Session 15 • Mortgage & Securitization (MBS)
Pass-throughs, prepayments, agency vs non-agency, pipeline, who the big players are, 2008 lessons, what’s hot now, and why MBS differ from Treasuries.
0) MBS 101 — fast, plain-English
- Mortgage-Backed Security (MBS) = a bond made from many home loans.
- Pass-throughs: monthly homeowner payments (interest + principal) flow to investors.
- Why bundle? Diversify across many borrowers; standardize; trade as a single security.
- Main flavors: Agency (Ginnie/Fannie/Freddie) vs Non-Agency (private label).
Key idea: In MBS, you don’t just get coupons—you also get principal back early when people refinance or sell. That early payback is “prepayment.”
1) Who are the players?
| Role | Who |
|---|---|
| Borrower | Homeowner (pays monthly P&I, taxes/insurance via escrow) |
| Originator | Banks & non-bank lenders (Rocket, UWM, etc.) |
| Aggregator/Issuer | Large banks, GSEs (Fannie/Freddie), Ginnie program issuers |
| Guarantor | Ginnie Mae (explicit gov’t), Fannie/Freddie (GSE guarantee) |
| Servicer | Collects payments, manages escrow, handles delinquencies; MSR = servicing right |
| Investor | Banks, insurers, asset managers, hedge funds, and increasingly PE-backed funds |
How big/important?
- Mortgages are one of the largest fixed-income markets in the U.S.
- MBS spreads and prepayment behavior matter for rates, bank balance sheets, and Fed policy transmission.
- Housing is a core macro channel—mortgage costs drive affordability and refi waves.
2) How a loan becomes a bond (pipeline explorer)
Risk hand-offs: underwriting → pooling/standardizing → (often) guarantee → investors take rate/prepayment risk; servicer handles cash-flows.
3) Agency vs. Non-Agency (quick compare)
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Ratings 101 — (agency vs non‑agency)
Agency pass‑throughs: Often treated as top‑tier because of the guarantee (Ginnie explicit; Fannie/Freddie GSE). When rated, the rating reflects the guarantee, not borrower credit.
Non‑agency/private‑label: Structured deals with a loss waterfall. Bonds are sliced into tranches: seniors first in line for cash, last to take losses; juniors/equity take losses first.
Who rates? NRSROs such as S&P, Moody’s, and Fitch based on pool data, enhancement, and legal docs.
Non‑agency/private‑label: Structured deals with a loss waterfall. Bonds are sliced into tranches: seniors first in line for cash, last to take losses; juniors/equity take losses first.
Who rates? NRSROs such as S&P, Moody’s, and Fitch based on pool data, enhancement, and legal docs.
| Piece | Typical rating | First-loss? | Protected by… |
|---|---|---|---|
| Senior | AAA/AA | No | Subordination, reserves, excess spread, OC |
| Mezzanine | A/BBB | After equity & junior | Some subordination & excess spread |
| Junior/Sub | BB/B | Before mezz/senior | Thin protection; higher yield |
| Equity/Residual | Unrated | Yes, first | Takes first losses; gets any leftover cash |
Credit enhancement = subordination, excess spread, over‑collateralization (OC), and reserve accounts. Together they defend senior bonds if defaults rise.
Cheat sheet:
- Agency = strong guarantee of timely principal & interest (credit losses shifted).
- Non-Agency = investor carries credit risk (uses structures like tranches/credit support).
- Both face prepayment and interest-rate dynamics.
4) Prepayment & “convexity” — no math
SlowAverageFast
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Intuition:
- Rates fall → refis up → principal returns early (you lose future higher coupons).
- Rates rise → refis dry up → you’re stuck earning a below-market rate longer (extension risk).
- This twisty response is the “convexity” story.
Visual: Rates vs Prepayments (use the slider above)
Prepayment “packets” moving to you
Rates ↓ → refis ↑ → dots move faster
Rates ↑ → refis ↓ → dots move slower
Tip: this adds a short, temporary burst of extra dots (simulating a refinance wave). They auto-clear after ~4 seconds.
How to use this mini-viz:
- Move the slider (Slow / Average / Fast). Dots loop along the curved path between Mortgage Pool and You (Investor) to show the pace of principal coming back.
- Click Describe impact for a plain-English summary at the chosen pace.
- Press Refi wave (burst) to simulate a sudden drop in rates — you’ll see extra dots rush toward you for a few seconds.
- The looping path is just a visualization shortcut to show continuous flow — in reality, payments move one-way from borrowers to investors.
Rule of thumb: More dots faster = contraction risk (you lose future high coupons); fewer dots slower = extension risk (stuck with below-market coupons longer).
What does “Refi wave (burst)” mean? When mortgage rates drop enough below borrowers’ current coupons, many refinance at once. That creates a temporary surge in principal coming back to investors — the extra dots simulate that surge.
Why do the extra dots clear quickly here? It’s a teaching simplification. Real refinance waves play out over weeks to months, not seconds. We auto-clear after ~4 s so the screen doesn’t overload. It also hints at burnout: after a wave, fewer borrowers remain with a strong incentive to refinance, so prepayment speeds cool naturally.
Reality check — does this happen in markets? Yes. Speeds depend on the rate incentive (current rate vs borrower’s rate), lender capacity/underwriting, seasonality, and loan “seasoning.” Empirically, speeds follow an S-curve: small incentive → small changes; bigger incentive → refis jump; very large incentive → the wave fades as the eligible pool shrinks (“burnout”).
5) TBA market — how most agency MBS trade
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Why it exists: Standardization + liquidity. Exact loans get delivered later as long as they meet the agreed specs.
6) MBS vs Treasuries — what’s different?
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7) 2008: what went wrong (short & sober)
Core issues (then):
- Lax underwriting (e.g., “no-doc/NINJA” loans) + speculative lending.
- Private-label structures that didn’t absorb losses as modeled.
- Rating failures and risk underestimated by many participants.
- Short-funding complex products → runs when confidence cracked.
Plain English — What went wrong in 2008:
- Easy lending: lots of risky mortgages (little income/asset proof) were made during the housing boom.
- Pooled & rated too kindly: many private‑label bonds were modeled as very safe; risks were underestimated.
- House prices fell: refinancing stopped, defaults rose, and expected cash‑flows didn’t show up.
- Short‑term funding risk: firms relied on overnight/short‑term borrowing; when confidence cracked, lenders pulled back (margin calls, runs).
- Feedback loop: forced selling pushed prices down further, spreading losses to banks/investors that held “safe” tranches.
What changed after:
- Stricter underwriting & ability-to-repay rules (plain W-2 + docs).
- GSE reforms; capital/liquidity changes for banks; more oversight.
- Agency MBS stayed the standard core; private-label came back smaller & more specialized.
8) Today’s watchlist (what people monitor)
Pick one or more…
Important: The MBS market today is dominated by agency paper. Private-label & other ABS sectors (like subprime auto) are separate securitization markets with their own cycles.
9) What happens to your mortgage?
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MSR (Mortgage Servicing Right): the right to service your loan is often bought/sold. Your loan terms don’t change if the servicer changes; the payment address and app may.
10) Homework — Debate (no math)
Debate Are MBS “toxic assets”?
- Claim: Under normal underwriting with agency guarantees, MBS are mainstream fixed‑income.
- But they can turn “toxic” when: lax underwriting, mis‑rated private‑label tranches, short‑term funding dependence, and sharp home‑price declines collide.
Discuss Key questions (answer briefly)
- Key factors: underwriting quality, leverage/funding, prepayment & house‑price dynamics, ratings/credit enhancement, liquidity.
- Are you worried today? Explain why or why not in 2–3 sentences, referencing at least one factor above.
- What could trigger a 2008‑style episode via MBS? Sketch a plausible chain (e.g., underwriting loosens + price shock + funding stress), and note what post‑2008 safeguards might fail.
Watch Mortgage‑Backed Securities in 1 Minute
Watch (longer) What are Mortgage-Backed Securities? How the 2008 Financial Crisis Happened
Mini‑task on ratings: In 2–3 sentences, describe how the loss waterfall works and which tranche takes losses first vs last. Name one credit enhancement that helps protect senior bonds.
How to submit: 2–3 paragraphs, plain English, one near-term and one longer-run point, plus a concluding policy suggestion. Cite one source if you use a fact.
Ready to check your understanding?
15 quick questions • no math • takes just a few minutes.
After you watch: In 2–3 sentences, describe (i) what an MBS is, and (ii) one lesson regulators/investors say they learned after 2008.