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Mortgage-Backed Securities

PRIMER

Introduction to Mortgage-Backed Securities (MBS)


and Other Securitized Assets

Executive Summary
A large and diverse market
The US mortgage market, with $7.2 trillion in mortgage-related debt outstanding, has developed into one
of the largest segments of the US bond market, surpassing both the US Treasury and US corporate sectors.1
The MBS sector offers investors diverse investment options and tools for evaluating mortgage securities.

Mortgage passthrough securities


Agency mortgage passthrough securities, issued by US Federal Housing Agencies, are the most common
type of mortgages. Agencies create pools of mortgages by purchasing mortgage collateral and
repackaging it for resale in the securities market. The cash flows of the underlying mortgages in the pool
‘pass through’ to the holders of the mortgage securities. Cash flows are based on the interest rates,
maturities and payment schedules of the underlying mortgages.

One of the most important aspects of the underlying mortgage is the embedded prepayment option,
where the buyer can accelerate the prepayment of principal beyond what is set by the payment schedule.
Since borrowers will tend to prepay in falling rate environments, and they ultimately benefit at the
expense of the lender, the prepayment option exposes the mortgage securities holder to risks associated
with changing prepayments rates. Mortgage passthrough securities are also subject to additional risks,
such as interest rate risk, spread risk and model risk.

When valuing a mortgage, it is critical to consider its underlying prepayment option. To most accurately
determine the value of mortgage securities, the option-adjusted spread model was developed. This
valuable tool takes into account the embedded option.

Diversity of investment options


The introduction of collateralized mortgage obligations (CMOs) in the early 1980s widened investor
participation in the mortgages market by creating securities with a broad range of risk/return profiles.
Other investment options introduced to the mortgage/securitized market were commercial mortgage-
backed securities (CMBS) and asset-backed securities (ABS). CMBS, which are backed by pools of
commercial mortgage loans, differ from agency passthroughs in prepayment risk and structure. ABS
differ from traditional residential mortgages, as their cash flows tend to be much less sensitive to interest
rates and are, thus, more stable.

Why include securitized assets in a US Treasury portfolio?


We believe investors have the opportunity to significantly improve their risk/return profile by strategically
allocating a portion of their portfolio to the MBS/securitized sector for two important reasons:
1) the historically attractive risk/return profile of the securitized sector and attractive yield opportunities
relative to Treasuries and 2) the diversification benefits from introducing new sources of risk and
potential return to the portfolio.

1 As of December 2007. Includes GNMA, FNMA and FHLMC mortgage-backed and CMOs and private label MBS/CMOs.
Introduction to Mortgage-Backed Securities and Other Securitized Assets

Milestones in the Mortgage Market


1930s
Prior to the mid 1930s, most mortgages were balloons with the entire principal due at once. During the Great
Depression, these mortgages were adversely affected by the lack of liquidity in the capital markets and contributed to
the high level of defaults.

1934
Congress passes the National Housing Act. This act establishes the Federal Housing Authority (FHA) and what is to
become the Federal National Mortgage Association (Fannie Mae). FHA is intended to provide mortgage insurance and
FNMA to provide liquidity to the mortgage market.

1968
Federal National Mortgage Association breaks into Fannie Mae and the Government National Mortgage Association
(Ginnie Mae). Fannie Mae becomes privately owned, while Ginnie Mae is wholly owned by the US government.

1970
US government establishes Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae starts its mortgage
passthrough program.

EARLY 1980s
First collateralized mortgage obligation (CMO) deals are issued.

1986
Lehman Brothers launches the Aggregate Index that includes MBS Agency passthroughs for the first time. The initial
market capitalization of these mortgages is $300 billion.

1992
Lehman Brothers adds asset-backed securities (ABS) to the Aggregate Index.

Late 1990s
The ease of refinancing via the internet leads to more rapid refinancing.

1999
Lehman Brothers adds commercial mortgage-backed securities (CMBS) to the Aggregate Index.

2003-2006
A boom in housing market and strong originations lead to rapid growth of the mortgage market. The mortgage market
reaches $6.5 trillion in 2006.

2007
Lehman Brothers adds adjustable rate mortgages (ARMs) to the Lehman Aggregate Bond Index.

2008
The market capitalization of passthroughs in the Lehman Brothers Aggregate index is $3.7 trillion, the largest component
of the Index. The overall mortgage market (including Agency and Non-agency mortgages) surpasses $7 trillion.

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should
not be construed as research or investment advice. Please see additional disclosures.

2 | Goldman Sachs Asset Management


Introduction to Mortgage-Backed Securities and Other Securitized Assets

I. Introduction and Historical Perspective


Prior to the 1970s, the What is a mortgage?
mortgage market was
A mortgage loan is a debt instrument by which a borrower gives the lender a lien on real property as
largely a primary market.
security for a repayment of the loan. The borrower has the use of the property and the lien is removed
During the 1970s, the US when the obligation is fully paid.
government established an
active secondary market by What is a mortgage-backed security?
introducing securitization. Mortgage-backed securities (MBS) are bonds that are secured by a collection of underlying mortgage
This development led to loans. The mortgage payments of the individual real estate assets are used to pay interest and principal
significant growth in the on the bonds.
market’s size and the
The development of today’s mortgage-backed securities market
diversity of securities
available for investment. Prior to the 1970s, the US mortgage market was largely a primary market. Financial institutions, such
as thrifts and commercial banks, would make residential loans directly to individuals and then hold
these mortgages on their balance sheets until maturity. Due to the lack of a robust secondary market,
individual financial institutions were limited in the number of mortgages they could extend and this, in
turn, limited the size of the overall mortgage market.

Financial institutions were restricted in mortgage lending in terms of their level of capital and risk in
their loan portfolio. For instance, since many thrifts were local in nature, collecting deposits from a
local community and making loans to this same community could create imbalances. If in aggregate,
the community wanted to borrow more than save, the thrift would not be able to meet the demand for
mortgages and not everyone would be able to borrow. Also, if a bank thought that its portfolio had
become too risky due to either credit or liquidity concerns, the bank might choose to reduce this risk by
extending fewer mortgages.

During the 1970s and 1980s, the US government, through its agencies and enterprises, began to
establish an active secondary mortgage market by introducing the concept of securitization. The
agencies would pool individual residential mortgage loans originated by the private sector, issue
securities against the pool and provide some guarantee for the payments expected from these securities.
These newly created securities were called mortgage passthrough securities.

The introduction of securitization provided great benefits to the marketplace. On the supply side, it
provided greater flexibility to financial institutions originating mortgage loans by removing the
constraints mentioned earlier. On the demand side, it introduced many new investors, such as pension
funds, to the mortgage marketplace. These benefits helped the market grow significantly in size and
diversity of securities since the 1970s. Alongside this growth, there have been significant developments
in the investment technology used to value these securities and measure their risk.

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

II. The US Agencies and their Role in the Mortgage Market


The Government National Three US Federal Housing Agencies account for nearly all the mortgage passthrough issuance in the US
Mortgage Association mortgage market. These agencies are formally known as the Government National Mortgage Association
(GNMA), the Federal (GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage
Corporation (FHLMC), though they are usually referred to by their nicknames. GNMA differs from
National Mortgage
FNMA and FHLMC in several important ways.
Association (FNMA) and
the Federal Home Loan Year
Formal Name Nickname Abbreviation Established Tie to Federal Government
Mortgage Corporation
Government National Ginnie Mae GNMA 1968 Backed by full mortgage faith
(FHLMC) are the main Association and credit of the US Government
government issuers of
Federal National Fannie Mae FNMA 1938 Line of credit
mortgage passthroughs. Mortgage Association to the US Treasury

Federal Home Loan Freddie Mac FHLMC 1970 Line of credit


While GNMA is explicitly Mortgage Corporation to the US Treasury
backed by the full faith This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should
and credit of the US not be construed as research or investment advice. Please see additional disclosures.
Source: Goldman Sachs Asset Management
government, FNMA and
FHLMC are not. FNMA Explicit versus implicit backing of the US federal government
and FHLMC only have an
First, while GNMA is explicitly backed by the full faith and credit of the federal government, the other
implicit backing from the two agencies are not. FNMA and FHLMC only have the implicit backing of the federal government.
US government. This difference is very important and in recent years the marketplace has become more focused on its
practical implications. If, due to some financial crisis, GNMA were hampered from honoring its
guarantees, the law would require that the federal government honor the agency’s obligations for them.
The federal government does not have such an explicit legal responsibility in the case of FNMA or
FHLMC. However, many marketplace participants believe that although there is not an explicit
obligation, the federal government would nonetheless take action in a crisis, since these two agencies
are so important to the mortgage market and the US economy.

Agencies as quasi-public corporations


Second, GNMA is a public federal agency whereas FNMA and FHLMC are federally chartered,
publicly owned corporations. This means that one of FNMA’s and FHLMC’s primary goals is to
produce a profit for shareholders. These two agencies are accountable, not only to the federal
government, but also to their shareholders.

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

III. Mortgage Passthrough Securities


Agency mortgage passthrough securities are the most common type of mortgage and represent one of
the largest capital markets in the world. To gain a better understanding of how these securities behave,
it is useful to study the characteristics of the underlying mortgage loans.

The creation of mortgage passthroughs


As outlined earlier, the agencies create passthrough securities by securitizing residential mortgages. The
agencies create pools of mortgages that are underwritten by the private sector and provide a credit
enhancement to these pools. The diagram below illustrates the flow of this process.

Individual Home Mortgage Deed Financial Institution US Agency Investor

쑺쑺 쑺쑺 쑺쑺 쑺쑺

Mortgages are Two mortgage loan Commercial banks, GNMA, FNMA and Pools of individual
loans secured by structures are most savings and loans and FHLMC are mortgages, now
real property. common: insurance companies governmental packaged in a
100% of the Fixed Rate and lend money agencies that provide standard, diversified
collateral consists Adjustable Rate. collateralized by the liquidity and credit form, are sold to
of residential real property directly to enhancement in the institutional investors.
In both cases, the home owner. mortgage market. These include
estate, with single principal and interest
family homes They purchase pension funds, banks,
are typically repaid in conforming mortgage governments,
representing 70% of equal installments
the total. collateral and corporations and
over 15-30 years. repackage it for insurance companies.
resale in the
securities market.

The resulting passthrough securities represent a pro-rata share of the underlying pool of individual
mortgages and receive a proportionate amount of the pool’s net cash flows. These cash flows are the
payments made by borrowers into the pool less the fees associated with servicing (the processing of the
mortgage payments), agency guarantees and any other costs. These resulting cash flows ‘pass through’
to the holders of the mortgage securities.

Mortgage characteristics
To understand how these cash flows behave and, consequently, how the passthrough security behaves,
it is helpful to understand the structure of the underlying mortgages in the pool. The agencies have
simplified their passthrough securities by only pooling together mortgages with similar structures. This
underlying homogeneity eases some of the complexity in analyzing these securities and this
simplification has led to increased trading and market liquidity.

Rate
Mortgages may have either a fixed rate or a floating rate. A fixed rate mortgage charges a fixed rate of
interest over the life of the mortgage, while a floating rate mortgage does not. The interest charged on a
floating rate mortgage will reset periodically according to some preset formula. The formula used to
determine the newly set rate is usually a fixed basis point spread over the yield of a specified short debt
instrument (e.g., Treasury bill rate or LIBOR rate).

Another important attribute of a mortgage is the interest rate that the borrowers pay. The coupon of
the passthrough security will be a function of the interest that the borrowers are paying less the fees
mentioned earlier. The higher the interest rate, the higher the coupon the investor in the passthrough
will receive. When the agencies pool the individual mortgages, they will ensure that only mortgages
with approximately similar interest rates are aggregated in the same pool.

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

To understand how an One widely used measure of the interest rate paid by the underlying mortgages is the weighted
Agency passthrough average coupon (WAC). This measure is the interest rate of each individual mortgage weighted by its
behaves, an investor outstanding balance. The coupon represents the interest that flows through to the passthrough investor
(the WAC less any fees). Depending on the level of the coupon relative to the market, the bond will
should be familiar with
either be trading at a premium, at par or at a discount.
the underlying mortgage
loans. Some important Level of the Coupon Price Name

characteristics of the Above the Market Premium (above $100) Premium Coupon

individual loans are: At the Market Par ($100) Current Coupon

• Fixed or floating Below the Market Discount (below $100) Discount Coupon
interest rate charged to Source: Goldman Sachs Asset Management
the borrower
Bonds that are trading very close to par (typically with coupons either 100 bps below or 50 bps above
• Term or maturity (15- the current coupon) are often referred to as cusp coupons. Given the relatively small changes in rates,
year and 30-year their prepayment speeds can change significantly.
maturities are most
Term
common)
Another important feature of a mortgage is its term (also called maturity) and its payment schedule
• Payment schedule over
over its term. The most common mortgage terms are 15-year and 30-year. When creating a passthrough
the term
security, the agencies will only pool mortgages with similar terms together.
• Prepayment option
Payment schedule
When a fixed rate mortgage is originated, a set payment schedule is established. Most mortgages do not
have a single bullet payment of principal at maturity, but rather, are amortizing. These amortizing
mortgages will pay back principal over the entire life of the loan. Another market convention is that the
payments on the fixed rate mortgage are constant over time–that is, all the periodic scheduled payments
are an equal dollar amount.

Each payment will represent interest on the outstanding principal and a paydown of principal.
Payments made early in the life of the mortgage will represent mostly interest, as the outstanding
principal is high. Payments made late in the life of the mortgage will represent mostly principal, as the
outstanding principal is much lower. The figure below illustrates how the composition between interest
and principal varies over time for the net cash flows of a mortgage pool with no prepayments.
Payments on a Pool of 30 Year 8% $100,000 Mortgages with no Prepayments

$800

$700 Interest
Principal
$600

$500
Payment

$400

$300

$200

$100

0
0 5 10 15 20 25 30
Years

For illustrative purposes only.


Source: Goldman Sachs Asset Management

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

Prepayment options
One of the most critical aspects of the underlying mortgages is the embedded prepayment option. Each
individual borrower has the option to accelerate the payment of principal beyond what is required by
the set payment schedule. When exercising this option, the borrower has the right to pay down a
portion of the outstanding principal or all of the outstanding principal. These prepayments can occur
for a number of reasons:
• Buyer sells home: If a home owner chooses to relocate to another home, the owner will probably sell
his current house and entirely prepay the home’s current mortgage. The one exception to this occurs
when the mortgage is ‘assumable.’ With an assumable mortgage, the buyer can assume the
obligations of the previous mortgage. The mortgage, along with the house, is passed from the seller
to the new buyer. This assumption option is particularly attractive when rates have risen and the
property has not appreciated significantly. Only Federal Housing Administration (FHA) or the
Veterans Administration (VA) loans securitized by GNMA passthroughs have this assumable option.
• Buyer refinances: When rates fall, a home owner will consider closing his current mortgage and
taking out a new mortgage at a lower rate.
• Borrower defaults: In a passthrough security, any defaults will be treated as prepayment of principal
that is guaranteed by the agencies. The impact of these defaults is relatively small.

Quantifying prepayments: CPR and PSA

One of the most For a pool of mortgages, the level of prepayments is typically based on housing turnover or, in falling
critical aspects of the
rate environments, refinancing activity. One of the most widely used measures to quantify the impact of
prepayment is the Constant Prepayment Rate (CPR). This metric expresses prepayments on an
underlying mortgages
annualized basis as a percentage of principal outstanding. For instance, if the historical CPR were 5%
is the embedded over the past two years, this means that each year the borrowers prepaid 5% of the outstanding
prepayment option, principal in addition to the scheduled principal payments. CPR can be used to quote realized historical
which allows a experience or to quantify future expected experience.
borrower to accelerate
Another prepayment measure sometimes used by the market is the Public Securities Association (PSA)
the payment of standard. This measure, developed in the mid 1980s, was designed to reflect the gradual ramp-up in
principal beyond what mortgage prepayments experienced by new mortgages, an effect called seasoning. Newly issued
is required. mortgages tend to have lower initial prepayments because new home owners will usually live for several
years in a house before moving. However, after several years, the expected housing turnover
experienced by the pool will rise as people may move to larger houses or to a new community, and
prepayments will rise accordingly.

CPR Vector Implied by Different PSA Levels

10
150% PSA
8

6 100% PSA
CPR (%)

4
50% PSA
2

0
0 60 120 180 240 300 360
Months

Source: Goldman Sachs Asset Management

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

The embedded option is The benchmark PSA curve, or 100% PSA, assumes that the CPR gradually ramps up from 0% to 6%
always going to benefit over 30 months and then levels off at 6%. These assumptions are based on historical numbers and
the borrower at the actual experience may differ. The measure is flexible, as it can be quoted as varying percentages of the
base case. For instance, 200% PSA would mean that over 30 months, the CPR ramps up to 12%
expense of the lender.
instead of 6%. This flexibility permits mortgage portfolio managers to use the PSA curve to 1) reflect
their best estimate of future prepayments or 2) analyze the sensitivity of the mortgages to changes in
prepayment rates.

Prepayments will affect the cash flow composition between interest and principal and the level of overall
payments that are passed through the pool to the investor. With greater prepayments, a greater portion
of the principal will be returned early in the life of the security and the later total payments will decrease.
The graph below depicts how, under an assumption of 100% PSA, principal payments are front-loaded
in the life of a mortgage passthrough security and in later years the overall payments decline.

Payments on a $100,000 Pool of 30 Year 8% Mortgages at 100% PSA

$1200
Interest
Principal
$1000

$800
Payment

$600

$400

$200

0
0 5 10 15 20 25 30
Years

For illustrative purposes only.


Source: Goldman Sachs Asset Management

The embedded option is always going to benefit the borrower at the expense of the lender. The
borrower has received a valuable option from the lender in exchange for agreeing to a relatively high
nominal yield. A simple example might be helpful to illustrate how this option would work against the
lender. A borrower who takes out a mortgage at an 8% interest rate may choose to refinance if rates
fall to 6%. This is a very attractive for the borrower, as it will significantly lower his monthly payment;
now he is paying only 6% interest instead of 8%. However, it is unattractive to the lender who must
now reinvest the returned principal at 6%, well below the 8% rate he previously enjoyed.

The risk of receiving principal back at an inopportune time (i.e., a lower rate environment) is called
prepayment risk. The prepayment risk associated with the individual mortgages will pass through to
the holder of a mortgage security, as prepayments are shared across all the mortgage securities on a
pro-rata basis.

Path dependency and prepayments


The level of future expected prepayments is a function of historical interest rates. For instance, a mortgage
security may be issued in a high rate environment and experience significant refinancing when rates fall.
The more informed borrowers will refinance quickly, but others may lag because they are less aware of
the refinancing opportunity or they are constrained from refinancing. A potential refinancing constraint
may be that the borrowers’ credit-worthiness has fallen and they cannot refinance or, perhaps, the value
of their home has fallen making refinancing difficult. After this initial wave of refinancing, the passthrough
is backed by mortgages of borrowers that are less likely to refinance. This effect is called ‘burnout.’ So,
if rates move back up and then come down again, the increase in prepayments will be much less in this
second cycle than it was when rates dropped initially. This aspect of prepayment risk is called path
dependency and it makes modeling and understanding how mortgages behave much more challenging.

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

Trading conventions
Trading conventions in the mortgage market have developed over many years as the market tends to be
quite technical from an operational standpoint. Operational challenges have deterred non-US asset
managers from entering the market, despite the large weight of passthroughs in the Lehman Brothers
Global Aggregate Index.

Most passthrough securities are traded on a To Be Allocated (TBA) basis. An investor does not know
the specific security he will receive, only its general characteristics, e.g., GNMA 6% 30 year. All the
TBA trades of a similar type settle on one specified day each month. Securities can also be purchased
on an individual pool basis, ‘specified pools,’ but this is less common. The TBA market, like many
other forward and future markets, allows an investor to gain economic exposure to an asset class
without necessarily taking delivery of actual securities.

The Non-Agency Mortgage Market


Option-adjusted duration While the three housing agencies account for the majority of MBS issuance, private companies also
measures the interest rate issue MBS. The housing agencies are limited to the types of mortgages they can securitize. Agencies
risk of mortgages by taking
securitize “conforming” mortgage loans, i.e., the borrower credit and loan characteristics must meet the
agencies’ underwriting standards. Non-conforming loans do not meet agency underwriting standards
into account the changes in
due to one or a combination of the following factors: mortgage balance exceeds the amount permitted
prepayments that occur at by the agencies, borrower and loan characteristics fail to meet the underwriting standards established
different interest rate levels. by the agencies, and/or loan documentation required by the agencies is not complete due to either the
borrower’s inability to provide or the lender’s decision to waive.

“Private-label” MBS, or non-agency MBS, are typically issued by homebuilders or financial institutions
through subsidiaries and are backed by residential loans that do not conform to the agencies’
underwriting standards. Non-agency issued mortgage-backed securities are now a major component of
the MBS market.

Below, we have provided a description of the general “sectors” of the agency and non-agency mortgage
markets and the typical characteristics of the collateral type which falls under each of those sectors.

Mortgage collateral
Mortgage securities can be backed by a wide variety of loans with different borrower characteristics but
the market is generally divided into four main sectors: agency mortgages, prime jumbo mortgages, Alt-
A mortgages and subprime mortgages.
• Agency mortgages: Must conform to the agencies’ standards in terms of loan size, the borrower’s
credit score and documentation, and the loan amount relative to the value of the home (loan-to-value
ratio). Other types of mortgages do not comply with these standards for one or more reasons.
• Prime Jumbo: Exceed the agency maximum loan size (traditionally $417,000 but the maximum was
raised to $729,000 through 2008), but borrowers generally have high credit scores.
• Alt-A: Generally conform with agency standards in terms of loan size and borrower credit score, but
have other features that do not conform, such as low documentation.
• Subprime: Do not conform with agency standards primarily due to lower credit scores (generally
605-640 out of a possible 850, compared to 680-730 for agency mortgages as measured by FICO)
and higher borrower leverage (as measured by the debt-to-income ratio, typically 40% for subprime
borrowers). Documentation on subprime mortgages also tends to be significantly lower than agency
standards, but may actually be higher than documentation on an Alt-A mortgage.

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

IV. Risks of Mortgage Passthrough Securities


The main risks of mortgage passthroughs are interest rate risk, convexity/volatility risk due to
prepayments, spread risk, credit risk and model risk.

Interest rate risk


The main risk of agency passthroughs is interest rate risk. Just like other fixed income securities, when
yields rise, passthrough prices fall; and when yields fall, passthrough prices rise. However, due to the
embedded options in these agency passthroughs, traditional measures such as Macaulay duration and
modified duration are not appropriate for measuring the interest rate risk of mortgages. To address this
issue, option-adjusted duration, a new measure of interest rate risk that incorporates the impact of
embedded options, was developed.

Option-adjusted duration will take into account the changes in prepayments that occur at different
interest rate levels. For instance, when rates rise, the expected cash flows for the passthrough will tend
to extend; borrowers are less likely to refinance at higher rates. When rates fall, the expected cash flows
for the passthrough will tend to shorten; borrowers are more likely to refinance since lower rates are
more attractive.

The option-adjusted duration captures these effects by shocking the yield curve up and down by equal
amounts and recalculating the security’s price in each scenario, given the new expected cash flows. The
price changes that result from these shocks are then used to estimate the security’s sensitivity to changes
in interest rates. This sensitivity is the option-adjusted duration.

There are other measures of interest rate sensitivity that the market will sometimes quote, but they are
not as useful as an option-adjusted duration estimate. These other measures include weighted average
life (WAL), which is an average time to receive back principal on the underlying loans and weighted
average maturity (WAM), which is weighted average maturity of the underlying loans.

Convexity/volatility risk due to prepayments


For non-callable securities (plain vanilla bonds), duration measures underestimate price gains and
overestimate price losses. This estimation error (the curvature of the price/yield relationship) is called
convexity and, in the case of a non-callable bond, it favors the investor and is called positive convexity.
The opposite occurs for mortgages with prepayment risk. Duration measures overestimate price gains
and underestimate price losses. In this case, the estimation error is called negative convexity and will
always work against the investor. The more prepayment risk a security has, the worse the estimation
error will be and, in turn, the more negative its convexity will be.

Unlike non-callable Negative Convexity

bonds, mortgages have Example: Conventional 30 year


Price change estimated by duration
negative convexity, which 108
Actual price change
works against the
investor. Convexity 103
Duration underestimates
becomes more negative, the price appreciation
Price ($)

Duration overestimates
as the prepayment risk of 98 the price appreciation
the security increases.

93

88
-200 -150 -100 -50 0 50 100 150 200

For illustrative purposes only.


Source: Goldman Sachs Asset Management

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

The chart below illustrates that as yields move, negative convexity becomes more costly. Since this
negative convexity is tied to prepayment risk, this relationship should make sense. When markets are
very volatile, the prepayment option is worth more and, as a result, the security’s performance relative
to non-callable securities suffers more.

Price Performance vs. Treasury*

-1
Convexity ($)
Loss from

-2

-3

-4
-200 -150 -100 -50 0 50 100 150 200

* Assumes no dynamic hedging. For illustrative purposes only.


Source: Goldman Sachs Asset Management

Many managers will adjust their mortgage hedges frequently. This practice of constantly hedging the
portfolio is called ‘dynamically hedging.’ The cost of this practice reflects the portfolio’s negative
convexity. Whenever prices go down (rates up), the manager has to sell securities and whenever prices
go up (rates down), the manager has to buy securities. In very volatile markets, the cost of negative
convexity becomes expensive, reflecting the increased value of the options that the manager is short.
Investors in mortgages are often said to be short volatility because when volatility increases, a mortgage
investor loses as the cost of hedging rises (i.e., the cost of the negative convexity rises).

If a portfolio manager decides not to hedge, the portfolio’s duration will tend to drift. In rallying
markets, the portfolio will become shorter and in sell-offs, the portfolio will become longer. In trending
markets, this could lead to significant underperformance. Additionally, if liabilities are being matched
with these securities, it may lead to an asset/liability mismatch.

Spread risk

A major component of The mark-to-market risk of mortgages may be broken into several components. The most volatile
component of this risk is Treasury interest rate risk, which was described earlier. This risk may be
mark-to-market risk is
hedged by taking short positions on US Treasuries or more easily by selling US Treasury interest
referred to as ‘spread rate futures.
risk.’ This risk is driven
The other two components of mark to market risk are associated with the swap spreads (the yield
by swap spreads and the
difference between swap rates and Treasury rates) and the mortgage/swap basis (the yield differential,
mortgage/swap basis.
adjusted for embedded options, between mortgage rates and swap rates). These two risks are often
referred to as ‘spread risk’: the risk that a change in either of these two spreads will lead to a
change in price.

Many investors will use swaps or eurodollar contracts to hedge any unwanted swap risk in their
portfolios. As swap spreads are positive in the US, most managers will want to be exposed to this type
of risk. However, if the manager thinks that the portfolio has too much swap spread risk or the
manager has a negative tactical view on swap spreads, then he will hedge back this risk. This type of
hedging became more common after the second half of 1998.

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Introduction to Mortgage-Backed Securities and Other Securitized Assets

Typically, most managers do not hedge the mortgage/swap basis risk for two reasons. First, most
managers do not have the ability to hedge this risk because it requires carrying short mortgage
positions which are usually not permitted. Second, many managers do not wish to hedge this risk as the
risk may be embedded in their benchmark or the managers view the risk as attractive.
Estimated Volatility
Source of Mark to Market Risk Definition of spread/rate Hedging Vehicles
MBS/Swap Basis MBS Spread 30-50 bps Shorting other mortgages
(adjusted for option)
less Swap Spreads
Swap Spread Swap rates less 20-30 bps Selling interest rate swaps
Treasury rates or eurodollar contracts
Treasury Rates Treasury rates 100-110 bps Selling Treasury interest rate
contracts or shorting Treasuries
Source: Goldman Sachs Asset Management

Credit risk

Modeling the aggregate The credit risk in agency passthrough securities is fairly minimal. In the case of GNMA passthroughs,
the investor may view these bonds as secure as US Treasuries since they carry an explicit federal
behavior of many
guarantee. In the case of FNMA and FHLMC passthroughs, though there is not an explicit guarantee
individual residential
upon which to rely, there are several other sources of credit support. First, there is the credit-worthiness
mortgage borrowers is of the two agencies themselves. Even without federal support, the market considers these agencies
extremely challenging financially sound. Second, there is an implicit guarantee. It is thought by many market participants that
and, as a result, models if the agencies were in financial trouble, the federal government would assist them. Finally, these
may not be perfectly passthrough securities are not general obligations of the agencies but are collateralized by the
underlying pool of mortgages.
reliable.
Credit risk resides primarily in the non-agency mortgage market. As mentioned above, for agency MBS,
agency guarantees assure investors that they will receive timely payment of interest and principal,
regardless of the delinquency or default rates on the underlying loans. Because non-agency MBS have
no such guarantees, some other form of protection is needed to shield investors from borrower
delinquencies.

Private-label MBS are rated by rating agencies and often feature credit enhancements, such as
subordination and overcollateralization, that are designed to help protect investors from delinquencies
or losses on the underlying loans.

12 | Goldman Sachs Asset Management


Introduction to Mortgage-Backed Securities and Other Securitized Assets

Subordination
Senior-subordinated credit structures are created with single or multiple subordinated credit classes. In
these structures, the “junior” tranches are subordinated to the “senior” tranches in terms of the
prioritization of principal cash flows. In addition, the subordinate tranches are designed to absorb
losses before they are allocated to senior tranches. In other words, these designated junior securities
provide the credit support to the senior securities.

The diagram below illustrates a typical mortgage pool capital structure:

Cash Flow Mechanics

Mortgage Generic Deal Loss Principal


Loans Structure Priority Payments

AAA / Aa

Loss Position

Cash Flow
Pool of
Mortgage
Loans
AA / Aaa
A/A
BBB / Baa
BB / Ba
B/B
Unrated First Loss

A typical capital structure will include investment grade bonds, as well as “junk” or unrated bonds.
The senior bonds are rated AAA and have first priority on cash flow. The investment grade
subordinates are rated AA to BBB and have a lower priority on cash flow. At the bottom of the credit
stack are the non-investment grade subordinates. These bonds are rated BB+ or lower and are
significantly exposed to losses from the underlying mortgage loans.

Model risk
A final risk to investing in mortgages is the reliability of the quantitative model used to predict
prepayments. For most callable securities, such as agency or corporate callables, there is little
uncertainty about how the borrowers will behave. They will nearly always call the bonds if it is
attractive to call them or will not call them if it is unattractive to call them.

On the other hand, not every individual residential borrower may refinance when it looks as if they
should. This behavior may be driven by economic constraints or a lack of information on the individual
borrower’s part. It is more difficult to predict the aggregate decisions of many individual borrowers
than it is to predict the decision of a single corporation. A model must attempt to predict this overall
behavior of borrowers and the model may not always be successful in this attempt.

One way to manage this model risk is to stress test the assumptions underlying the model and see how
much the model’s results change as a result of varying assumptions. For instance, if normal housing
turnover were 25% greater or less than the model’s base case, what happens to the model’s output? It is
important to understand the sensitivities of models and not treat them as a perfectly reliable black box.

Goldman Sachs Asset Management | 13


Introduction to Mortgage-Backed Securities and Other Securitized Assets

V. Relative Value in Mortgage Passthrough Securities


In many fixed income markets, a primary driver in valuing a security is its nominal spread relative to
a comparable maturity Treasury. Typically, nominal spreads of mortgages relative to Treasuries tend
to be very high and would suggest that mortgages are very attractive. However, nominal spread
analysis, as an indicator of relative value, is not complete in the case of mortgages and will yield
misleading conclusions.

Option-adjusted spread
The option-adjusted spread The reason that nominal spreads are a misleading indictor of value with respect to mortgages is that
model is a helpful indicator mortgages are composed of two separate underlying investment positions. The investor is long a set of
of relative value because it
fixed cash flows but is also short an option. The nominal yield does not incorporate the value of the
option that the investor has sold to the borrowers and, thus, this yield tends to overstate a mortgage’s
takes into account the short
attractiveness. As a result of this shortcoming, option-adjusted spread (OAS) models were developed to
embedded option. create a measure of valuation that accounts for the embedded short option. This type of model adjusts
the nominal spread to account for the option value and provides a better indicator of relative value.
This same model is also used for calculating the option adjusted duration discussed earlier.

Interest rate and prepayment models


An OAS model is based upon two submodels: an interest rate model and a prepayment model. The
interest rate model is a tool that will simulate future, potential interest rate paths.

One of the critical inputs into the interest rate model is the level of volatility. The level of volatility used
can potentially make the OAS look attractive or unattractive. The more volatile interest rates are
expected to be, the more valuable the embedded option will be and the lower the OAS will be, if all
else is equal. This occurs because more volatile markets are more likely to create refinancing
opportunities for borrowers. The less volatile interest rates are expected to be, the less valuable the
embedded option will be and the higher the OAS will be. At the extreme, if volatility were zero, there
ceases to be any uncertainty regarding the option and the time premium of the option is zero.

The prepayment model predicts how individuals behave regarding prepayments. It predicts prepayments
stemming from normal housing turnover, interest rate shifts and any other factor deemed relevant. To
predict housing turnover, modelers will examine factors such as historical experience, demographic
trends and any recent changes to the tax law. Even the impact of the internet has been incorporated
into these models.

Predicting refinancing activity due to interest rate shifts is very important as this suggests how
efficiently the borrower’s option will be used against the lender. Predicting how a corporation will
behave when it has a refinancing opportunity is usually fairly simple. If it is profitable to refinance, a
company will usually do so. This is not the case with home owners. While some may be quite efficient
in refinancing, others may not be. Some may only refinance after the opportunity has existed for a
while and some may not refinance at all. Generally, individuals have become more efficient at
refinancing due to the internet, which has improved the flow of information and market access and has
made refinancing easier. The outputs of different OAS models can vary a great deal. When examining
the output of an OAS model, it is important to understand the model’s biases and limitations. It also
makes sense to stress test the model and understand how it behaves under different assumptions.
Mortgage traders regularly use these models as a tool in managing mortgage positions but should not
use them as black boxes.

14 | Goldman Sachs Asset Management


Introduction to Mortgage-Backed Securities and Other Securitized Assets

VI. Other Types of Mortgage-Backed Securities


This introduction to mortgage-backed securities has focused entirely on agency mortgage passthroughs.
Passthroughs are the most basic type of mortgage-backed security. One of the unique aspects of the
mortgage market is the diversity of instruments and products available to market participants. We have
highlighted below some other types of residential mortgage-backed securities:

Adjustable Rate Mortgage (ARM)


A passthrough security that has predetermined adjustments of the interest rate at specific intervals.
Mortgage payments are tied to varying indices, such as the interest rate on US Treasury bills, LIBOR or
the average national mortgage rate. Adjustments are made regularly, usually at intervals of one, three,
or five years. Different types of ARMs, include Hybrid ARMs, where the interest rate on the note is
fixed for a period of time and then floats thereafter, as well as Option ARMs, where the borrower has
the option to make minimal payments which allow for negative amortization or to make fully
amortizing payments.

Collateralized Mortgage Obligations (CMOs)


The introduction of One disadvantage of standard agency passthrough securities is that their durations often do not match
CMOs in the early 1980s the duration of the investor’s liabilities. The introduction of CMOs in the early 1980s solved this
increased the mortgage
problem and increased the investment universe for mortgage securities.
investor base by The most basic CMO structure is called a ‘sequential.’ This structure breaks an agency passthrough
broadening the range of into multiple bonds or tranches. Instead of passing through all cash flows on a pro-rata basis to these
MBS investment options new securities, principal payments are paid in sequential order. A simple deal might be broken into
three tranches with principal payments being sequentially paid to only one tranche at a time. Once the
available.
first tranche has been completely paid down, principal payments would be directed towards the second
tranche. Once the second tranche has been completely paid down, principal payments would be
directed towards the third tranche. This methodology would break the passthrough into three securities
with varying interest rate risk: a short duration tranche, an intermediate duration tranche and a long
duration tranche. The securities created from this type of structure would be called ‘sequentials.’ The
figure below illustrates how the principal would be directed in this type of sequential structure:

Sequential Structure at 100% PSA


Tranche A (Weighted-Average Life 3.5)
$600
Tranche B (Weighted-Average Life 10.1)
$500 Tranche C (Weighted-Average Life 20.5)
Principal Payment

$400

$300

$200

$100

0
0 5 10 15 20 25 30
Year
For illustrative purposes only.
Source: Goldman Sachs Asset Management

Goldman Sachs Asset Management | 15


Introduction to Mortgage-Backed Securities and Other Securitized Assets

By using a CMO structure to break up an agency passthrough in this way, many investors, who might
not normally purchase mortgages, may now find opportunities in the mortgage market given the
broader range of investments available. Since the early 1980s, CMO deals have become increasingly
complex as a wide variety of CMOs were created in response to the needs of individual investor bases.
CMOs may be created from either agency passthroughs or from pools of non-agency mortgages.
The CMOs created with non-agency collateral are often referred to as ‘private label’ and most tranches
are AAA-rated. CMOs are not included in the Lehman Aggregate Index since the agency mortgage
passthroughs that are backing many of these structures are already included in the index.

VII. Non-Residential Securitized Assets


So far, we have focused only on residential mortgage-backed securities. However, there are other sectors
of the market that are interesting in the current environment. These include commercial mortgage-
backed securities (CMBS) and asset-backed securities (ABS). CMBS are bonds backed by pools of
mortgages on commercial mortgage loans. ABS are one of the most diverse sectors in the global fixed
income markets, but have one trait in common: they are backed by a pool of homogeneous assets.

Commercial Mortgage-Backed Securities (CMBS)


CMBS, which are backed CMBS are securities backed by pools of commercial mortgage loans. These loans are typically secured
by pools of commercial by commercial property, such as apartment buildings, shopping malls, warehouse facilities, hotels and
office buildings. This asset class emerged in the early 1990s as a result of the weak commercial real
mortgage loans, differ from
estate market. This weak market caused many traditional lenders, such as banks, insurance companies
agency passthroughs in
and pensions funds making direct loans, to exit the market. The CMBS market replaced some of this
prepayment risk, credit traditional lending and began to grow significantly in the late 1990s. Though CMBS share many
quality and structure. similarities with residential passthroughs, there are many differences as well.

Lower prepayment risk


CMBS have much less prepayment risk than agency passthroughs. This lower level of risk is a result of
prepayment lockouts and prepayment penalties embedded in the underlying commercial loans. A
lockout prevents any prepayments over a particular specified time period, while a prepayment penalty
reduces the economic benefit of refinancing as interest rates fall.

Credit enhancement in CMBS


There is no government guarantee for securities in the CMBS market as the housing agencies do not
have the mandate to offer such credit support. However, the majority of the market is AAA-rated.
CMBS securities achieve a AAA-rating through senior/subordinated structuring. In each deal, a certain
amount of the securities will be junior to the AAA-rated bonds and will absorb losses prior to the
senior bonds. The deals are often broken into four credit classes of bonds:
• Senior bonds: Nearly always AAA-rated
• Mezzanine bonds: Investment grade, but subordinated to senior bonds
• Junior bonds (or B-pieces): Below investment grade with significant credit exposure
• First loss piece: Most junior class and likely to experience complete loss if there is a significant
credit event.

16 | Goldman Sachs Asset Management


Introduction to Mortgage-Backed Securities and Other Securitized Assets

Balloon structures
Unlike residential mortgages that are typically fully amortizing, loans in the commercial real estate
market usually have a balloon structure with a 5- to 10-year term. In a balloon structure there is a large
payment of principal (often called a bullet) at the end of the loan’s term. This balloon structure
introduces the risk that the borrower may not be able to refinance their loan at the end of its term,
often called ‘balloon extension risk.’ However, this risk is primarily borne by the subordinate
bondholders.

Deal types
Adding MBS, CMBS and CMBS deal types are generally classified by the level of diversification of the underlying collateral. The
ABS to a 100% US most common deal type is collateralized by loans originated in a securitization conduit. The conduit
enables an investment bank to originate and securitize commercial loans while minimizing balance sheet
Treasury portfolio can
exposure to the loans. This strategy differs from that of banks and insurance companies, which
increase the portfolio’s
typically originate and retain commercial mortgages. The loans in these conduits tend to be very well
return without diversified with multiple borrowers, property types and locations and are typically backed by a hundred
increasing its risk. or more loans. The originators strive for this diversification because it is favorably looked upon by the
rating agencies. The good credit ratings that come from strong diversification are important to the
originator as they make the economics of the deal much more attractive and the deal more profitable.

Many investors prefer these diversified conduit deals to other deals with more concentrated real estate
risk as extensive real estate experience may not give an investor a significant advantage over other
investors. For example, an isolated default on a $5 million loan will not jeopardize a senior bond
holder in a $1 billion deal. The most important skill in these deals is an understanding of the structure,
the credit enhancement and the overall quality of the loan underwriting procedures. Other deal types
that are less common are single asset/borrower deals, large loan deals and fusion deals. Single
asset/borrower and large loan deals have more concentrated real estate risk. Understanding the quality
of each of the underlying loans and related real estate collateral becomes more important.

Asset-Backed Securities (ABS)


Asset-backed securities can represent attractive, conservative core portfolio holdings due to their cash
flow stability and strong structural credit support. Unlike traditional residential mortgages, ABS cash
flows are relatively insensitive to changes in interest rates and display much greater cash flow stability
than typical passthroughs. From a credit perspective, ABS are secured by diversified pools of obligors
and due to various potential credit enhancements, are often rated AAA. These credit enhancements may
include insurance wrappers, junior/senior structures and certain performance triggers that dynamically
adjust the level of protection based on actual credit performance. The ABS sector is comprised of many
collateral subtypes, including credit card, auto, home equity, manufactured housing and utility rate-
reduction receivables.

Goldman Sachs Asset Management | 17


Introduction to Mortgage-Backed Securities and Other Securitized Assets

VIII. Why Do Investors Buy Mortgages?


A question of interest to a high credit quality investor is whether to include mortgages in their
investment universe. Historically, mortgages have offered investors attractive yield pick-up versus
Treasuries with little credit risk:

Agency Mortgage Spreads (vs. Treasuries)

300

250
Spread vs. Treasuries

200

150

100

50

0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

As May 28, 2008


Source: Lehman Brothers

We believe that inclusion of the securitized sector in a fixed income portfolio can offer very attractive
advantages:
• Historically, the securitized sectors have been very attractive on a risk/return basis. Although
mortgage passthrough securities are short prepayment options, the incremental yield advantage of
these securities has more than made up for the cost of these embedded options.
• Adding these other sectors to a fixed income portfolio should provide diversification benefits to the
portfolio. Though mortgages, like Treasuries, have exposure to general interest rate risk, they also
have potential exposure to many other risks (described earlier) that do not affect Treasuries.

18 | Goldman Sachs Asset Management


Introduction to Mortgage-Backed Securities and Other Securitized Assets

VIII. Conclusion
Since the introduction of the first agency passthrough securities over thirty years ago, the
mortgage/securitized market has grown significantly in size, diversity of investment options, and
capacity of investment tools.
• Size: The US mortgage market has developed into the largest fixed income market in the United
States, with a market capitalization of $7.2 trillion. Additionally, the success of securitization in the
agency passthrough market has given rise to other securitized markets such as the CMO, CMBS and
ABS markets.
• Diversity: As the secondary passthrough market matured, the diversity of investment options in the
securitized market increased. The introduction of CMOs in the early 1980s made it possible to create
securities with a broad range of risk/return profiles. This innovation increased the number of market
participants as some investors, previously not active in the passthrough market, could now find
investments suitable for their portfolios. The development of the CMBS and ABS markets also
introduced further investment options to the market.
• Credit quality and depth: Agency market is AAA, and senior/subordinated credit enhancement allows
AAA creation from non-agency mortgage loans. While the bulk of the mortgage universe is highly
rated, equity-like risk is available in credit tranching whole loans (passthroughs not wrapped by the
agencies) and commercial mortgages.
• Investment tools: Alongside this growing market, the investment community has increased and
refined its understanding of these securities and has developed tools to evaluate their distinctive
risk/return profiles. Such tools include option-adjusted spread and option-adjusted duration
technology. Given the risk/return profile of the securitized sector, fixed income investors should
consider a strategic allocation to it.

The inclusion of the securitized sector as a strategic asset class has largely been embraced by fixed
income investors in the US, and is becoming a growing part of fixed income portfolios of global
investors. This adoption is apparent in the widespread use of the Lehman Aggregate Index (which
includes the securitized sectors) over the older Lehman Government Corporate Index. A similar trend is
emerging globally as fixed income investors outside of the United States also begin to embrace the
securitized sector on a strategic basis. This trend is apparent in the growing popularity of the Lehman
Global Aggregate (which includes the securitized sectors) at the expense of older, traditional all-
government benchmarks. This trend will gain momentum as these global investors increase their
understanding of this market and how it can play a beneficial role in their portfolios.

Goldman Sachs Asset Management | 19


These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. This material is provided for
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