Chapter 18

Mortgage-Backed Securities Risk*

This chapter turns to the pricing and risk management of mortgage-backed securities (MBSs). These are securities whose cash flows are backed by pools of mortgage loans, residential or commercial. The MBS market is an example of securitization, which is the process by which assets are pooled, and securities representing interests in the pool are issued.

Payments on mortgage loans are typically structured as annuities, which involve a regular payment covering interest and principal amortization. A key feature of a mortgage loan, however, is that the homeowner has the ability to repay the principal early at any time. Thus, the homeowner is long a prepayment option.

This makes the risk analysis of MBSs considerably more complex than for regular bonds. In addition to the usual interest rate risk and credit risk, MBSs involve prepayment risk. This is covered in Section 18.1. Due to this embedded short option, MBSs are exposed to volatility risk. This explains why yields on MBS securities are higher than otherwise, by an amount known as the yield spread. This spread can be decomposed into an option component and an option-adjusted spread (OAS).

Section 18.2 then discusses MBSs and the process of securitization. It discusses drawbacks to this securitization process that have become apparent in the latest credit crisis. Finally, Section 18.3 describes the tranching of MBS products into collateralized mortgage obligations (CMOs).


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