Fixed Income Securities: Valuation, Risk, and Risk Management

CHAPTER 8

BASICS OF RESIDENTIAL MORTGAGE BACKED SECURITIES

The residential mortgage backed securities market reached a market size of about $8.9 trillion by the end of 2008. This is almost $3 trillion larger than the marketable U.S. Treasury debt at the same time. Clearly related to the real estate market, it is no surprise that the size of this market has been growing steadily over the years. The market for mortgage backed securities serves the important role of transferring risks from those who have it, the small banks, savings and loans, and so forth, to those who are better able to bear it, namely, investors. The latter are more diversified and thus potentially in a better position to bear the risks of lending money to individuals. The process through which mortgages to individuals are sold to others is called securitization. While we expand our discussion on residential mortgage backed securities, a very similar procedure is followed to securitize almost any type of security, from credit cards, to car loans, from commercial loans to corporate bonds.

8.1 SECURITIZATION

Before we delve into a discussion of the market for residential mortgage backed securities, let’s take a closer look at the concept of securitization. The essential idea is in fact simple: Some institutions hold in their assets investments that are too risky for them, and they would like to sell them to investors who are better able to bear their risk. Since the assets per se are too concentrated and not sufficiently ...