Mortgage Backed Security

The mortgage-backed securities market is simultaneously the most government-supported segment of the fixed income market — through the guarantee structures of Ginnie Mae, Fannie Mae, and Freddie Mac that eliminate credit risk from agency securities — and the segment whose failure in its private-label form was most central to the 2007 through 2009 financial crisis, when the collapse of subprime residential mortgage-backed securities and the collateralised debt obligations backed by them produced the largest financial losses since the Great Depression and required extraordinary government intervention to prevent the complete collapse of the global financial system. Mortgage-backed securities are tested on the Series 7 and Series 65 examinations in the context of fixed income securities, government-sponsored enterprises, prepayment risk, the distinction between agency and non-agency securities, and the regulatory reform produced by the financial crisis.

The Foundational Economics — Why Mortgage-Backed Securities Exist

The mortgage-backed security exists to solve a fundamental problem of capital allocation — mortgage lenders who originate loans to homebuyers and commercial real estate investors would rapidly exhaust their available capital if they held every loan they originated in their own portfolios, unable to make new loans until existing borrowers repaid their principal. By selling originated mortgages into securitisation structures that issue securities to investors, lenders receive cash that can be redeployed into new mortgage originations — creating a continuous cycle of lending, securitisation, and reinvestment that channels the savings of investors worldwide into the housing and commercial real estate markets of the United States.

The investor who purchases a mortgage-backed security receives in exchange a claim on the cash flows generated by a pool of mortgage loans — the monthly payments of principal and interest made by homeowners and commercial borrowers that are collected, processed, and passed through to certificate holders. The investor accepts the economic characteristics of the underlying mortgage pool — its interest rate, its credit quality, and critically its prepayment behaviour — in exchange for the yield the security provides above comparable Treasury securities.

Agency Versus Non-Agency Mortgage-Backed Securities — The Critical Distinction

The most important structural distinction in the mortgage-backed securities market is between agency securities — those issued or guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac — and non-agency or private-label securities issued by private financial institutions without any government or quasi-government guarantee. This distinction determines the credit risk profile, the regulatory capital treatment, the investor base, and the pricing of mortgage-backed securities.

Agency mortgage-backed securities carry either the explicit full faith and credit guarantee of the United States government — as in the case of Ginnie Mae securities — or the implied guarantee of the two government-sponsored enterprises Fannie Mae and Freddie Mac whose securities the market treats as effectively government-backed by virtue of their conservatorship status under the Federal Housing Finance Agency since September 2008. For investors in agency mortgage-backed securities there is effectively no credit risk — the timely payment of principal and interest is guaranteed regardless of the performance of the underlying mortgage pool. Losses from borrower defaults in the underlying pool are absorbed by the guarantee rather than by investors, who receive their scheduled payments as if every borrower had paid on time. This credit guarantee makes agency securities accessible to the broadest possible investor base — including money market funds, pension funds, insurance companies, foreign central banks, and other investors who require the highest credit quality.

Non-agency mortgage-backed securities — also called private-label securities — are issued by banks, thrifts, and independent mortgage companies without any government guarantee. Investors in non-agency securities bear the credit risk of the underlying mortgage pool directly — if borrowers default in numbers or at severities exceeding the credit enhancement built into the structure, investors suffer principal losses. Non-agency securities are rated by credit rating agencies and structured with subordination, overcollateralisation, and excess spread to achieve investment-grade ratings on senior tranches — but as the financial crisis demonstrated, these credit enhancements can prove insufficient when the entire housing market declines simultaneously and correlation assumptions embedded in the rating models prove catastrophically wrong.

The Three Types of Agency Securities — Ginnie Mae, Fannie Mae, and Freddie Mac

The three principal issuers or guarantors of agency mortgage-backed securities have distinct legal structures and guarantee mechanisms that are directly tested on the Series 7 examination.

Ginnie Mae — the Government National Mortgage Association — is a government corporation within the Department of Housing and Urban Development. Ginnie Mae securities carry the explicit full faith and credit guarantee of the United States government — the same guarantee that backs Treasury securities — making them legally equivalent to direct government obligations for credit purposes. Ginnie Mae guarantees securities backed by loans insured by the Federal Housing Administration, the Department of Veterans Affairs, and other federal agencies, providing the government guarantee that makes these programs accessible to first-time homebuyers and veterans at below-market rates. Ginnie Mae itself does not issue securities or purchase mortgages — it guarantees the timely payment of principal and interest on securities issued by private lenders who have pooled FHA-insured and VA-guaranteed mortgages.

Fannie Mae — the Federal National Mortgage Association — and Freddie Mac — the Federal Home Loan Mortgage Corporation — are government-sponsored enterprises, originally created by Congress as private companies with a public mission of supporting the secondary mortgage market but placed in conservatorship by their regulator the Federal Housing Finance Agency in September 2008 when their capital was exhausted by losses on their mortgage portfolios. Their securities carry an implied rather than explicit government guarantee — there is no statutory obligation for the United States Treasury to make good on Fannie Mae or Freddie Mac obligations — but the federal government's actions in September 2008, when it effectively guaranteed all outstanding Fannie Mae and Freddie Mac obligations to prevent systemic financial collapse, have been interpreted by the market as confirming the implicit guarantee in practical terms. Fannie Mae and Freddie Mac purchase conforming mortgages from lenders, pool them, and issue guaranteed mortgage-backed securities against the pools.

Pass-Through Certificates — The Basic Structure

The most fundamental form of mortgage-backed security is the pass-through certificate — also called a mortgage pass-through or participation certificate — in which a pool of mortgage loans is assembled and investors receive proportional undivided interests in the entire pool, with all principal and interest collections from the pool passed through directly to certificate holders each month in proportion to their ownership interest.

The investor in a pass-through certificate receives a monthly payment consisting of the interest earned at the certificate rate on the outstanding balance, the scheduled principal reduction from the borrowers' normal amortisation payments, and any prepaid principal from borrowers who have paid off their loans early — whether through refinancing, home sale, or other prepayment. This monthly principal return is what fundamentally distinguishes mortgage-backed securities from other fixed income instruments — the investor receives principal back continuously throughout the security's life rather than in a lump sum at maturity.

Prepayment Risk — The Defining Characteristic

Prepayment risk is the most distinctive and most analytically complex risk associated with mortgage-backed securities — the risk that the underlying mortgage borrowers will repay their loans faster than anticipated, returning principal to investors at a time and pace that the investor cannot control and may not prefer. Prepayment risk has no equivalent in Treasury or corporate bond investing, where the issuer's repayment schedule is contractually fixed and cannot be accelerated by the borrower's unilateral decision.

Prepayment occurs primarily through three mechanisms. Refinancing is the most economically significant driver — when interest rates fall below the rate on outstanding mortgages, homeowners have a powerful financial incentive to refinance into a lower-rate mortgage, paying off the existing loan and therefore prepaying the mortgage-backed security backed by that loan. The interest rate sensitivity of refinancing is what makes mortgage-backed securities negatively convex — when interest rates fall and other bonds appreciate, mortgage-backed securities appreciate less because their expected life shortens as prepayments accelerate, returning capital to investors who must reinvest at the lower prevailing rates. Home sales are the second prepayment driver — when a homeowner sells their property the existing mortgage is typically paid off, generating a prepayment to the pool. Prepayment due to home sales is relatively stable and predictable compared to refinancing-driven prepayment. Default followed by liquidation of the collateral is the third source — in agency securities the guarantee absorbs the credit loss but the principal is still returned to investors, constituting a form of prepayment.

Prepayment speed is conventionally measured using the Public Securities Association prepayment model — a standard expressing actual prepayment as a percentage of a theoretical baseline prepayment rate. One hundred percent PSA represents the baseline model prepayment assumption — higher percentages indicate faster than baseline prepayment and lower percentages indicate slower prepayment.

Extension risk is the opposite of prepayment risk — the risk that mortgage borrowers prepay more slowly than anticipated, extending the average life of the security and keeping investors in a lower-yielding investment for longer than expected. Extension risk is most acute in rising interest rate environments when homeowners have no incentive to refinance — keeping their low-rate mortgages intact — and home sales slow as affordability declines.

Collateralised Mortgage Obligations — The Structured Form

The collateralised mortgage obligation — CMO — is a more complex form of mortgage-backed security that restructures the cash flows of a pool of mortgage pass-throughs or whole loans into multiple classes — called tranches — with different maturity profiles, interest payment structures, and risk characteristics. CMOs were developed to address the prepayment uncertainty of simple pass-through certificates by creating tranches with more predictable cash flow schedules that could be targeted to investors with specific maturity preferences.

In a sequential pay CMO — the most basic structure — multiple tranches are created with letters designating their priority — Class A, Class B, Class C, and so on. All principal payments received by the structure — whether scheduled amortisation or prepayments — are directed entirely to the Class A tranche until it is completely retired. Only after Class A is paid off do principal payments flow to Class B, and so on through the structure. This sequential allocation of principal creates a range of effective maturities from the shortest tranche — Class A — which receives all early principal and has a relatively short and predictable average life — to the longest tranche — the final class — which receives no principal until all earlier tranches are retired and therefore has the longest and most uncertain average life.

Planned amortisation class tranches — PAC tranches — are designed with a defined principal payment schedule that is maintained across a specified range of prepayment speeds, providing investors with a level of cash flow certainty approaching that of a regular bond within the PAC band. The PAC mechanism works by directing prepayment variability to a companion tranche — also called a support or TAC tranche — which absorbs the prepayment volatility that would otherwise flow to the PAC, accepting greater uncertainty in its own cash flows in exchange for the PAC achieving its predictable schedule.

The Non-Agency Market and the Financial Crisis

The non-agency mortgage-backed securities market grew dramatically during the housing boom of 2003 through 2007, as private financial institutions issued securities backed by pools of mortgage loans that did not meet the conforming loan standards required for purchase by Fannie Mae and Freddie Mac — including jumbo loans that exceeded the conforming size limit, Alt-A loans made to borrowers with limited documentation, and subprime loans made to borrowers with impaired credit histories.

The subprime residential mortgage-backed securities issued during this period were rated by credit rating agencies using models that assumed regional rather than national housing price declines — the models effectively treated a nationwide simultaneous decline in housing prices as essentially impossible because it had not occurred in any historical period the models covered. When housing prices declined simultaneously across all major United States markets beginning in 2006 and 2007, the correlation assumptions in the rating models proved catastrophically wrong, losses in the underlying mortgage pools far exceeded the credit enhancement protecting rated tranches, and triple-A rated senior tranches of subprime mortgage-backed securities suffered principal losses that their ratings had predicted were essentially impossible.

The secondary failure of collateralised debt obligations — structured securities whose underlying assets were themselves tranches of subprime mortgage-backed securities — amplified the losses through multiple layers of leverage and correlation, producing the concentrated credit crisis that required the emergency government interventions of September and October 2008 including the conservatorship of Fannie Mae and Freddie Mac, the rescue of AIG Financial Products, and the Troubled Asset Relief Programme.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 responded to the non-agency mortgage-backed securities market failures with the five percent risk retention requirement — requiring securitisers to retain at least five percent of the credit risk of any asset-backed securities they issue, eliminating the originate-to-distribute incentive misalignment in which originators had no economic stake in the quality of the loans they sold into securitisation structures.

Tax Treatment and the State and Local Tax Exemption

Interest income from agency mortgage-backed securities — Ginnie Mae, Fannie Mae, and Freddie Mac — is subject to federal income tax. Ginnie Mae interest is also exempt from state and local income taxes under the same intergovernmental immunity principles that apply to Treasury securities — because Ginnie Mae carries the explicit full faith and credit guarantee of the United States government. Fannie Mae and Freddie Mac interest is generally subject to state and local income taxes, reflecting their original status as private corporations even though they have operated under government conservatorship since 2008.

Examination Relevance and Key Takeaways

Mortgage-backed securities are tested on the Series 7 and Series 65 examinations in the context of fixed income securities, government-sponsored enterprises, prepayment risk, agency versus non-agency securities, and the regulatory reform produced by the financial crisis.

The key points to retain are these.

A mortgage-backed security is a fixed income instrument backed by a pool of residential or commercial mortgage loans — passing through to investors the principal and interest payments from the underlying borrowers. The critical distinction is agency versus non-agency — agency securities issued or guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac carry government or quasi-government backing eliminating credit risk for investors, while non-agency private-label securities carry the full credit risk of the underlying mortgage pool. Ginnie Mae carries the explicit full faith and credit guarantee of the United States government — the strongest possible backing. Fannie Mae and Freddie Mac carry an implied guarantee and have operated under Federal Housing Finance Agency conservatorship since September 2008.

Prepayment risk is the defining and most distinctive risk of mortgage-backed securities — the risk that borrowers repay loans faster than anticipated, returning principal at inopportune times and forcing reinvestment at lower rates. Prepayment is driven primarily by refinancing activity when interest rates fall — making mortgage-backed securities negatively convex, appreciating less than comparable bonds when rates fall because prepayments accelerate and shorten the effective life of the security. Extension risk is the opposite — slower than expected prepayment in rising rate environments. Pass-through certificates distribute all principal and interest proportionally to certificate holders monthly. Collateralised mortgage obligations restructure cash flows into multiple tranches with different maturity profiles — sequential pay CMOs direct all principal to the shortest tranche first, PAC tranches provide defined principal payment schedules across a prepayment speed range. The collapse of subprime non-agency mortgage-backed securities and CDOs backed by them was the central mechanism of the 2007 through 2009 financial crisis — producing the Dodd-Frank Act's five percent risk retention requirement for securitisers.