About MBS/ABS
The Building Blocks of Mortgage-Backed Securities
The creation of a mortgage-backed security begins with a mortgage loan extended by a financial institution to finance a borrower’s home or other real estate. The borrower usually repays the mortgage loan in monthly installments composed of both interest and principal. Characteristics of loans may vary. For instance, some loans allow borrowers to pay just interest for a period of time (‘interest only’ loans), or allow borrowers to make payments that are lower than the interest due on the loan (‘option ARMs’). Over the life of most mortgage loans, the interest component of a payment gradually declines while the principal component increases. Typically, interest comprises the majority of a payment in the early life of the loan.
To obtain funds to make more loans, mortgage lenders pool groups of loans with similar characteristics to create securities or sell the loans to issuers of mortgage securities. As the borrowers whose loans are in the pool make their mortgage loan payments, the money is collected and distributed on a pro rata basis to the holders of the securities.
While the creation of mortgage pass-through securities has greatly increased the secondary market for mortgage loans, the structures of these securities have some limitations. Mortgage pass-through securities only appeal to investors with a longer investment horizon.
Collateralized mortgage obligations were developed to offer investors a wider range of investment time frames and greater cash-flow certainty than is available for mortgage pass-through securities. The CMO issuer assembles a package of mortgage pass-through securities or mortgage loans, and uses them as collateral for a multiclass security offering. The different classes of securities in a CMO offering are known as tranches, from the French word for “slice.” The CMO structure enables the issuer to direct the principal and interest cashflow generated by the collateral to the different tranches in a prescribed manner in order to meet different investment objectives.
All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.