Learn the Lingo (Mortgages)

So with the whole subprime market going bust and the Bear Stearns fund nearly going belly-up, I figured there might be some people who would like a mortgage markets primer. In case you're wondering, I did a good bit of prepayment modeling for a mortgage book. Here we go!

MBS - mortgage backed security. This is the fundamental building block. Basically a pool of mortgages are put together into one entity and then the entity pays off a coupon every month based on those mortgage payments. If you own an MBS you have effectively lent to this entity which has lent the money out to all the people who took out mortgages. If the people pay their mortgage off early then you get your money back early (this can be good or bad, depending). If they default on their mortgages you may have to take that loss as well.

Securitization - the act of creating a security from a set of assets. In the case we are talking about today, it is the act of pooling mortgages, enhancing the credit and selling it off.

FNMA - Fannie Mae, often refers to MBS backed by Fannie Mae. Fannie Mae guarantees the mortgages it packages. All FNMA securities have a set coupon and high credit ratings. These are all securitized with credit enhancement so they are AAA rated by credit agencies. Basically FNMA securities are considered default free and backed by the government (note that I said "basically." They aren't technically backed by the government).

GNMA - Ginnie Mae, much like Gannie Mae backs MBS. If you want the details between FNMA, GNMA and other quasi-government agencies that back MBS, I suggest you google around a bit (or e-mail me).

Credit Rating - Credit agencies (Standard and Poors, Fitch, etc) give credit ratings according to the likelihood of an entity's default. AAA is good, AA is a little worse, and it goes all the way down to B, C and technical default.

FICO - Fair Isaac's COrporation score refers to a commonly used method of rating a customer/individual's credit (likelihood to default).

Pool - a pool is a set of mortgages that go into a given security. Pools are often characterized by average size of loan, average FICO of borrower, average mortgage rate, etc.

Coupon - the % of notional that a given security pays off. A 5% FNMA security pays an annual 5% in monthly buckets.

Sub-Prime - Subprime mortgages refer to mortgages made to customers of "sub-prime" FICO score. Prime FICO scores generally are considerd those over 660. It is important to know that FNMA and other major agencies do not securitize sub-prime mortgages (remember, they make all their stuff AAA rated), so a lot of these are securitized directly by banks.

CMBS - Commercial Mortgage Backed Security. These are much like MBS, but they are backed by commercial mortgage loans (think: the loan taken out to fund the local mall or the grocery store).

Prepayment - refers to a mortgage holder's right to pay off the mortgage early to pay off part of the balance of the mortgage and thus reduce the life of the loan. This is often called the "prepayment option" embedded in the mortgage, which is the equivalent of an embedded put option.

ARM - Adjustable Rate Mortgage refers to mortgages that have an interest rate reset over time. These are often seen as "X-N ARMs," which means the rate is fixed for the first X years and then resets on an N year interval. Commonly you'll see things like 5-1 ARMs and 7-1 ARMs.

FRM - Fixed Rate Mortgage. These are mortgages where the rate is fixed from the beginning and never changes.

IO - Interest Only. These mortgages are like ARMs, but you only pay interest payments for the first X years. Kinda scary if you think about it. IOs can also refer to IO securities, which are the interest only portion of a loan. In mortgage space this means you can get the interest portion of a mortgage pool's payments. That means in the event of prepayment, you get basically nothing because they mortgage owner decided to pay off the entire balance before interest kicked in.

PO - Principal Only. You can't take out a principal only mortgage. I don't even know how you could make something of the sort. POs refer to the principal only securities. Clearly if you're securitizing IOs, you're going to have a PO portion left. The POs are the opposite of IOs in that if there is a prepayment, suddenly all the money you were expecting comes to you a lot early than expected (bonus!) and you can earn returns off of it some other way.

CMO - Collateralized Mortgage Obligation. These are a type of MBS (specifically called a "pass-through" MBS). These are special because they have a payment hierarchy, so you can get protection from prepayment (and default) through the structure. Thus AAA CMOs are protected more than A CMOs. These slices of hierarchy are called tranches.

CDO - Collateralized Debt Obligation. These usually refer to something that looks the same as CMOs except in non-mortgage space. They also can refer to a collection of CMO tranches collected into one item. So, for example, if I create an entity backed by a bunch of different CMO BBB tranches, I have effectively created a derivative off of the mortgage derivative (risk management for these are a bitch because they involve all sorts of weird correlations). Sometimes the CDOs of CDOs or CDOs of CMOs are called CDO-squares.

CPR - Conditional Prepayment Rate. This is how expected prepayment is measured in mortgage space. For example, a 10% CPR means 10% of the remaining balance is expected to be paid off in that period.

PSA - Public Securities Association prepayment model. This model is also used to measure prepayment rate (although not as commons as CPR). It assumes some constant prepayment rate and gives the forecasted rate according to that reference rate. See: http://en.wikipedia.org/wiki/PSA_prepayment_model for the details.

SMM - Single Monthly Mortality rate. This is directly related to CPR by the equation: SMM = 1-(1-CPR)^(1/12).

MSR - Mortgage Servicing Right. These are a residual security to compensate companies that service mortgages. When a mortgage is created, someone actually has to do the collection of the payments, process the payments and divvy it up among the holders of the MBS. The MSR is this form of payment, it gets .25 bps off of every payment. As you can imagine, these value much like IO securities --if prepayment occurs it's worth a lot less than if it drags on for a long time.

Mortgage Servicer - People will often talk about big players in the markets. Mortgage servicers are one of the big players. They are one of the whale accounts that often smash the market with billion dollar trades. The reason they do such ridiculous size is because they tend to be out there hedging their loads of MSRs. As it turns out mortgage servicing is an economies of scale business, so people who hold MSRs tend to have a lot of them. Hedging them is a rather complicated endeavor, but it's often done with a combination of swaps, swaptions, treasuries and MBS.

Mortgage Hedger - Another type of big player in the market. Mortgage hedgers are a superset of mortgage servicers. A lot of big mortgage originators hold a lot of those mortgages on their balance sheet instead of structuring them and selling them off. These people also need to hedge their balance sheet exposure via the capital markets and tend to do so in big size.

I'm sure I'm missing a whole bunch of stuff, but that's what rolls off my head at the moment. As always, feel free to e-mail me with questions.