Legal Definitions - stripped mortgage-backed security

A stripped mortgage-backed security is an investment product created by taking a pool of mortgage loans and separating the future principal payments from the future interest payments. These two distinct streams of payments are then sold as individual investment products. Instead of receiving both principal and interest from a traditional mortgage-backed security, an investor in a stripped version receives either only the principal payments (known as a "principal-only" or PO strip) or only the interest payments (known as an "interest-only" or IO strip). This separation allows investors to target specific cash flow streams and manage their exposure to interest rate changes and mortgage prepayment risks.

• Example 1: An Investor Seeking Accelerated Principal Repayment

  Imagine an investor, Sarah, who believes that a significant drop in market interest rates is imminent. She anticipates that many homeowners will quickly refinance their mortgages to take advantage of lower rates, leading to a faster repayment of the original loan principal. To capitalize on this, Sarah invests in a principal-only (PO) stripped mortgage-backed security. This security entitles her to receive only the principal portions of the payments from the underlying pool of mortgages.

  How this illustrates the term: Sarah's investment is a stripped mortgage-backed security because she has chosen to receive only one component (principal) of the mortgage payments, rather than both principal and interest. Her strategy relies on the "stripping" of these payment streams, allowing her to benefit specifically from accelerated principal repayments.

• Example 2: A Fund Manager Hedging Against Rising Rates

  A large institutional fund manager, David, holds a substantial portfolio of traditional mortgage-backed securities. He is concerned about the potential for rising interest rates, which could cause homeowners to keep their existing mortgages longer, reducing the speed of principal repayment and potentially decreasing the value of his current holdings. To mitigate this risk, David purchases an interest-only (IO) stripped mortgage-backed security. This security pays him only the interest portions of the mortgage payments from its underlying pool.

  How this illustrates the term: David's investment is a stripped mortgage-backed security because he has isolated the interest component of the mortgage payments. If interest rates rise and homeowners pay interest for a longer duration, his IO strip would likely perform well, helping to offset potential losses in his other mortgage-related investments. This demonstrates how the separated payment streams can be used for specific investment or hedging strategies.

• Example 3: A Retirement Fund Targeting Long-Term Interest Income

  The managers of a retirement fund are looking for a stable, long-term income stream that is sensitive to interest rate movements. They project that interest rates will remain relatively stable or even increase slightly over the next decade, meaning homeowners will likely continue making interest payments on their mortgages for an extended period. The fund decides to invest in a diversified portfolio of interest-only (IO) stripped mortgage-backed securities.

  How this illustrates the term: By investing in IO strips, the retirement fund is specifically targeting the interest component of mortgage payments, which has been "stripped" away from the principal. This allows them to create an investment portfolio focused purely on receiving interest income, aligning with their long-term income generation goals and their outlook on interest rate stability.