Legal Definitions - SMBS

SMBS stands for Stripped Mortgage-Backed Security.

A Stripped Mortgage-Backed Security (SMBS) is a type of investment created from a pool of residential or commercial mortgages. Unlike a standard mortgage-backed security where investors receive a share of both the principal and interest payments from the underlying loans, an SMBS separates these two components into distinct investment products.

This means an investor can purchase a security that entitles them exclusively to either:

• the principal payments from the mortgages (known as a Principal-Only or PO strip), or
• the interest payments from the mortgages (known as an Interest-Only or IO strip).

This "stripping" allows investors to tailor their investments to specific risk appetites and market expectations regarding interest rates and mortgage prepayment speeds.

Examples:

• Pension Fund Seeking Stable Income: A large pension fund, responsible for paying out regular benefits to retirees, might invest in an Interest-Only (IO) SMBS. This security provides a steady stream of interest payments as long as the underlying mortgages are active. The fund is primarily interested in generating consistent cash flow to meet its long-term obligations, making the predictable interest income from an IO strip a suitable choice, rather than focusing on the timing of principal repayments.

  How it illustrates SMBS: The pension fund is specifically choosing to receive only the interest portion of the mortgage payments, which has been separated from the principal component, demonstrating the "stripped" nature of the security.

• Hedge Fund Speculating on Prepayments: A hedge fund anticipates that a significant drop in market interest rates is imminent, which would likely lead many homeowners to refinance their mortgages quickly. To capitalize on this, the hedge fund might purchase a Principal-Only (PO) SMBS. If interest rates fall as expected, the accelerated refinancing activity would cause the underlying mortgages to be paid off faster than anticipated, thereby accelerating the principal payments to the PO strip holders and potentially generating a higher return for the hedge fund.

  How it illustrates SMBS: This example shows an investor focusing solely on the principal component of the mortgage payments, betting on its accelerated repayment due to specific market conditions, which is the core characteristic of a PO strip SMBS.

• Individual Investor with Interest Rate Outlook: An experienced individual investor believes that interest rates will remain stable or even rise slightly over the next few years, making it less likely for homeowners to refinance their mortgages early. Based on this outlook, the investor might consider an Interest-Only (IO) SMBS. If interest rates remain high, the underlying mortgages will stay outstanding for longer, ensuring a prolonged stream of interest payments to the IO strip holder. The investor benefits from the extended duration of these interest payments, which would otherwise be cut short by rapid prepayments.

  How it illustrates SMBS: Here, the investor is specifically targeting the interest component of the mortgage payments, aligning their investment strategy with their forecast for interest rate stability and the resulting extended duration of interest income, which is precisely what an IO strip offers.