Baird Capital Markets
Portfolio & Product Integration Group
Introduction to the MBS Market
March 2010
Prepared by Kirill A. Krylov, CFA,
Steven Scheerer, CFA, FRM
SangWoo Park, FRM
Institutional Use Only
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Introduction to the MBS Market
MBS Pass-Through or Pool
Asset Manager
Institutional Use Only
Insurance Company
Bank
Hedge Fund
2
Introduction to the MBS Market:
Why Invest in MBS
 Asset Class Diversification.
 Principal Cash Flow is produced even in a rising rate environment.
 “Smooth” Cash Flow Profile vs. Callable Agency.
 Retail Option vs. Institutional Option.
 Investor is able to quantify the amount of risk taken.
 Higher Yield vs. positively convexed instruments.
 Recent Housing market troubles offer extension protection.
 MBS are fun to analyze.
Institutional Use Only
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Introduction to the MBS Market:
MBS Basics: Let’s Start with Some Definitions
 Cashflows consist of monthly payment of interest, scheduled principal, and
prepayments.
 Prepayments: Mortgages are continuously callable. Prepayment of mortgages could
come in any of four forms – refinance, turnover, curtailment or default.
 Home owners make payments at the start of the month to the servicer. These
payments are passed along to the investor with a “delay.”
 The difference between what the borrower pays and what the investor receives goes
towards the servicing fee and guarantor fee for agency pass-through securities.
 Pass-throughs or pools: Collection of mortgage loans securitized in a way such that
pro-rata payment of P + I cash flow received from mortgage borrowers goes to
investors/bond holders. Interest payments are based on principal balance outstanding
at the beginning of the month.
Institutional Use Only
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Introduction to the MBS Market:
MBS Basics: Prepayments Defined
Difference between scheduled principal payment and actual principal paid,
which includes payment due turnover, refinance, curtailment or default.
Prepayment standards
1. SMM or Single Monthly Mortality: It calculates the % of
principal prepaid in any month and is expressed as a percentage of
the expected balance.
ActualBalance 

SMM  100 1 

 ScheduleBalance
2. Constant Prepayment Rate or CPR is an annualized number.
Calculated by converting the SMM into an annual rate.


CPR  100 1  1  SMM
100
Institutional Use Only
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
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Introduction to the MBS Market:
MBS Basics: Prepayments by Vintage
Institutional Use Only
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Introduction to the MBS Market:
MBS Basics: Prepayment Drivers
Key drivers of prepayment speeds:
•
WAC: Weighted Average Coupon / Loan Rate
•
Remaining Amortization Schedule: 30yr, 20yr, 15yr, 10yr, balloon etc
•
Loan Size: AOLS = Average Original Loan Size
Secondary drivers of prepayment speeds:
•
LTV: Loan to value and Credit Profile (FICO)
•
Documentation
•
Investor/Owner – Occupied
•
State Specific Factors
•
Local HPA (Home Price Appreciation)
•
Servicer Profile
Institutional Use Only
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Introduction to the MBS Market:
MBS Analytics: Positive Convexity Defined

For a given decrease in rates, the realized
increase in price is greater than the duration
PactualA
predicted increase in price
PA

Conversely, for the same increase in rates, the
realized decrease in price is less than the
P0
duration predicted decrease in price
PactualB
PB
∆y
∆y
YA
Y0
YB
Yield
Institutional Use Only
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Introduction to the MBS Market:
MBS Analytics: Negative Convexity Defined

For a given decrease in rates, the realized
increase in price is less than the duration
predicted increase in price
PA

PactualA
Price
Conversely, for the same increase in rates, the
realized decrease in price is greater than the
P0
duration predicted decrease in price
PB
PactualB
∆y
∆y
YA
Y0
YB
Yield
Institutional Use Only
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Introduction to the MBS Market:
MBS Analytics: Some MBS Analytics
• Weighted Average Life (WAL): The units of WAL are in years.
• It is the weighted average time to return of principal.
• Its calculation does not include the effect of interest payments. It is
synonymous with maturity of a bullet bond.
• Modified Duration: Based on a static prepayment assumption. Assumes cash
flows are not volatile in rate scenarios.
• Effective Duration adjusts for the optionality of the cash flows. Cash flows
fluctuate depending on changing rate scenarios.
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Generic Snapshot
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Important Terminology
 Factor = Current balance outstanding / original principal balance.
Adjustment for pay downs. Trader messages will refer to current balance
outstanding as Current Face or just “CF”. Original Face or just “OF”.
 TBA (To Be Announced): For generic MBS no need to specify the pool
number. This sector is available for 30yr and 15yr amortization
schedules and trades in 50bps coupon increments.
 The most liquid market within the mortgage universe. Baseline for
non-TBA eligible pools, specified pools, and 10/1 hybrids (more on this
shortly).
 Specified Pools: Offered at a pay up to TBA. Example: +9+/TBA,
which means the pool in question is offered at a 9+/32 pay up to its
comparable TBA.
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-through Sectors: Important Terminology
 Specified Pools: Trade relative to their TBA counterparts.
 They trade at a pay up to TBA because of a special feature that enhances convexity.
 This special feature could be added call protection for premiums and/or extension
protection for discounts.
 Common specified pool characteristics: Seasoning, Loan Balance, Geographic
composition, credit score (FICO score) and loan-to-value (LTV) ratio.
 Seasoning is determined by the Weighted Average Loan Age (WALA) or the production
year of the underlying loans (e.g., 2003 vintage).
 Loan Balance is determined by the Average Original Loan Size (AOLS) or Maximum
Original Loan Size. Loan size determines the borrower’s incentive to refinance. Low
loan size borrowers have a lower incentive to refinance when rates drop because the
dollar amount of the net savings is less. Low loan balance pools off premium
coupons demand a pay up for added call protection.
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through: Prepayment (Convexity Stories)
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Loan Balance Stories
Specified Pool “ Convexity Stories”:
• Loan Balance
• Investment Property
• Gross WAC
• GEO / Negative Equity
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Loan Balance Stories
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Investor Property
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Gross WAC
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: GEO
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through: Current State of the Housing Market (HPA)
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Negative Equity
Institutional Use Only
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Introduction to the MBS Market:
MBS Pass-Through Sectors: Introduction to CMOs
The World’s Shortest Introduction to CMOs
Institutional Use Only
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Introduction to the MBS Market:
CMO Structures: Generic Sequential Deal
2-yr Seq.
5-yr Seq.
Collateral
10-yr Seq.
Long Seq.
Institutional Use Only
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Introduction to the MBS Market:
CMO Structures: Generic PAC / Support Deal
2-yr PAC
5-yr PAC
PAC
10-yr PAC
Collateral
Long PAC
PAC-2
Support
Cash Flows
Support
Institutional Use Only
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Introduction to the MBS Market:
Important MBS Market Relationships
Important MBS Market Relationships
Institutional Use Only
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Introduction to the MBS Market:
Important MBS Market Relationships – 30yr vs. 15yr MBS
Institutional Use Only
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Introduction to the MBS Market:
Important MBS Market Relationships – 30yr CC MBS vs. Callables
Institutional Use Only
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Introduction to the MBS Market:
Important MBS Market Relationships – 30yr CC MBS vs. Corporates
Institutional Use Only
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Kirill A. Krylov, CFA
Lead Portfolio Strategist
312-609-4668
kkrylov@rwbaird.com
Steven Scheerer, CFA, FRM
Portfolio Analyst
312-609-4669
sscheerer@rwbaird.com
SangWoo Park, FRM
Portfolio Strategist
(312) 578-2757
swpark@rwbaird.com
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Institutional Use Only
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