15 - DP models: structuring asset-backed securities

Summary

The structuring of collateralized mortgage obligations will give us an opportunity to apply the dynamic programming approach studied in Chapter 13.

Mortgages represent the largest single sector of the US debt market, surpassing even the federal government. In 2000, there were over $5 trillion in outstanding mortgages. Because of the enormous volume of mortgages and the importance of housing in the US economy, numerous mechanisms have been developed to facilitate the provision of credit to this sector. The predominant method by which this has been accomplished since 1970 is securitization, the bundling of individual mortgage loans into capital market instruments. In 2000, $2.3 trillion of mortgage-backed securities were outstanding, an amount comparable to the $2.1 trillion corporate bond market and $3.4 trillion market in federal government securities. A mortgage-backed security (MBS) is a bond backed by a pool of mortgage loans. Principal and interest payments received from the underlying loans are passed through to the bondholders. These securities contain at least one type of embedded option due to the right of the home buyer to prepay the mortgage loan before maturity. Mortgage payers may prepay for a variety of reasons. By far the most important factor is the level of interest rates. As interest rates fall, those who have fixed rate mortgages tend to repay their mortgages faster.