Mortgage-Backed Security (MBS)

An MBS is created when mortgage loans are pooled and securitized. In a pass-through, investors receive a pro rata share of the pool’s monthly principal and interest, net of servicing and guarantee fees. Agency MBS are issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac, so credit risk is limited; non-agency (private-label) residential MBS and commercial MBS (CMBS) carry borrower credit risk and are usually tranched. Much agency trading takes place in the TBA (to-be-announced) market, where buyer and seller agree issuer, coupon, maturity and settlement month, and the specific pools are allocated just before settlement.

The defining risk is prepayment: borrowers can repay early, especially when rates fall, which shortens the security’s life and returns principal when reinvestment yields are lower. Prepayment speeds are expressed as CPR or as a percentage of the PSA benchmark. Extension risk works the other way when rates rise.

How funds account for MBS. Holdings are tracked in original face and adjusted each month by the pool factor, the proportion of original principal still outstanding. Operations must book monthly paydowns (principal returned at par, creating realized gains or losses against cost), accrue interest on the current face, and handle payment delays that differ by program. Premiums and discounts are amortized with prepayment assumptions. Pricing comes from evaluated vendor prices, usually Level 2; esoteric non-agency or subordinate tranches can be Level 3.

Pitfalls. Frequent errors include stale pool factors (so face value and interest accruals are overstated), paydowns booked as sales, TBA dollar rolls mis-booked or not rolled at all, mismatched payment delays, and accruing interest on the original rather than current face. Factor and paydown data should be reconciled monthly to the custodian and to vendor data before NAV sign-off.

Example

A fund holds USD 5M original face of an agency pass-through with a pool factor of 0.8200, so current face is USD 4.1M. If next month’s factor is 0.8100, the fund books a principal paydown of USD 50,000 and accrues interest on USD 4.05M going forward.