Investor's Guide On CMBS
Investor's Guide On CMBS
Investor's Guide On CMBS
mortgaGe-backed
securities (MBS)
and collateralized
mortgage obligations
(CMOs)
CONTENTS
Securitization: An Overview
1
Mortgage Securities: An Overview
2
The Building Blocks of
Mortgage-Backed Securities
4
A Different Sort of Bond:
Prepayment Rates and Average Lives
5
Agency vs. Private Label
7
Interest Rates and Yields on
Mortgage Securities
9
Mortgage Security Types
11
Types of CMOs
14
Tax Considerations
19
Minimum Investments, Transaction
Costs and Liquidity
21
Important Considerations for
Investing in Mortgage Securities
22
Comparison of Pass-Through
Mortgage Securities Characteristics
23
Comparison of CMO/REMIC
Mortgage Securities Characteristics
24
Glossary
25
M o r t g a g e S ec u r i t i es :
An O v e r v i e w
2500
2000
Source: Thomson Reuters
1500
1000
500
0
96 97 98 99 00 01 02 03 04 05 06 07 08 08
portfolios until they either matured or were paid
off. These loans were financed by bank deposits
and occasionally debt obligations of the bank itself.
However, after World War II, depository institutions
were unable to keep pace with the rising demand
for household credit.
T h e B u i l d i n g B l oc k s
of Mortgage-Backed
S ec u r i t i es
ing are known as tranches, from the French word
for slice. The CMO structure enables the issuer to
direct the principal and interest cashflow generated
by the collateral to the different tranches in a pre-
scribed manner in order to meet different investment
objectives.
A D i f f e r ent S o r t o f B on d :
P r ep a y ment R a tes a n d
A v e r a g e L i v es
A mortgage security matures when the investor
receives the final principal payment. Both mortgage
pass-through securities and CMO tranches have a
stated maturity based on the last date on which the
principal from the collateral is scheduled to be paid
in full. This date is theoretical because it assumes
no prepayments on the underlying mortgage loans.
Most mortgage pass-through securities are based on
fixed-rate mortgage loans with an original maturity of
30 years, but typically most of these loans will be paid
off much earlier.
older, seasoned mortgage loans. Projected and
historical prepayment rates are often expressed
as percentage of Prepayment Speed Assumptions
(PSA). Other common measures of prepayment
speeds include the conditional prepayment rate
(CPR) and single monthly mortality (SMM).
A g enc y v s . P r i v a te L a be l
and/or issued by these entities are known generical-
ly as agency mortgage securities. Readers should bear
in mind that each agency is a separate entity, and the
securities issued by Fannie Mae or Freddie Mac dif-
fer from those guaranteed by Ginnie Mae.
eventual payment of principal. Neither Fannie Mae
nor Freddie Mac securities carry the additional full
faith and credit U.S. government guarantee.
To the extent that private-label mortgage securities use agency mortgage pass-
through securities as collateral, that specific agency collateral carries the respective
agencys guarantees, but the entire mortgage security that is issued does not.
and distributing the monthly payments to investors.
Furthermore, Fannie Mae and Freddie Mac collect
guarantee fees as compensation for their guarantees
on their agency securities. Interest rates on mortgage
securities are higher than Treasury and corporate
bonds to reflect the compensation for the uncertainty
of their average lives as well as their higher credit risk.
10
prices of most outstanding mortgage securities
generally rise, creating the opportunity for capital
appreciation if the security is sold prior to the time
when the principal is fully repaid.
M o r t g a g e S ec u r i t y T y pes
11
have both interest rate floors and caps, setting
minimum and maximum interest rates on a loan.
These option-like characteristics require that pass-
throughs backed by ARMs have higher yields than
pure floating-rate debt securities.
12
or offering circular. The tranche receiving principal
repayment is referred to as active or currently paying.
In more complex structures, more than one tranche
may receive principal (or be active) at a given time.
13
T y pes o f C M O s
Sequential Pay
SEQUENTIAL-PAY CMO
P I P I P I
TRANCHE
TRANCHE
1
2 TRANCHE
3
PERIOD 1
P I P I P I
TRANCHE
TRANCHE
2
3
PERIOD 2
P I P I P I
TRANCHE
3
PERIOD 3
P PRINCIPAL I INTEREST
14
the third tranche 10-12 years, and so forth. This type
of CMO is known as a sequential pay, clean or plain
vanilla offering. The CMO structure allows the
issuer to meet different maturity requirements and
to distribute the impact of prepayment variability
among tranches. This flexibility has led to increas-
ingly varied and complex CMO structures. CMOs
may have multiple tranches, each with unique char-
acteristics that may be interdependent with other
tranches in the offering. The types of CMO tranches
include:
15
function as support tranches to higher-priority
PAC tranches and maintain their schedules under
increasingly narrower ranges of prepayments.
16
turn have companion tranches further down in the
principal payment priority. Companion tranches are
often offered for sale to retail investors who want
higher income and are willing to take more risk of
having their principal returned sooner or later than
expected.
17
The market values of POs are extremely sensitive
to prepayment rates. If prepayments accelerate, the
value of the PO will increase. On the other hand,
if prepayments decelerate, the value of the PO will
drop. A companion tranche structured as a PO is
called a Super PO.
18
index. These so-called super-floaters offer leverage
when rates rise. The interest rates on inverse float-
ers move in a direction opposite to the changes in
the designated index and offer leverage to investors
who believe rates may move down. The potential for
high coupon income in a rally can be rapidly eroded
when prepayments speed up in response to falling
interest rates. All types of floating-rate tranches may
be structured as PAC, TAC, companion, or sequen-
tial tranches, and are often used to hedge interest
rate risks in portfolios.
T a x C ons i d e r a t i ons
19
that interest income from Treasury securities is
exempt from state and local income tax.
20
M i n i m u m In v estments ,
T r a ns a ct i on C osts a n d
Liquidity
21
Impo r t a nt C ons i d e r a t i ons
f o r In v est i n g i n
M o r t g a g e S ec u r i t i es
22
Comparison of Mortgage Pass-Through
Securities Characteristics
Minimum
Security Guarantee Payment Date
Investment
Ginnie Mae Full and timely $1,000 thereafter; 15th or 20th of the
I and II payment of principal $1 increments month for Ginnie
and interest, backed ($25,000 minimum Mae I and II pools,
by the full-faith-and- for securities issued respectively,
credit guarantee of before 11/1/2005) following the record
the U.S. government date and every
month thereafter
Ginnie Mae Full and timely $1,000 thereafter; 15th or 20th of the
Platinum payment of principal $1 increments month for Ginnie
and interest, backed ($25,000 minimum Mae I and II pools,
by the full-faith-and- for securities issued respectively,
credit guarantee of before 11/1/2005) following the record
the U.S. government date and every
month thereafter
Fannie Mae MBS Full and timely pay- $1,000 minimum; $1 25th of the month
ment of principal and increments following the record
interest guaranteed date and every
by Fannie Mae month thereafter
Freddie Mac Full and timely $1,000 minimum; 15th of the second
(75-day PC) payment of interest $1 increments month following
and ultimate payment the record date
of principal guaran- and every month
teed by Freddie Mac thereafter
Freddie Mac Full and timely $1,000 minimum; 15th of the month
Gold PC payment of interest $1 increments following the record
and scheduled date and every
principal guaranteed month thereafter
by Freddie Mac
23
Comparison of CMO/REMIC Mortgage
Securities Characteristics
Minimum
Security Guarantee Payment Date
Investment
Ginnie Mae Full and timely $1,000 minimum; 16th or the 20th of
REMIC payment of principal $1 increments the month for
and interest, backed by Ginnie Mae I and II
the full-faith-and-credit collateral,
guarantee of respectively,
the U.S. government following the record
date and every
month thereafter
Freddie Mac Full and timely $1; $1 increments 15th of the month
REMIC payment of interest (most dealers, following the record
and scheduled however, require a date and every
principal guaranteed by minimum investment month thereafter
Freddie Mac of $1,000 or more)
Fannie Mae Full and timely $1,000 minimum; 18th or the 25th of
REMIC payment of interest $1 increments the month following
and scheduled the record date
principal guaranteed by and every month
Fannie Mae thereafter
(collateral of Fannie
Mae G series is also
backed by the full faith
and credit of the U.S.
government)
24
G l oss a r y
25
CMO (Collateralized Mortgage Obligation): A
multiclass bond backed by a pool of mortgage pass-through
securities or mortgage loans. See REMIC.
26
Current face: The current remaining monthly principal
on a mortgage security. Current face is computed by multi-
plying the original face value of the security by the current
principal balance factor.
27
IO (interest-only) security: A security or tranche
that pays only interest and not principal. IO securities are
priced at a deep discount to the notional amount of prin-
cipal used to calculate the amount of interest due.
28
Negative convexity: A characteristic of CMOs and
other callable or prepayable securities that causes inves-
tors to have their principal returned sooner than expected
in a declining interest rate environment, and later than
expected in a rising interest rate environment.
29
Private label: The term used to describe a mortgage
security whose issuer is an entity other than a U.S. gov-
ernment agency or U.S. government-sponsored enter-
prise. Such issuers may be banks, subsidiaries of invest-
ment banks, other financial institutions, or home builders,
for example.
30
Settlement date: The date for the delivery of bonds
and payment of funds agreed to in a transaction.
31
Tranche: A class of bonds in a CMO offering. Tranche
is the French word for slice.
32
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