Download - Chapter17-Mortgage Based 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