Residential Mortgages and Mortgage-Backed Securities

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Residential Mortgages and Mortgage-Backed Securities

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Title: Residential Mortgages and Mortgage-Backed Securities

1
Residential Mortgages and Mortgage-Backed
Securities
2
Mortgage-Backed Securities
3
Mortgage-Backed Securities

A mortgage originator with a pool of mortgages
has the option of holding the portfolio, selling
it, or selling it to be used to securitize a MBS
issue or deal.
Depending on the types of mortgages, the
originator who sells mortgages to become a
securitized asset can sell them to one of the
three agencies (Fannie Mae, Ginnie Mae, or
Freddie Mac) or to a private-sector conduit.
As noted in Chapter 7, Fannie Mae and Freddie Mac
are Government-sponsored enterprises (GSEs),
whereas Ginnie Mae is a federal agency. In our
discussion of MBSs, we will refer to all three as
being agencies.

4
Mortgage-Backed Securities

Agency MBSs are MBSs created by one of the
agencies they are collectively referred to as
agency MBSs,
Nonagenecy MBS are MBS created by private
conduits also called private labels.

5
Mortgage-Backed Securities

Residential mortgages can be divided into prime
and subprime mortgages.
Prime mortgages include those that are both
conforming (meet the agencys underwriting
standards) and nonconforming but still meeting
credit quality standards.
Subprime mortgages include those with low credit
ratings.

6
Mortgage-Backed Securities

Note
Typically, agency residential MBSs are created
from conforming loans.
In more recent periods, though, agency MBS issues
backed by pools of lower quality mortgages were
issued.
All other mortgages that are securitized are
nonagency MBS.

7
Mortgage-Backed Securities

After the mortgages are sold to an agency or
private conduit, the originator typically
continues to service the loan for a service fee
(that is, collect payments, maintain records,
forward tax information, and the like).
The service fee is typically a fixed percentage
(25 to 100 basis points) of the outstanding
balance.
The originator can also sell the servicing to
another party.
Investors who buy the MBSs receive a pro rata
share from the cash flow of the pool of
mortgages.

8
Ginnie Mae Mortgage-Backed Securities

Ginnie Mae (Government National Mortgage
Association's (GNMA)) is a true federal agency.
As such, the MBSs that it guarantees are backed
by the full faith and credit of the U.S.
government.

9
Ginnie Mae Mortgage-Backed Securities

Creation
Ginnie Mae MBSs are put together by a
lender/originator (bank, thrift, or mortgage
banker), who presents a block of mortgages that
meets Ginnie Maes underwriting standards.
If Ginnie Mae finds them in order, it will issue
a guarantee and assign a pool number that
identifies the MBS that is to be issued.
The lender will then transfer the mortgages to a
trustee, and then issue the pass-through
securities as a Ginnie Mae pass-through security.

10
Ginnie Mae Mortgage-Backed Securities

Features
Ginnie Mae provides the guarantee, but does not
issue the Ginnie Mae MBS.
Thus, different from the standard MBS that is
issued by the other agencies or a conduit, Ginnie
Mae MBSs are issued by the lenders.
The minimum denomination on a Ginnie Mae
pass-through is 25,000 and the minimum pool is
1 million.

11
Ginnie Mae Mortgage-Backed Securities

Types
The mortgages underlying Ginnie Mae MBSs can be
grouped into one of two Ginnie Mae MBS programs
Ginnie Mae I and Ginnie Mae II.
The Ginnie Mae I program consists of MBSs backed
by single-family and multifamily mortgage loans
that have a fixed note rate and are sold by only
one issuer.
The Ginnie Mae II program consists of just
single-family mortgage loans that can have either
fixed or adjustable rates and have multiple
issuers.

12
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

Fannie Mae and Freddie Mac are Government-sponsore
d enterprises (GSE) initially created to provide
a secondary market for mortgages.
Today, there activities include not only the
buying and selling of mortgages, but also
creating and guaranteeing mortgage-backed
pass-through securities, as well as buying MBSs.

13
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

Note
Both GSEs are regulated by the Office of Federal
Housing Enterprise Oversight (OFHEO) and both
were placed in conservatorship in September 2008.
Prior to being placed in conservatorship, the
Fannie Mae and Freddie Mac MBSs were guarantee by
each of the companies, but not the government.
As part of the banking bailout in 2008, though,
government backing was provided to their MBSs.

14
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

Freddie Mac issues MBSs that it refers to as
participation certificates (PCs).
Freddie Mac and Fannie Mae have regular MBSs
(also called a cash PC), which are backed by a
pool of conforming mortgages that they have
purchased from mortgage originators.
They also offer a pass-though formed through
their Guarantor/Swap Program. In this program,
mortgage originators can swap mortgages for a
Fannie Mae or Freddie Mac pass-through.

15
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

Unlike Ginnie Mae, Fannie Maes and Freddie Mac's
MBSs are formed with more heterogeneous
mortgages.
The minimum denomination on a Freddie Mac and
Fannie Mae pass-through is 100,000 and their
mortgage pools range up to several hundred
million dollars.

16
Nonagency MBS

Nonagency pass-throughs or private labels are
sold by commercial banks, investment banks, other
thrifts, and mortgage bankers.
As noted, nonagency pass-throughs are often
formed with prime or subprime nonconforming
mortgages.
Larger issuers of nonagency MBSs include
Citigroup, Bank of America, and G.E. Capital
Mortgage.

17
Nonagency MBS

Features
Nonagency MBSs are often guaranteed against
default through external credit enhancements,
such as the guarantee of a corporation or a bank
letter of credit or by private insurance from a
monocline insurer.
Many are also guaranteed internally through the
creation of senior and subordinate classes of
bonds with different priority claims on the
pool's cash flows in the case some of the
mortgages in the pool default.
The more subordinate claims sold relative to the
senior claims, the more secure the senior claims.

18
Nonagency MBS

Features
Nonagency MBSs are rated by Moody's and Standard
and Poor's.
They must be registered with the SEC when they
are issued.

19
Nonagency MBS

Features
Most financial entities that issue private-label
MBSs or derivatives of MBSs are legally set up so
that they do not have to pay taxes on the
interest and principal that passes through them
to their MBS investors.
The requirements that MBS issuers must meet to
ensure tax-exempt status are specified in the Tax
Reform Act of 1983 in the section on trusts
referred to as Real Estate Mortgage Investment
Conduits, REMIC.
Private-labeled MBS issuers who comply with these
provisions are sometimes referred to as REMICs.

20
Nonagency MBS

Features
Nonagency residential MBSs differ fundamentally
from agency MBSs in that their cash flows are
subject to default risk, whereas agency MBSs with
their government and agency guarantees are
considered default free.

21
Cash Flows

Cash flows from MBSs are generated from the cash
flows from the underlying pool of mortgages,
minus servicing and other fees.
Typically, fees for constructing, managing, and
servicing the underlying mortgages (also referred
to as the mortgage collateral) and the MBSs are
equal to the difference between the rates
associated with the mortgage pool and the rate
that is paid to the MBS investors (pass-through
(PT) rate).

22
Cash Flows Terms

Weighted Average Coupon Rate, WAC Mortgage
portfolio's (collaterals) weighted average rate.
Weighted Average Maturity, WAM Mortgage
portfolio's weighted average maturity.
Pass-Through Rate, PT Rate Interest rate paid on
the MBS PT rate is lower than WACthe difference
going to the MBS issuer.
Prepayment Rate or Speed Assumed prepayment rate.

23
Cash Flow from a MBS

Example
The next slide shows the monthly cash flows for
a MBS issue constructed from a 100 million
mortgage pool with the following features
Current balance 100 million
WAC 8
WAM 355 months
PT rate 7.5
Prepayment speed equal to 150 of the standard
PSA model PSA 150

24
Projected Cash Flows from an Agency MBS
IssueMortgage Portfolio 100,000,000, WAC
8, WAM 355 Months, PT Rate 7.5, Prepayment
150 PSA
25
Cash Flow from a MBS

Notes
The first month's CPR for the MBS issue reflects
a 5-month seasoning in which t 6, and a speed
that is 150 greater than the 100 PSA. For the
MBS issue, this yields a first month SMM of
.0015125 and a constant SMM of .0078284 starting
in month 25.
The WAC of 8 is used to determine the mortgage
payment and scheduled principal, whereas the PT
rate of 7.5 is used to determine the interest.
The monthly fees implied on the MBS issue are
equal to .04167 (8 - 7.5)/12 of the monthly
balance.

26
Cash Flow from a MBS

First Months Payment

27
Cash Flow from a MBS

From the 736,268 payment, 625,000 would go
towards interest and 69,601 would go towards the
scheduled principal payment

28
Cash Flow from a MBS

Using 150 PSA model and seasoning of 5 months
the first month SMM .0015125

29
Cash Flow from a MBS

Given the prepayment rate, the projected prepaid
principal in the first month is 151,147

30
Cash Flow from a MBS

Thus, for the first month, the MBS would generate
an estimated cash flow of 845,748 and a balance
at the beginning of the next month of 99,779,252

31
Cash Flow from a MBS

Second Month Payment, Interest, Scheduled
Principal, Prepaid Principal, and Cash flow

32
Market

As noted, investors can acquire newly issued
mortgage-backed securities from the agencies,
originators, or dealers specializing in specific
pass-through.
There is also a secondary market consisting of
dealers who operate in the OTC market as part of
the Mortgage-Backed Security Dealers Association.
These dealers form the core of the secondary
market for the trading of existing pass-through.

33
Market

MBSs are normally sold in denominations ranging
from 25,000 to 250,000, although some
privately-placed issues are sold with
denominations as high as 1 million.

34
Price Quotes

The prices of MBSs are quoted as a percentage of
the underlying MBS issues balance.
The mortgage balance at time t, Ft, is usually
calculated by the servicing institution and is
quoted as a proportion of the original balance,
F0.
This proportion is referred to as the pool
factor, pf

35
Price Quotes

Example
A MBS backed by a mortgage pool originally worth
100 million
Current pf of 0.92
quoted at 95 - 16 (Note 16 is 16/32)
The current balance, Ft, would be 92 million
and the market value would be 87.86 million

36
Price Quotes

Note
The market value is the clean price it does not
take into account accrued interest.
For MBS, accrued interest is based on the time
period from the settlement date (typically two
days after the trade) and the first day of the
next month.

37
Price Quotes

Example
If the time period is 20 days, the month is 30
days, and the WAC 9, then the accrued interest
is 460,000
The full market value (clean price plus accrued
interest) would be 88,320,000

38
Price Quotes

The market price per share is the full market
value divided by the number of shares.
Example
If the number of shares is 400, then the price of
the MBS based on a 95 - 16 quote would be
220,800

39
Extension Risk

Like other fixed-income securities, the value of
a MBS is determined by the MBS's future cash flow
(CF), maturity, default risk, and other features
germane to fixed-income securities.

40
Extension Risk

In contrast to other bonds, MBSs are also subject
to prepayment risk.
Prepayment affects the MBSs CF.
Prepayment, in turn, is affected by interest
rates.

41
Extension Risk

Thus, interest rates affects the MBSs CFs

42
Extension Risk

With the CF a function of rates, the value of a
MBS is more sensitive to interest rate changes
than those bonds whose CFs are not.
This sensitivity is known as extension risk.

43
Extension Risk

If interest rates decrease, then the prices of
MBSs, like the prices of most bonds, would
increase as a result of the lower discount rates.
However, the decrease in rates will also augment
prepayment speed, causing the earlier cash flow
of the mortgages to be larger which, depending on
the level of rates and the maturity remaining,
could also contribute to increasing the MBSs
price.

44
Extension Risk

Rate Decrease

45
Extension Risk

If interest rates increase, then the prices of
MBSs will decrease as a result of higher discount
rates and possibly the smaller earlier cash flow
resulting from lower prepayment speeds.

46
Extension Risk

Rate Increase

47
Average Life

The average life of a MBS or mortgage portfolio
is the weighted average of the securitys time
periods, with the weights being the periodic
principal payments (scheduled and prepaid
principal) divided by the total principal

48
Average Life

The average life for the MBS issue with WAC 8,
WAM 355, PT Rate 7.5, and PSA 150 is 9.18
years

49
Average Life

The average life of a MBS depends on prepayment
speed
If the PSA speed of the 100 million MBS issue
were to increase from 150 to 200, the MBSs
average life would decrease from 9.18 to 7.55,
reflecting greater principal payments in the
earlier years.
If the PSA speed were to decrease from 150 to
100, then the average life of the MBS would
increase to 11.51.

50
Average Life and Prepayment Risk

For MBSs and mortgage portfolios, prepayment risk
can be evaluated in terms of how responsive a
MBS's or mortgage portfolios average life is to
changes in prepayment speeds

51
Average Life and Prepayment Risk

A MBS with an average life that did not change
with PSA speeds, in turn, would have stable
principal payments over time and would be absent
of prepayment risk.

52
MBS Derivatives
53
MBS Derivatives

One of the more creative developments in the
security market industry over the last three
decades has been the creation of derivative
securities formed from MBSs and mortgage
portfolios that have different prepayment risk
characteristics, including some that are formed
that have average lives that are invariant to
changes in prepayment rates.
The most popular of these derivatives are
Collateralized Mortgage Obligations, CMOs
Stripped MBS

54
Collateralized Mortgage Obligations

Collateralized mortgage obligations, CMOs, are
formed by dividing the cash flow of an underlying
pool of mortgages or a MBS issue into several
classes, with each class having a different claim
on the mortgage collateral and with each sold
separately to different types of investors.

55
Collateralized Mortgage Obligations

The different classes making up a CMO are called
tranches or bond classes.
There are two general types of CMO tranches
Sequential-Pay Tranches
Planned Amortization Class Tranches, PAC

56
Sequential-Pay Tranches

A CMO with sequential-pay tranches, called a
sequential-pay CMO, is divided into classes with
different priority claims on the collateral's
principal.
The tranche with the first priority claim has its
principal paid entirely before the next priority
class, which has its principal paid before the
third class, and so on.
Interest payments on most CMO tranches are made
until the tranche's principal is retired.

57
Sequential-Pay Tranches

Example
A sequential-pay CMO is shown in Slide 59.
This CMO consist of three tranches, A, B, and C,
formed from the collateral making up the 100
million MBS in the previous example F 100
million, WAM 355, WAC 8, PT Rate 7.5, PSA
150.
Tranche A 50 million
Tranche B 30 million
Tranche C 20 million

58
Sequential-Pay Tranches

Priority Disbursement Rules
Tranche A receives all principal payment from the
collateral until its principal of 50 million is
retired. No other tranche's principal payments
are disbursed until the principal on A is paid.
After tranche A's principal is retired, all
principal payments from the collateral are then
made to tranche B until its principal of 30
million is retired.
Finally, tranche C receives the remaining
principal that is equal to its par value of 20
million.
Although the principal is paid sequentially, each
tranche does receive interest each period equal
to its stated PT rate (7.5) times its
outstanding balance at the beginning of each
month.

59
Cash Flows from Sequential-Pay CMOCollateral
Balance 100m, WAM 355 Months, WAC 8, PT
Rate 7.5, Prepayment 150 PSA, Tranches A
50 million, B 30 million, C 20 million
60
Sequential-Pay Tranches

Given the assumed PSA of 150, the first month
cash flow for tranche A consist of a principal
payment (scheduled and prepaid) of 220,748 and
an interest payment of 312,500
Interest (.075/12)(50,000,000)
312,500
In month 2, tranche A receives an interest
payment of 311,120 based on the balance of
49,779, 252 and a principal payment of 246,153.

61
Sequential-Pay Tranches

Based on the assumption of a 150 PSA speed, it
takes 88 months before A's principal of 50M is
retired.
During the first 88 months, the cash flows for
tranches B and C consist of just the interest on
their balances, with no principal payments made
to them.
Starting in month 88, tranche B begins to receive
the principal payment.
Tranche B is paid off in month 180, at which time
principal payments begin to be paid to tranche C.
Finally, in month 355 tranche C's principal is
retired.

62
Sequential-Pay Tranches

Features of Sequential-Pay CMOs
By creating sequential-pay tranches, issuers of
CMOs are able to offer investors maturities,
principal payment periods, and average lives
different from those defined by the underlying
mortgage collateral.

63
Sequential-Pay Tranches

Features of Sequential-Pay CMOs
Maturity
Collateral's maturity 355 months (29.58 years)
Tranche As maturity 88 months (7.33 years)
Tranche B's maturity 180 months (15 years)
Tranche Cs maturity 355 months (29.58 years)
Window The period between the beginning and
ending principal payment is referred to as the
principal pay-down window
Collaterals window 355 months
Tranche As window 87 months
Tranche B's window 92 months
Tranche C's window 176 months
Average Life
Collateral's average 9.18 years
Tranche As average life 3.69 years
Tranche Bs average life 10.71 years
Tranche Cs Average life 20.59 years

64
Sequential-Pay Tranches

Features of Sequential-Pay CMOs
A CMO tranche with a lower average life is still
susceptible to prepayment risk.
The average life of each of the tranches still
varies as prepayment speed changes.

65
Sequential-Pay Tranches

Note
Issuers of CMOs are able to offer a number of CMO
tranches with different maturities and windows by
simply creating more tranches.

66
Different Types of Sequential-Pay Tranches

Sequential-pay CMOs often include tranches with
special features. These include
Accrual Bond Tranche
Floating-Rate Tranche
Notional Interest-Only Tranche

67
Accrual Tranche

Many sequential-pay CMOs have an accrual bond
class.
Such a tranche, also referred to as the Z bond,
does not receive current interest but instead has
it deferred.
The Z bond's current interest is used to pay down
the principal on the other tranches, increasing
their speed and reducing their average life.

68
Accrual Tranche

Example
Suppose in our preceding sequential-pay CMO
example we make tranche C an accrual tranche in
which its interest of 7.5 is to paid to the
earlier tranches and its principal of 20 million
and accrued interest is to be paid after tranche
B's principal has been retired
Slide 69 shows the principal and interest
payments from the collateral and Tranches A, B,
and Z.

69
Cash Flows From Sequential-Pay CMO with Z
TrancheCollateral Balance 100M, WAM 355
Months, WAC 8, PT Rate 7.5, Prepayment 150
PSA, Tranches A 50M, B 30M, C 20M
70
Accrual Tranche

Features
Since the accrual tranche's current interest of
125,000 is now used to pay down the other
classes' principals, the other tranches now have
lower maturities and average lives.
For example, the principal payment on tranche A
is 345,748 in the first month (220,748 of
scheduled and projected prepaid principal and
125,000 of Z's interest) in contrast, the
principal is only 220,748 when there is no Z
bond.
As a result of the Z bond, tranche A's window is
reduced from 87 months to 69 months and its
average life from 3.69 years to 3.06 years.

71
Floating-Rate Tranche

In order to attract investors who prefer
floating-rate securities, CMO issuers often
create floating-rate and inverse floating-rate
tranches.
The monthly coupon rate on the floating-rate
tranche is usually set equal to a reference rate
such as the London Interbank Offer Rate, LIBOR,
while the rate on the inverse floating-rate
tranche is determined by a formula that is
inversely related to the reference rate.

72
Floating-Rate Tranche

Example Sequential-pay CMO with a floating and
inverse floating tranches
Note The CMO is identical to the preceding
CMO, except that tranche B has been replaced with
a floating-rate tranche, FR, and an inverse
floating-rate tranche, IFR.

Tranche Par Value PT Rate
A FR IFR Z 50 million 22.5 million 7.5 million 20 million 7.5 LIBOR 50bp 28.3 3 LIBOR 7.5
Total 100 million 7.5
73
Floating-Rate Tranche

The rate on the FR tranche, RFR, is set to the
LIBOR plus 50 basis points, with the maximum rate
permitted being 10.
The rate on the IFR tranche, RIFR, is determined
by the following formula
This formula ensures that the weighted average
coupon rate (WAC) of the two tranches will be
equal to the coupon rate on tranche B of 7.5,
provided the LIBOR is less than 9.5.

RIFR 28.5 - 3 LIBOR
74
Floating-Rate Tranche

Example If the LIBOR is 8, then the rate on
the FR tranche is 8.5, the IFR tranche's rate is
4.5, and the WAC of the two tranches is 7.5

75
Notional Interest-Only Class

Each of the fixed-rate tranches in the previous
CMOs have the same coupon rate as the collateral
rate of 7.5.
Many CMOs are structured with tranches that have
different rates.
When CMOs are formed this way, an additional
tranche, known as a notional interest-only (IO)
class, is often created.
The notional interest-only tranche receives the
excess interest on the other tranches
principals, with the excess rate being equal to
the difference in the collaterals PT rate minus
the tranches PT rates.

76
Notional Interest-Only Class

Example
A sequential-pay CMO with a Z bond and notional
IO tranche is shown in the next slide.
This CMO is identical to the previous CMO with a
Z bond, except that each of the tranches has a
rate lower than the collateral rate of 7.5 and
there is a notional IO class.

77
Sequential-Pay CMO with Notional IO
TrancheCollateral Balance 100m, WAM 355
Months, WAC 8, PT Rate 7.5, Prepayment 150
PSA, Tranches A 50m, B 30m, Z 20m,
Notional IO 15.333333m
78
Notional Interest-Only Class

The notional IO class receives the excess
interest on each tranche's remaining balance,
with the excess rate based on the collateral rate
of 7.5.
In the first month, for example, the IO class
would receive interest of 87,500

79
Notional Interest-Only Class

The IO class is described as paying 7.5 interest
on a notional principal of 15,333,333.
This notional principal is determined by summing
each tranche's notional principal.
A tranche's notional principal is the number of
dollars that makes the return on the tranche's
principal equal to 7.5.

80
Notional Interest-Only Class

The notional principal for tranche A is
10,000,000, for B, 4,000,000, and for Z,
1,333,333, yielding a total notional principal
of 15,333,333

81
Planned Amortization Class, PAC

A CMO with a planned amortization class, PAC, is
structured such that there is virtually no
prepayment risk.
In a PAC-structured CMO, the underlying mortgages
or MBS (i.e., the collateral) is divided into two
general tranches
The PAC (also called the PAC bond)
The support class (also called the support bond
or the companion bond)

82
Planned Amortization Class, PAC

The two tranches are formed by generating two
monthly principal payment schedules from the
collateral
One schedule is based on assuming a relatively
low PSA speed lower collar.
The other schedule is based on assuming a
relatively high PSA speed upper collar.
The PAC bond is then set up so that it will
receive a monthly principal payment schedule
based on the minimum principal from the two
principal payments.

83
Planned Amortization Class, PAC

The PAC bond is designed to have no prepayment
risk provided the actual prepayment falls within
the minimum and maximum assumed PSA speeds.
The support bond, on the other hand, receives the
remaining principal balance and is therefore
subject to prepayment risk.

84
Planned Amortization Class, PAC

Example
PAC and support bond formed from the 100
million collateral with WAC 8, WAM 355
months, and PT rate 7.5
Minimum monthly principal payments for the PAC
generated using 100 and 300 collars
Lower Collar 100 PSA Minimum speed of 100
PSA
Upper Collar 300 PSA Maximum speed of 300 PSA

85
Planned Amortization Class, PAC

The next slide shows the cash flows for the PAC,
collateral, and support bond. The exhibit shows
In columns 2 and 3 the principal payments
(scheduled and prepaid) for selected months at
both collars.
In the fourth column the minimum of the two
payments.
For example, in the first month the principal
payment is 170,085 for the 100 PSA and 374,456
for the 300 PSA thus, the principal payment for
the PAC would be 170,085.

86
PAC And Support BondsPAC formed 100 and 300 PSA
ModelCollateral Balance 100m, WAM 355
Months, WAC 8, PT Rate 7.5, Prepayment
150 PSA
87
Planned Amortization Class, PAC

Note
For the first 98 months, the minimum principal
payment comes from the 100 PSA collar, and from
month 99 on the minimum principal payment comes
from the 300 PSA collar.

88
Planned Amortization Class, PAC

Based on the 100-300 PSA range, a PAC bond can be
formed that would promise to pay the principal
based on the minimum principal payment schedule
shown in the exhibit.
The support bond would receive any excess monthly
principal payment.

89
Planned Amortization Class, PAC

The sum of the PAC's principal payments is
63.777 million. Thus, the PAC can be described
as having
Par value of 63.777 million
Coupon rate of 7.5
Lower collar of 100 PSA
Upper collar of 300 PSA
The support bond, in turn, would have a par value
of 36.223 million (100 million - 63.777
million) and pay a coupon of 7.5.

90
Planned Amortization Class, PAC

The PAC bond has no prepayment risk as long as
the actual prepayment speed is between 100 and
300.
This can be seen by calculating the PAC's average
life given different prepayment rates.
The next exhibit shows the average lives for the
collateral, PAC bond, and support bond for
various prepayment speeds ranging from 50 PSA to
350 PSA.

91
Planned Amortization Class, PAC

The average lives for the collateral, PAC bond,
and support bond for various prepayment speeds
ranging from 50 PSA to 350 PSA.

92
Planned Amortization Class, PAC

Features
The PAC bond has an average life of 6.98 years
between 100 PSA and 300 PSA its average life
does change, though, when prepayment speeds are
outside the 100-300 PSA range.
In contrast, the support bond's average life
changes as prepayment speed changes.
Changes in the support bond's average life due to
changes in speed are greater than the underlying
collateral's responsiveness.

93
Other PAC-Structured CMOs

The PAC and support bonds can be divided into
different classes.
Often the PAC bond is divided into several
sequential-pay tranches, with each PAC having a
different priority in principal payments over the
other.
Each sequential-pay PAC, in turn, will have a
constant average life if the prepayment speed is
within the lower and upper collars.
In addition, it is possible that some PACs will
have ranges of stability that will increase
beyond the actual collar range, expanding their
effective collars.

94
Other PAC-Structured CMOs

A PAC-structured CMO can also be formed with PAC
classes having different collars.
Some PACs are formed with just one PSA rate.
These PACs are referred to as targeted
amortization class (TAC) bonds.
Different types of tranches can also be formed
out of the support bond class. These include
sequential-pay, floating and inverse-floating
rate, and accrual bond classes.

95
Stripped MBS

Stripped MBSs consist of two classes
Principal-only (PO) class that receives only the
principal from the underlying mortgages.
Interest-only (IO) class that receives just the
interest.

96
Principal-Only Stripped MBS

The return on a PO MBS is greater with greater
prepayment speed.
For example, a PO class formed with 100 million
of mortgages (principal) and priced at 75
million would yield an immediate return of 25
million if the mortgage borrowers prepaid
immediately. Since investors can reinvest the
25 million, this early return will have a
greater return per period than a 25 million
return that is spread out over a longer period.

97
Principal-Only Stripped MBS

Because of prepayment, the price of a PO MBS
tends to be more responsive to interest rate
changes than an option-free bond.

98
Principal-Only Stripped MBS

If interest rates are decreasing, then like the
price of most bonds, the price of a PO MBS will
increase.
In addition, the price of a PO MBS is also
likely to increase further because of the
expectation of greater earlier principal payments
as a result of an increase in prepayment caused
by the lower rates.

99
Principal-Only Stripped MBS

If rates are increasing, the price of a PO MBS
will decrease as a result of both lower discount
rates and lower returns from slower principal
payments.

100
Principal-Only Stripped MBS

Thus, like most bonds, the prices of PO MBSs are
inversely related to interest rates, and, like
other MBSs with embedded principal prepayment
options, their prices tend to be more responsive
to interest rate changes.

101
Interest-Only Stripped MBS

Cash flows from an I0 MBS come from the interest
paid on the mortgages portfolios principal
balance.
In contrast to a PO MBS, the cash flows and the
returns on an IO MBS will be greater, the slower
the prepayment rate.

102
Interest-Only Stripped MBS

If the mortgages underlying a 100 million, 7.5
MBS with PO and IO classes were paid off in the
first year, then the IO MBS holders would receive
a one-time cash flow of 7.5 million
If 50 million of the mortgages were prepaid in
the first year and the remaining 50 million in
the second year, then the IO MBS investors would
receive an annualized cash flow over two years
totaling 11.25 million
If the mortgage principal is paid down 25
million per year, then the cash flow over four
years would total 18.75 million

7.5m (.075)(100m)
11.25m (.075) (100m) (.075)(100m - 50m)
18.75m (.075)(100m) (.075)(100m - 25m)
(.075)(75m - 25m)
(.075)(50m - 25m)
103
Interest-Only Stripped MBS

Thus, IO MBSs are characterized by an inverse
relationship between prepayment speed and
returns the slower the prepayment rate, the
greater the total cash flow on an IO MBS.

104
Interest-Only Stripped MBS

Note
If inverse relationship between prepayment speed
and returns dominates the price and discount rate
relation, then the price of an IO MBS will vary
directly with interest rates.

105
IO and PO Stripped MBS

An example of a PO MBS and an IO MBS are shown in
the next slide.
The stripped MBSs are formed from collateral
with
Mortgage Balance 100 million
WAC 8
PT Rate 8
WAM 360
PSA 100

106
Projected Cash Flows for Stripped PO and
IOCollateral Mortgage Portfolio 100 million,
WAC 8, WAM 360 Months, Prepayment 100 PSA
107
IO and PO Stripped MBS

The table shows the values of the collateral, PO
MBS, and IO MBS for different discount rate and
PSA combinations of 8 and 150, 8.5 and 125, and
9 and 100.
Note The IO MBS is characterized by a direct
relation between its value and rate of return.

Price Sensitivity
Discount PSA Value of Value of Value of
Rate PO IO Collateral
8.00 150 54,228,764 47,426,196 101,654,960
8.50 125 49,336,738 49,513,363 98,850,101
9.00 100 44,044,300 51,795,188 95,799,488
108

Evaluating Mortgage-Backed Securities

109
Evaluating Mortgage-Backed Securities

Like all securities, MBSs can be evaluated in
terms of their characteristics.
With MBSs, such an evaluation is more complex
because of the difficulty in estimating cash
flows due to prepayment.
One approached used to evaluate MBS and CMO
tranches is yield analysis.

110
Yield Analysis

Yield analysis involves calculating the yields on
MBSs or CMO tranches given different prices and
prepayment speed assumptions or alternatively
calculating the values on MBSs or tranches given
different rates and speeds.

111
Yield Analysis

Example
Suppose an institutional investor is interested
in buying a MBS issue that has a par value of
100 million, WAC 8, WAM 355 months, and a
PT rate of 7.5.
The value, as well as average life, maturity,
duration, and other characteristics of this
security would depend on the rate the investor
requires on the MBS and the prepayment speed she
estimates.

112
Yield Analysis

If the investors required return on the MBS is
9 and her estimate of the PSA speed is 150, then
she would value the MBS issue at 93,702,142.
At that rate and speed, the MBS would have an
average life of 9.18 years.
Whether a purchase of the MBS issue at
93,702,142 to yield 9 represents a good
investment depends, in part, on rates for other
securities with similar maturities, durations,
and risk, and in part, on how good the prepayment
rate assumption is.
For example, if the investor felt that the
prepayment rate should be 100 PSA and her
required rate with that level of prepayment is
9, then she would price the MBS issue at
92,732,145 and the average life would be 11.51
years.

113
Yield Analysis

In general, for many institutional investors the
decision on whether or not to invest in a
particular MBS or tranche depends on the price
the institution can command.
For example, based on an expectation of a 100
PSA, our investor might conclude that a yield of
9 on the MBS would make it a good investment.
In this case, the investor would be willing to
offer no more than 92,732,145 for the MBS issue.

114
Yield Analysis

One common approach used in conducting a yield
analysis is to generate a matrix of different
yields by varying the prices and prepayment
speeds.
The next slide shows the different values for our
illustrative MBS given different required rates
and different prepayment speeds.
Using this matrix, an investor could determine,
for a given price and assumed speed, the
estimated yield, or determine, for a given speed
and yield, the price. Using this approach, an
investor can also evaluate for each price the
average yield and standard deviation over a range
of PSA speeds.

115
Yield and Vector Analysis Mortgage Portfolio
100M, WAC 8, WAM 355 Months, PT Rate 7.5
Rate/PSA 50 100 150
7 8 9 10 Average Life Rate 7 8 9 10 Value 106,039,631 98,251,269 91,442,890 85,457,483 14.95 Vector Month Range PSA 1-50 200 51-150 250 151-250 150 251-355 200 Value 103,729,227 98,893,974 94,465,328 90,395,704 Value 105,043,489 98,526,830 92,732,145 87,554,145 11.51 Vector Month Range PSA 1-50 200 51-150 300 151-250 350 251-355 400 Value 103,473,139 98,964,637 94,794,856 90,929,474 Value 104,309,207 98,732,083 93,702,142 89,146,871 9.18 Vector Month Range PSA 1-50 200 51-150 150 151-250 100 251-355 50 Value 104,229,758 98,756,370 93,826,053 89,,364,229
116
Yield Analysis

One of the limitations of the above yield
analysis is the assumption that the PSA speed
used to estimate the yield is constant during the
life of the MBS.
In fact, such an analysis is sometimes referred
to as static yield analysis.
In practice, prepayment speeds change over the
life of a MBS as interest rates change in the
market.

117
Vector Analysis

A more dynamic yield analysis, known as vector
analysis, can be used.
In applying vector analysis, PSA speeds are
assumed to change over time.
In the above case, a matrix of values for
different rates can be obtained for different
PSA vectors formed by dividing the total period
into a number of periods with different PSA
speeds assumed for each period.
A vector analysis example is also shown at the
bottom of the last exhibit slide.

118
Web Sites

MBS Price Information
Wall Street Journal
Go to http//online.wsj.com/public/us, Market,
Bonds, Rates, Credit Markets, and
Mortgage-Backed Securities, CMO.
Investinginbonds.com
MBS Price Index The Merrill Lynch
Mortgage-Backed Securities (MBS) Index is a
statistical composite tracking the overall
performance of the mortgage-backed securities
market over time. The index includes U.S.
dollar-denominated 30-year, 15-year and balloon
pass-through mortgage securities.
Go to http//investinginbonds.com/ click
MBS/ABS Market At-A-Glance.

119
Web Sites

Agency MBS Prospectus and other information
Fannie Mae Information and Prospectus
Use Advance Search to find a MBS and its pool
number
Go to Fannie Mae www.fanniemae.com Site Map
Mortgage-Backed Securities More Search
Options.
Or go to http//sls.fanniemae.com/slsSearch/Home.d
o
Use pool number to find information on Fannie Mae
MBS
Information includes Prospectus and Common Pool
Information

120
Web Sites