Suppose that 8% coupon pass-throughs are stripped into two classes. Class X-1 receives 75% of the principal and 10% of the interest. Class X-2 receives 25% of the principal and 90% of the interest. Answer the below questions

Question

What type of MBS would this be?

Answer 1

The stripped MBS described in the question is a synthetic-coupon pass-through with each class receives an unequal distribution of principal and interest. More details are given below.

Stripped mortgage-backed securities (MBSs), introduced by Fannie Mae in 1986, are another example of derivative mortgage products. A pass-through divides the cash flow from the underlying pool of mortgages on a pro rata basis across the security holders. A stripped MBS is created by altering the distribution of principal and interest from a pro rata distribution to an unequal distribution. Some of the securities thus created will have a price-yield relationship that is different from the price-yield relationship of the underlying mortgage pool. There are three types of stripped MBS: (i) synthetic-coupon pass-throughs, (ii) interest-only/principal-only securities, and (iii) CMO strips.

The first generation of stripped mortgage-backed securities is called synthetic-couponpass-throughs. This is because the unequal distribution of coupon and principal results in a synthetic coupon rate that is different from that of the underlying collateral. In the example above, each class receives an unequal distribution of coupon and principal. Thus, they are synthetic-coupon pass-throughs.