Online Finance – Mortgage Backed Securities (MBS) – Valuation of Mortgage Backed Securities (MBS)
Valuation of Mortgage Backed Securities
Valuation of Mortgage Backed Securities is a complex process with multiple layers. We start with a simple high level review of pricing and valuation of Mortgage Backed Securities and then delve deeper into individual factors.
The following is a high level outline of the methodology followed to value mortgage backed securities:
Determine the amortization schedules for the mortgages in the pool
We start with a sample pool comprising of 1 30-year fixed rate mortgage of par value 100,000 and contract rate 4.56%. The servicing fee is 0.5% (applied to outstanding par amounts) and a prepayment model that is 100% of PSA prepayment rates.
Determine the cash flows to the security holders
- For Mortgage Pass-Throughs this is based on a pro rata basis. That is given that there are 40 units issued, each unit will receive a 1/40th share of the cash flows of the underlying mortgage pool.
- For Collateralized Mortgage Obligations (CMOs) this is based on some prioritized based. We have assumed that there are two classes of CMOs. Class A of CMOs account for 60% of the original par value, where as class B CMOs account for the remaining 40%. Class A will receive all principal payments (scheduled and unscheduled) until their par value is completely paid off and then Class B will receive the principal payments. The interest payments will be based on their respective outstanding par values.
We have further assumed that there are 20 units issued of Class A and B respectively. Each unit will receive a prorata share of Class A/ B cash flows.
- For STRIPs cash flows will be paid as follows:
- We have assumed 0.25% of servicing fee is charged from IOs and 0.25% of servicing fee is charge from POs. If you are valuing servicing rights, this serves as the cash flow stream for servicing rights.
- For interest only securities, the investors will receive the interest payments of the underlying mortgages/ mortgage pass throughs net of the servicing fee specified above. The net interest % will apply to the outstanding balance of the underlying mortgages/ mortgage pass throughs as IOs do not have a par value.
- For principal only securities, the investors will receive both scheduled and unscheduled principal payments net of the servicing fee.
- We assume 20 units each of IO and PO securities have been issued which will receive a prorata share of the IO/PO cash flows.
Discount the cash flows
We have done this using a constant discount rate equal to the 30-year national monthly average mortgage yield for July 2010. Alternatively we have projected annual 30-year US Treasury Yields over the next 360 months, using a CIR interest rate model and have used this together with the spread between the Treasury yield curve and mortgage rates to determine the discount factors for each respective future period.
Price of the securities
The price of the MBS is the sum of the discounted cash flows over all future periods.