• Document: The Financial Risks Associated with Mortgage-Backed Securities
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The Financial Risks Associated with Mortgage-Backed Securities Global Association for Risk Professionals (GARP) Raleigh, NC Chapter Meeting October 25, 2012 Tao Pang, PhD, FRM Department of Mathematics North Carolina State University 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 Mortgage Money Mortgage Mortgage MBS Lender Investors Borrowers Monthly MBS Payments Payments The Cash-Flow for MBS Bonds 2 An example of Pass-though MBS Mortgage 1 1000 MBS bonds $200k, i=6.5% Maturity: 30 years face value: $1000 A pool of mortgages coupon rate: 6.4% (payable monthly) Mortgage 2 Principal=$1 million Maturity: 30 years $300k, i=7%  WAC=6.4%  Maturity: 30 years Remark: The MBS Maturity: 30 years investors will receive both Mortgage 3 principal payments $500k, i=6% and interest Maturity: 30 years payments 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 Senior Tranche Mortgage 1 Principal: $75 million Mortgage 2 Return = LIBOR + 70bp Mortgage 3 Special Mezzanine Tranche  Purpose Principal:$20 million Vehicle Return = LIBOR+ 200bp Mortgage n Principal: Equity Tranche $100 million Principal: $5 million Return =LIBOR+1,000bp 6 Cash Flow Allocation Order Mortgage Principal Cash Flows Senior Tranche Principal Mezzanine Tranche Principal Equity Tranche Principal 7 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 8 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 CMO Payment Scheme (No Prepayment) 1200.00 Tranche A Tranche B Tranche C Tranche A Interest Tranche B Interest Tranche C Interest 1000.00 800.00 Payment 600.00 400.00 200.00 0.00 1 25 49 73 97 121 145 169 193 217 241 265 289 313 337 Month

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