Lecture 05 Mortgage Backed Securities I
Lecture 05 Mortgage Backed Securities I
Lecture 05 Mortgage Backed Securities I
▪ Fully amortizing fixed-rate loans have a payment that is constant over the
life of the loan.
▪ For example, suppose a loan has an original balance of $200,000, a note
rate of 7.5%, and a term of 30 years.
✓ Then the monthly mortgage payment would be $1,398.43.
✓ The formula for calculating the monthly mortgage payment is:
i (1 + i ) n
MP = MB0 n
(1 + i ) − 1
where MP = monthly mortgage payment ($), MB0 = original mortgage balance
($), i = note rate divided by 12 (in decimal), and n = number of months of
the mortgage loan
Cont.
(1 + i )n − (1 + i )t
MBt = MB0 n
(1 + i ) − 1
where MBt = mortgage balance after t months, MB0 = original
mortgage balance ($), i = note rate divided by 12 (in
decimal), and n = number of months of the mortgage loan.
Cont.
i (1 + i ) t −1
SPt = MB0 n
=
(1 + i ) − 1
0.00625(1.00625)12−1
$200 ,000 12
= $158.95
(1.00625) − 1
Cont.
1) Credit risk
2) Liquidity risk
3) Price risk
4) Prepayment risk
Securitization
This paper models and provides empirical evidence for the quality of assets that are se-
curitized through bankruptcy remote special purpose vehicles (SPVs). The model predicts
that assets sold to SPVs will be of lower quality ("lemons") compared to assets that are not
sold to SPVs. We find strong empirical support for this prediction using a comprehensive
data set of sales of mortgage-backed securities (Freddie Mac Participation Certificates, or
PCs) to SPVs over the period 1991 through 2002. Valuation estimates based on a structural
two-factor model indicate that PCs sold to SPVs are on average valued $0.39 lower per
$100 of face value relative to PCs not so sold. For the four largest coupon groups in our full
sample of Freddie Mac PCs, we find a "lemons spread" of 4-6 basis points in terms of yield-
to-maturity, and this spread accounts for 13-45% of the overall prepayment spread of these
securities.
• Our main hypothesis is that credit rating agencies (Moody's, S&P, and Fitch)
favour large issuers because these issuers bring in more businesses and
revenues. Moreover, the incentive towards favouritism ought to be stronger
during market booming period (He et al, 2011).
• In the regression models developed, we find that higher initial LTV ratios are
associated with greater default risk. The relation between the probability of
default and LTV seems to be nonlinear, and a sharp increase is seen for values
greater than 80%. Our findings confirm the adequacy of the new Basel III
proposal that sets nonlinear capital requirement levels for banks holding
residential mortgage loans at different LTV ratios. However, the significance
shown in the regression models estimated with the "seasoning" variable could
be considered in order to improve the models used to measure capital
requirements (Otero et al, 2016).
Sectors of the RMBS Market
❑ All of the prime and subprime loans can be securitized in
different sectors of the RMBS market.
❑ Loans that satisfy the underwriting standard of the
agencies are typically used to create RMBS that are
referred to as agency mortgage-backed securities (MBS).
❑ All other loans are included in what is referred to
generically as nonagency MBS.
❑ The agency MBS market includes three types of securities:
1) agency mortgage pass-through securities
2) agency collateralized mortgage obligations (CMOs)
3) agency stripped MBS
Figure 1 Breakdown of Residential Mortgage Loan Market and the
Sectors of the RMBS Market
❑ Not all of the mortgages that are included in the loan pool that are
securitized need to have the same note rate and the same maturity.
❑ After origination of the MBS, the WAM of a pool changes. Fannie Mae
and Freddie Mac report the remaining number of months to maturity for
a loan pool, which they refer to as weighted average remaining
maturity (WARM).
❑ Both Fannie Mae and Freddie Mac also report the weighted average of
the number of months since the origination of the security for the loans
in the pool.
▪ This measure is called the weighted average loan age (WALA).
Loan Outstanding mortgage balance ($) Weight in pool Mortgage rate (%) Months remaining
1 125,000 22.12% 7.50 275
2 85,000 15.04% 7.20 260
3 175,000 30.97% 7.00 290
4 110,000 19.47% 7.80 285
5 70,000 12.39% 6.90 270
Total 565,000 100.00% 7.28 279
WAC = WAM =
Prepayment Conventions and Cash Flow
Using our formula to determine the SMM for a given CPR, we get:
SMM = 1 – (1 – CPR)1/12 = 1 – (1 – 0.06)1/12 ➔
SMM = 1 – (0.94)
0.08333 = 0.005143
SMM Rate and Monthly Prepayment
100% PSA
6
0 30