Mortgage-Backed and Asset-Backed Securities

Why this matters

An investor in a broad bond fund may own mortgage-backed securities without ever having chosen to. They look like the safest of bonds, since many carry a government-related guarantee, and they behave unlike any bond covered so far. Every other bond in this track told you when you'd be repaid. This one doesn't. Duration and Convexity mentioned bonds whose price curve bends the wrong way, and this is where that comes from.

From a mortgage to a security

Start with one loan. A homeowner borrows $300,000 for 30 years at 6% and makes the same payment every month, $1,798.65. In the first month, $1,500 of that is interest and $298.65 repays principal. Each month the interest part shrinks a little and the principal part grows, and after ten years the balance is still $251,057. Over the full term the borrower pays $347,515 of interest. The borrower also has a right the lender doesn't: to repay the whole loan early, at any time, by selling the house or refinancing.

In the basic structure of a mortgage-backed security, or MBS, a group of such loans is sold to a trust, which issues securities against them. In the simplest kind, called a pass-through, investors are paid the principal and interest received from payments on the loans.¹ They receive it less amounts kept to cover the cost of servicing the loans and the fee for the guarantee.²

So an MBS differs from an ordinary bond in three ways before any risk is considered. It pays monthly. Each payment is part interest and part principal, so the amount invested shrinks as time passes. And it has no fixed maturity date, only a final one that few of the loans will reach.

Who guarantees what

Most mortgage-backed securities are issued by one of three bodies.³

Securities issued outside these three are called private-label, and they're typically not guaranteed by the issuer.¹ Their investors bear the risk that homeowners default, which is a matter for Credit Analysis and for the section on tranches below.

The agency guarantee is easy to misread. It covers the credit of the borrowers: if a homeowner stops paying, the investor is still paid. It says nothing about the timing of repayment. An agency MBS has little credit risk and a great deal of another kind.

The risk of not knowing when

Prepayment risk is the risk that principal on the underlying loans is paid earlier or later than expected.¹ The speed at which a pool pays down is usually stated as the share of the remaining balance that's prepaid in a year, on top of the scheduled payments.

Share of the balance prepaid each year	Average life of the investment	Principal returned within 5 years	Within 10 years
None	19.3 years	7%	16%
3%	14.0 years	20%	38%
6%	10.6 years	32%	55%
15%	5.5 years	59%	84%
25%	3.3 years	78%	95%
40%	1.9 years	93%	99%

Average life is the average time until each dollar of principal is returned. The same security can behave like a two-year bond or a fourteen-year bond, depending on what the homeowners do.

If prepayments were random, this would be a nuisance. They aren't random. When interest rates fall, borrowers commonly prepay their loans and refinance at lower rates. When prepayments are slower than expected, it often means rates have risen.¹ The investor is on the wrong side both times.

• Rates fall. Homeowners refinance, and the investor is handed back principal to reinvest at the new, lower rates. This is the call risk of Yield Measures, exercised by thousands of borrowers one at a time.
• Rates rise. Nobody refinances a cheap mortgage, and fewer people move. Repayment slows, and the investor is left holding a below-market security for longer than planned. This is extension risk.

The swings in US mortgage rates show how strong the incentive can be. The average rate on a 30-year fixed mortgage was 2.65% in January 2021 and 7.79% in October 2023.⁵ A homeowner who borrowed near the low had no reason to refinance at any point in the years that followed, and a strong reason not to give up the loan by moving.

The rest of this lesson is for members

Still to come in this lesson: What that does to the price, Slicing the pool, Asset-backed securities, Where an individual investor meets these, the key takeaways, and 2 quiz questions with explanations.

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