Preface

It is not the critic who counts;…The credit belongs to the man who is actually in the arena,…who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.

Theodore Roosevelt

Welcome to the arena of structured finance. The purpose of this book is to hone the skills needed to successfully compete in the arena. Bond Lab and the Companion to Investing in MBS are the training tools, both of which are programmed in the R computing language. This analysis presented in this book is based on Bond Lab version 0.0.0.9000. Bond Lab is, to my knowledge, the first open source object-oriented software designed for the analysis of structured securities. Bond Lab allows the reader to replicate the analysis presented herein, as well as extend the analysis in any direction she chooses thereby creating a richer learning experience and greater understanding of the material.

Investing in Mortgage-Backed and Asset-Backed Securities, was written in the spirit of reproducible research and its underlying philosophy is simple: Mortgage-backed securities are not too complex to understand. In fact, the basic valuation techniques applicable to all fixed-income securities also form the foundation for the valuation of mortgage-backed securities (MBS) and asset-backed securities (ABS). The perceived complexity of investing in structured products, like MBS, can be attributed to four sources:

  1. The contingency of residential MBS cash flows, which manifest because the borrower holds the option to prepay and terminate her mortgage obligation early.
  2. Cash flow structuring techniques based on the allocation of principal and interest across real estate mortgage investment conduit (REMIC) structures.
  3. Credit structuring techniques that allocate losses through the capital structure of a transaction.
  4. Valuation techniques that “simulate” the economy—interest rate models.

Organization of the Book

The main goal of this book is to develop a basic framework for the analysis of mortgage- and asset-backed securities using open source software. The financial models presented throughout the book are developed using R [R Core Team 2013], a freely downloaded open source software development environment.

Many people think of R as a statistics package, however it is much more. The R environment is an “integrated suite of software facilities for data manipulation, calculation, and graphical display” [Smith and R Core Team 2013]. As such, R lends itself easily to the development of an integrated financial analysis tool.

Investing in structured products also requires managing large sets of data. Aside from market data, like swap rates and Treasury prices and yields, the structured product investor must also follow borrower transaction data. Examples include voluntary prepayment rates, payment of scheduled principal and interest, and borrower delinquency and default. More often than not the investor must monitor this information at the loan level. Loan level data are becoming more available, and there are a host of vendors that offer the aggregation and delivery of this kind of data. The loan level data that is needed by the investor to monitor collateral performance is also freely available via trustee and/or issuer websites. In this book, we will use MySQL®, also open source, as the data management solution.

Investing in MBS is divided into five parts. Part One, Valuation of Fixed-Income Securities, introduces the reader to the techniques used to value all fixed-income securities.

Part Two, Residential Mortgage-Backed Securities, introduces the reader to mortgage-backed securities.

Part Three, Valuation of Mortgage-Backed Securities, introduces the reader to the basic valuation techniques used to determine relative value in the mortgage-backed securities market.

Part Four, Structuring Mortgage-Backed Securities, introduces the reader to the structuring techniques used in the mortgage-backed securities market. MBS structuring relies on the division of principal and interest to create notes derived from MBS cash flows that are tailored to meet investors' unique risk/reward profiles. Further, the structuring techniques used by dealers alter both the timing and valuation of MBS cash flows. Option-adjusted spread analysis is used throughout the section to explore how the division of principal and interest alter mortgage cash flow valuations.

Part Five, Mortgage Credit Analysis, covers default modeling, self-insuring mortgage structures, and the basics of sizing mortgage credit enhancement. A self-insuring structure is one whose credit enhancement is internally created which may subject the investor to principal loss resulting from borrower defaults. Thus, it is imperative that the investor understands default modeling, loss simulation, and the allocation of losses across the transaction's capital structure.