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Mortgage-Backed Securities

A Mortgage-Backed Security (“Mortgage Security”), or mortgage pass-through security, is a common asset-backed security. A mortgage security is secured by a pool of home mortgages. Just like an individual home mortgage, mortgage security payments are comprised of principal and interest. A mortgage security is known as a “pass-through” because the interest and principal payments made by homeowners passes through the issue’s originator to the bondholders. Bob Dall and Lewis Ranieri, two former traders of former investment firm Salomon Brothers, created the market for mortgage securities in 1978.

Mortgage-backed securities have prepayment risk because the principal of a mortgage can be paid by a homeowner at anytime. In addition, mortgage securities tend to have negative convexity, meaning their prices tend to go up less when traditional coupon bond prices are rising due to falling interest rates and experience greater downward price pressure than traditional coupon bonds when prices are falling due to rising interest rates. Mortgage securities usually offer higher yields than comparable bonds to attract investors for these reasons.

The following summarizes why mortgage-backed securities yield more than traditional coupon bonds with similar maturities and coupon rates:

Principal can be returned at any time.
Reinvestment risk is higher because principal is usually returned when interest rates are low.
Negative Convexity

Mortgage-Backed Securities issued by U.S. Government Associations

The Government National Mortgage Association (Ginnie Mae) originates mortgage-backed securities. The corporation guarantees the payment of both principal and interest regardless of whether or not homeowners make timely payments. Ginnie Maes are backed by the “full faith and credit” of the United States Government.

The Federal National Mortgage Association (Fannie Mae) offers mortgage-backed securities similar to Ginnie Maes although they are not guaranteed by the “full faith and credit” the United States Government. However, it is commonly believed that the government would assist Fannie Mae in the event of a financial crisis. Fannie Maes yield slightly higher returns than Ginnie Maes.

The Federal Home Loan Mortgage Corporation (Freddie Mac) is similar to the associations mentioned above. Freddie Mac guarantees timely interest payments on its mortgage-backed securities, but can delay principal payments up to a year. Freddie Macs are not backed by the government and offer yields similar to Fannie Maes.

Summary

The following chart details the advantages and disadvantages of Mortgage-Backed Securities:

Mortgage-Backed Securities

Advantages
     • Often high quality due to government backing
     • Yields are higher than treasuries
     • Pays coupons monthly

Disadvantages
     • Coupon payments fluctuate in amount
     • Vulnerable to interest rate risk
     • Subject to taxation
     • Lower yields than corporate bonds

Questions:

1. What is a mortgage-backed security?

2. Why do mortgage-backed securities offer higher yields than other bonds with comparable coupon rates and lengths-to-maturity?

3. What are the advantages and disadvantages of mortgage-backed securities?

Answers:

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