3.3 Mortgage-Backed Securities

Mortgage-Backed Securities (MBS)

A mortgage-backed security (MBS) is created when many individual home loans are pooled and sold to investors, whose return comes from the homeowners' monthly principal-and-interest payments. The defining feature, and the source of nearly every Series 7 question on MBS, is that homeowners can prepay their mortgages at any time, making the timing of the cash flow uncertain.

Pass-Through Securities

The simplest MBS is the pass-through certificate. Each monthly mortgage payment in the pool is collected by a servicer and passed through to investors in proportion to their holdings. Crucially, every payment blends interest and a return of principal, so the investor's principal is repaid gradually over the life of the pool rather than in a lump sum at a maturity date.

Prepayment Risk and Extension Risk

Because homeowners control the timing, MBS investors face two opposite timing risks:

• Prepayment risk — when rates fall, homeowners refinance and pay off early. Principal floods back faster than expected and must be reinvested at the new, lower rates. This is the classic reinvestment problem.
• Extension risk — when rates rise, homeowners keep their cheap mortgages and prepay slowly. Principal returns slower than expected, leaving the investor's money locked at a below-market rate.

Memory Aid: Rates DOWN, money comes back too FAST (prepayment). Rates UP, money comes back too SLOW (extension). MBS hurt the investor in BOTH directions — this is negative convexity.

Because the payoff date is uncertain, MBS are described by average life (the weighted-average time to receive each dollar of principal) rather than a single maturity. Prepayment speed is conventionally measured against the PSA (Public Securities Association) model.

Collateralized Mortgage Obligations (CMOs)

A collateralized mortgage obligation (CMO) takes the unpredictable cash flow of mortgage pass-throughs and redirects it into multiple classes called tranches, each with a different priority for receiving principal. Investors who want predictable cash flow buy the protected tranches; investors who want extra yield, and will absorb the timing uncertainty, buy the support tranches. CMOs are commonly structured as REMICs (Real Estate Mortgage Investment Conduits) under the Tax Reform Act of 1986.

PAC Tranches (Planned Amortization Class)

PAC tranches are the safest CMO tranche. They follow a fixed principal-repayment schedule that holds within a stated band of prepayment speeds, so they are shielded from both prepayment and extension risk. That protection is supplied by companion tranches, and the trade-off is the lowest yield.

TAC Tranches (Targeted Amortization Class)

TAC tranches are protected against prepayment risk only. If prepayments slow, a TAC can still extend, so it offers a higher yield than a PAC but less protection.

Companion (Support) Tranches

Companion tranches absorb the prepayment and extension risk the PAC and TAC avoid. They receive excess principal when prepayments surge and shrink to nothing when prepayments slow. They have the most volatile cash flow, the least predictability, and therefore the highest yield.

Z-Tranches (Accrual Tranches)

A Z-tranche receives no cash, neither interest nor principal, until all earlier tranches are retired. Its interest accrues and is added to principal, so it behaves like a long zero-coupon bond with the longest average life and greatest interest-rate sensitivity.

IO and PO Tranches

• Interest-Only (IO) tranches receive only the interest stream. Their value rises when rates rise because slower prepayment means more interest is collected over time. IOs are used as hedges against falling MBS prices.
• Principal-Only (PO) tranches receive only principal. Their value rises when rates fall because faster prepayment returns the discounted principal sooner. POs behave like deep-discount zeros.

CMO Taxation and Disclosure

CMO interest is fully taxable at the federal, state, and local levels, exactly like corporate-bond interest. Do not extend Treasury's state/local exemption to CMOs even when the underlying mortgages are government-backed.

Under FINRA Rule 2216, communications about CMOs must disclose that yield and average life will fluctuate with actual prepayment experience and interest-rate changes, must not compare CMOs to other investments (such as CDs) in a misleading way, and must use prescribed educational disclosures. A registered representative must understand all CMO characteristics before recommending one. Suitable buyers are income-seeking investors who understand prepayment risk and, for support and Z tranches, can tolerate volatility; CMOs are generally unsuitable for investors needing certain cash flows or who do not grasp the risks.

Exam Tip: PAC = predictability for the investor; companion = the shock absorber that pays for it.

How CMOs Are Quoted and Settled

CMOs and agency pass-throughs are quoted as a percentage of par and trade over the counter through dealers. Because principal is returned continuously, a CMO does not have a clean coupon-and-maturity profile; instead, investors evaluate the average life of the specific tranche under various PSA prepayment speeds. A quote may be accompanied by a stated average life at, say, 100% PSA, with the warning that faster or slower prepayments will shorten or lengthen it. This is exactly the fluctuation FINRA Rule 2216 requires firms to disclose, and it is why comparing a CMO's quoted yield to a CD's fixed yield is considered misleading.

A classic exam scenario: an investor in a PAC tranche enjoys a stable schedule as long as prepayments stay within the PAC band. If prepayments run faster or slower than the band's outer limits for an extended period, the companion tranche can be exhausted, after which even the PAC begins to behave more like a plain pass-through. So PAC protection is strong but not unlimited — it is only as durable as the companion tranches backing it.