When a person purchases mortgage backed securities, he or she is essentially buying a stream of cash flows from a pool of mortgages. This cash flow is comprised of the mortgage payments that the homeowners make to the mortgage lender, typically a bank. Rather than waiting for each homeowner to make his or her monthly payments over possibly 30 years, a bank may decide to sell its interest in a group of mortgages at some discount in order to increase their short-term cash holdings. This allows it to make more loans and thereby expand its business as a lender.
Ultimately, some company or organization will take a group of mortgages and sell bonds to investors that provide them with the right to certain portions of the payments relating to those mortgages. These are referred to as mortgage backed securities ("MBS"). MBS are primarily sold by three government sponsored companies: Ginnie Mae, Fannie Mae and Freddie Mac. However, as MBS investing became more popular, MBS offered by non-government related entities grew substantially over time. While the federal government guaranteed the timely payment of principal and interest relating to Ginnie Mae, Fannie Mae and Freddie Mac mortgage pools, this did not extend to other non-agency MBS. As a result, they contained greater risk due to the possibility of default.
The government sponsored MBS, referred to as agency MBS, do not have default risk. This was questionable during the recent mortgage backed securities crisis when some believed that the U.S. government might refuse to assume the obligations of Ginnie Mae, Fannie Mae and Freddie Mac if they became insolvent since the amount involved was possibly huge. However, this concern disappeared as the extent of the financial crisis became known. Even when there is default risk, as in the case of non-agency MBS, it is diversified significantly due to the investment consisting of many mortgages rather than just one or a few.
However, even if there is no default risk, investors in agency mortgage backed securities are subject to prepayment risk. Unlike many types of loans, mortgages generally permit the borrower to prepay up to the entire loan amount early. When this occurs, no more interest accrues on the mortgage. While an investor in MBS will receive his or her allocation of the principal payment relating to the prepaid mortgage, this usually puts the investor at a disadvantage. This is because mortgage prepayments typically occur when a homeowner refinances his house because mortgage rates have dropped. Yet, if this occurs, the MBS investor is left with his or her cash position again with less promising bond investment opportunities due to the drop in interest rates.
Just like a birthday cake, the cash that flows from a pool of mortgages can be cut into many different sized "slices" depending on an investor's appetite for risk and desired return. Those who issue MBS have been very creative in creating different types of investments that appeal to different investment goals. Some of principal types available include the following:
1. PACs (planned amortization class tranche): a class or tranche that has priority in receiving payments from the mortgage pool provided that mortgage prepayments occur within a specific range. This reduces the prepayment risk, which is absorbed by the other classes, typically referred to as companion or support tranches. Because the support tranches assume higher risk, they have higher yields.
2. TACs (targeted amortization class tranche): a class or tranche that is similar to a PAC in that it is protected from higher than anticipated mortgage prepayments. However, TACs are not protected if prepayments fall below a certain level. Thus, there is more risk associated with a TAC investment.
3. Floaters: a class or tranche that has a variable interest rate that is based upon some reference rate plus a spread, subject to specific minimum and maximum ranges. This investment essentially acts like an adjustable rate mortgage, except it is an asset rather than debt. Because payments adjust with fluctuations in interest rates, interest rate risk is minimal. Since this risk is reduced, yield is lower. Non-floating tranches of a mortgage pool assume the interest rate risk that the floating tranche avoids, thus they are very interest rate sensitive.
4. Inverse Floaters: a class or tranche that receives payments that are inversely related to interest rates, which is essentially the opposite of a floater. Thus, as interest rates fall, the price and yield of an inverse floater increases. They are often issued in combination with floaters as tranches in a mortgage pool since their payouts can offset each other.
5. Strips: to create two types of bond classes from a pool of mortgages, the mortgages are divided, or stripped, into their two constituents: principal and interest.
a) The PO, or principal only tranche, receives just the principal portion of the mortgage payments. The yield of a PO strip depends on how quickly mortgages are prepaid by the borrowers. The quicker they are prepaid, the higher the yield. This investment gains value if interest rates fall and prepayments increase due to increased mortgage refinancing.
b) The IO, or interest only tranche, receives just the interest portion of the mortgage payments. The yield of an IO strip also depends on how quickly mortgages are prepaid by the borrowers. The quicker they are prepaid, the lower the yield. This investment retains or gains value if interest rates increase and prepayments are low since borrowers continue to make interest payments each month.
Keep in mind that there are other types of mortgage backed securities as well and that some of the types mentioned can be combined to form other new types. For example, one could purchase inverse IO floaters or PAC inverse floaters. In essence, the division of mortgage pool payments into various types of cash flow streams is only limited by the creativity of the human mind.
By: Greg Yanke
Tags: financial crisis, prepayment risk, PAC inverse floaters