Mortgage-backed securities

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Mortgage-backed securities

Cash flow pattern

A mortgage-backed security can be seen as a special case of an amortizing bond.

Unlike a standard bond, that repays all of the outstanding amount owing to the purchaser at maturity, an amortizing bond pays back its principal over the bond's lifetime. A commonly used arrangement is for equal payments to be made at each payment date.

A mortgage-backed (or asset-backed) security differs from an amortizing bond in that the issuer can make extra payments to the bond-holder during the lifetime of the security.

The PSA prepayment model

[Characteristics of the model]

[Effects of an amortizing schedule]

The cash flows of an amortizing bond are completely different to those of a vanilla 'bullet' bond and this changes its risk characteristics accordingly.

One effect is that the bulk of an MBS's cash flows are made much earlier in its lifetime than those of a vanilla bond.

Embedded option - repayment will be faster when interest rates are lower

[Convexity of bond is >0, convexity of MBS is <0]