Mortgage-backed Security - Types

Types

Most bonds backed by mortgages are classified as an MBS. This can be confusing, because a security derived from an MBS is also called an MBS. To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that "vanilla" designates an option with no special features.

Mortgage-backed security sub-types include:

• pass-through securities are issued by a trust and allocate the cash flows from the underlying pool to the securities holders on a pro rata basis. A trust that issues pass-through certificates are taxed under the grantor trust rules of the Internal Revenue Code. Under these rules, the holders of a pass-through certificate are taxed as a direct owner of the portion of the trust allocatable to the certificate. In order for the issuer to be recognized as a trust for tax purposes, there can be no significant power under the trust agreement to change the composition of the asset pool or otherwise to reinvest payments received, and the trust must have, with limited exceptions, only a single class of ownership interests.
  • A residential mortgage-backed security (RMBS) is a pass-through MBS backed by mortgages on residential property.
  • A commercial mortgage-backed security (CMBS) is a pass-through MBS backed by mortgages on commercial property.
• A collateralized mortgage obligation or "Pay-through bond" are debt obligations of a legal entity that is collateralized by the assets it owns. Pay-through bonds are typically divided into classes that have different maturities and different priorities for the receipt of principal and in some case of interest. They often contain a sequential pay security structure with at least two classes of mortgage-backed securities issued, with one class receiving scheduled principal payments and prepayments before any other class. For tax purposes, it is important for pay-through securities to be classified as debt for income tax purposes.
• A stripped mortgage-backed security (SMBS) where each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
  • An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.
    • A net interest margin security (NIMS) is resecuritized residual interest of a mortgage-backed security
  • A principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.

There are a variety of underlying mortgage classifications in the pool:

• Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
• Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)
• Subprime mortgages have weaker credit scores, no verification of income or assets, etc.
• Jumbo mortgages when the size of the loan is bigger than the "conforming loan amount" as set by Fannie Mae.

These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are not MBS can also have these subtypes.

There are two types of classifications based on the issuer of the securtity:

• Agency, or government, issued securities, by government-sponsored enterprise issuers such as Fannie Mae, Freddie Mac, and Ginnie Mae.
• Non-agency, or private-label, securities, by non-governmental issuers such as trusts and other special purpose entities like Real Estate Mortgage Investment Conduits.