From Sterwiki

A mortgage-backed security (MBS) is a bond whose cash flows are backed by homeowners' mortgage payments. The nuance which makes an MBS more interesting than the average bond is uncertainty in the cash flow timing. Since homeowners may repay their entire mortgage at any time (called prepayment) an investor can not be certain of the timing of the cash flows.

Finding the theoretical fair value

Pricing a vanilla corporate bond is based on two sources of uncertainty; default risk (credit risk), and interest rate (IR) exposure. The MBS adds a third risk; early redemption (prepayment). The number of homeowners who prepay is a falling function of the interest rate, so that they can refinance at a lower fixed interest rate (fixed rate).

Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. (The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution exists.) In models of this type numerical methods provide approximate theoretical prices. (These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo or Binomial Tree numerical solutions.)

The link between IR & prepayment

Mortgage prepayments are most often made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS-holder despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). Hence the term: prepayment risk.

To compensate investors for the prepayment risk these bonds are offered at an Option Adjusted Spread over treasury bonds.

There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, for instance:

• Economic growth, which is correlated with a faster turn over in the housing market
  
• House price inflation
  
• Regulatory risk; if borrowing requirements or tax laws in a country change this can change the market profoundly.
  
• Demographic trends, and a shifting risk aversion profile, which makes fixed rate mortgages relatively less attractive.
  

Credit risk

Main article: credit risk

Credit worthiness determines the likelihood of the MBS-holding receiving the promised cash flows. The credit rating of mortgage backed securities is fairly high because:

1. The initial Mortgage issuer will generally research the borrower's ability to repay, and will try to lend only to the credit-worthy.
   
2. Some MBS packagers (such as Fannie Mae, Freddie Mac, or Ginnie Mae) guarantee against homeowner default risk. This issuer's guarantee is itself considered very solid because, in the US, it is implicitly underwritten by the Federal Government.
   
3. Pooling many mortgages with similar default probabilities creates a bond with a much lower probability of total default, in which no homeowners are able to make their payments (see Copula). Although the risk neutral credit spread is theoretically identical between a Mortgage ensemble and the average Mortgage within it, the chance of catastrophic loss is reduced.
   
4. If the property owner should default, the property remains as collateral. Although real estate prices can move below the value of the original loan, this increases the solidity of the payment guarantees and deters borrower default.
   

If the MBS was not underwritten by the original real estate & the issuer's guarantee the rating of the bonds would be very much lower, because borrowers with improving credit ratings would opt-out of their mortgage to refinance at a lower credit risk, but those with deteriotating credit ratings never would. (An example of 'Adverse selection'.)

The MBS Market

The high liquidity of most MBS Markets means that any investor wishing to take a position need not deal with the difficulties of theoretical pricing described above; the price of any bond is essentially quoted at fair value, with a very narrow spread.

Reasons (other than speculation) for entering the market include the desire to hedge against a drop in prepayment rates. (This is a critical business risk for any company specializing in refinancing.)

Classes of MBS

Any financial product based on Mortgage-backed bond is classified as a 'MBS'. This can confuse, because MBS derivatives are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier 'Pass-through' is used, in the same way that 'Vanilla' designates an Option with no special features.

Therefore, mortgage-backed security sub-types include:

• Pass-through MBS: The simplest MBS, as described in the sections above. Essentially, a securitization of the Mortgage payments to retail banks. Divided into:
  
  • Residential Mortgage-Backed Security (RMBS): A RMBS is an Pass-through MBS on Residential property
    
  • Commercial Mortgage Backed Security (CMBS): A CMBS is an Pass-through MBS on Commercial property
    
  
  
• Collateralized mortgage obligation (CMO): This is a more complex MBS in which the Mortgages are ordered into Tranches by some quality (such as repayment time), with each Tranche (of a thousand mortgages, say) being sold as a separate security.
  
• Stripped Mortgage-Backed Securities (SMBS): Each mortgage payment is partly used to pay down the loan's principle and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
  
  • Interest-only Stripped Mortgage-Backed Securities: The IO SMBS is a bond with cash flows backed by the interest component of property owner's Mortgage payments.
    
  • Principal-only Stripped Mortgage-Backed Securities: The PO SMBS is a bond with cash flows backed by the principal repayment component of property owner's Mortgage payments.
    
  
  

Levels and flows

United States

Total MBS market value at the beginning of 2004 was reported to the National Secondary Market Conference ([1] (http://www.mortgagebankers.org/present/2004/Secondary/Wall%20Street%20Update/2nd%20Presentation-Goodman.ppt)) at over 2.75 trillion USD. This is much larger than Asset-Backed Securities, and overtook the size of the Treasuries market in 2000.

US Mortgage-backed securities, which accounts for nearly one-sixth of global underwriting, posted a record year in 2003.

US isses reported by Thomson Financial ([2] (http://www.thomson.com/financial/investbank/fi_investbank_league_tablearchive_debt.jsp)) ($ billions and number of issues)

• 2003: 900 (1,203) (Q4 2003 report)
  
• 2002: 805 (?) (Q4 2003 report) 768 (980) (Q4 2002 report)
  
• 2001: 597 (?) (Q4 2002 report)
  

Homeowners (in the United States) are almost universally given the option to repay their entire mortgage.

See also

• Asset Backed Security (ABS)
  
• Interest rate lock commitment (IRLC) Is a feature of the US residential mortgage market which makes many of the home owner's payments underlying the MBS fixed payments.
  
• Interest rate cap
  
• Securitization
  

Data

• Thomson Financial League Tables