Mortgage-Backed Securities 101
A mortgage-backed security is simply an instrument that represents an interest in a large pool of mortgages. Mortgage payments consist of interest and principal, the percentages of which in the total monthly payment change with the age of the mortgage itself.
You and I, as homeowners, typically have a fixed schedule of payments to make each month, the holder of a securitized interest in a pool of mortgages, however, may not receive the same cash flow per month. This, of course, is due to the fact that we, as debtors, can pre-pay the mortgage at our discretion (and thus reduce the potential interest payments from our particular mortgage that would normally make it into our pool's cash flow).
This creates a variability in the form of pre-payment risk to the cash flow coming from the pool that mortgage-backed security analysts attempt to predict using models that can get very complex. Ordinarily, this pre-payment risk can be significant and can cause an embedded premium (via extra yield) to be priced into the pool above yields of comparable duration in, say, US treasuries.
But here's the rub: the mortgage-backed market largely perceives that this credit risk is negligible owing to the fact that most mortgages have Fannie Mae, Freddie Mac and Ginnie Mae guaranteeing the principal and interest payments on those mortgages. This moral hazard has produced the unintended consequence of reducing the risk premium of this paper, making mortgage rates otherwise structurally lower than they would be if FNM, FRE et al did not "guarantee" the paper; and of course, allowing folks who might otherwise not afford a mortgage to be able to afford one. This was the original purpose of the creation of FNM in 1938 (thanks FDR).
Mortgage pools themselves can be split up into myriad different "sub-pools" with specific risk, maturity and cash flow dynamics. The issuers themselves of course have different financial characteristics (credit ratings, etc.), as well, the types of mortgages that make it into these pools can be altered radically: single family, condo, apartment, commercial, etc. All of these things affect the rating that the pool receives. And of course, where there are cash flows, you can bet Wall Street is right there.
Sell-side desks (Solomon Brothers used to be a huge player in this area - the book Liar's Poker is based partly on the development of this novel financial instrument) have experts that pool these mortgages in ways that they try to make attractive to investors looking for specific cash flow and risk attributes in a fixed-income security. They then act as the financial intermediary between the issuers of these pools and the investors who seek to benefit from their aggregation, pricing and moving the bonds in a way not dissimilar to how capital markets desks price and move IPOs.
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