Handbook of Finance: Financial Markets and Instruments

Chapter 32. Introduction to Mortgage-Backed Securities

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

ANAND K. BHATTACHARYA, PhD

Managing Director, Countrywide Securities Corporation

WILLIAM S. BERLINER

Executive Vice President, Countrywide Securities Corporation

Abstract: Mortgage-backed securities (MBSs) are constructed by aggregating large numbers of similar mortgage loans in mortgage pools. There are two mechanisms for secu-ritizing MBS pools; they can be issued by governmental agencies and quasi-agencies (that is, the government-sponsored enterprises, or GSEs) as agency pools, or structured with separate credit enhancement as "private-label" securities. MBS trading conventions reflect the nature of mortgage lending. Loans begin as an application that is "locked" at some point prior to the loan's closing date, while it is being underwritten and processed. Trading in many securities is done on a forward basis, where trading is executed to settle at some date in the future. This trading convention also implicitly creates a financing vehicle, where securities can be financed in an efficient and inexpensive fashion. CMOs are created by carving up MBS principal and interest cash flows in order to target the needs of specific investor clienteles. As MBS pools are closed universes of cash flows, structuring involves transferring prepayment and (for private-label structures) credit risk within the deal, with the goal of maximizing the deal's ...