Mortgage Backed Securities

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Mortgage Backed Securities
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History

• 1977 at Salomon Bros
• see Liars Poker by Michael Lewis
• basic structure pass-through

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Prepayment Risk

• Homeowners have a call option.
• They will exercise the option when interest rates
  are low.
• If interest rates are low, the bank (or owner of
  the MBS) will have to reinvest the proceeds at a
  lower rate of interest.
• If interest rates are high, rates of prepayment
  decline and the bank (or owner of the MBS) dont
  have the opportunity to reinvest at the higher
  rates.

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Recall fixed payment loans
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Principal Only Strip
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Interest Only Strip
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Duration

• Calculated by weighting the time period by the
  cashflows received.
• Principal only strip has a longer duration.
• The longer the duration the greater the interest
  rate risk.

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Convexity

• Degree of interest rate risk.
• If the price of the security is sensitive to
  changes in the yield the convexity is high.

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1000 in 2 years
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1000 in 20 years
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Negative Convexity

• Usually debt instrument go up in value when
  interest rates fall.
• But when interest rates fall prepayment rates
  rise which can cause MBSs to lose
  valueespecially IO strips.

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IO PO Strips at Different Rates of Prepayment
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IO-PO strip some prepayment
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