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Mortgage-backed securities

Many investors are attracted to mortgage-backed securities because of their potential for relatively high yields, monthly interest payments, and good liquidity. First created in 1970, the mortgage-backed securities market is now one of the largest fixed income markets, second only to the U.S. Treasury market. As this market has grown, so has the extent of the terminology describing mortgage-backed securities. What follows is a brief glossary explaining some of the more common terms.

Issuers Home Loan Mortgage Corp and principal; this is dependent The majority of mortgage-backed (FHLMC) were placed under U.S. solely upon the creditworthiness securities are issued by agencies of Government conservatorship of the underlying borrowers. the U.S. Government or government- through the Federal Housing Finance Agency (FHFA). At this sponsored enterprises. However, General terms juncture, they are not considered some private institutions, such as • Mortgage pass-through security investment banks and financial to be direct obligations of the U.S. government, but both maintain — This most basic of all mortgage- institutions, package mortgage loans backed products is created when to create securities. their status as Government Sponsored Enterprises (GSE). For a group of mortgages are pooled • Ginnie Mae — Government both their pass-through securities together and “securitized,” in National Mortgage Association and CMOs, the full and timely which ownership represents (GNMA) is a United States payment of interest and principal, a direct interest in the pool of government agency whose scheduled principal in the case mortgages. Monthly principal and securities are backed by the of CMOs, is guaranteed by Fannie interest payments paid by the full faith and credit of the U.S. Mae or Freddie Mac. The principal homeowners on the underlying government. For both pass- payment guarantee applies only mortgages are “passed through” through securities and CMOs, to the face (par) value of the to the bondholders on a pro-rata the full and timely payment security, not to any premium paid. basis, after deduction of a servicing of principal is backed by the fee. They are also referred to as full-faith guarantee of the U.S. • Private labels — Private label participation certificates (PCs). or whole loan mortgage-backed government. The principal payment • Collateralized Mortgage guarantee applies only to the securities are issued by banks, investment banks or mortgage Obligation (CMO) — The CMO face (par) value of the security, is a multi-class bond backed not to any premium paid. companies. The mortgages that make up these securities are by pools of mortgage pass- • Fannie Mae and Freddie Mac — usually too large to conform to throughs or mortgage loans. The In September 2008, as a result of the underwriting guidelines for CMO is structured into classes the severe downturn in the U.S. securities issued by government (“tranches”), which are designed to economy and rapid deterioration sponsored enterprises such as meet different financial objectives. in the U.S. housing market, both Fannie Mae or Freddie Mac. These Each bond in a class has a similar the Federal National Mortgage issues carry no guarantee as to the coupon rate, cash-flow pattern, and Association (FNMA) and Federal full and timely payment of interest expected maturity. The cash flow

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from the underlying collateral is • Prepayment — The unscheduled • Weighted Average Loan Age allocated to the various classes in partial or complete repayment (WALA) — The weighted average a pre-determined order. of the principal amount number of months since the outstanding on a mortgage origination of the mortgage loans • Real Estate Mortgage Investment loan. Prepayment occurs when underlying an issue. Once the WALA Conduit (REMIC) — As a result homeowners sell their homes, is greater than 30 months, the of the 1986 Tax Reform Act, most refinance, or for other reasons, loans are considered “seasoned,” CMO bonds are now issued in prepay their mortgage loans. and prepayments are typically REMIC form to create certain tax more predictable. advantages for the issuer. The • Weighted Average Coupon (WAC) terms CMO and REMIC are now — The weighted average interest • Weighted Average Maturity used interchangeably. rate on all mortgages that serve as (WAM) — The weighted average collateral for the security. number of months until the final • Amortization of principal — payment of all the mortgages Mortgage securities are “self- • Constant Prepayment Rate backing a mortgage security. amortizing,” that is, principal is (CPR) — A method of describing distributed to security holders over the prepayment rate of mortgage a period of time (months or years) loans, calculated as the percentage Risks instead of a lump-sum payment, as of outstanding mortgage loan As with all fixed income securities, with conventional bonds. principal that prepays in one year. mortgage-backed securities are • Factor — Because mortgage- • Standard Prepayment Model subject to interest rate risk: when backed securities distribute (PSA) — A model, based on interest rates rise, prices fall and principal over time, the factor is historical mortgage prepayment vice versa. However, interest rate used to determine the amount of rates, that is used to estimate movements have an additional principal remaining. It is calculated prepayment rates on mortgage impact on mortgage-backed by dividing the current principal securities. The model, established securities because they affect balance of a pool by the original by the Public Securities Association prepayment speeds. Changing principal balance at issuance. Thus, (PSA), assumes that prepayments prepayment speeds cause the the factor starts at 1.00, and as the on new mortgage loans will be very estimated average life to shorten or principal pays down, it decreases. little the first month, will gradually extend: call risk or extension risk. increase over the next 29 months, These changes in average life will • Payment delay — The administrative and then (after these first 30 also impact the ultimate yield an delay in passing through payments months) will level off at a constant investor receives on their mortgage- of principal and interest to investors prepayment rate until maturity. backed security. in mortgage-backed securities. • Call risk — For a CMO, the risk • Tranche — “Tranche” is the French Maturity measures that investors may have their word for “slice.” It represents principal returned to them sooner An important point to understand a class of bonds within a CMO than expected, because declining about mortgage-backed securities is offering having the same interest rates can accelerate that they are sold and traded in terms characteristics (coupon rate, prepayment speeds. In this case, of average life rather than maturity. estimated maturity, cash-flow). investors may face the risk of • Weighted Average Life (WAL) — reinvesting at lower interest rates. Estimated average number of Return measures • Extension risk — For a CMO, the years that each principal dollar will • Yield — The expected annual risk that the life of the security may be outstanding. WAL is the most percentage rate of return on an be extended beyond expectations commonly used maturity measure investment. Yield is a function of because rising interest rates have in the mortgage market. a security’s purchase price and slowed prepayment rates. This coupon rate. • Projected final maturity creates a situation where investors — The theoretical last date • Bond Equivalent Yield (BEY) — An may find their principal committed upward adjustment to a mortgage- by which the final principal for a longer period of time and backed security yield, to reflect payment would be paid. may miss out on an opportunity of reinvesting at higher rates. its more frequent payments. • Window — In a CMO, the period Mortgage-backed securities pay of time between the expected • Credit risk — Private Label interest monthly rather than semi- first payment of principal and the CMOs are rated by the major annually, as with most other types expected last payment of principal. rating agencies. Following the of bonds. deterioration in the U.S. housing Page 3 of 3 Mortgage-backed securities, continued

market and the severe U.S. • Planned Amortization Class • Support (companion) — Provides economic downturn in 2008-2009 (PAC I) — Within the CMO prepayment protection for the rating agencies significantly structure, this class offers the PAC classes. This class has an downgraded many issues. In some most stable average life because almost unpredictable average cases, this has created situations principal prepayments are life, but offers the potential where investors bought highly rated absorbed by support classes (to a for higher yields. If interest issues and now own structures certain point). rates decline, it will absorb all rated below investment grade. prepayment cash flows first • Broken PAC (X-PAC) — A PAC which (more call risk); if interest rates has lost its support class(es). rise, it will receive cash flows CMO class structures Thus, it is no longer protected from last (more extension risk). As mentioned, CMOs usually have principal prepayments and will several different classes (tranches), resemble a sequential pay class. • Accrual class (Z-bond) — This class is similar to a zero-coupon with each one structured to either • Retail class — This class is bond because it makes no interest minimize risks or enhance returns. typically structured as either a payments to investors for a period Listed below are some of the more PAC or sequential pay, with the of time, during which interest common class structures. benefit of simplified tax filings accrues at the coupon rate. and principal returned in $1000 • Sequential pay (plain vanilla) Once the class begins to receive increments. — The most basic CMO structure. principal, interest is paid monthly Interest is paid to all classes each • PAC II — Not to be confused with based upon the principal balance month. Principal is allocated to the a PAC I class, PAC IIs provide remaining. The accrual class is first tranche until it is retired, then prepayment protection for PACs subject to high volatility with the second tranche, then the third because they absorb excess cash respect to interest rate risk and tranche, and so on. flows if the support classes are prepayment risk. • Callable sequential pay — retired. If the support classes are Identical to the sequential pay not retired, PAC IIs have a relatively class described above; however, stable average life. the callable CMO can be redeemed (called) at par plus accrued interest beginning one to two years after issuance.

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