Asset Backed Securities

Chapter 11
Securitization and
Mortgage-Backed Securities
Securitization
Securitization refers to a process in which the
assets of a corporation or financial institution are
pooled into a package of securities backed by the
assets.

The process starts when an originator, who owns
the assets (e.g., mortgages or accounts
receivable), sells them to an issuer.

The issuer then creates a security backed by the
assets called an asset-backed security or pass-
through that he sells to investors.
Securitization
The securitization process often involves a third-
party trustee who ensures that the issuer complies
with the terms underlying the asset-backed
security.

Many securitized assets are backed by credit
enhancements, such as a third-party guarantee
against the default on the underlying assets.

The most common types of asset-backed
securities are those secured by mortgages,
automobile loans, credit card receivables, and
home equity loans.
Securitization
By far the largest type and the one in which the
process of securitization has been most
extensively applied is mortgages.

Asset-backed securities formed with mortgages
are called mortgage-backed securities, MBSs, or
mortgage pass-throughs.
Mortgage-Backed Securities: Definition
Mortgage-Backed Securities (MBS) or
Mortgage Pass-Throughs (PT) are claims
on a portfolio of mortgages.

The securities entitle the holder to the cash
flows from a pool of mortgages.
Mortgage-Backed Securities: Creation
Typically, the issuer of a MBS buys a portfolio or
pool of mortgages of a certain type from a
mortgage originator, such as a commercial bank,
savings and loan, or mortgage banker.

The issuer finances the purchase of the mortgage
portfolio through the sale of the mortgage pass-
throughs, which have a claim on the portfolio's
cash flow.

The mortgage originator usually agrees to
continue to service the loans, passing the
payments on to the MBS holders.
Agency Pass-Throughs
There are three federal agencies that buy certain types of
mortgage loan portfolios (e.g., FHA- or VA-insured
mortgages) and then pool them to create MBSs to sell to
investors:
Federal National Mortgage Association (FNMA)
Government National Mortgage Association (GNMA)
Federal Home Loan Mortgage Corporation (FHLMC)

Collectively, the MBSs created by these agencies are
referred to as agency pass-throughs.

Agency pass-throughs are guaranteed by the agencies, and
the loans they purchase must be conforming loans,
meaning they meet certain standards.
Government National Mortgage Association, GNMA
GNMA mortgage-backed securities or pass-throughs are
formed with FHA- or VA-insured mortgages.

They are put together by an originator (bank, thrift, or
mortgage banker), who presents a block of FHA and VA
mortgages to GNMA.

If GNMA finds them in order, they will issue a guarantee
and assign a pool number that identifies the MBS that is
to be issued.

The originator will transfer the mortgages to a trustee, and
then issue the pass-throughs, often selling them to
investment bankers for distribution.
Government National Mortgage Association, GNMA
The mortgages underlying GNMAs MBSs are very
similar (e.g., single-family, 30-year maturity, and fixed
rate), with the mortgage rates usually differing by no more
than 50 basis point from the average mortgage rate.

GNMA does offer programs in which the underlying
mortgages are more diverse.

Note: Since GNMA is a federal agency, its guarantee of
timely interest and principal payments is backed by the
full faith and credit of the U.S. government -- the only
MBS with this type of guarantee.
Federal Home Loan Mortgage Corporation, FHLMC
The FHLMC (Freddie Mac) issues MBSs that they refer
to as participation certificates (PCs).

The FHLMC has a regular MBS (also called a cash PC),
which is backed by a pool of either conventional, FHA, or
VA mortgages that the FHLMC has 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 FMLMC pass-
through.
Federal Home Loan Mortgage Corporation
Unlike GNMAs MBSs, Freddie Mac's MBSs are
formed with more heterogeneous mortgages.

Like GNMA, the Federal Home Loan Mortgage
Corporation backs the interest and principal
payments of its securities, but the FHLMC's
guarantee is not backed by the U.S. government.
Federal National Mortgage Association, FNMA
FNMA (Fannie Mae) offers several types of pass-
throughs, referred to as FNMA mortgage-backed
securities.

Like FHLMCs pass-throughs, FNMAs
securities are backed by the agency, but not by
the government.

Like the FHLMC, FNMA buys conventional,
FHA, and VA mortgages, and offers a SWAP
program whereby mortgage loans can be swapped
for FNMA-issued MBSs.
Federal National Mortgage Association
Like the FHLMC, FNMA's mortgages are more
heterogeneous than GNMA's mortgages, with
mortgage rates in some pools differing by as
much as 200 basis points from the portfolio's
average mortgage rate.
Conventional Pass-Throughs
Conventional pass-throughs are sold by
commercial banks, savings and loans, other
thrifts, and mortgage bankers.

These nonagency pass-throughs, also called
private labels, are often formed with
nonconforming mortgages; that is, mortgages that
fail to meet size limits and other requirements
placed on agency pass-throughs.
The larger issuers of conventional MBSs
include:
Citicorp Housing
Countrywide
Prudential Home
Ryland/Saxon
G.E. Capital Mortgage
Conventional pass-throughs are often guaranteed
against default through external credit
enhancements, such as:
Guarantee of a corporation
Bank letter of credit
Private insurance from such insurers as the Financial
Guarantee Insurance Corporation (FGIC), the Capital
Markets Assurance Corporation (CAPMAC), or the
Financial Security Assurance Company (FSA)
Some conventional pass-throughs are 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.

Example: A conventional pass-through, known as an A/B
pass-through, consists of two types of claims on the
underlying pool of mortgages - senior and subordinate.
The senior claim is backed by the mortgages, while the
subordinate claim is not.
The more subordinate claims sold relative to senior,
the more secured the senior claims.
Conventional MBSs are rated by Moody's
and Standard and Poor's.

They must be registered with the SEC
when they are issued.

Most financial entities that issue private-labeled 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 I nvestment Conduits, REMI C.

Private-labeled MBS issuers who comply with these
provisions are sometimes referred to as REMI Cs.
Market
Primary Market: Investors buy MBSs issued by
agencies or private-label investment companies
either directly or through dealers. Many of the
investors are institutional investors. Thus, the
creation of MBS has provided a tool for having
real estate financed more by institutions.

Secondary Market:
Existing MBS are traded by dealers on the
OTC
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 rates
paid on the MBS (pass-through (PT) rate).
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 WAC -- the
difference going to MBS issuer.

Prepayment Rate or Speed: Assumed
prepayment rate.
Prepayment
A number of prepayment models have been
developed to try to predict the cash flows from a
portfolio of mortgages.

Most of these models estimate the prepayment
rate, referred to as the prepayment speed or
simply speed, in terms of four factors:
Refinancing incentive
Seasoning (the age of the mortgage)
Monthly factors
Prepayment burnout
Prepayment
Refinancing I ncentive
The refinancing incentive is the most important
factor influencing prepayment.

If mortgage rates decrease below the mortgage
loan rate, borrowers have a strong incentive to
refinance.

This incentive increases during periods of falling
interest rates, with the greatest increases
occurring when borrowers determine that rates
have bottomed out.
Prepayment
Refinancing I ncentive
The refinancing incentive can be measured by the
difference between the mortgage portfolio's WAC
and the refinancing rate, R
ref
.

A study by Goldman, Sachs, and Company found
that the annualized prepayment speed, referred to
as the conditional prepayment rate, CPR, is
greater the larger the positive difference between
the WAC and R
ref
.
Prepayment
Seasoning
A second factor determining prepayment is the
age of the mortgage, referred to as seasoning.

Prepayment tends to be greater during the early
part of the loan, then stabilize after about three
years. The figures on the next slide depicts a
commonly referenced seasoning pattern known as
the PSA model (Public Securities Association).
Prepayment
PSA Model:
CPR(%)
Month
30 360 0
02 .
60 .
-
90 .
30 .
-
-
100 PSA
50 PSA
150 PSA
1
Prepayment
Seasoning
In the standard PSA model, known as 100 PSA,
the CPR starts at .2% for the first month and then
increases at a constant rate of .2% per month to
equal 6% at the 30th month; then after the 30th
month the CPR stays at a constant 6%. Thus for
any month t, the CPR is

30 t f i , 06 . CPR
, 30 t if ,
30
t
06 . CPR
> =
s
|
.
|
\
|
=
Prepayment
Seasoning
Note that the CPR is quoted on an annual
basis.
The monthly prepayment rate, referred to
as the single monthly mortality rate, SMM,
can be obtained given the annual CPR by
using the following formula:
12 / 1
] CPR 1 [ 1 SMM =
Prepayment
Seasoning
The 100 PSA model is often used as a benchmark. The
actual aging pattern will differ depending on where
current mortgage rates are relative to the WAC.

Analysts often refer to the applicable pattern as being a
certain percentage of the PSA.

For example:
If the pattern is described as being 200 PSA, then the
prepayment speeds are twice the 100 PSA rates.
If the pattern is described as 50 PSA, then the CPRs
are half of the 100 PSA rates (see figures on previous
slide).
Prepayment
Seasoning
A current mortgage pool described by a 100 PSA
would have a annual prepayment rate of 2% after
10 months (or a monthly prepayment rate of
SMM = .00168), and a premium pool described
as a 150 PSA would have a 3% CPR (or SMM =
.002535) after 10 months.
Prepayment
Monthly Factors
In addition to the effect of seasoning, mortgage
prepayment rates are also influenced by the
month of the year, with prepayment tending to be
higher during the summer months.

Monthly factors can be taken into account by
multiplying the CPR by the estimated monthly
multiplier to obtain a monthly-adjusted CPR.
PSA provides estimates of the monthly
multipliers.
Prepayment
Burnout Factors
Many prepayment models also try to capture what
is known as the burnout factor.

The burnout factor refers to the tendency for
premium mortgages to hit some maximum CPR
and then level off.

For example, in response to a 2% decrease in
refinancing rates, a pool of premium mortgages
might peak at a 40% prepayment rate after one
year, then level off at approximately 25%.
Cash Flow from a Mortgage Portfolio
The cash flow from a portfolio of
mortgages consists
Interest payments
Scheduled principal
Prepaid principal
Cash Flow from a Mortgage Portfolio: Example 1
Example 1: Consider a bank that has a pool
of current fixed rate mortgages that are
worth $100 million (Par, F)
yield a WAC of 8%, and
have a WAM of 360 months.
For the first month, the portfolio would
generate an aggregate mortgage payment of
$733,765:
(
+
=
(
+
=
+
=

=
12 / R
)) 12 / R ( 1 /( 1 1
F
p
12 / R
)) 12 / R ( 1 /( 1 1
p F
)) 12 / R ( 1 (
p
F
A
M A
0
A
M A
0
M
1 t
t A
0
765 , 733 $
12 / 08 .
)) 12 / 08 (. 1 /( 1 1
000 , 000 , 100 $
p
360
=
(
+
=
From the $733,765 payment, $666,667 would go
towards interest and $67,098 would go towards
the scheduled principal payment:
098 , 67 $ 667 , 666 $ 765 , 733 $ Interest p Payment incipal Pr Scheduled
667 , 666 $ 000 , 000 , 100 $
12
08 .
F
12
R
Interest
0
A
= = =
=
|
.
|
\
|
=
|
|
.
|
\
|
=
The projected first month prepaid principal can
be estimated with a prepayment model. Using the
100% PSA model, the monthly prepayment rate
for the first month (t = 1) is equal to SMM =
.0001668:
0001668 . ] 002 . 1 [ 1 SMM
002 . 06 .
30
1
CPR
12 / 1
= =
=
|
.
|
\
|
=
Given the prepayment rate, the projected prepaid
principal in the first month is found by
multiplying the balance at the beginning of the
month minus the scheduled principal by the
SMM.
Doing this yields a projected prepaid principal of
$16,671 in the first month:
671 , 16 $ ] 098 , 67 $ 000 , 000 , 100 [$ 0001668 . principal prepaid
] principal Scheduled F [ SMM principal prepaid
0
= =
=
Thus, for the first month, the mortgage portfolio
would generate an estimated cash flow of
$750,435, and a balance at the beginning of the
next month of $99,916,231:
231 , 916 , 99 $ 671 , 16 $ 098 , 67 $ 000 , 000 , 100 $ 2 Month for Balance Beginning
principal prepaid principal Scheduled F 2 Month for Balance Beginning
435 , 750 $ 671 , 16 $ 098 , 67 $ 666 , 666 $ CF
principal prepaid principal Scheduled Interest CF
0
= =
=
= + + =
+ + =
In the second month (t = 2), the projected
payment would be $733,642 with $666,108
going to interest and $67,534 to scheduled
principal:
534 , 67 $ 108 , 666 $ 642 , 733 $ principal Scheduled
108 , 666 $ ) 231 , 916 , 99 ($
12
08 .
Interest
642 , 733 $
12 / 08 .
)) 12 / 08 (. 1 /( 1 1
231 , 916 , 99 $
p
359
= =
=
|
.
|
\
|
=
=
(
+
=
Using the 100% PSA model, the estimated
monthly prepayment rate is .000333946, yielding
a projected prepaid principal in month 2 of
$33,344:
344 , 33 ] 534 , 67 $ 231 , 916 , 99 [$ 000333946 . principal prepaid
000333946 . ] 004 . 1 [ 1 SMM
004 . 06 .
30
2
CPR
12 / 1
= =
= =
=
|
.
|
\
|
=
Thus, for the second month, the mortgage
portfolio would generate an estimated cash flow
of $766,986 and have a balance at the beginning
of month three of $99,815,353:
353 , 815 , 99 $
344 , 33 $ 534 , 67 $ 231 , 916 , 99 $ 3 Month for Balance Beginning
986 , 766 $ 344 , 33 $ 534 , 67 $ 108 , 666 $ CF
=
=
= + + =
The exhibit on the next slide summarizes the
mortgage portfolio's cash flow for the first two
months and other selected months.

In examining the exhibit, two points should be
noted:
1. Starting in month 30 the SMM remains constant at
.005143; this reflects the 100% PSA model's
assumption of a constant CPR of 6% starting in
month 30.
2. The projected cash flows are based on a static
analysis in which rates are assumed fixed over the
time period.
Period Balance Interest p Sch. Prin. SMM Prepaid Prin. CF
100000000
1 100000000 666667 733765 67098 0.0001668 16671 750435
2 99916231 666108 733642 67534 0.0003339 33344 766986
3 99815353 665436 733397 67961 0.0005014 50011 783409
4 99697380 664649 733029 68380 0.0006691 66664 799694
5 99562336 663749 732539 68790 0.0008372 83294 815833
6 99410252 662735 731926 69191 0.0010055 99892 831817
7 99241170 661608 731190 69582 0.0011742 116449 847639
23 94291147 628608 703012 74405 0.0039166 369010 1072023
24 93847732 625652 700259 74607 0.0040908 383607 1083866
25 93389518 622597 697394 74798 0.0042653 398017 1095411
26 92916704 619445 694420 74975 0.0044402 412234 1106653
27 92429495 616197 691336 75140 0.0046154 426250 1117586
28 91928105 612854 688146 75292 0.0047909 440059 1128204
29 91412755 609418 684849 75430 0.0049668 453653 1138502
30 90883671 605891 681447 75556 0.005143 467027 1148475
31 90341088 602274 677943 75669 0.005143 464236 1142179
32 89801183 598675 674456 75781 0.005143 461459 1135915
110 54900442 366003 451112 85109 0.005143 281916 733028
111 54533417 363556 448792 85236 0.005143 280028 728820
112 54168153 361121 446484 85363 0.005143 278148 724632
113 53804641 358698 444188 85490 0.005143 276278 720466
114 53442873 356286 441903 85617 0.005143 274417 716320
115 53082839 353886 439631 85745 0.005143 272565 712195
357 496620 3311 126231 122920 0.005143 1922 128153
358 371778 2479 125582 123103 0.005143 1279 126861
359 247395 1649 124936 123287 0.005143 638 125574
360 123470 823 124293 123470 0.005143 0 124293
] incipal Pr Scheduled Balance Beginning [ SMM incipal Pr epaid Pr
Balance ) 08 (. p incipal Pr Scheduled
) Balance )( 12 / 08 (. Interest
) 12 / 08 (.
))] 12 / 08 (. 1 /( 1 [ 1
Balance
p Payment Monthly
Periods maining Re
=
=
=
(
+
= =
Cash Flow from a MBS: Example 2
Example 2
The next exhibit shows the monthly cash
flows for a MBS issue constructed from a
$100M mortgage pool with the following
features
Current balance = $100M
WAC = 8%
WAM = 355 months
PT rate = 7.5%
Prepayment speed equal to 150% of the
standard PSA model: PSA = 150
Period Balance Interest p Scheduled SMM Prepaid Principal CF
100000000 Principal Principal
1 100000000 625000 736268 69601 0.0015125 151147 220748 845748
2 99779252 623620 735154 69959 0.0017671 176194 246153 869773
3 99533099 622082 733855 70301 0.0020223 201148 271449 893531
4 99261650 620385 732371 70627 0.0022783 225990 296617 917002
5 98965033 618531 730702 70936 0.002535 250701 321637 940168
6 98643396 616521 728850 71227 0.0027925 275262 346489 963011
20 91641550 572760 684341 73398 0.0064757 592971 666369 1239128
21 90975181 568595 679910 73408 0.0067447 613101 686510 1255105
22 90288672 564304 675324 73399 0.0070144 632804 706204 1270508
23 89582468 559890 670587 73370 0.0072849 652066 725436 1285327
24 88857032 555356 665702 73321 0.0075563 670873 744194 1299550
25 88112838 550705 660671 73253 0.0078284 689211 762463 1313169
26 87350375 545940 655499 73164 0.0078284 683243 756406 1302346
27 86593968 541212 650368 73075 0.0078284 677322 750397 1291609
28 85843572 536522 645277 72986 0.0078284 671448 744434 1280957
29 85099137 531870 640225 72897 0.0078284 665621 738519 1270388
30 84360619 527254 635213 72809 0.0078284 659840 732649 1259903
31 83627969 522675 630240 72721 0.0078284 654106 726826 1249501
32 82901143 518132 625307 72632 0.0078284 648416 721049 1239181
33 82180094 513626 620411 72544 0.0078284 642772 715317 1228942
100 44933791 280836 366433 66874 0.0078284 351237 418111 698947
101 44515680 278223 363564 66793 0.0078284 347965 414758 692981
102 44100923 275631 360718 66712 0.0078284 344718 411430 687061
103 43689493 273059 357894 66631 0.0078284 341498 408129 681188
200 16163713 101023 166983 59225 0.0078284 126073 185298 286321
201 15978416 99865 165676 59153 0.0078284 124623 183776 283641
353 148527 928 50171 49181 0.0078284 778 49958 50887
354 98569 616 49778 49121 0.0078284 387 49508 50124
355 49061 307 49388 49061 0.0078284 0 49061 49368
] incipal Pr Scheduled Balance Beginning [ SMM incipal Pr epaid Pr
Balance ) 08 (. p incipal Pr Scheduled
) Balance )( 12 / 075 (. Interest
) 12 / 08 (.
))] 12 / 08 (. 1 /( 1 [ 1
Balance
p Payment Monthly
Periods maining Re
=
=
=
(
(
+
= =
Notes:
The first month's CPR for the MBS issue reflects a five-
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, while 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.
First Months Payment:
268 , 736 $
12 / 08 .
)) 12 / 08 (. 1 /( 1 1
M 100 $
p
355
=
(
+
=
WAC
From the $736,268 payment, $625,000 would go
towards interest and $69,601 would go towards
the scheduled principal payment:
601 , 69 $
)] 000 , 000 , 100 )($ 12 / 08 [(. 268 , 736 $ Interest p Payment incipal Pr Scheduled
000 , 625 $ 000 , 000 , 100 $
12
075 .
F
12
R
Interest
0
A
=
= =
=
|
.
|
\
|
=
|
|
.
|
\
|
=
Rate PT WAC
Using 150% PSA model and seasoning of 5
months the first month SMM = .0015125:
0015125 . ] 018 . 1 [ 1 SMM
018 . 06 .
30
6
50 . 1 CPR
12 / 1
= =
=
|
.
|
\
|
=
Given the prepayment rate, the projected prepaid
principal in the first month is $151,147
0
= =
=
s difference rounding slight for Allow
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:
252 , 779 , 99 $ 147 , 151 $ 601 , 69 $ 000 , 000 , 100 $ 2 Month for Balance Beginning
principal prepaid principal Scheduled F 2 Month for Balance Beginning
748 , 845 $ 147 , 151 $ 601 , 69 $ 000 , 625 $ CF
0
= =
=
= + + =
+ + =
Second Month: Payment, Interest, Scheduled Principal,
Prepaid Principal, and Cash flow:
773 , 869 $ 194 , 176 $ 959 , 69 $ 620 , 623 $ CF
= + + =
+ + =
154 , 735 $
12 / 08 .
)) 12 / 08 (. 1 /( 1 1
252 , 779 , 99 $
p
354
=
(
+
=
959 , 69 $ )] 252 , 779 , 99 )($ 12 / 08 [(. 154 , 735 $ Interest p Payment incipal Pr Scheduled
620 , 623 $ 252 , 779 , 99 $
12
075 .
F
12
R
Interest
0
A
= = =
=
|
.
|
\
|
=
|
|
.
|
\
|
=
0017671 . ] 021 . 1 [ 1 SMM
021 . 06 .
30
7
50 . 1 CPR
12 / 1
= =
= |
.
|
\
|
=
0
= =
=
Market
As noted, investors can acquire newly issued
mortgage-backed securities from the agencies,
originators, or dealers specializing in specific
pass-throughs.

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-throughs.
Market
Mortgage pass-throughs 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.
Price Quotes
The prices of MBSs are quoted as a percentage
of the underlying MBS issues balance.
The mortgage balance at time t, F
t
, is usually
calculated by the servicing institution and is
quoted as a proportion of the original balance,
F
0
.
This proportion is referred to as the pool factor,
pf:
0
t
t
F
F
pf =
Price Quotes
Example: A MBS backed by a mortgage pool
originally worth $100M, a current pf of .92, and
quoted at 95 - 16 (Note: 16 is 16/32) would have a
market value of $87.86M:

M 92 $ ) M 100 ($ ) 92 (.
F ) pf ( F
0 t t
= =
=
M 86 . 87 $ ) M 92 ($ ) 9550 (. Value Market = =
Price Quotes
The market value is the clean price; it does not take
into account accrued interest, ai.

For MBS, accrued interest is based on the time
period from the settlement date (two days after the
trade) and the first day of the next month.

Example: If the time period is 20 days, the month is
30 days, and the WAC = 9%, then ai is $.46M:
M 46 . 0 $ M 92 $
12
09 .
30
20
ai =
|
.
|
\
|
|
.
|
\
|
=
Price Quotes
The full market value would be $88.32M:

M 32 . 88 $
M 46 . 0 $ M 86 . 87 $ Value Mkt Full
=
+ =
Price Quotes
The market price per share is the full market value
divided by the number of shares.

If the number of shares is 400, then the price of
the MBS based on a 95 - 16 quote would be
$220,800:
800 , 220 $
400
M 32 . 88 $
share per price MBS
=
=
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.

) R , CF ( f V
) R 1 (
CF
V
t MBS
M
1 t
t
t
MBS
=
+
=

=
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.

Thus, interest rates affects the MBSs CFs.
) R , CF ( f V
MBS
=
) R ( f CF =
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.
Extension Risk
If interest rates decrease, then the prices of
MBSs, like the prices of most bonds, 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.
Extension Risk
Rate Decrease
| +
M
V rate discount lower R if
bonds most like
+ | | + or V CFs Earlier prepayment Increases R if
M
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.
Extension Risk
Rate Increase
+ |
M
V rate discount greater R if
+ | + | or V CFs Earlier prepayment Decreases R if
M
bonds most like
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:
=
|
|
.
|
\
|
=
T
1 t
principal total
t at received principal
t
12
1
Life Average
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
years 18 . 9
000 , 000 , 100 $
061 , 49 ($ 355 ) 153 , 246 ($ 2 ) 748 , 220 ($ 1
12
1
Life Average
=
|
.
|
\
| + + +
=
Average Life
The average life of a MBS depends on
prepayment speed:
If the PSA speed of the $100M 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.
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:

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.
PSA
Life Average
risk prepayment
A
A
=
risk prepayment Zero 0
PSA
life Av
=
A
A
MBS Derivatives
One of the more creative developments in the
security market industry over the last two 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
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.
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
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.
Example: A sequential-pay CMO is shown in the
next exhibit.

This CMO consist of three tranches, A, B, and C,
formed from the collateral making up the $100M
MBS in the previous example: F = $100M, WAM
= 355, WAC = 8%, PT Rate = 7.5%, PSA = 150.
Tranche A = $50M
Tranche B = $30M
Tranche C = $20M
In terms of the priority disbursement rules:
Tranche A receives all principal payment from the collateral
until its principal of $50M 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 $30M is retired.

Finally, tranche C receives the remaining principal that is
equal to its par value of $20M.

Note: while 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.
Par = $100M Rate = 7.5% A: Par = $50M Rate = 7.5% B: Par =$30M Rate = 7.5% C: Par = $20M Rate = 7.5%
Period Collateral Collateral Collateral Tranch A A A Tranche B B B Tranche C C C
Month Balance Interest Principal Balance Interest Principal Balance Principal Interest Balance Principal Interest
100000000 50000000 30000000 20000000 0
1 100000000 625000 220748 50000000 312500 220748 30000000 0 187500 20000000 0 125000
2 99779252 623620 246153 49779252 311120 246153 30000000 0 187500 20000000 0 125000
3 99533099 622082 271449 49533099 309582 271449 30000000 0 187500 20000000 0 125000
4 99261650 620385 296617 49261650 307885 296617 30000000 0 187500 20000000 0 125000
5 98965033 618531 321637 48965033 306031 321637 30000000 0 187500 20000000 0 125000
85 51626473 322665 471724 1626473 10165 471724 30000000 0 187500 20000000 0 125000
86 51154749 319717 467949 1154749 7217 467949 30000000 0 187500 20000000 0 125000
87 50686799 316792 464204 686799 4292 464204 30000000 0 187500 20000000 0 125000
88 50222595 313891 460488 222595 1391 222595 30000000 237893 187500 20000000 0 125000
89 49762107 311013 456802 0 0 0 29762107 456802 186013 20000000 0 125000
90 49305305 308158 453144 0 0 0 29305305 453144 183158 20000000 0 125000
91 48852161 305326 449515 0 0 0 28852161 449515 180326 20000000 0 125000
92 48402646 302517 445915 0 0 0 28402646 445915 177517 20000000 0 125000
178 20650839 129068 222016 0 0 0 650839 222016 4068 20000000 0 125000
181 19990210 124939 216625 0 0 0 0 0 0 19990210 216625 124939
182 19773585 123585 214856 0 0 0 0 0 0 19773585 214856 123585
183 19558729 122242 213101 0 0 0 0 0 0 19558729 213101 122242
184 19345627 120910 211360 0 0 0 0 0 0 19345627 211360 120910
353 148527 928 49958 0 0 0 0 0 0 148527 49958 928
354 98569 616 49508 0 0 0 0 0 0 98569 49508 616
355 49061 307 49061 0 0 0 0 0 0 49061 49061 307
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:
[(.075/12)($50M) = $312,500]

In month 2, tranche A receives an interest
payment of $311,120 based on the balance of
$49.779252M and a principal payment of
$246,153.
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.
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.
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
Tranche Maturity Window Average Life
A 88 Months 87 Months 3.69 years
B 179 Months 92 Months 10.71 years
C 355 Months 176 Months 20.59 years
Collateral 355 Months 355 Months 9.18 years
Note: A CMO tranche with a lower average life is still
susceptible to prepayment risk.
The average lives for the collateral and the three tranches
are shown below for different PSA models
Note that the average life of each of the tranches still varies
as prepayment speed changes.

PSA Collateral Tranche A Tranche B Tranche C
50 14.95 7.53 19.4 26.81
100 11.51 4.92 14.18 23.99
150 9.18 3.69 10.71 9.18
200 7.55 3.01 8.51 17.46
300 5.5 2.26 6.03 12.82
Note: Issuers of CMOs are able to offer a
number of CMO tranches with different
maturities and windows by simply creating
more tranches.
Different Types of Sequential-Pay Tranches
Sequential-pay CMOs often include traches
with special features. These include:
Accrual Bond Trache
Floating-Rate Tranche
Notional Interest-Only Tranche

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.
Accrual Tranche
Example: suppose in our preceding equential-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 $20M and
accrued interest is to be paid after tranche B's
principal has been retired

The next exhibit shows the principal and interest
payments from the collateral and Tranches A, B,
and Z.
Accrual Tranche
Par = $100M Rate = 7.5% A: Par = $50M Rate = 7.5% B: Par = $30M Rate = 7.5% Z: Par = $20M Rate = 7.5%
Period Collateral Collateral Collateral A A A B B B Z Z Z
Month Balance Interest Principal Balance Interest Principal Balance Principal Interest Bal.+Cum Int Principal Interest
100000000 50000000 30000000 20000000 0
1 100000000 625000 220748 50000000 312500 345748 30000000 0 187500 20000000 0 0
2 99779252 623620 246153 49654252 310339 371153 30000000 0 187500 20125000 0 0
3 99533099 622082 271449 49283099 308019 396449 30000000 0 187500 20250000 0 0
4 99261650 620385 296617 48886650 305542 421617 30000000 0 187500 20375000 0 0
5 98965033 618531 321637 48465033 302906 446637 30000000 0 187500 20500000 0 0
68 60253239 376583 540668 1878239 11739 665668 30000000 0 187500 28375000 0 0
69 59712571 373204 536352 1212571 7579 661352 30000000 0 187500 28500000 0 0
70 59176219 369851 532069 551219 3445 551219 30000000 105850 187500 28625000 0 0
71 58644150 366526 527821 0 0 0 29894150 652821 186838 28750000 0 0
72 58116329 363227 523605 0 0 0 29241329 648605 182758 28875000 0 0
122 36470935 227943 350111 0 0 0 1345935 475111 8412 35125000 0 0
123 36120824 225755 347292 0 0 0 870824 472292 5443 35250000 0 0
125 35429038 221431 341719 0 0 0 0 0 0 35429038 341719 221431
126 35087319 219296 338966 0 0 0 0 0 0 35087319 338966 219296
354 98569 616 49508 0 0 0 0 0 0 98569 49508 616
355 49061 307 49061 0 0 0 0 0 0 49061 49061 307
Accrual Tranche
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, trache A's window is reduced
from 87 months to 69 months and its average life from
3.69 years to 3.06 years.
Accrual Tranche
Tranche Window Average Life
A 69 Months 3.06 Years
B 54 Months 8.23 Years
In order to attract investors who prefer variable
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.
Example: Sequential-pay CMO with a
floating and inverse floating tranches
Tranche Par Value PT Rate
A
FR
IFR
Z
$50M
$22.5M
$7.5M
$20M
7.5%
LIBOR +50BP
28.3 3 LIBOR
7.5%
Total $100 7.5%
Note: The CMO is identical to our preceding CMO, except that
tranche B has been replaced with a floating-rate tranche, FR, and an
inverse floating-rate tranche, IFR.
The rate on the FR tranche, R
FR
, is set to the
LIBOR plus 50 basis points, with the maximum
rate permitted being 9.5%.

The rate on the IFR tranche, R
IFR
, 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%.
R
IFR
= 28.5 - 3 LIBOR
For 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%:
% 5 . 7 R 25 . R 75 . WAC
% 5 . 4 LIBOR 3 5 . 28 R
% 5 . 8 BP 50 LIBOR R
% 8 LIBOR
IFR FR
IFR
FR
= + =
= =
= + =
=
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, though, are structured with tranches that
have different rates. When CMOs are formed this way,
an additional tranche, known as a notional interest-only
(I O) class, is often created.

This 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.
Example: A sequential-pay CMO with a Z bond
and notional IO tranche is shown in the next
exhibit.

This CMO is identical to our previous CMO with
a Z bond, except that each of the tranches has a
coupon rate lower than the collateral rate of 7.5%
and there is a notional IO 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:
500 , 87 $ 000 , 25 $ 500 , 62 $ Interest
000 , 000 , 30 $
12
065 . 075 .
000 , 000 , 50 $
12
06 . 075 .
Interest
= + =
|
.
|
\
|

+
|
.
|
\
|

=
Collateral: Par = $100M Rate = 7.5% Tranche A: Par = $50M Rate = 6% Tranche B: Par = $30M Rate = 6.5% Tranche Z: Par = $20M Rate = 7% Notional Par = $15.333M
Period Collateral Collateral Collateral A A A Notional B B B Notional Z Z Z Notional Notional
Month Balance Interest Principal Balance Interest Principal Interest Balance Principal Interest Interest Balance Principal Interest Interest Total CF
100000000 50000000 0.06 0.015 30000000 0.065 0.01 20000000 0 0.07 0.005
1 100000000 625000 220748 50000000 250000 345748 62500 30000000 0 162500 25000 20000000 0 0 0 87500
2 99779252 623620 246153 49654252 248271 371153 62068 30000000 0 162500 25000 20125000 0 0 0 87068
3 99533099 622082 271449 49283099 246415 396449 61604 30000000 0 162500 25000 20250000 0 0 0 86604
4 99261650 620385 296617 48886650 244433 421617 61108 30000000 0 162500 25000 20375000 0 0 0 86108
5 98965033 618531 321637 48465033 242325 446637 60581 30000000 0 162500 25000 20500000 0 0 0 85581
70 59176219 369851 532069 551219 2756 551219 689 30000000 105850 162500 25000 28625000 0 0 0 25689
71 58644150 366526 527821 0 0 0 0 29894150 652821 161927 24912 28750000 0 0 0 24912
72 58116329 363227 523605 0 0 0 0 29241329 648605 158391 24368 28875000 0 0 0 24368
122 36470935 227943 350111 0 0 0 0 1345935 475111 7290 1122 35125000 0 0 0 1122
123 36120824 225755 347292 0 0 0 0 870824 472292 4717 726 35250000 0 0 0 726
124 35773533 223585 344494 0 0 0 0 398533 398533 2159 332 35375000 -54038 206354 14740 15072
125 35429038 221431 341719 0 0 0 0 0 0 0 0 35429038 341719 206669 14762 14762
126 35087319 219296 338966 0 0 0 0 0 0 0 0 35087319 338966 204676 14620 14620
127 34748353 217177 336235 0 0 0 0 0 0 0 0 34748353 336235 202699 14478 14478
353 148527 928 49958 0 0 0 0 0 0 0 0 148527 49958 866 62 62
354 98569 616 49508 0 0 0 0 0 0 0 0 98569 49508 575 41 41
355 49061 307 49061 0 0 0 0 0 0 0 0 49061 49061 286 20 20
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%.
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:
333 , 333 , 15 $ incipal Pr Notional Total
333 , 333 , 1 $
075 .
) 07 . 075 )(. 000 , 000 , 20 ($
principal Notional s ' Z
000 , 000 , 4 $
075 .
) 065 . 075 )(. 000 , 000 , 30 $
principal Notional s ' B
000 , 000 , 10 $
075 .
) 06 . 075 )(. 000 , 000 , 50 ($
principal Notional s ' A
=
=
=
=
=
=
=
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)
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.
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.
To illustrate, suppose we form PAC and support
bonds from the $100M collateral that we used to
construct our sequential-pay tranches:
Underlying MBS = $100M, WAC = 8%, WAM = 355
months, and PT rate = 7.5%

To generate the minimum monthly principal
payments for the PAC, assume:
Minimum speed of 100% PSA; lower collar = 100
PSA
Maximum speed of 300% PSA; upper collar = 300
PSA
The next exhibit 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.
Period Pac Pac Pac Pac Pac Collateral Collateral Collateral Collateral Support Support Support Support
Month Low PSA Pr high PSA Pr Min. Principal Int CF Balance Interest Prncipal CF Principal Balance Interest CF
100 300 0.075 100000000 Col Pr - PAC Pr 0.075
1 170085 374456 170085 398606 568692 100000000 625000 220748 845748 50662 36222970 226394 277056
2 187135 425190 187135 397543 584678 99779252 623620 246153 869773 59018 36172308 226077 285095
3 204125 475588 204125 396374 600499 99533099 622082 271449 893531 67324 36113290 225708 293032
4 221048 525572 221048 395098 616147 99261650 620385 296617 917002 75568 36045966 225287 300856
5 237895 575064 237895 393716 631612 98965033 618531 321637 940168 83742 35970398 224815 308557
98 381871 386139 381871 135237 517108 45780181 286126 424898 711025 43028 24142190 150889 193916
99 380032 379499 379499 132851 512349 45355283 283471 421491 704962 41993 24099163 150620 192613
100 378204 372970 372970 130479 503449 44933791 280836 418111 698947 45141 24057170 150357 195498
101 376384 366552 366552 128148 494700 44515680 278223 414758 692981 48205 24012029 150075 198281
102 374575 360242 360242 125857 486099 44100923 275631 411430 687061 51188 23963824 149774 200962
201 235460 61932 61932 19312 81245 15978416 99865 183776 283641 121844 12888435 80553 202396
202 234395 60806 60806 18925 79731 15794640 98716 182266 280982 121460 12766592 79791 201251
203 233336 59699 59699 18545 78244 15612374 97577 180768 278345 121069 12645131 79032 200101
204 232283 58611 58611 18172 76783 15431606 96448 179282 275729 120671 12524062 78275 198946
205 231235 57542 57542 17806 75348 15252325 95327 177807 273134 120265 12403392 77521 197786
206 230193 56492 56492 17446 73938 15074517 94216 176344 270560 119852 12283127 76770 196622
354 124660 2559 2559 32 2591 98569 616 49508 50124 46948 93517 584 47533
355 124203 2493 2493 16 2509 49061 307 49061 49368 46568 46568 291 46859
Par = 63777030 Par = 36222970
Note: For the first 98 months, the minimum
principal payment comes from the 100%
PSA model, and from month 99 on the
minimum principal payment comes from
the 300% PSA model.
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.
The sum of the PAC's principal payments is
$63.777M. Thus, the PAC can be described as
having:
Par value of $63.777M
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 $36.223M ($100M - $63.777M) and pay a
coupon of 7.5%.
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.
Average Life
PSA Collateral PAC Support
50 14.95 7.90 21.50
100 11.51 6.98 19.49
150 9.18 6.98 13.05
200 7.55 6.98 8.55
250 6.37 6.98 5.31
300 5.50 6.98 2.91
350 4.84 6.34 2.71
Note:
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.
Other PAC-Structured CMOs
The PAC and support bond underlying a CMO
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.
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.
Stripped MBS
Stripped MBSs consist of two classes:

1. Principal-only (PO) class that receives only
the principal from the underlying mortgages.

2. I nterest-only (IO) class that receives just the
interest.
Principal-Only Stripped MBS
The return on a PO MBS is greater with greater
prepayment speed.

For example, a PO class formed with $100M of
mortgages (principal) and priced at $75M would
yield an immediate return of $25M if the
mortgage borrowers prepaid immediately. Since
investors can reinvest the $25M, this early return
will have a greater return per period than a $25M
return that is spread out over a longer period.
Because of prepayment, the price of a PO MBS tends to
be more responsive to interest rate changes than an
option-free bond.

That is, 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.
|
+
| | |
PO
PO
V rate discount lower ) 2 (
R
V return prepayment ) 1 (
In contrast, 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.
+
|
+ + +
PO
PO
V rate discount greater ) 2 (
R
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.
0
R
V
PO
<
A
A
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.
If the mortgages underlying a $100M, 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 $7.5M:

If $50M of the mortgages were prepaid in the first year and
the remaining $50M in the second year, then the IO MBS
investors would receive an annualized cash flow over two
years totaling $11.25M:

If the mortgage principal is paid down $25M per year, then
the cash flow over four years would total $18.75M:

$11.25M = (.075) ($100M) + (.075)($100M-$50M)
$18.75M = (.075)($100M) + (.075)($100M-$25M)
+ (.075)($75M-$25M) + (.075)($50M-$25M))
$7.5M = (.075)($100M)
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.

Interestingly, if this relationship dominates the price and
discount rate relation, then the price of an IO MBS will
vary directly with interest rates.
0
R
V
then , effect nd 2 effect st 1 If
V rate discount greater ) 2 (
R
IO
IO
IO
>
A
A
>
+
|
| | +
IO and PO Stripped MBS
An example of a PO MBS and an IO MBS
are shown in next exhibit.

The stripped MBSs are formed from
collateral with
Mortgage Balance = $100M
WAC = 8%
PT Rate = 8%
WAM = 360
PSA = 100
Period Collateral Collateral Collateral Collateral Collateral Collateral Stripped Stripped
Month Balance Interest Scheduled Prepaid Total CF PO IO
100000000 Principal Principal Principal
1 100000000 666667 67098 16671 83769 750435 83769 666667
2 99916231 666108 67534 33344 100878 766986 100878 666108
3 99815353 665436 67961 50011 117973 783409 117973 665436
4 99697380 664649 68380 66664 135044 799694 135044 664649
5 99562336 663749 68790 83294 152084 815833 152084 663749
100 58669646 391131 83852 301307 385159 776290 385159 391131
101 58284486 388563 83977 299326 383303 771866 383303 388563
200 27947479 186317 97308 143234 240542 426858 240542 186317
201 27706937 184713 97453 141996 239449 424162 239449 184713
358 371778 2479 123103 1279 124382 126861 124382 2479
359 247395 1649 123287 638 123925 125574 123925 1649
360 123470 823 123470 0 123470 124293 123470 823
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.
Discount PSA Value of Value of Value of
Rate PO IO Collateral
8% 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
Other Asset-Backed Securities
MBSs represent the largest and most extensively
developed asset-backed security. A number of other
asset-backed securities have been developed.

The three most common types are those backed by
Automobile Loans
Credit Card Receivables
Home Equity Loans

These asset-backed securities are structured as pass-
throughs and many have tranches.
Automobile Loan-Backed Securities
Automobile loan-backed securities are often referred to
as CARS (certificates for automobile receivables).

The automobile loans underlying these securities are
similar to mortgages in that borrowers make regular
monthly payments that include interest and a scheduled
principal.

Like mortgages, automobile loans are characterized by
prepayment. For such loans, prepayment can occur as a
result of car sales, trade-ins, repossessions and
subsequent resales, wrecks, and refinancing when rates
are low.

Some CARS are structured as PACS.
Automobile Loan-Backed Securities
CARS differ from MBSs in that
they have much shorter lives
their prepayment rates are less influenced by
interest rates than mortgage prepayment rates
they are subject to greater default risk.
Credit-Card Receivable-Backed Securities
Credit-card receivable-backed securities are
commonly referred to as CARDS (certificates for
amortizing revolving debts).

In contrast to MBSs and CARS, CARDS
investors do not receive an amortorized principal
payment as part of their monthly cash flow.
Credit-Card Receivable-Backed Securities
CARDS are often structured with two periods:
In one period, known as the lockout period, all
principal payments made on the receivables
are retained and either reinvested in other
receivables or invested in other securities.

In the other period, known as the principal-
amortization period, all current and
accumulated principal payments are paid.
Home Equity Loan-Backed Securities
Home-equity loan-backed securities are referred
to as HELS.

They are similar to MBSs in that they pay a
monthly cash flow consisting of interest,
scheduled principal, and prepaid principal.

In contrast to mortgages, the home equity loans
securing HELS tend to have a shorter maturity
and different factors influencing their
prepayment rates.
Websites
For more information on the mortgage industry,
statistics, trends, and rates go to www.mbaa.org

Mortgage rates in different geographical areas
can be found by going to www.interest.com.

For historical mortgage rates go to
http://research.stlouisfed.org/fred2 and click on
Interest Rates.
Websites
Agency information: www.fanniemae.com,
www.ginniemae.gov, www.freddiemac.com

For general information on MBS go to www.ficc.com

For information on the market for mortgage-backed
securities go to www.bondmarkets.com and click on
Research Statistics and Mortgage-Backed Securities.
For information on links to other sites click on Gateway
to Related Links.

For information on the market for asset-backed securities
go to www.bondmarkets.com and click on Research
Statistics and Asset-Backed Securities.
Evaluating Mortgage-Backed
Securities
Monte Carlo Simulation
Objective: Determine the MBSs theoretical value
Steps:
1. Simulation of interest rates: Use a binomial interest rate
tree to generate different paths for spot rates and
refinancing rates.

2. Estimate the cash flows of a mortgage portfolio, MBS, or
tranche for each path given a specified prepayment model
based on the spot rates

3. Determine the present values of each path.

4. Calculate the average value theoretical value.
Step 1: Simulation of Interest Rate
Determination of interest rate paths from a binomial
interest rate tree.
Example:
Assume three-period binomial tree of one-year
spot rates (S) and refinancing rates, (R
ref
) where:

With three periods, there are four possible rates
after three periods (years) and there are eight
possible paths.
1 . 1 / 1 9091 . d
1 . 1 u
% 6 S
0
= =
=
=
1 . 1 / 1 9091 . d
1 . 1 u
% 8 R
ref
0
= =
=
=
Step 1: Binomial Tree for Spot
and Refinancing Rates
% 00 . 8 R
% 00 . 6 S
ref
0
0
=
=
u = 1.10, d = .9091
2728 . 7 R
4546 . 5 S
ref
d
d
=
=
800 . 8 R
600 . 6 S
ref
u
u
=
=
680 . 9 R
260 . 7 S
ref
uu
uu
=
=
6117 . 6 R
9588 . 4 S
ref
dd
dd
=
=
00 . 8 R
00 . 6 S
ref
ud
ud
=
=
0107 . 6 R
5080 . 4 S
ref
ddd
ddd
=
=
2728 . 7 R
4546 . 5 S
ref
udd
udd
=
=
800 . 8 R
600 . 6 S
ref
uud
uud
=
=
648 . 10 R
9860 . 7 S
ref
uuu
uuu
=
=
Step 1: Interest Rate Paths
Path 1 Path 2

Path 3 Path 4
6.0000%
5.4546
4.9588
4.5080
6.0000%
5.4546
4.9588
5.4546
6.0000%
5.4546
6.0000
5.4546
6.0000%
6.6000
6.0000
5.4546
Path 5

Path 6 Path 7 Path 8
6.0000%
5.4546
6.0000
6.6000
6.0000%
6.6000
6.0000
6.6000
6.0000%
6.6000
7.2600
6.6000
6.0000%
6.6000
7.2600
7.9860
Step 2: Estimating Cash Flows
The second step is to estimate the cash flow for
each interest rate path.

The cash flow depends on the prepayment rates
assumed.

Most analysts use a prepayment model in which
the conditional prepayment rate (CPR) is
determined by the seasonality of the mortgages,
and by a refinancing incentive that ties the interest
rate paths to the proportion of the mortgage
collateral prepaid.
To illustrate, consider a MBS formed from a
mortgage pool with a par value of $1M, WAC =
8%, and WAM = 10 years.

To fit this example to the three-year binomial tree
assume that
the mortgages in the pool all make annual cash flows
(instead of monthly)
all have a balloon payment at the end of year 4
the pass-through rate on the MBS is equal to the WAC
of 8
The mortgage pool can be viewed as a four-year
asset with a principal payment made at the end of
year four that is equal to the original principal
less the amount paid down.

As shown in the next exhibit, if there were no
prepayments, then the pool would generate cash
flows of $149,029M each year and a balloon
payment of $688,946 at the end of year 4.
Mortgage Portfolio:
Par Value = $1M, WAC = 8%, WAM = 10 Yrs,
PT Rate = 8%, Balloon at the end of the 4th Year
Year Balance P Interest Scheduled
Principal
Cash
Flow
1
2
3
4
$1,000,000
$930,971
$856,419
$775,903
$149,029
$149,029
$149,029
$149,029
$80,000
$74,478
$68,513
$62,072
$69,029
$74,552
$80,516
$86,957
$149,029
$149,029
$149,029
$837,975
975 , 837 $ 072 , 62 $ 903 , 775 $
Interest ) 4 yr ( Balance CF
975 , 837 $ 029 , 149 $ 946 , 688 $
p Balloon CF
946 , 688 $ 957 , 86 $ 903 , 775 $
) 4 yr ( prin . Sch ) 4 yr ( Balance Balloon
4
4
= + =
+ =
= + =
+ =
= =
=
Such a cash flow is, of course, unlikely
given prepayment. A simple prepayment
model to apply to this mortgage pool is
shown in next exhibit.
The prepayment model assumes:
1. The annual CPR is equal to 5% if the mortgage pool rate is at
a par or discount (that is, if the current refinancing rate is
equal to the WAC of 8% or greater).

2. The CPR will exceed 5% if the rate on the mortgage pool is
at a premium.

3. The CPR will increase within certain ranges as the premium
increases.

4. The relationship between the CPRs and the range of rates is
the same in each period; that is, there is no seasoning factor.
Range
X = WAC R
ref

CPR
X s 0
0.0% < X s 0.5%
0.5% < X s 1.0%
1.0% < X s 1.5%
1.5% < X s 2.0%
2.0% < X s 2.5%
2.5% < X s 3.0%
X > 3.0%
5%
10%
20%
30%
40%
50%
60%
70%
With this prepayment model, cash flows can
be generated for the eight interest rate paths.

These cash flows are shown in Exhibit A
(next two slides).
Exhibit A
Path 1 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z
1,t-1
Z
t0 Value Prob.
1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5
2 0.066117 744776 0.08 59582 59641 0.30 205540 324764 0.074546 0.077270 279846 0.5
3 0.060107 479594 0.08 38368 45089 0.40 173802 257259 0.069588 0.074703 207255 0.5
4 260703 0.08 20856 281560 0.065080 0.072289 212972
Value = 1010465 0.125
Path 2 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5
2 0.066117 744776 0.08 59582 59641 0.30 205540 324764 0.074546 0.077270 279846 0.5
3 0.072728 479594 0.08 38368 45089 0.20 86901 170358 0.069588 0.074703 137245 0.5
4 347604 0.08 27808 375413 0.074546 0.074664 281461
Value = 1008945 0.125
Path 3 1.000000 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5
2 0.080000 744776 0.08 59582 59641 0.05 34257 153480 0.074546 0.077270 132253 0.5
3 0.072728 650878 0.08 52070 61192 0.20 117937 231200 0.080000 0.078179 184465 0.5
4 471749 0.08 37740 509489 0.074546 0.077270 378301
Value = 1005411 0.125
Path 4 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5
2 0.080000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5
3 0.072728 772918 0.08 61833 72666 0.20 140050 274550 0.080000 0.081996 216742 0.5
4 560202 0.08 44816 605018 0.074546 0.080129 444494
Value = 997720 0.125
Exhibit A
Path 5 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5
2 0.080000 744776 0.08 59582 59641 0.05 34257 153480 0.074546 0.077270 132253 0.5
3 0.088000 650878 0.08 52070 61192 0.05 29484 142747 0.080000 0.078179 113892 0.5
4 560202 0.08 44816 605018 0.086000 0.080129 444494
Value = 1001031 0.125
Path 6 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5
2 0.080000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5
3 0.088000 772918 0.08 61833 72666 0.05 35013 169512 0.080000 0.081996 133820 0.5
4 665240 0.08 53219 718459 0.086000 0.082996 522269
Value = 992574 0.125
Path 7 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5
2 0.096000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5
3 0.088000 772918 0.08 61833 72666 0.05 35013 169512 0.092600 0.086188 132277 0.5
4 665240 0.08 53219 718459 0.086000 0.086141 516247
Value = 985008 0.125
Path 8 1 2 3 4 5 6 7 8 9 10 11
Year
R
ref
1,t-1
Z
t0 Value Prob.
1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5
2 0.096000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5
3 0.106480 772918 0.08 61833 72666 0.05 35013 169512 0.092600 0.086188 132277 0.5
4 665240 0.08 53219 718459 0.099860 0.089590 509741
Value = 978502 0.125
Wt. Value $997,457
Path 1
The cash flows for path 1 (the path with three
consecutive decreases in rates) consist of
$335,224 in year 1 (interest = $80,000, scheduled
principal = $69,029.49, and prepaid principal =
$186,194.10, reflecting a CPR of .20)
$324,764 in year 2, with $205,540 being prepaid
principal (CPR = .30)
$257,259 in year 3, with $173,802 being prepaid
principal (CPR = .40)
$251,560 in year 4

The year 4 cash flow with the balloon payment is
equal to the principal balance at the beginning of
the year and the 8% interest on that balance.
Calculations for CF for Path 1:
$335,224 in year 1:
Interest = $80,000
scheduled principal = $69,029.49
prepaid principal = $186,194.10, reflecting a CPR of .20
224 , 335 $ 194 , 186 $ 029 , 69 $ 000 , 80 $ CF
194 , 186 $ ) 029 , 69 $ 000 , 000 , 1 ($ 20 . principal prepaid
029 , 69 $ 000 , 80 $ 029 , 149 $ principal scheduled
000 , 80 $ ) 000 , 000 , 1 ($ 08 . erest int
029 , 149 $
08 .
) 08 . 1 /( 1 ( 1
000 , 000 , 1 $
p
1
10
= + + =
= =
= =
= =
=
=
$324,764 in year 2:
Interest = $59,582
scheduled principal = $59,641
prepaid principal = $205,540, reflecting a CPR of .30
764 , 324 $ 540 , 205 $ 641 , 59 $ 582 , 59 $ CF
540 , 205 $ ) 641 , 59 $ 776 , 744 ($ 30 . principal prepaid
582 , 59 $ ) 776 , 744 ($ 08 . erest int
223 , 119 $
08 .
) 08 . 1 /( 1 ( 1
776 , 744 $
p
776 , 744 $ ) 194 , 186 $ 029 , 69 ($ 000 , 000 , 1 $ Balance
2
9
= + + =
= =
= =
= =
=
=
= + =
$257,259 in year 3:
Interest = $38,368
scheduled principal = $45,089
prepaid principal = $173,802, reflecting a CPR of .40
259 , 257 $ 802 , 173 $ 089 , 45 $ 368 , 38 $ CF
802 , 173 $ ) 089 , 45 $ 594 , 479 ($ 40 . principal prepaid
368 , 38 $ ) 594 , 479 ($ 08 . erest int
456 , 83 $
08 .
) 08 . 1 /( 1 ( 1
594 , 479 $
p
594 , 479 $ ) 540 , 205 $ 641 , 59 ($ 776 , 744 $ Balance
3
8
= + + =
= =
= =
= =
=
=
= + =
$281,560 in year 4:
The year 4 cash flow with the balloon payment is equal to
the principal balance at the beginning of the year and the
8% interest on that balance.
560 , 281 $ 856 , 20 $ 703 , 260 $ CF
856 , 20 $ ) 703 , 260 ($ 08 . erest int
703 , 260 $ ) 802 , 173 $ 089 , 45 ($ 594 , 479 $ Balance
4
= + =
= =
= + =
Path 8
In contrast, the cash flows for path 8 (the path with
three consecutive interest rate increases) are
smaller in the first three years and larger in year 4,
reflecting the low CPR of 5% in each period.
Step 3: Valuing Each Path
Like any bond, a MBS or CMO tranche should be valued
by discounting the cash flows by the appropriate risk-
adjusted spot rates.

For a MBS or CMO tranche, the risk-adjusted spot rate, z
t
,
is equal to the riskless spot rate, S
t
, plus a risk premium.

If the underlying mortgages are insured against default,
then the risk premium would only reflect the additional
return needed to compensate investors for the prepayment
risk they are assuming.

As noted in Chapter 4, this premium is referred to as the
option-adjusted spread (OAS).
If we assume no default risk, then the risk-
adjusted spot rate can be defined as

where: k = OAS

t t t
k S z + =
The value of each path can be defined as

where:
i = ith path
z
M
= spot rate on bond with M-year maturity
T = maturity of the MBS

T
T
T
3
3
3
2
2
2
1
1
T
1 M
M
M
M
Path
i
) z 1 (
CF
) z 1 (
CF
) z 1 (
CF
z 1
CF
) z 1 (
CF
V
+
+ +
+
+
+
+
+
=
+
=

=
For this example, assume the option-
adjusted spread is 2% greater than the one-
year, risk-free spot rates.
Binomial Tree for
Discount Rates

8%
% 6 . 8
74546% .
69588% .
8%
926% .
86% .
99860% .
74546% .
65080% .
Z
10
Z
11
Z
12 Z
13
From these current and future one-year spot rates,
the current 1-year, 2-year, 3-year, and 4-year
equilibrium spot rates can be obtained for each
path by using the geometric mean:
( ) 1 ) z 1 ( ) z 1 ( ) z 1 ( z
M / 1
1 M , 1 11 10 M
+ + + =

The set of spot rates z
1
, z
2
,

z
3
, and z
4
needed
to discount the cash flows for path 1 would
be:
( )
( )
( )
( )
( )
( ) 072289 . 1 ) 06508 . 1 )( 069588 . 1 )( 074546 . 1 ( ) 08 . 1 (
1 ) z 1 )( z 1 )( z 1 ( ) z 1 ( z
074703 . 1 ) 069588 . 1 )( 074546 . 1 ( ) 08 . 1 (
1 ) z 1 )( z 1 ( ) z 1 ( z
07727 . 1 ) 074546 . 1 ( ) 08 . 1 (
1 ) z 1 ( ) z 1 ( z
08 . z
4 / 1
4 / 1
13 12 11 10 4
3 / 1
3 / 1
12 11 10 3
2 / 1
2 / 1
11 10 2
1
= =
+ + + + =
= =
+ + + =
= =
+ + =
=
Using these rates, the value of the MBS
following path 1 is $1,010,465:
465 , 010 , 1 $
) 072289 . 1 (
560 , 281 $
) 074703 . 1 (
259 , 257 $
) 07727 . 1 (
764 , 324 $
08 . 1
224 , 335 $
V
4 3 2
Path
1
= + + + =
The spot rates and values of each of the eight paths are
shown in columns 9 and 10 of Exhibit A.
Step 4: Theoretical Path
The theoretical value of the MBS is defined as the
average of the values of all the interest rate paths:

In this example, the theoretical value of the MBS
issue is $997,457 or 99.7457% of its par value (see
bottom of Exhibit A).
=
=
N
1 i
path
i
V
N
1
V
Step 4: Theoretical Path
The theoretical value along with the standard
deviation of the path values are useful measures in
evaluating a MBS or CMO tranche relative to
other securities.

A MBS's theoretical value can also be compared to
its actual price to determine if the MBS is over or
underpriced.

For example, if the theoretical value is 98% of par
and the actual price is at 96%, then the mortgage
security is underpriced, '$2 cheap', and if it is
priced at par, then it is considered overpriced, '$2
rich.'
Option-Adjusted Spread
Instead of determining the theoretical value of the
MBS or tranche given a path of spot rates and
option-adjusted spreads, analysts can use a Monte
Carlo simulation to estimate the mortgage
security's rate of return given its market price.
Since the security's rate of return is equal to
a riskless spot rate plus the OAS (assuming
no default risk), many analysts use the
simulation to estimate just the OAS.

From the simulation, the OAS is determined
by finding that OAS that makes the
theoretical value of the MBS equal to its
market price.
This spread can be found by iteratively
solving for the k that satisfies the following
equation:
|
|
.
|
\
|
(
(
+ +
+ +
(
(
+ +
+
(
(
+ +
=

= = =
T
1 M
M
M ) N (
M ) N (
T
1 M
M
M ) 2 (
M ) 2 (
T
1 M
M
M ) 1 (
M ) 1 (
) k S 1 (
CF
) k S 1 (
CF
) k S 1 (
CF
N
1
ice Pr Market
where: N = number of paths
Effective Duration and Convexity
Effective duration and convexity can be used with a
binomial tree to measure the duration of a MBS.
rates in increase small a with associated price P
rates in decrease small a with associated price P
: where
=
=
+
2
0
0
0
) y ( ) P (
) P ( 2 P P
Convexity ;
y ) P ( 2
P P
Duration
A

=
A
=
+ +
Effective Duration and Convexity
Steps for using the binomial tree to estimate duration and
convexity:
1. Take yield curve estimated with bootstrapping and value the
MBS (theoretical value), P
0
, using the calibration approach.
2. Let the yield curve estimated with bootstrapping decrease by
a small amount and then estimate the price of the MBS using
the calibration approach -- P
-
.
3. Let the yield curve estimated with bootstrapping increase by
a small amount and then estimate the price of the MBS using
the calibration approach -- P
+
.
4. Calculate effective duration and convexity.
2
0
0
0
) y ( ) P (
) P ( 2 P P
Convexity ;
y ) P ( 2
P P
D
A

=
A
=
+ +
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.
Yield Analysis
For example, suppose an institutional investor is
interested in buying a MBS issue that has a par
value of $100M, 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.
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.
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.
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 exhibit 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.
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
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.
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.

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Chapter 11

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