FIXED-INCOME SECURITIES
Chapter 17
Mortgage-Backed Securities
Outline • Definition and Typology • Mortgage Pass-Throughs • Collateralized Mortgage Obligations • Stripped MBS • Pricing of MBS
Issuers of Bonds Definition and Typology • MBS are securities that are backed by the cashflows of a mortgage or a pool of mortgages • A mortgage is a loan secured by the collateral of some specified real estate property. • MBS can be divided into three types – Mortgage pass-through securities – Collateralized mortgage obligations – Stripped mortgage-backed securities
• MBS are subject to prepayment – Prepayment can be triggered mainly by home sales, refinancings, and defaults – For an investor prepayment risk is a serious issue as prepayment tends to occur when interest rates go down, i.e., at times when re-investment opportunities in similar securities are not particularly attractive
Issuers of Bonds Mortgage Pass-Throughs • Mortgage pass-throughs are the simplest form of MBS • They represent shares of the underlying mortgage pool, which entitle the security holder to monthly cash-flows generated by the pool on a pro rata basis • In the US, there exist two types of pass-throughs – Agency pass-throughs: mainly issued by three organizations, the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). – Non-agency (or simply conventional) pass-throughs
Issuers of Bonds Collateralized Mortgage Obligations • Collateralized Mortgage Obligations (CMOs) differ from mortgage pass-throughs in that they are structured in maturity classes, called tranches – All principal payments (regular principal payments as well as prepayments) are allocated to the first tranche until it is fully paid off – Then, it is the turn of the second tranche, and so on
• Hence, prepayment risk is redistributed among the different tranches, the first tranche absorbing prepayment first – Stripped MBSs are structured in two classes: an Interest Only class (IO) and a Principal Only class (PO) – The IO class receives all interest payments while the PO class receives all principal payments
Issuers of Bonds Stripped MBS • Stripped MBSs are structured in two classes: an Interest Only class (IO) and a Principal Only class (PO) • The IO class receives all interest payments while the PO class receives all principal payments • Stripped MBSs are highly sensitive to prepayment rates, and hence riskier than mortgage passthroughs • The higher the prepayment rate on the mortgage pool, the faster POs are paid off, that is the higher the price of POs, and the lower the total cash-flows received on IOs, that is the lower the price of IOs
Issuers of Bonds Pricing of MBS • Complex because of the prepayment issue • Refinancings changes the composition of the pool – – – –
Removes fast and capable refinancers from the pool at a faster rate than slow and less capable refinancers Therefore the pool will include a higher and higher proportion of slow refinancers over time This results in a decrease in the refinancing rate over time This feature makes MBS path-dependent securities, as their price is dependent on the past evolution of interest rates
• The valuation of a MBS with a MC method is a five-steps process – – – – –
Step 1: simulation of interest rate paths Step 2: simulation of prepayment rate paths based on a dynamic prepayment model Step 3: computation of the expected cash-flows along each path Step 4: computation of the MBS price along each path Step 5: computation of the MBS price as the average of its prices along each path