Securitization Overview
Mortgage-backed securities (MBS) and asset-backed securities (ABS) make up the
biggest sector of the bond market, forming the core holdings of almost all U.S.
institutional fi xed income investors. Wall Street dealers trade billions of dollars of these
securities each day. Because these securities are so complex and varied, and because
detailed information is hard to come by, very few people in the fi nancial industry or in
academia have a detailed understanding of their characteristics.
MBSs and ABSs are securities backed by the cash fl ows from a specifi ed pool of
assets. Securitization is the process that transforms non-tradable fi nancial assets, like
car loans or commercial mortgages, into these tradable securities. A majority of this
market is made up of securities backed by residential mortgage loans. The rest of the
market consists of other kinds of assets that have been securitized, including commercial
mortgage loans, car loans and credit card receivables.
The cash fl ow from the assets are channeled to investors in one of two ways:
1) They are passed through to investors, after administrative or servicing fees are subtracted.
This method, which creates a pass-through security, comprises the majority
of MBSs.
2) They can be allocated to investors according to specifi ed rules, creating structured
securities, such as collateralized mortgage obligations (CMOs).
Even with the variety of collateral types and cash fl ow allocation structures, most MBSs
and ABSs share particular characteristics:
• Most payments, including those received from the pool of assets and those paid to
security holders, are made monthly.
• The monthly payments from the assets typically consist of principal and interest.

• The scheduled principal refl ects the amortizing nature of most consumer loans: The
principal borrowed is paid back gradually over the term of the loan, rather than in
one lump sum at the maturity of the loan.
• Unscheduled payments of principal, or prepayments, refl ect the fact that most consumer
loans can be paid off early. When mortgage loans are paid off early, it’s usually
because the borrower sells the house or refi nances into a new, lower-rate mortgage.
• Because no one can predict when and how borrowers will make prepayments, cash
fl ow uncertainty is a fact of life for MBSs and ABSs.
• There is a minimal credit risk for most MBSs and ABSs, whereas for traditional
bonds, cash fl ow uncertainty arises from credit risk.