Title LM19 Mortgage-Backed Security (MBS) Instrument and Market Features IFT Notes.pdf ✅

LM19 MBS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 1 LM19 Mortgage-Backed Security (MBS) Instrument and Market Features 1. Introduction ........................................................................................................................................................... 2 2. Time Tranching .................................................................................................................................................... 2 3. Mortgage Loans and their Characteristic Features ................................................................................ 3 4. Residential Mortgage-Backed Securities (RMBS) ................................................................................... 5 5. Commercial Mortgage-Backed Securities (CMBS) .................................................................................. 8 Summary ...................................................................................................................................................................11 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM19 MBS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module focuses on the largest ABS market in the world – the mortgage-backed securities (MBS) market. In this module we will cover:  Prepayment risk and time tranching structures  Fundamental features of residential mortgage loans that are securitized  Types and characteristics of residential mortgage-backed securities  Commercial mortgage-backed securities 2. Time Tranching Prepayment Risk The cash flow of a mortgage consists of the following three components:  Interest  Scheduled principal payments  Prepayments (any principal repaid in excess of the scheduled principal). The risk associated with uncertainty in future cash flows of MBS securities because of unscheduled principal repayments of the underlying mortgages is called prepayment risk. It has two components: contraction risk and extension risk.  Contraction risk is the risk that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of purchase because homeowners refinance at now-available lower interest rates. For instance, assume the interest rate is 8% when the Smiths take the loan. If two years later it falls to 6%, then they will prepay the loan and refinance at the lower rate.  Extension risk is the risk that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. From an investor’s perspective, the security becomes longer in maturity than it was at the time of purchase. Instructor’s Note Contraction risk occurs when interest rates decline. Extension risk occurs when interest rates rise. Time Tranching Time tranching is a securitization structure that allows the redistribution of “prepayment risk” among bond classes. For example, in a sequential tranching structure, the principal repayments flow first to one tranche until its principal is fully repaid, then principal repayments flow to the next tranche and so on. This concept is covered later in this learning module.
LM19 MBS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 3 3. Mortgage Loans and their Characteristic Features A mortgage loan is a loan secured by the collateral of some specified real estate property which obliges the borrower to make a predetermined series of payments to the lender. In simple words, it is a loan a buyer takes for buying a real estate property (land, apartment, house, etc.); the collateral is the property being bought. If the buyer defaults on mortgage payments, then it gives the lender the right to foreclose on the loan, take possession of the property, and sell it to recover funds given as debt. The amount lent as loan towards the purchase of the property is always less than the purchase price. It is equal to the purchase price minus the down payment made by the buyer. The buyer’s initial equity is equal to the down payment made. The ratio of the mortgage loan amount to the property’s purchase price is called the loan-to- value (LTV) ratio. From a lender’s perspective, lower the LTV, the less likely the borrower is to default. Also, if the borrower does default, the lender will have better chances of recovering the amount loaned by repossessing and selling the property. Another consideration is the capacity to sustain debt payments measured by the debt-to- income ratio (DTI). This ratio compares an individual’s monthly debt payments to their monthly pre-tax, gross income. From the lender’s perspective, lower the DTI, the less likely the borrower is to default. In the United States, based on the credit quality of the borrower, mortgages can be classified as:  Prime loans – Borrower has high credit quality, strong credit history, sufficient income to service the loan, and substantial equity in the underlying property.  Subprime loans – Borrower has low credit quality, high DTI, and/or high LTV. Agency and Non-Agency RMBS Residential mortgage-backed securities are bonds created from the securitization of residential mortgage loans. In the U.S., residential mortgage-backed securities are divided into the following three sectors: 1. Those guaranteed by a federal agency (Ginnie Mae) whose securities are backed by the full faith and credit of the U.S. government. 2. Those guaranteed by either of the two government-sponsored enterprises or GSEs (Fannie Mae and Freddie Mac) but not by the U.S. government. They do not carry the full faith and credit of the U.S. government. 3. Those issued by private entities that are not guaranteed by a federal agency or a GSE.
LM19 MBS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 4 The first two sectors (guaranteed by the government or a quasi-government entity) are called the agency RMBS. The third sector is called non-agency RMBS. Examples of agency RMBS include:  Mortgage pass-through securities  Collateralized mortgage obligations The two differences between agency RMBS issued by GSEs and non-agency RMBS are as follows:  Non-agency RMBS use credit enhancements to reduce credit risk, while agency RMBS issued by the GSEs are guaranteed by the GSEs themselves.  For a loan to be included in a pool of loans backed by an agency RMBS, it must satisfy the underwriting standards of the government agencies. Mortgage Contingency Features Mortgages may contain certain features that give the borrower and the lender certain rights throughout the contract. Prepayment option: A ‘prepayment option’ or an ‘early repayment option’ entitles the borrower to prepay all or part of the outstanding mortgage principal prior to maturity. In some countries, there may be a penalty for prepayment as it hurts the lender (recall ‘prepayment risk’). The objective of imposing a penalty is to compensate the lender for the difference in the contract rate and the prevailing mortgage rate when the borrower prepays as rates decline. Recourse and non-recourse mortgage loans: If the borrower of a loan defaults on payments, then the lender can seize the property and sell it. The proceeds from the sale may be less than the outstanding mortgage balance, and not enough to recoup the losses. There are two types of mortgage loans in such cases:  Recourse loans: The lender can claim the shortfall (outstanding mortgage balance – after the property is sold) from the borrower. For instance, if the borrower has other