Loan-Backed Securities are types of investment securities that are backed by a pool of loans. They are designed to redistribute the cash flows from the underlying loans (such as mortgages) to investors. These securities effectively allow investors to fund collectively a variety of loans while also receiving regular payments derived principally from the borrowers’ repayments of interest and principal. Key types include:
Pass-Through Certificates (PTCs): These securities are a direct obligation of a pool of loans, typically mortgages, whereby the principal and interest payments collected from the borrowers are ‘passed through’ to the investors, typically after deducting administrative fees.
Collateralized Mortgage Obligations (CMOs): CMOs divide the mortgage pool into various groupings known as tranches, each with different interest rates, payment schedules and prioritization. Each tranche offers varying levels of risk and maturity.
Pricing and Risks
Payment for Loan-Backed Securities is heavily dependent on the inflow of payments from the underlying loan assets. Therefore, changes in borrowers’ repayment behaviors affect security stability and price. This becomes critically relevant during economic downturns when the rate of default or delayed payments may increase.
Investment risks usually associated with these securities include credit risk, liquidity risk, and the risk of price volatility due to changing interest rates.
Regulatory Environment
These financial instruments are governed by regulations that ensure proper functioning and disclosure. In the U.S., Loan-Backed Securities are primarily regulated under the Securities Act of 1933 and the Securities Exchange Act of 1934, and they are closely monitored by the Securities and Exchange Commission (SEC).
For further detailed legal guidance and investment analysis in loan-backed securities, reviewing the SEC’s Regulation on Mortgage-Backed Securities (MBS) PDF. and relevant laws like the Truth in Lending Act might be beneficial.
