Investment Strategies of Hedge Funds

9

Mortgage-Backed Securities Arbitrage

Home sweet loan. Assonant to the saying: Home sweet home.

In this chapter, we examine a special type of fixed income arbitrage based on a particular class of securities that are very popular on the US market: mortgage-backed securities (MBS).

A mortgage-backed security is the securitization of a set of mortgages collateralized by real estate. Through said securitization, the set of mortgages held by a financial institution is pooled and sold to investors. When a financial institution holds mortgages, pools them and sells units or certificates representing the pooled mortgages, the institution is said to have securitized the mortgages and issued a pass-through security, where the cash flows of the pooled mortgages pass from the originating entity to the owner of the pass-through security, after deducting the commissions charged by the originator.

To be eligible as underlying of MBS, mortgages must meet a number of minimum requirements, for example the loan maximum size, the required loan documentation, a given ceiling of the loan-to-value ratio, the demand for an insurance, if any, etc.

9.1 A BRIEF HISTORY OF MORTGAGE-BACKED SECURITIES

The practice of packaging mortgages into new securities backed by those pooled mortgages is relatively recent. In 1978 Bob Dall, trader of Salomon Brothers, and Stephen Joseph originated the first private issue of mortgages on behalf of Bank of America. In the autumn of 1981, the Congress approved a tax ...