Term mortgage means the loan provided against the physical asset. Mortgage backed securities are the chunks of fixed income securities which are backed by the physical assets in its early life cycle.
First the bank provides the required mortgage loan to the borrower. Now the next step is the schedule of repayment which is decided by the bank along with the borrower. This schedule includes monthly payments which in turn includes principal and interest components. Once the schedule is set, the guarantee (asset) is added to the portfolio of the bank. This portfolio includes interest rate, maturity date, monthly installments, etc.
This bank along with similar small scale banks will now look for other bigger organizations, Governmental agencies, Quasi-Governmental agencies or privately held entities to in turn sell those contracts or mortgages to them. These Governmental or Private agencies now have varying mortgages in their pool or portfolio with similar characteristics like interest rate, maturity date, monthly installments, etc.
These organizations now will break those mortgages into chunks of fixed income securities and will sell it in open secondary markets. These securities are then known as Mortgage Backed Securities.
Investors can invest in such securities thereby getting rights to claim interest and principle earned by the common pool of the organizations who own those pools of securities.
Different types of Mortgage Backed Securities
Based on some market driving factors and analysis, we have several kinds of Mortgage Backed Securities. Let us know see the 3 important and widely used types of MBS:
Pass Through: Pass through is the simplest form of MBS in which the issuer collects principle and the interest from the pool of mortgages and then distributes it among the investors proportionately (on pro rata basis). This kind of MBS is likely to be impacted by the market risks such as prepayment.
Collateralized Mortgage Obligation (CMOs): These are quite complex kinds of MBS where the cash flow is directed towards the investors based on the structure and the priority of the security. Pool of mortgages is divided into classes based on criteria like maturity, expected prepayment date etc… This helps to bring in some degree of predictability to the experienced investors. Distribution of principle and interest is also based on the class an MBS lays.
Stripped MBS: Stripped MBS are the special types of MBS which are strategically created for experienced investors by dividing the pool of chunks further into 2 kinds of securities as below:
Investors can maximize their holdings and profit by investing in various Stripped MBS depending upon the Interest Paying or Principle Paying capabilities of various Chunks of Securities.
Underlying assets on which mortgages are issued also fall into 2 broader categories. Depending upon the following categories also an MBS is analyzed in terms of risk and profitability by the market analysts and investors:
Prime: Prime Mortgages are the secured ones. These are referred to those mortgages which are verified in terms of documents of the asset and income of the borrower.
Subprime: These are non-verified and are also known as weak mortgages. These carry risk of defaulting.