8.5 Mortgage-backed securities
8 min read•august 21, 2024
Mortgage-backed securities transform home loans into tradable assets, boosting liquidity in housing finance. They combine fixed income analysis, risk management, and structured finance, requiring understanding of cash flows, interest rates, and prepayment behavior.
These securities come in various forms, from simple pass-throughs to complex collateralized mortgage obligations. Their valuation involves static analysis, option-adjusted spread, and Monte Carlo simulations, considering interest rate, prepayment, and credit risks.
Overview of mortgage-backed securities
- Mortgage-backed securities represent a crucial component of financial mathematics, combining elements of fixed income analysis, risk management, and structured finance
- These securities transform illiquid mortgage loans into tradable financial instruments, allowing for increased liquidity in the housing finance market
- Understanding mortgage-backed securities requires knowledge of cash flow modeling, interest rate dynamics, and prepayment behavior
Types of mortgage-backed securities
Pass-through securities
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- Simplest form of mortgage-backed securities, where investors receive a pro-rata share of all principal and interest payments from the underlying mortgage pool
- Characterized by a single class of securities with uniform cash flows for all investors
- Typically issued by government-sponsored entities (, Freddie Mac) or private institutions
- Subject to as homeowners can pay off their mortgages early
Collateralized mortgage obligations
- More complex structure dividing cash flows from mortgage pools into different tranches with varying risk and return profiles
- Tranches prioritized in a "waterfall" structure, with senior tranches receiving payments before junior tranches
- Allow for customization of risk exposure and maturity profiles to meet diverse investor needs
- Can include features like planned amortization classes (PACs) and support tranches to manage prepayment risk
Stripped mortgage-backed securities
- Separate the principal and interest payments from mortgage pools into distinct securities
- Interest-only (IO) strips receive only interest payments, while principal-only (PO) strips receive only principal payments
- Highly sensitive to changes in interest rates and prepayment speeds
- Used for speculative purposes or as hedging instruments in portfolio management
Structure and cash flows
Mortgage pool characteristics
- Composition of underlying mortgages (fixed-rate, adjustable-rate, conforming, non-conforming)
- Geographic distribution of properties to assess regional economic risks
- Average loan-to-value ratios and credit scores of borrowers
- Weighted average coupon (WAC) and weighted average maturity (WAM) of the pool
Payment waterfall
- Defines the order and priority of cash flow distributions to different security classes or tranches
- Typically follows a sequential structure, with senior tranches paid first
- May include triggers or performance metrics that alter the distribution of cash flows
- Incorporates mechanisms for dealing with prepayments and defaults
Prepayment risk
- Uncertainty in timing and amount of principal repayments due to borrowers paying off mortgages early
- Factors influencing prepayments include interest rate changes, home sales, and refinancing opportunities
- Measured using metrics like Conditional Prepayment Rate (CPR) or Public Securities Association (PSA) speed
- Impacts both the timing of cash flows and the overall yield of mortgage-backed securities
Valuation methods
Static cash flow analysis
- Simplest valuation approach assuming a fixed prepayment rate throughout the security's life
- Projects cash flows based on scheduled payments and assumed prepayment speed
- Discounts projected cash flows using a single yield to calculate present value
- Limitations include inability to capture interest rate sensitivity and dynamic prepayment behavior
Option-adjusted spread analysis
- More sophisticated approach accounting for embedded prepayment option in mortgages
- Uses interest rate simulations to model potential future interest rate paths
- Calculates option-adjusted spread (OAS) as the spread over the benchmark yield curve
- Provides a more accurate valuation by incorporating interest rate volatility and prepayment optionality
Monte Carlo simulation
- Advanced technique using thousands of random interest rate scenarios to model potential outcomes
- Generates probability distributions of cash flows and returns
- Allows for complex modeling of prepayment behavior and interest rate dynamics
- Computationally intensive but provides detailed risk metrics and scenario analysis
Risk factors
Interest rate risk
- Changes in interest rates affect both the value of mortgage-backed securities and prepayment behavior
- measures sensitivity to parallel shifts in the yield curve
- Convexity captures non-linear price changes due to large interest rate movements
- Negative convexity in most mortgage-backed securities due to prepayment optionality
Prepayment risk
- Uncertainty in timing of principal repayments impacts expected cash flows and yields
- Prepayment speeds increase when interest rates fall, potentially reducing returns for premium-priced securities
- Slowing prepayments when rates rise can extend the average life of securities
- Models like conditional prepayment rate (CPR) and Public Securities Association (PSA) used to estimate prepayment speeds
Credit risk
- Risk of borrower defaults leading to losses on underlying mortgages
- More significant for non-agency or private-label mortgage-backed securities
- Mitigated in through guarantees from government-sponsored entities
- Assessed through metrics like credit scores, loan-to-value ratios, and historical default rates
Market participants
Issuers and originators
- Financial institutions that create and sell mortgage-backed securities
- Include government-sponsored enterprises (Fannie Mae, Freddie Mac) and private banks
- Responsible for mortgages, structuring securities, and managing the securitization process
- May retain servicing rights or sell them to specialized mortgage servicers
Investors
- Wide range of entities purchasing mortgage-backed securities for various purposes
- Commercial banks seeking stable income and balance sheet management
- Insurance companies matching long-term liabilities with long-duration assets
- Pension funds looking for yield and diversification benefits
- Hedge funds exploiting market inefficiencies or implementing complex strategies
Government agencies
- Play crucial roles in supporting and regulating the mortgage-backed securities market
- Government National Mortgage Association () provides explicit government guarantee
- Federal Housing Finance Agency (FHFA) oversees Fannie Mae and Freddie Mac
- Department of Housing and Urban Development (HUD) sets housing policies affecting the market
Regulatory environment
Securities and Exchange Commission
- Oversees registration and disclosure requirements for publicly traded mortgage-backed securities
- Enforces regulations to protect investors and maintain fair, orderly, and efficient markets
- Implemented enhanced disclosure rules following the
- Regulates credit rating agencies that assess the creditworthiness of mortgage-backed securities
Financial Industry Regulatory Authority
- Self-regulatory organization overseeing broker-dealers in the United States
- Monitors trading practices and enforces rules to prevent market manipulation
- Provides education and resources for investors on mortgage-backed securities
- Conducts examinations and investigations to ensure compliance with industry standards
Basel III requirements
- International regulatory framework for banks, impacting their involvement in mortgage-backed securities
- Introduces stricter capital and liquidity requirements for financial institutions
- Affects risk-weighting of mortgage-backed securities held on bank balance sheets
- Implements the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) impacting funding strategies
Historical performance
Subprime mortgage crisis
- Severe downturn in the mortgage-backed securities market during 2007-2009
- Triggered by defaults on subprime mortgages and a collapse in housing prices
- Led to significant losses for investors and the failure of major financial institutions
- Revealed weaknesses in underwriting standards, risk assessment, and regulatory oversight
Market recovery and trends
- Gradual recovery of the mortgage-backed securities market following government interventions
- Increased focus on agency mortgage-backed securities with implicit or explicit government guarantees
- Stricter underwriting standards and improved transparency in securitization processes
- Evolution of new structures and risk management techniques to address lessons learned from the crisis
Analytical tools
Yield measures
- Nominal yield calculated as the coupon rate of the underlying mortgages
- Yield to maturity (YTM) considering the purchase price and expected cash flows
- Cash flow yield (CFY) accounting for prepayments and potential extensions
- Option-adjusted yield (OAY) incorporating the value of embedded prepayment options
Duration and convexity
- Effective duration measures price sensitivity to small parallel shifts in the yield curve
- Key rate duration captures sensitivity to changes in specific points on the yield curve
- Negative convexity reflects the price-yield relationship's curvature due to prepayment optionality
- Option-adjusted duration and convexity provide more accurate risk measures for mortgage-backed securities
Prepayment models
- Conditional Prepayment Rate (CPR) expresses annualized percentage of outstanding principal expected to prepay
- Public Securities Association (PSA) model defines a standard prepayment curve
- S-curve models capture the seasoning effect of mortgages on prepayment behavior
- Vector models incorporate multiple economic factors to predict prepayment speeds
Trading and liquidity
Primary vs secondary markets
- Primary market involves initial issuance and sale of new mortgage-backed securities
- Secondary market facilitates trading of existing securities among investors
- To-be-announced (TBA) market serves as the primary mechanism for trading agency MBS
- typically trade in less liquid over-the-counter (OTC) markets
TBA market
- Forward market for agency mortgage-backed securities with standardized terms
- Allows for efficient hedging and price discovery in the mortgage market
- Trades settle on a forward basis, typically one to three months after the trade date
- Specific pools of mortgages allocated to TBA trades shortly before settlement
Impact on housing finance
Mortgage availability
- Securitization increases liquidity in the mortgage market, potentially lowering borrowing costs
- Allows lenders to transfer , enabling them to extend more loans
- Standardization of mortgage terms to meet securitization criteria
- Potential for over-reliance on securitization leading to lax underwriting standards
Interest rate transmission
- Mortgage-backed securities market influences mortgage rates offered to borrowers
- Spreads between MBS yields and Treasury yields affect the cost of mortgage financing
- Federal Reserve's purchases of MBS can directly impact mortgage rates and housing affordability
- Global demand for U.S. mortgage-backed securities can affect domestic interest rates
Global perspective
US vs international markets
- U.S. market remains the largest and most developed for mortgage-backed securities
- European markets feature covered bonds as an alternative to U.S.-style securitization
- Differences in legal frameworks and property rights affect securitization practices globally
- Varying government support and guarantee mechanisms across countries
Currency considerations
- Cross-border investments in MBS expose investors to currency risk
- Use of currency hedging strategies to manage exchange rate fluctuations
- Potential for currency movements to impact relative attractiveness of U.S. vs foreign MBS
- Role of U.S. dollar as a global reserve currency influencing international demand for U.S. MBS
Future developments
Technological innovations
- Blockchain technology potential for improving transparency and efficiency in MBS markets
- Artificial intelligence and machine learning enhancing prepayment modeling and risk assessment
- Big data analytics enabling more granular analysis of underlying mortgage pools
- Digital platforms facilitating easier trading and price discovery for mortgage-backed securities
Regulatory changes
- Ongoing debates over the future of government-sponsored enterprises (Fannie Mae and Freddie Mac)
- Potential for new risk retention rules or capital requirements for issuers and investors
- Efforts to standardize and increase transparency in non-agency MBS markets
- Evolving global financial regulations impacting cross-border MBS investments and trading
Key Terms to Review (18)
2008 financial crisis: The 2008 financial crisis was a severe worldwide economic downturn that resulted from a collapse in the housing market and risky financial practices, leading to widespread bank failures and significant government interventions. This crisis highlighted systemic issues in financial regulation, mortgage-backed securities, and the broader economic landscape, prompting discussions about financial stability and the effectiveness of existing theories around interest rates and asset valuations.
Adjustable-rate mortgage: An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can change periodically based on changes in a corresponding financial index that is associated with the loan. Typically, ARMs start with a lower initial interest rate than fixed-rate mortgages, making them attractive for borrowers looking for lower monthly payments initially. However, as rates adjust over time, monthly payments can increase or decrease, impacting overall affordability.
Agency mbs: Agency mortgage-backed securities (MBS) are debt securities created by pooling together mortgage loans, which are guaranteed by government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae. These securities provide investors with a way to earn interest income while having a degree of safety due to the backing by GSEs, making them a popular choice in the fixed-income market.
Collateralized Mortgage Obligation: A Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed security that pools together a collection of mortgage loans and divides the pool into different classes or tranches, which have varying levels of risk and return. This structure allows investors to choose the tranche that aligns with their investment strategy, whether they seek higher yields or more secure returns. CMOs play a crucial role in the mortgage market by providing liquidity and spreading the risks associated with mortgage defaults across various investors.
Credit Risk: Credit risk is the possibility of loss due to a borrower's failure to repay a loan or meet contractual obligations. This risk is crucial for financial institutions as it directly affects their ability to lend money and their overall financial stability. Understanding credit risk is essential when analyzing interest rates, pricing derivatives, and evaluating the quality of mortgage-backed and asset-backed securities.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive piece of legislation enacted in 2010 to reform the financial industry in response to the 2008 financial crisis. It aims to increase regulation on financial institutions, enhance consumer protection, and prevent future economic collapses. The act introduced significant changes affecting various areas including derivatives, stress testing of banks, and mortgage-related securities.
Duration: Duration is a measure of the sensitivity of a bond's price to changes in interest rates, reflecting the average time it takes for a bond's cash flows to be received. It connects the time value of money to interest rate risk, serving as an essential tool for understanding how bond prices fluctuate in response to shifts in market rates. This concept plays a vital role in evaluating investments, pricing bonds, and assessing the overall risk exposure of fixed-income securities.
Fannie Mae: Fannie Mae, or the Federal National Mortgage Association, is a government-sponsored enterprise that was created to expand the secondary mortgage market in the United States. By purchasing mortgages from lenders, Fannie Mae provides them with increased liquidity, allowing them to offer more loans to homebuyers. This helps make homeownership more accessible and affordable for a larger segment of the population.
Fixed-rate mortgage: A fixed-rate mortgage is a type of home loan where the interest rate remains constant throughout the life of the loan, typically spanning 15 to 30 years. This stability in payments allows borrowers to budget effectively, as they can anticipate their monthly mortgage expenses without worrying about fluctuations in interest rates. This feature makes fixed-rate mortgages popular among homeowners who prefer predictability and long-term financial planning.
Ginnie Mae: Ginnie Mae, or the Government National Mortgage Association (GNMA), is a U.S. government agency that guarantees mortgage-backed securities (MBS) issued by approved lenders. By ensuring timely payments to investors, Ginnie Mae plays a critical role in the housing finance system, promoting affordable housing and facilitating access to mortgage credit for low- to moderate-income borrowers.
Housing bubble: A housing bubble is an economic cycle characterized by rapid increases in the market value of real estate, followed by a sharp decline. This phenomenon occurs when the demand for housing significantly outpaces supply, leading to unsustainable price rises that eventually burst, causing widespread financial instability. The bubble is closely tied to factors such as speculative investments, easy credit, and overvaluation in the housing market.
Non-agency MBS: Non-agency mortgage-backed securities (MBS) are bonds backed by mortgages that are not guaranteed by government-sponsored entities like Fannie Mae or Freddie Mac. These securities are issued by private institutions and typically carry a higher yield compared to agency MBS due to the increased risk associated with them. They play an important role in the financial markets by allowing investors to gain exposure to real estate assets without directly owning the properties.
Pass-through security: A pass-through security is a type of investment instrument that represents a claim on the cash flows generated from a pool of underlying assets, such as mortgage loans. Investors receive payments based on the actual cash flows from the assets, which can vary depending on borrower behavior and prepayment rates. This structure allows investors to gain exposure to the performance of the underlying mortgages while distributing the risks associated with them.
Pooling: Pooling refers to the practice of combining various financial assets or liabilities into a single group to create a diversified investment vehicle. This technique is commonly used in financial markets, especially in mortgage-backed securities, where multiple mortgages are bundled together to spread risk and enhance liquidity. By pooling, investors can access a broader range of assets, improving their chances of earning returns while mitigating the impact of individual asset defaults.
Prepayment risk: Prepayment risk is the risk that borrowers will pay off their loans earlier than expected, which can negatively impact the cash flows of securities backed by those loans. This risk is especially pertinent in mortgage-backed and asset-backed securities, where early repayments can lead to reduced interest income for investors and the potential reinvestment at lower prevailing rates. Understanding this risk is crucial for assessing the valuation and performance of these financial instruments.
SEC Regulations: SEC regulations are rules and guidelines established by the U.S. Securities and Exchange Commission to govern the securities industry, ensuring transparency, fairness, and investor protection. These regulations play a crucial role in maintaining the integrity of financial markets, impacting how companies issue securities, report financial information, and comply with legal obligations. They are especially significant in contexts involving various types of securities, including mortgage-backed securities, where adherence to these regulations helps mitigate risks for investors and ensures proper disclosure of relevant information.
Tranching: Tranching is the process of dividing financial products, particularly securities, into different classes or 'tranches' that have varying levels of risk, return, and maturity. This allows investors to choose the level of risk they are comfortable with while also enabling issuers to appeal to a broader range of investors. Each tranche may have different payment structures and priorities when it comes to receiving cash flows, making tranching a key feature in structured finance products.
Yield Spread: Yield spread refers to the difference in yields between two different debt instruments, often comparing a bond's yield to a benchmark yield, such as government bonds. This difference helps investors assess the relative risk and return of different securities. It serves as an important indicator of market sentiment, particularly regarding interest rates and credit risk, which connects to various financial concepts like term structure and credit risk assessment.