What is the difference between a mortgage-backed security and a credit default swap?

Whereas, MBS are only made up of mortgages, CDOs can be made up of a diverse set of assets—from corporate bonds to mortgage bonds to bank loans to car loans to credit card loans. CDS is a fancy term for insurance contracts that allow banks and hedge funds to protect against the risk of a CDO default.

Do mortgage-backed securities have credit risk?

Mortgage-backed securities are subject to many of the same risks as those of most fixed income securities, such as interest rate, credit, liquidity, reinvestment, inflation (or purchasing power), default, and market and event risk. In addition, investors face two unique risks—prepayment risk and extension risk.

What is a credit default swap mortgage?

A credit default swap is a financial derivative/contract that allows an investor to “swap” their credit risk with another party (also referred to as hedging). For example, if a lender is concerned that a particular borrower will default on a loan, they may decide to use a credit default swap to offset the risk.

What is the difference between asset backed securities and mortgage-backed securities?

Asset-backed securities (ABS) are created by pooling together non-mortgage assets, such as student loans. Mortgage-backed securities (MBS) are formed by pooling together mortgages. ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to acquire additional funding.

What is Agency MBS?

Agency MBS are mortgage-backed securities issued by the government-sponsored enterprises Freddie Mac and Fannie Mae, or the U.S. government agency Ginnie Mae in order to keep mortgage rates low and homeownership accessible. Fannie Mae and Freddie Mac are the major backers of conventional loans.

How do you evaluate MBS?

A statistic that is commonly used as a measure of the effective maturity of a MBS is the WAL, sometimes called just “average life.” To calculate the WAL, multiply the date (expressed as a fraction of years or months) of each payment by the percentage of total principal that is paid off at that date, then add up these …

What are the different types of risk associated with mortgage lending?

In a broader sense, mortgage lending can present many types of risk for the enterprise as a whole, including credit, market, reputational, legal, and compliance risks.

Which one of the following is the risk associated with receiving a mortgage bond’s principal payments sooner than anticipated?

Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When prepayment occurs, investors must reinvest at current market interest rates, which are usually substantially lower. Prepayment risk mostly affects corporate bonds and mortgage-backed securities (MBS).