FIXED INCOME PORTFOLIO

MANAGEMENT

Class 14

Mortgage-Backed Securities

1
 Outline

MBS and ABS

Securitization
Structure of MBS
Mortgage Pass-Throughs
Collateralized Mortgage Obligations (CMOs)
Stripped MBS
Pricing of MBS
Monte Carlo Simulation

2
Mortgage-Backed and Asset-Backed Securities

Mortgage-backed securities (MBSs) and asset-

backed securities (ABSs) make up what is called the
securitized debt market.
The MBS and ABS creation process, called
securitization, consists of transforming the illiquid
assets of a lending entity (financial institution or
corporation) into tradable securities, backed by these
assets.
MBSs and ABSs are collateralized by a pool of
loans.
The cash flow payments are used to pay the cash
flows on the securities.
3
 Advantages and Disadvantages
of MBS and ABS
They generally have a high credit quality (AAAAA).
They produce higher yields than bonds with
comparable quality and maturity.
They are more liquid than corporate securities.
They historically exhibit far less rating downgrades
than corporate securities.
They represent an attractive source of financing.

4
 Securitization

Three participants are involved in the securitization

process.
First, the originator, that is, the original lender.
Second, the issuer, also called the conduit, that is,
the investor who buys loans from the originator,
gathers them into a pool, and issues securities
backed by the pool.
Typically, the issuer creates a bankruptcy remote trust, also
known as a Special Purpose Vehicle (SPV).
The SPV is designed for holding the pool of loans
separately from the other assets of the originator.

5
 Securitization (continued)
This ensures that the cash flows from the pool are entirely
dedicated to servicing the securities backed by this pool.
In case the originator goes bankrupt, the SPV continues to
pay the proceeds from the loans to security holders.
Third, the trustee, that is, the entity that protects the
rights of the security holders.

6
 Securitization (continued)

MBSs and ABSs are complex.

They are very popular among issuers and investors
in the United States as well as in the United
Kingdom and in the Euro area.
Over the last 20 years, the securitized debt market
grew rapidly until 2007 and became a major means
of financing for corporations.
It also became an investment alternative to both the
Treasury debt market and high investment-grade
corporate debt market.

7
 Purpose of Asset Securitization

Asset securitization was originally developed by

banks for the purpose of generating value from the
assets on their balance sheet.
It allows a lending institution to:
Improve the liquidity of its balance sheet, since
the original loan is replaced by a bond that can be
traded.
Reduce the size of its balance sheet by
transferring a part of its assets, and free up
capital to invest elsewhere in its business.
Refinance at an attractive cost, since the interest
cost of ABSs and MBSs is lower than the interest
8
cost of the underlying loans.
Basic Securitization Structure

9
 Mortgage-Backed Securities
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 risk:

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.
10
 Mortgages

A mortgage is a loan secured by the collateral of

some specified real estate property.
If the borrower, also called the mortgagor, fails to
make the contracted payments, the lender, also
called the mortgagee, has the right to seize the
property so as to be paid back.
There basically exist two categories of property:
commercial property and residential property.
Commercial mortgages are backed by income-
yielding properties, such as office buildings,
multifamily apartments, hotels, industrial properties
and retail shopping centers.
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 Amortization Feature

Mortgage loans differ from one another as regards

their amortization pattern.
The simplest and most common mortgage type is the
fixed-rate, level-payment mortgage.
The borrower makes equal monthly payments (MPs)
at the beginning of every month until the loan is fully
amortized.
Each MP consists of an interest part, equal to one-
twelfth of the mortgage rate times the principal
outstanding amount at the beginning of the previous
month, and a principal part, corresponding to the
repayment of a fraction of the principal outstanding.
12
 Amortization Feature (continued)

Denote by P the initial principal amount of the

mortgage loan, by r the interest rate of the mortgage,
by n the maturity of the mortgage, as expressed in
number of months and by M the constant MP on the
mortgage.
The monthly periodic interest rate, equal to r/12 , is
the internal rate of return of the cash-flow series
(P,M,M,. . . ,M).

13
 Monthly Mortgage Payment

Since

it follows that

14
 Remaining Outstanding Principal

Let us now compute for month j, the interest

component ij and the principal component pj of the MP.
After j 1 months, the principal outstanding amount
Pj1 is equal to the present value of the remaining
monthly cash flows. So,

That is

15
 Remaining Outstanding Principal (continued)

We can deduce

and

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 Example

Consider a $1 million level-payment mortgage loan

with a 15-year maturity and a 12% interest rate.
Compute the amortization schedule.
Each of the 180 monthly payments M amounts to

12%
106
M 12
1
1 180
12%
1
12

M $12,001.68 17
 Example (continued)

The amortization schedule

18
 Prepayment Feature

Prepayment potentially affects all mortgage loans,

especially residential mortgages.
It designates any early principal payment made in
excess of the regular amortization schedule.
There are five sources of prepayment:
Home sales A mortgagor may sell his home,
following a job change compelling him to move, or
because he wants to buy a larger house.
Refinancings A mortgagor may have the
opportunity to refinance at a lower cost, if interest
rates fall below the interest rate of the mortgage.
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 Prepayment Feature (continued)

Defaults A mortgagor may be unable to honor his

obligations, in which case the mortgage is
foreclosed and liquidated. For a residential
mortgage, this means that the home is seized and
sold.
Extra payments A mortgagor may wish to pay
more than the scheduled payment each month so
as to build up equity in his home faster.
Accidents A mortgagor may have his home
destroyed by an accident or a natural disaster.

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 Effect of Prepayments on MBS
As MBSs are backed by mortgages, they are also
subject to prepayment.
This feature makes them equivalent to callable bonds.
For an investor, prepayment risk is a serious issue as
prepayments tend to take place when interest rates are
going down (refinancing motive), that is, at times when
reinvestment opportunities in similar securities are not
particularly attractive.
For an investor, prepayment risk translates into
Cash flow uncertainty because an MBS may be prepaid at any time
before maturity;
Reinvestment risk because the actual maturity of an MBS may be lower
than the investment horizon;
Negative convexity because an MBS has an embedded prepayment 21
option.
 Effect of Prepayments on MBS (continued)

Projecting prepayment is critical for the analysis and

valuation of an MBS.
A good prepayment model should be:
flexible so as to capture the time-varying nature of
the factors affecting prepayments (costs of
refinancing, borrower demographic characteristics,
etc.);
robust over time and apply to any case, whatever
may be the borrower and mortgage types.

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 Mortgage Pass-Throughs

Mortgage pass-throughs are the simplest form of

MBSs.
A pass-through unit represents a share of the
underlying mortgage pool.
The cash flows generated by the pool are passed on
to the security holders on a pro-rata basis.
They are delivered monthly and consist of three
components: interest payments, scheduled principal
payments, and prepayments.

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Example of a Mortgage Pass-Through Security

Consider 100 mortgage loans, each amounting to $1

million, gathered into a pool.
The value of the pool is $100 million.
Assume that 200 units of a pass-through backed by
that pool are issued.
Each unit amounts to $500,000 and is entitled to
0.5% of the cash flows.

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Collateralized Mortgage Obligations (CMOs)
CMOs differ from mortgage pass-throughs in that
they distribute cash flows to security holders on a
priority basis.
They are structured in maturity classes, called
tranches.
In the sequential pay structure, 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.
Prepayment risk is redistributed among the different
tranches.
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 Sequential Pay CMOs

The first tranche absorbs prepayments first, then the

second tranche, and so on.
As a result, the first tranche has the shortest
maturity, while the last tranche has the longest
maturity.
Note that all tranches still receive interest payments
on a pro rata basis.
Compared to mortgage pass-throughs, the maturity
of each CMO class is less uncertain.

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 Sequential Pay CMO Example

Returning to the previous example, assume a CMO

structured in three classes: A, B and C.
Class A amounts to $60 million, Class B $25 million,
and Class C $15 million.
Class A will receive all principal payments until $60
million are paid off.
Then Class B will receive all principal payments until
$25 million are paid off.
Class C is the last to receive principal payments.
Each unit of a given class is entitled to receive a
proportion of the payments on that class.
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 Stripped MBSs

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 the POs are paid off, that is, the higher the
price of the POs.
At the same time, the lower the total cash flows
received on the IOs, that is, the lower the price of the
IOs.
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 Market Quotes and Pricing

MBSs are traded in a highly active secondary market.

Until the 2007-2009 financial crisis, they were
generally considered as liquid as high-investment-
grade corporate bonds.
The major agency mortgage pass-throughs were
about as liquid as Treasury bonds.

29
 MBS Price Quotes
MBSs are quoted in basis points above the on-the-run
Treasury yield curve or above the swap yield curve.
For this purpose, market makers compute what is
called the weighted average life (WAL) of an MBS.
The WAL is based on some prepayment rate
assumption.
WAL is nothing but the average time for receiving
future principal payments, weighted by the amount of
each principal cash flow.

30
 MBS Price Quotes (continued)
Then the yield of the MBS is compared against either
the interpolated on-the-run Treasury bond yield with
maturity equal to the WAL of the MBS or the
interpolated swap yield with maturity equal to the WAL
of the MBS.
The coupon of an MBS is typically lower than the
weighted average coupon on the underlying mortgage
pool by an amount equal to the fee paid to the servicer
of the mortgage loans.

31
32
33
 Pricing of MBSs
Complex because of the prepayment issue.
Mortgage refinancings change 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.

34
 Pricing of MBSs

The valuation of an MBS comes down to the valuation of

a callable bond.
From the two pricing methods that have been presented
in Chapter 14, only one is used in practice, the Monte
Carlo simulation method.
The nonrecombining binomial tree method works also,
but not the recombining tree.
However, the nonrecombining tree method is seldom
used in practice.

35
 Prepayment

In any month, the prepayment rate is dependent on

whether there have been refinancing opportunities in the
past.
Refinancing opportunities depend on the level of interest
rates.
Broadly speaking, refinancings tend to increase
(respectively, decrease) as the interest rate on new
mortgage loans falls below (respectively, rises above)
that on existing mortgage loans.
A mortgage pool that has experienced refinancing
opportunities in the past will have, other things being
equal, lower refinancing rates than a pool that had no
such experience. 36
 Prepayment Rate Example

Consider a pool of 100 mortgage loans with two

categories of mortgagors: fast refinancers (50% of
the pool) and slow refinancers (50% of the pool).
The fast category has a refinancing rate equal to
70% per period, and the slow one a refinancing
rate of 30% per period.
At the end of the first period, the refinancing rate R1
of the pool is equal to

50 70% 50 30%
R1 50%
100
37
 Prepayment Rate Example (continued)

There remain 50 mortgages in the pool: 15 in the

fast category and 35 in the slow category.
At the end of the second period, the refinancing rate
R2 of the pool is equal to
15 70% 35 30%
R2 42%
50
and so on.
The refinancing rate of the pool decreases gradually
to the refinancing level of the slow category of the
pool.
38
 Monte Carlo Simulation

This methodology is used much less often than the

interest-rate tree methodology.
It is mostly dedicated to the pricing of path-dependent
securities like mortgage-backed securities.
The future cash flows of these securities do not
depend only on the future level of interest rates, like
bonds with embedded options.
They also depend on the path taken by the short-term
interest rate over time.

39
 Monte Carlo Methodology

Step 1 Given the current value of the short-term

interest rate r, a large number of future short-term
interest-rate paths are generated using the discrete-
time version of the general model for the dynamics of
the short-term rate (see equation (12.3) from
Chapter 12):

In this equation,
r designates the change in the short-term interest rate
over one period;
t designates the change in time from one period to
another; 40
 Monte Carlo Methodology (continued)

(., .) designates the expected absolute return on the

short-term interest rate per time unit: it is potentially a
function of both the short-term interest rate r and time t ;

(., .) designates the standard deviation of the absolute

change in the short-term interest rate per time unit: it is
potentially a function of both the short-term interest rate
r and time t ;

t designates independent normally distributed random

variables with zero mean and a standard deviation of 1.
41
 Monte Carlo Methodology (continued)

Choose for simplicity

or
In this approach,
designates the expected relative return on the
short-term interest rate per time unit;
designates the volatility of the short-term interest
rate per time unit (i.e., the standard deviation of the
relative change unit).

42
 Monte Carlo Simulation Example

Assume the current 1-year interest rate is 4%. is

assumed to be equal to 4.5% per annum and 5%
per annum.
The period frequency is annual, so t = 1.
Then the future 1-year interest rates are generated
from 1 year to another according to the following
formula:
r = 0.045r + 0.05r
If rk stands for the 1-year interest rate starting in year
k (year 0 meaning currently), we have
r0 = 4%
rn = 1.045rn1 + 0.05rn1 43
 Monte Carlo Simulation Example (continued)

In order to simulate you can use what is known as

the BoxMuller method.
If x1 and x2 are two independent random variables
uniformly distributed on ]0,1[, the following random
variables y1 and y2 defined as
y1 2 ln x1 cos 2x 2
y 2 2 ln x1 sin 2x 2
are independent standard normal random variables.
This is practically very easy to implement on an
Excel spreadsheet since x1 and x2 can be generated
by the function RANDOM(). 44
 Monte Carlo Simulation Example (continued)

Consider the simulation of 6 short-term interest-rate

paths with a 10-year length using the BoxMuller
method and the above formula for rn.
As r is a 1-year interest rate and the interest-rate
paths length equals 10 years, n is equal to 10.

45
Interest Rate Paths

46
 Monte Carlo Methodology (continued)

In practice, the model is calibrated to the current

term structure of interest rates by adding the same
drift term (obtained from the term structure) to each
simulated short-term interest rate maturing in the
same period.
Thus, the average present value of a par coupon
bond, discounted along all paths, is exactly equal to
100.

47
 Monte Carlo Methodology (continued)

Step 2 Along each interest-rate path, the price P

of the bond with embedded options is recursively
determined.
Consider a callable bond, with maturity n years (n >
5), annual coupon C, redemption value V, and call
price CP exercisable after 5 years.
Pk denotes the price of the bond in year k and rk the
1-year interest rate starting in year k.

48
Sequence of Bond Prices

49
 Monte Carlo Simulation Example (continued)

The table below shows the prices of a callable bond

with annual coupon 4.57%, maturity 10 years,
redemption value 100, and callable at 100 after 5
years, along the 6 interest-rate paths presented in
the previous example.

50
 Monte Carlo Methodology (continued)

Step 3 The price of the bond is computed as the

average of its prices along all interest-rate paths.

51
 Monte Carlo Simulation (continued)

The price of the callable bond is equal to

P = 1/6 (100.43 + 100.55 + 99.90 + 99.76 + 99.68 +
100.55) = 100.14.
The larger the number of interest-rate paths
simulated, the more accurate the pricing of a bond.
Generally speaking, you need to simulate at least
300 interest-rate paths in order to get a reasonable
valuation.

52
Valuation of MBS Using Monte Carlo Simulation

Using the Monte Carlo simulation method, the

valuation of an MBS is calculated according to a five-
step 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 all the paths. 53
 Prepayment Models

The valuation of an MBS is fairly complex because of

the prepayment feature.
There are two static prepayment models that are
popular among practitioners:
Constant Prepayment Rate (CPR) Model
PSA Experience-Based Model

54
Constant Prepayment Rate (CPR) Model
The prepayment rate is assumed to be constant.
It is expressed on an annual basis.
To review (from the fixed income securities course),
denote by the constant proportion of the outstanding
mortgages that are prepaid within a month.
1 is the constant proportion of the outstanding
mortgages that are still remaining after a month.
After 1 year, the constant proportion of the outstanding
mortgages that are still remaining is equal to (1 )12 or
1 CPR.
Hence the CPR is equal to: CPR = 1 (1 )12 .
55
 PSA Experience-Based Model

As you know from the fixed income securities

course, this is the most commonly used model.
It is based on the empirical observation that
prepayment rates tend to be stable after 30 months.
A mortgage is said to be 100% PSA when its initial
annualized prepayment rate is 0.2% and increases
linearly by 0.2% each month until reaching 6%
annualized at the end of the 30th month.
The CPR for month n is equal to

56
 PSA Experience-Based Model (continued)

More generally, a mortgage is said to be x% PSA

when it has an initial prepayment rate and increase
equal to x% times 100% PSA.
The CPR for month n is equal to

When computing the expected cash flows of a

mortgage loan, the prepayment rate is applied to the
end-of-month remaining principal balance (after
scheduled principal paydown has been calculated).

57
 Simple Static Pricing Framework

The following example illustrates how to use the PSA

experience-based model to compute the expected cash
flows of a mortgage loan.
The regular MPs in the absence of prepayment
(scheduled MP) are denoted by MP, the remaining
principal balance in the absence of prepayment at the
end of month n by Pn, the expected cash flow in month
n by E(CFn), and the CPR in month n by CPRn.
First, convert the annualized prepayment rate in month
n into a monthly prepayment rate n in month n:
CPRn = 1 (1 n)12
Hence n = 1 (1 CPRn)1/12
58
 Simple Static Pricing Framework (continued)
The expected cash flows are:
E(CF1) = MP + 1 P1
E(CF2) = (1 1) (MP + 2 P2)
E(CF3) = (1 1) (1 2) (MP + 3 P3)

More generally, for month n,

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 100%PSA
Month Remaining Scheduled Monthly Scheduled
Principal Monthly Prepayment And Unscheduled
Amount Payment Rate (%) Monthly Payments
0 1,000,000.00
1 997,998.32 12,001.68 0.02 12,168.17
2 995,976.62 12,001.68 0.03 12,332.23
3 993,934.71 12,001.68 0.05 12,493.76
4 991,872.37 12,001.68 0.07 12,652.68

90 710,030.00 12,001.68 0.51 10,668.98
91 705,128.62 12,001.68 0.51 10,597.01
92 700,178.23 12,001.68 0.51 10,525.34
93 695,178.33 12,001.68 0.51 10,453.95

177 35,296.77 12,001.68 0.51 5,302.17
178 23,648.05 12,001.68 0.51 5,248.96
179 11,882.85 12,001.68 0.51 5,195.90
180 0.00 12,001.68 0.51 5,142.99
60
The MPs of the Mortgage Loan Without
Prepayment and With Prepayment

61
 Mortgage Prepayment Example

Applying the PSA static prepayment function, it is

easy to compute the price of an MBS.
The price P is equal to

where rk denotes the zero-coupon rate with maturity k

months, E(CFk) the expected cash flow of the MBS
in month k, and n is the maturity, expressed in
months, of the MBS.

62
 Conclusions

Mortgage-backed securities (or MBSs) are securities

that are backed by the cash flows of a mortgage or a
pool of mortgages, which are loans secured by the
collateral of some specified commercial or residential
real estate property.
There are three main types of MBS: Mortgage Pass-
Throughs, Collateralized Mortgage Obligations
(CMOs), and Stripped MBSs.
CMOs differ from mortgage pass-throughs in that
they are structured in maturity classes, called
tranches.
Prepayment risk is redistributed among the different
tranches. 63
 Conclusions (continued)

Stripped MBSs are highly sensitive to prepayment

rates, and hence riskier than mortgage pass-throughs.
As MBSs are backed by mortgages, they are also
subject to prepayment risk, which potentially affects all
mortgage loans, and especially residential mortgages.
Prepayment can be triggered mainly by home sales,
refinancing, and defaults.
For an investor, prepayment risk is a serious issue as
prepayment tends to occur when interest rates go
down, that is, at times when reinvestment
opportunities in similar securities are not particularly
attractive.
64
 Conclusions (continued)

MBSs are path-dependent securities, as their price is

dependent on the past evolution of interest rates.
Projecting prepayments is critical for the analysis
and valuation of an MBS.
Pricing of MBS can be performed using the Monte
Carlo simulation method to generate interest-rate
paths and prepayment rate paths.
Because refinancings change the composition of the
pool, the pool will experience a decrease in the
prepayment rate over time.

65