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CFA® Level I · Fixed Income · free lesson
Mortgage-Backed Security (MBS) Instrument and Market Features
Mortgage-backed securities are one of the largest fixed-income markets in the world, and their defining feature is that homeowners can repay early. This module starts with the mortgage loan itself, then shows how pass-through securities transmit prepayments to investors, how prepayment speeds are measured, how collateralized mortgage obligations reshape prepayment risk, how agency and non-agency MBS differ in credit risk, and how commercial MBS are analyzed.
What you will learn
1. Describe the features of residential mortgage loans that shape the cash flows of mortgage-backed securities, including amortization, interest rate type, prepayment options, loan-to-value ratio and lender recourse.
- Fixed, adjustable and hybrid rates; fully amortizing, balloon or interest-only payment structures.
- A free prepayment option (standard in US mortgages) creates prepayment risk for investors.
- LTV = loan / property value; lower LTV means lower default probability and higher recovery.
- Recourse loans let lenders pursue other borrower assets; non-recourse loans do not.
- Falling house prices raise LTVs across a pool simultaneously.
2. Describe mortgage pass-through securities, calculate prepayment measures (SMM, CPR and the PSA benchmark), and explain contraction and extension risk.
- Pass-throughs distribute pooled interest, scheduled principal and prepayments pro rata, net of fees.
- SMM = prepayment / (beginning balance - scheduled principal); CPR = 1 - (1 - SMM)^12.
- 100 PSA: CPR rises 0.2% a month to 6% at month 30; x PSA scales those rates by x/100.
- Falling rates: faster prepayments, contraction risk, negative convexity.
- Rising rates: slower prepayments, extension risk, longer WAL and duration.
3. Describe collateralized mortgage obligations, including sequential-pay, planned amortization class and support tranches and floating and inverse floating tranches, and explain how they redistribute prepayment risk.
- CMOs redistribute, not eliminate, prepayment risk among tranches.
- Sequential pay: early tranches bear contraction risk, later tranches extension risk.
- PAC tranches follow a schedule within a PSA collar; support tranches absorb the variability.
- Inverse floater coupon = K - L x reference rate; it is a leveraged bet on falling rates.
- Combined floater and inverse floater interest equals the fixed-rate tranche's interest.
4. Distinguish agency from non-agency residential mortgage-backed securities and describe the credit enhancement used in non-agency transactions.
- Ginnie Mae MBS carry the full faith and credit of the US government.
- Fannie Mae and Freddie Mac guarantee their MBS and have been in conservatorship since 2008.
- Agency MBS: conforming loans, minimal credit risk; prepayment risk dominates.
- Non-agency RMBS: no government-related guarantee; credit enhancement and tranching protect seniors.
- Shifting interest mechanisms direct early prepayments to senior tranches to build subordination.
5. Describe commercial mortgage-backed securities, including the use of debt service coverage and loan-to-value ratios, call protection at loan and structure level, and balloon risk.
- CMBS loans are typically non-recourse: repayment depends on the property's income and value.
- DSCR = NOI / annual debt service; LTV = loan / appraised value.
- Loan-level call protection: lockouts, defeasance, prepayment penalty points, yield maintenance.
- Structure-level protection: sequential credit tranching.
- Balloon risk: inability to refinance at maturity extends the loan (extension risk).
Module at a glance
- Mortgage terms (rate type, amortization, prepayment options, LTV, recourse) drive MBS cash flows and risks.
- Pass-throughs distribute pooled interest, scheduled principal and prepayments, net of fees.
- SMM = prepayment / (balance - scheduled principal); CPR = 1 - (1 - SMM)^12; 100 PSA ramps to 6% CPR at month 30.
- Falling rates bring contraction risk and negative convexity; rising rates bring extension risk.
- CMOs reallocate prepayment risk: sequential tranches, PAC/support, floaters and leveraged inverse floaters.
- Agency MBS carry minimal credit risk (Ginnie Mae explicit; Fannie/Freddie in conservatorship); non-agency MBS need credit enhancement.
- CMBS: non-recourse property loans analysed by DSCR and LTV, with strong call protection but balloon (extension) risk.
This free module has 5 lessons, 14 practice questions with full explanations.