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Library of Congress Cataloging-in-Publication Data

The handbook of mortgage-backed securities / [edited] by Frank J. Fabozzi.—6th ed. p. cm.

Includes bibliographical references and index. ISBN 0-07-146074-8 (hardcover : alk. paper) 1. Mortgage-backed securities—United States. 2. Portfolio management—United States. I. Fabozzi, Frank J. HG4655.H36 2005 332.63'23—dc22



Preface xxi Contributors xxv



Chapter 1

An Overview of Mortgages and the Mortgage Market 3

Anand K. Bhattacharya, Frank J. Fabozzi, and William S. Berliner

Product Definition and Terms 4 Mortgage-Loan Mechanics 9 The Mortgage Industry 15 The Loan Underwriting Process 17 Generation of Mortgage Lending Rates 20 Risks Associated with Mortgages and MBS 27 The Evolving Roles of the GSEs 32

Chapter 2

MBS Investors 35

Steven Abrahams

The Sources of Competitive Advantage in Investing in MBS 35 Fannie Mae and Freddie Mac 39 Insurers 41

Total-Return Portfolios 42

Change in the Competitive Landscape 44

The Portfolio Meets the Market 44

Chapter 3

Mortgage Pass-Through Securities 45

Linda Lowell and Michael Corsi

Federally Sponsored Mortgage Pass-Through Programs 46 Pass-Through Cash Flows 52

Impact of Cash-Flow Variability on Yield and Average Life 58 Determinants of Prepayment Speeds 62 Gauging a Pool's Prepayment Risk 68 Anatomy of the Pass-Through Market 74

Chapter 4

Trading, Settlement, and Clearing Procedures for Agency MBS 81

Jeffrey D. Biby, Srinivas Modukuri, and Brian Hargrave

TBA Trading: Turning Pool-Specific Securities into Generic Securities 81

Settlement Procedures for Agency Pass-Throughs 82 BMA Good Delivery Guidelines 83 Variance 85

Trading and Settlement Procedures for Other

MBS Products 86 Clearing Procedures for MBS 86 Summary 87

Appendix: What Happens When an Investor Buys a Mortgage-Backed Security? 88 What if the Dealer Fails to Deliver 90

Chapter 5

Defining Nonagency MBS 93

Thomas Zimmerman

The Nonagency Market 93 Defining Characteristics 94 Credit 98

Distribution of Characteristics 101 Evolution of Loan and Borrower Characteristics 104 Credit and Prepayment Performance 106 Agency Expansion into Nonagency Zones 111 Summary 111

Chapter 6

Credit Enhancements for Nonagency MBS Products 113

Frank J. Fabozzi

External Credit Enhancements 113 Internal Credit Enhancements 116 Use of Interest-Rate Derivative Instruments 122

Chapter 7

Understanding the Prospectus and Prospectus Supplement 127

David M. Lukach, Yogesh Gupta, Thomas Knox, and John Gibson

Securities Act Registration Statements: The Disclosure Framework 128 Disclosures for Form S-3 Registered MBS Offerings 129 Typical Sections of a Prospectus and Prospectus Supplement 132 Conclusion 156

Chapter 8

Waterfall Cash-Flow Mechanics in European RMBS 157

Alexander Batchvarov, William Davies, and Altynay Davletova

General Forms of Waterfalls 157

Variations in European RMBS Waterfalls by Country 159 Combined or Split RMBS Waterfalls: Compare and Contrast 165 Summary 168



Exploring the MBS/ABS Continuum: The Growth and Tiering of the Alt-A Hybrid Sector 171

Satish Mansukhani

Exploring the MBS/ABS Continuum: Defining the Risk Space 172 The MBS/ABS Continuum in the Hybrid Sector 173

Prepayment and Credit Performance Follow Relative Placement along the Continuum 175 Deal Structures also Mirror Relative Placement along the Continuum 179 Sufficient Credit Enhancement to Withstand Multiples of Default Frequency

Experienced on Weaker Subprime Mortgages 180 The Value of Available Funds CAPS 183

Chapter 10

Alt-A Mortgages and MBS 187

Anand K. Bhattacharya, William S. Berliner, and Jonathan Lieber

Background 187

Loan-Level Characteristics 190

Factors Underlying Prepayment Behavior 192

Empirical Prepayment Performance 200

Recent Developments 204

Chapter 11

Fixed-Rate Alt-A MBS 207

Satish Mansukhani, Arjune Budhram, and Mu'taz Qubbaj

Fixed-Rate Alt-A Collateral 208 Alt-A Prepayments 222

Historical Drivers of Prepayments and Defaults 228 Credit Performance and Enhancement 234

Practical Portfolio Manager Opportunities and Considerations 252 Chapter 12

Hybrid Adjustable-Rate Mortgages (ARMs) 259

Anand K. Bhattacharya, Steve Banerjee, Ricardo Horowicz, and Wei Wang

Popularity and Issuance of Hybrid ARMs 260 Characteristics of Hybrid ARM Loans 261 Hybrid ARM Refinance Incentive 266 Comparing Hybrid ARM S-Curves 272 Comparing Hybrid ARM Seasoning Curves 275 Loan-Level Drivers of Hybrid ARMs 277 Interest-Only (IO) Hybrid ARMs 282 Jumbo Hybrid ARM Credit Performance 284 Conclusions 285

Chapter 13

Hybrids: Product, Performance, Investor Base, and Frameworks to Assess Relative Value 287

Satish Mansukhani, Adama Kah, and Mu'taz Qubbaj

Hybrid Origination and Issuance 288 Securitization of Hybrids 290 The Hybrid Borrower 291

Prepayment Profiles of Hybrids 295 Trading Conventions in the Hybrid Market 311 Investors in the Hybrid Secondary Markets 314

A Conceptual Framework for Relative-Value Assessments of Hybrids 316 Cap Valuations on Hybrids 319

Index Levels: Implied Forwards and Historical Peaks 319

Relative Value of Hybrids 320

Identifying Characteristics/Features of Hybrids 327

Chapter 14

Interest-Only ARMs 333

David Liu

Overview of IO ARMs 335 Credit Implications 347 Prepayment Experience 353 Conclusion 361

Chapter 15

Residential Asset-Backed Securities 363

John McElravey

Market Development 364 Characteristics of Subprime Borrowers 366 Prepayment Speeds 369 Relative-Value Consequences 372 Key Aspects of Credit Analysis 374 Structural Considerations 378 Conclusion 387

Chapter 16

Customized Mortgage-Backed Securities 389

Anand K. Bhattacharya and Paul Jacob

Historical Perspective 389

Major Categories of Customized MBS 391

Determinants of Market Payups 397

Evaluation of Customized Pools: Current-Yield Approach 400 Evaluation of Customized Pools: Option-Adjusted Spread Analysis 401 Measuring the Duration of a Customized Pool 407 Challenges and Issues in Customized MBS Valuation 410

Chapter 17

The Prepayment and Credit Characteristics of Reperforming FHA/VA Loans 413

Anand K. Bhattacharya, William S. Berliner, and Jonathan Lieber

The Process of Delinquency Curing 414

Prepayments 416

Credit Fundamentals: Overview 426

Chapter 18

Prepayment-Penalty Mortgage-Backed Securities 441

Anand K. Bhattacharya, William S. Berliner, and Jonathan Lieber

Legal Framework for Imposition of Prepayment Penalties 442

Prepayment-Penalty Loan Structures 443

The Dynamics of the Prepayment Penalty 448

Borrower and Lender Dynamics 449

Prepayment Behavior of Prepayment-Penalty Loans 452

The Impact of Prepayment Penalties on Security Performance and Duration 458

Conclusions 462



Stripped Mortgage-Backed Securities 465

Cyrus Mohebbi, Gary Li, and Todd White

Overview of the SMBS Market 466 Investment Characteristics 470 Summary 480

Chapter 20

PAC Bond Features and Performance 481

Linda Lowell and Michael Corsi

Collars 482 Effective Collars 484 PAC Collar Drift 485

How Likely Is Breaking the PAC Bands? 486 Pay Order and Average Life Stability 488 Average-Life Profile versus Option-Pricing Models 490

Wide Window versus Tight Window 491 Conclusion 493

Chapter 21

Z Bonds 495

Linda Lowell

The Basic Accrual Structure 495

How the Z Interacts with Other Bonds in the Structure 499 Accretion-Directed or VADM Bonds 503 Z Bonds in PAC Companion Structures 503 Performance of Z Bonds 504 Conclusion 506

Chapter 22

Companions with Schedules 507

Linda Lowell

Companion Basics 508 Companion TAC Bonds 512 Reverse TACs 514 Layered PAC Bonds 518 Scheduled Companions 522 Conclusion 522

Chapter 23

Inverse Floating-Rate CMOs 523

Cyrus Mohebbi and Raymond Yu

Structural Features 523 Investment Characteristics 526 Conclusion 530



Overview of Recent Prepayment Behavior and Advances in Its Modeling and Valuation 535

Michael Bykhovsky

Generic Model 536

Modeling Reliability and Accuracy 548

Overview of Valuation of the Prepayment Option 549 Prepayment Score 551 Conclusion 553

Chapter 25

Agency Prepayment Model: Modeling the Dynamics of Borrower Attributes 555

Dale Westhoff and V S. Srinivasan

Housing Turnover 557 Cash-Out Refinancing 563 Rate Refinancing 569

The GNMA Sector: Special Modeling Considerations 590 Putting It All Together: The Case of the 1992 FNMA 7.5% 596 The Value of Attribute-Sensitive Prepayment Models 598 Appendix: Mortgage-Rate Prediction 600

Chapter 26

Loan-Level Prepayment Models 603

Anand K. Bhattacharya and Steve Banerjee

Minimizing Loan Dispersion 604

The Full Picture 605

Loan-Level Modeling 614

Predictive Strength of Loan-Level Models 617

Appendix: Use of Survival Analysis in Loan-Level Modeling 619

Chapter 27

Analyzing Specified MBS Pools Using Agency Enhanced Data and Active-Passive Decomposition 623

Dan Szakallas, Alexander Levin, and Andrew Davidson

Prepayment Modeling Using Active-Passive Decomposition 624 Enhanced Agency Data and Prepayment Modeling 630 Valuation Consequence: A Payup 637

Chapter 28

Prepayment Models to Value Nonagency MBS 645

Dale Westhoff and V. S. Srinivasan

Innovative Features: A True Loan-Level Implementation 646 The Bear, Stearns Nonagency Prepayment Database 647 The Impact of the Agencies on Nonagency Prepayment Behavior 648 Defining the Subsectors within the Nonagency Market 649

Deconstructing Our Nonagency Prepayment Forecast 652

Defining the Baseline Nonagency Refinancing Profile 653

Understanding Borrower Self-Selection and Burnout 654

Modeling Borrower Refinancing Intensity 656

The Impact of Loan Size on Nonagency Refinancing Behavior 659

Credit Quality 666

Rate Premium 669

Secondary Refinancing Effects: Documentation, Loan Purpose,

Occupancy Status 671 The Yield Curve and Refinancing Transitions 674 The Value of Updated LTV Ratio Information 676 Housing Turnover Prepayments: Seasoning and Lock-In 677 Seasonality 680

Adverse Selection in Housing Turnover Prepayments 682 Involuntary Prepayments and Curtailments 682 Refinancing Efficiency: The Next Frontier 683 Modeling the Mortgage Rate Process 685 Model Testing 687 Conclusion 688

Appendix: Model Projected versus Actual Results for Representative Deals 689 Chapter 29

A Prepayment Model for Hybrid Mortgages 693

Dale Westhoff and V S. Srinivasan

Market Background 693 Modeling Hybrid Prepayments 703 Summary and Valuation Implications 716

Chapter 30

Modeling Nonprime Mortgage Prepayment, Delinquency, and Default 719

Glenn Schultz, Christopher Flanagan, and Christopher Muth

Modeling Framework 719 Model-Building Strategy 723 Adjustable-Rate Analysis 731 Fixed-Rate Analysis 735 Other Factors Influencing Prepayments 739 Collateral Credit Performance 744 Involuntary Prepayments 747 Loss Severity and Cumulative Losses 752 Summary 753



Valuation of Mortgage-Backed Securities 759

Frank J. Fabozzi, Scott F. Richard, and David S. Horowitz

Static Valuation 760 Dynamic Valuation Modeling 761 Illustrations 769 Summary 781

Chapter 32

Risk-Neutral Prepayment Modeling and Valuation with prOAS 783

Alexander Levin and Andrew Davidson

Prepayment Risk and OAS 784

Equivalent Risk-Neutral Prepay Model 786

Stochastic Property of Prepay Risk Factors 788

A prOAS Pricing Model with Refinancing and Turnover Risk 789

Determining Prices of Risk: Calibration to TBAs 791

Valuation of MBS Strips with prOAS 794

Modernized Greeks 796

Concluding Remarks 798

Chapter 33

An Option-Theoretic Approach to MBS Valuation 799

Andrew Kalotay, Deane Yang, and Frank J. Fabozzi

Traditional Approaches to MBS Valuation 800 An Option-Based Prepayment Model for Mortgages 801 Valuation of Mortgages 805 A Closer Look at Leapers and Laggards 813 Valuation of MBS 817

Chapter 34

Approaches for Measuring the Duration of Mortgage-Related Securities 823

Bennett W. Golub

What Do We Mean by the Term Duration? 825 Current Approaches to Measuring Mortgage Durations 832

Comparison of Alternative Duration Measures S51 Future Approaches to Mortgage Durations S52 Implications for Investors S55

Chapter 3S

Duration and Average-Life Drift of CMOs 8S7

David P. Jacob and Tim Lu

Review of Duration and Convexity for Treasuries S5S Evolution of Average Life for CMOs S59 Implications for Performance and Risk Management S61 Conclusion S67

Chapter 36

Managing Against the Lehman Brothers MBS Index: MBS Index Prices 869

Bruce D. Phelps

Overview S69

The Lehman MBS Index and Index Pricing SS3 Calculating the Index Price SS5 Conclusion S9S

Chapter 37

Managing Against the Lehman Brothers MBS Index: MBS Index Returns 901

Bruce D. Phelps

Overview 9Q1

Example: Comparing Return Calculations Using Index and

PSA Prices 91S Conclusion 92S

Chapter 38

Dollar Rolls 931

Frank J. Fabozzi and Steven V. Mann

Determination of the Financing Cost 932

Illustrations of Dollar Roll Agreements 933

Risks in a Dollar Roll From the Investor's Perspective 937

MBS Dollar-Roll Automation 93S

Chapter 39

Uncovering the Risk-Adjusted Carry in MBS 943

Steven Abrahams and Adam Rilander

Uncovering the Risk-Adjusted Carry in TBA 944 Start with Carry, and Hedge Duration 944 Move on to Hedging Convexity 945 Finish with Hedging Long-Term Volatility 946 The Art of Interpreting the Risk-Adjusted Carry 948 Summary 948

Chapter 40

Mortgage Credit Quantified 951

Thomas Zimmerman and Laurent Gauthier

Delinquencies and Defaults 952 Loss Severity and Losses 970 Summary 977

Chapter 41

Specified Pool Trades: Ranking the Alternatives 979

Laurie S. Goodman

Specified Pool Payups 979 Prepayment Protection: The Data 980 Credit Curing 983

Prepayment Protection: The Ranking 989 Extension Protection: The Data 990 Ranking Extension Protection 993 Nonagency Investor Pools 994 Conclusion 996

Chapter 42

Analysis of Cleanup Calls 997

Laurent Gauthier

Factors Driving the "Optimal" Call Decision 998

A Tricky Exercise 998

Nonagency Call Exercises 999

Call Decisions by Issuer 1000

Call Decision Timing 1001



A Three-Factor Approach for Hedging Mortgage-Backed Securities 1009

Kenneth B. Dunn, Frank J. Fabozzi, Michael M. Luo, and Roberto M. Sella

Yield-Curve Risk and Key Rate Duration 1009

How Interest Rates Change Over Time 1012

How to Implement Three-Factor Hedging 1013

Summary 1022

Chapter 44

Mortgage Options 1023

Joseph R. Prendergast

Mortgage Option Markets 1023 Mortgage Option Users 1024 Pricing Mortgage Options 1029 Mortgage Option Risk Characteristics 1032 Conclusion 1037

Appendix: Decomposing Mortgage Option Duration and Convexity 1037 Chapter 45

Mortgage Prepayment Derivatives 1041

Andrew Aymen Samawi

Prepayment Derivatives History and Products 1042 Prepayment Derivatives Hedging Applications 1045 Auction Announcements 1051 Conclusion 1052

Chapter 46

Hedging IOs and Mortgage Servicing 1053

William L. Smith, Jr. and Laurie S. Goodman

Growth—Mortgage Servicing Industry 1054 Difficulties in Hedging IOs and MSRs 1054 Hedge Instruments 1056 Hedge Correlations 1057 Measuring Hedge Effectiveness 1060

Empirical Hedge Results 1060 Hedging with TBAs 1062 Use of Options 1064 A Few Additional Comments 1065 Thoughts On Servicing Models 1067 Caveats 1067 Conclusion 1068

Chapter 47

Mark-to-Market Methodology, Mortgage Servicing Rights, and Hedging Effectiveness 1069

Bennett W. Golub and Sree Sudha Yemeni

Approach to Back Testing 1074 Extending the Analysis to Servicing 1087

Alternative Hedge Methodology ("Swap + Mortgage" Hedge) 1089 Conclusion 1095

Appendix A: Monthly Durations and Prepayment Speeds 1097 Appendix B: OAS, Spreads, and Yields Used in Computing

Daily Prices 1102 Appendix C: OASs and Key Rate Durations as of 7/31/03 1103

Chapter 48

Prepayment-Linked Notes 1105

Laurie S. Goodman

Themes and Variations 1105

Why Will Prepayment-Linked Notes Gain Popularity? 1107 Relative Value 1108 Conclusion 1116



Commercial Mortgage-Backed Securities 1119

Anthony B. Sanders

The CMBS Deal 1119

The Underlying Loan Portfolio 1125

The Role of the Servicer 1129

Loan Origination, the Lemons Market, and the Pricing of CMBS 1131 Summary 1132

Chapter 50

The Impact of Structuring on CMBS Bond Class Performance 1133

David P. Jacob, James M. Manzi, and Frank J. Fabozzi

Loan Cash Flow: The Raw Material for CMBS 1136

CMBS Structures 1141

The Impact of Maturity Dispersion 1145

The Impact of Coupon Dispersion 1146

The Impact of Prepayments 1147

The Impact of Defaults 1149

Sample Default Scenarios 1150

Effects of Servicer Modifications on CMBS 1151

Summary 1155

Chapter 51

Investment Characteristics of GNMA Project Loan Securities 1157

Arthur Q. Frank and Tim Lu

A Brief History of GNMA Multifamily Pools 1157 Major FHA Project Loan Insurance Programs 1158 Prepayment Behavior of GNMA Multifamily Pools 1163 Default Behavior of GNMA Multifamily Pools 1175 Cumulative Defaults by Production Year and the GNMA Project

Loan Default Curve 1176 Recent Breakdown of GNMA Multifamily Prepayments into Defaults, Refinancings with Penalties, and Refinancings without Penalties 1181

The Refinancing History of Health Care Loans Compared with Apartment Complexes 1181 On the Investment Characteristics of GNMA Multifamily Pools and REMICs 1185

Chapter 52

CMBS Collateral Performance: Measures and Valuations 1187

Philip O. Obazee and Duane C. Hewlett

Mortgage Loan Default Rates and Loss Severities 1187 Factors Influencing Default Rates and Loss Severity 1190 Age 1193

Default Rate, Loss Severity, and Valuation Issues 1193 Conclusion 1198

Chapter 53

Value and Sensitivity Analysis of CMBS IOs 1199

Philip O. Obazee and Duane C. Hewlett

Value Drivers of CMBS IOs 1200 CMBS IO Relative Value 1205 Conclusion 1208

Chapter 54

Cash-Flow CDOs for CMBS Investors 1209

Peter Leffler, John Malysa, Jennifer Story, and Susan S. Merrick

Capital Structure 1210 Reinvestment (or Revolving) Period 1213 Cash-Flow Diversion Tests 1214 Preferred-Share Caps and Reverse Turbos 1215 Interest-Rate Hedging 1215 Conclusion 1216

Index 1217


The sixth edition of The Handbook of Mortgage-Backed Securities is designed to provide not only the fundamentals of these securities and the investment characteristics that make them attractive to a broad range of investors but also extensive coverage on state-of-the-art strategies for capitalizing on the opportunities in this market. The book is intended for both individual investors and professional managers.

To be effective, a book of this nature should offer a broad perspective. The experience of a wide range of experts is more informative than that of a single expert, particularly because of the diversity of opinion on some issues. I have chosen some of the best-known practitioners to contribute to this book. Most have been actively involved in the evolution of the mortgage-backed securities market.

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