Chapter 20

Mortgages and Mortgage-Backed Securities

The Overview introduced and highlighted the importance and size of the mortgage market in the United States. This chapter describes mortgage loans and mortgage-backed securities (MBS), presents the most popular methods used for valuation and hedging, and illustrates how prices behave as a function of the relevant variables.


Mortgage loans come in many different varieties. They can carry fixed or variable rates of interest and they can be extended for residential or commercial purposes. This chapter will focus almost exclusively on fixed rate residential mortgages. Residential mortgages typically mature in 15 or 30 years and constitute 80% of the total principal of securitized mortgages in the United States.

Given the importance of the securitization process, which will be discussed ahead, residential loans are typically classified by how they might be subsequently securitized. Agency or conforming loans are eligible to be securitized by such entities as Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC), or Government National Mortgage Association (GNMA). The exact criteria vary by program, but these loans are relatively creditworthy1 and limited in principal amount.

Non-agency or non-conforming loans have to be part of private-label securitizations. The relevant loan types include jumbos, which are larger in notional than conforming loans but otherwise similar; Alt-A

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