Mortgage-Backed Security

Residential mortgagors in the United States have the option to pay more than the required monthly payment (curtailment) or pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of a MBS is not known in advance, and therefore presents an additional risk to MBS investors.

Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.

Reasons for issuing mortgage-backed securities

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities

1. transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. can be used by Wall Street banks to monetise the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6.allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilise capital more efficiently and achieve compliance with risk-based capital standards.

Finding the theoretical fair value

Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure. The MBS adds a third risk: early redemption (prepayment). The number of homeowners in residential MBS securitizations who prepay goes up when interest rates go down. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection.

Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution exists. In models of this type numerical methods provide approximate theoretical prices. These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.

Real-world Pricing

Most traders and money managers use Bloomberg and Intex to analyze MBS pools. Intex is also used to analyze more esoteric products. Some institutions have also developed their own proprietary software. TradeWeb is used by the largest bond dealers ("primaries") to transact round lots ($1 Million+).

The Premier Group was created with the design and desire in mind to be a one-stop business centre. The objective was to manage and fulfil all of our client�s financial requirements comprehensively under one Group. The client, in essence, would not have the need to go to any other financial institution or competitor, as all of their needs can be dealt with within one organisation. This has been achieved by creating a four-division structure, containing a 30 plus strong of highly qualified Head Office staff that are able to ensure that the Group�s objectives are met.

By : Kaloyan Banev