Mortgage Backed Securities: Most Asked Interview Questions and Answers

Mortgage Backed Securities:Most Asked Interview Questions and Answers

Q1) What are the key attributes that define Mortgages?

There are a number of key attributes that define the Mortgages:

Loan Size
Loan term
Lien status
Credit classification (Credit Scores, LTV, Income Ratios, Documentations)
Interest rate type
Amortization type
Credit guarantees
Prepayments and prepayment penalties

Q2) What is the difference between Prime, Subprime, and Alt-A mortgage loans?

Prime, subprime, and Alt-A are types of mortgage loans that are classified based on the creditworthiness of the borrower.

Prime loans: Prime loans generally have FICO scores of 660 or higher, income ratios (front ratio and back ratio) with a maximum of 28% and 36%, respectively, LTVs less than 95%, and have a low debt-to-income ratio. The majority of loans originated are of high-credit quality, where the borrowers have strong employment and credit histories, income sufficient to pay the loans without compromising their creditworthiness, and substantial equity in the underlying property. They typically have lower interest rates since they are given to borrowers who are considered low-risk.
Subprime loans: While subprime loans typically have FICO scores below 660, the loan programs and grades are highly lender-specific. They are given to borrowers with less-than-perfect credit, lower income, or a high debt-to-income ratio. They typically have higher interest rates to compensate for the higher risk of default.
Alt-A loans are in between prime and subprime loans and are given to borrowers who do not fully meet the criteria for a prime loan, but are not as risky as subprime borrowers. They may have lower credit scores or more limited documentation of their financial status. They often have higher interest rates than prime loans but lower than subprime loans.

In short, the loan type a borrower qualifies for is largely dependent on their creditworthiness and financial history.

Q3) Define Loan-to-Value ratio (LTV) and Combined Loan-to-Value (CLTV) ratio?

The Loan-to-Value (LTV) ratio is a measure of the amount of a mortgage loan compared to the value of the property being purchased. It is calculated as the loan amount divided by the appraised value of the property. For example, if a borrower wants to purchase a property for $100,000 and takes out a loan for $80,000, the LTV ratio would be 80%.

Lenders use the LTV ratio as one of the factors to determine the risk of a loan. A higher LTV ratio means that the borrower has a smaller down payment and is borrowing more money relative to the value of the property. This increases the risk for the lender, as the property may not be worth enough to cover the loan if the borrower defaults. As a result, borrowers with higher LTV ratios may have higher interest rates or may need to pay for mortgage insurance.

The Combined Loan-to-Value (CLTV) ratio is a measure of the total amount of all loans on a property relative to the property’s value. It is calculated by adding the outstanding balances of all mortgages on the property and dividing that amount by the property’s appraised value. For example, if a homeowner has a first mortgage of $200,000 and a second mortgage of $50,000 on a property worth $300,000, the CLTV ratio would be calculated as ($200,000 + $50,000) / $300,000 = 0.75, or 75%.

The CLTV ratio is an important factor used by lenders to assess the risk of a loan. A higher CLTV ratio indicates that the homeowner has a higher level of outstanding mortgage debt relative to the value of the property, which increases the risk for the lender. As a result, borrowers with higher CLTV ratios may be required to pay higher interest rates or may need to purchase mortgage insurance to secure the loan.

Q4) What are Cash-out refinancing and No-cash refinancing?

Cash-out refinancing is a type of mortgage refinancing in which the borrower takes out a new loan that is larger than the existing mortgage loan. The difference between the two loans is given to the borrower in cash. This type of refinancing is often used to convert home equity into cash.

For example, if a homeowner has a mortgage loan of $200,000 and the current value of the property is $300,000, they may be able to refinance the loan for $250,000 and receive $50,000 in cash. The new loan will replace the old mortgage, and the homeowner will use the cash for various purposes such as home improvement, debt consolidation, or investments.

No Cash Refinancing, also known as a rate and term refinance, is a type of mortgage refinancing in which the borrower takes out a new loan to replace their existing mortgage, but does not receive any cash from the transaction. The purpose of a no cash refinancing is to change the terms of the existing mortgage, such as the interest rate or loan term, without taking out any additional funds.

For example, if a homeowner has an existing mortgage with a high-interest rate, they may choose to refinance to a lower interest rate without taking any cash out of the equity in their home. This can result in lower monthly mortgage payments and overall interest costs.

Q5) Which income measures are used by lenders to determine a borrower’s ability to make mortgage payments?

The front income ratio and back income ratio are measures used by lenders to determine a borrower’s ability to make mortgage payments.

The front ratio is calculated by dividing the total monthly payments on the home (including principal, interest, property taxes, and homeowners’ insurance) by pretax monthly income.
The back ratio is similar, but adds other debt payments (including auto loan and credit card payments) to the total payments.

In order for a loan to be classified as prime, the front and back ratios should be no more than 28% and 36%, respectively. Because consumer debt figures can be somewhat inconsistent and nebulous, the front ratio is generally considered the more reliable measure, and accorded greater weight by underwriters.

Q6) What are the different types of Primary Mortgages?

A fixed-rate mortgage and an adjustable-rate mortgage (ARM) are two types of primary mortgages that differ in how the interest rate on the loan is determined.

A Fixed-Rate Mortgage has an interest rate that remains the same for the entire term of the loan. Once locked in, the interest rate does not fluctuate with market conditions. This means that the monthly mortgage payment will stay the same, making it easier to budget and plan for the future. Fixed-rate mortgages are typically offered with terms of 15, 20, or 30 years.

An Adjustable Rate Mortgage (ARM), on the other hand, has an interest rate that can change over time, typically based on changes in a financial index such as the London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR). ARMs usually start with a lower interest rate than fixed-rate mortgages, but the rate can increase or decrease over time. ARMs are typically offered with terms of 3, 5, 7, or 10 years, after which the interest rate will adjust based on changes in the index. ARMs generally have caps that limit how much the interest rate and/or payments can rise per year or over the lifetime of the loan.

Both fixed-rate and adjustable-rate mortgages have their own advantages and disadvantages. Fixed-rate mortgages offer stability and predictability, but may have a higher interest rate than ARMs. ARMs offer lower initial rates, but the monthly payment can increase over time, making it more difficult to budget and plan for the future.

Q7) What are the different risks associated with Mortgage Loans?

There are several risks associated with mortgage loans, including:

Prepayment risk: It is the possibility that borrowers may repay their loans earlier than the agreed upon terms, causing a loss for the lender.
Credit risk: The risk that a borrower will default on the loan and be unable to repay the debt.
Property value risk: The risk that the value of the property securing the loan will decline, reducing the lender’s ability to recover the loan in the event of default.
Liquidity risk: The risk that the lender will not be able to sell the loan on the secondary market, or will have to sell it at a discount, reducing the value of the loan.
Interest rate risk: Changes in interest rates can affect the value of the mortgage loan, causing either a gain or loss for the lender.
Regulatory risk: Changes in laws and regulations affecting the mortgage market can impact the value of the loan, or the ability of the lender to collect on the loan.
Servicing risk: The risk that the loan servicing company will not perform as expected, causing financial losses for the lender or borrower.

Q8) Define Mortgage-Backed Securities (MBS)?

A Mortgage-Backed Security (MBS) is a type of financial security that is created by pooling together a large number of mortgage loans and selling securities that represent ownership in the pool. The investor who buys a mortgage-backed security is essentially lending money to home buyers. The cash flows generated by the underlying mortgage loans are passed through to the investors in the form of periodic payments of interest and principal.

MBSs offer investors a way to invest in the mortgage market and earn a return that is linked to the performance of the underlying mortgage loans. The credit risk associated with MBSs is dependent on the credit quality of the underlying mortgage loans, the structure of the MBS, and the performance of the housing market. MBSs can be structured as fixed-rate or adjustable-rate securities, and can be further divided into different tranches, each with its own risk and return profile.

Q9) What is the difference between Agency MBS and Non-Agency MBS?

Agency MBS are created by pooling together a large number of individual mortgages and then selling bonds backed by the cash flows generated from the underlying mortgages. The government-sponsored entities, such as Fannie Mae and Freddie Mac, guarantee the timely payment of interest and principal on the bonds to investors. This guarantee reduces the credit risk associated with investing in the bonds and makes them a relatively safe investment.

On the other hand, non-Agency MBS are securities backed by mortgages that are not guaranteed by any government-sponsored entities. These securities are typically backed by mortgages that do not meet the underwriting standards set by the government-sponsored entities and are considered to be higher risk. As a result, non-Agency MBS typically offer higher yields compared to Agency MBS to compensate investors for the increased risk.

In summary, Agency MBS are considered to be a safer investment due to their government backing, while non-Agency MBS are considered to be riskier but offer the potential for higher returns.

Q10) What is duration and convexity with respect to fixed income?

Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.

Certain factors can affect a bond’s duration, including:

Time to maturity: The longer the maturity, the higher the duration, and the greater the interest rate risk. Consider two bonds that each yield 5% and cost $1,000, but have different maturities. A bond that matures faster—say, in one year—would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.
Coupon rate: A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception of their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

Convexity is a risk-management tool, used to measure and manage a portfolio’s exposure to market risk. Convexity is a measure of the curvature in the relationship between bond prices and bond yields. Convexity demonstrates how the duration of a bond changes as the interest rate changes. If a bond’s duration increases as yields increase, the bond is said to have negative convexity. If a bond’s duration rises and yields fall, the bond is said to have positive convexity.

Q11) Which convexity does Mortgage-Backed Securities (MBS) exhibits?

Mortgage-back securities exhibit negative convexity because, when interest rates fall, prepayment risk increases, and when interest rates rise, then default risk increases for those mortgage holders who have variable interest rate loans. This causes MBSs to rise slower when interest rates fall, and to fall faster when interest rates rise.

Q12) What is the process of pooling loans into MBS?

The process of pooling loans into Mortgage-Backed Securities (MBS) typically involves the following steps:

Loan Underwriting: The first step is for mortgage lenders to underwrite individual mortgage loans. They evaluate the borrower’s creditworthiness, income, and ability to repay the loan. Only loans that meet certain criteria are eligible to be included in an MBS.
Pooling: The next step is to pool the individual mortgage loans together into a larger pool. The pool is then divided into a number of tranches, or slices, with each tranche having a different level of risk and return.
Securitization: After the pool of mortgage loans has been formed, the loans are packaged into securities and sold to investors. The securities are backed by the cash flows generated by the underlying mortgage loans. The securities can be structured in a variety of ways, including pass-through securities and collateralized mortgage obligations (CMOs).
Due Diligence: Before the securities are sold to investors, they undergo a due diligence process, where they are thoroughly reviewed by third-party professionals to ensure they are structured and priced appropriately. This step also involves obtaining a credit rating from a credit rating agency.
Trading: Once the securities have been issued, they can be traded in the secondary market, allowing investors to buy and sell the securities as they see fit.

Throughout the process, various parties, such as credit rating agencies and securitization specialists, may be involved to ensure that the pooling process meets regulatory requirements and that the securities are structured and priced appropriately. The end result of the pooling process is an MBS that provides investors with a way to invest in the mortgage market and earn returns based on the performance of a pool of mortgage loans.

Q13) What is the difference between in-the-money MBS and out-of-the-money MBS?

“In-the-money” Mortgage-Backed Securities (MBS) are securities that are backed by a pool of mortgage loans and have a market value that is higher than the face value of the underlying mortgages. This can occur when the coupon rate (the yield paid by the MBS) is higher than the current market interest rates. In such a scenario, the market value of the MBS would be higher than its face value, making it “in-the-money.” Investors who purchase “in-the-money” MBS would expect the interest rates to remain stable or rise, which would maintain or increase the market value of the MBS.

“Out-of-the-money” Mortgage-Backed Securities (MBS) are securities that are backed by a pool of mortgage loans, but have a lower market value than the face value of the underlying mortgages. This can happen when the coupon rate (the yield paid by the MBS) is lower than the current market interest rates. In such a scenario, the market value of the MBS would be lower than its face value, which would make it “out-of-the-money.” Investors who purchase out-of-the-money MBS would expect the interest rates to fall, which would increase the market value of the MBS and make them “in-the-money.”

Q14) Define prepayment with respect to MBS?

For mortgages, the monthly scheduled payment consists of scheduled principal and interest payments which is constant throughout the amortization term. If the borrower pays more than the monthly scheduled payment, the extra payment will be used to pay down the outstanding balance faster than the original amortization schedule, resulting in a prepayment (or, as it is sometimes referenced, an “unscheduled principal payment”). If the outstanding balance is paid off in full, the prepayment is a “complete prepayment”; if only a portion of the outstanding balance is prepaid, the prepayment is called either a “partial prepayment” or “curtailment.”

Prepayment can occur for a variety of reasons, such as a borrower refinancing their mortgage to obtain a lower interest rate or selling their home. When a mortgage loan is prepaid, the investor in the MBS no longer receives the expected stream of income from that loan, and the value of the MBS can be impacted as a result. The impact of prepayment on MBS is often measured by a metric known as “prepayment speed.” Prepayment speed reflects the rate at which borrowers are prepaying their mortgages, and it can have a significant impact on the price and yield of MBS.

For example, if prepayment speed increases, it may mean that a higher-than-expected number of borrowers are refinancing their mortgages and paying off their loans early. This can result in a reduction in the expected cash flows to the investors in the MBS, which can cause the value of the securities to decline. On the other hand, if prepayment speed decreases, it may indicate that fewer borrowers are prepaying their loans, which can result in a more stable stream of income for the investors in the MBS and potentially increase the value of the securities.

Q15) What all factors affect prepayment in Mortgage-Backed Securities (MBS)?

Mortgage turnover and refinancing can both have a significant impact on prepayment of mortgages.

Refinancing: Refinancing refers to the process of taking out a new mortgage loan to pay off an existing loan. When interest rates fall, more borrowers may choose to refinance their loans in order to take advantage of the lower rates and reduce their monthly mortgage payments. This can result in a higher rate of prepayments, as the borrowers pay off their old loans and take out new loans with lower interest rates. In addition, refinancing can also lead to a higher rate of prepayments because borrowers may choose to pay off a portion of their loans in order to reduce their monthly payments and increase their home equity.

Turnover: Turnover refers to the rate at which properties are sold and resold in a given market. When there is high turnover, more borrowers are likely to prepay their loans as they sell their properties and move to new ones. This can result in a higher rate of prepayments, as the new borrowers take out new loans and the old borrowers pay off their existing loans. For example, when a property is sold, the buyer may choose to pay off a portion of the mortgage to reduce their monthly payments, or they may choose to pay off the entire loan and own the property outright.

Creditworthiness of borrowers:

The effect of creditworthiness and borrower wealth on prepayments is complex. Evidence suggests that both very high and very low credit borrowers tend to prepay somewhat faster than the “average” borrower.

a. High Creditworthiness

Borrowers with very high credit scores and significant financial resources tend to respond to refinancing opportunities very actively, in large part due to their greater financial acumen and resources.

b. Low Creditworthiness

Loans made to borrowers with very low credit scores also tend to prepay somewhat faster than average. This is mainly because these borrowers have higher incidences of delinquencies and defaults, caused by either the inability or unwillingness to make timely loan payments.

When loans go into default and foreclosure, they eventually are pulled out of the pool and the recovered principal is passed on to investors. These actions create a so-called involuntary prepayment.
Borrowers that lose their jobs and become unemployed may sell the property before going into default in what might be called a “semi voluntary” prepayment.
Lenders may proactively approach delinquent borrowers offering products that will reduce their monthly financial burden in what is often described as “lender aid.”
Borrowers whose credit has improved may take advantage of the increased options available to refinance into a product with a lower rate or reduced payment in a transaction referenced as “credit curing.”

4. LTV:

Loan-to-Value Ratios

Loan-to-value ratios (or LTVs) have had a clear affect on prepayments historically, although the impact has varied over time. Early historical data suggested that high-LTV loans (e.g., loans with LTVs of 90% or higher) prepaid more slowly than loans with lower LTVs; however, this behavior changed after 2000, where high-LTV loans became faster than the rest of the population.

Q16) Define the term Conditional Prepayment Rate (CPR) and Single Monthly Mortality Rate (SMM). What is the relationship between CPR and SMM?

Conditional Prepayment Rate (CPR)

Conditional Prepayment Rate (CPR) is a measure of the rate at which borrowers are prepaying their mortgage loans that are included in a mortgage-backed security (MBS). The CPR is a key metric for evaluating the risk associated with MBS and can have a significant impact on the price and yield of the securities. A higher CPR indicates that a greater proportion of the mortgage loans included in the MBS may be prepaid in the near term, which can reduce the expected future cash flows to the investors. Conversely, a lower CPR suggests that fewer loans are expected to be prepaid, which can lead to a more stable stream of income for the investors.

In practice, the CPR is often estimated using complex models that take into account a variety of factors, including the current interest rate environment, the credit characteristics of the borrowers, and the history of prepayment rates for similar MBS.

Single Monthly Mortality Rate (SMM)

The CPR is an annual rate. However, because mortgage cash flows are a monthly phenomenon, calculating the CPR requires the generation of a monthly prepayment rate, called the single monthly mortality rate (SMM). The SMM is the most fundamental measure of prepayment speeds; it is the unit upon which all other prepayment measures are based. SMM measures the monthly prepayment amount as a percentage of the previous month’s outstanding balance minus the scheduled principal and interest payment.

Relationship between SMM and CPR:

Given the SMM, a CPR can be computed using the following formula:

CPR = 1 – (1 – SMM)^12

To convert an SMM into a CPR, the following formula is used:

SMM = 1 – (1 – CPR)^(1/12)

Q17) Why prepayment occurs in MBS?

Prepayment occurs in mortgages when the borrower pays off the loan in full or in part before the due date. This can happen for a variety of reasons, including:

Sale of Property: If the borrower sells the property, the existing mortgage loan must be paid off in full.
Early Payoff: Some borrowers may choose to pay off their mortgage loan early, either to save on interest costs or to free up cash.
Default: If the borrower defaults on the loan, the lender may initiate foreclosure proceedings, which typically result in the repayment of the mortgage loan.
Refinancing: When a borrower refinances their mortgage loan, they are essentially paying off the remaining balance of the old loan and starting a new loan with a different lender or different terms. As a result, the investor may receive a lump sum payment that can negatively impact the overall return on their investment.

Q18) What is the “S curve” in Mortgage-Backed Securities (MBS)?

The “S curve” in Mortgage-Backed Securities (MBS) refers to the relationship between the rate of prepayments on the underlying mortgages and the changes in interest rates. The S curve represents the expected rate of prepayments for a given change in interest rates, and it is used to model the expected cash flows for an MBS.

The S curve is called an “S” curve because it is shaped like the letter “S”. The curve starts out flat, meaning that small changes in interest rates result in a small change in the rate of prepayments. However, as interest rates change further, the rate of prepayments on the underlying mortgages changes more quickly, resulting in a steep portion of the curve. Finally, the curve levels off, meaning that further changes in interest rates result in a smaller change in the rate of prepayments.

Q19) What is your opinion on this: Prepayment decreases with increase in the interest rate?

The relationship between interest rates and prepayment speed for Mortgage-Backed Securities (MBS) is complex and can be influenced by various factors. In general, higher interest rates tend to result in lower prepayment speeds, while lower interest rates tend to result in higher prepayment speeds.

When interest rates increase, homeowners are less likely to refinance their loans, as the cost of borrowing becomes more expensive. This results in a slower rate of prepayments on the underlying mortgages, which means that the original loans will be outstanding for a longer period of time. As a result, the cash flows from the MBS are less likely to be impacted by prepayments, which can make the MBS a more attractive investment.

However, there are many factors that can influence the relationship between interest rates and prepayment speed, including the credit quality of the underlying mortgages, the size of the pool of eligible borrowers, and changes in the housing market. In some cases, higher interest rates may actually result in higher prepayment speeds if the housing market is strong and there is a high demand for refinancing.

While higher interest rates tend to result in lower prepayment speeds, this relationship is not always straightforward and may be influenced by various factors.

Q20) Can you talk about the Public Securities Association (PSA) model which is used for mortgage prepayment behavior?

The PSA Prepayment Model is a prepayment scale developed by the Public Securities Association in 1985 for analyzing American mortgage-backed securities. The PSA model assumes increasing prepayment rates for the first 30 months after mortgage origination and a constant prepayment rate thereafter. The standard model (also called “100% PSA“) works as follows: Starting with an annualized prepayment rate of 0.2% in month 1, the rate increases by 0.2% each month, until it reaches 6% in month 30. From the 30th month onward, the model assumes an annualized prepayment rate of 6% of the remaining balance

Mathematically, 100% PSA model is expressed as follows:

If t ≤ 30 then CPR = 6% × (t/30)
If t > 30 then CPR = 6%.

where “t” is the number of months since the mortgage was originated. Since the CPR prior to month 30 rises at a constant rate, this period is sometimes referred to as the ramp, and loans are considered to be “on the ramp” when they are less than 30 months old.

Slower or faster speeds are then referred to as some percentage of PSA. For example, 50 PSA means one-half the CPR of the PSA benchmark prepayment rate; 150 PSA means 1.5 times the CPR of the PSA benchmark prepayment rate; 300 PSA means three times the CPR of the benchmark prepayment rate. A prepayment rate of 0 PSA means that no prepayments are assumed.

Note: In the industry, much more complex models are used to understand the MBS prepayment behavior. PSA was just the starting point. But it’s good to know some standard model for interview purpose.

Q21) How real state appreciation could impact prepayment behavior?

Real estate appreciation can have a significant impact on pre-payment of mortgages. Appreciation refers to an increase in the value of a property over time, and when a property appreciates, its owner may have more equity in the property. This increased equity can provide the homeowner with the ability to pay off a portion or all of their mortgage through a pre-payment.

For example, if a homeowner bought a property for $200,000 and over time the property appreciates to $250,000, the homeowner would have an additional $50,000 in equity. They could use this equity to pay off a portion of their mortgage through a pre-payment, which would lower their monthly mortgage payments and reduce the overall interest they would pay over the life of the loan.

Additionally, if the appreciation is significant, it could also increase the homeowner’s overall financial stability, making it easier for them to make pre-payments on their mortgage. However, it’s important to note that real estate appreciation can also be unpredictable and subject to market fluctuations.

Q22)How do you know if the underlying pool of mortgage loans is delinquent or default?

When the underlying pool of assets is mortgage loans, the two commonly used methods for classifying delinquencies are those recommended by the Office of Thrift Supervision (OTS) and the Mortgage Bankers Association (MBA).

The OTS method uses the following loan delinquency classifications.

■ Payment due date to 30 days late: Current

■ 30–60 days late: 30 days delinquent

■ 60–90 days late: 60 days delinquent

■ More than 90 days late: 90+ days delinquent

The MBA method is a somewhat more stringent classification method, classifying a loan as 30 days delinquent once payments are not received after the due date. Thus, a loan classified as “current” under the OTS method would be listed be as “30 days delinquent” under the MBA method.

Q23) What is Mortgage Pass-Throughs? What are the risks associated with it?

A mortgage pass-through is backed by a pool of mortgages for which the monthly payments are the sole source of cash flow for the security. The security is called a pass-through because the monthly payments generated from the underlying pool of mortgages are passed from the borrowers to the investors of the security. The portion of the payment (i.e., principal and interest) that is passed through to the investors in the mortgage pass-through is based on their ownership share.

Risks of Pass-Through Securities are:

Credit Risk: The risk of default on the debts associated with the securities is an ever-present factor, as failure to pay on the debtor’s part results in lower returns. Should enough debtors’ default, the securities can essentially lose all value. Moreover, if a large number of borrowers default on their mortgage loans, it can lead to a reduction in the cash flow generated by the pass-through, which can impact the returns received by investors.
Interest Rate Risk: If interest rates fall, there is a higher likelihood that current debts may be refinanced to take advantage of the low-interest rates. This results in smaller interest payments, which mean lower returns for the investors of pass-through securities.
Prepayment Risk: Prepayment on the part of the debtor can also affect return. Should a large number of debtors pay more than minimum payments, the amount of interest accrued on the debt is lower—and of course, it becomes non-existent if the debtor entirely repays the loan ahead of schedule. Ultimately, these prepayments result in lower returns for securities investors. In some instances, loans will have prepayment penaltiesthat may offset some of the interest-based losses a prepayment will cause.
Liquidity Risk: Mortgage pass-through securities are not as liquid as other fixed income investments, such as corporate bonds, which can make them difficult to sell in a market downturn. This lack of liquidity can make it challenging for investors to exit their positions and may result in price volatility.

Q24) What does senior-subordinated structure refer to in the mortgage pass-through investment?

In a mortgage pass-through investment, the senior-subordinated structure refers to the way the cash flows from the underlying mortgage loans are divided among different classes of investors. The senior-subordinated structure involves the creation of two or more classes of securities that have different levels of priority in receiving the cash flows from the underlying mortgage loans. The senior class typically receives payments first, while the subordinated class receives payments only after the senior class has been fully paid.

The senior class is considered less risky than the subordinated class because it has a higher priority in receiving payments. The subordinated class, on the other hand, has a higher potential for return because it is riskier and receives payments only after the senior class has been fully paid.

The senior-subordinated structure is used to create securities that appeal to different types of investors with varying risk tolerance and return requirements. For example, conservative investors who prioritize safety and stability may prefer to invest in the senior class, while more aggressive investors who are willing to take on greater risk for the potential of higher returns may prefer to invest in the subordinated class. Overall, the senior-subordinated structure is a way to create securities with different risk profiles and potential returns from the same pool of mortgage loans.

Q25) What are credit enhancement techniques used for mortgage-backed securities (MBS)?

Credit enhancement techniques are used to reduce the credit risk associated with mortgage-backed securities (MBS) and to improve their credit ratings. These techniques help to ensure that investors are more likely to receive their promised payments, even in the event of defaults by the borrowers.

Some common credit enhancement techniques used for MBS include:

Overcollateralization: This involves creating a pool of mortgage loans that has a total value that is greater than the value of the MBS being issued. The excess value of the underlying mortgage loans provides a cushion that can absorb any losses due to defaults on the mortgage loans.
Subordination: This technique involves creating multiple tranches of MBS, with each tranche having a different priority of repayment. The most senior tranche receives the first payments from the mortgage pool and is the least risky, while the lower tranches receive payments only after the higher tranches have been paid. This allows the MBS to be structured in a way that provides a higher level of safety for investors.
Mortgage insurance: Mortgage insurance can be used to protect investors from credit losses due to borrower defaults. Mortgage insurance is typically purchased by the issuer of the MBS and can provide protection against a portion of the losses that may result from defaults.
Cash reserves: The issuer of the MBS can set aside a cash reserve to absorb any losses from defaults. The cash reserve is created by diverting a portion of the payments from the underlying mortgage loans into a reserve account.
Guarantees: Guarantees can be provided by government-sponsored entities such as Fannie Mae and Freddie Mac. These entities guarantee the timely payment of principal and interest on the MBS, even in the event of borrower defaults.

These credit enhancement techniques can improve the creditworthiness of MBS and make them more attractive to investors. It is important for investors to understand the credit enhancement techniques used in a particular MBS before making an investment decision.

Q26) Define the term “waterfall” with respect to mortgage-backed securities (MBS)?

The term “waterfall” in the context of mortgage-backed securities (MBS) refers to the process by which cash flows from the underlying mortgage loans are distributed to different classes of investors. The waterfall is essentially a payment priority structure that determines the order in which investors receive payments from the underlying mortgage loans.

In a typical MBS structure, the waterfall may be divided into several different tranches or classes of securities. The highest tranche, often referred to as the “A” tranche or senior tranche, is the first to receive payments from the underlying mortgage loans. Once the “A” tranche has been fully paid, the next tranche in the waterfall, often referred to as the “B” tranche or mezzanine tranche, receives payments until it is fully paid. This process continues for each tranche in the waterfall until all investors have been paid.

The waterfall structure is an important factor to consider when investing in MBS because it determines the order in which investors receive payments and the risk associated with each tranche. The higher tranches in the waterfall are generally considered to be less risky because they have a higher priority of payment, while the lower tranches are riskier but may offer higher potential returns.

Q27) What are Collateralized mortgage obligations (CMOs)?

Collateralized mortgage obligations (CMOs) are a type of mortgage-backed security (MBS) that is structured differently from traditional pass-through MBS. CMOs are divided into different tranches or classes based on their maturity and the order in which they receive payments from the underlying mortgage loans. Each tranche in a CMO has a unique risk profile and may offer different yields and principal repayment structures.

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