Mortgage Backed Securities

Jesse Laeuchli, Paul Romine, Katherine Reid, Hui Fang

Introduction to MBS Valuation

Mortgage Backed Securities

16% 5%

A security backed by monthly mortgage payments Is an important sector of the bond market
$468.9 billion

18%

17% 8%

36%

Need to price security

Figure 1. Percentages of each security in the Debt Market in 2006 http://www.bondmarkets.com/story.asp?id=98

Municipal Sec. Treasury Sec. Fed. Agency Debt MBS Asset Backed Sec. Corporate Debt

Basic MBS Cash Flow

Homeowners
Mortgage Rate

Service
Pass-through Rate

Investors

Homeowners make monthly payments of principal and interest at the mortgage rate. The service retains a portion of the interest components of each monthly payments as the Monthly servicing fee. The pass-through rate is the mortgage rate net of the servicing rate.

MBS Valuation
Key Idea: The price of any security can be written in terms of the net present value (NPV) of its discounted cash flows under the risk neutral probability measure.
M M ! " ! " Q Q P = E # ' PV (t ) $ = E # ' d (t )C (t ) $ % t =0 & % t =0 &

Where d(t) : Discounting Factor, available from market. C(t): Payment at time t. Q: Risk-Neutral Measure.

Monthly Payment
Casualty insurance tax property

Interests

C(t) = SP(t) + PP(t) SP(t) = PRIN(t) + INT(t) TPP(t) = PP(t) +PRIN(t), Where
SP(t): Scheduled Payments TPP(t): Total Principal Payments

Principal

Prepayment

INT(t): Interest Payments PRIN(t): Scheduled Principal Payment PP(t): Principal Prepayments

How to Value MBS?

Observation: Cashflow C(t) is interest-rate path dependent.
Questions:
1. What is the Cashflows of MBS? 2. How to predict the Interest Rate ? Interest rate models! 3. How to predict the prepayment Behavior? Prepayment models!

Interest Rate Modeling

Pricing Along One Path

Zero-Curve Interest Rate Models
Realized Forward-Rate

Prepayment Model
d(t) SMM(t)

Predicted Cashflow
C(t)

PVi (t ) = ! t =0 d (t )C (t )

IR Model Hull-White Model

Implement Hull-White Model via Trees

dr (t ) = (! (t ) $ " (t )r (t ))dt + # (t )dW (t )

IR ModelLibor Market Model

Arbitrage-Free Market Models

Prepayment Model

Prepayment Terminology
Key Idea: The survival factor Q(t) links MBS cash flow with prepayments models.

Q(t ! 1) ! Q(t ) SMM (t ) = Q(t ! 1) Q(t ) = " n =1 (1 ! SMM (n))

Where Q(t): Fraction of Mortgage that has not been prepaid. SMM(t): Fraction of pool prepaid during month t.
t

Prepayment Model--Cox Model

Prepayment is governed by a hazard function h(t)

h(t ) = h0 (t )e
Where

! v (t )

h0(t): baseline hazard function. v(t): is a vector of explanatory variable for prepayment. SMM(t) = h(t) dt Notice: h(t) is calibrated by historical data. v(t) is functional of interest rates.

Probability of Prepayment
Coxs proportional hazard specification

Figure 5. Example Prepayment Probability

Numerical Example and Results

Numerical Examples
Mortgage Description: 1 Million 30y mortgage with 8.5% mortgage rate and 7.25% coupon rate.
Model Input: 1. Interest Rate Models (Libor Market Model) 1.1 Zero Curve 1.2 Forward Rate Covariance Structure 1.3 Instantaneous volatility function. 2. 3. Prepayment Models. OAS

Scheduled Payments
C(t) =PRIN(t)+INT(t)

Cashflow with Prepayment

C(t) =PRIN(t)+INT(t)+PP(t)

Monte Carlo Simulation Results

The model demonstrate good converged rate. Able to predict value of security.

Figure 6. Histogram of MBS Net Present Value

Questions?

Cash Flow with Prepayments

Let SP(t), PRIN(t), INT(t), BAL(t) be the corresponding quantities with prepayments

SP '(t ) = SP (t ) ! Q (t " 1) PRIN '(t ) = PRIN (t ) ! Q (t " 1) INT '(t ) = INT (t ) ! Q (t " 1) PP '(t ) = ( BAL '(t ) " PRIN '(t )) ! SMM (t ) BAL '(t ) = BAL(t ) ! Q (t )
Qestion: How to compute SMM(t)? Answer: History repeats!

CashFlow without Prepayment

G = WAC 12 G SP (t ) = 1 ! U R (t ) G( 1 ! U R ( t ) +1 ) INT (t ) = 1!U N GU R ( t ) +1 PRIN (t ) = 1!U N

Where, WAC: Wighted Average Coupon Rate U =1/(1+G): Monthly Discouting Factor. R(t) = N t: Remaining Loan Terms.