A complete guide to investing in and managing a portfolio of mortgage- and asset-backed securities Mortgage- and asset-backed securities are not as complex as they might seem. In fact, all of the information, financial models, and software needed to successfully invest in and manage a portfolio of these securities are available to the investment professional through open source software. Investing in Mortgage and Asset-Backed Securities + Website shows you how to achieve this goal. The book draws entirely on publicly available data and open source software to construct a complete analytic framework for investing in these securities. The analytic models used throughout the book either exist in the quantlib library, as an R package, or are programmed in R and incorporated into the analytic framework used. * Examines the valuation of fixed-income securities metrics, valuation framework, and return analysis * Covers residential mortgage-backed securities security cash flow, mortgage dollar roll, adjustable rate mortgages, and private label MBS * Discusses prepayment modeling and the valuation of mortgage credit * Presents mortgage-backed securities valuation techniques pass-through valuation and interest rate models Engaging and informative, this book skillfully shows you how to build, rather than buy, models and proprietary analytical platforms that will allow you to invest in mortgage- and asset-backed securities.
Foreword iii Acknowledgments v Introduction ix Preface xix Part I Valuation of Fixed Income Securities 1 Chapter 1 The Time Value of Money 3 1.1 Present Value 4 1.2 Future Value 5 1.3 Present Value of an Annuity 6 1.4 Future Value of an Annuity 7 1.5 Solving Financial Questions with Present and Future Value 8 1.6 Application to Fixed Income Securities 9 Chapter 2 Theories of the Term Structure of Interest Rates 11 2.1 The Rational or Pure Expectations Hypothesis 13 2.2 The Market Segmentation Theory 17 2.3 The Liquidity Preference Theory 17 2.4 Modeling the Term Structure of Interest Rates 19 2.5 Application of Spot and Forward Rates 21 Chapter 3 Fixed Income Metrics 27 3.1 Maturity 28 3.2 Yield to Maturity 28 3.3 Weighted Average Life 34 3.4 Duration 36 3.4.1 Macaulay Duration 37 3.4.2 Modified Duration 39 3.5 Convexity 42 3.6 Fisher-Weil Duration and Convexity 45 3.7 Effective Duration 51 3.8 Effective Convexity 53 3.9 Summing the Aforementioned Measures of Duration and Convexity 54 3.10 Key Rate Duration 55 Chapter 4 The Valuation of Fixed Income Securities 59 4.1 A Valuation Framework for Fixed Income Securities 60 4.2 Application of the Framework to Structured Securities 61 4.3 Twist and Shift: Characterizing Changes in the Level, Steepness, and Curvature of the Term Structure 63 4.4 Case Study: 4.00% 30-year MBS 65 4.5 Scenario Comparative Analysis 74 Chapter 5 Fixed Income Return Analysis 77 5.1 Return Strategies 78 5.2 The Components of Return 80 5.3 The Buy and Hold Strategy 80 5.4 Total and Absolute Returns 83 5.5 Deconstructing the Fixed Income Return Profile 84 5.6 Estimating Bond Returns with Price and Risk Measures 86 Part II Residential Mortgage Backed Securities 89 Chapter 6 Understanding Mortgage Lending and Loans 91 6.1 Classification of Real Estate 92 6.2 Residential Mortgage Loan Amortization 100 6.3 Deconstructing the Amortization Table 103 6.4 Mortgage Servicing 104 Chapter 7 Modeling Cash Flows 107 7.1 Prepayment Conventions 108 7.2 Modeling MBS Cash Flows 111 7.2.1 0% PPC Assumption - No Prepayment 112 Chapter 8 Mortgage Prepayment Analysis 117 8.1 Big Data - What is it? 118 8.2 The Statistical Learner 118 8.3 Survival Analysis 120 8.4 The Cox Proportional Hazards Model 125 8.5 Data Types 127 8.6 Case Study: FHLMC 30-yr Loan Level Prepayment Analysis 128 8.7 Survival Analysis - Modeling Loan Cohorts 139 Chapter 9 The Predictive Prepayment Model 145 9.1 Turnover 147 9.2 Loan Seasoning 147 9.3 Seasonality 149 9.4 Borrower Incentive to Refinance 150 9.5 Borrower Burnout 153 9.6 Application of the Prepayment Model 162 Part III Valuation of Mortgage Backed Securities 167 Chapter 10 Mortgage Dollar Roll 169 10.1 Evaluating the Dollar Roll 171 10.2 Risk Associated with the Dollar Roll 179 Chapter 11 Relative Value Analysis 183 11.1 Liquidity 184 11.2 Static Cash Flow Analysis 185 11.3 Return Analysis 189 Chapter 12 Option Adjusted Spread Analysis 197 12.1 Numerical Methods of Modern Financial Theory 199 12.2 Cox, Ingersoll, Ross Theory of the Term Structure 201 12.3 Calibrating the Model 206 12.4 Building the Option Adjusted Spread (OAS) Model 208 12.5 OAS Analysis as a Decision Making Tool 216 12.6 OAS Distribution Analysis 219 12.7 OAS Analysis Strengths and Limitations 225 Part IV Structuring Mortgage Backed Securities 227 Chapter 13 Introduction to REMICs 229 13.1 Background and Legal Structure 230 13.2 Two Tiered REMICs 234 13.3 REMIC Arbitrage 235 13.4 Bond Lab MBS Structuring Model 237 Chapter 14 Stripped Mortgage Backed Securities 239 14.1 Key Rate Duration Analysis 243 14.2 Option Adjusted Spread Analysis 245 14.3 The Information Content of the IO-PO Market 249 Chapter 15 Sequentially Structured REMIC 255 15.1 Key Rate Duration Analysis 259 15.2 Option Adjusted Spread Analysis 261 15.3 Weighted Average Life and Spot Spread Analysis 261 15.4 Static Cash Flow Analysis 266 Chapter 16 Planned Amortization Class (PAC) and Companion REMICs 269 16.1 The PAC Bond Sinking Fund Schedule 270 16.2 Key Rate Duration Analysis 277 16.3 Option Adjusted Spread Analysis 279 16.4 OAS Distribution Analysis 280 16.5 A Final Word Regarding PAC Bands 284 16.6 Static Cash Flow Analysis 285 Chapter 17 Sequential IO REMIC 287 17.1 Key Rate Duration Analysis 290 17.2 OAS Distribution Analysis 292 Chapter 18 PAC-Floater-Inverse Floater REMIC 295 18.1 Structuring the Floater and Inverse Floater 296 18.2 A Framework for Floating Rate Securities 301 18.3 Option Adjusted Spread Analysis 304 18.4 Key Rate Duration Analysis 304 Chapter 19 Accrual REMIC Z-bond 311 19.1 Key Rate Duration Analysis 317 19.2 Option Adjusted Spread Analysis 318 Part V Mortgage Credit Analysis 323 Chapter 20 Mortgage Default Modeling 325 20.1 Case Study FHLMC 30-year Default Analysis 327 20.2 Other Variables Influencing Borrower Default 335 20.3 Spread at Origination (SATO) and Default 340 20.4 Default Model Selection 340 Chapter 21 The Predictive Default Model 345 21.1 Constant Default Rate 347 21.2 Borrower Original Loan to Value Default Multiplier 348 21.3 Updated Loan to Value Default Multiplier 349 21.4 Spread at Origination (SATO) Default Multipliers 351 21.5 Completing the Prepayment Model 353 Chapter 22 The Basics of Private Label MBS 357 22.3 Y Structure 359 22.4 Shifting Interest 362 22.5 Deep Mortgage Insurance MI 363 22.6 Excess Interest 365 22.7 Overcollateralization 366 22.8 Structural Credit Protection 366 22.9 Hedging Asset/Liability Mismatches 369 Chapter 23 Sizing Mortgage Credit Enhancement 373 23.1 Simulating Borrower Default Rates 375 23.2 Estimation of Cumulative Default Rates 375 23.3 Translating Credit Enhancement to a Third Party Guarantee Fee 378 23.4 Role of the Credit Rating Agencies (NRSROs) 379 Chapter 24 Index 383
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