The Mortgage-Backed Securities is a $7.4 Trillion market.

Source: Securities Industry and Financial Markets Association - www.sifma.org

To finance a real estate purchase, a buyer is required to take on debt which is a mortgage on the property. Mortgage originators can either

• 1. Hold a new mortgage in their portfolio
• 2. Sell the mortgage to an investor or conduit
• 3. Use the mortgage as collateral for the issuance of a security

A new security was created called mortgage-backed security (MBS) which is a pool of mortgages that represent the collateral for a security. The cash flow pattern associated with a MBS is based on the payment of the individual mortgage loans underlying the security. The ability of borrowers/ homeowners to prepay part or all of the mortgage at any time creates uncertainty regarding cash flow (above and beyond possible delinquencies), so investors usually wish to be compensated for accepting the risk of unscheduled payments. A targeted MBS is a security collateralized by a pool of mortgages originated to borrowers/ homeowners whose incomes are 80 percent or below the area median income.

How Mortgage-backed Securities Work

There are two markets for mortgage backed securities: primary market and secondary market.

The primary mortgage market process.

Each month, the mortgage payments made by homeowners flow to the holders of the mortgage-backed securities. Here's how the process works:

• 1. A homeowner sends the monthly mortgage payment to a lender or loan servicer.
• 2. If the mortgage has been purchased by Mortgage Bank, the lender sends the homeowner's mortgage payment on to Mortgage Bank.
• 3. Mortgage Bank passes the mortgage payment through to the holders of the mortgage-backed security, minus the fee they charge for guaranteeing the timely payment to the investor, as well as some additional fees.

The secondary mortgage market process.

Mortgage Bank might purchases mortgages from across the country that share similar characteristics – payment terms, interest rates, loan terms, and other characteristics that vary. For example, some mortgages may carry greater credit risk than others, based on the type of property or the credit history of the borrowers.

Mortgage Bank purchases large numbers of mortgages that they "pool", or bundle together, into large groups. They guarantee timely payment of principal and interest to the investors who invest in these pools.

Pooled mortgages are used to back the issuance of a particular type of instrument known as a mortgage-backed security (MBS). Many investors – typically large-scale institutional investors such as pension funds or mutual funds – find mortgage-backed securities very attractive.

Sometimes mortgage-backed securities are called "pass-through" securities, because Mortgage Bank "passes through" to securities investors the funds homeowners pay for their mortgages.

By investing in mortgages, Mortgage Bank attracts funds for primary mortgage market lenders from debt investors who would not otherwise invest in the U.S. residential mortgage market or who might be averse to prepayment risk. The bank finances these mortgages by issuing debt securities.

Mortgage Backed Securities (MBS)

An MBS is similar to a loan. When an investor purchases an MBS, it effectively lends money to the borrower/homeowner who promises to pay interest and to repay the principal. The purchase effectively enables the lender to make more mortgage loans. MBSs are known as “fixed-income” investments and represent an ownership interest in mortgage loans. Other types of bonds include U.S. government securities, municipal bonds, corporate bonds and federal agency (debt) securities.

Here is how MBSs work

Lenders originate mortgages and provide groups of similar mortgage loans to organizations like Bank of America, which then securitize them. Originators use the cash they receive to provide additional mortgages in their communities. The resulting MBSs carry a guarantee of timely payment of principal and interest to the investor and are further backed by the mortgaged properties themselves.

The MBS issuer or servicer collects monthly payments from homeowners and “passes through” the principal and interest to investors.

Thus, these pools are known as mortgage pass-through or participation certificates (PCs). Most MBSs are backed by 30-year fixed-rate mortgages, but they can also be backed by shorter-term fixed-rate mortgages or adjustable rate mortgages.

Collateralized Mortgage Obligation (CMO)

The prepayment uncertainty of MBSs led to development of the collateralized mortgage obligation (CMO) in 1983. This more complex type of mortgage security helps compartmentalize prepayment risk and better addresses investment time frames and cash-flow needs.

Since 1986, most CMOs have been issued in real estate mortgage investment conduit (REMIC) form for tax purposes. The terms are now used interchangeably. MBSs are pooled to create CMOs. In structuring a CMO, an issuer distributes cash flow from the underlying collateral over a series of classes called tranches, each having average lives designed to meet specific investment objectives. As the payments on the underlying mortgage loans are collected, the CMO issuer usually first pays the coupon rate of interest to the bondholders in each tranche. All scheduled and unscheduled principal payments go first to investors in the first tranches. Investors in later tranches do not start receiving principal payments until the prior tranches are paid off.