1. MORTGAGE-BACKED SECURITIES
CHAPTER TWENTY
MORTGAGE-BACKED SECURITIES
Practical Investment Management
Robert A. Strong

2. The Mortgage Backed Securities Market
Outline
Mortgages
Types
Mortgage Mathematics
Mortgage Risk
The Mortgage Backed Securities Market
History
Types of Securities

3. Considerations in Pricing Mortgage Backed Securities
Outline
Considerations in Pricing Mortgage
Backed Securities
The Importance of Prepayment Rates
The PSA Convention
The Risks of MBS
The Risk of Collateralized Mortgage Obligations
The Risk of Stripped Mortgage Backed Securities

4. Introduction
A mortgage is a loan with real estate
as collateral. The lender, called the
mortgage originator, often charges
points as a fee for preparing and
placing the mortgage.
It is quite common for the lender to sell the mortgage to another party.
The homeowner may be unaware of this, as the lender normally continues to be the mortgage servicer.

5. Mortgages: Types
A fixed rate mortgage is one with payments
based on a set interest rate that does not change.
An adjustable rate mortgage (ARM), also
called a variable rate mortgage, has an interest rate that moves with some market interest rate, such as the Treasury bill rate.
Most ARMS have an annual reset to the
interest rate. Many also have either a cap or a floor on the interest rate.

6. Mortgages: Types
With a convertible mortgage, the borrower has the option to exchange it for a fixed rate at the prevailing ARM rate.
There are other mortgage arrangements:
biweekly - payments are due every two weeks
semi-monthly - payments are due two times each month
graduated payment - the monthly payments increase following a predetermined schedule

7. Mortgages: Types
shared appreciation - the borrower splits the rise in the value of the property with the lender in exchange for a reduced interest rate
reverse - the homeowner sells the property to a bank and receives monthly mortgage payments

8. Mortgage Mathematics Example :
A bank approves a prospective homeowner for a 30-year, $100,000 mortgage at an 8% annual rate.
 There will be 30×12 = 360 monthly payments at a
monthly interest rate of 8÷12 = %

9.  The monthly payment will be $733.76
Mortgage Mathematics
For an annuity:
C = the monthly payment
R = the monthly interest rate
N = the number of payments
where
So:
 The monthly payment will be $733.76

10. Mortgage Mathematics
If the borrower pays the bank $1,500 instead of $ for the thirteenth payment, how will the amortization schedule be affected?
The bank considers the extra $ the borrower paid a principal reduction, and the anticipated life of the loan will decrease.

11. Mortgage Risk
Default risk is the risk that the borrower is
unable or unwilling to repay the debt as agreed.
Interest rate risk is the risk that the general
level of interest rates rises, such that the value of the mortgage’s cash flow stream declines.
Prepayment risk is the risk of an early
payment of the original mortgage, such as when the home is sold or when the mortgage is refinanced at a lower rate.

12. The Mortgage Backed Securities Market
The Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), & the Federal Home Loan Mortgage Corporation (Freddie Mac) support the US mortgage market by providing liquidity, buying conforming mortgages from banks across the country for resale elsewhere.
The term mortgage-backed securities refers to all products based on mortgage loans.

13. A pass-through security is a share of a pool of mortgages.
Types of Securities
A pass-through security is a share of a pool
of mortgages.
Individual Individual Individual
Mortgages Mortgages Mortgages
Mortgage Pool
Pass-Through Security
The holders receive a monthly check for their
portion of the scheduled principal and interest payments, plus their share of any prepayments that may occur.

14. Types of Securities
Pass-through securities may be issued and guaranteed by a government agency, or they may be private label.
Two types of derivative securities that spring from pass-through securities are collateralized mortgage obligations and stripped mortgage-backed securities.

15. Types of Securities
A collateralized mortgage obligation (CMO) is
a security backed by a pool of mortgages and structured to transfer prepayment or interest rate risk from one group of security holders to another.
A given pool of mortgages backs two or more
classes of securities called tranches.

16. Collateralized Mortgage Obligation
Types of Securities
Collateralized Mortgage Obligation
Individual Individual Individual
Mortgages Mortgages Mortgages
Mortgage Pool
A Tranche B Tranche C Tranche Other Tranches

17. Types of Securities
Insert Table 20-3 here.

18. Types of Securities
With a sequential pay CMO, all the tranche
holders receive monthly interest payments based on the principal amount outstanding in their tranche.
All principal payments go to the A tranche
until the A tranche principal is completely returned. Only then will the investors in the next tranche begin to receive principal.

19. Types of Securities
Insert Table 20-4 here.

20. There are two types of stripped mortgage backed securities, or strips.
Types of Securities
There are two types of stripped mortgage
backed securities, or strips.
Individual Individual Individual
Mortgages Mortgages Mortgages
Mortgage Pool
Interest Only Security Principal Only Security
All the interest goes to the interest only (IO)
security holders, while the entire principal goes to the principal only (PO) holders.

21. Pricing Mortgage Backed Securities
Considerations in
Pricing Mortgage Backed Securities
The price risk of a MBS comes from the
uncertainty about the timing of cash flows.
Prepayments can affect the realized return on
a M BS substantially.
The offering memorandum for a M BS will
state the assumptions used in estimating cash flows from the mortgage pool.
A benchmark assumption for the rate of
mortgage prepayment is offered by the Public Securities Association (PSA).

22. Pricing Mortgage Backed Securities
Considerations in
Pricing Mortgage Backed Securities
Constant Prepayment Rate
The standard PSA assumption is that a 30-year mortgage will see prepayments of 0.2% for the first month and that prepayments will increase by 0.2% for each of the next 29 months, after which they remain constant.
The 0.2% per month prepayment assumption is called 100% PSA.

23. Pricing Mortgage Backed Securities
Considerations in
Pricing Mortgage Backed Securities
A MBS has default, interest rate, and prepayment risks.
Riskiness of Cash Flows
variable rate
non-callable
bond
fixed rate
principal only
security
interest
only
$ Amount
Unknown
Timing
Known

24. The Risk of Collateralized Mortgage Obligations
Declining interest rates will increase the
value of a cash flow stream and will lead to prepayments.
If a mortgage pool sells at a discount,
prepayments will increase the value of each of the tranches, with the higher duration tranches benefiting the most.
If the pool sells at a premium, then
prepayments will reduce everyone’s yield, with the effect most pronounced for the holders of the longer duration tranches.

25. The Risk of Stripped Mortgage Backed Securities
Prepayment has different consequences for
IO and PO strips. An extension of the mortgage decreases the value of the principal payments but increases the value of the interest payments.
Declining interest rates will increase the
value of a series of known cash flows, as well as the likelihood of prepayment. Normally, the prepayment effect overwhelms the interest rate effect.

26. The Risk of Stripped Mortgage Backed Securities
Insert Table 20-6 here.

27. The Risk of Stripped Mortgage Backed Securities
Insert Table 20-7 here.

28. The Risk of Stripped Mortgage Backed Securities
Insert Table 20-8 here.

29. The Risk of Stripped Mortgage Backed Securities
Insert Table 20-9 here.

30. The Mortgage Backed Securities Market
Review
Mortgages
Types
Mortgage Mathematics
Mortgage Risk
The Mortgage Backed Securities Market
History
Types of Securities

31. Considerations in Pricing Mortgage Backed Securities
Review
Considerations in Pricing Mortgage
Backed Securities
The Importance of Prepayment Rates
The PSA Convention
The Risks of MBS
The Risk of Collateralized Mortgage Obligations
The Risk of Stripped Mortgage Backed Securities