Mortgage -Backed Securities
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Asset-Backed Securities
Mortgage-Backed Securities
Prof. Ian Giddy
Stern School of Business New York University
Mortgages and MBS
l Mortgage Loans l Pass-throughs and Prepayments l CMOs l Analysis of MBS Pricing and Convexity
Copyright ?1999 Ian H. Giddy
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Structure of the US MBS Market
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Copyright ?1999 Ian H. Giddy
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Mortgage-Backed Securities 4
US Mortgage-Backed Securities
AGENCY PASS-THROUGHS
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Copyright ?1999 Ian H. Giddy
PRIVATE-LABEL PASS-THROUGHS
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Form of cash flow allocation
Pay-through obligation
Pass-through obligation
Different tranches
PAC
(planned aamortization class)
TAC
(targeted amortization plan)
Copyright ?1999 Ian H. Giddy
IO/PO strips
Mortgage-Backed Securities 6
Mortgage-Backed Securities
Mortgage 1
Equal monthly payments
prepayable
GNMA mortgage pool
security
Mortgage
...
2
Mortgage n
n Mortgage-backed securities are prepayable, so one cannot measure returns or values easily
n They tend to pay down early when rates fall, and later when rates rise.
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Mortgage Prepayments
Complexity of the option l Systematic risk: exercise of the interest
rate option l Unsystematic risk: reasons unrelated to
mortgage interest rates (eg demographic)
Copyright ?1999 Ian H. Giddy
Mortgage-Backed Securities 8
Mortgage Pool Prepayment Conventions
Traditional method is to forecast prepayments by adjusting the PSA (Public Securities Association) benchmark of a prepayment rate that reaches 6% a year for 30 year mortgages.
Annual prepayment rate (CPR): 100% PSA:
If t30 CPR=6% 170% PSA: If t30 CPR=170%[6%] Monthly prepayment rate (SMM): SMM=[1-(1-CPR)]/12 Prepayment amount in dollars: = (Beginning Principal Balance - Scheduled Principal Repayment)*SMM
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Prepayment Assignment
l Consider a $100,000 10-year, 9% mortgage loan, with monthly equal payments.
l Make the following calculations, using a computer spreadsheet or financial calculator:
1. What are the scheduled monthly payments? 2. After 1 month and 3 months,
u What is the CPR and SMM, assuming 200% PSA? u What is scheduled principal payment? u If it pays down at 200% PSA, what is the
prepayment amount? u What is the remaining principal balance?
Copyright ?1999 Ian H. Giddy
Mortgage-Backed Securities 10
CMOs and Strips
The technique:
l Allocate cash flows (interest & principal) of MBS to mitigate prepayment risk
l Pay different returns based on risk
l The sum of the part should be worth more than the whole alone.
Example: MDC Series J CMO with underlying pool WAC 9.5%, 297 months final maturity
Copyright ?1999 Ian H. Giddy
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CMOs and Strips
l First-priority classes
l Z-class: last to be paid off
l Floating/inverse floating CMOs
l Planned Amortization Class bonds (PACs) and TACs
l Companions with priority schedules (PAC IIs)
l VADM bonds (use early principal and interest to pay priority bondholders)
l CMO residuals (collateral interest - CMO interest)
l IOs and POs
Copyright ?1999 Ian H. Giddy
Mortgage-Backed Securities 12
The Negative Convexity of MBS
Securities backed by fixed-rate mortgages have "negative convexity." This refers to the fact that when interest rates rise, the MBS behave like long-term bonds (their prices fall steeply); but when rates fall, their prices rise slowly or not at all.
Price
Price-yield curve of 20 year bond callable in 3 years
20-year
Callable bond
Copyright ?1999 Ian H. Giddy
3-year
Yield
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Convexity of Callables
Mortgage-backed securities and other callable bonds may have negative convexity which cushions a bond's price rise and accelerates its fall!
PRICE
102 100
Copyright ?1999 Ian H. Giddy
YIELD
Mortgage-Backed Securities 14
MBS: Fannie Mae REMIC Pass-Throughs
l What are the underlying mortgage pools?
l Look at different asset groups: l Yields on different classes l Price risks on each class l What do the seller & servicer gain?
Group work
Copyright ?1999 Ian H. Giddy
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Bond Valuation, Duration and Convexity
Bond Valuation
The formula for a bond's price is B0 = Ix(PVIFAk ,n ) + Mx (PVIFn )
B0
=
nI
t =1(1
+
k
)t
+
M (1 + k )n
Copyright ?1999 Ian H. Giddy
Mortgage-Backed Securities 17
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