4.1.7 Mortgages and Mortgage-Backed Securities

7. Mortgages and Mortgage-Backed Securities

7.1 Mortgage and Mortgage Pools

7.1.1 Mortgage

Mortgages are used to finance residential and commercial property and are secured by the specified real estate property that obliges the borrower to make a predetermined series of payments to the lender.

7.1.2 Various Residential Mortgage Product

Interest rate type classifications:
Adjustable-rate mortgages (ARMs): rate of interest is floating. It is usually based on “base rate + spread”. For example, LIBOR+250bps.

Fixed-rate mortgages: rate of interest is fixed.

Prepayment option: mortgages will be prepaid because interest rates have declined and thus the property can be refinanced at a lower interest rate.

7.1.3 Calculating Mortgage Payments

To calculate the monthly interest payments on a fixed-rate mortgage, it is necessary to first convert the quoted rate to a rate with monthly compounding.

In US mortgage market, most are fixed-rate and fully amortized mortgage loans(全摊销，等额本息), and these loans often have monthly payment.

$$\sum _{i=1}^m\frac{X}{(1+\frac{R}{12}{)}^i}=A\to \frac{X}{\frac{R}{12}}\left[1-\frac{1}{(1+\frac{R}{12}{)}^m}\right]=A$$

• $A$: the amount borrowed
• $R$: the interest rate(compounded monthly)
• $X$: the monthly payment

Consider a 30-year U.S. mortgage where the fixed rate is $6\%$ with monthly compounding. If the amount borrowed is USD $250,000$, what is the monthly payment?

$PV=250,000$, $FV=0$, $I/Y=6\%/12=0.5\%$, $N=360$, $PMT=-1498.88$

An amortization table shows the monthly principal and interest payments on a mortgage (assuming no prepayment of principal). At the beginning of the mortgage, most of the monthly payment is interest. Toward the end of the mortgage, most of the monthly payment is principal.

In the USD $250,000$ mortgage in the previous example, the interest rate is $6\%$ per year (i.e., $0.5\%$ per month) and the monthly payment is USD $1,498.88$.

In the first month the interest on the mortgage is $0.005\times 250,000=1,250.00$, repayment of principal is $1,498.88-1,250.00=248.88$.

At the beginning of the second month, the principal is therefore: $250,000-248.88=249,751.12$. The interest during the second month is $0.005\times 249,751=1,248.76$. The repayment of principal is therefore: $1,498.88-1,248.76=250.12$

Month	Total Monthly Payment	End of Month Interest Payment	End of Month Principal Payment	Principal Left at the End of Month
0				250000.00
1	1498.88	1250.00	248.88	249751.12
2	1498.88	1248.76	250.12	249501.00
3	1498.88	1247.51	251.37	249249.63
4	1498.88	1246.25	252.63	248997.00
...	...	...	...	...
357	1498.88	29.61	1469.27	4452.05
358	1498.88	22.26	1476.62	2975.43
359	1498.88	14.88	1484.00	1491.43
360	1498.88	7.46	1491.42	0.01

7.1.4 Characteristics of Mortgage Pools

Mortgage pools (also known as Mortgage portfolios) can be created for investment purposes. The mortgages in a pool are usually similar in terms of loan type, interest rate, and origination date.

The weighted-average coupon (WAC) weights the mortgage rate of each mortgage loan in the pool based on their outstanding principal.

The weighted-average maturity (WAM) weights the remaining number of months to maturity for each mortgage loan in the pool based on their outstanding principal.

Suppose a pool consists only of a USD $200,000$ mortgage with an interest rate of $4\%$ and maturities of $340$ months and a USD $400,000$ mortgage with an interest rate of $5\%$ and maturities of $280$ months. Calculate WAC and WAM.

$$WAC=\frac{200,000}{600,000}\times 4\%+\frac{400,000}{600,000}\times 5\%=4.667\%$$

$$WAM=\frac{200,000}{600,000}\times 340+\frac{400,000}{600,000}\times 280=300$$

The weighted-average FICO score is a FICO score that measures the creditworthiness of the borrower. It can range from $300$ to $850$, with a score above $650$ being considered acceptable by many lenders.

The weighted-average loan-to-value ratio (LTV) for a mortgage is the principal amount of the loan divided by the assessed value of the mortgaged property at the time of the loan.

The average loan balance is the total current outstanding principal of the mortgages in the pool divided by the number of mortgages.

The pool’s factor is the total current outstanding pool principal as a percentage of the original pool principal. A pool’s factor declines with time because part of each monthly payment by the borrower is a repayment of principal. It also declines as a result of prepayments.

The prepayment options is the choice borrowers can make to pay back any outstanding principal above the amount scheduled by the amortization table.

Single monthly mortality (SMM) rate is the presentage of the outstanding principle that was prepaid during a given month.

$$SMM=\frac{\text{Prepayment for the month}}{\text{Beginning mortgage balance for the month}-\text{Scheduled principal payment for the month}}$$

Conditional prepayment rate (CPR) is the annualized(年化) SMM.

$$CPR=1-(1-SMM{)}^{12}\to 1-CPR=(1-SMM{)}^{12}$$

A mortgage pool has a beginning monthly balance of $ $50,525$ and a scheduled principal payment of $ $67$. The actual principal payment is $ $327$. Please calculate the SMM and CPR of the loan.

The prepayment for the month is $327-67=260$.

$SMM=\frac{260}{50,525-67}=0.5143\%$

$CPR=1-(1-0.5143\%{)}^{12}=6\%$

PSA prepayment benchmark: a monthly series of CPRs by Public Security Association (PS), assuming prepayment rates are low for newly originated mortgages and then speed up as the mortgages become seasoned. The benchmark is said to be $100$ PSA.

The annualized prepayment rate is $0.2\%$ in month one. It then increases by $0.2\%$ each month until reaching $6\%$ in month 30. After month 30, it remains constant at $6\%$.

7.2 Mortgage Backed Securities(MBSs)

7.2.1 Securitization

During the process

After the process

Securitization is the process of transforming illiquid assets (bank loan, auto loan and credit card receivables etc.) to more liquid assets (like MBS or ABS).

• Increase the liquidity of financial asset.
• SPV buys the assets and issues ABS (MBS), and is a bankruptcy-remote vehicle.
• Allows investors to achieve better legal claims on the underlying.

7.2.2 Classifications of MBSs

A mortgage-backed security(MBS) is a debt investment secured by a mortgage or collection of mortgages. It is a type of asset-backed security(ABS).

Agency MBSs are MBSs issued by government agency or government sponsored enterprises. Agencies create mortgage pools and provide investors with protection against defaults (but not against prepayments),

• Government National Mortgage Association/Agency; Ginnie Mae (GNMA)
• Government sponsored enterprises: Fannie Mae (FNMA); Freddie Mac (FHLMC). Not explicitly guaranteed by the U.S. government, but consider that there is an implicit guarantee.

Non-Agency MBSs are issued by private entities and are not guaranteed by a federal agency or a GSE. No guarantee protecting investors against defaults.

7.2.3 Mortgage Pass-through Securities

The simplest form of agency MBSs, with all investor in a pool receiving the same return. Investor get their share of the cash flows from the mortgages in the pool minus the agency’s fees for guaranteeing and servicing the mortgages.

Drawback for MPS: investor has no choice but to accept prepayment risk-the uncertainty of the amount of cash flow received from the mortgage pool.

7.2.4 Collateralized Mortgage Obligation

To resolve the prepayment issue, another type of agency MBS was created: CMO. CMO redistributes the cash flow from a mortgage pool to different classes, which are referred to as tranches.

Sequential-Pay Tranches: each class of bond(the tranches) would be retired sequentially.

• Tranche 1 is protected against extension risk but faces more contraction risk.
• Tranche 3 is protected against contraction risk but faces more extension risk.

7.2.5 Stripped MBSs

Interest-only securities(IOs): All the interest payments go to the IOs.
As prepayments increase, IOs become less valuable because fewer interest payments are made overall.

Principal-only securities(POs): All the principal payments go to the POs.
As prepayments increase, POs become more valuable because cash flows are received earlier than expected.

7.2.6 Two Ways of Trading of MPSs

Specified Pool(SP): buyers and sellers agree to trade a certain amount of a specified pool at a specified price.

To-be Announced(TBA): buyers and seller agree to trade a certain kind of pool.

The TBA market is a forward market and is more liquid than the specified pools market because the particular mortgage pool to be delivered is not specified.

Example of TBA: FMNA 30-year $4.5\%$ pool with a par value of USD $100$ million for USD $104.5$ million in August.

• Buyers and sellers agree on: issuer, maturity(original maturity), coupon, price, settlement month
• “Cheapest to deliver” option
• Rules to define the remaining maturities of mortgage to be delivered
• A specified pool to be announced 2 days before settlement
• Accrued interest to be added

7.2.7 Dollar Roll

Repo Transaction: one party sells the pool to another party and agrees to buy them back at a future time for a slightly higher price.

Dollar Roll: one party sells a TBA to another party for one settlement month and buys a similar TBA for the following settlement month.

For example, a trader could sell a 30-year FNMA pool with a $4.5\%$ coupon for August settlement and buy a 30-year FNMA pool with a $4.5\%$ coupon for September settlement.

Two differences between Repo and Dollar Roll:

• The repo seller is always returned with the same pool that was originally posted as collateral while the dollar roll trader could be returned with different pool.
• Interest is added to the price at which the securities are repurchased during a repo transaction while this is not the case for a dollar roll transaction.

Value of the roll: $A-B+C-D$

• A: The price at which the pool is sold during the first month (including accrued interest)
• B: The price at which the pool is purchased during the second month (including accrued interest
• C: The interest earned on the proceeds of the sale for one month.
• D: The coupon and the principal repayment that would have been received on the pool sold during the first month.

Suppose that a USD $1$ million par value of a $4.5\%$ pool is sold for USD $102.50$ in March and repurchased for USD $102.00$ in April. The payment date is the twelfth of the month for both months. Assume that the proceeds of the sale in the first month can be invested at $0.1\%$ for the month and interest and principal payments on the pool during the month of the roll would have amounted to $0.45\%$ of the par value. Please calculate the value of dollar roll.

$AI=12/30\times 4.5\%/12\times 1,000,000=1,500$
$A=1,025,000+1500=1,026,500$
$B=1,020,000+1500=1,021,500$
$C=1,026,500\times 0.1\%=1,026.5$
$D=1,000,000\times 0.45\%=4,500$

Value of the roll: $1,026,500-1,021,500+1,026.5-4,500=1526.5$

---

7.3. Valuation of MBS

7.3.1 Prepayment Modeling

Reasons to prepay earlier:

1. Refinancing

• Decline in interest rate
• Improvement of credit rating
• Burnout effect: with the decrease of interest rate, the increase of the prepayment rate decreases. This is because the mortgage holders most likely to refinance will tend to already do so in the early decline of the rate while the remaining mortgage holder are less likely to refinance. This shows the prepayment function is path-dependent.
• Incentive function: $I=WAC-R$
  • $WAC$: the weighted average coupon rate
  • $R$: the current mortgage rate available to the borrower

2. Turnover: when the borrower needs to sell the house

• Higher in the summer than in the winter months
• Lower in the early life of the mortgage

3. Curtailment: when the loans are old and the balances are low.

4. Default

• When the borrower defaults, the agency will pay the outstanding balance on the mortgage.
• Models use average FICO score, LTVs(Loan-to-Value ratio) and the history of housing price movements to predict the default component of prepayments.

7.3.2 Valuation of MBS

Monte Carlo simulation considers the path dependence issue for MBS valuation; Other analytical tools like the use of trees, cannot easily accommodate this feature.

Step 1: Sample a month-by-month path for risk free interest rate and housing prices;

Step 2: For each month, determine prepayment rates using specified prepayment model;

Step 3: Use the prepayment rates to calculate the month-by-month cash flows from the MBS;

Step 4: Starting at the end of the life of MBS, discount cash flows month-by-month back to today to get the PV of MBS for one month;

Step 5: Repeat 1 to 4 many times to have many MBS PVs;

Step 6: The value of MBS is the average of all the PVs.

7.3.3 Option Adjusted Spread

The prepayment option feature in mortgages increases their yield. The yield spread that removes the influence of embedded option is called the Option-adjusted spread (OAS).

The OAS is the spread between the discount rate and the applicable Treasury rate that leads to the value of an MBS equaling its market price.

Limitation of OAS: the OAS calculated depends on underlying model. If the model is incorrect or has not been calibrated properly, the results cannot be relied upon.