FI Set 6

Fixed Income: MBS Mechanics
Lecture Set VI
Professor John P. Miller
Professor John P. Miller Fixed Income: MBS Mechanics 1 / 49

How Important Is the MBS Market?
Year Home U.S.
Mortgages Treasuries
Size: currently $12.98 trillion 2005 9,444.7 4,334.2
mortgage balance outstanding 2006 10,526.0 4,486.0
2007 11,265.7 4,676.1
Second in size only to U.S. Treasury 2008 11,182.8 5,937.1
2009 10,987.0 7,412.1
securities (recent development) 2010 10,516.4 9,000.4
Experienced a 12.1% growth rate 2011 10,274.9 10,082.9
2012 10,043.7 11,203.3
from 2001 to 2007 ($5.7 - $11.3 2013 9,952.6 11,998.4
trillion) 2014 9,938.5 12,643.2
2015 10,082.0 13,325.6
Held in most fixed-income portfolios 2016 10,272.2 13,867.2
(25-45%) 2017 10,568.9 14,423.1
2018 10,855.3 15,455.9
Diverse investor base: banks, money 2019 11,178.0 16,628.9
2020 11,648.5 20,946.2
managers, pension funds, insurance 2021 12,548.5 22,557.5
companies, mortgage originators, 2022 Q2 12,984.8 23,253.4
GSEs and hedge funds Billions of dollars
Source: Federal Reserve Z.1: Mortgage Debt
Complexity of products Outstanding (Table 217) and Treasury
Securities (Table L.210, lines 3, 4 and 7).

Definitions and Terms
Mortgage
Loan secured by a specified real estate property
Lender has right to repossess property in case of default
Lien status
Most mortgages are first lien: Mortgage holder has first rights to
foreclosure and liquidation proceeds
In some cases, borrowers add second mortgages (such as a home equity
loans, HEL) to keep the loan-to-value (LTV) below a certain level
which is typically 80%. These loans have rights to any proceeds after
first lien obligations are satisfied
Loan Terms
30-year fixed-rate, level pay, amortized on a monthly basis
Terms of 10, 15 and 20 years are also popular
Most loans amortize over loan term, however, some loans require a
balloon payment before 30 years (typically 5 or 7 years)

Interest Rate Type
Fixed-rate
Level payment
Majority of payment is interest at beginning of term and principal at
the end of term
Adjustable Rate (ARMs)
Rate indexed to benchmark rate (LIBOR, or constant maturity
Treasury, CMT)
LIBOR (London Interbank Offered Rate)
Historically determined by using the BBA Method (British Banker’s
Association) where the offer rates from 16 BBA banks are ordered, the
highest four and the lowest four rates of discarded, and the remaining 8
rates averaged.
In February 1, 2014, ICE Benchmark Administration (IBA) took
control, and is transitioning from bank submissions to tradable quotes.
Hybrid ARMs: Rate is initially fixed for a period of 3, 5, 7 or 10 years,
then reset annually like a traditional ARM

Credit Guarantees
Government Loans
Backed by the “full faith and credit” of the U.S. government
Originating federal agencies
FHA (Federal Housing Authority): Provides loans to low income
borrowers who can only afford low down payments
VA: Provides loans to veterans
Both agencies require borrowers to purchase mortgage insurance
provided by the federal government
Conventional conforming Loans
Originated by government sponsored enterprises (GSEs): Fannie Mae
and Freddie Mac
Originators paid an average of 38 bps in 2012
GSEs introduced loan level price adjustments (LLPAs) in 2008:
Upfront fees paid by lenders based on LTV and other risk factors
Loans securitized on a non-recourse basis
Private label loans
Also termed jumbo or whole loans
Loan sizes tend to be large
Originator does not offer credit enhancements
Loan Characteristics: 2020 Loan Limits
FHA Loan Limits Limit1 Fannie Mae/Freddie Mac

Single Family $498,257 $766,550
Two Unit $637,950 $981,500
Three Unit $771,125 $1,186,350
Four Unit $958,350 $1,474,400
VA $766,550
Loan sizes above the conventional limits are sold under a “private
label”
1
Limit is higher for certain high-cost regions.
Mechanics of Mortgage Loans: Determining Monthly
Payments
PT h i
M i
Loan amount = t=1 (1+i)t ⇒ M = Loan Amount × 1−(1+i)−T
Where
i = mortgage rate divided by 12
M = monthly mortgage payment
T = number of years times 12
Example: $250,000 30-year fixed-rate mortgage at 6%
i = 0.06/12 = 0.005
0.005
M = 250, 000 × 1−1.005 −360 = $1, 498.88
In Excel = pmt(0.06/12, 360, −250000)

Mechanics of Mortgage Loans: Cash Flows
Example: 30-year fixed-rate mortgage at 6%
Month Pmt Int Princ Bal Month Pmt Int Princ Bal
1 1,498.88 1,250.00 248.88 249,751.12 349 1,498.88 87.08 1,411.80 16,003.54
2 1,498.88 1,248.76 250.12 249,501.00 350 1,498.88 80.02 1,418.86 14,584.68
3 1,498.88 1,247.51 251.37 249,249.63 351 1,498.88 72.92 1,425.95 13,158.73
4 1,498.88 1,246.25 252.63 248,997.00 352 1,498.88 65.79 1,433.08 11,725.65
5 1,498.88 1,244.99 253.89 248,743.11 353 1,498.88 58.63 1,440.25 10,285.40
6 1,498.88 1,243.72 255.16 248,487.95 354 1,498.88 51.43 1,447.45 8,837.95
7 1,498.88 1,242.44 256.44 248,231.51 355 1,498.88 44.19 1,454.69 7,383.26
8 1,498.88 1,241.16 257.72 247,973.80 356 1,498.88 36.92 1,461.96 5,921.30
9 1,498.88 1,239.87 259.01 247,714.79 357 1,498.88 29.61 1,469.27 4,452.03
10 1,498.88 1,238.57 260.30 247,454.49 358 1,498.88 22.26 1,476.62 2,975.42
11 1,498.88 1,237.27 261.60 247,192.88 359 1,498.88 14.88 1,484.00 1,491.42
12 1,498.88 1,235.96 262.91 246,929.97 360 1,498.88 7.46 1,491.42 0.00
Interest
1400
Principal
Let Bt be the mortgage balance
1200
at time t, It be the interest at
1000
time t, and Pt be the principal
Amount ($)
800
paid at time t
600
Then, It = i × Bt−1 and 400
Pt = M − It
200
0 50 100 150 200 250 300 350
Month

Mechanics of Mortgage Loans: Amortization
1 − (1 + i)n−T
Current balance = Original Balance ×
1 − (1 + i)−T
where n is the payment month
100,000
30−Year
20−Year
15−Year
80,000
Principal Balance ($)
60,000
40,000
20,000
0 50 100 150 200 250 300 350
Month

Mechanics of Mortgage Loans: Components of
Adjustable-Rate Mortgages
Initial Rate: Usually ARMs are “teased” at a low initial rate and
reset each period (usually annually) subject to periodic caps, life cap
and floor
Margin: Amount added to the index
Example: 1-yr CMT is 4.5% and the margin is 200 bps, then the rate
will be 4.5% + 2% = 6.5%
Floor: Minimum rate
Periodic Cap: Maximum change in the rate during any reset
Life Cap: Maximum rate
When the rate changes, the loan is recast such that it fully amortizes
by the maturity date

The Mortgage Industry
Origination channel
Retail: Originators work directly with borrower
Wholesale: Originators work indirectly with borrower through mortgage
brokers
Type of institution
Depository (banks, savings and loans, and credit unions): loan
originations either held on balance sheet or sold to market
Nondepository (mortgage banks): loans are accumulated and sold to
capital markets
Originators underwrite and fund the loan
Servicers collect the monthly payments, deal with delinquencies, and
sometimes also collect property taxes and insurance
Originators and servicers can be different entities

Loan Underwriting Process
Determine the borrowers ability to repay the loan

Credit scores: Fair Isaac Corporation (FICO) credit scores
Scores range from 350 to 850 with 660 being the “prime”/“subprime”
cutoff
Income ratios
Front ratio: total monthly mortgage payments, including insurance and
property taxes, divided by borrower’s pretax monthly income
Back ratio: total of mortgage payments plus any other debt including
auto loans, school loans and credit card debt
General front and back ratio limits are 29% and 41%
Documentation: pay stubs, bank statements and tax returns and credit
report from either Experian, Transunion or Equifax
Determine the value of the property
Property inspection
Real estate appraisal
Loan-to-value (LTV): borrowers may be required to purchase private
mortgage insurance if the LTV is above 80%

The Mortgage Origination Process
Application

Underwriting / Commitment
h
Pipeline Risk
Loan o
7 Closed 1. Interest Rate changes
2. Fallout
w
Warehousing Risk: / Loan Sold
Interest rate changes
(
Settlement

Originator Risks
Lender/Originator assumes “fallout” and interest rate risks for time

between mortgage commitment and loan is closed.
Lender assumes interest rate risk while loan is warehoused between
the time closing and loan sale settles.
To reduce the interest rate risks, the market has developed what is
known as the To-Be-Announced (TBA) market.

Creating a 30-Year Mortgage Pass-through
Loan #1 - 30Yr Mortgage

$250,000 balance
Pass-through: $1 million face value
6.25%
358 remaining term
$150,000 balance
6.50%
360 remaining term

Loan #3 - 30Yr Mortgage + Pooled monthly cash flow
$200,000 balance / Interest
6.50% Scheduled principal payments
360 remaining term 3 Prepayments
7
$100,000 balance Rule for distribution of cash flow
6.25% Pro rata basis
355 remaining term
$300,000 balance Mortgage servicer and securitizing
7.00% agency receive a portion of interest
360 remaining term rate paid by the borrower

Pool Characteristics
Pool Balance = $250,000 + 150,000 + 200,000 + 100,000 +

300,000 = $1,000,000
Weighted average coupon (WAC) is current balance-weighted-average
mortgage rate on loans in pool:
P5
bi ri 6,562,500
WAC = Pi=1 5 = = 6.5625
i=1 bi
1,000,000
Weighted average maturity (WAM) is the current

balance-weighted-average of remaining term of loans in pool:
P5
bi Ti 359,000,000
W AM = Pi=1 5 = = 359
i=1 bi
1,000,000
WAC and WAM, along with the current pool balance will be used to
generate cash flows for the pool.

Agency Mortgage Rate Components
Net coupon is paid the holder of the MBS: generally traded on whole
and half coupons
Required servicing is portion of interest rate required to be held by
servicer - generally 25 bps
Guarantee fee is fee paid to the agencies to insure loan in the event of
a default and loss
Ginnie Mae g-fees are typically 6 bps
Fannie Mae and Freddie MAC g-fees depend on the loan type,
borrower characteristics, and securitizing institution
Excess servicing is amount of servicing above the required amount
and is sometimes sold
Net coupon = gross rate – required servicing – g-fee – excess servicing

Development of MBS Market
Federal Housing Administration (FHA) was established through the

National Housing Act of 1934. FHA developed and promoted
long-term, self-amortizing mortgage loans. It also provided for
mortgage insurance to protect lenders from default risks.
After WWII (1948), the Veterans Administration also had a
standardized mortgage loan program.
FNMA was established in 1938 to provide liquidity by purchasing
qualified loans from lenders. FNMA was also responsible for
establishing a secondary market for mortgages.
In 1968 Congress split FNMA into two organizations:
FNMA - securitized conventional mortgages
GNMA - securitized FHA and VA mortgages, issued first
mortgage-backed pass-through (MBS)
In 1970 Congress created FHLMC. In 1971, FHLMC issued its first
participation certificate (PC) which pooled conventional mortgages.

Development of MBS Market (cont)
FNMA created first fix-rate mortgage pass-through in 1981, and was

first agency to create adjustable-rate mortgage pass-throughs in 1984.
By the mid-1970s, depository institutions held 64% of loans, of which
S&Ls held 37%.
A sharp rise in short-term interest rates at the end of the 1970s led to
an asset-liability mismatch for holders of mortgage loans.
In response to market demands for assets that matched liabilities,
FHLMC created the first collateralized mortgage obligation (CMO).

Credit Characteristics of Agency Mortgages
GNMA guarantees full timely payment of principal and interest.

GNMA’s guarantee is backed by “full faith and credit of the U.S.”
FNMA and FHLMC also offer guaranteed timely payment of principal
and interest payments, however, their guarantee is NOT backed by
the “full faith and credit of the U.S.”
Post-2008 financial crisis
September 7, 2008, the Treasury Secretary Hank Paulson placed
FNMA and FHLMC in conservatorship (Lehman files for bankruptcy
9/15/2008)
Combined mortgage portfolios of both agencies was $1.8 trillion, 6/08
Both agencies guaranteed another $3.7 trillion in mortgages with
FNMA equity of $41.2 billion and FHLMC $12.9 billion
Risk: Foreign investors held $800 of their debt and Russia sold $100
billion in 2008. Largest foreign holder was the People’s Bank of China
(PBOC) and further large sales of their debt would further disrupt
mortgage market
Was determined that both agencies were insolvent (9/08)
To-Be-Announced (TBA) Market
Newly issued pass-through MBS trade on a forward basis

Settlement occurs once a month
Each type of mortgage is assigned a particular settlement day
At a particular point in the month, settlement rolls forward to the
following month
Forward settlement allows originators to sell pools prior to creation
Originators can sell up to nine months forward in the TBA market
allowing them to ”lock in” the price for the mortgages
Forward settlement also facilitates the creation of CMOs by allowing
dealers to purchase collateral used to construct the CMO
Current-month occurs two days before the settlement date
Dealers in need of collateral to settle a CMO deal, as settlement
approaches, bid aggressively to attract the necessary collateral
Collateral demand may also impact the dollar roll market

Features of the TBA Market
Lenders can sell forward up to nine months

Purchaser does not know the characteristics of the pool until the “call
out” date, however, the Bond Market Association sets good delivery
standards
Specifies delivery date
Net coupon
Maximum number of pools delivered
Maximum seasoning
Fannie Mae, Freddie Mac and Ginnie Mae permit a ± 0.01% variance
in the amount delivered
Example: If you purchased a $10 million FNMA 6s for October delivery,
your actual delivery could be between $9,999,900 and $10,000,100
The Bond Market Association Uniform Practices Manual can be
found www.sifma.org

FGMLC 30Yr TBA Quotes2
2
Bloomberg command APX2
Features of the Specified Pool Market
Pools can also be traded in the specified pool market according to

stipulations (or stips) agreed to by the parties
Some tradable characteristics
A minimum spread between the WAC and the net coupon
Seasoning parameters
Geographic parameters
Average and maximum loan size
The specified pool market has grown tremendously since 1995

Agency Pass-Throughs: Payment Delays
Normal delay: Monthly payments are made in arrears. Principal &
interest for September is paid at beginning of October
Actual delay: Number of days the agency uses to process the
payments and forward the proceeds onto the MBS investors. For
example, if the payment is made on October 15th, then the actual
delay is 14 days.
Stated delay. Normal delay + actual delay+1. For example, have 30
days of normal delay plus fourteen days of actual delay, so the stated
delay is 45 days.
Agency Ginnie Mae I Ginnie II Fannie Mae Freddie Mac
Stated Delay 45 50 55 45
Actual Delay 14 19 24 14
Accrued interest and principal is paid to owner of record on last day of

previous month and paid on the Actual Delay + 1 the following month
MBS accrued interest is 30/360
How Does the Actual Delay Impact Pricing?
Using our pricing formula:

W AM
X+∆ W AM
100 CFt 1 100 X CFt
P = =
Face Amount t=1+∆
(1 + y)t (1 + y)∆ Face Amount t=1 (1 + y)t
where
Actual delay
∆=
30
Examples
14 day actual delay, 5% yield: $0.19 or 0-06 ticks
24 day actual delay, 5% yield: $0.33 or 0-10+ ticks
24 day actual delay, 4% yield: $0.27 or 0-08+ ticks

Pricing a MBS Pass-Through: No Prepayments
Assuming that there are no prepayments:
W AM
100 X CFt
P =
Face t=1 (1 + y)t
y = current periodic yield
W AC/1200
CFt = CF = current face ×
1 − (1 + W AC/1200)−W AM
Example: What is the price of a $100,000 MBS pool with a 6.5%
WAC and 360 WAM, assuming a 6.20% yield?

6.5/1200
CF = 100,000 × = 632.07
1 − (1 + W AC/1200)−360
1 − (1 + 0.062/12)−360

100
P = × 632.07 ×
100,000 0.062/12
100
= × 103,200.33 = 103.20033 or 103-06+
100,000
Note: Can only solve this way because of no prepayment assumption;

however, in practice, prepayments dramatically impact the monthly
cash flows!
Prepayments: SMM
Single Monthly Mortality:

Actual balancet
SM Mt = 100 × 1 −
Scheduled balancet
Example: A 30-year 6% mortgage with a $200,000 original balance.

Prior to month 60th, there were no prepayments, and at month 60th,
the actual balance was 185,000. What is the SMM that month?
Using our formula Schedule balance60 = P60 = $186,108.71
Actual balance60 = $185,000
SM M = 100 × (1 − 185,000/186,108.71) = 0.596%
How much was prepaid?
$ 186,108.71 − 185,000 = $1,108.71

Prepayments: CPR
Constant prepayment rate (CPR): SMM’s annualized prepayment rate
CP R = 100 × 1 − (1 − SM M/100)12

Example: What is CPR when the SM M = 0.596%?
CP R = 100 × (1 − (1 − 0.596/100)12 ) = 6.92%
Interpretation: If pool prepaid at 0.596% SMM for 12 months then

the actual remaining factor would be lower than the scheduled factor
by 6.92% at the end.
Use the following expression to go from CPR back to SMM

SM M = 100 × 1 − (1 − CP R/100)1/12

Prepayments: PSA Prepayment Standard
100% PSA is defines the CPR according the pool WALA

(weighted-average loan age) as follows:
100% PSA = min(WALA × 0.2, 6)
Example: if the prepayment is 6.92% CPR when WALA is 60, what is

the PSA?
6.92
× 100 = 115%
min(60 × 0.2, 6)
100% PSA at 28 WALA:
min(28 × 0.2, 6) = 5.6% CPR

3 × min(28 × 0.2, 6) = 16.8% CPR

1.5 × min(60 × 0.2, 6) = 9% CPR

Projecting Monthly Cash Flows
Survival factor: ft = ft−1 (1 − SM Mt /100)
Pool mortgage payment: Mt = ft−1 M0
Net interest received by investor: It = Pt−1 (r − s)
Monthly servicing: St = Pt−1 s
Scheduled monthly princ pmt: Scht = Mt − It − St
Monthly prepayment: P Pt = SM Mt /100 × [Pt−1 − Scht ]
Monthly CF received by investor: CFt = It + Scht + P Pt
Period-end principal balance: Pt = Pt−1 − Scht − P Pt

Monthly Cash Flows at 300% and 800% PSA
Original Balance 100,000 WAM 360
PSA 300% WAC 6.5%
Serv. 0.5%
t CPRt SMMt ft−1 Mt It St Scht PPt CFt Pt
1 0.6 0.0501% 1.00000 632 500 42 90 50 640 99860
2 1.2 0.1006% 0.99950 632 499 42 91 100 690 99668
3 1.8 0.1513% 0.99849 631 498 42 91 151 740 99426
4 2.4 0.2022% 0.99698 630 497 41 92 201 790 99134
5 3.0 0.2535% 0.99497 629 496 41 92 251 839 98791
6 3.6 0.3051% 0.99244 627 494 41 92 301 887 98398
7 4.2 0.3569% 0.98942 625 492 41 92 351 935 97954
8 4.8 0.4091% 0.98589 623 490 41 93 400 983 97462
9 5.4 0.4615% 0.98185 621 487 41 93 449 1029 96919
10 6.0 0.5143% 0.97732 618 485 40 93 498 1075 96329
11 6.6 0.5674% 0.97229 615 482 40 93 546 1120 95690
12 7.2 0.6208% 0.96678 611 478 40 93 593 1165 95004
Original Balance 100,000 WAM 360

PSA 800% WAC 6.5%
Serv. 0.5%
t CPRt SMMt ft−1 Mt It St Scht PPt CFt Pt
1 1.6 0.1343% 1.00000 632 500 42 90 134 725 99775
2 3.2 0.2707% 0.99866 631 499 42 91 270 859 99415
3 4.8 0.4091% 0.99595 630 497 41 91 406 994 98917
4 6.4 0.5496% 0.99188 627 495 41 91 543 1129 98283
5 8.0 0.6924% 0.98643 623 491 41 91 680 1262 97512
6 9.6 0.8375% 0.97960 619 488 41 91 816 1394 96605
7 11.2 0.9850% 0.97139 614 483 40 91 951 1524 95564
8 12.8 1.1349% 0.96182 608 478 40 90 1084 1652 94390
9 14.4 1.2873% 0.95091 601 472 39 90 1214 1776 93086
10 16.0 1.4424% 0.93867 593 465 39 89 1341 1896 91656
11 17.6 1.6003% 0.92513 585 458 38 88 1465 2012 90102
12 19.2 1.7609% 0.91032 575 451 38 87 1585 2123 88430

Pricing a MBS Pool with Prepayments
Generation of monthly cash flows is required to compute the price of

the pool: The net present value of the monthly cash flows divided by
the face amount and multiplied by 100 to convert price into a
percentage of par:
WAM+∆
100 X CFt
P MBS =
Face Amount t=1+∆
(1 + y)t
Need to account for payment delay, ∆ (see slide 26), which depends
on the type of pool being priced
Prepayment assumption changes impact pricing as cash flows change,
with one exception being the case where the discount yield equals the
net coupon
Since prepayment rates depend on mortgage rates, changing interest
rate assumptions impacts the discount rate and the structure of the
underlying cash flows!

Computing the Invoice Amount for a MBS Pool
Agency MBS trade in half-coupon increments. This is known as the

net coupon.
Since MBS cash flows are monthly, so are the monthly cash flows for
the investor
Each month the investor receives 1/12th of the annual coupon based
on the remaining balance
Additionally, for settlements during the month, the accrued interest is
computed using a 30/360 day count convention
For example, what is the total invoice for a 3% MBS pool with a
remaining balance of $993,419.77, priced at $99-04 with 12 days
accrued interest?
Cost of the principal: 993, 419.77 × (99 + 4/32)/100 = 984, 727.35
12 days of accrued interest: 993, 419.77 × 3/1200 × 12/30 = 993.42
So the total invoice = 984, 727.35 + 993.42 = 985, 720.77

Impact of Prepayments on Principal Cash Flows
W AM
1 X t × (principal received at time t)
Average Life =
12 total principal
t=1
100,000
0 PSA
50 PSA
100 PSA
300 PSA
80,000
1000 PSA
60,000
PSA Avg. Life (in yrs)
Pool Balance ($)
0% 19.6
50% 14.7
40,000
100% 11.5
300% 5.8
1000% 2.3
20,000
0 50 100 150 200 250 300 350
Month

Prepayments Are Volatile: FNMA 30-Year Prepayments
Iss Amt Remaining CPR
CPN YR $mm $mm Pools WAC WAM Age May Apr Mar Feb Jan
3.0 2013 150,439 149,056 3890 3.589 355 3 2.7 1.9 1.3 0.8 0.5
3.0 2012 161,500 153,412 4423 3.591 349 8 7.9 5.1 4.4 4.6 6.8
3.5 2013 42,582 42,213 3152 4.028 354 3 3.1 2.2 1.4 1.1 0.5
3.5 2012 232,747 199,822 9730 4.007 344 12 15.4 11.0 11.8 13.7 17.7
3.5 2011 50,951 34,607 1272 4.029 335 20 22.0 17.6 19.0 24.7 30.9
3.5 2010 23,326 14,311 658 4.122 322 31 25.3 22.0 23.9 26.4 30.7
4.0 2012 74,741 64,230 6105 4.472 341 13 16.6 13.7 13.3 12.8 14.5
4.0 2011 118,061 77,394 4104 4.469 332 23 26.0 24.1 25.0 25.8 30.5
4.0 2010 127,504 67,927 3191 4.494 322 32 30.5 27.7 29.6 30.3 33.8
4.5 2012 8,443 7,304 1746 4.962 340 15 16.9 15.2 13.4 11.0 12.3
4.5 2011 101,877 65,491 6025 4.934 330 24 27.2 26.0 25.7 23.3 25.6
4.5 2010 138,481 67,294 4686 4.941 317 36 32.6 32.4 31.7 29.9 32.0
4.5 2009 292,664 99,108 4403 4.935 304 47 40.3 39.2 39.3 37.7 40.6
5.0 2011 29,485 20,777 3356 5.373 329 25 24.0 22.4 20.1 19.0 19.1
5.0 2010 66,211 36,744 2949 5.363 317 37 28.2 26.8 25.0 23.1 24.4
5.0 2009 81,946 30,291 3401 5.425 307 46 35.1 33.3 32.0 28.8 30.2
5.0 2008 90,286 13,622 2096 5.656 291 61 55.0 53.2 51.1 48.4 51.2
5.0 2007 21,612 3,541 985 5.744 278 74 49.0 50.0 48.3 45.4 49.0
5.5 2009 10,502 4,528 1436 5.939 306 46 31.1 26.3 26.6 22.9 24.2
5.5 2008 150,993 22,674 4411 6.044 292 61 52.8 50.3 47.8 44.4 46.9
5.5 2007 155,984 21,064 4003 6.14 280 72 51.9 49.7 46.4 44.4 48.8
6.0 2008 81,036 12,850 4425 6.538 292 60 50.0 47.8 44.9 41.5 43.1
6.0 2007 188,828 28,253 6000 6.573 282 71 48.6 46.7 42.7 40.4 42.9
6.0 2006 160,327 21,625 6201 6.561 268 83 47.1 44.6 42.8 39.2 42.8

Prepayments are Path Dependent
Unlike stock prices, prepayments do not follow a Markov process

Cannot use any closed-form methods or binomial trees for valuation
purposes
MBS valuation depends heavily on econometric prepayment models to
forecast cash flows as a function of the future mortgage rates
Prepayment from refinancing is the greatest source of prepayment risk

Path Dependence: A Simple Prepayment Example
Assume model with three classes of borrowers who initially are equally
represented in the pool
Prepayment rates when prevailing mortgage rate is 2% lower than
current mortgage rate
Fast: 90% CPR
Medium: 50% CPR
Slow: 30%
Pool prepayment speed = (90% + 50% + 30%)/3 = 56.7%
Prepayments after one year of rate exposure
Fast now represents only 7.7% of pool, medium represents 38.5% of
the pool and slow represents 53.8% of the pool
Prepayment speed
= 0.077 × 90% + 0.385 × 50% + 0.538 × 30% = 42.3%

Basic Structure of Prepayment Models
SMM = Turnover + Refinancing

Turnover Factors
Loan Age
LockIn: Spread to current mortgage rate (WAC − rt ) < 0
Home Price Appreciation
Slope at Origination
Share of Refinancers
Spread at Originationg (SatO)
Refinancing Factors
Spread to current mortgage rate: WAC − rt > 0
Burnout
Surge Effect
Loan Size
Credit Quality
Geography
Prepayment Penalties

Prepayment S-Curve
Prepayment S-curve was generated using Bloomberg median forecasts
for a FNMA 30Yr 3% coupon with 359 WAM and 3.7% WAC
1650
1500
1250
1000
PSA
750
500
250
100
50
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5
Mortgage Yield (%)

MBS Price-Yield Curve with Prepayments
The price-yield relationship curves assuming 0 prepayments, a 3%
10-Yr Treasury and prepayments using the S-curve from previous slide
150
140
130
0% CPR Price
120
MBS 3% Coupon Price
110
3% 10−Yr Treasury
S−Curve Price
100
90
80
70
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0
Mortgage Yield (%)

Mortgage Securities Lending
Provides market participants liquidity and flexibility
Reason for MBS lending
Cover short positions such as an investment bank collecting collateral
for a CMO deal
Increase leverage: hedge funds use collateral to leverage and increase
returns (and risk!)
Institutional investors can earn extra income and defray custodial fees
by lending securities
Types of MBS lending
Repurchase agreements (or “repos”): immediate sale simultaneous
future repurchase agreements
Dollar rolls: A simultaneous sell and future buy order
Repo Dollar Roll
Security Any MBS pass-through
Financing Rate Collateral dependent spread to repo rate
Principal & Interest Original owner Holder of record
Used to Cover Short No Yes
Haircut Yes No
Same Securities Returned Yes No, but similar
Prepayment Risk No Yes

Repo Basics
Collateral: Besides MBS pass-throughs can include CMOs,

corporates, Treasuries, etc.
Haircut: Determines the margin, generally range from 1% to 10%,
higher the haircut less that can be financed
Term
Overnight repo: 1 day
Term repo: periods exceeding 1 day, but less than 3 months
Open repo: rate reset each day
Title: Loses title, but receives principal and interest payments
Risks
Credit: Either party may default
Liquidity: Short squeezes lead to failed transactions as lenders can’t
replace securities
Market: Price declines lead to margin calls with T+0 settlement
Settlement: failure of either party (cash or collateral at settlement)

Repo Example
Repo $5 million of FNMA 30-Yr 3.5% for 10 days at 0.45% with a
5% haircut
Current price (bid side) and accrued interest (settlement on 10th day
of month):
9
$100-22 + 3.5 = 100.775
360
Bond value: 5,000,000 × 1.00775 = 5,038,750
Repo Principle: 5,038,750 × (1 − 0.05) = 4,786,812.50
10
Repo interest: 4,786,812.50 × 0.0045 360 = 598.35
+3
$5,038,750 FN 30Yr 3.5%
Day 1: Seller (borrower) Buyer (lender)
ks
$4,786,812.50
+3
$4,786,812.50 + $598.35
Day 10: Seller (borrower) Buyer (lender)
ks
$5,038,750 FN 30Yr 3.5%
Dollar Roll Basics
Selling the roll: Sell “front month” and buy “back month”
Seller gives up principal and interest to buyer of roll
Securities returned are “substantially similar”, but not necessarily the
same
Dollar rolls do not require “haircuts”
Forward Drop: Difference between immediate price and forward price
(a positive value)
Requires prepayment assumption
Roll buyer must account for difference between forward date and date
principal and interest is received

Dollar Roll Example: Screen Calculations

Dollar Roll Example
Roll $1m FHMLC 30Yr 3%, WAC = 3.829% and May WAM = 337
Settle: 5/13/19, fwd date: 6/13/19 (31 days), funding rate: 2.5%
Imm. price: $99-06, prepayment speed: 120 PSA, forward drop: 0-02
Roll purchase:
Mortgage roll:
(99 + 6/32)/100 × 1,000,000 = 981,875.00
Accrued interest (12 days):
12
1,000,000 × 0.03 = 1,000
360
Amount invested:
981,875.00 + 1,000 = 992,875
Interest earned:
31
0.025 × 992,875 = 2,137.44
360
Total future value:
992,875 + 2,137.44 = 995,012.44
Dollar Roll Example: Continued Holding
May coupon:
0.03
1,000,000 × = 2,500
12
Scheduled balance:
1 − (1 + 0.03829/12)−336

1,000,000 = 998,343.19
1 − (1 + 0.03829/12)−337
Scheduled principal payment:

1,000,000 − 998,343.19 = 1,656.81
CPR: Loan age = 360 − 337 + 1 = 24

24 × 0.2 × 120/100 = 5.76
SMM:
(1 − (1 − 5.76/100)1/12 ) = 0.004931588
Prepayment:
998,343.19 × 0.004931588 = 4,923.42

Dollar Roll Example: Continued Holding
Net Cash Flow: Coupon + Sch Princ + Prepayments
2,500 + 1,656.81 + 4,923.42 = 9,080.23
PV net cash flow:

9,080.23
= 9,078.97
1 + 0.025 × 2/360
Ending principal:
1,000,000 − 1,656.81 − 4,923.42 = 993,419.77
June accrued interest:

12
993,419.77 × 0.03 = 993.42
360
Total future value:
9,078.97 + (99 + 4/32)/100 × 993,419.77 + 993.42 = 994,799.74
Roll-vs-Own difference:
995,012.44 − 994,799.74 = 212.70

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Fixed Income: MBS Mechanics

Professor John P. Miller

Professor John P. Miller Fixed Income: MBS Mechanics 1 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 2 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 3 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 4 / 49

FHA Loan Limits Limit1 Fannie Mae/Freddie Mac

In Excel = pmt(0.06/12, 360, −250000)

Professor John P. Miller Fixed Income: MBS Mechanics 7 / 49

Let Bt be the mortgage balance

0 50 100 150 200 250 300 350

Professor John P. Miller Fixed Income: MBS Mechanics 8 / 49

0 50 100 150 200 250 300 350

Professor John P. Miller Fixed Income: MBS Mechanics 9 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 10 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 11 / 49

Determine the borrowers ability to repay the loan

Professor John P. Miller Fixed Income: MBS Mechanics 12 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 13 / 49

Lender/Originator assumes “fallout” and interest rate risks for time

Professor John P. Miller Fixed Income: MBS Mechanics 14 / 49

Loan #1 - 30Yr Mortgage

Professor John P. Miller Fixed Income: MBS Mechanics 15 / 49

Pool Balance = $250,000 + 150,000 + 200,000 + 100,000 +

Weighted average maturity (WAM) is the current

Professor John P. Miller Fixed Income: MBS Mechanics 16 / 49

Professor John P. Miller Fixed Income: MBS Mechanics 17 / 49

Federal Housing Administration (FHA) was established through the

Professor John P. Miller Fixed Income: MBS Mechanics 18 / 49

FNMA created first fix-rate mortgage pass-through in 1981, and was

Professor John P. Miller Fixed Income: MBS Mechanics 19 / 49

GNMA guarantees full timely payment of principal and interest.

Newly issued pass-through MBS trade on a forward basis

Professor John P. Miller Fixed Income: MBS Mechanics 21 / 49

Lenders can sell forward up to nine months

Professor John P. Miller Fixed Income: MBS Mechanics 22 / 49

Pools can also be traded in the specified pool market according to

Professor John P. Miller Fixed Income: MBS Mechanics 24 / 49

Accrued interest and principal is paid to owner of record on last day of

Using our pricing formula:

Professor John P. Miller Fixed Income: MBS Mechanics 26 / 49

Note: Can only solve this way because of no prepayment assumption;

Single Monthly Mortality:

Example: A 30-year 6% mortgage with a $200,000 original balance.

Professor John P. Miller Fixed Income: MBS Mechanics 28 / 49

Constant prepayment rate (CPR): SMM’s annualized prepayment rate

Example: What is CPR when the SM M = 0.596%?

CP R = 100 × (1 − (1 − 0.596/100)12 ) = 6.92%

Interpretation: If pool prepaid at 0.596% SMM for 12 months then

Professor John P. Miller Fixed Income: MBS Mechanics 29 / 49

100% PSA is defines the CPR according the pool WALA

Example: if the prepayment is 6.92% CPR when WALA is 60, what is

300% PSA at 28 WALA:

150% PSA at 60 WALA:

Professor John P. Miller Fixed Income: MBS Mechanics 30 / 49

Survival factor: ft = ft−1 (1 − SM Mt /100)

Pool mortgage payment: Mt = ft−1 M0

Net interest received by investor: It = Pt−1 (r − s)

Monthly servicing: St = Pt−1 s

Scheduled monthly princ pmt: Scht = Mt − It − St

Monthly prepayment: P Pt = SM Mt /100 × [Pt−1 − Scht ]

Monthly CF received by investor: CFt = It + Scht + P Pt

Period-end principal balance: Pt = Pt−1 − Scht − P Pt

Professor John P. Miller Fixed Income: MBS Mechanics 31 / 49