CHAPTER TWENTY
MORTGAGE-BACKED SECURITIES
Practical Investment Management
Robert A. Strong
Outline

Mortgages
Types
 Mortgage Mathematics
 Mortgage Risk


The Mortgage Backed Securities Market
History
 Types of Securities

South-Western / Thomson Learning © 2004
20 - 2
Outline

Considerations in Pricing Mortgage
Backed Securities
The Importance of Prepayment Rates
 The PSA Convention
 The Risks of MBS
 The Risk of Collateralized Mortgage Obligations
 The Risk of Stripped Mortgage Backed Securities

South-Western / Thomson Learning © 2004
20 - 3
Introduction
A mortgage is a loan with real estate
as collateral. The lender, called the
mortgage originator, often charges
points as a fee for preparing and
placing the mortgage.
It is quite common for the lender to sell the
mortgage to another party.
The homeowner may be unaware of this, as
the lender normally continues to be the
mortgage servicer.
South-Western / Thomson Learning © 2004
20 - 4
Mortgages: Types

A fixed rate mortgage is one with payments
based on a set interest rate that does not
change.

An adjustable rate mortgage (ARM), also
called a variable rate mortgage, has an
interest rate that moves with some market
interest rate, such as the Treasury bill rate.

Most ARMS have an annual reset to the
interest rate. Many also have either a
cap or a floor on the interest rate.
South-Western / Thomson Learning © 2004
20 - 5
Mortgages: Types

With a convertible mortgage, the borrower has
the option to exchange it for a fixed rate at the
prevailing ARM rate.

There are other mortgage arrangements:
biweekly - payments are due every two weeks
semi-monthly - payments are due two times
each month
graduated payment - the monthly payments
increase following a predetermined
schedule
South-Western / Thomson Learning © 2004
20 - 6
Mortgages: Types
shared appreciation - the borrower splits the
rise in the value of the property
with the lender in exchange for a
reduced interest rate
reverse - the homeowner sells the property to
a bank and receives monthly
mortgage payments
South-Western / Thomson Learning © 2004
20 - 7
Mortgage Mathematics
Example :
A bank approves a prospective homeowner for
a 30-year, $100,000 mortgage at an 8% annual
rate.
 There will be 30×12 = 360 monthly payments at a
monthly interest rate of 8÷12 = 0.66667%
South-Western / Thomson Learning © 2004
20 - 8
Mortgage Mathematics
For an annuity:
1

1
present value  C  
N 
 R R1  R  
where C = the monthly payment
R = the monthly interest rate
N = the number of payments
So:
 1

1
$100,000  C 

360 
0
.
66667
0.666671  0.66667  

 The monthly payment will be $733.76
South-Western / Thomson Learning © 2004
20 - 9
Mortgage Mathematics
If the borrower pays the bank $1,500 instead
of $733.76 for the thirteenth payment, how
will the amortization schedule be affected?
The bank considers the extra $766.24 the borrower
paid a principal reduction, and the anticipated life of
the loan will decrease.
South-Western / Thomson Learning © 2004
20 - 10
Mortgage Risk

Default risk is the risk that the borrower is
unable or unwilling to repay the debt as
agreed.

Interest rate risk is the risk that the general
level of interest rates rises, such that the
value of the mortgage’s cash flow stream
declines.

Prepayment risk is the risk of an early
payment of the original mortgage, such as
when the home is sold or when the
mortgage is refinanced at a lower rate.
South-Western / Thomson Learning © 2004
20 - 11
The Mortgage Backed Securities Market

The Federal National Mortgage Association
(Fannie Mae), the Government National
Mortgage Association (Ginnie Mae), & the
Federal Home Loan Mortgage Corporation
(Freddie Mac) support the US mortgage
market by providing liquidity, buying
conforming mortgages from banks across the
country for resale elsewhere.

The term mortgage-backed securities refers to
all products based on mortgage loans.
South-Western / Thomson Learning © 2004
20 - 12
Types of Securities

A pass-through security is a share of a pool
of mortgages.
Individual
Mortgages
Individual
Mortgages
Individual
Mortgages
Mortgage Pool
Pass-Through Security

The holders receive a monthly check for their
portion of the scheduled principal and
interest payments, plus their share of
any prepayments that may occur.
South-Western / Thomson Learning © 2004
20 - 13
Types of Securities
 Pass-through securities may be issued and
guaranteed by a government agency, or
they may be private label.
 Two types of derivative securities that
spring from pass-through securities are
collateralized mortgage obligations and
stripped mortgage-backed securities.
South-Western / Thomson Learning © 2004
20 - 14
Types of Securities

A collateralized mortgage obligation (CMO) is
a security backed by a pool of mortgages
and structured to transfer prepayment or
interest rate risk from one group of security
holders to another.

A given pool of mortgages backs two or more
classes of securities called tranches.
South-Western / Thomson Learning © 2004
20 - 15
Types of Securities
Collateralized Mortgage Obligation
Individual
Mortgages
Individual
Mortgages
Individual
Mortgages
Mortgage Pool
A Tranche
B Tranche
South-Western / Thomson Learning © 2004
C Tranche
Other Tranches
20 - 16
Types of Securities
Insert Table 20-3 here.
South-Western / Thomson Learning © 2004
20 - 17
Types of Securities

With a sequential pay CMO, all the tranche
holders receive monthly interest payments
based on the principal amount outstanding
in their tranche.

All principal payments go to the A tranche
until the A tranche principal is completely
returned. Only then will the investors in the
next tranche begin to receive principal.
South-Western / Thomson Learning © 2004
20 - 18
Types of Securities
Insert Table 20-4 here.
South-Western / Thomson Learning © 2004
20 - 19
Types of Securities

There are two types of stripped mortgage
backed securities, or strips.
Individual
Mortgages
Individual
Mortgages
Individual
Mortgages
Mortgage Pool
Interest Only Security

Principal Only Security
All the interest goes to the interest only (IO)
security holders, while the entire principal
goes to the principal only (PO) holders.
South-Western / Thomson Learning © 2004
20 - 20
Considerations in
Pricing Mortgage Backed Securities

The price risk of a MBS comes from the
uncertainty about the timing of cash flows.

Prepayments can affect the realized return on
a MBS substantially.

The offering memorandum for a MBS will
state the assumptions used in estimating
cash flows from the mortgage pool.

A benchmark assumption for the rate of
mortgage prepayment is offered by the
Public Securities Association (PSA).
South-Western / Thomson Learning © 2004
20 - 21
Considerations in
Pricing Mortgage Backed Securities
Constant Prepayment Rate
 The standard PSA assumption is that a 30year mortgage will see prepayments of
0.2% for the first month and that
prepayments will increase by 0.2% for each
of the next 29 months, after which they
remain constant.
 The 0.2% per month prepayment
assumption is called 100% PSA.
South-Western / Thomson Learning © 2004
20 - 22
Considerations in
Pricing Mortgage Backed Securities
A MBS has default, interest rate, and prepayment
risks.

Riskiness of Cash Flows
Timing
Known
Timing
Unknown
$ Amount
Known
fixed rate
non-callable
bond
principal only
security
$ Amount
Unknown
variable rate
non-callable
bond
interest
only
security
South-Western / Thomson Learning © 2004
20 - 23
The Risk of Collateralized Mortgage Obligations

Declining interest rates will increase the
value of a cash flow stream and will lead to
prepayments.

If a mortgage pool sells at a discount,
prepayments will increase the value of each
of the tranches, with the higher duration
tranches benefiting the most.

If the pool sells at a premium, then
prepayments will reduce everyone’s yield,
with the effect most pronounced for the
holders of the longer duration tranches.
South-Western / Thomson Learning © 2004
20 - 24
The Risk of Stripped Mortgage Backed Securities

Prepayment has different consequences for
IO and PO strips. An extension of the
mortgage decreases the value of the
principal payments but increases the value
of the interest payments.

Declining interest rates will increase the
value of a series of known cash flows, as
well as the likelihood of prepayment.
Normally, the prepayment effect overwhelms
the interest rate effect.
South-Western / Thomson Learning © 2004
20 - 25
The Risk of Stripped Mortgage Backed Securities
Insert Table 20-6 here.
South-Western / Thomson Learning © 2004
20 - 26
The Risk of Stripped Mortgage Backed Securities
Insert Table 20-7 here.
South-Western / Thomson Learning © 2004
20 - 27
The Risk of Stripped Mortgage Backed Securities
Insert Table 20-8 here.
South-Western / Thomson Learning © 2004
20 - 28
The Risk of Stripped Mortgage Backed Securities
Insert Table 20-9 here.
South-Western / Thomson Learning © 2004
20 - 29
Review

Mortgages
Types
 Mortgage Mathematics
 Mortgage Risk


The Mortgage Backed Securities Market
History
 Types of Securities

South-Western / Thomson Learning © 2004
20 - 30
Review

Considerations in Pricing Mortgage
Backed Securities
The Importance of Prepayment Rates
 The PSA Convention
 The Risks of MBS
 The Risk of Collateralized Mortgage Obligations
 The Risk of Stripped Mortgage Backed Securities

South-Western / Thomson Learning © 2004
20 - 31