Mark Gritter (markgritter) wrote,
Mark Gritter

I heart finance

A mortgage-backed security packages up the income streams from the principal and interest payments of individual mortgages. You may have seen a lot in the news about such things. :) In addition to the usual risks involved in buying a security (risk of default and interest-rate risk) there is a third risk, that the mortgage will be paid off early. Although the principal is repaid, there are no more interest payments coming in.

I was looking at U.S. treasury bonds a while back. A treasury bond that pays both interest payments and a final principal payment can be "stripped" into separate zero-coupon securities for each payment. (So you pay, say, $95 now and get the $100 interest payment from somebody else's bond later.) This made me wonder whether the same technique could be applied to MBS, splitting the streams of principal and interest payments into separate securities.

And, in fact, it can! These are known as "Stripped mortgage-backed securities (SMBS)". I think this is really cool. You can make a bet either on high home turnover or on low home turnover. If lots of mortgages get paid off earlier, the principal-backed bonds are in great shape because the investors get their money early. If mortgages get held for a while or the principal payments are slowed down, the interest-backed bonds benefit because the income stream is larger than expected. (If the borrower defaults, both get screwed as usual.)

Now let's get really strange. You could split up the two components of an fixed-interest-bearing account the same way. A depositor puts $1000 into a money-market account. Investor A gets some cash now but an obligation to pay $1000 on demand at any time. Investor B also gets some cash now but an obligation to make interest payments to the depositor. Let's call these (admitted silly) instruments "stripped savings-fronted obligations". ;)

A bank can be thought of as generating both the securities and the obligations. The traditional picture is that the income and obligation streams are matched up in-house. But it should be obvious that the two instruments, while dually defined, don't have dual characteristics. This is why it's been attractive for banks to sell off its mortgage assets as MBS's. (Not the only reason, of course--- they get some $$ for originating the loans so the more they can originate the better off they are.) Under what circumstances might a bank pay investors to take its obligations in the form of my (purely hypothetical, I hope) SFO's?
Tags: finance, geek
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