Chapter 11
Valuation of Mortgage
Securities
Chapter 11
Learning Objectives
Understand the valuation of mortgage
securities
 Understand cash flows from various
types of mortgage securities
 Understand how changes in interest
rates affect mortgage securities values
 Understand mortgage securities and
hedging against interest rate risk

TRADITIONAL DEBT
SECURITY VALUATION
Typically fixed, semi-annual interest
payments with face value paid at
maturity
 Value moves inversely with market
interest rates
 Yield to maturity at a given point in
time is based on current market value

MORTGAGE-RELATED
SECURITIES
Cash flows have three components:
interest, principal amortization, and
prepayments
 Total principal on mortgage pool is
constant but principal payments may be
accelerated or delayed based on
changes in market rates

MORTGAGE RELATED
SECURITIES
Market rates rise, mortgage prepayment
slows down as borrowers hold onto lowrate loans
 Market rates decline, mortgage
prepayment increases due to
refinancing

PASS-THROUGHS
The rate of mortgage prepayment is
crucial in pass-through valuation
 Several models of expected
prepayment:

FHA Twelve-Year Prepaid Life
 Constant Prepayment Rate
 FHA Experience

PASS-THROUGHS

Prepayment models (cont.):

Public Securities Association (PSA) Model
Current industry standard
 Combines FHA experience with CPR model

Econometric Prepayment Models
 Refinancing Models


Based on title search activity which precedes
refinancing
PASS-THROUGHS
No rearranging of the cash flows from
the mortgage pool
 Prepayments have a significant impact
on the timing of cash flows and thus
the value of those cash flows
 If selling at a discount, accelerated
(delayed) prepayment increases
(decreases) the realized yield

PASS-THROUGHS
For pass-throughs selling at a premium,
delayed prepayment increases yield and
accelerated prepayment decreases yield
 Coupon rates reflect market rates at
time of issue
 High coupon pass-throughs suffer price
compression due to prepayment
expectations

PASS-THROUGHS
Changes in market rates have two
impacts on pass-through value: both
the discount rate and the assumed
prepayment will change
 In senior/subordinated pass-throughs
the senior security has enhanced rights
to cash flows and subordinated security
bears all the default risk

MORTGAGE-BACKED BONDS
Cash flows are structured as traditional
non-callable debt with periodic interest
payments and face value at maturity
 Seek to be sufficiently overcollateralized
 Cash flows not paid to investors are
placed in a sinking fund
 Financial rating based on amount of
overcollateralization

MORTGAGE-BACKED BONDS
Overcollateralization is related to the
balance in the sinking fund
 Variables that affect the balance of the
sinking fund at maturity include the
mortgage prepayment rate, the
reinvestment rate on the sinking fund,
the initial overcollateralization, and the
default rate

COLLATERALIZED MORTGAGE
OBLIGATIONS
Cash flows are made up of various
tranches and residual class
 Any mortgage prepayments are passed
to bondholders thus there is no sinking
fund
 This means that the CMO issuer faces
no interest rate or reinvestment risk
 Yield is higher on longer tranches

COLLATERALIZED MORTGAGE
OBLIGATIONS
CMOs are structured differently from
pass-throughs thus prepayment
behavior affects pricing and yield
differently
 Price and yield on shorter-term tranches
will not vary as much with prepayment
as compared to pass-throughs

STRIPS
Cash flows may be rearranged to
produce principal-only and interest-only
strips
 Principal-only (PO) strips receive all
principal payments when they are
received
 Amount of principal equals the initial
pool balance but the timing is unknown

STRIPS
If prepayment accelerates, principal is
returned faster
 Interest-only strips receive the interest
when it is paid
 Total amount of interest is not known
but is based on principal outstanding
 Accelerated prepayment reduces
principal and reduces interest amount

STRIPS
Thus accelerated prepayment may be
advantageous for PO investors and
disadvantageous for IO investors
 A change in market interest rates
changes the discount rate used to value
securities and alters prepayment
behavior

STRIPS
PO Strip: Interest rate goes up,
discount rate goes up, prepayment goes
down and net effect is value goes down
 IO Strip: Interest rate goes up, discount
rate goes up, prepayment goes down
and net effect is value goes up

FLOATERS
Floaters are classes of a CMO that have
a rate that moves with the market
 These are matched with an institution’s
short-term liabilities that move with the
market
 The interest rate on the floater is
usually pegged to some short-term rate
such as LIBOR

FLOATERS
Since rate is variable, there is a risk of
loss if market rates risk significantly
 To solve this problem an inverse floater
is created out of the same tranche
 Inverse floater is a bond on which the
interest rate moves opposite to the
market rate

SERVICING RIGHTS
Lenders sell off loans and often retain
the servicing rights
 Servicing includes collecting monthly
payments, maintaining escrow
accounts, forwarding proper payments
to purchasers, sending delinquency and
default notices, initiating foreclosure
proceedings and collecting on PMI

SERVICING RIGHTS
Revenue from servicing includes the
servicing fee, float on the escrow
accounts, and float between receipt of
monthly payments and payments to
purchasers
 Costs include administrative costs and
overhead

SERVICING RIGHTS
Fee is usually between 0.25 and 0.50
percent of the mortgage balance
 Value is affected by interest rate
changes similar to IO strips
 Rates rise, discount rate goes up and
prepayment accelerates. Combines to
reduce the value of servicing rights

SERVICING RIGHTS
Excess servicing rights are fees greater
than “normal”
 Usually occurs when mortgages are sold
with a promised rate less than the
coupon on the mortgages
 The greater the spread, the larger the
excess servicing fees

SERVICING RIGHTS

Reasons for excess servicing rights
Mortgage-backed securities generally have
coupons in one-half point intervals
 Premium securities may sell at unattractive
prices due to fears of prepayment
 Mortgage pools may contain loans with
different coupons thus some loans may
have excess servicing

VALUE CREATION IN MBSs
Value is created even though no
additional cash flow is created
 Securitization eliminates liquidity risk
and makes the market larger
 Securitization rearranges the cash flows
into more and less risky components
 Asymmetric information may distort
values - lenders may have superior
