Lecture Note Ten: Mortgage and

Mortgage-Backed Securities

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

10-1
 Outline
Mortgage participants: originators, insurers, servicers
Types of mortgages: fixed rate mortgages and adjustable
rate mortgages
Mortgage-backed securities:
Mortgage pass-through securities
Collateralized mortgage obligations (CMOs)
Stripped mortgage-backed securities

Reference: Fabozzi’s chapter 10-12, Tuckman’s chapter 20

10-2
 Mortgages
A mortgage is a loan secured by the collateral of
specified real estate property, which obliges the
borrower to make a predetermined series of payments
• Lender: mortgagee
• Borrower: mortgagor
The lender makes the loan based on the credit of the
borrower and on the collateral for the mortgage.
The lender has the right to seize/foreclose the property if
payments are not received.

10-3
Mortgages: Residential vs. Non-Residential

There are two broad categories of mortgages:

• Residential mortgage loan
• Residential properties include houses, condominiums,
cooperatives, and apartments.
• Residential real estate can be sub-divided into single-family
(one-to-four-family) structures and multifamily structures.
• Non-residential property includes commercial and farm
properties.
We focus on residential mortgage loans.

10-4
 Mortgage Participants: Originators
Mortgage originators generate income by:
• Collecting origination fee, expressed in points (1 point =
1% borrowed funds)
• Holding mortgage as part of portfolio
• Receive principal and interest according to payment
schedule
• Selling mortgage at a profit in secondary market
• Mortgage faces interest rate risk, like any other bond

10-5
 Mortgage Originators
Originators will perform a credit evaluation. Two
primary factors in the lending decision.
• Payment to Income (PTI)
• Measures ability to make monthly payments
• The lower this ratio, the greater the likelihood that the
applicant will be able to meet the required payments.
• Loan to Value (LTV): amount of loan to market price of
the property
• Provides measure of protection lender has in a default.
Lower this ratio, more protection.

10-6
 Mortgage Insurers
Mortgage insurance is usually required on loans with
LTV > 80% (down payment is less than 20%). There are
two types of insurance:
• Government Sponsored (if borrower qualifies)
• Federal Housing Administration (FHA)
• Veterans Administration (VA)
• Mortgage Insurance Programme (MIP in HK)
• Private mortgage insurance companies (PMI)
Cost of insurance is paid by lender, but passed along to
borrower.
10-7
 Mortgage Insurers: Credit Life
Credit life is another kind of mortgage insurance offered
by life insurance companies.
Credit life is not required by the lender. The policy
provides for a continuation of mortgage payments after
the death of the insured person, which allows the
survivors to continue living in the house.
From the lender’s perspective, mortgage insurance is
more important than credit life.

10-8
Mortgage Participants: Mortgage Servicers

Mortgage servicers provide services of a mortgage loan.

• Collect monthly payments
• Forward proceeds (net of fees) to owners
• Send payment notices to mortgagors/borrowers
• Remind mortgagors when payments are overdue
• Maintain records of principal balances, etc
Collecting servicing fee
• A fixed proportion of the outstanding balance – dropping
as mortgage balance is paid off.

10-9
 Types of Mortgage
The interest on the mortgage loan is called contract rate
or mortgage rate. The contract rate must be higher than
the risk-free rate to compensate for costs of
collection/servicing, costs associated with default,
poorer liquidity and prepayment option.
Loans can be mainly classified by the contract rate :
• Fixed rate mortgages (FRMs)
• Adjustable rate mortgages (ARMs)

10-10
 Fixed Rate Mortgages
An FRM (fixed rate mortgage) is a mortgage that makes
payment in equal installments over the life of the
mortgage (amortization schedule).
Monthly payments include
• Interest payment: 1/12 of the annual contract rate times
the remaining balance of the outstanding mortgage
• Principal payment: a portion of the outstanding mortgage
principal

10-11
 FRMs: Mathematics
Monthly payment in fixed rate mortgages are just
annuities.

Where
• MP is the periodic mortgage payment
• y is the periodic interest rate
• n is the number of periods
• MB0 is the original balance

10-12
 FRMs: Example
Example: a 30-year loan with initial principal of
$250,000 and fixed contract rate of 6%
• Monthly rate = 0.06/12 = 0.005
• Number of periods: 30x12 = 360
• Monthly payment

• Using financial calculator: PV = 250,000, I/Y = 0.5%, N

= 360, FV = 0  PMT = – 1,498.88

10-13
 FRMs: Example (cont’d)
The monthly payment is $1,498.88. What portion of the
first month payment is interest and what portion is
principal?
• First month interest payment is the monthly rate times the
initial principal:

• Principal Repay is the difference between the monthly

payment and the interest payment:

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 FRMs: Example (cont’d)
Principal Ending
Month Balance Payment Interest Repay Balance
1 $250,000 $1,498.88 $1,250.00 $248.88 $249,751
2 $249,751 $1,498.88 $1,248.76 $250.12 $249,501
3 $249,501 $1,498.88 $1,247.50 $251.38 $249,250

Initial Balance = 250,000

Monthly Payment = 1,498.88
Interest = Current Balance*(0.005)
Principal Repay = Monthly Payment – Interest
Ending Balance = Current Balance – Principal
Repay
10-15
 FRMs: Example (cont’d)
Principal Ending
Month Balance Payment Interest Repay Balance
1 $250,000 $1,498.88 $1,250.00 $248.88 $249,751
2 $249,751 $1,498.88 $1,248.76 $250.12 $249,501
3 $249,501 $1,498.88 $1,247.50 $251.38 $249,250
50 $236,220 $1,498.88 $1,181.10 $317.78 $235,902
100 $218,220 $1,498.88 $1,091.10 $407.78 $217,812
200 $165,480 $1,498.88 $827.40 $671.48 $164,809
300 $78,636 $1,498.88 $393.18 $1,105.70 $77,530
359 $2,975 $1,498.88 $14.88 $1,484.00 $1,491
360 $1,491 $1,498.88 $7.46 $1,491.42 $0

Final payment sufficient to cover interest owed and

outstanding principal balance. The mortgage is fully
amortized. 10-16
 FRMs: Amortization Schedule
Note that the proportion of monthly payment that goes
towards paying down principal varies dramatically over
the life of the mortgage:
 Month 1: Principal/Payment = 16%
 Month 100: Principal/Payment = 27%
 Month 360: Principal/Payment = 99%

The repayment schedule is referred to as an

amortization schedule.

10-17
 FRMs: More about Mortgage Math
If MB0 is the original balance and MP is the periodic
mortgage payment, after j payments, the remaining
principal is

In the (j+1)th payment,

• the interest payment is .
• the principal repayment is .

10-18
 Adjustable Rate Mortgages
An ARM (adjustable-rate mortgage) is a loan in which
the contract rate is reset periodically in accordance with
some appropriately chosen reference rate, typically one
based on a short-term interest rate.
• One typical reference rate is the Treasury-based rates.
• Another typical reference rate is the National Cost of
Funds Index and it is calculated based upon all federally
insured S&Ls.

10-19
 Adjustable Rate Mortgages
Aggregate interest rate risk cannot be made to disappear.
However, who faces that risk can be controlled by
choice of contract written.
• FRM: Lender takes on interest rate risk
• ARM: Borrower takes on interest rate risk
Most common type of ARM’s are hybrid ARM’s where
the interest rate is locked in for a few years:
• Example: 3/1 ARM – rate locked in for 3 years
– rate reset every 1 year

10-20
 Adjustable Rate Mortgages
To encourage borrowers to accept ARMs (and take on
the interest rate risk) rather than fixed-rate mortgages,
mortgage originators generally offer an initial contract
rate (teaser rate) that is less than the prevailing market
mortgage rate.

There are other terms that affect the monthly mortgage

payment: periodic caps and lifetime caps that set the
maximum mortgage payment adjustments.

10-21
 Other Mortgages
Reverse mortgages: A type of mortgage in which a
homeowner can borrow money against the value of his
or her home.
• No repayment of the mortgage (principal or interest) is
required until the borrower dies or the home is sold.
• Advantage: provides income; the borrower's credit is not
relevant, and is often unchecked.
• Disadvantage: large origination costs relative to other
types of mortgages; high interest rate.

10-22
 Other Mortgages
Assumable mortgages: A type of financing
arrangement in which the outstanding mortgage and its
terms can be transferred from the current owner to a
buyer.
• Attractive during times of rising interest rates.
• By assuming the previous owner's remaining debt, the
buyer can avoid having to obtain his or her own mortgage.
• The interest rate on assumable mortgages is generally
higher than the interest rate on non-assumable mortgages.

10-23
 Other Mortgages
Prepayment penalty mortgage: a mortgage designed to
mitigate the borrower’s right to prepay.
• All mortgage loans have a “due on sale” clause, which
means that the remaining balance of the loan must be paid
when the house is sold.
• Homeowners often repay all or part of their mortgage
balance prior to the scheduled maturity date.
The design reduces the uncertainty in the cash flows.

10-24
 Mortgage Prepayment
Prepayment occurs for a variety of reasons:
• Moving  homeowner sells home
• Property is refinanced
• Lower interest rates
• Improved financial condition of borrower
• Homeowner cannot meet obligation
• House repossessed and sold
• Property is destroyed
• Insurance prepays for owner

10-25
Risks Associated with Investing in Mortgages

Investors face four main risks by investing in residential

mortgage loans:
• credit risk: the risk that the homeowner / borrower will
default.
• liquidity risk: mortgage loans are large and indivisible,
tend to be rather illiquid with large bid-ask spreads.
• price risk: value of the loan will move in an opposite
direction from market interest rates.
• prepayment risk: the risk associated with a mortgage’s
cash flow due to prepayments.

10-26
 Mortgages: Secondary Market
Historically, mortgage loans on individual homes were
extremely illiquid, typically remaining with bank that
originated loan
• Difficult to diversify risk of ‘bust-town’
• Difficult to provide funds for ‘boom-town’
To create liquidity and to provide support to the
mortgage market, government agencies were created to
convert illiquid residential mortgage loans into liquid
mortgage-backed securities (MBS) through
securitization.
10-27
 Mortgages: Secondary Market
This can be done privately or through government
organizations such as:
• Federal Home Loan Mortgage Corporation (Freddie Mac)
• Federal National Mortgage Association (Fannie Mae)
• Government National Mortgage Association (Ginnie Mae)
• The Hong Kong Mortgage Corporation Limited (HKMC):
mortgage-backed securities programme

10-28
 Types of MBS
Mortgage pass-through securities: created when one or
more holders of mortgages form a collection (pool) of
mortgages and sell shares or participation certificates in the
pool
Collateralized mortgage obligations (CMOs): created
when the cash flows of mortgage-related products are
redistributed to different bond classes
Stripped mortgage-backed securities: created for investors
to receive either principal or interest payment from a pool of
mortgage loans.

10-29
 MBS: WAC and WAM
Not all mortgages in pool have same rate and maturity.
Hence, mortgage pool is described by
Weighted average coupon rate (WAC): mortgage rate
of loan in pool weighted by the amount of balance
outstanding.
Weighted average maturity (WAM): the remaining
number of months to maturity for each loan weighted by
the amount of balance outstanding

10-30
 MBS: Average Life
Macaulay duration is sometimes used to determine an
“average maturity” associated with the expected cash
flows of a MBS. More commonly, however is the
Average Life, defined as

where the weights are the proportion of principal

expected to be received at date .

10-31
 Mortgage Pass-Throughs
Payments of a pass-through security are made each
month.
• However, neither the amount nor the timing of the cash
flow from the loan pool is identical to that of the cash
flow passed through to investors.
• The monthly cash flow for a pass-through security is less
than the monthly cash flow of the loan pool by an amount
equal to servicing and other fees.
• Pass-through rate < WAC
Because of prepayments, the cash flow of a pass-through
is also not known with certainty.
10-32
 Mortgage Pass-Throughs
Government-sponsored pass-throughs are free of default
risk
• Government-sponsored entities (GSEs) cover losses due
to defaults so that defaults basically look like
prepayments.

As such, prepayment risk is the major source of risk in

government-backed pass-throughs.
• Pricing of government-sponsored pass-throughs reduces
to estimating the prepayment rate.
10-33
 Prepayment Conventions
To value a pass-through security, it is necessary to
project its cash flow.
• To do this, one needs a “prepayment model”: making
some assumption about the prepayment rate over the life
of the underlying mortgage pool.
The yield calculated based on the projected cash flow is
called a cash flow yield.
Appendix provides some discussion on prepayment
convention, especially the PSA convention with an
example.
10-34
 Prepayment Risks
Compare pass-through to “portfolio of Treasuries”
whose cash flows equal expected cash flows of pass-
through:
• When interest rates drop, prepayments increase just when
you don’t want them to
• Forced to reinvest at lower rates
• “Contraction Risk”
• When interest rates rise, prepayments decrease just when
you don’t want them to
• Have less funds to reinvest at the higher rates
• “Extension Risk”
10-35
 Limitation of Pass-Throughs
Pass-throughs may not generate stream of cash flows
that some potential investors are interested in. This has
led to the creation of some more exotic securities:

• Collateralized Mortgage Obligations (CMO’s)

• Principal Only Stripped Mortgage-Backed Securities
(PO’s)
• Interest Only Stripped Mortgage-Backed Securities (IO’s)

10-36
 Mortgage-Backed Securities
It should be emphasized that risk is not created or
destroyed by creating these different securities. Rather,
risk is only redistributed.
• Sometimes, there can be a “win-win” situation where two
investors can purchase securities with more desirable risk
characteristics.
• For example, one derivative can be made low-risk by
creating another that faces a lot of risk.
• As a 2nd example, CMOs create some “tranches” with
shorter “average lives” and other “tranches” with longer
“average lives”.
10-37
Collateralized Mortgage Obligations (CMO)

In standard pass-though, each ‘share’ has claim to given

% of all principal and interest payments received.
Standard ‘sequential-pay CMO’ has all principal going
to tranche-A, until its original designated principal is
paid. Then, all principal payments go to tranche-B, etc.
• Intuitively, the “average life” associated with tranche-A
will be less than the “average life” associated with
tranche-B, which is less than….

10-38
 Accrual Bonds and CMO’s
In many sequential pay CMO’s, at least one tranche does
not receive any interest payments early on. Instead, the
“interest due” would accrue and be added to the
principal balance. This tranche is known as the
“accrual tranche”
Moreover, the interest that would typically go to the
accrual tranche instead goes to paying down the
principal of the most senior tranche.
• Note that the accrual tranche will not receive any cash
flows for a long time, reducing “reinvestment rate” risk,
at least for several years.
10-39
 Stripped MBS’s
Principal Only: claim to all principal payments
Interest Only: claim to all interest payments
Because principal payments are guaranteed by GSE’s,
CF’s associated with PO securities are known. Due to
prepayment risk, however, the timing of the CF’s is
unknown.
• PO investors want prepayment to be fast.
In contrast, when prepayments occur, future interest
payments are never paid.
• IO investors want prepayment to be slow.
10-40
End of the Notes!

10-41
Appendix

PSA CONVENTION

10-42
 Prepayment Conventions
To value a pass-through security, it is necessary to
project its cash flow.
• To do this, one needs a “prepayment model”: making
some assumption about the prepayment rate over the life
of the underlying mortgage pool.

10-43
 Prepayment Conventions
Several conventions have been used as a benchmark for
prepayment rates:
• Federal Housing Administration (FHA) experience
• Assumes that the prepayment rate will be the same as the
FHA experience with 30-year mortgage loans.
• This convention is no longer used.
• Public Securities Association (PSA) prepayment
benchmark
• The conditional prepayment rate

10-44
 Prepayment Conventions: CPR
The model assumes that some fraction of the remaining
principal in the pool is prepaid each month for the
remaining term of the mortgage.
The prepayment rate assumed for a pool, called the
conditional prepayment rate (CPR), is based on the
characteristics of the pool (including its historical
prepayment experience) and the current and expected
future economic environment.
• Conditional on the remaining balance.

10-45
 Prepayment Conventions: CPR
The Conditional Prepayment Rate (CPR) is an annual
prepayment rate.
To estimate monthly prepayments, the CPR must be
converted into a monthly prepayment rate, commonly
referred to as the single-monthly mortality rate (SMM).
A formula can be used to determine the SMM for a
given CPR:

10-46
 Prepayment Conventions: CPR
SMM Rate and Monthly Prepayment
• An SMM of w% means that approximately w% of the
remaining mortgage balance at the beginning of the
month, less the scheduled principal payment, will prepay
that month.
• That is,

10-47
 Prepayment Conventions: CPR
Example: Suppose that an investor owns a pass-through
in which the remaining mortgage balance at the
beginning of some month is $290 million. Assuming that
the CPR is 6% and the scheduled principal payment is
$3 million, what is the estimated prepayment for the
month?
Solution:
• SMM rate is
• Prepayment:

10-48
 Prepayment Conventions: PSA
The Public Securities Association (PSA) provides a
benchmark conditional prepayment rate (CPR).
• CPRs are low for newly originated mortgages and then
will speed up with seasoning.
• if month t < 30: CPR =
• if month t > 30 CPR = 6%
The benchmark is referred to as “100 PSA”.
Note: this is only a convention/benchmark:
• Not sophisticated enough for pricing
• Predicts that prepayments independent of rates
10-49
 PSA Models
PSA Models

0.0

10-50
 “Survival” in Pass Through
In month t, the Single-Monthly Mortality Rate (SMM) is
:
• is the probability of a mortgage being prepaid in month t
conditional on surviving up to month t.
• is the probability of a mortgage ‘surviving’ in month t
conditional on surviving up to month t.

10-51
 “Survival” in Pass Through
0 1 2
Prepay? No (1 – SMM1) No (1 – SMM1) (1 – SMM2)
Yes (SMM1) Yes (1 – SMM1) (SMM2)

The probability of a typical mortgage prepaying during

month t is

10-52
 PSA Prepayment Benchmark
Once you have determined the proportion of mortgages
that remain in the pool, it is straightforward to determine
the cash flows of the pass through.
Intuitively, if a proportion p(t) of the mortgages remain
in the pool at month-t, then the outstanding balance is
p(t) times the outstanding balance of the amortization
schedule.
Ex: if p(t) = ½, then the remaining balance is ½ of that
implied from the amortization schedule.

10-53
 PSA Prepayment Benchmark: Example

Consider a pool with 1000 mortgages

• Number of Mortgages = 1000
• Initial Balance on each = 250,000
• WAC = 6% (.5% monthly)
• Pass-Through Rate = 5.5%
• Speed of Prepayments= 200 PSA
• WAM = 360 months
• Initial Mortgage Length = 360 months

10-54
 PSA Prepayment Benchmark: Example

Amortization Schedule
period balance payment interest
1 250,000,000 1,498,876 1,250,000
2 249,751,124 1,498,876 1,248,756
3 249,501,003 1,498,876 1,247,505
principal end balance
248,876 249,751,124
250,121 249,501,003
251,371 249,249,632

Initial Balance = 250,000,000

Monthly Payment =
Interest = Current Balance*(0.005)
Principal Repay = (Monthly Payment – Interest)
Ending Balance = (Current Balance – Principal Repay)

10-55
 PSA Prepayment Benchmark: Example

Survival Schedule
Prepayment Assumption: 200PSA

period CPR SMM Prob_Suv

1 0.004 0.00033395 0.999666
2 0.008 0.00066912 0.998997
3 0.012 0.00100554 0.997993
CPR (month t, 200 PSA) = for
SMM =
Prob_Suv_t =

10-56
 PSA Prepayment Benchmark: Example

period
balance payment interest principal int-5.5% total principal
CF
1 250,000,000 1,498,876 1,250,000 248,876 1,145,833 332,280 1,478,113
2 249,667,720 1,498,376 1,248,339 250,037 1,144,310 416,928 1,561,239
3 249,250,792 1,497,373 1,246,254 251,119 1,142,399 501,499 1,643,898

1) pass-through interest (5.5%) = (.055/12)*balance

1,145,833 = 250,000,000*(.055/12)
2) Balance (pass-though) = Balance(amortization)*survival
249,667,720 = (.999666)*(249,751,123)

3) Total Principal = old balance – new balance

332,280 = 250,000,000 – 249,667,720 10-57
 Factors Affecting Prepayment
PSA guidelines are only a convention. PSA guidelines
assume prepayment rate is independent of current
interest rates.
In reality, we can predict much better than the PSA
convention what prepayments will look like. Some of
the most important factors include:
• Ratio between WAC and current rates (refinancing ratio)
• Path that rates have taken
• Seasonal factors
• Age of pass through
10-58