Mortgage Loans
Key attributes that define mortgages are lien status, original loan term, credit classification, interest rate type, prepayments/prepayment penalties, and credit guarantees.
Agency MBSs are those that are guaranteed by government-sponsored enterprises (GSEs). Most of the MBSs are issued by these GSEs.
The GSEs have restrictions on which mortgages they can guarantee/securitize, which opened up the private label market (non-agency MBSs) for those participants willing to take on the risks inherent in nonconventional loans—jumbo loans and/or loans with high loan-to-value ratios.
Fixed-Rate, Level-Payment Mortgages
A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial. A level-payment, fixed-rate conventional mortgage has a fixed term, a fixed interest rate, and a fixed monthly payment. Even though the term, rate, and payment are fixed, the cash flows are not known with certainty because the borrower has the right to repay all or any part of the mortgage balance at any time.
Mortgage Prepayment Option And Other Factors
Mortgage prepayments come in two forms: (1) increasing the frequency or amount of payments and (2) repaying/refinancing the entire outstanding balance. Prepayments are much more likely to occur when market interest rates fall and borrowers wish to refinance their existing mortgages at a new and lower rate.
Other factors that influence prepayments include seasonality, age of mortgage pool, personal, housing prices, and refinancing burnout.
Mortgage-Backed Securities
To reduce the risk from holding a potentially undiversified portfolio of mortgage loans, a number of financial institutions (originators) will work together to pool residential mortgage loans with similar characteristics into a more diversified portfolio. They will then sell the loans to a separate entity, called a special purpose vehicle (SPV), in exchange for cash. An issuer will purchase those mortgage assets in the SPV and then use the SPV to issue mortgage-backed securities (MBSs) to investors; the securities are backed by the mortgage loans as collateral.
Fixed-rate pass-through securities trade in one of the following ways:
- The specified pools market.
- The To Be Announced (TBA) market.
The value of an MBS is a function of:
- Weighted average maturity (WAM).
- Weighted average coupon (WAC).
- Speed of prepayments.
Regarding prepayment speeds, the single monthly mortality (SMM) rate is derived from the conditional prepayment rate and is used to estimate monthly prepayments for a mortgage pool:
SMM = 1 − (1 − CPR)1/12
Dollar Roll Transaction
A dollar roll transaction occurs when an MBS market maker is buying positions for one settlement month and, at the same time, selling those same positions for another month.
Prepayment Modeling
Borrowers may prepay a mortgage due to the sale of the property or a desire to refinance at lower prevailing rates. In addition, prepayments may occur when the borrower has defaulted on the mortgage or when the borrower has cash available to make partial prepayments (curtailment).
Dynamic Valuation
The Monte Carlo methodology is a simulation approach for valuing MBSs. The binomial model is not appropriate for valuing MBSs because MBSs have embedded prepayment options and the historical evolution of interest rates over time impacts prepayments.
A mortgage security is valued using the Monte Carlo methodology by simulating the interest rate path and refinancing path, projecting cash flows for each interest rate path, calculating the present value of cash flows for each interest rate path, and calculating the theoretical value of the mortgage security.
Option-Adjusted Spread
The option-adjusted spread (OAS) is the spread that, when added to all the spot rates of all the interest rate paths, will make the average present value of the paths equal to the actual observed market price plus accrued interest. The zero-volatility spread (z-spread) is the spread that an investor realizes over the entire Treasury spot rate curve, assuming the mortgage security is held to maturity. The option cost is the implied cost of the embedded prepayment option and is calculated as the difference between the z-spread and OAS.
Four major limitations of OASs are related to:
- (1) modeling risk associated with Monte Carlo simulations,
- (2) required adjustments to interest rate paths,
- (3) model assumption of a constant OAS over time, and
- (4) dependency on the underlying prepayment model.
Price-Rate Behavior
With prepayments, the mortgage is effectively a shorter-term security than a mortgage without prepayments, and the dollar value of a basis point is less for mortgages with a prepayment option.
