Mortgage-Backed Security (MBS) Instrument and Market Features

Prepayment risk is the risk associated with the early repayment of principal by borrowers, which can alter the cash flows expected from an MBS. It includes contraction risk, where prepayments increase when interest rates fall, and extension risk, where prepayments decrease when interest rates rise.

Time tranching is a structuring technique in securitizations that creates multiple tranches with different expected maturities. This method helps mitigate prepayment risk by allowing the redistribution of these risks among different classes of bonds, each tailored to specific investor needs regarding cash flow timing.

Contraction risk occurs when the actual prepayments exceed the anticipated prepayments due to falling interest rates, leading to a shorter than expected life for the MBS. This forces investors to reinvest the returned principal at potentially lower interest rates.

Extension risk arises when actual prepayments are less than expected due to rising interest rates, extending the life of the MBS beyond expectations. This results in receiving payments over a longer period at a time when newer investments might offer higher returns.

Mortgage loans are secured by real estate property and require the borrower to make scheduled payments. The lender has a first lien on the property, which can be foreclosed upon default to recover the loan amount.

LTV is the ratio of the mortgage amount to the property's value. It is a critical measure used by lenders to assess the risk of the loan, with lower LTVs indicating less risk and higher borrower equity.

DTI measures a borrower's monthly debt payments against their pre-tax gross income. It helps lenders evaluate a borrower's ability to manage and repay debts. A lower DTI indicates a better balance between debt and income.

Agency RMBS are backed by government or quasi-government entities and carry guarantees for timely payment. Non-agency RMBS are issued by private entities without government backing, often using credit enhancements like subordination.

These features include options for borrowers to prepay the loan, which introduces prepayment risk for lenders. Lenders may use prepayment penalties as a risk mitigation strategy.

Recourse loans allow lenders to claim against borrowers for any shortfall after foreclosure, while non-recourse loans limit recovery to the property's value only. This affects the default risk and financial stability of the mortgage.

These are securities created by pooling mortgages and selling the cash flows from these mortgages to investors. The cash flows include principal, interest, and prepayments, which are passed through to the security holders after deducting administrative and servicing fees.

CMOs are structured to redistribute the cash flows from mortgage pass-through securities or multiple pools of loans to different bond classes or tranches. This structure aims to create securities with varying exposures to prepayment risk, catering to different investor needs.

In this CMO structure, tranches are retired sequentially, meaning that principal payments are directed to the first tranche until it is fully paid before moving to the next tranche. This structure helps manage extension risk for earlier tranches and contraction risk for later tranches.

These tranches do not receive interest payments until a preset date, at which point both principal and accrued interest payments start. This structure benefits other tranches by freeing up cash flows and protects Z-tranche holders from reinvestment risk when market yields decline.

CMBS are structured with features like call protection and balloon maturity provisions. Call protection prevents early prepayments, making CMBS trade more like corporate bonds. Balloon maturity involves large final payments at the loan's maturity, adding complexity to the repayment structure.

CMBS face several risks including default risk, which is heightened due to the potential concentration of loans within the pool. Prepayment risk is generally low due to call protection, but extension risk can be high, especially if balloon payments are not made and the loan term is extended.

DSC is a key metric in commercial real estate lending, calculated as the net operating income divided by the debt service. It indicates whether the income generated by the property is sufficient to cover the debt payments.