Debating the Merits of Federal Agency Backed Mortgage Securities

A

Let's evaluate the statements made by Analyst A and Analyst B regarding federal agency-backed mortgage securities, specifically mortgage passthroughs and collateralized mortgage obligations (CMOs).

Statement by Analyst A: "Investors in mortgage pass-through securities backed by one mortgage pool have equal exposure to prepayment risk, whereas investors in the CMOs of one pool have different exposures to prepayment risk."

This statement is correct. In mortgage pass-through securities, investors receive a pro-rata share of the principal and interest payments from a pool of underlying mortgages. Therefore, all investors in a mortgage pass-through security backed by a single mortgage pool have equal exposure to prepayment risk. If some homeowners in the pool decide to prepay their mortgages, it affects all investors equally.

On the other hand, collateralized mortgage obligations (CMOs) are structured differently. CMOs divide the cash flows from the underlying mortgage pool into separate tranches with different risk and return characteristics. Each tranche has a different priority of receiving principal and interest payments. As a result, investors in different tranches of a CMO have varying exposures to prepayment risk. Some tranches may be more sensitive to prepayments, while others may be less affected.

Therefore, Analyst A's statement is correct.

Statement by Analyst B: "Investors in CMOs have greater protection against default risk than investors in mortgage pass-through securities due to additional credit enhancement."

This statement is incorrect. While CMOs can have additional credit enhancement measures compared to mortgage pass-through securities, it does not necessarily mean that investors in CMOs have greater protection against default risk.

Credit enhancement measures are designed to mitigate default risk by providing additional security to investors. These measures can include subordination of tranches, overcollateralization, and the use of reserve accounts. However, the effectiveness of credit enhancement depends on the quality of the underlying mortgages and the specific structure of the CMO. If the underlying mortgages default, the credit enhancement measures may not be sufficient to fully protect investors from default losses.

Mortgage pass-through securities also carry default risk, but it is important to note that they are typically issued or guaranteed by federal agencies such as Fannie Mae or Freddie Mac. These agencies have explicit or implicit government backing, which provides a level of credit support to the investors in mortgage pass-through securities.

Therefore, Analyst B's statement is incorrect.

In summary:

• Analyst A's statement is correct. Investors in mortgage passthrough securities backed by one mortgage pool have equal exposure to prepayment risk, whereas investors in the CMOs of one pool have different exposures to prepayment risk.
• Analyst B's statement is incorrect. Investors in CMOs do not necessarily have greater protection against default risk than investors in mortgage pass-through securities.

Based on this analysis, the correct answer is C. Neither analyst is correct.