Mortgage Backed Securities

History

• 1977 at Salomon Bros

• see Liar’s Poker by Michael Lewis

• basic structure: pass-through

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) don’t have the opportunity to reinvest at the higher rates.

Recall fixed payment loans

Principal Only Strip

Interest Only Strip

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.

Convexity

• Degree of interest rate risk.

• If the price of the security is sensitive to changes in the yield the convexity is high.

$1000 in 2 years

$1000 in 20 years

Negative Convexity

Usually debt instrument go up in value when interest rates fall.

But when interest rates fall prepayment rates rise which can cause MBS’s to lose value—especially IO strips.

IO & PO Strips at Different Rates of Prepayment

IO-PO strip: some prepayment

120t

$ IO stripin blue, PO stripin red

120t

$ PSA 400