Default Risk: if loan is not repaid (in full or partially)
Prepayment risk: if prepays faster or slower
3 ways of managing mortgage default risk
Don't allow the loan to exceed value of property
Obtain mortgage insurance on borrower
Carefully uw borrower's ability and willingness to repay
Define mortgage pass through
Pool mortgages to reduce impact of prepayment risk, and then pass the collective payments to various investors in the form of bonds
Define Collateralized Mortgage Obligations (CMO)
Similar to a pass through mortgage, but the interest and principal are not passed through to all investors on a pro-rata basis: various tranches are created, where principal payment is usually allocated sequentially.
Define Stripped MBS (IO & PO)
More extreme case of a CMO in which some investors receive the cash flow only from interest pmt (Interest Only or IO strip) and some others only from principal (Principal Only or PO strip)
Note: IO has negative duration since interest rate rise raises its price (because people have less incentive to refinance so we get more interest pmt than expected). It is therefore a useful tool for modifying the duration of a portfolio.
Define Asset-Backed Securitization (ABS)
Similar to MBS but w/ a broader choice of underlying asset (collateral) as car loans, credit card payments, etc.
When the collateral is a bond we call that Collateralized Debt Obligation (CDO)