Mortgage-Backed Securities

An up-to-date look at the latest innovations in mortgage-backed securities

Since the last edition of Mortgage-Backed Securities was published over three years ago, much has changed in the structured credit market. Frank Fabozzi, Anand Bhattacharya, and William Berliner all have many years of experience working in the fixed-income securitization markets, and have witnessed many cycles of change in the mortgage and MBS sectors. And now, with the Second Edition of Mortgage-Backed Securities, they share their knowledge on many of the products and structuring innovations that have taken place since the financial crisis and fiscal reform.

Written in a straightforward and accessible style, and containing numerous illustrations, this timely guide skillfully addresses the investment characteristics, creation, and analysis of mortgage-backed securities. Each chapter contains cutting-edge concepts that you'll need to understand in order to thrive within this arena.

• Discusses the dynamic interaction between the mortgage industry, home prices, and credit performance
• Addresses revised valuation techniques in which all non-agency MBS must be treated as credit pieces
• Examines the shift in this marketplace since the crisis and the impact on industry and investors

Filled with in-depth insights and expert advice, Mortgage-Backed Securities, Second Edition offers you a realistic assessment of this field and outlines the products, structures, and analytical techniques you need to know about in this evolving arena.

Preface xi

About the Authors xv

PART ONE Introduction to Mortgage and MBS Markets 1

CHAPTER 1 Overview of Mortgages and the Consumer Mortgage Market 3

Overview of Mortgages 4

Mortgage Loan Mechanics 12

Risks Associated with Mortgages and Mortgage Products 17

Concepts Presented in this Chapter 22

CHAPTER 2 Overview of the Mortgage-Backed Securities Market 23

Creating Different Types of MBS 24

MBS Trading 35

The Role of the MBS Markets in Generating Consumer Lending Rates 40

Cash Flow Structuring 44

Concepts Presented in this Chapter 46

PART TWO Prepayment and Default Metrics and Behavior 47

CHAPTER 3 Measurement of Prepayments and Defaults 49

Prepayment Terminology 50

Calculating Prepayment Speeds 52

Delinquency, Default, and Loss Terminology 66

Concepts Presented in this Chapter 76

CHAPTER 4 Prepayments and Factors Influencing the Return of Principal 77

Prepayment Fundamentals 77

Factors Influencing Prepayment Speeds 85

Defaults and “Involuntary” Prepayments 92

Concepts Presented in this Chapter 97

PART THREE Structuring 99

CHAPTER 5 Introduction to MBS Structuring Techniques 101

Underlying Logic in Structuring Cash Flows 102

Structuring Different Mortgage Products 103

Fundamentals of Structuring CMOs 106

CHAPTER 6 Fundamental MBS Structuring Techniques: Divisions of Principal 109

Time Tranching 110

Planned Amortization Classes (PACs) and the PAC–Support Structure 116

Targeted Amortization Class Bonds 130

Z-Bonds and Accretion-Directed Tranches 130

A Simple Structuring Example 134

Concepts Presented in this Chapter 140

CHAPTER 7 Fundamental MBS Structuring Techniques: Divisions of Interest 141

Coupon Stripping and Boosting 143

Floater–Inverse Floater Combinations 147

Two-Tiered Index Bonds (TTIBs) 156

Excess Servicing IOs 160

Concepts Presented in this Chapter 166

CHAPTER 8 Structuring Private-Label CMOs 167

Private-Label Credit Enhancement 169

Private-Label Senior Structuring Variations 176

Governing Documents 189

Concepts Presented in this Chapter 191

CHAPTER 9 The Structuring of Mortgage ABS Deals 193

Fundamentals of ABS Structures 194

Credit Enhancement for Mortgage ABS Deals 199

Factors Influencing the Credit Structure of Deals 201

Additional Structuring Issues and Developments 203

Concepts Presented in this Chapter 208

PART FOUR Valuation and Analysis 209

CHAPTER 10 Techniques for Valuing MBS 211

Static Cash Flow Yield Analysis 211

Z-Spread 213

Valuation Using Monte Carlo Simulation and OAS Analysis 214

Total Return Analysis 226

Concepts Presented in this Chapter 229

CHAPTER 11 Measuring MBS Interest Rate Risk 231

Duration 231

Convexity 238

Yield Curve Risk 241

Other Risk Measures 242

Concepts Presented in this Chapter 244

CHAPTER 12 Evaluating Senior MBS and CMOs 245

Yield and Spread Matrices 246

Monte Carlo and OAS Analysis 262

Total Return Analysis 268

Evaluating Inverse Floaters 274

Concepts Presented in this Chapter 279

CHAPTER 13 Analysis of Nonagency MBS 281

Factors Impacting Returns from Nonagency MBS 281

Understanding the Evolution of Credit Performance within a Transaction 284

The Process of Estimating Private-Label MBS Returns 290

Concepts Presented in this Chapter 304

APPENDIX An Option-Theoretic Approach to Valuing MBS 305

Option-Theoretic Models for Valuing MBS 306

An Option-Based Prepayment Model for Mortgages 307

Valuation of Mortgages 311

A Closer Look At Leapers and Laggards 319

Valuation of MBS 323

Index 327

FRANK J. FABOZZI, PHD, CFA, is Professor of Finance at EDHEC Business School and a member of the EDHEC-Risk Institute. Prior to joining EDHEC, he held various professorial positions in finance at Yale University's School of Management from 1994 to 2011 and, from 1986 to 1992, was a visiting professor of finance and accounting at MIT's Sloan School of Management. He is also Editor of the Journal of Portfolio Management.

ANAND K. BHATTACHARYA, PHD, is a Professor of Practice in the Department of Finance, W. P. Carey School of Business, Arizona State University, and a Fixed Income Strategist with Stifel, Nicolaus & Company, Inc. He has consulted with various financial institutions on issues of balance sheet restructuring and asset valuation.

WILLIAM S. BERLINER is the Principal of Berliner Consulting & Research, LLC, a boutique firm specializing in mortgages and mortgage-backed securities. His primary focus is security and loan valuation and hedging, serving both institutional investors and mortgage originators. Berliner also writes a monthly column for Asset Securitization Report.

Even with the recent events that have occurred in this field, mortgage-backed securities (MBS) continue to comprise one of the largest securities markets in the world. However, since the publication of the first edition of Mortgage-Backed Securities, both the consumer mortgage and MBS sectors have undergone significant changes—many of them resulting directly, and indirectly, from the collapse in mortgage performance that initially appeared in late 2006 and led to the financial crisis of 2007–2008.

That's why the expert author team of Frank Fabozzi, Anand Bhattacharya, and William Berliner—who have witnessed many cycles of change in the mortgage and MBS sectors—have returned to create the Second Edition of Mortgage-Backed Securities. In it, they skillfully reassess the MBS sector in the context of the changes resulting from the crisis, as well as explore the insights gained in the post-crisis period.

Engaging and informative, this updated edition continues to address the investment characteristics, creation, and analysis of mortgage-backed securities, but now does so with the lessons and data accumulated from post-2006 events in mind. Along the way, it offers valuable insights that reflect the current market environment: reexamining prepayment behavior and analysis to describe the latest thinking on prepayment speeds and behavior, while taking into account credit and housing-related factors; and devoting an entirely new chapter to the evaluation of non-agency MBS.

Divided into four comprehensive parts, this reliable resource contains cutting-edge concepts you'll need to understand in order to succeed within this arena.

Part One: introduces the essential aspects of the mortgage and MBS markets

Part Two: discusses prepayment and default behavior, along with an array of metrics and conventions used to quantify these activities

Part Three: describes a variety of structures and tranches, along with techniques used in structuring them

Part Four: outlines the metrics and methodologies necessary to evaluate the potential risks and returns associated with mortgage-backed securities

The mortgage and MBS markets remain in a highly unsettled state, which makes a broad and sophisticated understanding of MBS markets and products essential. The Second Edition of Mortgage-Backed Securities offers you a realistic assessment of this field and will put you in a better position to excel in one of the most dynamic and challenging areas of finance.