Mortgage-Backed Securities

Mortgage-backed securities represent an ownership interest in mortgage loans made by financial institutions to finance the purchasers of homes or other real estate. As the homeowners pay off the mortgages, investors receive interest and principal payments.

The Government National Mortgage Association (GNMA, commonly known as Ginnie Mae) is a government-owned corporation found within the Department of Housing and Urban Development. Ginnie Maes are guaranteed by the full faith and credit of the U.S. government. Government-sponsored enterprises (GSEs) such as the Federal Home Loan Mortgage Corporation (FHLMC, also known as Freddie Mac) or the Federal National Mortgage Association (FNMA, also known as Fannie Mae), are chartered by Acts of Congress, but owned by stockholders. The U.S. government does not officially back these. However, many investors understand they carry an implied government backing.

Some of the basic categories of mortgage-backed securities are:

Pass-Through Securities

Collateralized Mortgage Obligations 

Stripped Mortgage-backed Securities

Pass-Through Securities

The creation of a pass-through security begins with a pool of mortgages. This pool is packaged together and a single security is created. The important distinction between a pass-through and any other mortgage-backed security is that the pass-through is the only security created from the pool of mortgages. Other types of mortgage-backed securities could start with the same mortgages, but create numerous different securities.

An investor in a pass-through security receives monthly cash flow payments consisting of interest and principal. The monthly interest payment is based on its stated coupon. The monthly principal payment is based on how much of the principal the underlying mortgage holders of that pool decide to pay back in that particular month. The investor then receives their pro-rata share of the total principal of that month.

Collateralized Mortgage Obligations 

This type of mortgage-backed security was developed to provide investors a greater range of time frames and a greater cash-flow certainty than previously offered by mortgage-backed, pass-through securities.

The difference between a CMO and a pass-through security is that in a CMO structure, many different securities are created from pools of mortgages by redirecting the cash flows of principal and interest. The issuer collateralizes a pool of various class mortgage loans and creates a tranche. A tranche segregates portions of the cash flow from the CMO in order to redirect its principal and interest payments to other tranches based on a predetermined distribution schedule established when the CMO was created. One CMO may be entitled to receive a certain amount of principal from the pool before all the others.

Stripped Mortgage-Backed Securities (SMBS)

Stripped mortgage-backed securities are a form of a pass-through securities where investors purchase the rights of either the principal (PO, or principal only) or the interest (IO, or interest only) produced by cash flows from specified mortgages.

Safety

Ginnie Maes are backed by the full faith and credit of the U.S. government.

Freddie Mac and Fannie Mae are not direct obligations of the U.S. government, but they both have a line of credit to the U.S. Treasury. Credit markets consider their safety to be nearly equivalent to agencies that have the full faith and credit backing of the U.S. government.

The mortgage-backed market is one of the largest financial markets in the world. At the end of 2014, the number of U.S. mortgage-related securities outstanding was $8.73 billion.

These securities issued by GNMA, FHLMC or FNMA carry an implied AAA credit rating.

Yield

Most investors of mortgage-backed securities receive interest and principal payments on a monthly basis throughout the life of that security.

The yield on these can be affected by homeowners making mortgage pre-payments. However, mortgage-backed-type securities generally offer higher yields than other securities with comparable credit quality. What the investor gives up for that higher yield is certainty about the maturity of the investment.

Diversity

Mortgage-backed securities offer a range of maturities that include 30, 15, seven or five-year terms.

The secondary market is sizable and active due to the network of dealers executing trade transactions with other dealers on a national basis.

Limitations

Generally, inherent prepayment risk exists for investors of mortgage-backed securities. The unpredictable nature of mortgage prepayments usually increases as long-term interest rates decrease. If mortgage rates fall, this may cause a rise in the price of mortgage bonds. The homeowner (mortgagor) has the right to call the mortgage away from the investor at par when its value may be more or less than par.

Reinvestment risk can be realized if principals are received earlier than expected.