Mortgage Backed Security

Asset-backed securities are bonds that are based on underlying pools of assets. A special purpose trust or instrument is set up which takes title to the assets and the cash flows are "passed through" to the investors in the form of an asset-backed security. The types of assets that can be "securitized" range from residential mortgages to credit card receivables.

The wonder of securization is that it takes a wide variety of formerly illiquid and directly held assets and makes them available to many investors in the form of asset-backed securities. This simple process can be applied to all sorts of cash flow producing assets. If a retailer needs cash, it securitizes part of its outstanding credit card balances from its customers into a "credit card receivables trust". An auto leasing firm takes the outstanding automobile lease balances and turns them into an "auto receivables trust". A bank takes a group of its higher quality customers and creates an "evergreen revolving financing trust" which constantly takes high quality receivables and finances them by issuing bonds from the trust.

Securitization of Financial Assets

GENERAL BACKGROUND

Mortgage backed (MBS) and asset backed (ABS) securitizations, or more generally, the securitization of financial assets (for purposes of this outline, Securitizations), is a form of structured finance initially developed in the early 1980's in MBS format. It matured in the late 1980's in both MBS and ABS formats and is now a $400 billion industry in the U.S. alone. In recent years, it has spread to Europe (the largest market outside the U.S.), Latin America and Southeast Asia (primarily Japan).

Virtually all forms of debt obligations and receivables (Receivables) have been securitized in the U.S.: residential mortgages; home equity loans; manufactured housing loans; timeshare loans; auto, truck, RV, aircraft and boat loans and leases; credit card receivables; equipment loans and leases; small business loans; student loans; trade receivables (just about any type, i.e., airline tickets, telecommunications receivables, toll road receipts); lottery winnings; and record album receivables (David Bowie and Pavarotti). Although the basic concepts, many based upon tax and accounting effects and desired results, are essentially the same, each asset class presents unique structuring considerations, and the players are constantly looking for ways to improve structures to achieve higher ratings (and thus lower costs) and reduced expenses. Securitizations outside the U.S. have been more limited because of certain impediments (discussed below). In Latin America the principal asset class securitized has been trade receivables (primarily the "future flow" from trade receivables, discussed in more detail below).

BASIC STRUCTURE

In its simplest form a Securitization involves (1) the sale of a large pool of Receivables by an entity (Originator) that creates such Receivables (or purchases the Receivables from entities that create them) in the course of its business to a "bankruptcy-remote," special purpose entity (SPE) in a manner that qualifies as a "true sale" (vs. a secured loan) and is intended to achieve certain results for accounting purposes, as well as protecting the Receivables from the claims of creditors of the Originator, and (2) the issuance and sale by the SPE (Issuer), in either a private placement or public offering, of debt securities (Securities) that are subsequently satisfied from the proceeds of and secured by the Receivables. When the Securitization is "closed," funds flow from the purchasers of the Securities (Investors - usually banks, insurance companies and pension funds) to the Issuer and from the Issuer to the Originator. All of these transactions occur virtually simultaneously.

In the United States, the Issuer in the basic structure is normally a trust (grantor, owner or business, depending upon the Originator's objectives and the structure), which issues Securities consisting of notes or other forms of commercial paper (Notes) and certificates evidencing an undivided ownership in the Issuer (Certificates). Frequently, there is also created a residual interest in the Issuer that entitles the holder (usually the Originator) to funds remaining after all obligations to the holders of the Notes and Certificates (Securityholders) have been satisfied. During the term of the Securitization, payments on the Receivables are collected by a servicing entity, usually the Originator (Servicer), deposited and invested (in "eligible securities") in various accounts under the control of a trustee (Trustee), and disbursed by the Trustee to the Securityholders in payment of the Securities.

In many instances a "two step" structure has been used whereby the Receivables are first transferred by the Originator to an intermediate SPE (Intermediate SPE) that is a wholly owned subsidiary of the Originator, but which is only permitted to engage in the business of acquiring, owning and selling the Receivables, has at least one independent director and is restricted in various ways from entering into voluntary bankruptcy and other prohibited acts. Frequently, this transfer is, at least in part, a contribution of capital by the Originator to the Intermediate SPE. In the second of the "two steps," the Intermediate SPE sells the Receivables to the Issuer. This structure is intended to enhance the "true sale" and "bankruptcy remote" characteristics of the transaction. That is, the transaction is structured to insure that the sale of Receivables to the Intermediate SPE is a "true sale" rather than a financing device, which is necessary for the Originator to get the Receivables off its balance sheet and book a profit or loss for accounting purposes and, combined with the second transfer by the Intermediate SPE to the Issuer, an essential part of the required protection from the claims of creditors, including by avoiding consolidation of the Receivables with the assets of the Originator in the event of the bankruptcy of the Originator. Beginning in 1997, a change in accounting rules in the U.S. pursuant to FASB 125 has virtually mandated the use of the two step structure to obtain an "isolation of assets" and, therefore, a "true sale," whenever the Originator retains an interest in the Securities issued by the Issuer (usually for credit enhancement purposes, as discussed below). However, it should be noted that in some cases the Originator does not want a true sale to occur (and book a gain or loss) and deliberately structures the transaction as a secured loan.

The above description of the Securitization structure is very basic. Actual structures involve many more elements and participants. The classes of assets also result in different and, in many cases, more complex structures. For example, in securitizing motor vehicle leases, to avoid the very high costs of multiple transfers of titles to the vehicles, a new structure was developed several years ago (in which the author of this outline participated) where the vehicles are initially titled in and the leases made through an "origination trust" and that trust then issues, in a series of complex transfers to other trusts, limited partnerships and limited liability companies, units and sub-units of beneficial interest in the trust which are actually the "receivables" that are securitized, the Securityholders having no interest, beneficial or otherwise, in the underlying vehicles or leases.

ADVANTAGES

The Securitization structure is intended to provide significant advantages to Originators, such as:

1. The Receivables are moved "off balance sheet" and replaced by a cash equivalent (less expenses of the Securitization), thus improving the Originator's balance sheet and resulting in gain or loss, which itself is usually an intended, beneficial consequence.

2. The Originator does not have to wait until it receives payment of the receivables (or, in a "future flow" securitization, until it even generates them) to obtain funds to continue its business and generate new Receivables. In many cases this is essential, and a role otherwise filled by more traditional methods of financing, including factoring (in some ways Securitization is a very sophisticated form of factoring). This is more significant when the Receivables are relatively long term, such as with real property mortgages, auto loans, student loans, etc., and not as significant with short term Receivables, such as trade and credit card Receivables.

3. The Securities issued in the Securitization are more highly rated by participating rating agencies (because of the isolation of the Receivables in a "bankruptcy-remote" entity), thus reducing the cost of funds to the Originator when compare to traditional forms of financing. In instances where the Receivables bear interest, there is usually a significant spread between the interest paid on the Securities and the interest earned on the Receivables. Ultimately, the Originator receives the benefit of the spread. In addition, the Originator usually acts as Servicer and receives a fee for its services.

4. In non-revolving structures, and those with fixed interest rate Receivables, assets and related liabilities can be matched, eliminating the need for hedges.

5. Because the Originator usually acts as Servicer and there is normally no need to give notice to the obligors under the Receivables, the transaction is transparent to the Originator's customers and other persons with whom it does business.

These advantages are tempered by the fact that the Securitization structure results in higher costs than traditional forms of financing, but this is more than offset by the advantages. However, these higher costs mean that the value of a pool of Receivables must be significant to justify Securitization. An offering of Securities in a Securitization should be valued at $30,000,000 or more and most are in excess of $100,000,000, a number even in excess of $1 billion. In fact, most Securitizations at the low end are not structured by the Originators, but use "conduit" Issuers maintained by banks and investment bankers. In these securitizations, Originators sell Receivables to conduits that aggregate Receivables from multiple Originators (even different forms of Receivables) to create large pools to support the Securities issued by the Issuer-conduit. Because the operators of the conduits keep a bigger share of the "pie," an Originator is usually better off structuring a Securitization that uses its own Issuer in a "stand-alone" Securitization when its pool of Receivables is sufficiently large.

MAJOR PLAYERS

The major "players" in the securitization game, all of whom require legal representation to some degree, are as follows (this terminology is typical, but different terms are used; for example the "originator" is often referred to as the "issuer" or "seller"):

Originator - the entity that either generates Receivables in the ordinary course of its business, or purchases and assembles portfolios of Receivables (in that sense, not a true "originator"). Its counsel works closely with counsel to the Underwriter/Placement Agent and the Rating Agencies in structuring the transaction and preparing documents and usually gives the most significant opinions. It also retains and coordinates local counsel in the event that it is not admitted in the jurisdiction where the Originator's principal office is located, and in situations where significant Receivables are generated and the security interests that secure the Receivables are governed by local law rather than the law of the state where the Originator is located.

Issuer - the special purpose entity, usually an owner trust (but can be another form of trust or a corporation, partnership or fund), created pursuant to a Trust Agreement between the Originator (or in a two step structure, the Intermediate SPE) and the Trustee, that issues the Securities and avoids taxation at the entity level. This can create a problem in foreign Securitizations in civil law countries where the trust concept does not exist (see discussion below under "Foreign Securitizations").

Trustees - usually a bank or other entity authorized to act in such capacity. The Trustee, appointed pursuant to a Trust Agreement, holds the Receivables, receives payments on the Receivables and makes payments to the Securityholders. In many structures there are two Trustees. For example, in an Owner Trust structure, which is most common, the Notes, which are pure debt instruments, are issued pursuant to an Indenture between the Trust and an Indenture Trustee, and the Certificates, representing undivided interests in the Trust (although structured and treated as debt obligations), are issued by the Owner Trustee. The Issuer (the Trust) owns the Receivables and grants a security interest in the Receivables to the Indenture Trustee. Counsel to the Trustee provides the usual opinions on the Trust as an entity, the capacity of the Trustee, etc.

Investors - the ultimate purchasers of the Securities. Usually banks, insurance companies, retirement funds and other "qualified investors." In some cases, the Securities are purchased directly from the Issuer, but more commonly the Securities are issued to the Originator or Intermediate SPE as payment for the Receivables and then sold to the Investors, or in the case of an underwriting, to the Underwriters.

Underwriters/Placement Agents - the brokers, investment banks or banks that sell or place the Securities in a public offering or private placement. The Underwriters/Placement Agents usually play the principal role in structuring the transaction, frequently seeking out Originators for Securitizations, and their counsel (or counsel for the lead Underwriter/Placement Agent) is usually, but not always, the primary document preparer, generating the offering documents (private placement memorandum or offering circular in a private placement; registration statement and prospectus in a public offering), purchase agreements, trust agreement, custodial agreement, etc. Such counsel also frequently opines on securities and tax matters.

Custodian - an entity, usually a bank, that actually holds the Receivables as agent and bailee for the Trustee or Trustees.

Rating Agencies - Moody's, S&P, Fitch IBCA and Duff & Phelps. In Securitizations, the Rating Agencies frequently are active players that enter the game early and assist in structuring the transaction. In many instances they require structural changes, dictate some of the required opinions and mandate changes in servicing procedures.

Servicer - the entity that actually deals with the Receivables on a day to day basis, collecting the Receivables and transferring funds to accounts controlled by the Trustees. In most transactions the Originator acts as Servicer.

Backup Servicer - the entity (usually in the business of acting in such capacity, as well as a primary Servicer when the Originator does not fill that function) that takes over the event that something happens to the Servicer. Depending upon the quality of the Originator/Servicer, the need and significance of the Backup Servicer may be important. In some cases the Trustee retains the Backup Servicer to perform certain monitoring functions on a continuing basis.

CREDIT ENHANCEMENT

Credit enhancements are required in every Securitization. The nature and amount depends on the risks of the Securitization as determined by the Rating Agencies, Underwriters/Placement Agents and Investors. They are intended to reduce the risks to the Investors and thereby increase the rating of the Securities and lower the costs to the Originator. Typical forms of credit enhancement are:

1. Over-collateralization - transferring to the Issuer, Receivables in amounts greater than required to pay the Securities if the proceeds of the Receivables were received as anticipated). The amount of over-collateralization (usually 5% to 10%) is determined by the Rating Agencies and the Underwriters/Placement Agents, and this in turn will depend upon the quality of the Receivables, other credit enhancement that may be available, the risk of the structure (such as the possible bankruptcy of the Originator/Servicer), the nature and condition of the industry in which the Receivables are generated, general economic conditions and, in the case of foreign-based Securitizations, the "Sovereign risk" (see discussion below under "Foreign Securitizations"). If all goes well, it is repurchased at the end of the transaction (see "Anatomy of a Securitization")or returned as part of the residual interest. This form of credit enhancement is required in virtually all Securitizations.

2. Senior/subordinated structure - issuance of subordinated or secondary classes of Securities, which are lower-rated (and bear higher interest rates) and sold to other Investors or held by the Originator. In the event of problems, the higher rated (senior) Securities receive payments prior to the lower rated (subordinated) Securities. It is not uncommon for there to be a number of classes of Securities that are each subordinated to the more highly rated, resulting in a complex "waterfall" of payments of principal and interest. In the common structure described above, senior and subordinated classes of Notes would be paid, in order of priority, prior to classes of Certificates, and Certificates prior to any residual interest in the Issuer. This form of credit enhancement has become routine, but cannot be used in a grantor trust structure, which is why the owner trust has become most common.

3. Early amortization - if certain negative events occur, all payments from Receivables are applied to the more senior securities until paid. Very common.

4. Cash collateral account - the Originator deposits funds in account with Trustee to be used if proceeds from Receivables are not sufficient. Adjustable depending upon events. May be in the form of a demand "loan" by the Originator to the account.

5. Reserve fund - subordinated Securities retained by the Originator or Trustee and pledged for the benefit of the Trust (and, therefore, the Investors).

6. Security bond - guarantee (or wrap) of all payments due on the Securities. Issued by AAA-rated monoline insurance companies (if available).

7. Liquidity provider - in effect, a guarantee by the Originator (or its parent) or another entity of all or a portion of payments due on the Securities.

8. Letter of credit (for portion of amounts due on Securities) - not used much anymore because of costs. These were common in the late 1980's when issued by Japanese banks at low rates.

LEGAL OPINIONS

Legal opinions are very important documents in every Securitization and result in considerable negotiations among counsel for the Originator, Underwriter/Placement Agent and Rating Agencies. The opinions given by the Originator's counsel are the most extensive, frequently running 50 or more pages because of the need for reasoned opinions, as courts have not ruled upon many of the underpinnings of the Securitization structure. In addition to the usual opinions regarding due organization, good standing, corporate power, litigation, etc, others deal with the validity and priority of security interests, true sale vs. secured loan, substantive consolidation in bankruptcy, fraudulent transfer, tax consequences and compliance with securities laws and ERISA. Opinions are also given by counsel for the Trustees and frequently by counsel to the Underwriter/Placement Agent in regard to tax and securities matters. As indicated above, local counsel opinions may be required as well.

For reasons of structuring and such opinions, in addition to attorneys who are experienced in Securitizations, expertise is required in the areas of securities law, tax law, bankruptcy and the UCC. Expertise is also required in many instances in the substantive laws relating the business of the Originator and the nature of the Receivables.

FOREIGN SECURITIZATIONS

This Securitization structure has presented problems in civil law-based countries, where the concepts of trust law have traditionally not existed. In addition, in many countries there are concerns about government intervention in the international flow of funds and other aspects of Securitizations, the ability of the Servicer and Trustee to enforce the collection of Receivables in a commercially reasonable manner, additional tax burdens, the unpredictable nature of courts and government instability. These are known as the "sovereign risk" and have either completely blocked in-country Securitizations or have resulted in ratings of the Securities no higher than the rating of the country. As a result, many Securitizations, particularly those involving Latin American originated Receivables, have used a structure where the Receivables are transferred to offshore entities ("offshore" may be in the U.S.) and the entire transaction takes place outside the country of origin.

This situation continues to prevail in most countries, but a few have adopted legislation to permit the limited use of trusts (Argentina and Brazil) or the creation of special purpose corporations to serve the same purpose (France). However, even where such legislation has been adopted, sovereign risk issues may prevent a Securitization that is able to take advantage of international money markets, particularly outside of Western Europe. Further, such legislation has often been incomplete or flawed. For example, Securitizations are rarely based in France because it decided it should impose a tax on the special purpose corporations permitted under the new law.

Nevertheless, economic and financial market conditions in many countries have provided strong incentives for Originators in countries such as Brazil and Argentina, and the non-US market is growing every year, although the Asian and South American markets are very difficult at this time. Moreover, because of a lack of experienced underwriters, trustees and attorneys in most countries, many such service providers have expanded into Europe and Latin America.

In Latin America, one of the most common asset classes is "future flow" receivables. In this type of Securitization, involving trade receivables of short duration, only a relatively small amount of existing Receivables are transferred to the Issuer and the Investors purchase Securities with a much higher face value based upon the subsequent transfer by the Originator to the Issuer of a "future flow" of Receivables to be generated by the Originator with the proceeds of the Securitization. In effect, the Originator receives payment for Receivables that do not exist, and will only come into existence through the future conduct of the Originator's business. Obviously, this can only be accomplished by Originators with strong track records and engaged in businesses with a high likelihood of continuing at profitable levels. In addition, it usually involves foreign Receivables that can readily be transferred and collected offshore. An example of this is the Securitization of airline ticket receivables by Varig.

How REMICs are constructed

Basic REMIC structure
A REMIC may include any number of classes of regular interests and must include a single residual interest class. These regular interest classes, or tranches, are identified by letters such as A class, B class, etc. These classes are assigned a coupon (fixed, floating, or zero interest rate), and the terms and conditions for payments to the investor. Often, one or more Z classes, which are similar to a zero coupon or accrual bond, are included as regular interest classes. The R class is the residual interest class.

In the simplest REMIC structure, principal on the regular classes is retired sequentially in alphabetical order. An investor in a regular class is paid interest calculated on the remaining principal balance of the class; however, principal repayments to an investor do not start until the previous class is retired or as described in the security's prospectus supplement. The final regular tranche to be paid is the Z, or accrual, tranche. This class receives no interest payment until certain other classes have been paid. Instead, the interest accrues and the balance of the Z tranche grows until all other priority classes have been paid in full.

Payments to owner
Generally, Fannie Mae REMICs pay investors monthly through the Federal Reserve Bank from the cash flows from the underlying MBS. Payments generally are paid to the REMIC "record holder," which usually is a financial institution such as a bank, brokerage firm, or security clearing organization, permitted to have accounts with Federal Reserve Banks. The individual owner of the REMIC certificate is the "beneficial owner." The record holder has the responsibility to establish and maintain accounts for and distribute funds to its customers.

Types of Mortgage-Backed Securities

The REMIC structure offers issuers a flexible tool with which to design tranches to meet investor needs and respond to market conditions. Certain REMIC tranches have been designed to reduce an investor's prepayment risk. The tranche types described below are defined according to general characteristics; however, investors should carefully evaluate how the security is likely to perform under a range of economic assumptions.

Sequential pay (SEQ) classes
Sequential pay classes are the most basic classes within a REMIC structure. They are also called Plain Vanilla, Clean Pay, or Current Pay classes. The principal on these classes is retired sequentially; that is, one class begins to receive principal payments from the underlying securities only after the principal on any previous class has completely paid off. The principal payments, including prepayments, are directed to the first sequential class (A) until it is retired, then the payments are directed to the next sequential class (B) until it is retired. The process continues until the last sequential pay class (C) is retired. While the class A principal is paying down, B and C class holders receive monthly interest payments at the coupon rate on their principal.

When prepayments are faster than the prepayment speed assumed when the security is purchased (at pricing), the principal is retired earlier than expected, thereby shortening the average life of the class. Changes in the average life of the class may affect the yield-to maturity of the bond. "Average life" represents the average amount of time that each principal dollar is expected to be outstanding. If the bond was purchased at a discount (below par), the shortened average life will increase the bond's yield-to-maturity. If the bond was purchased at a premium (above par), the shortened average life will decrease the bond's yield-to-maturity.

The opposite occurs when prepayments are slower than those assumed at pricing-the average life of a sequential pay class will extend. Under this condition securities purchased at a discount will produce a lower yield-to-maturity than anticipated at pricing, while those purchased at a premium will produce a higher yield-to-maturity.

Planned amortization (PACs) classes
PACs are designed to produce more stable cash flow by redirecting prepayments from the underlying securities to other classes called companion or support classes. The PAC investor is scheduled to receive fixed principal payments (the PAC "schedule") over a predetermined period of time (the PAC 94 "window") through a range of prepayment scenarios (the PAC "band"). The schedule will be met only if the underlying securities prepay at a constant rate within the range assumed for the structuring of the PAC. The initial or "stated" PAC band, principal payment schedule, and window of the PAC are set out in the REMIC prospectus supplement.

Cash flow variability from changes in prepayment speed of the underlying securities is redistributed among other classes, but it is not eliminated from the underlying securities as a whole. The integrity of the PAC schedule is directly influenced by the amount and structure of the companion classes, so it is essential to understand the nature of the companion classes in a particular issue when evaluating a PAC.

A REMIC may contain any number of PAC classes. When more than one PAC is present in a REMIC issue, the PACs are classified according to the relative width of their stated bands (e.g., PAC I, PAC II).

The underlying securities are not likely to prepay at a constant rate within the PAC band. The range of prepayment speeds that will in fact preserve the principal payment schedule may change from month to month ("PAC band drift"). The range of prepayment speeds that will maintain the principal payment schedule at any given time is the "effective band." The effective band changes because of the impact of prepayments on the support class(es) and on the amount of underlying securities available to produce principal cash flow. The effective band is more important to an investor than the stated band because it gives the investor an idea of the actual range of prepayment speeds that will protect the schedule.

Sustained periods of fast prepayments may completely eliminate a PAC's outstanding support class(es). When this occurs the PAC is called a "busted" or "broken" PAC. A busted PAC behaves like a sequential pay class and the investor is subject to the same yield fluctuations as a sequential pay class investor. On the other hand, when prepayments are very slow, there may not be enough cash flow to meet the PAC's schedule resulting in an extension of the average life of the class and a negative effect on the investor's yield.

Because PAC classes have less cash flow variability, their average lives and yields-to-maturity are more stable than other REMIC class types. They are priced to yield less than less stable REMIC classes such as sequential pay classes with similar average lives. In addition, all other things being equal, a PAC with a wide band should be priced to yield less than a PAC with a narrower band. Busted PACs are priced like sequential pay classes.

Targeted amortization (TACs) classes
TACs pay a "targeted" principal payment schedule at a single, constant prepayment speed. As long as the underlying securities do not prepay at a rate slower than this speed, the schedule will be met. TACs may provide protection against increasing prepayments and early retirement of the investment ("call" or "contraction" risk). In contrast, PACs offer investors both call and extension protection. In some cases, if prepayments increase, excess cash flow will be paid to companion classes and the TAC will pay principal according to the schedule given in the prospectus supplement. If prepayments are slow, the average life of the TAC will extend because there will be insufficient funds available to meet the principal payment schedule.

TACs are usually found in REMIC issues that have PAC classes and they may act as companion classes. The actual behavior of a TAC class depends on the amount and structure of the companion classes and whether or not PACs are present in the issue. The companion classes absorb the cash flow variability redistributed from both the PAC and TAC classes, while the TAC serves to absorb some of the cash flow variability directed away from PAC classes.

TAC investors can expect higher yields than PAC investors because TACs have more cash flow uncertainty and greater extension risk. TACs may be priced to yield less than SEQs because TACs may have more stable cash flow than SEQs.

Companion or support (SUP) classes
Prepayment variability from the underlying securities cannot be eliminated; it can only be redistributed. PACs, TACs, and other scheduled classes rely on companion classes to absorb this variability. Companion classes have the most volatile cash flow behavior, even more than the underlying MBS.

When prepayment speeds fluctuate, the average life of a companion class can change dramatically. Their average lives extend during periods of low prepayments and shorten during periods of faster prepayments. Principal cash flows are paid to any PAC, TAC, or other scheduled class in a REMIC issue before they are paid to companion classes. Any excess principal cash flow is used to pay down the principal on the outstanding companion class(es). If no companion class remains outstanding, then the principal cash flow is used to retire the PACs, TACs, and scheduled classes then outstanding, in order of their stated priorities, without regard to the principal repayment schedule for that class. On the other hand, when principal cash flow is slower than expected, companion classes may not receive any principal during that period.

Since the prepayment behavior of the underlying securities has a direct impact on a companion class, it is important to understand the nature of the underlying securities and how they may be expected to prepay. It is also important to understand the number and type of classes that the companion supports as well as the number of companion classes in a REMIC issue. The more classes that a companion supports, the more volatile its average life will be.

Companion class average lives and yields-to-maturity may vary widely over time. They are priced at a higher yield than more stable classes to compensate investors for that variability. However, if prepayments vary over time, this yield advantage may be lost. For example, faster-than expected prepayments will increase the actual yield-to-maturity on a companion class purchased at a discount, while slower-than-expected prepayments will decrease the actual yield on such a class.

Accrual (Z) classes
Z class investors receive no cash flow from the security until certain other classes are paid off. Unlike other classes that pay interest each month, interest that would have been paid is added to the principal balance of the accrual class until the applicable previous classes have paid off. Over time the balance grows and the interest earned, but not paid, is calculated upon this increasing balance. Once the previous classes have paid off, the class becomes an interest-paying amortizing class that pays down like a sequential pay class.

In this illustration, the Z class receives no principal or interest payment for the first 14 years. Instead, interest accrues and is added to the outstanding principal balance. After year 14, the Z class begins paying both principal and interest and the principal balance decreases.

Z classes are often the last regular class in a REMIC issue and have long average lives.

Interest only and principal only (IO/PO) classes
REMIC structures can contain two classes that resemble a stripped mortgage-backed security (SMBS). Each class receives a portion of the monthly principal or interest payments from the underlying securities by "stripping apart" the principal and interest cash flow streams. The underlying securities' scheduled principal amortization and prepayments go to the principal only (PO) class. The interest cash flow goes to the interest only (IO) class.

IOs and POs are complex securities that are extremely sensitive to interest rate changes because prevailing rates affect prepayments. Slower-than-expected prepayments (usually associated with rising interest rates) will have a negative effect on the yield of a PO class. Faster-than-expected prepayments (usually associated with falling interest rates) will have a negative effect on the yield of an IO class.

Because 10 classes will produce cash flow to the investor only if the underlying MBS have principal outstanding on which to base an interest calculation, in certain cases, the investor may receive less cash back than invested, resulting in an actual loss on the investment.

Floating-rate and inverse floating-rate (FLT/INV) classes
A floating-rate class (Floater) is structured so that the coupon rate payable to the investor adjusts periodically (usually monthly) by adding a certain amount (the spread) to a benchmark index (the index), subject to a lifetime maximum coupon (the cap). The one-month LIBOR (London Interbank Offered Rate) is the most popular index, but other indices such as the 11th District Cost of Funds Index (COFi) or various constant maturity Treasury indexes have been used.

Inverse floating-rate classes (Inverse Floaters) have coupon rates that periodically adjust in the opposite direction of the index. The coupon payable often is derived by subtracting a calculated amount from a given lifetime cap [i.e., Coupon Life cap - (Multiplier x Index)].

The yield of any Floater or Inverse Floater is sensitive to the rate of prepayments as well as the level of the applicable index, particularly if the coupon fluctuates as a multiple of the index (so-called Super Floaters). Low levels of the index will reduce the yield of a floating-rate class and the interest rate cap will limit the investor's yield when the level of the index is high. Because the rate of interest paid on an inverse floating-rate often varies inversely with a multiple of the index, any change in the index may have an exaggerated effect on the yield to the investor. High levels of the index will significantly lower the yield of an inverse floating-rate class because its interest rate can fall to 0 percent.

Moreover, changes in the level of the index may not correlate with changes in prevailing mortgage interest rates. Some indexes used for floating-rate and inverse floating-rate classes are more sensitive to fluctuations in short-term rates than others. LIBOR is very sensitive to short-term rates. Mortgage interest rates usually respond to longer term rate movements. It is possible that lower prevailing interest rates, which might be expected to result in faster prepayments, could occur at the same time as an increase in the level of the index. Under these high prepayment/high index situations, investors in inverse floating-rate classes may not recoup their initial investment, resulting in an actual loss on the investment.

Any REMIC issue that contains a Floater also contains an Inverse Floater tied to the same index. Together, the pair act as a companion class and together their cash flow behavior can be as volatile as a companion class. Once the previous classes have paid off or the specified event occurs, the Z class becomes an interest-paying amortizing class.

COMPARISON OF MORTGAGE SECURITIES CHARACTERISTICS

COMPARISON OF PASS-THROUGH MORTGAGE SECURITIES CHARACTERISTICS
SECURITY	GUARANTEE	MINIMUM INVESTMENT	PAYMENT DATE
GINNIE MAE I AND II	Full and timely payment of principal and interest, backed by the full-faith-and-credit guarantee of the U.S. government	$25,000 minimum; $1 increments	15th or the 20th of the month for Ginnie Mae I and II pools, respectively, following the record date and every month thereafter
GINNIE MAE PLATINUM	Full and timely payment of principal and interest, backed by the full-faith-and-credit guarantee of the U.S. government	$25,000 minimum; $1 increments	15th or the 20th of the month for Ginnie Mae I and II pools, respectively, following the record date and every month thereafter
FANNIE MAE MBS	Full and timely payment of principal and interest guaranteed by Fannie Mae	$1,000 minimum; $1 increments	25th of the month following the record date and every month thereafter
FREDDIE MAC PC (75-day PC)	Full and timely payment of interest and ultimate payment of principal guaranteed by Freddie Mac	$1,000 minimum; $1 increments	15th of the second month following the record date and every month thereafter
FREDDIE MAC Gold PC	Full and timely payment of interest and scheduled principal guaranteed by Freddie Mac	$1,000 minimum; $1 increments	15th of the month following the record date and every month thereafter
COMPARISON OF CMO/REMIC MORTGAGE SECURITIES CHARACTERISTICS
SECURITY	GUARANTEE	MINIMUM INVESTMENT	PAYMENT DATE
GINNIE MAE REMIC	Full and timely payment of principal and interest, backed by the full-faith-and-credit guarantee of the U.S. government	$1,000 minimum; $1 increments	16th or the 20th of the month for Ginnie Mae I and II collateral, respectively, following the record date and every month thereafter
FREDDIE MAC REMIC	Full and timely payment of interest and scheduled principal, guaranteed by Freddie Mac.	$1; $1 increments (most dealers, however, require a minimum investment of $1,000 or more)	15th of the month following the record date and every month thereafter
FANNIE MAE REMIC	Full and timely payment of interest and scheduled principal guaranteed by Fannie Mae (collateral of Fannie Mae "G" series is also backed by the full faith and credit of the U.S. government)	$1,000 minimum; $1 increments	18th or the 25th of the month following the record date and every month thereafter
AGENCY-BACKED, PRIVATE-LABEL CMO/REMIC	Collateral guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac. Structure provides basis for AAA rating, but these securities carry no explicit government guarantee; they are the sole obligation of their issuer	Varies	Varies; may be monthly, quarterly or semiannually; with or without payment delay
WHOLE-LOAN BACKED, PRIVATE- LABEL CMO/REMIC	Credit support provided by some combination of issuer or third-party guarantee, letter of credit, overcollateralization, pool insurance, and/or subordination. Generally rated AA or AAA	Varies	Varies; may be monthly, quarterly or semiannually; with or without payment delay

Glossary

Accrued Interest–Interest earned but not yet paid.

Adjustable-Rate Mortgage (ARM)–A mortgage loan with an interest rate and payments that are subject to change periodically over the life of the loan.

Amortize–To repay a mortgage loan through a series of periodic payments that cover both principal and interest.

Average Life–(see Weighted-Average Life.)

Book Entry–An electronic issuance and transfer system for securities transactions, such as those maintained by the Federal Reserve system. Unless otherwise stated in the prospectus supplement, Fannie Mae MBS are issued in book-entry form.

Call Risk–The possibility that prepayments will increase above an anticipated rate, causing earlier-than-expected return of principal, usually occurring during a time of falling interest rates.

Cap–The maximum rate of interest payable on an adjustable-rate security or mortgage loan.

Collateral–In the case of Fannie Mae MBS, assets that back the MBS.

Constant Maturity Treasury (CMT)–An index published by the Federal Reserve Board calculated from the average yield of a range of Treasury securities adjusted to constant maturities of various time periods (six months, one year, ten years).

Constant Prepayment Rate (CPR)–A prepayment measure calculated by assuming that a constant portion of the outstanding mortgage loans will prepay each month. See also PSA Prepayment Speed.

Cost of Funds index (COFi)–An index of the weighted-average interest rate paid by savings institutions for funds, usually by members of the 11th Federal Home Loan Bank District.

Coupon Rate–The stated annualized percentage rate of interest paid on an investment.

Credit Risk–The possibility that an issuer or another party may default on in its financial obligations to the investor, may have its credit rating downgraded by a rating agency, or may experience changes in the market's perception of its creditworthiness.

Current Face Value–The current amount of principal outstanding on a security, which is calculated by multiplying the original face value by the most recent factor.

CUSIP Number–A unique, nine-digit number assigned to each publicly traded security maintained and transferred on the Federal Reserve book-entry system.

Default–Failure to perform an obligation. (In the case of a note or mortgage loan, usually by nonpayment of principal and interest installments.)

Disclosure Documents–(See Prospectus and Prospectus Supplement)

Discount–The amount by which the purchase price of a security is less than its face value, which has the effect of raising the effective yield of the security above the coupon rate.

Distribution Date–The date on which payments from a security to an investor are made (usually the 25th of the month for Fannie Mae MBS).

Effective Yield–The annual return on an investment, which is calculated by dividing the coupon interest rate by the amount invested expressed as a percent of par value.

Extension Risk–The possibility that prepayments will be slower than an anticipated rate, causing later-than-expected return of principal. This usually occurs during times of rising interest rates.

Face Value–The principal amount of a security.

Factor–The decimal value, calculated monthly, that represents the proportion of the original principal amount outstanding at a given time.

Final Distribution Date or Maturity Date–The latest possible date on which an MBS receives payment. The actual final payment of any MBS will likely occur earlier, and could occur much earlier than the final distribution date or maturity.

Fixed-Rate Mortgage–A mortgage loan with an interest rate and payments that do not change over the life of the loan.

Floor–The minimum rate of interest payable on an adjustable-rate mortgage.

Index–A published interest rate used to determine the interest rate payable on an adjustable-rate mortgage.

Interest–The amount paid for the use of money, usually expressed as an annual percentage rate.

IO (Interest Only)–A security that pays the investor some or all of the interest payments on the underlying assets and little or no principal. Declining interest rates have an adverse effect on IOs.

Issue Date–The date as of which a security is originally formed.

LIBOR (London Interbank Offered Rate)–The interest rate charged among banks for short-term Eurodollar loans. A common index for adjustable-rate mortgages.

Liquidity–The capability of ready conversion of an asset or investment to cash.

Margin–The amount added to a reference index that is used to determine interest rate changes on an adjustable-rate mortgage.

Market Price–The current price of a security in the market.

Market Risk–The possibility that the price of a security will change over time.

Maturity Date–(see Final Distribution Date)

Mortgage–A pledge of real property as security for the repayment of a debt; the document that creates and represents the lien upon the real property that secures the debt.

Mortgage-Backed Security (MBS)–An investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay principal and interest on the MBS.

Option Risk–The possibility that a borrower may prepay a mortgage in a time frame that adversely affects the investor's yield.

Original Face Value–The original principal amount of a security on its issue date.

PO (Principal Only)–A security that usually does not bear interest and is entitled to receive only payments of principal from the underlying assets. Rising interest rates will have an adverse effect on POs.

Pool–A group of mortgages backing an individual MBS issue.

Premium–A price in excess of 100 percent of face value.

Prepayment–The unscheduled payment of all or part of the outstanding principal of a mortgage loan, including voluntary payments by the borrower as well as liquidations from foreclosures, condemnations, or casualty.

Prepayment Risk–The possibility that the mortgages underlying the security are repaid faster or slower than expected.

Price–The amount paid for a security, usually stated as a percentage of its face value. A par price is 100 percent, a premium price is higher than par, and a discount price is lower than par.

Principal–The remaining balance of a security or loan, exclusive of accrued interest.

Prospectus and Prospectus Supplement–The legal documents that outline all material details of an investment.

PSA Prepayment Speed–A measure of the rate of prepayment of mortgage loans developed by the PSA. This model represents an assumed rate of prepayment each month of the then-outstanding principal balance of a pool of new mortgage loans. A 100 percent PSA assumes prepayment rates of 0.2 percent per annum of the then unpaid principal balance of mortgage loans in the first month after origination and an increase of an additional 0.2 percent per annum in each month thereafter (for example, 0.4 percent per annum in the second month) until the 30th month. Beginning in the 30th month and in each month thereafter, 100 percent PSA assumes a constant annual prepayment rate (CPR) of 6 percent. Multiples are calculated from this prepayment rate; for example, 150 percent PSA assumes annual prepayment rates will be 0.3 percent in month one, 0.6 percent in month two, reaching 9 percent in month 30, and remaining constant at 9 percent thereafter. A zero percent PSA assumes no prepayments.

Public Securities Association (PSA)–The national trade association of banks, dealers, and brokers that underwrite, trade, and distribute mortgage-backed securities, U.S. government and federal agency securities, and municipal securities.

Record Date–The date used to determine the owner of a security for purposes of distributing the next scheduled payment.

REMIC (Real Estate Mortgage Investment Conduit)–A multiple-class mortgage cash flow security.

Scenario Analysis–An examination of expected investment performance over a variety of assumed economic conditions.

Secondary Mortgage Market–The market in which existing mortgages or mortgage securities are bought and sold.

Settlement Date–The date of the delivery of and payment for a security.

Stripped Mortgage-Backed Security (SMBS)–A mortgage security that separates principal and interest payments from the underlying mortgage-backed securities.

Weighted-Average Coupon (WAC)–The weighted average of the interest rates on the mortgage loans underlying an MBS.

Weighted-Average Life (WAL)–The average amount of time that will elapse from the date of a security's issuance until each dollar of principal is repaid to the investor. The weighted-average life of an MBS is only an assumption. The average amount of time that each dollar of principal is actually outstanding is influenced by, among other factors, the rate at which principal, both scheduled and unscheduled, is paid on the mortgage loans underlying the MBS.

Weighted-Average Maturity (WAM)–The weighted average of the remaining terms to maturity (expressed in months) of the mortgage loans underlying the MBS.

Yield–The rate of return on an investment over a given time, expressed as an annual percentage rate. Yield is affected by the price paid for the investment as well as the timing of principal repayments.

Yield-to-Maturity–The annual percentage rate of return on an investment, assuming it is held to maturity.