Mortgage-backed security Study Guide

📖 Core Concepts Mortgage‑Backed Security (MBS) – An asset‑backed security whose cash‑flows come from a pool of residential or commercial mortgages. Factor – The remaining proportion of the original principal in the pool; it declines as borrowers pay principal. Pass‑through – Cash‑flows (interest + principal) are sent directly to investors on a pro‑rata basis; the issuing trust is taxed as a grantor trust (investors taxed as owners). Collateralized Mortgage Obligation (CMO) – Structured MBS that split the pool’s cash‑flows into several tranches, each receiving a different share of principal and interest. Stripped MBS – Separate securities that receive only interest (IO) or only principal (PO) portions of the mortgage payments. Mortgage Bonds – Traditional bonds backed by a pledge of specific real‑estate assets rather than a diversified mortgage pool. Weighted‑Average Maturity (WAM) – Balance‑weighted average of loan maturities in the pool at issuance. Weighted‑Average Coupon (WAC) – Balance‑weighted average of the underlying mortgages’ coupon rates at issuance. Pass‑through Rate – Rate received by investors after servicing fees; usually below the $WAC$. Prepayment Risk – The risk that borrowers refinance or pay off loans early, causing cash‑flows to arrive sooner than expected. Negative Convexity – When prepayments increase as interest rates fall, investors must reinvest at lower rates, creating a “bent‑down” price curve. Conditional Prepayment Rate (CPR) – Annualized prepayment speed; often modeled with the PSA (Public Securities Association) standard. Agency vs. Private‑Label – Agency MBS (e.g., Ginnie Mae, Fannie Mae, Freddie Mac) carry government‑backed credit guarantees; private‑label MBS are issued by banks/investment banks and lack such guarantees. Fast‑Pay vs. Slow‑Pay – Fast‑pay securities receive principal quickly; slow‑pay securities receive principal more slowly, affecting duration and cash‑flow timing. --- 📌 Must Remember MBS = pooled mortgages → investors get the pool’s cash‑flows. Factor ↓ = principal paid down; price = factor × par. Pass‑throughs are taxed as grantor trusts; investors own their slice directly. $WAM$ = weighted‑average loan maturity; $WAC$ = weighted‑average coupon. Prepayment speed measured by $CPR$ (or PSA); higher $CPR$ → faster principal return. Prepayment risk → negative convexity (price falls faster when rates drop). Agency guarantees: Ginnie Mae = full faith & credit of U.S. government. Fannie Mae / Freddie Mac = limited credit lines, often require private mortgage insurance for < 20 % down. Fast‑pay = short duration, higher yield; slow‑pay = longer duration, lower yield. Stripped securities: IO receives only interest, PO receives only principal. --- 🔄 Key Processes Securitization Acquisition: Lender sells mortgages to a special‑purpose vehicle (SPV). Pooling: SPV groups loans into a diversified pool. Issuance: MBS (pass‑through, CMO, stripped, etc.) are created representing interests in the pool’s cash‑flows. CMO Tranche Allocation Define tranche priority → allocate principal payments first to senior tranches, then to mezzanine, then to junior. Interest is distributed proportionally or per tranche rules. Pricing & Valuation Input: $WAM$, $WAC$, CPR/PSA, credit spreads, interest‑rate term structure. Use Monte Carlo simulation or modified binomial trees to model cash‑flows with prepayment, credit, and rate risk. Prepayment Modeling Choose a CPR (or PSA) curve → calculate expected monthly prepayment factor → adjust cash‑flow schedule. --- 🔍 Key Comparisons Pass‑through vs. CMO Pass‑through: single class, uniform cash‑flow, simple, lower yield. CMO: multiple tranches, tailored risk/return, higher yields, more complex. Interest‑Only (IO) vs. Principal‑Only (PO) IO: receives only interest → sensitive to prepayment (higher when rates fall). PO: receives only principal → benefits from rapid prepayment (higher when rates fall). Agency vs. Private‑Label Agency: government or GSE guarantee → lower credit risk. Private‑Label: no guarantee → higher credit risk, contributed to subprime crisis. Fast‑Pay vs. Slow‑Pay Fast‑pay: principal returned quickly → shorter duration, higher yield, less interest‑rate risk. Slow‑pay: principal returned slowly → longer duration, lower yield, more interest‑rate risk. High‑Coupon vs. Low‑Coupon MBS High‑coupon: attractive to refinance → higher prepayment risk. Low‑coupon: less incentive to refinance → lower prepayment risk. --- ⚠️ Common Misunderstandings Factor = price. Factor is the remaining principal proportion; price = factor × par (may be adjusted for spreads). All MBS have no credit risk. Only agency securities have government‑backed credit protection; private‑label MBS carry credit risk. Negative convexity is “good.” It actually hurts investors when rates fall because cash‑flows accelerate. WAM = maturity of the security. WAM is an average of the underlying loan maturities, not the exact maturity date of the MBS. Liquidity is uniform. Simple pass‑throughs trade very liquidly; CMOs and CDOs often require dealer quotes and have wider spreads. --- 🧠 Mental Models / Intuition Water‑Tank Analogy: The mortgage pool is a tank; borrowers’ payments are the outflow. Prepayments are “holes” that open when rates drop, letting water (principal) rush out faster. Negative Convexity as a Rubber Band: When rates fall, the rubber band (price) stretches less because the pool empties quickly; when rates rise, the band stretches more because payments linger. Tranche Cake: Imagine a layered cake; each layer (tranche) gets its slice of the cash‑flow first before the next layer gets any. --- 🚩 Exceptions & Edge Cases Loan‑Balance Buckets: Smaller loans (< $85 k) often have higher “pay‑up” (higher price) because borrowers face higher refinancing costs. Stripped Securities: IOs can lose value sharply if prepayment slows (rates rise); PO values rise when prepayment speeds up. Mortgage Bonds vs. MBS: Mortgage bonds are backed by a single property, not a diversified pool, so they behave more like traditional corporate bonds. Ginnie Mae Guarantees: Full government guarantee eliminates credit risk, unlike the limited lines from Fannie Mae/Freddie Mac. --- 📍 When to Use Which Pass‑through: Want a simple, liquid exposure to the mortgage market; minimal structuring risk. CMO: Need a specific risk/return profile (e.g., higher yield, targeted duration). IO vs. PO: IO – Use when you anticipate falling rates and want to capture higher interest income. PO – Use when you expect accelerating prepayments (e.g., falling rates) and want principal return. Fast‑Pay vs. Slow‑Pay: Fast‑pay – Ideal for investors seeking quick cash‑flow or shorter duration. Slow‑pay – Suitable for long‑duration liabilities or investors comfortable with slower principal recovery. Agency vs. Private‑Label: Choose agency for low credit risk; private‑label when higher yields are needed and credit risk is acceptable. --- 👀 Patterns to Recognize High coupon → early prepayment when rates decline. Look for spikes in CPR in the first 2–3 years of a pool. Narrow bid‑ask spreads usually signal an agency pass‑through; wide spreads hint at a complex CMO or private‑label issue. PSA 100 is the standard prepayment curve; deviations (e.g., PSA 150) indicate faster prepayment expectations. Liquidity hierarchy: Pass‑through > simple CMOs > structured CMOs/CDOs. --- 🗂️ Exam Traps Confusing factor with price: Remember price = factor × par, not just the factor itself. Assuming all MBS are “risk‑free.” Only Ginnie Mae securities have full government backing. Mixing CPR with PSA: CPR is a raw annualized rate; PSA is a standardized model (PSA 100 ≈ 6 % CPR). Treating negative convexity as positive convexity: It makes MBS prices fall faster when rates drop, not rise. Believing stripped securities eliminate prepayment risk: IOs are more exposed to prepayment acceleration; PO’s value is tied to the speed of principal return. ---