Fixed Income Analysis, Second Edition

CHAPTER 12

VALUING MORTGAGE-BACKED AND ASSET-BACKED SECURITIES

I. INTRODUCTION

In the two previous chapters, we looked at mortgage-backed and asset-backed securities. Our focus was on understanding the risks associated with investing in these securities, how they are created (i.e., how they are structured), and why the products are created. Specifically, in the case of agency mortgage-backed securities we saw how prepayment risk can be redistributed among different tranches to create securities with a prepayment risk profile that is different from the underlying pool of mortgages. For asset-backed securities and nonagency mortgage-backed security, we saw how to create tranches with different degrees of credit risk.

What we did not discuss in describing these securities is how to value them and how to quantify their exposure to interest rate risk. That is, we know, for example, that a support tranche in a CMO structure has greater prepayment risk than a planned amortization class (PAC) tranche. However, how do we determine whether or not the price at which a support tranche is offered in the market adequately compensates for the greater prepayment risk? In this chapter, we will describe and then apply a methodology for valuing mortgage-backed securities and some types of asset-backed securities—Monte Carlo simulation. As we stressed in Chapter 9, a byproduct of a valuation model is the option-adjusted spread. We will see how the option-adjusted spread for a mortgage-backed ...