Mortgage-backed security
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by
the principal and interest payments of a set of mortgage loans. Payments are typically made
monthly over the lifetime of the underlying loans
However not all securities backed by mortgages are considered mortgage-backed securities.
Housing Bonds (Mortgage Revenue Bonds) are backed by the mortgages which they fund, but
aren't MBSs.
Residential mortgages in the United States have the option to pay more than the required
monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because
curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an
MBS is not known in advance, and therefore presents an additional risk to MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily
properties (such as apartment buildings, retail or office properties, hotels, schools, industrial
properties and other commercial sites). The properties of these loans vary, with longer-term
loans (5 years or longer) often being at fixed interest rates and having restrictions on
prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
History
In 1938, a governmental agency named the National Mortgage Association of Washington was
formed and soon was renamed Federal National Mortgage Association (FNMA or Fannie Mae). It
was chartered by the US government as a corporation which buys Federal Housing
Administration (FHA) and Veterans Administration (VA) mortgages on the secondary market,
pools them, and sells them as "mortgage-backed securities" to investors on the open market.
FNMA was privatized in 1968 as a "government sponsored enterprise" listed on the stock
exchange.
Additionally, the 1970 Emergency Home Finance Act created a new secondary mortgage market
participant, the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) to support
conventional mortgages originated by thrift institutions. The Act also allowed FNMA to buy
conventional mortgages in addition to FHA & VA.
Freddie Mac competed in the secondary market, where Fannie Mae had enjoyed a monopoly.
Market size and liquidity
Mortgage backed securities can be considered to have been in the tens of trillions, if Credit
Default Swaps are taken into account.
The total market value of all outstanding mortgages at the end of the first quarter of 2006 was
approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger
than the market value of outstanding asset-backed securities. The MBS market overtook the
market for US Treasury notes and bonds in 2000.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
2005: USD 967 billion
2004: USD 1,019 billion
2003: USD 2,131 billion
2002: USD 1,444 billion
2001: USD 1,093 billion
The high liquidity of most mortgage-backed securities means that any investor wishing to take
a position need not deal with the difficulties of theoretical pricing described below; the price
of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than speculation) for entering the market include the desire to hedge against a
drop in prepayment rates (a critical business risk for any company specializing in refinancing)
and certain predatory lending schemes.
Structure and features
Weighted-average maturity
The weighted-average maturity (WAM) of an MBS is the average of the maturities of the
mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an
average across mortgages, as distinct from concepts such as weighted-average life and
duration, which are averages across payments of a single loan.
To illustrate the concept of WAM, let's consider a mortgage pool with just three mortgage loans
that have the below mentioned outstanding mortgage balances, mortgage rates, and months
remaining to maturity.
Loan Outstanding Mortgage
Balance
Mortgage
Rate
Remaining Months to
Maturity
Each Loan's
Weighting
Loan
1 $200,000 6.00% 300 22.22%
Loan
2
$400,000 6.25% 260 44.44%
Loan
3
$300,000 6.50% 280 33.33%
The weightings are computed by dividing each outstanding loan amount by total amount
outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts
at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists
of three loans is computed as follows:
WAM = 22.22% (300) + 44.44% (260) + 33.33% (280)
= 66.67 + 115.56 + 93.33
= 275.56 Months or 276 months after rounding
Weighted-average coupon
The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages
in the pool, weighted by their original balances at the issuance of the MBS.
Why and where we use WAM and WAC
WAM and WAC are used for describing a mortgage passthrough security, and they form the basis
for the computation of cash flows from that mortgage passthrough. Just as we describe a bond
by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for
example, "this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month
WAM."
Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that
the investor would receive if he/she holds this mortgage passthrough security (or simply
mortgage passthrough). Almost always, the passthrough rate is less than the WAC. The
difference goes to servicing (i.e., costs incurred in collecting the loan payments and
transferring the payments to the investors) the mortgage loans in the pool.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because some
securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from
other mortgage-backed instruments the qualifier pass-through is used, in the same way that
'vanilla' designates an option with no special features.
Mortgage-backed security sub-types include:
Pass-through mortgage-backed security is the simplest MBS, as described in the
sections above. Essentially, a securitization of the mortgage payments to the mortgage
originators. These can be subdivided into:
o Residential mortgage-backed security (RMBS) - a pass-through MBS backed by
mortgages on residential property
o Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by
mortgages on commercial property
Collateralized mortgage obligation (CMO) - a more complex MBS in which the
mortgages are ordered into tranches by some quality (such as repayment time), with
each tranche sold as a separate security.
Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to
pay down the loan's principal and partly used to pay the interest on it. These two
components can be separated to create SMBS's, of which there are two subtypes:
o Interest-only stripped mortgage-backed securities (IO) - a bond with cash
flows backed by the interest component of property owner's mortgage
payments.
o Principal-only stripped mortgage-backed securities (PO) - a bond with cash
flows backed by the principal repayment component of property owner's
mortgage payments.
Varieties of underlying mortgages in the pool:
Prime: conforming mortgages: prime borrowers, full documentation (such as
verification of income and assets), strong credit scores, etc.
Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some
way, often lower documentation (or in some other way: vacation home, etc.)
Subprime: weaker credit scores, no verification of income or assets, etc.
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as
set by FannieMae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are
not MBS can also have these subtypes.
Covered bonds
In Europe there exists a type of asset-backed bond called a "covered bond" (commonly known
by the German term Pfandbriefe). Pfandbriefe were first created in 19th century Germany
when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated
since the creation of a law governing the securities in Germany in 1900. The key difference
between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make
loans and package them into Pfandbriefe keep those loans on their books. This means that
when a company with mortgage assets on its books issue the covered bond its balance sheet
grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities
payments.
Uses
Risk, Return, Rating & Yield relate
There are many reasons for mortgage originators to finance their activities by issuing mortgagebacked
securities. Mortgage-backed securities
1. transform relatively illiquid, individual financial assets into liquid and tradable capital
market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for
additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the
origination of an underlying mortgage (private market transaction) and the yield
demanded by bond investors through bond issuance (typically, a public market
transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with
other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more
traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve
various financial ratios, utilise capital more efficiently and achieve compliance with
risk-based capital standards.
Pricing
Theoretical pricing
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit
risk) and interest rate (IR) exposure.The MBS adds a third risk: early redemption (prepayment).
The number of homeowners in residential MBS securitizations who prepay goes up when
interest rates go down. One reason for this phenomenon is that homeowners can refinance at a
lower fixed interest rate. Commercial MBS often mitigate this risk using call protection
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of
MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of
the IR model, and the sophistication of the prepayment IR dependence, to the point that no
closed form solution (i.e. one you could write it down) is widely known. In models of this type
numerical methods provide approximate theoretical prices. These are also required in most
models which specify the credit risk as a stochastic function with an IR correlation.
Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.
Interest rate risk and prepayment risk
Theoretical pricing models must take into account the link between interest rates and loan
prepayment speed. Mortgage prepayments are most often made because a home is sold or
because the homeowner is refinancing to a new mortgage, presumably with a lower rate or
shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they
receive the money, because it tends to occur when floating rates drop and the fixed income of
the bond would be more valuable (negative convexity). Hence the term: prepayment risk.
To compensate investors for the prepayment risk associated with these bonds, they trade at a
spread to government bonds.
There are other drivers of the prepayment function (or prepayment risk), independent of the
interest rate, for instance:
Economic growth, which is correlated with increased turnover in the housing market
Home prices inflation
Unemployment
Regulatory risk; if borrowing requirements or tax laws in a country change this can
change the market profoundly.
Demographic trends, and a shifting risk aversion profile, which can make fixed rate
mortgages relatively more or less attractive.
Credit risk
The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying
the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high
because:
1. The mortgage originator will generally research the mortgage taker's ability to repay,
and will try to lend only to the credit-worthy.
2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against
homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the
full faith and credit of the US Federal government. This is not the case with Fannie Mae
or Freddie Mac, but these two entities have lines of credit with the US Federal
government; however, these lines of credit are extremely small when compared with
the average amount of money circulated through Fannie Mae or Freddie Mac in one
day's business. Additionally, Fannie Mae and Freddie Mac generally require private
mortgage insurance on loans in which the borrower provides a down payment that is
less than 20% of the property value.
3. Pooling many mortgages with different default probabilities creates a bond with a
much lower probability of total default, in which no homeowners are able to make
their payments (see Copula). Although the risk neutral credit spread is theoretically
identical between a mortgage ensemble and the average mortgage within it, the
chance of catastrophic loss is reduced.
4. If the property owner should default, the property remains as collateral. Although real
estate prices can move below the value of the original loan, this increases the solidity
of the payment guarantees and deters borrower default.
If the MBS was not underwritten by the original real estate & the issuer's guarantee the rating
of the bonds would be very much lower. Part of the reason is the expected adverse selection
against borrowers with improving credit (from MBSs pooled by initial credit quality) who would
have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).
Real-world pricing
Most traders and money managers use Bloombergand Intex to analyze MBS pools. Intex is also
used to analyze more esoteric products. Some institutions have also developed their own
proprietary software. TradeWeb is used by the largest bond dealers ("primaries") to transact
round lots ($1 million+).
For "vanilla" or "generic" 30-year pools (FN/FG/GN) with coupons of 4% - 7%, one can see the
prices posted on a TradeWeb screen by the primaries called To Be Announced (TBA). This is due
to the actual pools not being shown. These are forward prices for the next 3 delivery months
since pools haven't been cut — only the issuing agency, coupon and dollar amount are revealed.
A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a
"pay-up" depending on characteristics. These are called "specified pools" since the buyer
specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR
or PSA. When a mortgage refinances or the borrower prepays during the month, the
prepayment measurement increases.
If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they
are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every
dollar that's prepaid, possibly significantly decreasing the yield. This is likely to happen as
holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the lowcoupon
MBS pool was bought at a discount. This is due to the fact that when the borrower pays
back the mortgage he does so at "par". So if the investor bought a bond at 95 cents on the
dollar, as the borrower prepays he gets the full dollar back and his yield increases. This is
unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS
pools are loan amount ranges that each mortgage in the pool must pass. Typically, high
premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance
command the largest pay-ups. Even though the borrower is paying an above market yield, they
are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
The large number of factors needed, makes it difficult to calculate the value of an MBS
security. Quite often, market participants do not concur resulting in large differences in
quoted prices for the same instrument. Practitioners constantly try to improve prepayment
models and hope to measure values for input variables implied by the market. Varying liquidity
premiums for related instruments as well as changing liquidity over time, makes this a
devilishly difficult task
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by
the principal and interest payments of a set of mortgage loans. Payments are typically made
monthly over the lifetime of the underlying loans
However not all securities backed by mortgages are considered mortgage-backed securities.
Housing Bonds (Mortgage Revenue Bonds) are backed by the mortgages which they fund, but
aren't MBSs.
Residential mortgages in the United States have the option to pay more than the required
monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because
curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an
MBS is not known in advance, and therefore presents an additional risk to MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily
properties (such as apartment buildings, retail or office properties, hotels, schools, industrial
properties and other commercial sites). The properties of these loans vary, with longer-term
loans (5 years or longer) often being at fixed interest rates and having restrictions on
prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
History
In 1938, a governmental agency named the National Mortgage Association of Washington was
formed and soon was renamed Federal National Mortgage Association (FNMA or Fannie Mae). It
was chartered by the US government as a corporation which buys Federal Housing
Administration (FHA) and Veterans Administration (VA) mortgages on the secondary market,
pools them, and sells them as "mortgage-backed securities" to investors on the open market.
FNMA was privatized in 1968 as a "government sponsored enterprise" listed on the stock
exchange.
Additionally, the 1970 Emergency Home Finance Act created a new secondary mortgage market
participant, the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) to support
conventional mortgages originated by thrift institutions. The Act also allowed FNMA to buy
conventional mortgages in addition to FHA & VA.
Freddie Mac competed in the secondary market, where Fannie Mae had enjoyed a monopoly.
Market size and liquidity
Mortgage backed securities can be considered to have been in the tens of trillions, if Credit
Default Swaps are taken into account.
The total market value of all outstanding mortgages at the end of the first quarter of 2006 was
approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger
than the market value of outstanding asset-backed securities. The MBS market overtook the
market for US Treasury notes and bonds in 2000.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
2005: USD 967 billion
2004: USD 1,019 billion
2003: USD 2,131 billion
2002: USD 1,444 billion
2001: USD 1,093 billion
The high liquidity of most mortgage-backed securities means that any investor wishing to take
a position need not deal with the difficulties of theoretical pricing described below; the price
of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than speculation) for entering the market include the desire to hedge against a
drop in prepayment rates (a critical business risk for any company specializing in refinancing)
and certain predatory lending schemes.
Structure and features
Weighted-average maturity
The weighted-average maturity (WAM) of an MBS is the average of the maturities of the
mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an
average across mortgages, as distinct from concepts such as weighted-average life and
duration, which are averages across payments of a single loan.
To illustrate the concept of WAM, let's consider a mortgage pool with just three mortgage loans
that have the below mentioned outstanding mortgage balances, mortgage rates, and months
remaining to maturity.
Loan Outstanding Mortgage
Balance
Mortgage
Rate
Remaining Months to
Maturity
Each Loan's
Weighting
Loan
1 $200,000 6.00% 300 22.22%
Loan
2
$400,000 6.25% 260 44.44%
Loan
3
$300,000 6.50% 280 33.33%
The weightings are computed by dividing each outstanding loan amount by total amount
outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts
at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists
of three loans is computed as follows:
WAM = 22.22% (300) + 44.44% (260) + 33.33% (280)
= 66.67 + 115.56 + 93.33
= 275.56 Months or 276 months after rounding
Weighted-average coupon
The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages
in the pool, weighted by their original balances at the issuance of the MBS.
Why and where we use WAM and WAC
WAM and WAC are used for describing a mortgage passthrough security, and they form the basis
for the computation of cash flows from that mortgage passthrough. Just as we describe a bond
by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for
example, "this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month
WAM."
Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that
the investor would receive if he/she holds this mortgage passthrough security (or simply
mortgage passthrough). Almost always, the passthrough rate is less than the WAC. The
difference goes to servicing (i.e., costs incurred in collecting the loan payments and
transferring the payments to the investors) the mortgage loans in the pool.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because some
securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from
other mortgage-backed instruments the qualifier pass-through is used, in the same way that
'vanilla' designates an option with no special features.
Mortgage-backed security sub-types include:
Pass-through mortgage-backed security is the simplest MBS, as described in the
sections above. Essentially, a securitization of the mortgage payments to the mortgage
originators. These can be subdivided into:
o Residential mortgage-backed security (RMBS) - a pass-through MBS backed by
mortgages on residential property
o Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by
mortgages on commercial property
Collateralized mortgage obligation (CMO) - a more complex MBS in which the
mortgages are ordered into tranches by some quality (such as repayment time), with
each tranche sold as a separate security.
Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to
pay down the loan's principal and partly used to pay the interest on it. These two
components can be separated to create SMBS's, of which there are two subtypes:
o Interest-only stripped mortgage-backed securities (IO) - a bond with cash
flows backed by the interest component of property owner's mortgage
payments.
o Principal-only stripped mortgage-backed securities (PO) - a bond with cash
flows backed by the principal repayment component of property owner's
mortgage payments.
Varieties of underlying mortgages in the pool:
Prime: conforming mortgages: prime borrowers, full documentation (such as
verification of income and assets), strong credit scores, etc.
Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some
way, often lower documentation (or in some other way: vacation home, etc.)
Subprime: weaker credit scores, no verification of income or assets, etc.
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as
set by FannieMae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are
not MBS can also have these subtypes.
Covered bonds
In Europe there exists a type of asset-backed bond called a "covered bond" (commonly known
by the German term Pfandbriefe). Pfandbriefe were first created in 19th century Germany
when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated
since the creation of a law governing the securities in Germany in 1900. The key difference
between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make
loans and package them into Pfandbriefe keep those loans on their books. This means that
when a company with mortgage assets on its books issue the covered bond its balance sheet
grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities
payments.
Uses
Risk, Return, Rating & Yield relate
There are many reasons for mortgage originators to finance their activities by issuing mortgagebacked
securities. Mortgage-backed securities
1. transform relatively illiquid, individual financial assets into liquid and tradable capital
market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for
additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the
origination of an underlying mortgage (private market transaction) and the yield
demanded by bond investors through bond issuance (typically, a public market
transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with
other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more
traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve
various financial ratios, utilise capital more efficiently and achieve compliance with
risk-based capital standards.
Pricing
Theoretical pricing
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit
risk) and interest rate (IR) exposure.The MBS adds a third risk: early redemption (prepayment).
The number of homeowners in residential MBS securitizations who prepay goes up when
interest rates go down. One reason for this phenomenon is that homeowners can refinance at a
lower fixed interest rate. Commercial MBS often mitigate this risk using call protection
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of
MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of
the IR model, and the sophistication of the prepayment IR dependence, to the point that no
closed form solution (i.e. one you could write it down) is widely known. In models of this type
numerical methods provide approximate theoretical prices. These are also required in most
models which specify the credit risk as a stochastic function with an IR correlation.
Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.
Interest rate risk and prepayment risk
Theoretical pricing models must take into account the link between interest rates and loan
prepayment speed. Mortgage prepayments are most often made because a home is sold or
because the homeowner is refinancing to a new mortgage, presumably with a lower rate or
shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they
receive the money, because it tends to occur when floating rates drop and the fixed income of
the bond would be more valuable (negative convexity). Hence the term: prepayment risk.
To compensate investors for the prepayment risk associated with these bonds, they trade at a
spread to government bonds.
There are other drivers of the prepayment function (or prepayment risk), independent of the
interest rate, for instance:
Economic growth, which is correlated with increased turnover in the housing market
Home prices inflation
Unemployment
Regulatory risk; if borrowing requirements or tax laws in a country change this can
change the market profoundly.
Demographic trends, and a shifting risk aversion profile, which can make fixed rate
mortgages relatively more or less attractive.
Credit risk
The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying
the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high
because:
1. The mortgage originator will generally research the mortgage taker's ability to repay,
and will try to lend only to the credit-worthy.
2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against
homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the
full faith and credit of the US Federal government. This is not the case with Fannie Mae
or Freddie Mac, but these two entities have lines of credit with the US Federal
government; however, these lines of credit are extremely small when compared with
the average amount of money circulated through Fannie Mae or Freddie Mac in one
day's business. Additionally, Fannie Mae and Freddie Mac generally require private
mortgage insurance on loans in which the borrower provides a down payment that is
less than 20% of the property value.
3. Pooling many mortgages with different default probabilities creates a bond with a
much lower probability of total default, in which no homeowners are able to make
their payments (see Copula). Although the risk neutral credit spread is theoretically
identical between a mortgage ensemble and the average mortgage within it, the
chance of catastrophic loss is reduced.
4. If the property owner should default, the property remains as collateral. Although real
estate prices can move below the value of the original loan, this increases the solidity
of the payment guarantees and deters borrower default.
If the MBS was not underwritten by the original real estate & the issuer's guarantee the rating
of the bonds would be very much lower. Part of the reason is the expected adverse selection
against borrowers with improving credit (from MBSs pooled by initial credit quality) who would
have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).
Real-world pricing
Most traders and money managers use Bloombergand Intex to analyze MBS pools. Intex is also
used to analyze more esoteric products. Some institutions have also developed their own
proprietary software. TradeWeb is used by the largest bond dealers ("primaries") to transact
round lots ($1 million+).
For "vanilla" or "generic" 30-year pools (FN/FG/GN) with coupons of 4% - 7%, one can see the
prices posted on a TradeWeb screen by the primaries called To Be Announced (TBA). This is due
to the actual pools not being shown. These are forward prices for the next 3 delivery months
since pools haven't been cut — only the issuing agency, coupon and dollar amount are revealed.
A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a
"pay-up" depending on characteristics. These are called "specified pools" since the buyer
specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR
or PSA. When a mortgage refinances or the borrower prepays during the month, the
prepayment measurement increases.
If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they
are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every
dollar that's prepaid, possibly significantly decreasing the yield. This is likely to happen as
holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the lowcoupon
MBS pool was bought at a discount. This is due to the fact that when the borrower pays
back the mortgage he does so at "par". So if the investor bought a bond at 95 cents on the
dollar, as the borrower prepays he gets the full dollar back and his yield increases. This is
unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS
pools are loan amount ranges that each mortgage in the pool must pass. Typically, high
premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance
command the largest pay-ups. Even though the borrower is paying an above market yield, they
are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
The large number of factors needed, makes it difficult to calculate the value of an MBS
security. Quite often, market participants do not concur resulting in large differences in
quoted prices for the same instrument. Practitioners constantly try to improve prepayment
models and hope to measure values for input variables implied by the market. Varying liquidity
premiums for related instruments as well as changing liquidity over time, makes this a
devilishly difficult task
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