What it means
A mortgage-backed security (MBS) is a bond backed by a pool of home loans, and the borrowers' monthly payments pass through to its investors. Each payment contains two parts: interest on the outstanding balance and a repayment of principal.
A stripped MBS separates these, so that one class gets all the interest, called the interest-only or IO class, and the other gets all the principal, called the principal-only or PO class. The reason this matters is prepayment, because homeowners can repay or refinance early, especially when interest rates fall.
When they do, the principal comes back sooner, which helps the PO holder because the fixed total is received earlier. The IO holder suffers because the balance on which interest is paid shrinks faster, so total interest received falls.
As a result, the PO class rises in value when rates fall and prepayments increase, while the IO class falls. When rates rise, prepayments slow, which hurts the PO and helps the IO.
An IO is therefore unusual because its price can move in the same direction as interest rates, which makes it a useful hedge for other mortgage holdings. The price of each class is the present value of its expected cash flows, and these depend on assumed prepayment speeds.
Analysts use models of borrower behaviour, and different models can produce quite different values. This model risk is one reason stripped securities are considered complex.
Because both classes are sensitive to rates and prepayments, stripped MBS can lose or gain value rapidly. They are generally bought by institutions such as banks, insurers and hedge funds, with the trade-off being higher potential return and higher volatility.
Some investors would find them unsuitable. A stripped MBS is different from a collateralised mortgage obligation, which divides cash flows into time-based tranches.
It is also different from a strip bond, which splits a single bond rather than a pool of mortgages.
In practice
Real-world examples.
Example
A mortgage bank earns servicing fees that shrink when borrowers refinance, so its income falls when rates fall. It buys PO strips, which gain when prepayments speed up. The PO position partly offsets the loss on its mortgage servicing rights.
Example
A hedge fund expects interest rates to climb over the next year and slow mortgage prepayments. It buys an IO class, which should receive interest on a balance that stays outstanding longer. It sizes the position small because the price could fall sharply if rates drop instead.
Example
An insurance company wants a return that rises when other holdings fall. Its investment team adds a modest holding of IO strips as a hedge against falling rates, funded by selling part of a plain mortgage pass-through bond.
Formula
Calculation
IO cash flow in a month = outstanding balance x annual coupon rate / 12
PO cash flow in a month = scheduled principal repayment + prepayments
Suppose a pool of mortgages has an outstanding balance of $10,000,000 and a pass-through coupon of 6%. The IO holder's cash flow for the month is $10,000,000 x 0.06 / 12 = $50,000. If homeowners repay $12,000 of scheduled principal and $88,000 of extra prepayments that month, the PO holder receives $12,000 + $88,000 = $100,000. The balance drops to $10,000,000 - $100,000 = $9,900,000, so next month's interest cash flow for the IO falls to $9,900,000 x 0.06 / 12 = $49,500.Case study
Seen in the real world.
Cedar Point Savings is an illustrative, fictional bank whose mortgage servicing business earns fees on a $2,000,000,000 loan book. When interest rates fell, borrowers refinanced rapidly, and the servicing fees dried up because the loans were repaid and replaced elsewhere.
The treasury team realised that its exposure was similar to owning an interest-only stream, which loses value when prepayments rise. To offset it, the bank purchased principal-only strips, which gain when prepayments speed up, in an amount sized by its risk models.
In the next rate decline the servicing income dipped, but the gain on the PO strips covered a large part of the loss. The illustrative lesson is that the two halves of a mortgage can be used to match opposite exposures, but only with careful modelling of prepayment behaviour.
Watch out
Common mistakes.
- Assuming that principal-only strips are low risk because the principal is eventually repaid, when the speed of repayment drives the price.
- Expecting an interest-only strip to behave like a normal bond, when its value can fall even as the investor keeps receiving payments.
- Relying on a single prepayment forecast, when real borrower behaviour often differs from the model.
Questions
People also ask.
Why can an interest-only strip lose value when rates fall?
Falling rates encourage homeowners to refinance, which shrinks the balance on which interest is paid and cuts the total interest received.
Who buys stripped MBS?
Mostly institutions such as banks, insurers and hedge funds, which use them to hedge or to take a view on rates and prepayments.
Is a stripped MBS the same as a CMO?
No, a CMO splits cash flows into time-based tranches, while a stripped MBS splits them into interest-only and principal-only classes.
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