MBS Overview Flashcards
What is a mortgage backed security
An asset backed security backed by a pool of mortgages
What is duration
Duration of a MBS refers to the price sensitivity as it relates to interest rates. The higher the duration, the more sensitive prices are to changes in interest rates. Positive durations are more common and mean that as interest rates go up, prices fall (ie. inverse relationship)
What is convexity
Convexity is the derivative of duration and refers to the whether the rate at which interest rate changes affect price is increasing or decreasing. As an example, MBS have an inverse convexity, meaning that as interest rates fall, prices rise at a decreasing rate. As interest rates rise, prices fall at an increasing rate
Why do MBS have a negative convexity
MBS have prepayment risk because in the US there aren’t penalties for prepayment. A homeowner can refinance or pay off their mortgage early, which would result in either lower value or fewer number of cash flows for investors depending on the type of prepayment. This means that as interest rates rise, the risk of prepayment increases, so the price of the security falls at a faster rate.
What is the S curve
The S curve refers to how moneyness impacts prepayment rates. Moneyness is the difference between the rates of loans and the current rates, and if that difference is high and the rates are higher, prepayment rates are also higher. The S curve is shaped as an S because there are other non interest rate factors influencing prepayment.
How does Freddie Mac make money
Freddie Mac charges a guarantee fee to investors of MBS for guaranteeing timely payment of principal and interest to the investor. This is backed by FM and not the full faith and credit of the US government, though there is an additional layer of an implicit guarantee there.
How does Freddie Mac provide liquidity to the US housing market
A homeowner buys a house and takes out a mortgage, and so a lender sells that mortgage to freddie mac, which is one source of liquidity. Freddie mac then pools these loans together and securitizes them, and sells them to investors including banks, the Fed, and lenders. The servicer then sends monthly P&I from the mortgage to MBS investors and charges a servicing fee. So the sources of liquidity here are the stream of cash flows the MBS provides the lenders after they receive the MBS, or the cash they get from selling this loan to freddie Mac. And so then they use this money to make out more loans to potential buyers.
What does high duration signify
High price sensitivity to interest rates
When can an MBS duration turn negative
When prepayment increases tremendously to the point where when interest rates fall, prices fall as well since everyone who would have prepaid have already prepaid. Also, I’m not sure if interest only MBS strips are a thing, but if they are I can imagine they could have negative duration
What variables would you look at if you were an underwriter
Low LTV, low DTI, and high FICO
Explain prepayment risk
The coupon payment investors receive are based on p&i of mortgage payments. So if people refinance or pay off their mortgage early, the coupon payments either are lowered or cut short.
Explain the current state of the housing market
High inflation ticking down, low unemployment ticking up, high mortgage rates ticking down, low housing supply and high housing demand driving home prices up, low sale volume, quantitative tightening, expectations of rate cuts in September
What is moneyness
Difference between rates of loans in an MBS pool and the current market rates. Positive moneyness drives prepayment
What is a G-fee
Lenders make out loans to homeowners based on our underwriting standards, and they send loans to Freddie. We package these into MBS, and we guarantee timely principal and interest payments to investors and charge a G-fee, which is how we make money so then investors receive these monthly payments and assume market, credit, and prepayment risk.
What is the difference between the TBA market and CMOs
TBA market facilitates forward trading of MBS (contract to buy or sell on a specific date). CMOs are comprised of tranches of different risk levels to create a structure of some custom duration and risk characteristics
What is amortization
Schedule of paying off debt in increments at a time
Option adjusted spread
Measures MBS yield vs risk free return
What does a higher OAS mean
Higher expected return for investors
Why freddie mac
- mission: volunteered at homeless shelter second year and just started volunteering at food pantry. I am very aware of the real world impacts of a recession, and providing liquidity to the housing market smooths the effects of the business cycle to lessen adverse outcomes. I want to work in fixed income in an analytics or modeling role where I can explore different roles, and I want to work for a company where I get almost an additional boost in drive because of the mission of the company, and I’ve been very motivated in my two summers here because of freddie Mac’s mission.
What happens to an MBS when a borrower defaults?
If a lender has sold the mortgage to Freddie Mac, then Freddie Mac will take control of the property, as the property itself is the collateral. The investor of the MBS still receives that guaranteed coupon payment that the principal and interest of the mortgage would have yielded.
How is pooling a tool used against prepayments?
Diversification; allows the pool to act in a statistically predictable manner, giving us an understanding of their prepayment rates as well as their path dependence, the trend that the prepayment rates experience (low to high vs high to low, etc)
How are REMICS used to deal with prepayments?
Mortgage pools are sliced and diced to produce tranches, which have either reduced or concentrated risk to better appeal to certain investors. Tranches are based on duration and prepayment risk characteristics
What is Vega
Price sensitivity to implied volatility
What is implied volatility
The market’s forecast of a likely movement in a security’s price
What does interest rate volatility do to mortgage spreads
It increases the spread
What did you do this summer
I studied loan acquisitions, so what I did was I looked at different loan subpopulations and how that characteristic affects net income of those loans after controlling for various credit risk characteristics. I presented my findings to my team and the director, which I learned a lot from because I had to present technical findings to a non technical audience
What did you do this summer
I studied loan acquisitions, so what I did was I looked at different loan subpopulations and how that characteristic affects net income of those loans after controlling for various credit risk characteristics. I presented my findings to my team and the director, which I learned a lot from because I had to present technical findings to a non technical audience.
How are you?
I’m doing great! I have a physics exam to take after this, and then I have several light workload weeks which I’m really looking forward to.
Tell me something not on your resume
I love climbing, I volunteer a lot, and I love exploring the Charlottesville food scene
What kind of techniques did you use in your analysis
Ordinary least squares and logistic regression, I checked for heteroskedasticity and tried to minimize omitted variables. We also looked into oversampling some subpopulations, I’m blanking on the name but I think it was renovation loans that were like 1% of the dataset.
What did you find in your model
There was some interesting jump in net income of the loans between two fico bands in the 600’s which was interesting, we were using exhibit 19. Also I found that when controlling for a bunch of credit risk metrics, certain loan subpopulations were still more prone to lower net income than others due to the belonging in that specific category, like something about being an HFA advantage loan meant there was less net income for that loan.
What is the difference between a pass through security and a CMO? Which one are sold in the TBA market
Pass-through securities provide investors with a pro-rata share of the cash flows from a pool of mortgage loans, while CMOs divide the cash flows into multiple tranches with different risk profiles. Pass throughs are sold in the TBA market
How does securitization help in the mortgage market?
Securitization allows lenders to offload mortgage loans from their balance sheets, freeing up capital for new lending and increasing liquidity in the mortgage market.
How do mortgage servicers play a role in mortgage-backed securities?
Mortgage servicers collect payments from borrowers and distribute them to investors in
mortgage-backed securities, ensuring a smooth cash flow for investors.
What is the
difference between a fixed-rate mortgage-backed security and an adjustable-rate mortgage-backed security?
Fixed-rate mortgage-backed securities have a fixed interest rate for the life of the security, while adjustable-rate securities have interest rates that can change over time.
What is the
difference between prime and subprime mortgage-backed securities?
Prime mortgage-backed securities are backed by high-quality loans, while subprime securities are backed by loans with higher credit risk.
Explain how mortgage pools are tranches
Agency MBSs are tranches based on duration and prepayment risk
Why credit risk does not matter to FM when we tranche mortgage pools
Tranches are slices of an overall pool. The total credit risk to FM is the same regardless of how the pool is sliced, so we can model credit risk if the overall pool since pooling lets us treat the pool as a statistical distribution rather than a probability. We have to cover the P&I of loans that default regardless of tranche and the total credit risk remains the same.
What are TBA forwards and how does the forwards market introduce counterparty credit risk
MBSs are sold on the TBA market such that a buyer is given a contract and is obliged to buy a MBS on a specific date. Counterparty credit risk comes into play when the counterparty defaults and the trade doesn’t settle.
Quantitative easing vs quantitative tightening
QE is where the Fed buys MBS to increase money supply, QT is where the fed lets securities mature to decrease money supply
How do fed rate cuts affect mortgage backed securities
It can guide mortgage rates to be lower and can improve new residential construction. Lower mortgage rates would also lead to higher MBS prices.
How do fed rate cuts affect mortgage rates
When the Fed makes it less expensive for banks to borrow through a lower federal funds rate, banks have less costs to pass on to their customers, so mortgage rates could go down a bit.
Explain the dollar roll and what market it operates under
The dollar roll is similar to the overnight repo market in that you are essentially using forward contracts as collateral for lending. This allows investors to either keep MBSs off their balance sheets but maintain economic exposure, or to obtain a short term loan at favorable rates using MBS as collateral
Why would you initiate a dollar roll and in what market.
In the TBA market.
You might initiate a dollar roll if you are bearish in MBS. You might sell an MBS and use the TBA market to buy a forward contract for a month later if you’re betting that the value will fall. Alternatively, you might initiate one to keep MBSs off their balance sheets but maintain economic exposure, or to obtain a short term loan at favorable rates using MBSs as collateral.
What is theta
Price sensitivity to time, typically a negative value since it represents time decay
What is delta of an MBS
price sensitivity to a $1 change in the underlying asset
What is gamma of an MBS
change in delta given a $1 change in the underlying security
What is Vega
Price sensitivity to a change in implied volatility.
What is implied volatility
Measure of market expectations of future stock price fluctuations
Explain Fed action from 2020-2024
2020- Fed cut rates to zero to stimulate the economy in Covid
2022- Fed raised rates to handle inflation
2024- Fed cut rates in September by X basis points
What did the Fed do in the open market (OMOs) for both treasuries and MBSs since 2020 and what does this mean for MBSs
The Fed began buying MBS to increase money supply in 2020. They then began to reduce holdings of MBS in 2022 and stopped purchasing T-bonds.
What are inflation, unemployment, mortgage rate, and federal funds rate & trends
fill in
Two types of prepayment
Refinancing and paying off the loan balance early
Factors affecting prepayment
Lower interest rates (positively affect prepayment), poor credit/low equity/rate indifference (predictors of people who will not prepay), low number of payments left (predictor of ppl who won’t prepay), and rate trends (weighing preference to wait for market bottom before refinancing vs locking in low rates)
Why do MBS prices and coupon payments have an inverse relationship?
Because when new MBSs are issued they may have a higher interest rate so preexisting MBS prices have to fall in order to compete.
Summarize CAPM (capital asset pricing model)
Anything that outperforms its benchmark is alpha, let’s say the benchmark is the total market, that means alpha is returns above market return and beta shows the volatility and how two assets correlate with each other. So all else being equal, if two assets have the same beta, but one has a significantly higher alpha, a buyer is going to go for the one with higher alpha bc that’s higher return.
What is the CAPM formula
Expected ROI = beta times market risk premium, and then plus the risk free rate
How to find alpha using using CAPM model
Alpha = portfolio return minus risk free rate minus beta times the risk premium
What do you say if you don’t know smth
I’m not sure what the answer is, but this is how I would think about it
Explain how to calculate duration
weighted average, function of coupon amount and the maturity
Weight = ratio of coupon to sum of all coupons
Duration = w1(discounted payment) + w2(discounted payment 2)…
Append vs concatenation
With the concat function, you have the flexibility to modify the original DataFrame using the “inplace” parameter, while the append function can’t modify the actual DataFrame, instead it creates a new one with the combined data.
Join vs merge in Python
Join: Joins two DataFrames based on their index.
Syntax: df1.join(df2)
Merge: The merge function is more versatile, allowing you to specify the columns on which you want to join the DataFrames. It applies inner join by default, but can be customized to use different join types like left, right, outer, inner, and cross.
Syntax: pd.merge(df1, df2, on=”column_names”)
Look at data by groups— what method do you use
Groupby
Numpy vs pandas
Numpy: arrays with same data type
Pandas: data frames that can have different data types
How to sort in python
Pandas, sort values method
How to drop a row/column in Python
Pandas, drop method and specify the column/row, and set axis to 1 if column and 0 if row
Append in Python
Add rows from dataframe to existing dataframe
What is numpy used for
Arrays
R method to select column A and then filter by rows with values greater than 100. Display as a two way table
Import and load dplyr package.
Newdf= df%>%select(ColumnA)%>%filter(varA > 100)%>% table()
Do you have questions for us?
I was looking into yen carry trade around August and was curious how the string of margin calls affected the TBA market
Do you have any questions for us (2)
I know Japan and China both are significant investors in agency MBSs, and I saw that neither cut rates in September, which threatensa spike in their respective currencies. How do you anticipate this affecting their demand for mortgage backed securities
What are things you considered in your model
Monotonic constraints
Heteroskedasticity
Normalcy
Under and over represented data
Impute variables
What are things you considered in your model
Heteroskedasticity
Normalcy
Under and over represented data
Impute variables
Initial model was overfitting and essentially forcing a fit so had to step back and think about multicollinearity and was able to solve both issues
Should have considered monotonic constraints, but it didn’t occur to me over the summer
