Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

CHAPTER 5

Introduction to MBS Structuring Techniques

The mortgage-backed securities (MBS) market has, over the past two decades, exemplified the development and evolution of the structured transaction market. Structuring has expanded from its simplest form (a pass-through security, which “passes through” principal and interest to investors) to include techniques that allow investors to meet maturity and duration targets while choosing from different risk/reward trade-offs. Arguably, the ability to carve up and redirect mortgage cash flows to meet the needs of different investor clienteles has contributed strongly to the growth of the MBS market, which, at this writing, is the largest securities market in the world.

Many types of securitized and nonsecuritized assets can be used as the “collateral” (i.e., the assets providing the principal and interest cash flows) for structured deals. However, mortgages and MBS are the most interesting asset group around which to frame a discussion of structuring ideas and techniques. This is attributable to a number of factors:

• Mortgages are typically amortizing assets that generate principal cash flows throughout much of the loan’s term.

• The product has varying degrees of credit risk, depending on the characteristics of the obligors.

• Mortgages have the unique dimension of prepayment risk, impacting returns in ways often difficult to foresee.

The interplay of these factors, and the varying appetites for each of the associated risk ...