NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsMedium
A portfolio manager is constructing a diversified portfolio and is considering including a debt security that represents an ownership interest in a pool of mortgage loans. These securities often pay monthly interest and principal and are subject to prepayment risk. Which of the following best describes this investment?
- AGeneral Obligation Bond
- BCollateralized Debt Obligation (CDO)
- CAsset-Backed Security (ABS)
- DMortgage-Backed Security (MBS)
Show answer & explanationAnswer & explanation
Correct answer: D. Mortgage-Backed Security (MBS)
A Mortgage-Backed Security (MBS) is a debt security backed by a pool of mortgage loans. Investors receive monthly payments of principal and interest from the underlying mortgages and are exposed to prepayment risk, where homeowners refinance their mortgages early.
Why the other options are wrong
- A. General Obligation Bonds are municipal bonds backed by the taxing power of a government entity, not mortgage loans.
- B. CDOs are backed by a diverse pool of debt (e.g., corporate bonds, bank loans), not specifically mortgage loans.
- C. ABS are backed by various types of assets (e.g., auto loans, credit card receivables), but MBS are a specific type of ABS backed by mortgages.
Mortgage-Backed Security (MBS)
A debt security that is backed by a pool of mortgage loans, allowing investors to receive payments derived from the principal and interest paid by homeowners.
- Backed by a pool of mortgage loans
- Pays monthly principal and interest
- Subject to prepayment risk (mortgage refinancing)
- Issued by government agencies (e.g., Ginnie Mae) or private entities
Memory trick: Securitized debt bundles loans; MBS is 'Mortgage-Backed' special.