Learning Module 19
MBS Instrument and Market Features

Prepayment risk: The risk that the borrower repays principal at a different pace than scheduled.

Contraction risk: The risk that the borrower repays principal faster than anticipated (e.g., refinancing when rates fall). Adverse consequences: investors must reinvest at lower rates; price appreciation is capped.

Extension risk: The risk that the borrower repays principal slower than planned (e.g., when rates rise and refinancing decreases). Adverse consequences: payments are stretched out and discounted at higher rates.

Time tranching: Creating bond classes with different expected maturities to redistribute prepayment risk among investors.

Sequential‑pay CMO: Principal repayments flow first to Tranche A until fully repaid, then to Tranche B, then to Tranche C, etc. Each tranche has different exposure to contraction/extension risk.

Mortgage loan: Secured by real estate property; lender has first lien and can foreclose if borrower defaults.

Loan‑to‑value (LTV): LTV = Loan Amount / Property Value. Lower LTV → higher borrower equity → lower default risk; more protection for lender.

Debt‑to‑income (DTI): DTI = Monthly Debt Payments / Monthly Pre‑Tax Gross Income. Lower DTI → borrower has more capacity to sustain debt payments.

Amortizing loans: Principal repaid over time with level payments (interest + principal). Fully amortizing → principal reaches zero at maturity.

Prepayment option: Borrower can prepay all or part of principal before maturity. Creates prepayment risk for investors.

Recourse vs. non‑recourse: In a recourse loan, lender can claim borrower's other assets if foreclosure proceeds are insufficient. In a non‑recourse loan, lender can only look to the property.

Agency RMBS: Issued by government agencies (Ginnie Mae) or GSEs (Fannie Mae, Freddie Mac) — guarantee timely payment of interest and principal.

Non‑agency RMBS: Issued by private entities — use credit enhancements (subordination, insurance) to mitigate credit risk.

Pool of mortgages is securitized; cash flows (principal, interest, prepayments) are "passed through" to investors.

Weighted Average Coupon (WAC): Weighted average of the mortgage rates in the pool, weighted by current balances.

Weighted Average Maturity (WAM): Weighted average of the remaining months to maturity, weighted by current balances.

Pass‑through rate: WAC minus servicing and guarantee fees.

CMOs securitize mortgage pass‑through securities or multiple loan pools to redistribute cash flows across tranches.

Sequential‑pay CMO: Principal repaid to one tranche at a time in sequence. Provides protection against extension risk for shorter tranches and contraction risk for longer tranches.

Planned Amortization Class (PAC): Provides predictable principal payments within a prepayment range. Support tranches absorb the prepayment risk.

Z‑tranche (Accrual bond): Does not receive interest payments until a preset date; interest accrues and is added to principal. Last tranche to be paid.

Principal‑Only (PO) and Interest‑Only (IO): Created by splitting cash flows. PO holders receive principal repayments; IO holders receive interest payments. PO values rise when prepayments accelerate; IO values fall.

Floating‑rate tranches: Interest rate linked to an index; can be structured as inverse floaters.

Backed by commercial mortgages on income‑producing properties (office buildings, retail, multifamily, hotels, healthcare).

Call protection: CMBS offer protection against early prepayments, making them trade more like corporate bonds than RMBS.

Structural call protection: Sequential‑pay tranches — junior tranches cannot be paid until senior tranches are retired.

Loan‑level call protection: Prepayment lockout (no prepayments allowed for a period), prepayment penalty points, and defeasance (borrower must purchase government securities that replicate the remaining cash flows).

Balloon risk: Commercial mortgages are often balloon loans — not fully amortizing, with a large principal payment due at maturity. If the borrower cannot refinance or sell the property, the loan defaults. Balloon risk is a form of extension risk.

Concentration risk: CMBS pools may have few loans, so a single default can have a significant impact.

Debt Service Coverage Ratio (DSCR): DSCR = Net Operating Income / Debt Service. Higher DSCR → stronger creditworthiness. A DSCR above 1.0× indicates cash flows are sufficient to cover debt service.