MODULE 19: Mortgage-Backed Security (MBS) Instrument and Market Features

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1. Prepayment Risk: You own a callable bond (and interest rate falls) → They prepay and buy back their now cheaper bond issued at a high interest rate. Interest Rate falls to 2% and you take a cheaper loan and payback your expensive loan. For the bond investor, high-coupon mortgage cash flows disappear right when they’re most valuable, that is why a risk.
2. Extension Risk: Interest Rate rises, Duration falls and Price falls. Bond sellers (borrowers) won't exercise their call option. Expected cash-flows get extended. The market rate is higher but the bond buyer (investor) keeps receiving scraps from mortgages issued at low rates.
3. Contraction Risk: Interest Rate falls, Duration rises and Price rises. Prepayments speed up. Bond sellers (borrowers) will exercise their call option. Cash-flows would arrive sooner than expected.
4. Because the prices of MBS reflect expectations for prepayments in low-rate environments, they will not rise as much in response to decreasing interest rates as other fixed-income instruments that do not have an embedded prepayment option.
5. Convexity is acceleration of prices with falling rates. Prepayments are friction. When rates fall, you lose the deals you earlier did (bought high coupon mortgages), so price of your MBS doesn't rise proportionally. So traditional FI instruments have +ve convexity and MBS have a -ve convexity

1. A mortgage pool pays principal into two tranches: Tranche S (short) first, Tranche L (long) later.
2. When payments speed up, principal rushes in. Tranch S is unaffected (it was already on the front line to get paid off). The contraction risk gets pushed to back of the line Tranch L.
3. When payments slow down (rates rise), prepayments stagnates. Tranch L is unaffected (it was already on the back of the line to get paid off). The extension risk hurts the front of the line.
4. If I take a loan of $100 against and pledge my asset of $200, my Loan to Value (LTV) is 200/100 = 2.
5. A mortgage of USD 300,000 has an annual interest rate of 6%, is to be repaid monthly over 25 years, and the borrower’s annual pretax gross income is $80,000. Calculate DTI. Here, PV=-300,000, FV = 0, N = 25×12 = 300, I/Y = 6/12 = 0.5. This gives PMT = 1932. DTI = (1932 * 12) / 80000 = 0.289 ~ 28.9 %
6. Prime loans are made to creditworthy people, subprime loans are made to broke people.
7. Residential mortgages are different because you can’t freely prepay. If you do, you pay a penalty,. They can be recourse or non-recourse: in recourse loans, the lender can come after your other assets; in non-recourse, they’re stuck with just the house.
8. A 30-year US home loan that meets standards gets pooled and guaranteed by Fannie Mae or Freddie Mac. These Agency RMBS are backed either directly by the government or by government-sponsored agencies (quasi-government companies). Credit risk is basically off your plate. Non-agency RMBS: private-issued, no government/GSE backstop → investors eat credit risk. 2008: subprime RMBS (e.g., Lehman Brothers) blew up; defaults surged, protections failed, MBS holders lost money.
9. Mortgage pass-through = claim on cash flows from a pool of mortgages, net of admin fees. Pool can have any number of mortgages; each is a securitized mortgage.
10. Mortgage A has an outstanding principal of USD 80, a coupon rate of 6%, and a final maturity of 30 years. Mortgage B has an outstanding principal of USD 20, a coupon rate of 4%, and a final maturity of 15 years. Total outstanding principal in the pool is USD 100. Weighted average coupon (WAC) = (80/100 × 6%) + (20/100 × 4%) = 5.6%. Weighted average maturity (WAM) = (80/100 × 30) + (20/100 × 15) = 27 years.

1. A Collaterized Mortgage Obligation (CMO) is a tranched MBS. The underlying cash flows are the same mortgages. What changes is how those cash flows are split and ordered. Senior tranche gets paid first and lowest tranche gets paid the last. Total prepayment risk stays the same; it is redistributed across tranches.
2. Z-tranche = a CMO tranche that gets no cash interest at first. During this phase, interest is not paid out; it is added to principal instead. Suppose Start: principal = USD 100, coupon = 5%. End of year: no cash paid, principal becomes USD 105. You didn’t get money; your claim just got bigger.
3. So the bond grows silently while other tranches take the cash. After the accrual period, Z-tranche starts receiving normal interest and principal payments. Z-tranche is usually last in line. It sacrifices early cash so other tranches get paid first.
4. Principal-only (PO) securities and Interest-only (IO) securities are interest-rate / prepayment bets, not boring bonds. - If rates fall, people refinance → prepayments speed up.

5. You get only interest payments, no principal. You want loans to stay alive as long as possible. If rates rise or stay high → prepayments slow → more coupon checks. Used by investors who want to bet on rising/stable rates and slow prepayments.

6. Principal comes back faster, IRR shoots up.