Understanding Residential Mortgage-Backed Securities | CFA Level I Fixed Income
Residential Mortgage-Backed Securities (RMBS) are a popular type of asset-backed security. In the US, RMBS are divided into three sectors:
- Securities guaranteed by a federal agency, such as Ginnie Mae
- Securities guaranteed by government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac
- Non-agency RMBS issued by private entities
Agency vs. Non-Agency RMBS
- Credit risk reduction: Agency RMBS have reduced credit risk due to GSE guarantees, while non-agency RMBS use credit enhancements.
- Underwriting standards: Loans in agency RMBS must meet specific criteria, while non-agency RMBS can include non-conforming mortgages.
Breaking Down an RMBS Example
Tyler, Lee, and Ashok have mortgages that satisfy conforming mortgage criteria. These mortgages are pooled together to form a mortgage passthrough security. The total principal is $10 million, the weighted average coupon is 10%, and the weighted average maturity is 15 years.
Investors Mario and Kim purchase this security, investing $7 million and $3 million, respectively. As the homeowners make their regular mortgage payments, the principal and interest are passed through to the investors. However, a portion of the interest is used to pay servicing or other fees, resulting in a pass-through rate of 9.5% for Mario and Kim.
Prepayment Risk and CPR
Prepayment risk arises when borrowers make unscheduled mortgage payments, causing unpredictable cash flows for RMBS investors. To account for this, issuers estimate an expected prepayment rate (CPR). A CPR of 15% means that 15% of the outstanding mortgage balance is expected to be prepaid by year-end.
In the US, CPR is compared to the Public Securities Association (PSA) prepayment benchmark. A PSA of 100 means the MBS is expected to have prepayment rates that match the benchmark. Higher PSA values indicate faster prepayments and shorter average lives, while lower PSA values indicate slower prepayments and longer average lives.
Contraction and Extension Risk
Market interest rate changes can significantly impact prepayment rates:
- Contraction risk: If market interest rates fall, prepayment rates increase, and the average life of the RMBS is shorter than expected.
- Extension risk: If market interest rates rise, prepayment rates decrease, and the average life of the RMBS is longer than expected.
In our example, the underwriters estimated a PSA of 250 for the RMBS. However, actual prepayment rates may differ from expectations due to market interest rate fluctuations, resulting in either contraction or extension risk.
Investor Preferences and Reallocating Prepayment Risk
When it comes to residential mortgage-backed securities (RMBS), handling prepayment risk effectively is crucial. This can be done by reallocating the risk according to investor preferences, such as in our earlier example:
EXAMPLE: Mario is fine with contraction risk, but not extension risk. Kim, on the other hand, prefers the opposite. To accommodate both investors, a mortgage passthrough security’s cash flow can be divided into two tranches.
Tranching and Collateralized Mortgage Obligations (CMO)
A time tranching structure can be used to redistribute cash flows in RMBS, resulting in collateralized mortgage obligations (CMOs). These are structured as sequential pay tranches, with each tranche retired in order before the next tranche receives principal repayments. This differs from credit tranching, which distributes credit risk amongst tranches.
EXAMPLE: We can analyze how prepayment risk distribution works in a sequential pay CMO with two tranches. Tranche A is the short tranche, providing more protection against extension risk but higher exposure to contraction risk. Tranche B is the long tranche, offering more protection against contraction risk but higher exposure to extension risk.
Planned Amortization Class (PAC) CMOs
For investors seeking protection against both extension and contraction risk, a planned amortization class (PAC) CMO may be more appropriate. PAC tranches have their prepayment risk reduced by increasing the prepayment risk of the CMO’s support tranches. These tranches work within an initial collar, with the support tranche absorbing faster or slower prepayments up to a certain limit.
Non-Agency RMBS and Credit Enhancements
Non-agency RMBS are issued by entities other than Ginnie Mae, Fannie Mae, or Freddie Mac, and are not guaranteed by the government. As a result, credit risk becomes an important consideration. Credit enhancements, such as credit tranching and other mechanisms, play a vital role in obtaining favorable credit ratings and making non-agency RMBS more marketable to investors.
With this knowledge of residential mortgage-backed securities and their risk management strategies, you’re well-prepared for the next lesson on commercial mortgage-backed securities.