Mortgage-Backed

Securities
Leah DiMartino
Matt Houser
Brendan LaCerda
Kaity McCoy
Brian Seremet
Justin Sibears
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Introduction

Mortgage-backed securities (MBS) are debt

obligations that represent claims to cash flows
from pools of mortgage loans
Mortgages are purchased and assembled into
pools by governmental, quasi-governmental, or
private entities
These entities then issue securities that
represent claims to the principal and interest
payments on the mortgages
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Types

Most simple MBS are pass-through securities in

which the holder of the security is entitled to a
pro-rata share of all interest and principal
payments
CMOs

Divide pool into tranches so that securities with

different maturities and different risks can be issued

Benefits and Risks

Benefits

High yields for the amount of risk taken

Credit risk minimal due to diversification

Risks

Prepayment risk risk that some homeowners will make

principal payments ahead of schedule, especially prevalent
during low interest rate periods in which many homeowners
refinance

Detrimental to investors because money must then be reinvested at

lower interest rates

Extension risk sometimes prepayments can occur slower

than expected, which leads to longer maturity and more
exposure to interest rate risk
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Market for MBS

Fast Growth
$110.9 billion outstanding in 1980
$3,968 billion outstanding in 2006

General pricing strategy

Previous attempts

Econometric models

Use historical prepayment data

Disadvantage is that changes in economic factors can make historical
data obsolete as predictor of future prepayments
For example, Internet and widespread dissemination of information has
dramatically decreased the drop in interest rates needed before
homeowners refinance

Option-theoretic models

Attempt to value option of homeowners to refinance, this reduces the

value of MBS to investors from value of bond with similar cash flows
and no prepayment risk
Assume unrealistic homeowner behavior and have had trouble fitting
market data

Our Model

Proposed by Kalotay, Yang, Fabozzi

Shares similarities with option-theoretic
Based on idea of homeowners exercising option
to refinance
Model allows for varying behavior of
homeowners using imputed coupon
Distinguishes between mortgage interest rates
and MBS interest rates unlike previous models
Allows for multiple types of prepayments
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Interest Rate Model

Based on Black-Derman-Toy
d(ln r) = [(t) + ln r ((t)/ (t))]dt + (t)dWt
Binomial model
Fits current yield curve
Assumes constant volatility ( = 10%)
For fixed w, interest rates in the binomial tree
related by: rwT = rwH e2t
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Treasury Securities

10

Yield Curve
Yield Curve
6.00%
5.50%

Yield

5.00%
4.50%
4.00%
3.50%
3.00%
0

10

11

Years to Maturity

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Creating Binomial Tree

Set r0 = 4.97%, the current yield on a treasury

security with one year to maturity.
Consider treasury security with 2 years to
maturity, coupon of 3.125, and price of 97:00

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Creating Binomial Tree

Three cells at each node

Top cell PV of future cash flows
Middle cell Coupon payment
Bottom cell Interest rate
Input is interest rate in lowest node
for time 1.

Compare PV at time 0 to
current price of two year
security
96.053 < 97 rT too
high
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Creating Binomial Tree

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Creating Binomial Tree

Now consider
treasury security with
3 years to maturity,
coupon of 4, and
price of 98:07
Input is interest rate
in lowest node of
time 2
98.898 > 98.21975
interest rate too low

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Creating Binomial Tree

This process is continued until we find a binomial

tree for interest rates with ten time periods
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Simulation

There are 210 different

paths for interest rates
under this model.
Randomly select 21 of
these that are
representative of all the
possible paths.

Interest rate paths

Risk-free interest rate

10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
0

10

Year

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Prepayments

Housing Turnover
Mortgage usually repaid when home sold
Significant cause of prepayments
Important to forecast housing turnover rate which
depends on such factors as economic growth and
federal taxation of home sales

Refinancing

Homeowners repay old loan and take out new loan

to benefit from decrease in interest rates
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Prepayments

Default
When foreclosure or liquidation of mortgage occur
Minor cause of prepayments, less than 0.5% CPR

Curtailments

Homeowners pay more than scheduled payment to

build up equity in home, less than 0.5% CPR

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Modeling Refinancing

Model based on behavior of individual

homeowners
Most homeowners do not refinance optimally
and in particular they refinance too late
Assigned each homeowner a value for a variable l
Assume mortgage rate of m
Homeowner refinances as if they have mortgage
with rate of m - l.
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Assumptions

MBS consists of eight groups of investors with

equal principal
Values of l range from 0.0% to 3.5% in
increments of 0.5%

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Binomial Mortgage Tree

Each node contains two cells

Top cell Rw PV of mortgage assuming that refinancing occurs
if optimal
Rw= min(Vw, Pw * (1 + c) where Pw is the principal
remaining on the (m-l)% mortgage after w has been followed
and c is the cost of refinancing
Bottom cell Vw PV of mortgage payments assuming no
refinancing
Vw=_______________________
K + 0.5RwH + 0.5RwT
1 + rmortgagew
where K is the mortgage payment on (m-l)% mortgage
and rmortgagew = rw + 0.008
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Binomial Mortgage Tree

And the corresponding binomial mortgage tree:

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Binomial Mortgage Tree

Consider the following interest rate path:
6.0%
5.0%

Interest Rate

4.0%
3.0%
2.0%
1.0%
0.0%
0

10

Time

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Cash Flows

Refinancing occurs at time 6. Use this to get cash flows from

MBS for this group of homeowners and then repeat for other
seven groups.

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MBS Prices

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Assumptions

Used 10-year mortgages with yearly payments,

obviously unrealistic but easily can be extended
to 30-year mortgages with monthly payments
Mortgage interest rates 80 basis points above
risk-free rate at any period and MBS interest
rate 30 basis points above risk-free rate at any
period
Assume refinancing decision based on
movement of short term interest rates, in
actuality long term rates also considered
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Assumptions

Assumed simply model for prepayments due to

housing turnover

Initially 0.0% and then increases by 0.2% per month

until reaching 6.0%, at which time the rate stabilizes

Ignored prepayments due to defaults or

curtailments

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