Chapter 17

Mortgage-Backed Securities

FIXED-INCOME SECURITIES

Outline

• Definition and Typology

• Mortgage Pass-Throughs

• Collateralized Mortgage Obligations

• Stripped MBS

• Pricing of MBS

Issuers of Bonds Definition and Typology

• MBS are securities that are backed by the cash-flows of a mortgage or a pool of mortgages

• A mortgage is a loan secured by the collateral of some specified real estate property.

• MBS can be divided into three types – Mortgage pass-through securities– Collateralized mortgage obligations– Stripped mortgage-backed securities

• MBS are subject to prepayment – Prepayment can be triggered mainly by home sales, refinancings, and

defaults– For an investor prepayment risk is a serious issue as prepayment tends to

occur when interest rates go down, i.e., at times when re-investment opportunities in similar securities are not particularly attractive

Issuers of Bonds Mortgage Pass-Throughs

• Mortgage pass-throughs are the simplest form of MBS

• They represent shares of the underlying mortgage pool, which entitle the security holder to monthly cash-flows generated by the pool on a pro rata basis

• In the US, there exist two types of pass-throughs– Agency pass-throughs: mainly issued by three organizations, the

Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae).

– Non-agency (or simply conventional) pass-throughs

Issuers of Bonds Collateralized Mortgage Obligations

• Collateralized Mortgage Obligations (CMOs) differ from mortgage pass-throughs in that they are structured in maturity classes, called tranches

– All principal payments (regular principal payments as well as prepayments) are allocated to the first tranche until it is fully paid off

– Then, it is the turn of the second tranche, and so on

• Hence, prepayment risk is redistributed among the different tranches, the first tranche absorbing prepayment first

– Stripped MBSs are structured in two classes: an Interest Only class (IO) and a Principal Only class (PO)

– The IO class receives all interest payments while the PO class receives all principal payments

Issuers of Bonds Stripped MBS

• Stripped MBSs are structured in two classes: an Interest Only class (IO) and a Principal Only class (PO)

• The IO class receives all interest payments while the PO class receives all principal payments

• Stripped MBSs are highly sensitive to prepayment rates, and hence riskier than mortgage pass-throughs

• The higher the prepayment rate on the mortgage pool, the faster POs are paid off, that is the higher the price of POs, and the lower the total cash-flows received on IOs, that is the lower the price of IOs

Issuers of Bonds Pricing of MBS

• Complex because of the prepayment issue• Refinancings changes the composition of the pool

– Removes fast and capable refinancers from the pool at a faster rate than slow and less capable refinancers

– Therefore the pool will include a higher and higher proportion of slow refinancers over time

– This results in a decrease in the refinancing rate over time– This feature makes MBS path-dependent securities, as their price is dependent on

the past evolution of interest rates

• The valuation of a MBS with a MC method is a five-steps process

– Step 1: simulation of interest rate paths– Step 2: simulation of prepayment rate paths based on a dynamic prepayment model– Step 3: computation of the expected cash-flows along each path– Step 4: computation of the MBS price along each path– Step 5: computation of the MBS price as the average of its prices along each path