I'm trying to understand the entire Mortgage Backed Securities market. I understand the concept, but I'm a little confused by the actual number values, mainly because I don't know what the pricing is. For example, let's say I'm a bank. I give out 10 mortgages for $1million each, for a total of $10 million. Now, let's say I create an MBS from these 10 mortgages. They are all prime borrowers, and the rates are all 5% for 30 years. How much would the total value of these MBSs go for? Would they sell for much higher than $10 million? I know that the bank is out-of-pocket for $10 million, so I'm assuming that once these mortgages are packaged and sold as MBSs, the total price would exceed $10 million so that the bank would get back the cash it invested. My guess is that there is some way to value these that would take the future value of these mortgages, and then come up with a price that values them based on payment risk, interest rate risk, etc. Does anyone have a rough value how much these MBS would be priced at? In addition, how much do Investment bankers charge to create this MBS?
If you research (SRP) Service Release Premium and (YSP) Yield Spread Premium, you can see how this work.
There are a lot of factors that go into this. First, it depends on whether it's a GSE MBS or Private Label MBS GSE MBS are guaranteed by Freddie, Fannie & Ginnie. Almost always 15 or 30 year fixed mortgages. Simplest example are typical Passthru securities. Since they are guaranteed by the GSE, there is no default risk to the security holder. The primary risk is called prepayment risk. Essentially this is the risk that more homeowners pay down (either partial or full) their mortgage. If this happens, the holder of the MBS loses out on potential interest. Generally, as interest rates fall, homeowners are more likely to refi and pay down their mortgage. Therefore the traditional convex nature of Price-Yield of most bonds becomes concave at low interest rates (yields). Now, common derivative product in this space are IOs (Interest Only) and POs (Principal Only). As the name suggests IO holders get only the interest portion of an MBS... so they fall in value if prepayment speeds increase. PO holders, on the other hand, benefit from prepayments. The private label space is anything that isn't issued by GSEs, so there is no guarantee to the holder. Unlike GSE mortgages, these can be variable rate and have all sorts of other features. As a result of no guarantee, not only do you have to worry about prepayment risk, but also default risk. This can entirely depend on the types of mortgages in the security, the geographical areas the mortgages come from, the size of the mortgage, whether income was verified, etc. From pools of mortgages you can then create CMOs (Collateralized Mortgage Obligations). These are more complicated, so I'll be brief unless you want me to expand upon it. Essentially you pool together MBS and if it is a private label, create different credit levels (credit tranching). The lowest is generally an equity stake, then lower credit quality, all the way up to (possibly) AAA. Defaults start at the equity portion and move upwards. Once a level is wiped out, the defaults continue up until (if everyone somehow defaults) the highest level is wiped out. They can also be prepayment tranched (ranks holders to receive prepayments as they come in) and furthered into coupon tranching (more complicated, involves structures similar to IOs/POs). Anyway, I'd call this sort of a primer, hope it was helpful.
Thanks, trendlover and Chelsea_FC! This is the info I was looking for!! Chelsea_FC, if you wouldn't mind answering a few additional questions, I would greatly appreciate it! 1) I don't want to bug you too much, so if I wanted to read up on how these MBSs are valued, which keywords should I use to search in Google? Something I'm interested in is looking for examples of how MBS value is calculated, but because I lack the proper knowledge, the searches I use don't produce concrete examples. 2) In your example of the CMO, where the mortgages are divided up into tranches, I'm assuming that all tranches get paid from the combination of interest payments from all of the mortgages. What if, for example, all the prime mortgages stop paying, but all the subprime ones keep paying. Would the equity tranche of the CMO still be the first to take the hit? In other words, do the various tranches of a CMO equate to just different payout levels, ie. the lowest tranches will get back less money when payments decrease, regardless of which tier of mortgage those payments came from? Or are the payment streams for each tranche dictated by the pool of mortgages assigned to each tranche, so if the prime borrowers stop paying, then the highest quality tranche would take a hit in their payment before the lowest quality trache? Thanks again for the info!
There are many variations of these, but some generalizations: 1) The purpose of these structures is to pool all payments (not just interest) and then divide them among classes by a set of rules that vary by structure. The rules are called something like a cash flow waterfall. So a dedicated pool of mortgages per tranche would kind of defeat the purpose. But to make things confusing, there are deals with a group of mortages as collateral for several tranches and a separate group of mortgages for other tranches - like multiple CMOs combined into one deal with one name. 2) I think it is more common to have relatively homogenous mortgages used as collateral. So I don't think your example of prime mortages mixed with subprime is common, and having them assigned to separate tranches is less likely, and having the prime default faster is even more unlikely. Just out of curiousity, what is your interest? After learning about this stuff for a job I spent a little time trying to figure out how to make money on it as an individual and didn't come up with anything worthwile. There are/were some closed end funds and mortgage REITs you could use to get generic exposure with but I couldn't find anything meaty to analyze and trade. And you can/could buy individual MBS pieces or CMO pieces from a retail broker but the prices and selection sucked, and spreads were a mile wide so you couldn't really trade them. As far as I could tell the stuff I learned was impossible to apply outside an institution. Also, I found this book plus excel very helpful: http://www.flipkart.com/book/mortgage-backed-securities-workbok-andrew/1557389152
Thank you both, and thanks for the explanation black diamond and the link to the workbook! I think I will look into getting that. I'm basically just really curious about these things after hearing about them for the past couple of years because of the financial crisis, and realizing that I have no clue how they work, although I have a big-picture idea. I have zero ambition to start trading them, especially given the expertise level and how much money I think I'd need. I started reading "The Big Short" by Michael Lewis, and when it started getting into CDSs and touching upon how the one fund manager from San Jose was trying to negotiate deals with investment banks for CDSs, I realized I had no clue how any of this worked, and that got me pretty curious what the mechanism behind that was. I know what he was dealing with was CDOs as opposed to MBSs, but I figured I could get familiar with the basics. Not sure how useful this is, but I'm gambling it will make me a huge hit with the ladies at parties!