About MBS/ABS
Mortgage Security Types
Mortgage Pass-Through Securities. An issuer of a pass-through or participation certificate (PC) collects monthly payments from the borrowers whose loans are in a given pool and “passes through” the cash flow to investors in monthly payments, less any servicing and/or guarantee fees. Most pass-throughs are backed by fixed-rate mortgage loans; however, adjustable-rate mortgage loans (ARMs) are also pooled to create the securities. Most ARMs have both interest rate floors and caps, setting minimum and maximum interest rates on a loan. These option-like characteristics require that pass-throughs backed by ARMs have higher yields than pure floating-rate debt securities.
Callable Pass-Throughs. Developed in the 1990s, a callable pass-through is created by splitting a pass-through into two classes: a callable class and a call class. The callable class receives all of the principal and interest from the underlying collateral. The call class receives no principal or interest. The holder of the call class has a right to call the underlying pass-through at a stated price (usually par plus accrued interest) from the callable class holders after a specified period of time has passed from issuance of the two classes.
The investor holding the callable class has the right to direct the security’s trustee to: 1) redeem the outstanding principal amount of the call class at a specified price, and 2) receive the underlying collateral in return.
CMOs. The CMO is a multiclass bond backed by a pool of mortgage pass-throughs or mortgage loans. CMOs may be collateralized by both mortgage pass-through securities or mortgage loans, or some combination thereof. In structuring a CMO, an issuer distributes cash flow from the underlying collateral over a series of classes, called tranches, which constitute the bond issue. Each CMO is a set of two or more tranches, each having average lives and cash-flow patterns designed to meet specific investment objectives. The average life expectancies of the different tranches in a four-part deal, for example, might be two, five, seven and 20 years.
Cash flows from the CMO collateral may be allocated in a variety of ways. Usually, it is first allocated to meet the interest obligations on all tranches in the offering. Principal repayments, both scheduled and prepaid, are then distributed to the different classes of bondholders according to a predetermined priority schedule which is outlined in the CMO prospectus or offering circular. The tranche receiving principal repayment is referred to as active or currently paying. In more complex structures, more than one tranche may receive principal (or be active) at a given time.
Each CMO tranche has an estimated first payment date on which investors can expect to begin receiving principal payments, and an estimated last principal payment (or maturity) date on which they can expect their final dollar of principal to be returned. The period when investors receive interest-only payments before principal payments begin in a give tranche is known as the lockout period. The window is the period in which principal repayments are expected to occur. Both first and last principal payment dates are estimates based on prepayment assumptions and can
vary according to actual prepayments made on the underlying collateral of a CMO.
Investors who purchase CMOs at their issuance date may find that their transaction takes up to a month to settle due to the time required to assemble the collateral, deposit it with the trustee, and complete other legal and reporting requirements. In the secondary market, CMO transactions typically settle in three business days.
Because payments to CMO investors depend on the collection and distribution of payments made by the holders of the underlying mortgage collateral, a payment delay occurs when the security is first purchased. Payment dates for CMO tranches are defined in the prospectus and are usually stated as the 15th or 25th day of the month following the record date. Depending on when the CMO transaction settles, the investor may have to wait up to two months for the first payment; this delay is factored into the yield quoted at the time of purchase. Once the first payment is received, future payments are made monthly or quarterly.
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.