Mortgage Backed Securities

Section: Mortgage-Backed Securities Estimated study time: 60 minutes Content: Mortgage-backed securities (MBS) are fixed income instruments whose cash flows are derived from pools of mortgage loans. At CFA Level 2, the primary focus is on agency MBS (backed by Fannie Mae, Freddie Mac, or Ginnie Mae), non-agency residential MBS (RMBS), and commercial MBS (CMBS). The defining analytical challenge of MBS is prepayment risk — the right of mortgage borrowers to repay their loans early. Prepayments return principal to investors earlier than scheduled, which is harmful when interest rates have fallen (because investors must reinvest at lower rates) and beneficial when rates have risen (because investors get principal back at par in a declining-price environment). This optionality is the fundamental difference between MBS and bullet bonds. The prepayment process is measured using two conventions. The Single Monthly Mortality (SMM) rate is the monthly prepayment rate as a fraction of the outstanding balance: SMM = prepayments in month / (beginning balance - scheduled principal). The Conditional Prepayment Rate (CPR) is the annualized equivalent: CPR = 1 - (1 - SMM)^12. The Public Securities Association (PSA) benchmark assumes prepayments ramp up from 0% in month 1 to 6% CPR over 30 months, then remain at 6% CPR. A pool prepaying at 150% PSA is prepaying at 1.5 times the PSA standard model (more aggressive); at 50% PSA, it is prepaying half as fast (slower). PSA provides a common language for comparing prepayment behavior across MBS pools. The pricing of MBS requires accounting for the embedded prepayment option. Because borrowers hold a refinancing option, MBS cannot be priced using standard discount bond formulas — the cash flows are uncertain. The option-adjusted spread (OAS)…