Mortgage backed securities (MBS) are asset-backed securities representing claims on the cash flows from pools of mortgage loans. MBS are created through a process called securitization where mortgages are pooled together and tranched into different risk levels. This allows risk to be transferred and spread across various tranches, generating rated securities from unrated assets. The main types of MBS include pass-through securities for residential and commercial loans, as well as collateralized mortgage obligations.

1. Mortgage Backed Security

2. Structured Finance A sector of finance that was created to help transfer risk using complex legal and corporate entities Ability to repackage risk and create safe assets from risky collaterals. Important Features – Securitization , Tranching .

4. Securitization A structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool. Steps Involved : a) Pooling and Transfer b) Issuance

5. Tranching Individual securities are often split into tranches /classes. Each tranche has a different level of credit protection or risk exposure than another Cash flow waterfall arrangement Benefit - Generates rated securities from a pool of unrated assets

8. Mortgage Backed Security An asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans. Mostly issued by the Government National Mortgage Association ( Ginnie Mae ) , the Federal National Mortgage Association ( Fannie Mae ) and the Federal Home Loan Mortgage Corporation ( Freddie Mac )

9. Structure Basically 4 important players : a) Home-owners – Apply for mortgage loan b) Originator – Banks that service the loan. Also transfer the pool of assets to the Issuer. c) Issuer – Usually SPV that handle securitization and tranching d) Investors – Trade in the MBS

10. Features Weighted average maturity Weighted-average coupon Pass Through Rate

12. WAM = 22.22% (300) + 44.44% (260) + 33.33% (280) = 276 months WAC = 22.22% (6.00) + 44.44% (6.25) + 33.33% (6.50) = 6.28% Used for describing a mortgage passthrough security, e.g. $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month WAM An important relative value tool in MBS portfolio management and analysis .

13. Types Pass-through mortgage-backed security a) Residential mortgage-backed security b) Commercial mortgage-backed security Collateralized Mortgage Obligation Stripped mortgage-backed securities a) Interest-only stripped mortgage-backed securities b) Principal-only stripped mortgage-backed securities

14. Risk Interest rate risk and Prepayment risk The number of homeowners in residential MBS securitizations who prepay goes up when interest rates go down . Credit risk Depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time

15. Uses Transforms relatively illiquid , individual financial assets into liquid and tradable capital market instruments. Allow mortgage originators to replenish their funds, which can then be used for additional origination activities. Frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives

16. US MBS Market Total U.S. mortgage debt outstanding : $ 1.54 trillion Total U.S. mortgage-related securities : $ 45 billion Reasons (other than investment or speculation) for entering the market include the desire to hedge against a drop in prepayment rates Highly liquid securities

17. Reference www.wikipedia.org www.hbs.edu/research/pdf/09-060.pdf www.federalreserve.gov www.investopedia.com

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