What Are Some Examples of Mortgage-Backed Securities?

The main examples of mortgage-backed securities (MBS) are pass-through securities, such as the Uniform Mortgage-Backed Security (UMBS) and Ginnie Mae MBS; collateralized mortgage obligations (CMOs), which split a pool's payments into slices called tranches; and stripped securities that separate a pool's interest from its principal. They hold the same kind of home loans. What differs is who gets each dollar of principal and interest, and so how each one reacts when borrowers pay off their loans early. What a mortgage-backed security is explains how loans are pooled in the first place.

Pass-through securities: UMBS and Ginnie Mae MBS

A pass-through gives every holder a proportional share of all the principal and interest the pool's borrowers pay, after servicing and guaranty fees. If you own 1% of a pool, you get 1% of every monthly payment and 1% of every early payoff.

• UMBS are issued by Fannie Mae and Freddie Mac and backed by fixed-rate single-family loans, in 30-, 20-, 15-, and 10-year terms. A UMBS from either company can be delivered to settle the same trade. Before June 2019, Freddie Mac issued Gold Participation Certificates (PCs) instead, and those older securities still trade.
• Ginnie Mae MBS are backed by FHA, VA, and USDA loans. Ginnie Mae's guarantee carries the full faith and credit of the U.S. government; Fannie Mae's and Freddie Mac's guarantees do not.

How prepayments reach you: directly. When rates fall and borrowers refinance, you get principal back sooner and must reinvest it at the lower rates. When rates rise, payoffs slow and your money stays at the old rate longer. This is the risk the SEC calls out for MBS: principal tends to come back exactly when reinvesting it pays less.

Example: you own $10,000 of remaining principal in a 5.5% UMBS. If borrowers holding 2% of the pool's remaining balance refinance this month, $200 of your principal comes back at once, on top of the scheduled paydown, and you stop earning 5.5% on it.

Collateralized mortgage obligations (CMOs)

A CMO, also called a real estate mortgage investment conduit (REMIC) after its tax status, takes the payments from pass-through pools and splits them among several classes of bonds. Each class, or tranche, has its own balance, interest rate, expected life, and prepayment risk, and payments flow to the tranches in a set order of priority. Agency CMOs are built from agency pass-throughs.

Common tranche types:

• Sequential tranches: in a typical sequential structure, all principal goes to the first tranche until it is paid off, then to the second, and so on. The first tranche has the shortest expected life and the last has the longest.
• Scheduled tranches (planned amortization classes, or PACs): receive principal on a set schedule as long as prepayments stay within an assumed range.
• Support tranches (also called companion tranches): receive principal only after the scheduled tranches they support get their payments. They absorb the swings, so Freddie Mac warns that a support class may receive no principal for long periods and that its payments can change sharply from month to month.
• Accrual tranches (Z tranches): pay no cash for an extended period; interest is added to the balance instead. That added interest is taxable as it accrues, which is why brokers often suggest these for tax-deferred accounts.

CMO vs MBS: how do they differ?

A CMO is a type of MBS, so the real comparison is a CMO tranche against a plain pass-through.

How MBS differ from other bonds covers why both behave differently from Treasury and corporate bonds.

Interest-only (IO) and principal-only (PO) strips

Stripping splits a pool's payments into two securities. They can be issued on their own or as tranches within a CMO.

• Interest-only (IO): pays interest on a notional balance, a reference amount that shrinks as the pool's loans are paid down. There is no principal to get back. When rates fall and prepayments speed up, the interest stream ends sooner, and FINRA notes that an IO holder can receive less cash than it paid. When rates rise and prepayments slow, IO values can rise if the extra interest outweighs the effect of higher discount rates, which reduce the current value of future payments. Otherwise, IO values can fall.
• Principal-only (PO): pays only principal and sells at a deep discount to face value. Faster prepayments mean you collect the face value sooner, so PO values rise when rates fall and drop when rates rise.

Example: you pay $70,000 for a PO with $100,000 of face value. You earn the same $30,000 whether borrowers repay over 5 years or 15, but collecting it in 5 years is a much higher yearly return. FINRA tells brokers that high-risk tranches such as IOs are generally suitable only for sophisticated investors who understand the risks, and Freddie Mac issues IO and PO classes in minimums of $100,000.

What are tranches?

A tranche is one of several bonds created from the same pool, each with its own claim on the pool's payments. Tranches split two different risks:

• Prepayment and timing risk, as in the agency CMOs above. Tranches determine which principal and interest payments you receive and when. Agency guarantees do not cover premiums paid above principal value or ensure that IO investors recover their investment.
• Credit risk, in private-label MBS that have no agency guarantee. Payments go first to the senior tranche, then to subordinate tranches, then to the bottom or equity tranche. Losses run the other way: the equity tranche absorbs losses first.

The Federal Reserve illustrates the credit case with a pool split into three equal tranches. Applied to a $300 million pool with three $100 million tranches, $50 million of cumulative losses after recoveries from defaulted loans would wipe out half of the equity tranche and leave the subordinate and senior tranches whole. The subordinate tranche loses money only after those losses pass $100 million, and the senior tranche only after they pass $200 million. Senior tranches carry the least credit risk, and junior tranches carry the most because they take the first losses.

How does each type react to interest rates?

Refinancing drives most of these swings: borrowers pay off old loans when rates drop, which ends the interest those loans paid investors. What it means to refinance explains the borrower side of that decision.

Residential mortgage-backed securities (RMBS) covers the home-loan market these examples come from, and how CDOs differ from MBS explains securities built from other debt. How to invest in mortgages compares buying MBS directly with funds, mortgage REITs, and private notes.