Mortgage backed security essay

Notion and background of MBS

Mortgage-backed securities are debt securities refinanced by means of obligations under one or more mortgage loans. Interest payments and principal of loan payments on such securities are produced from funds received from providing credits. Mortgage-backed securities are the particular case of asset-backed securities, giving their holders the right to receive cash flows from a particular pool (set) of assets. In the case of MBS assets represent contractual rights to the mortgage loans collateralized by real estate objects. Mortgage loans are repaid by monthly (or quarterly) payments. Holders of MBS secured by this pool, get most of these payments by some predetermined scheme.

During the first 3 decades of the 20th century there was not observed involvement of state or government in securing financing for real estate market in Western countries. Much of financing of this market came from the personal funds of citizens, and from private investment mortgage companies; only a small percentage of mortgage companies and banks were involved in the development of the property market. As a result, the value of interest rates changed frequently, and loans were given on a very short period, which finally provoked an economic crisis and contributed to the situation, when the entire economy was depressed. However, at that time the economists concluded that the policy of ensuring a sufficient number of mortgages provided on economically favorable conditions and stimulating the development of housing sector would be wise. It was recognized that mortgage investments in real estate should be low-risk investments; it also became clear that real estate could be a very effective means of reviving the economy.

Two models of mortgage have formed in the world: the Franco-Scandinavian model (Germany, Italy, etc.) and the American one. In the U.S., mortgage loans funding primarily takes place on the share market through issuing mortgage bonds (52%); and in Germany funds are mobilized through the loan-saving system and only 20% – by means of securities.

Types of mortgage securities

In world practice, a great variety of MBS is used, which differ by type of ensuring assets, guarantees, risk allocation, etc. Among them we can list the following MBS types:

1) Residential Mortgage-Backed Securities (RMBS) – the most common securitization in the form of pool of homogeneous mortgage loans secured by residential real estate;

2) Commercial Mortgage-Backed Securities (CMBS) – securities securitized by one or more pools of mortgage loans. Securitization in this case may consist of one or more loans secured by commercial real estate (multifamily houses, trade, office and industrial centers and hotels); 3) Collateralized Mortgage Obligation (CMO) – security ensured by a pool of mortgage loans or a combination of loans and agency securities. Such securities are issued, as a rule, in several classes with different maturities and coupons.

New development level of the secondary mortgage started in the early 1970s in the US with the advent of mortgage loans securitization, which is the issue of securities secured by the package (pool) of mortgages. Pool makes a collection of mortgages of the same type, matching by lending terms: period, payment scheme, categories of borrowers, type of mortgaged property. Securities issued in securitization process are pass-through securities.

Specificity of mortgage-backed securities

Despite different types of mortgage securities, MBS share the following characteristics:

1) In most cases, the payments paid to MBS holders are periodic;

2) Assets pool payments consist of two parts: interest (fee for loans) and amortization (loans repayment). Amortization payments can be schedule or pre-schedule, full or partial;

3) Schedule amortization represents the gradual repayment of loan balance, so that by the end of the mortgage loan balance is repaid, unlike corporate bonds, when over the bond maturity only a coupon is paid, and the balance (nominal) is repaid at the end of the term;

4) Pre-schedule MBS repayment reflects the fact that in most cases the borrower on a mortgage is entitled to a partial or full advance payment of the loan, for example, when selling an apartment, which is a part of collateral on the loan;

5) Level of profitability of mortgage bonds depends on non-payment risk level and circulation period. Risk of mortgage bonds non-payment is, in turn, directly connected with its securing. Securing by real estate and state guarantees for mortgage bonds suggests that they will be less risky than corporate bonds, but more profitable than public ones.

In general, MBS are characterized by reliability, transparency, accessibility and longevity. However, disadvantages of MBS are low liquidity and prepayment risk, which doesn’t allow determining duration and profitability. Development of mortgage bonds market is constrained by weak stock market infrastructure; reluctance of financial institutions to invest in long-term projects; legal framework imperfection. The way to reduce interest rates and risks of default on MBS are state guarantees for mortgage loans. The rate on mortgage also depends not only on long-term prospects, but on borrower’s ability to repay the loan.

MBS yield is determined by the profitability of mortgage loans ensuring these securities. But the rate on these loans should be reduced for a wider spreading of mortgage. It’s like a vicious circle. In this regard, one of the main objectives of MBS issuer is reducing credit risk of securitized assets for MBS holders, and increasing the credit rating of bonds.

Analysis of risks and investing in mortgage-backed securities

The market for mortgage securities in the U.S. is the fastest growing segment of the national stock market. In 2002, the total amount of mortgage bonds amounted to 4.3 trillion dollars (22% of the total amount of bonds in the U.S.), 1.67 trillion of which made mortgage securities issued last year (36,6% of the whole debt obligations’ issue). Today, mortgage-backed securities are in demand worldwide. They are provided with real estate, which is always highly prized. Hence, the guarantee of this financial instrument’s profitability is the dynamics of property prices growth. In recent years, it showed an increase by 50% in some regions. Surely, not every type of investment can bring such earnings.

MBS assign in front of investors the tasks unknown in other markets, tasks which are both the source of new opportunities and the source of serious difficulties. The main problem is formed by the combination of the complexities of structuring a deal and the unpredictability of human behavior. That is why in many cases, securities produced in securitization are marked with the human factor, when the dynamics of human life is intertwined with the mechanism of financial markets.

There are many methods for the analysis of risk, associated with MBS. The below-mentioned approach consists of four consecutive phases, which are listed in the table.

Table 1. Characteristics of the analytical approach. Risk Measurement.


Stage Components
Studying methodology Rate of interestEconomics

Demand and Supply

Legislature, Accounting and Taxation

Evaluation of security Early repaymentDefaults and Losses
Development of the structure Payment flow, generated by provisionPayment priority

Investment portfolio

Results IncomeMarketable value


At studying methodology stage, the set of possible states of market (able to influence the results of analysis) are generally considered, and the types of risks are determined. The main objective is to define the set of factors reflecting the results of market behavior of securities, which should be included into the analysis. The phase of evaluating security is focused on characteristics of a specific pool of assets, particularly in terms of early repayment, losses and other aspects, that could affect the flow of payments. The purpose here is to identify factors influencing payment flow, as well as the fulfillment of obligations on issued securities.

When considering the structure, the payment rates of the securities is calculated for each concrete scenario, taking into account early repayments, losses and other indicators, including peculiarities of structures applied in issuing specific types of securities, as well as other relevant factors. The basis of calculation are the assumptions regarding future economic conditions, estimates obtained in the phase of evaluating security, as well as features of credit contracts included in the coverage and legal implementation of securitization transactions.

The results obtained in the last stage are usually the compilation of all the characteristics of the payment flow, carried out in one way or another. The aim of determining generalized indicators is to help companies in the investment process. As a rule, analytical results give a complete picture of revenue, costs and risks. Assessment of income gives an indication of the timetable of the future payment flow and the future income value.

The structure of income on mortgage securities consists of two components: the payment of principal debt and interest. The terms of payment of principal debt determine how the sums paid by end-borrowers to repay principal on the mortgage loans are allocated to tranches of mortgage-backed securities, secured by the payment flow.

In the case of securities with consistent repayment (sequential bonds), the full repayment of the senior tranche is first made, and then the payment of principal on the next tranche (class of bonds) is started. Securities with the consistent repayment were designed to transform MBS into an investment tool, similar to traditional corporate bonds. The specificity of such bonds lies in the fact that the period of payment of principal debt is substantially reduced. Thus, they resemble debt obligations (bonds), the return of principal on which is carried out at the end of circulation period.

At the same time, securities with proportional allotment are two or more bonds, the holders of which receive payments in accordance with totally equal rules. The payment flow, due to which the payments on these bonds are carried out, is allocated proportionally. Bonds with the proportional allotment were created in order to make possible the existence of classes, providing the same order for repayment of principal and different order for interest payments. Changing the rules of interest payments alters the risk characteristics of bonds and makes them more attractive to the different groups of investors. However, investors seeking for maximum protection against risks prefer bonds with a specific repayment schedule, which ensures greater certainty of payment flows.

Moreover, the dominant majority of MBS have a very high credit rating. The reason is not only the provision of MBS in the form of mortgage. In fact, every issuer makes every effort to improve the credit rating of his securities. The task of an issuer or an organizer of MBS issue is to reduce the credit risk of securitized assets, and thereby achieve the higher, (comparing with securitized assets) credit rating of bonds. An important factor is the preferential system of taxation of investors’ incomes, received from investments in mortgage-backed securities, which is the practice of most countries of the world.

Measures for increasing MBS credit rating

An important factor of increasing MBS credit rating is the segregation of securitized assets on the balance of special purpose vehicle (SPV), which is usually not legally affiliated with securitization organizer. This vehicle becomes the assets holder and issues MBS. By statute it has no right to be involved in any other business, so MBS are subject to credit risk of securitized assets only. In particular, they become isolated from the business risk of securitization organizer. This factor allows raising the securitization bonds credit rating higher than securitization organizer’s credit rating.

There are also other measures to reduce credit risks:

– Payment interruption insurance (in case of default on mortgage loans from MBS securing, the insurer starts paying interest for the borrower up to realization of the pledge).

– Additional guarantee or insurance provided by financial assurance companies.

– Surety bonds (obligation of the insurance company to cover 100% of bonds losses regardless of their causes. Frequently, issuing of new types of market financial instruments is fully covered surety bond, until the market gets used to this type of instruments.

– Guaranteed letter of credit (obligation of an exterior financial institution (bank) to pay the full amount of debt and interest in case of issuer’s default).

– A special reserve fund may also be formed from the proceeds of securitized assets and a guarantee issued of the securitization organizer.

Driving force making the issuer structure the issued securities is the size of credit enhancement needed to achieve the desired credit rating. Estimation of probable losses for each security class helps to choose a mechanism of increasing the credit quality and determining the credit enhancement amount.

In general case, with respect to transactions on MBS issue, rating agencies determine the amount sufficient to cover losses, as the product of foreclosure frequency by loss severity. Foreclosure frequency reflects the share of loans in the pool, obligations on which will not be executed during the transaction term. Loss severity describes the size of expected losses, which may occur during the transaction, when applying sanctions in case of default.

Table 2. Trends in the qualitative degree of MBS securitization


The process of rating assignment starts with a study of the financial condition and business performance of originator and service company. Then, the agency examines the financial assets the company assumes to securitize, verifies that they meet certain standards including the level of geographical diversification, loan type, etc. Then, rating agency determines the overall expenditure level necessary to compensate for possible losses. They also examine the structure of the upcoming securitization transactions.

Credit enhancement size is a function of risks associated with the peculiarities of securitized coverage; and means of increasing credit quality can be both internal and external. Examples of means of increasing domestic credit quality are: 1) payments overflow; 2) subordination (or tranches structuring); 3) overcollaterization; 4) spread accounts.

In the structuring of the issue in several tranches is often applied at MBS market, i.e. the issue of unequal classes of MBS for the redistribution of default risk and early repayment, when subordinate classes have a lower rating and consequently pay a higher interest rate.

In most cases, subordinated tranches are not placed on the market, but are purchased by the initiator. Income is first allocated to senior tranches, and then to subordinate ones in accordance with residual principle. Mainly, the issue consists of more than two tranches, when each subsequent tranche is subject to all previous one.

Credit support and structural protection insulate the investor from the majority of potential risks, pool of loans and securitization bonds are subject to. Along with legal protection, this allows to create securities, which are fundamentally different from other financial instruments.

This provides a credit rating, close to the rating of sovereign debt. Typically, most of MBS receive the highest credit rating AAA, according to the version of Standard & Poors credit agency. In general, the use of restructuring payment flows generated by mortgage assets allows to create securities with the variety of investment characteristics.

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