Mortgage-Backed Securities (MBS)

Mortgage-backed securities are created when mortgages are pooled together and sold to investors as securities. The cash flows from homeowners' mortgage payments are "passed through" to investors.

Pass-Through Securities

Pass-through securities are the simplest form of MBS. Mortgage payments (principal and interest) from a pool of mortgages are collected and distributed proportionally to investors.

How Pass-Throughs Work

1. Thousands of individual mortgages are pooled together
2. The pool is sold to investors as securities
3. As homeowners make payments, cash flows "pass through" to investors
4. Investors receive a proportional share of principal and interest

Types of Pass-Through Issuers

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Prepayment Risk

Prepayment risk is the primary risk associated with mortgage-backed securities. When homeowners pay off their mortgages early (usually due to refinancing when rates fall), investors receive their principal back sooner than expected.

Why Prepayment Risk Matters

• When interest rates FALL: Homeowners refinance → prepayments INCREASE
• Investors receive principal back early
• Must reinvest at lower prevailing rates
• Expected 15-year investment might become 5-year investment

Extension Risk

Extension risk is the opposite of prepayment risk:

• When interest rates RISE: Homeowners keep existing mortgages → prepayments DECREASE
• Investors receive principal back slower than expected
• Money is locked in at lower rates while market rates are higher
• Expected 15-year investment might extend to 20+ years

Memory Aid: Prepayment risk = rates fall, money comes back fast. Extension risk = rates rise, money comes back slow.

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Collateralized Mortgage Obligations (CMOs)

CMOs are complex securities that divide mortgage cash flows into different classes called tranches. Each tranche has different risk and return characteristics.

Why CMOs Were Created

Pass-through securities have unpredictable cash flows due to prepayment risk. CMOs were designed to:

• Create more predictable cash flows for different investors
• Separate prepayment and extension risk into different tranches
• Allow investors to choose their preferred risk profile

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CMO Tranche Types

PAC Tranches (Planned Amortization Class)

PAC tranches are the SAFEST type of CMO tranche.

Key Characteristics:

• Most predictable prepayment schedule
• Protected from both prepayment AND extension risk
• Protection provided by companion tranches
• Lowest yield (due to lowest risk)

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TAC Tranches (Targeted Amortization Class)

TAC tranches offer moderate protection.

Key Characteristics:

• Protected from prepayment risk only (NOT extension risk)
• Higher yield than PAC tranches
• Still supported by companion tranches

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Companion (Support) Tranches

Companion tranches absorb the prepayment risk that PAC and TAC tranches avoid.

Key Characteristics:

• Most volatile cash flows
• Absorb excess prepayments first
• Extend duration when prepayments slow
• Highest yield (compensates for highest risk)
• Also called "support tranches"

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Z-Tranches (Accrual Tranches)

Z-tranches receive NO payments until all other tranches are retired.

Key Characteristics:

• Interest accrues but is not paid (added to principal)
• Longest maturity of all CMO tranches
• Highest duration (most sensitive to rate changes)
• Most exposed to prepayment risk
• Suitable for investors with very long time horizons

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IO and PO Tranches

Interest-Only (IO) Tranches:

• Receive ONLY the interest portion of payments
• Value increases when interest rates rise (counterintuitive!)
• When rates rise → fewer prepayments → more interest paid over time
• Used as hedging instruments

Principal-Only (PO) Tranches:

• Receive ONLY the principal portion of payments
• Value increases when interest rates fall
• When rates fall → more prepayments → principal returned faster
• Behave like zero-coupon bonds

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CMO Tranche Risk Comparison

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CMO Tax Treatment

Interest received from CMOs is fully taxable at federal, state, and local levels—the same as corporate bond interest.

Exam Tip: Don't confuse CMO taxation with Treasury taxation. CMOs backed by government mortgages do NOT get Treasury tax treatment.

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Suitability Considerations

CMOs may be suitable for:

• Investors seeking regular income
• Investors who understand prepayment risk
• Those with specific maturity needs (can match tranches)

CMOs are generally NOT suitable for:

• Investors who don't understand the risks
• Those needing guaranteed cash flows
• Risk-averse investors (especially companion/Z tranches)