Tao Pang, PhD, FRM

Department of Mathematics
North Carolina State University

The Financial Risks Associated with
Mortgage-Backed Securities

Global Association for Risk Professionals (GARP)
Raleigh, NC Chapter Meeting
October 25, 2012
1. Introduction
MBS(Mortgage-Backed Securities) is a very important
class of financial instruments. It is directly related to
the recent financial crisis.
Ownership of a unit of an MBS entitles the owner to a
cash flow from the principal and/or interest of the
mortgage payment.

1






The Cash-Flow for MBS Bonds

2
Mortgage
Borrowers
Mortgage
Lender
MBS
Investors
Monthly
Payments
MBS
Payments
Mortgage
Money
An example of Pass-though MBS
Mortgage 1
$200k, i=6.5%
Maturity: 30 years
1000 MBS bonds

face value: $1000
coupon rate: 6.4%
(payable monthly)
Maturity: 30 years

Remark: The MBS
investors will
receive both
principal payments
and interest
payments
A pool of mortgages
Principal=$1 million
WAC=6.4%
Maturity: 30 years
Mortgage 2
$300k, i=7%
Maturity: 30 years

Mortgage 3
$500k, i=6%
Maturity: 30 years
WAC=Weights average coupon rate (all coupon rates weighted by principal
weights
3

MBS Agencies
There are three major housing finance agencies,
Ginnie Mae, Fannie Mae and Freddie Mac.
MBS products issued by those three agencies are
considered to have no credit risk (default risk) or
to have negligible credit risk.
However, there are also private-label MBS which
are issued by other agencies and they do bear
credit risk.

4

More MBS Products
The cash flows backed by a pool of mortgage payment
can be reallocated to create various MBS products
Collateralized Mortgage Obligations (CMO)
Different tranches with different average life
A tranche can not receive principal payment until the tranche
before it has been paid off
5
Cash Flow for a CMO:
An example with floating rates
6
Mortgage 1
Mortgage 2
Mortgage 3





Mortgage n

Principal:
$100 million
Special
Purpose
Vehicle
Senior Tranche
Principal: $75 million
Return = LIBOR + 70bp
Mezzanine Tranche
Principal:$20 million
Return = LIBOR+ 200bp
Equity Tranche
Principal: $5 million
Return =LIBOR+1,000bp
Cash Flow Allocation Order
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Senior Tranche Principal
Mezzanine Tranche Principal
Mortgage
Principal
Cash Flows
Equity Tranche Principal
Effects of Prepayment
Prepayment is allowed for Mortgage loans
Form of prepayment:
Sell the house
Refinance
Pay more than scheduled payment
Prepayment is a call option sold to mortgage borrower
Mortgage rate is higher with this option embedded.
Investors needs to consider the prepayment risk
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An Example with fixed rates:
Total Principal: $200k; Interest rate: 4.875%
Maturity: 30 years
Tranche A: $80k; Tranche B: $30k; Tranche C: $90k
No Prepayment
0.00
200.00
400.00
600.00
800.00
1000.00
1200.00
1 25 49 73 97 121 145 169 193 217 241 265 289 313 337
P
a
y
m
e
n
t
Month
CMO Payment Scheme (No Prepayment)
Tranche A Tranche B Tranche C Tranche A I nterest Tranche B I nterest Tranche C Int erest
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Total Principal: $200k; Interest rate: 4.875%
Maturity: 30 years
Tranche A: $80k; Tranche B: $30k; Tranche C: $90k
Prepayment Rate: 100%PSA
0.00
200.00
400.00
600.00
800.00
1000.00
1200.00
1400.00
1600.00
1800.00
2000.00
1 25 49 73 97 121 145 169 193 217 241 265 289 313 337
P
a
y
m
e
n
t
Month
CMO Payment Scheme (100%PSA Prepayment)
Tranche A Tranche B Tranche C Tranche A Interest Tranche B Interest Tranche C Interest
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Total Principal: $200k; Interest rate: 4.875%
Maturity: 30 years
Tranche A: $80k; Tranche B: $30k; Tranche C: $90k
Prepayment Rate: 300% PSA
0.00
500.00
1000.00
1500.00
2000.00
2500.00
3000.00
3500.00
1 25 49 73 97 121 145 169 193 217 241 265 289 313 337
P
a
y
m
e
n
t
Month
CMO Payment Scheme (300%PSA Prepayment)
Tranche A Tranche B Tranche C Tranche A I nterest Tranche B I nterest Tranche C Int erest
11
More MBS Products (continued)

Planed Amortization Class (PAC) and Companions
Prepayment risk is absorbed by companions with a certain
limit
Interest only (IO) and principal only (PO)
Floaters and inverse floaters
Products with floating interest rates can be created

12
Total Principal: $200k; Interest rate: 4.875%
Maturity: 30 years
PAC with Planed Prepayment Rates between 300% and 100% PSA
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PAC Payment
0.00
500.00
1000.00
1500.00
2000.00
2500.00
3000.00
1 15 29 43 57 71 85 99 113127141155169183197211225239253267281295309323337351
P
a
y
m
e
n
t

Month
PAC Payment Scheme (300%/100% PSA)
Slow Principal Payment Fast Principal Payment PAC Principal
2. Risks involved in MBS Products
2.1 Prepayment risks

Typically, mortgage borrowers have the right to prepay
a mortgage at any time during the life of the loan.
Note: Refinancing is also a type of prepayment.
Mortgage borrowers tend to prepay when interest rate
is low, which is not good for the investors.

14
Four factors to effect the prepayment rates:
Refinancing Incentive
Age of the mortgage (Seasoning)
The month of the year (Seasonality)
Premium Burnout (Principal balance).

15

Terminology of the prepayment model

WAC: weighted average coupon rate (for a
combination of loans)
CPR: conditional prepayment rate
PSA prepayment rate: industry convention
adopted by the Public Securities Association
(PSA) in which CPRs are assumed to follow a
standard path over time.





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Standard PSA Prepayment Rate
0.00%
1.50%
3.00%
4.50%
6.00%
7.50%
9.00%
1 31 61 91 121 151 181 211 241 271 301 331 361
P
r
e
p
a
y
m
e
n
t



r
a
t
e

Months
150% PSA
100% PSA
75% PSA
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Refinancing Incentive (RI(t))
Most Crucial Component of CPR model.
It is a function of the (refinancing) interest rate R
and the current mortgage coupon rate C.
18
Seasoning Multiplier (SM(t))
Seasoning or aging reflects the observation that
newer loans tend to prepay slower than older loans.
19
0
0.2
0.4
0.6
0.8
1
1.2
0 30 60 90 120
S
e
a
s
o
n
i
n
g


M
u
l
t
i
p
l
i
e
r

Months
Seasonality Multiplier (MM(t))
Seasonality takes into consideration the time of year.
It is believed that prepayments peak in the fall and
decrease in the winter.
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0
0.2
0.4
0.6
0.8
1
1.2
1.4
1 2 3 4 5 6 7 8 9 10 11 12
Monthly Multiplier
Months
Burnout Multiplier (BM(t))
Premium Burnout takes into account the
tendency for prepayment to diminish over time.
In our simulation, the Burn% is calculated as a
function of the pool factor.
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0
0.2
0.4
0.6
0.8
1
1.2
0 24 48 72 96 120 144 168 192 216 240 264 288 312 336 360
B
u
r
n
o
u
t

M
u
l
t
i
p
l
i
e
r

Months
0%
10%
20%
30%
40%
50%
0 36 72 108 144 180 216 252 288 324 360
Prepayment rate with a random interest rate path
(all four factors are considered)

Prepayment rate=RI(t) x SM(t) x MM(t) x BM(t)
P
r
e
p
a
y
m
e
n
t

r
a
t
e

Months
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2.2 Interest Rate Risks
In reality, the interest rate path is not fully predictable.
We use certain stochastic processes to model the
interest rates
Equilibrium Models
Vasicek Model:
Cox, Ingersoll, and Ross (CIR) model:

Courtadon Model:

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dr
t
= c(r
t
r )dt +odw
t

dr
t
= c(r
t
r )dt +o r
t
dw
t

dr
t
= c(r
t
r )dt +or
t
dw
t
More interest rate models
No Arbitrage Models
Ho-Lee Model
Hull-White Model:
Black-Karasinski (B-K) Model:

Other models
Heath-Jarrow-Morton (HJM) Model: Modeling forward
rate instead of short rates
LIBOR Market Model: Easy to implement using market
data
24

dr
t
=u(t)dt +odw
t

dr
t
= c(r
t
u(t))dt +odw
t

dlnr
t
= c(lnr
t
u(t))dt +odw
t
An interest rate path generated using Vasicek Model
0%
2%
4%
6%
8%
10%
12%
14%
0 24 48 72 96 120 144 168 192 216 240 264 288 312 336
Months
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2.3 Default Risks
Mortgage borrowers tends to default when
House value is less than the principal balance (if the
house price drop dramatically)
No sufficient income to pay monthly payments
(Mortgage rate increases, loss jobs, live expense
increases, etc.)
When mortgage borrowers default, all (pass-through)
MBS bond investors will face the same default risk:
partial of their bond principal can not be repaid.
To decrease default risks, mortgage lenders should use
higher standard when issuing new mortgage loans
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3. Price MBS bonds
3.1 Basic Idea
Present Value of a payment of X payable at a future
time T:
Present value = where is the interest rate.
For a bond with payments
1
,
2
, ,

which are
payable at
1
,
2
, ,

the current price is the total

present value of the cash flow:
=

1
+

2
++

Due to random interest rates and random prepayment,
the cash flow for MBS bond is not pre-deterministic.
Price is given by taking expectations:

27

e
rT
X

P = E
Q
e
r
k
t
k
c
k
k=1
n

(

(

r

3.2 Monte-Carlo Simulation
Law of large numbers: Let be i.i.d. r.v.s.
Then
Important tool in the pricing of complex financial
instruments.
Advantage: the convergence speed does not depend of
the dimension of .
Drawback: The convergence speed is very slow
( )
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X
1
, X
2
,L , X
N

lim
N
X
1
+ X
2
+L + X
N
N
= E[X
1
]

1
N

X

3.3 Steps to pricing a MBS product
The expectation can be evaluated by Monte Carlo
Simulation
Specify an interest rate model
Generate interest rate paths
Generate cash flows for each interest rate path using
the prepayment model
Calculate the total present values for cash flows for
each interest rate path
Take average for all possible present values to get the
price
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ABS CDOs or Mezz CDOs (Simplified)
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Assets Senior Tranche (80%)
AAA
Mezzanine Tranche (15%)
BBB
Equity Tranche (5%)
Not Rated
Senior Tranche (65%)
AAA
Mezzanine Tranche
(25%) BBB
Equity Tranche (10%)
The mezzanine tranche is
repackaged with other
mezzanine tranches
4. Subprime Mortgage Crisis:

Note: The slides of this section are mainly from the materials accompanied with John Hulls book, Options, Futures
and Other Derivatives , 8th Edition.
Losses to AAA Senior Tranche of ABS CDO
(Table 8.1, page 184)
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Losses on
Subprime
portfolios
Losses on
Mezzanine
Tranche of
ABS
Losses on
Equity
Tranche of
ABS CDO
Losses on
Mezzanine
Tranche of
ABS CDO
Losses on
Senior
Tranche of
ABS CDO
10% 33.3% 100% 93.3% 0%
13% 53.3% 100% 100% 28.2%
17% 80.0% 100% 100% 69.2%
20% 100% 100% 100% 100%
U.S. Real Estate Prices, 1987 to 2010: S&P/Case-Shiller
Composite-10 Index
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0.00
50.00
100.00
150.00
200.00
250.00
Jan 87 Jan 90 Jan 93 Jan 96 Jan 99 Jan 02 Jan 05 Jan 08
What happened
Starting in 2000, mortgage originators in the US relaxed their
lending standards and created large numbers of subprime
first mortgages.
This, combined with very low interest rates, increased the
demand for real estate and prices rose.
To continue to attract first time buyers and keep prices
increasing they relaxed lending standards further
Features of the market: 100% mortgages, ARMs, teaser
rates, liar loans, non-recourse borrowing
Mortgages were packaged in financial products and sold to
investors

33
What happened...
Banks found it profitable to invest in the AAA rated tranches
because the promised return was significantly higher than the
cost of funds and capital requirements were low
In 2007 the bubble burst. Some borrowers could not afford their
payments when the teaser rates ended. Others had negative
equity and recognized that it was optimal for them to exercise
their put options.
Foreclosures increased supply and caused U.S. real estate prices
to fall. Products, created from the mortgages, that were
previously thought to be safe began to be viewed as risky
Many banks incurred huge losses


34
What Many Market Participants Did Not
Realize
Default correlation goes up in stressed market
conditions
The BBB tranches used to create ABS CDOs were
typically about 1% wide and had all or nothing loss
distributions.
This is quite different from the loss distribution for a
BBB bond from a BBB bond

35
Regulatory Arbitrage
The regulatory capital banks were required to keep
for the tranches created from mortgages was less
than that for the mortgages themselves
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Incentives
The crisis highlighted the dysfunctional incentives
of
Mortgage originators (Their prime interest was in in
originating mortgages that could be securitized)
Valuers (They were under pressure to provide high
valuations so that the loan-to-value ratios looked
good)
Traders (They were focused on the next end-of
year bonus and not worried about any longer term
problems in the market)
37
The Aftermath

A huge amount of new regulation including:
Banks required to hold more capital
Banks required to satisfy liquidity ratios
More emphasis on stress testing and the use of
historical data from stressed market conditions
Clearing houses for OTC derivatives
Taxes on bonuses (UK)
Limits to proprietary trading


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Thanks!
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