Mortgage Backed Securities
When money is borrowed to finance the purchase of real property, the note issued by the borrower to the lender is called a mortgage. Mortgages are generally not liquid securities because they vary widely in size and in other terms. Mortgage backed securities are financial products which transform mortgages from an illiquid asset into a liquid asset.
Collateralized Mortgage Obligations or CMOs, are a type of Mortgage Backed security that usually offer monthly income, relative safety, and notable yield advantages over other fixed income securities of comparable credit quality. A wide assortment of CMO securities with different cash flow and expected maturity characteristics is available to meet specific investment objectives.
Most Mortgage securities are either issued and/or guaranteed by an agency of the U.S. Government, the Government National Mortgage Association (Ginnie Mae), or by government-sponsored enterprises (GSEs) such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae is a government-owned corporation within the Department of Housing and Urban Development. Fannie Mae and Freddie Mac are chartered by Congress, but owned by stockholders.
While most bonds pay interest semiannually, mortgage securities may pay interest and principal monthly, quarterly or semiannually, depending on the structure and terms of the issue. Pass-through securities and most newly issued CMO's and Real Estate Mortgage Investment Conduit (REMIC) securities provide monthly payments. CMO's are created by forming pools of loans, known as tranches. Each tranche has its own rate, payment schedule, estimated yield, and average life.
Mortgage securities also tend to carry higher coupon rates than U.S. Treasury securities. In part, this is because the interest rates charged on mortgage loans are higher than the interest rates charged to the U.S. Government. But the higher rates on mortgage securities also reflect the higher level of investment risk created by prepayment uncertainty. Investors in mortgage securities may have their principal returned to them sooner or later than initially projected at the time of investment.
MBS-CMO Highlights
- Principal and interest are paid monthly (most fixed income securities return principal only at maturity).
- Estimated average life and payment characteristics can vary over the life of the security depending on prepayments.
- Low minimum investments of $1,000 (with exception of GNMA's MBS which has a minimum investment of $25,000).
