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Financially Engineered Investment
ProductsMortgaged-Backed Securities

• Blackwell, Griffiths, and Winters, chapter 14,
  Van Horn, chapter 13,
• and other material

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Mortgage-Backed Securitiesalso know as MBS

• A means by which a secondary market was developed
  for residential mortgages
• Essentially, many residential mortgaged are
  pooled together and securities are issued against
  the pool the securities are called
  mortgage-backed securities
• The mortgages are more than simple collateral
• The mortgages provide the cash flow to service
  the securities
• Securities are called pass through securities
  because the cash flow passes through the issuer
  of the security to the holder of the security

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Mortgages Securitization

• In the securitization process, a large number of
  similar, illiquid loans (such as mortgages) are
  bundled together in an asset pool.
• Mortgage-backed securities (MBS) are the
  dominating type of asset-backed securities (ABS)
  in the U.S.
• Securitization allows for unbundling of the three
  major activities of the mortgage business
  origination, servicing, and investment.

• Steps
• The institution that intends to issue MBS
  assembles a pool of relatively similar mortgages
  (e.g., in terms of maturity and coupon rate)
• A trustee is hired to verify the existence of the
  mortgages and to ensure that they are not sold
  after the MBS are issued
• The pool is insured by a third party
• The responsibility for servicing the mortgage is
  transferred to an independent servicer
• MBS are issued and sold to investors.

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Mortgages Securitization

• Servicing and responsibilities of the servicer
• Collecting payments from borrowers and
  transferring those funds to the mortgage pool
• Collecting taxes and insurance escrow payments
• Interacting with borrowers, answering questions
  and resolving problems
• Pursuing delinquent payments and forcing
  foreclosure in the case of default
• Servicing business has become highly automated
  it is characterized by economies-of-scale.

• The MBS
• The issuer starts with the expected cash flows of
  the pool and sets the rules that govern how these
  cash flows will be distributed among investors.
• The goal of the MBS issuer is to create a set of
  securities that have the highest possible value
  to investors.
• The issuers profit comes from selling the MBS
  for more money than was spent to assemble the
  pool, design the MBS, and market them to
  investors.
• MBS are owned by various investors.

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Mortgage-Backed SecuritiesThe Process of
Generating an MBS

• First Student National Bank

• FSNB Trust- 2003-1a

Cash 2000
MBS Securities 2000
Mortgages -2000
Mortgages -2000
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Mortgage-Backed SecuritiesTypes

• FNMA (FannieMae)
• Publicly chartered but privately owned it is a
  sponsored government agency
• Charged with providing liquidity to the mortgage
  market
• Since 1972, FNMA did this by buying FHA/VA
  guaranteed mortgages from mortgage lenders
• It sold securities to obtain funds to buy
  mortgages
• Mortgages held as investments
• 1980 authorized to purchase conventional
  non-FHA/VA mortgages
• 1981 began to issue MBSs
• Pass-throughs are guaranteed by FNMA for timely
  payment of interest and principal

• FHLMC (FreddieMac)
• Established in 1970 as a sponsored government
  agency
• Purchased and pooled mortgages and issued
  securities backed by the cash flow from the
  mortgages
• Mostly conventional mortgages
• These securities are called participation
  certificates
• Cash program and securities are called
  conventional regular PCs
• Conventional Guarantor/Swap ProgramGuarantees
• New securities Gold PC timely payment of
  interest and principal
• Previous to 1990 guaranteed only for timely
  payment of interest principal paid as received

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Mortgage-Backed SecuritiesTypes

• GNMA (GinnieMae)
• 1968 FNMA split into a new FNMA and GNMA
• GNMA is a government agency
• GNMA guaranteed securities issued by private
  mortgage lenders
• Underlying mortgages must satisfy underwriting
  GNMA standard

• Private label
• Issued by other than the three agencies
• Mortgages are nonconforming mortgages
• Rated
• Credit enhancements are used at times

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Impact of Securitization on Risk

• Traditional Risks
• Liquidity risk MBS are much more liquid than
  whole mortgages.
• This liquidity is not costless. Fees for trustees
  and servicing must be deducted from the mortgage
  pools cash inflows.
• Interest-rate risk of the underlying mortgages is
  not reduced.
• Possible to create securities with different
  levels of interest-rate risk from the underlying
  pool.
• Default risk Most securitized mortgages are
  essentially free from default risk.
• Geographic Concentration risk Widespread
  securitization virtually eliminates problems of
  geographic

• Newer Risks
• Systemic risk the risk that the market as a
  whole will experience a breakdown. It is possible
  because the market is dominated by a small group
  of participants.
• Servicer risk. If the servicer does a poor job
  interacting with borrowers, it may influence the
  borrowers repayment or prepayment decisions.
• Model risk. Automated models are used to make the
  initial lending decision and valuation models are
  used to price MBS. There is always the risk that
  the model is inaccurate.

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Managing MBS Interest-Rate Risk

• Because of prepayments, the duration of a
  mortgage portfolio changes as interest rates
  change.
• These changes in duration suggest that mortgages
  have very different risk characteristics in
  rising and falling rate environments.
• This instability makes interest-rate risk
  management difficult for mortgage portfolios and
  MBS.

A perfect hedge will always gain in value exactly
what the investment portfolio loses and vice
versa. Creating a perfect hedge is equivalent
of targeting duration of zero (i.e., the goal is
complete insensitivity to changes in interest
rates).
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Managing MBS Interest-Rate Risk

• An alternative goal might be to reduce the risk
  to an acceptable level, called target duration.
• That is, an investor wants to take on less
  interest-rate risk but not zero interest-rate
  risk.

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Managing MBS Interest-Rate Risk

• Hedging MBS with Treasury forwards
• Duration of a forward contract is equal to the
  duration of the underlying T-bond or T-note.
• Most MBS have a positive duration and the
  investor will need a short position in the
  forwards. Some MBS (e.g., IO strips) have
  negative effective durations. In this case, the
  investor needs a long position in the forwards.
• Because the correct hedge amount will change
  with interest rates, this is a dynamic hedge.
• In contrast, a static hedge does not need to be
  adjusted as interest rates change.

• Hedging MBS with options
• Forwards provide a two-sided hedge (gains and
  losses in the two sides cancel each other out).
• An alternative is one-sided hedging with options.
• The option premium is paid in advance. If the
  portfolio loses value, the option hedge position
  will gain in value to offset the loss.
• If the portfolio gains in value, the option hedge
  will not lose value. This makes options similar
  to insurance contracts.
• A common choice to hedge interest-rate risk are
  options on Treasury f

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Basis Risk

• Basis risk is a possibility of the price of the
  risky security (an MBS) and the value of the
  hedge changing in an unexpected way.
• When hedges are designed, the assumption
  generally made is that changes in the value of
  the hedge will exactly offset changes in the
  value of the risky security.
• There may be a time when a risky security loses
  value and the hedge position doesnt gain enough
  to make up for the loss.
• No hedge is perfect!