The creation of a mortgage-backed security begins with a mortgage lender such as a bank extending a loan to a homeowner. The lender can either keep the loan on its books or sell the loan to a government-sponsored enterprise (GSE or agency) or private entity. The lender may continue to service the mortgage or this may be assumed by the purchaser. MBS are created when the agency or private entity takes multiple mortgage loans it has purchased and bundles them together into a “pool.” The number of loans comprising the pool can range from a few loans to thousands of loans. This pool produces a regular cash flow as homeowners make monthly mortgage payments. The agency or private entity then sells claims to these cash flows in the form of securities to investors. These securities are commonly known as mortgage-backed securities (MBS).
Most agency MBS are issued by the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae). GNMA is a U.S. Government agency, whereas FHLMC and FNMA are GSEs, although all three are commonly referred to as agencies. Securities issued by GNMA are the only MBS backed by the full faith and credit of the United States. Securities issued by the other two agencies have an implied guarantee, although these enterprises are not explicitly guaranteed by the federal government.
Other MBS are known as non-agency or “private label” mortgage-backed securities (PMBS) and contain mortgages ineligible for purchase by an agency as they do not conform to the agencies’ requirements, e.g., lack of full documentation, loan size, etc. PMBS are rated by rating agencies and have features such as credit enhancements which are designed to protect investors from delinquencies or losses on the underlying mortgages.
Mortgage-backed securities can be structured in a number of ways, but the two most common are Pass-Throughs and Collateralized Mortgage Obligations (CMOs). Pass-through securities are the most basic mortgage-backed bonds. They are securitized by pools of similar mortgage loans, and most are issued by an agency. As homeowners continue to make mortgage payments, the payments go to the mortgage servicer and then to the security holder.
Collateralized mortgage obligations (CMOs) are a more complex type of MBS, and are formed by bundling pools of mortgage loans and structuring them into multiple classes of securities. Each security class, or tranche, has a different maturity and cash flow pattern, unlike pass-through securities which have a regular cash flow pattern. CMOs are a potentially viable option for investors with unique investment objectives, as they allow for risk and reward to be reapportioned according to investor needs.
