Prime brokers have been intimately involved with the most notorious security from the housing foreclosure crisis. Mortgage-backed securities (MBS) represent an investment in mortgage loans. An MBS investor owns an interest in a pool of mortgages, which serves as the underlying assets and source of cash flow for the security. The loans backing the MBS are issued by a national network of lenders consisting of mortgage bankers, savings and loan associations, commercial banks, and other lending institutions.
MBS payments can contain a mix of coupon interest and principal, depending on the type of MBS. The rate of the mortgage determines the division between monthly interest and principal repayment. Only the interest portion of a payment can be booked as Profit & Loss (P&L) income.
A major complication in determining the ultimate P&L of an MBS investment is principal paydowns. An investment that is paid down quickly will provide a different return than one that pays down at a slower rate. Reinvestment risk and default risk factor into the calculation of the total return on an MBS investment. Notwithstanding the pattern of principal paydowns, the original face value remains unchanged – paydowns affect only the current face value of the investment.
Mortgage products, including collateralized mortgage obligations, or CMOs, typically trade with a payment delay feature. Accrued interest on CMO trades is usually calculated using a factor, which is announced before the payment of the actual coupon. These coupon payments are impacted by the days delay feature of the bonds, which generally range between 0 and 24 days after the end of the accrual period.
There are several types of MBS. We’ll discuss pass-throughs this time, and look at CMOs and Strips in an upcoming blog.
In a pass-through MBS, an issuer collects monthly payments from homeowners and then passes on a proportionate share of the collected principal and interest to the investor.
Pass-through MBS have three components of cash-flow:
- Scheduled principal (usually fixed)
- Scheduled interest (usually fixed)
- Prepaid principal (usually variable depending on the actions of homeowners, as governed by prevailing interest rates)
Pass-throughs represent a share of an investment pool consisting of multiple mortgages. Prepayment risk is reduced when the investment is subject to increasingly larger numbers of mortgages because each mortgage prepayment would then have a reduced effect on the total pool. Pass-through securities allow investors to reduce their prepayment risk by diversifying rather than making a single mortgage investment.