A mortgage-backed security (MBS) is a bond backed by an undivided interest in a pool of mortgages. MBSs traditionally enjoy high returns, wide ranges of products, high credit quality, and liquidity [432]. The mortgage market has witnessed tremendous innovations in product design [54]. The complexity of the products and the prepayment option mandate the deployment of advanced models and software techniques. In fact, the mortgage market probably could not have operated efficiently without them [659]. Although our focus will be mainly on residential mortgages, the underlying principles are applicable to other types of assets as well.

Introduction

A mortgage is a loan secured by the collateral of real estate property. The lender – the mortgagee – can foreclose the loan by seizing the property if the borrower – the mortgagor – defaults, that is, fails to make the contractual payments. An MBS is issued with pools of mortgage loans as the collateral. The cash flows of the mortgages making up the pool naturally reflect upon those of the MBS. There are three basic types of MBSs: mortgage pass-through security (MPTS), collateralized mortgage obligation (CMO), and stripped mortgage-backed security (SMBS).

The mortgage sector is by far the largest in the debt market (see Fig. 28.1). The mortgage market conceptually is divided between a primary market, also called the origination market, and a secondary market in which mortgages trade.The secondary market includes the market for loans that are not securitized, called whole loans, and the market for MBSs.