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19
Mortgage-Backed Securities

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 Mortgage-Backed Securities

• Our goal in this chapter is to examine the investment

characteristics of mortgage pools.

• Mortgage pools are simply sets of home mortgages,

which are "bonds" issued by home owners.

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 A Brief History of
Mortgage-Backed Securities

• Traditionally, local banks wrote most home mortgages

and then held the mortgages in their portfolios of
interest-earning assets.

• Then, when market interest rates climbed to near 20%

in the early 1980s, bank customers flocked to withdraw
funds from their savings deposits to invest in money
market funds.

• Today, a mortgage originator usually sells the

mortgage to a mortgage repackager, who accumulates
them into mortgage pools.

19-4
 A Brief History of
Mortgage-Backed Securities, Cont.

• Financed by mortgage-backed bonds (also called

mortgage pass-throughs), each mortgage pool is set
up as a trust fund.

• A servicing agent collects the mortgage payments

from the home-owners and then passes the cash flows
through to the bondholders.

• The transformation from mortgages to mortgage-

backed securities (MBSs) is called mortgage
securitization.

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 Fixed-Rate Mortgages

• A Fixed-Rate Mortgage is a loan that specifies

constant monthly payments at a fixed interest rate over
the life of the mortgage.

• The size of the monthly payment is determined by the

requirement that the present value of all monthly
payments, based on the financing rate specified in the
mortgage contract, be equal to the original loan
amount.

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 Fixed-Rate Mortgage, Monthly Payments

• The equation to calculate the payment required to

“retire” a fixed rate mortgage is:

loan amount  r
Monthly payment  12
1
1

1 r
12

T 12

• In the equation, r is the annual mortgage financing

rate, and T is the number of years in the mortgage
term.
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Mortgage Payments, by Rate and Time

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 Fixed-Rate Mortgage Amortization

• Each monthly mortgage payment has two separate

components:
– Payment of interest on outstanding mortgage principal
– Pay-down, or amortization, of mortgage principal

• The relative amounts of each component change

throughout the life of the mortgage.

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Example: Fixed-Rate Mortgage Amortization
• Suppose a 30-year $100,000 mortgage loan is financed at a fixed
interest rate of 8%.

$100,000  .08 12
Monthly Payment   $733.76
1  1 1  .08 12 
3012

• In the first month:

Interest payment = $100,000  .08/12 = $666.67
Principal payment = $733.76 – $666.67 = $67.09
New principal = $100,000 – $67.09 = $99,932.91

• In the second month:

Interest payment = $99,932.91  .08/12 = $666.22
Principal payment = $733.76 – $666.22 = $67.54
New principal = $99,932.91 – $67.54 = $99,865.37

19-10
 Fixed-Rate Mortgage Amortization

• Mortgage amortization can be described by an

amortization schedule.

• An amortization schedule states the scheduled

principal payment, interest payment, and remaining
principal owed in any month.

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Mortgage Amortization Schedule

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Mortgage Interest and Principal,
by Age of Mortgage

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 Fixed-Rate Mortgage Prepayment
and Refinancing

• A mortgage borrower has the right to pay off all or part

of the mortgage ahead of its amortization schedule.
This is similar to the call feature of corporate bonds and
is known as mortgage prepayment.

• During periods of falling interest rates, mortgage

refinancings are an important reason for mortgage
prepayments.

• This means that mortgage investors face the risk of a

reduced rate of return.

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Government National Mortgage Association

• The Government National Mortgage Association

(GNMA), or “Ginnie Mae,” is a government agency
charged with the mission of promoting liquidity in the
secondary market for home mortgages.

• GNMA mortgage pools are based on mortgages issued

under programs administered by
– The Federal Housing Administration (FHA)
– The Veteran’s Administration (VA), and
– The Farmer’s Home Administration (FmHA).

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Government National Mortgage Association

• Mortgages in GNMA pools are said to be fully

modified because GNMA guarantees bondholders
full and timely payment of both principal and interest.

• Although investors in GNMA pass-throughs do not face

default risk, they still face prepayment risk.
– Prepayments are passed through to bondholders.
– If a default occurs, GNMA fully “prepays” the bondholders.

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 GNMA Clones

• Besides GNMA, there are two other significant

mortgage repackaging sponsors.
– Federal Home Loan Mortgage Corporation (FHLMC), or
“Freddie Mac,” and
– Federal National Mortgage Association (FNMA), or “Fannie
Mae.”

• Both are government-sponsored enterprises (GSEs)

and trade on the New York Stock Exchange.

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 GNMA Clones, Cont.

• Like GNMA, both FHLMC and FNMA operate with

qualified underwriters who accumulate mortgages into
pools financed by an issue of bonds.

• However, because FHLMC and FNMA are only GSEs,

their fully modified pass-throughs do not carry the
same default protection as GNMA fully modified
pass-throughs.

• That is, Congress may or may not be willing to rescue

a financially strapped GSE.

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 PSA Mortgage Prepayment Model, I.

• Mortgage prepayments are typically described by

stating a prepayment rate, which is the probability that
a mortgage will be prepaid in a given year.

• Conventional industry practice states prepayment rates

using a model specified by the Public Securities
Association (PSA).
– Prepayment rates are stated as a percentage of a PSA
benchmark.

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 PSA Mortgage Prepayment Model, II.

• In the PSA model, the rates are conditional on the age

of the mortgages in the pool. They are conditional
prepayment rates (CPRs).

• For seasoned ( > 30 months old) mortgages, the CPR

is constant at 6% annually for 100% of the PSA
benchmark (100 PSA).

• For unseasoned (< 30 months old) mortgages, the

CPR rises steadily in each month until it reaches an
annual rate of 6% in month 30 (for 100 PSA).

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PSA Mortgage Prepayment Model, III.

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 PSA Mortgage Prepayment Model, SMM

• By convention, the probability of prepayment in a given

month is stated as a single monthly mortality (SMM).

• The SMM is based on the conditional prepayment rate,

CPR.
• The equation for an SMM is:

SMM = 1 – (1 – CPR)1/12

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 PSA Mortgage Prepayment Model,
Average Life

• The average life of a mortgage in a pool is the average time for

a single mortgage in the pool to be paid off, either by
prepayment or by making scheduled payments until maturity.

• For a pool of 30-year mortgages:

Prepayment Schedule Average Mortgage Life (years)

50 PSA 20.40
100 PSA 14.68
200 PSA 8.87
400 PSA 4.88

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 Cash Flow Analysis
GNMA Fully Modified Mortgage Pools

• Each month, GNMA mortgage-backed bond investors

receive pro rata shares of cash flows derived from fully
modified mortgage pools.

• Each monthly cash flow has three components (less

the servicing and guarantee fees):
– Payment of interest on outstanding mortgage principal.
– Scheduled amortization of mortgage principal.
– Mortgage principal prepayments.

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Principal and Cash Flows for a GNMA Bond

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 Macaulay Durations
for GNMA Mortgage-Backed Bonds

• The interest rate risk for a bond is often measured by

Macaulay duration, which assumes a fixed schedule of
cash flow payments.

• However, the schedule of cash flow payments for

mortgage-backed bonds is not fixed.
– With falling interest rates, prepayments speed up, and vice
versa.

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 Macaulay Durations
for GNMA Mortgage-Backed Bonds

• Historical experience indicates that interest rates

significantly affect prepayment rates, and that
Macaulay duration is a very conservative measure of
interest rate risk.

• In practice, effective duration is used to calculate

predicted prices for mortgage-backed securities based
on hypothetical interest rate and prepayment
scenarios.

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 Collateralized Mortgage Obligations

• Collateralized mortgage obligations (CMOs) are

securities created by splitting mortgage pool cash flows
according to specific allocation rules.

• The three best-known types of CMOs are:

 interest-only (IOs) and principal-only (POs) strips,
 sequential CMOs, and
 protected amortization class securities (PACs).

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Interest-Only and Principal-Only Strips

• Interest-only strips (IOs) pay only the interest cash

flows to investors, while principal-only strips (POs) pay
only the principal cash flows to investors.

• IO strips and PO strips behave quite differently in

response to changes in prepayment rates and interest
rates.
– Faster prepayments imply lower IO strip values and higher PO
strip values, and vice versa.

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Cash Flows for GNMA IO and PO Strips

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 Sequential CMOs, I.

• Sequential CMOs carve a mortgage pool into a number

of tranches (slices).
– For example, A, B, C, and Z-tranches.

• Each tranche is entitled to a share of mortgage pool

principal and interest on that share of principal.

• However, because cash flows are distributed

sequentially, this creates securities with a range of
maturities.

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 Sequential CMOs, II.

• Cash flows are passed through as follows:

– All principal payments goes to the topmost tranche (in
alphabetical order), until all the principal in that tranche has
been paid off.

– Except for the Z-tranche, all tranches receive proportionate

interest payments, which are passed through immediately.

– Until all the principal in the topmost tranche has been fully paid
off, interest on Z-tranche principal is paid as cash to the
topmost tranche in exchange for an equal amount of principal.

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Sequential CMO Principal and Cash Flows

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 Protected Amortization Class Bonds

• Protected amortization class (PAC) bonds take

priority for scheduled payments of principal.

• The residual cash flows are paid to PAC support (or

companion) bonds.

• PAC cash flows are predictable as long as

prepayments remain within a specified band.

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Protected Amortization Class Bonds, Cont.

• Creating a PAC bond entails three steps.

 Specify two PSA prepayment schedules that form the upper

and lower prepayment bounds of the PAC bond. These
bounds define a PAC collar.

 Calculate principal-only (PO) cash flows for the two

prepayment schedules specified in .

 On a priority basis, at any point in time, PAC bondholders

receive payments of principal according to the PSA
prepayment schedule with the lower PO cash flow as
calculated in .

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PAC Cash Flows and Total Cash Flows

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 Yields for MBSs and CMOs

• The yield to maturity for a mortgage-backed security,

conditional on an assumed prepayment pattern, is
called the cash flow yield.

• Essentially, cash flow yield is the interest rate that

equates the present value of all future cash flows on
the mortgage pool to the current price of the pool,
assuming a particular prepayment rate.

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MBS Yields

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 Useful Websites

• www.investinginbonds.com (for information on bonds, bonds,

bonds)

• www.ginniemae.gov (GNMA)

• www.hud.gov (HUD)

• www.fanniemae.com (FNMA)

• www.freddiemac.com (FHLMC)

• www.bondmarkets.com (Visit the Public Securities Association)

19-39
 Chapter Review, I.

• A Brief History of Mortgage-Backed Securities

• Fixed-Rate Mortgages
– Fixed-Rate Mortgage Amortization
– Fixed-Rate Mortgage Prepayment and Refinancing

• Government National Mortgage Association

– GNMA Clones

• Public Securities Association Mortgage Prepayment

Model

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 Chapter Review, II.

• Cash Flow Analysis of GNMA Fully Modified Mortgage

Pools
– Macaulay Durations for GNMA Mortgage-Backed Bonds

• Collateralized Mortgage Obligations

– Interest-Only and Principal-Only Mortgage Strips
– Sequential Collateralized Mortgage Obligations
– Protected Amortization Class Bonds

• Yields for Mortgage-Backed Securities and

Collateralized Mortgage Obligations

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