MBS Glossary

Agency CMO: CMO backed by FNMA, FHLMC or GNMA pass-throughs.

Agency MBS: An MBS issued and guaranteed by a government agency such as FNMA, FHLMC, or GNMA.

Asset-backed Security: A security backed by a pool of consumer or commercial receivables. Term not usually used to refer to standard MBS, even though MBS are technically asset-backed securities. Auto loans and credit-card receivables are the most common form of collateral for asset-backed securities.

Basis Point: 1/100th of 1 percent; e.g., if a security yields 150 basis points over Treasuries, and Treasuries yield 6%, the security yield is 7.5%.

Cap: In the interest rate derivatives market, an instrument in which the buyer receives payments from the seller in the event interest rates rise above a specified level; used by the buyer as a hedge against rising interest rates.

In the bond market, the cap of a floating-rate security is its maximum possible interest rate. See “Floor”

CMO: Collateralized mortgage obligation; a bond issue in which cash flows from a pool of mortgage collateral have been split into multiple securities, called tranches; each tranche is a separate bond.

CMT: Constant Maturity Treasury

COFI: 11th District Cost of funds index

Companion: See "PAC".

Convexity: The tendency of the price movement of a security to accelerate as it appreciates. Positively convex securities experience accelerated price action as they appreciate, while negatively convex securities experience dampened price action as they appreciate. The negative convexity of many MBS is one of the critical risk factors that must be hedged.

Default Risk: The risk of a mortgage-backed security arising from potential losses on foreclosed properties; the major form of credit risk in lower-rated MBS.

Duration: A measure of the price variability of a security relative to changes in interest rates. For a given change in interest rates, high (or "long") duration instruments experience large price changes, whereas low (or "short") duration instruments experience small price changes. Duration is the most basic risk factor of a security in determining a hedge.

Floater: A bond whose coupon varies as interest rates change, usually resetting at a spread over a market index such as LIBOR.

Floor: In the interest rate derivatives market, an instrument in which the buyer receives payments from the seller in the event interest rates decline below a specified level; used by the buyer as a hedge against falling interest rates. In the bond market, the floor of a floating-rate security is its minimum possible interest rate. See “Cap”

Hedge: For a security or portfolio of securities, offsetting trading positions designed to mitigate the risks associated with the securities.

Interest Rate Derivative: An instrument whose value and payments are determined by, and often extremely sensitive to, levels in interest rates. It usually takes the form of a contract between an investor and a dealer. Typical interest rate derivatives include swaps, caps, and floors.

Interest Rate Process: A mathematical model, which creates a multitude of possible interest rate scenarios, which are then used for the evaluation of, fixed income securities. With an interest rate process, the performance and risk of securities can be calculated and compiled over a wide range of possible scenarios.

Inverse Floater: A variable-rate bond whose coupon resets in the opposite direction of interest rates, according to a formula involving a market index such as LIBOR. A typical formula might be: 18% - 2xLIBOR, in which case the coupon would decline by 2% if LIBOR increases by 1%.

IO (Interest Only): A mortgage-backed security whose payments derive exclusively from the interest payments on the underlying mortgages. Unexpected prepayments or defaults impair the value of IOs, curtailing payments of interest on the mortgages. (See “PO”)

Leverage: A technique whereby borrowed funds are used in addition to investor capital to purchase securities. This technique has the effect of magnifying the gains or losses on the investments. "Buying on margin" is a typical form of leverage.

LIBOR: (London Interbank Offered Rate) The interest rate at which major international banks in London lend to each other,

MBS: Mortgage-backed security; a security whose payments are derived from payments on residential or commercial mortgages.

MBS Derivative: A mortgage-backed security with concentrated risk relative to one or several of the typical MBS risk factors: prepayment risk, interest rate risk, volatility risk, or default risk.

Non-Agency MBS: An MBS neither issued nor guaranteed by a government agency.

OAS: Option-adjusted spread; a measure of the theoretical profit obtainable by holding a security to maturity, after taking into account the costs of financing and fully hedging with interest rate derivatives. OAS calculations are only approximations, since they ignore transaction costs and unhedgeable risk factors. OAS is typically quoted in basis points per annum.

PAC: "Planned Amortization Class"; a CMO tranche structured to be insulated from prepayment variability for a specified range of prepayment speed. Other tranches, known as support tranches (or "companions"), absorb most of the prepayment variability.

Pass-through: An MBS in which principal and interest payments by homeowners are passed through as principal and interest payments to security holders.

PO (Principal Only): A mortgage-backed security that pays no coupon. Its payments derive exclusively from the principal payments on the underlying mortgages. Prepayments always enhance the value of POs. (See “IO”)

Prepayment: Repayment of a mortgage before its maturity, usually resulting from a refinancing or home sale.

Prepayment Model: model that attempts to describe the mathematical relationship between the level of interest rates and the level of prepayments. Prepayment models are usually based on statistical analysis of historical prepayment data, and are primarily used as inputs in valuation and hedging models (such as OAS models).

Prime rate: Rate at which banks lend to their most favored costumers.

REMIC: Real Estate Mortgage Investment Conduit; a specific tax status for a mortgage-backed security issuance. Often used synonymously with CMO, since almost all CMOs are issued as REMICs.

REPO: Repurchase agreement; a borrowing mechanism whereby securities are posted as collateral for a loan. REPOs are technically structured as a sale of securities by the borrower to the lender, with a commitment by the borrower to repurchase at a later date. REPO is the most common form of borrowing used to leverage fixed income securities.

Senior: Having a priority claim to cash flows (over "subordinate" tranches). In a CMO with default risk, senior tranches are the last to absorb credit losses.

Sequential CMO: The original CMO structure, consisting of a few tranches paying principal in sequence. Sequential tranches have less prepayment variability than support tranches, but more variability than PACs.

Subordinate: Having lower priority to cash flows (relative to "senior" tranches). In a CMO with default risk, subordinate tranches are the first to absorb credit losses.

Support: See "PAC".

Swap: An interest rate derivative contract in which two parties agree to make payments to one another over some period of time; the amounts of these future payments may be dependent on future market factors. The most common form of swap consists of one party making floating rate payments while the other makes fixed rate payments. Since the terms of the contract can be customized, swaps make ideal risk management tools.

Tranche: An individual bond in a CMO structure. See "CMO".

Volatility: Frequent changes in interest rates, or the anticipation of frequent changes in interest rates. Since large drops in interest rates can cause MBS to prepay and to underperform other fixed income instruments, MBS generally perform better than other securities in a low volatility environment. Interest rate derivatives can be used to hedge the risks associated with changes in actual or anticipated volatility.

Whole Loan: A mortgage loan that has not been insured or guaranteed by a government agency. Typically these include "jumbo" (high-balance) mortgages.

Whole Loan CMO: A CMO backed by whole loan collateral.

Yield Curve: A graphical representation of the relationship between short-term and long-term interest rates. In a "steep" yield curve, long-term rates are much higher than short-term rates. In a "flat" yield curve, long-term and short-term rates are relatively close. In an "inverted" yield curve, long-term rates are lower than short-term rates.