Derivatives created from pools of home mortgages have gotten some investors into trouble this year. Two of the most volatile mortgagebacked derivatives are the interest-only security and the principal-only security.

Both types are frequently derived from simpler mortgage-backed securities and are sold at a deep discount to face value.

A simple mortgage-backed security passes through payments from an underlying pool of mortgages. As home owners make their scheduled monthly payments of principal and interest, the funds go into the pool and the money is passed on to security holders. An interest-only security receives only the interest payments in the pool. The price of the security is the current value of that stream of interest. Since the interest will be paid over time, the sum is discounted to its present value. The interest-only security is a wasting asset, losing value over time. It never receives principal repayments, even at maturity. Once its holder has received all of the interest to be paid on the mortgages, the security is worthless.

The mortgage pools are usually backed by some form of credit enhancement, so default risk is minimal. But the market value of an interestonly security is highly dependent on the rate at which the mortgages are refinanced.

When interest rates drop, home owners retire their existing mortgage loans and take out new ones. When an existing loan is retired, the expected stream of interest payments vanishes.

The interest-only security is based on a pool of mortgages, so the effect of one refinancing is minimal. However, as more and more home owners retire their old loans, the amount of interest from the pool keeps shrinking.

The price of an interest-only security reflects the market's current estimate of the refinancing rate in the future. But home owners' actions have defied predictions on more than one occasion, causing the value of the securities to drop precipitously.

A principal-only security receives only the principal payments from the pool. Since even a refinancing home owner has to pay back the full principal amount, the security will always receive a preset, predictable amount of cash -- eventually.

Timing is the key variable for the principal-only security. If the home owners refinance rapidly, the security gets paid back sooner.

That enhances the return, since the security was priced at a deep discount with the expectation that payments would come m slowly.

But if rates rise, home owners stop refinancing and the payments dribble in.

To smooth out some of the volatility in mortgage-backed pass-throughs and derivatives, firms concocted more finely sliced securities.

Known as planned amortization classes, the securities do not strictly divide pnncipal and interest payments among different securities. Instead, all paymems into the pool during a certain period go to a particular class.

But the actions of home owners are still unpredictable. Where does all that unpredictabihty, and volatility, go when planned amortization classes are sold?

It resides in securities made up of the leftovers. These securities, known as Z-class bonds and sometimes called kitchen-sink bonds, are paid after all the planned amortization classes get their due.

Valuing a Z-class security taxes the limits of technology. In some cases, the value of a Z-class security can only be determined by valuing the entire Underlying pool of mortgages and subtracting the value of the basic securties. The remainder is the value of the Z-class bond.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.