Mortgage-Backed Security

Securitization begins when an originator sells a pool of mortgage loans to a special purpose entity, which issues certificates against them. Each loan carries its own rate, balance and remaining term, so the pool is described by weighted averages: the weighted average coupon, the weighted average maturity and, for adjustable-rate collateral, the weighted average life to reset. The coupon actually paid to certificate holders, the pass-through rate, is lower than the weighted average coupon because the servicer retains a servicing fee and, for agency deals, a guarantee fee is deducted as well.

Each month the servicer collects scheduled interest, scheduled amortization and any unscheduled principal, then remits the net amount. Because principal arrives continuously, the outstanding balance declines from the first payment date and the investor's exposure shrinks over the life of the deal. This is why an MBS is analysed through average life rather than a single stated maturity.

Borrowers hold a free option to repay early, typically by refinancing, moving or defaulting into a guarantee payout. When rates fall, prepayments accelerate and principal returns faster than expected, forcing reinvestment at lower yields; this is contraction risk. When rates rise, prepayments slow, the investor stays locked into a below-market coupon and duration extends; this is extension risk. The combination produces negative convexity: price appreciation in a rally is capped while depreciation in a selloff is not.

Prepayments are quantified with the single monthly mortality rate, the fraction of the beginning balance prepaid in a month, and its annualised equivalent, the conditional prepayment rate, obtained by compounding one minus the monthly rate over twelve months and subtracting from one. The PSA benchmark expresses speeds as a percentage of a standard ramp in which the annualised rate rises steadily during the first thirty months and then levels off.

Collateralised mortgage obligations do not change the total cash flow of the pool; they reorder it. In a sequential structure, all principal is directed to the first tranche until it retires, then to the next, creating short, intermediate and long average lives from one collateral pool. Planned amortisation class tranches go further: a predetermined schedule is honoured as long as prepayments stay inside a specified collar, with support or companion tranches absorbing the variation. The PAC holder buys prepayment stability; the support holder is paid to accept far greater uncertainty.

Non-agency deals add a second dimension. Because there is no agency guarantee, losses must be allocated, so the capital structure is tranched by seniority with subordination, excess spread and overcollateralisation providing credit enhancement. Senior holders absorb losses only after junior classes are exhausted.

Be able to move from a pool description to a cash flow: separate scheduled interest computed on the beginning balance at the pass-through rate, scheduled amortisation, and prepaid principal derived from the monthly mortality rate applied to the balance net of the scheduled payment. Be able to convert between monthly and annualised prepayment measures and to interpret a quoted PSA speed as faster or slower than the benchmark.

Be able to explain why average life, not maturity, is the relevant horizon measure, and why it shortens as speeds rise. Be able to identify which tranche of a given structure bears contraction risk and which bears extension risk. Finally, be able to justify why option-adjusted spread rather than nominal or zero-volatility spread is used for valuation: the embedded prepayment option must be stripped out before the residual compensation for credit and liquidity can be compared with other bonds.