one of the three primary agencies (GNMA, FHLMC, and FNMA), and it is a common practice for the lending institution to buy back the new security after it is restructured, because the new security will be guaranteed by the agency against loss of principal.

Adjustable Rate Mortgages (ARMs)

Compared to normal MBS securities, Adjustable Rate Mortgages (ARMs) present additional issues. Not only is the coupon variable, but also the paydown of principal is often variable. There are two types of caps associated with ARMs: interest rate caps (maximum change in interest rates allowed, either at the time of a single index adjustment, or over the life of the loan, or both) and payment caps (either a maximum change on a borrower's monthly payment when an index changes, or an absolute maximum monthly payment that a borrower is required to make, or both). Mortgagee prepayments have a direct effect on the accrual and accretion/amortization schedules associated with the security. In certain instances, due to interest rate caps, negative accretion/amortization occurs. If interest rates rise to the point that the payment made does not cover the amount of the interest due, the difference between the interest due and payment made is added to the principal amount. The process of adding additional principal to the current face of a mortgage-backed security is known as a payup transaction.

Collateralized Mortgage Obligations (CMOs)

Another class of mortgage-backed securities is Collateralized Mortgage Obligations (CMOs). Typically, in a CMO, a series of bonds or certificates are issued in multiple classes, with each class called a "tranche." Tranches typically have different interest rates and repayment schedules. The objective of a CMO is to redirect cash flows of the mortgages, to create securities with more desirable characteristics (greater certainty of repayment stream, less/more interest rate sensitivity, and so on). One type of CMO is Real Estate Mortgage Investment Conduits, or REMICs. REMICs have a special tax election under the 1986 Tax Reform Act. Essentially it is considered a separate entity for tax purposes; "generally exempt from federal income tax, but the income from the underlying securities is reported by investors." REMICs have two interests: a regular interest, which is subject to bond accounting for tax purposes, and a residual interest. Whoever holds the residual interest is considered to hold the equity in the REMIC; this equity holder receives a quarterly statement reporting the REMIC's gross income and interest expense for all the regular interest bonds issued above it.

Types of CMO Tranches

This section describes several types of CMO tranches:

• Sequential Pay Tranche. Pays down principal in ascending alphabetic (or numeric) order. Usually, interest is paid currently for all classes (except principal only and Z classes mentioned below), on the outstanding principal.

• Z Tranche. A tranche that receives no principal or interest payments until principal and interest of prior tranches are satisfied. Instead, interest is simply added to the beginning outstanding principal of the tranche and earned on a compounding basis. Once the prior classes are paid, cash flows are directed to this class to pay off both interest and the accumulated principal balance.

• PAC Tranche. An investor in a Planned Amortization Class (PAC) receives fixed payments over a predetermined period of time, under a range of prepayment scenarios. In other words, unless prepayments dramatically speed up or slow down, this class is assured a predetermined cash flow (principal and interest).

• TAC Tranche. A Targeted Amortization Class (TAC) provides more limited prepayment protection than a PAC. If prepayment speeds increase, the excess cash flow is shunted to other classes and the TAC is not prepaid faster; however, if prepayments slow, the TAC is paid off more slowly.

• Jump Z Tranche. An accrual class for which principal paydowns on the class are triggered by the occurrence of a certain event or events (usually these events are associated with a PAC tranche). This class has many different subcategories, including:

  • Regular Jump. In its simplest form, a Jump Z is paid any excess cash left over after the cumulative amounts due the PAC are satisfied.

  • Payment Jump. If the cash flows received exceeds the payment due a PAC in a given individual month, the excess is paid to the Jump Z.

  • Percent Jump. If the percentage reduction in principal exceeds the amount planned to be paid to the PAC in a given individual month, the excess is paid to the Jump Z.

  • Treasury Jump. If a base index (usually the Treasury 10-year index) falls below a certain rate, the Jump Z automatically receives any excess cash flows.

Any of these Jump Z items can be either "Non-Sticky" or "Sticky." For a non-sticky jump, excess payments are directed to the jump only in those months that the condition is satisfied. A sticky jump requires payments to be made to the jump in each period following the satisfaction of the condition, whether or not the condition continues to apply.