House Loan Bond Vibes (HLBV)

An MBS be like a financial playlist that hits up investors with a monthly drip of any 💸 principal and interest payments homeowners make. 📆

Types of MBS

Pass-throughs

In a pass-through MBS, the squad collects monthly payments from a pool of mortgages and then passes on a squad-goals share of the scooped principal and interest to bondholders. 💁‍♀️ A pass-through MBS slides cash flow through three vibes:

• Scheduled principal (kinda like that fixed rent) 🏠
• Scheduled interest (pretty much staying the same) 💰
• Prepaid principal (basically on a wild ride depending on homeowners and interest rates) 🎢

Collateralized mortgage obligations (CMOs)

CMOs are like remix versions of pass-throughs, switching up the cash flows in a VIP lineup based on bond structure. 🚀 A CMO aims to ghost prepayment risk better than pass-throughs while keeping that credit score lit and giving high-key yields.

CMOs take cash vibes from pass-throughs and split it into different bond classes called tranches, giving a sorta playlist for repayment. 🔀 This helps investors dodge surprises. The tranches organize principal payments among different classes and act as a timeline for the mortgage pool's life. ⌛️

CMOs versus traditional mortgage-backed securities

The major difference between your old-school mortgage pass-throughs and those boujee CMOs? It's all about that principal payment game:

• With a traditional MBS, each investor gets a monthly share of all principal and interest payments made by homeowners. Bondholders cop a return of principal until the grand finale, when homeowners settle all debts. Uncertainty kinda rules when it comes to the principal return, as borrowers can pay off early.
• CMOs bring order by offering a priority schedule among tranches for paying down principal, which gives more predictability vibes compared to pass-throughs.

Types of issuers

MBS could be backed or pumped out by squads like the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae).

Government National Mortgage Association (Ginnie Mae):

• The only fully-owned government flex, backed by the trusted vibes of the US government 🇺🇸
• Exists to make sure mortgage funds are within everyone's reach across the US
• Guarantees the on-time vibes of principal and interest on loans rolling through the Federal Housing Association (FHA), the Department of Veterans Affairs (VA), and other squads
• Plays a big role in scratching out differences in mortgage credit availability across regions
• Bonds come in all kinds of durations
• Minimum buy-in for new securities is $25,000, then it goes up in $1,000 beats
• For investments under $25,000, scoop up securities either on discount or with some principal gone

Federal Home Loan Mortgage Corporation (Freddie Mac):

• A publicly-owned hustle without an explicit government guarantee
• Its mission is all about boosting residential mortgage availability
• Gets those funds by keeping a fired-up secondhand market for residential mortgages
• Drops both mortgage-backed securities and standard GSE bonds
• Securities sell in $1,000 increases

Federal National Mortgage Association (Fannie Mae):

• A publicly owned entity without explicit US government backing
• Keeps the ball rolling with an active secondary market for mortgages
• Drops both mortgage-backed securities and standard corporate coupon bonds
• Stashes available in $1,000 increments

Features and benefits

Attractive yields

MBS often come with juicy yields that beat government bonds. Higher coupon securities hold the promise of bigger returns but bring along increased credit and prepayment risks. That means what you actually make could be less than the initial hype. Investors could see bigger checks compared to normal investment-grade corporate cash flow. Part of these payments might be a principal return thanks to prepayments. 💸

Credit quality

Credit risk is kinda linked to how many homeowners in the mortgage pool default on their loans. For mortgages backed by federal agencies or government-sponsored enterprises, the risk is minimal. 👍

Risks

Credit and default risk

MBS backed by GNMA scream low risk of default, but there's some shady default risk for MBS issued by FHLMC and FNMA—not to mention an even higher risk for unbacked securities. But pooling mortgages helps level out that risk. For those eyeing mortgage-backed securities, especially ones without backing, break down the deal on the underlying mortgage pool (like mortgage terms and underwriting standards). Also, the issuer's own credit rep might factor in, depending on the legal setup and who holds the underlying mortgages. 🤔

Interest rate risk

Generally, when interest rates drop, bond prices pop... and when rates rise, prices dip. But mortgage-backed securities mix in some prepayment and extension risk, especially CMOs. This means they might not rise as much as your typical bond when rates drop, but might take a harder L when rates climb. So, these securities might carry more interest rate risk than other bonds. 📉

Prepayment risk

This is the risk that homeowners may bust out higher-than-expected monthly payments or peace out on their mortgages entirely by refinancing—especially when rates are on the DL. When this goes down, the principal in the bond shrinks faster than projected, cutting short the bond duration by sending principal back to the bondholder early. This happens when interest rates drop, often making reinvestment options kinda meh. Pooling a ton of mortgages can chill some prepayment risk since a single mortgage prepayment has less impact on the whole bang.

This risk is a big deal with MBS; thus, cash flow keeps you guessing. That means the quoted yield is more of a best guess.

For CMOs, if prepayments roll in more than expected, the security clocks out sooner than expected. Some CMO tranches are designed to brush off variable prepayment effects, but the average life is always an estimate—it depends on how closely the actual prepayments match the guesswork. 🎯

Extension risk

This is the risk that homeowners won't prepay their mortgages as much as initially predicted, often vibes when interest rates are climbing, discouraging refinances of fixed-rate mortgages. This could lock up assets longer than you've budgeted and cut lower-than-expected coupons due to reduced principal repayment amounts. 🔒 Thus, in facetime of spiking market interest rates, MBS would see exaggerated price drops due to the shrinking coupon rate. 📉

Liquidity

Depending on the hustle, MBS secondary markets are generally liquid, with dealers and investors playing around. Particular security features, like having or lacking GSE backing, can affect its liquidity compared to other mortgage-backed securities.

CMOs might not vibe as liquid as other mortgage-backed securities due to the various tranches. Investors should have mad skills to grasp the hustle of tranche specifics. Besides, selling a CMO might give more or less than the initial investment. 👀💼