A mortgage-backed security packages thousands of home loans into a tradeable bond. The structure decides who absorbs which risks, and time tranching is the exam's favorite tool for redistributing prepayment uncertainty.
A residential mortgage is a loan secured by real property. An analyst should be able to describe the fundamental features that securitized residential mortgage loans share:
- Amortization: fully amortizing, partially amortizing (balloon), or interest-only for a period.
- Maturity: typically 15 or 30 years in the US.
- Interest rate: fixed, adjustable (ARM tied to a reference rate), or hybrid.
- Prepayment option: US conforming loans allow prepayment without penalty. Other jurisdictions impose penalties or lockouts.
- Recourse: in recourse states the lender can pursue other borrower assets. Non-recourse states limit the claim to the property.
- Credit quality: prime, alt-A, or subprime, based on credit score, documentation, and loan-to-value ratio (LTV).
KEY: The prepayment option is the source of nearly all MBS modeling difficulty. It is an embedded call option: the borrower is long it, and the MBS investor is short it.
Common mistakes
- Confusing contraction and extension. Rates down causes contraction and reinvestment risk; rates up causes extension and opportunity cost. Trap: "extension risk hurts premium MBS."
- Believing CMOs eliminate prepayment risk. Tranching redistributes; the pool total is unchanged. Trap: "PAC tranches are immune to prepayment."
- Mixing up agency and non-agency credit risk. Agency RMBS carry minimal credit risk; non-agency need internal enhancement. Trap: "Fannie Mae bonds require subordination."
Bottom line
- Prepayment risk has two sides: contraction (rates fall, refi accelerates) and extension (rates rise, prepayments slow).
- Pass-throughs distribute pro-rata; CMOs carve cash flows into tranches that redistribute, not eliminate, prepayment risk.
- Sequential-pay retires tranches in order; PAC tranches follow a stable schedule while support tranches absorb prepayment volatility.
- Agency RMBS carry guarantee credit support; non-agency RMBS rely on internal credit enhancement.
Exam shortcut
For prepayment direction: "C for Contraction, C for Cut rates." Cut rates, get contraction. For CMBS call protection, remember LDYP: Lockout, Defeasance, Yield maintenance, Prepayment penalty points. PAC is the planned tranche, support is the shock absorber. If a question features a 1.25 DSCR threshold or 75% LTV, it is testing CMBS underwriting standards.
The full lesson (about 2,333 words, 16 min read) adds 8 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- MBS instrument and market features
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