Jump to content

Mortgage-backed Bonds - how do they really work?

Recommended Posts

Mortgage-backed Bonds - how do they really work?

I want to get "into the guts" for a future article



It may seem a silly question - but having seen all the nonsense written about Derivatives exposure by people who really understand little or nothing, I thought it was time for a thread like this. I want to understand more, and maybe others do too.


The Treasury will be buying these things on behalf of the US taxpayer. Is it really possible to calculate what they are woirth? How would one do that?




Here's what Mike Stathis said about them on FS yesterday:


"This process assumes the Treasury would be able to properly value the debt – something that in many cases would be impossible to determine. And if the Treasury does not offer a price the banks feel is fair, they may decide not to sell much of this debt. This could force the Treasury to pay very high prices for these junk bonds, ensuring massive losses to taxpayers. Also consider that banks will sell off only their worst junk bonds – bonds that have the highest chance of losing it all.


I will guarantee you most if not all of the debt purchased by the Treasury will need to be marked down many times over. That means they will have to apply a huge discount to this junk yard of debt securities. And banks might not agree to such discounts. But there would be no bluffing game because the banks know the Treasury’s main purpose is to clean up their balance sheets to unlock the credit markets. In the end, the banks will get a good price for their junk at the expense of taxpayers."


(but Mike's own solution is not very practical IMHO):


"With about 10% of current homeowners mortgage value (of the $11.5 trillion outstanding) in default or in foreclosure, Washington could create an agency to service the loans and dump $1.4 trillion of taxpayer funds into it along with the $75 billion in Wall Street bonuses. This would be enough to pay off 100% of the outstanding loans with no further funds needed, unlike the current plan which is only the very beginning of what will amount to trillions of taxpayer dollars. Under this plan, taxpayers would receive a modest return. But the real benefit would be the stabilization of home prices which would benefit all homeowners"


/see: http://www.financialsense.com/fsu/editoria.../2008/1009.html

Share this post

Link to post
Share on other sites



According to The Bond Market Association, gross U.S. issuance of agency MBS was:


2005: USD 967 billion

2004: USD 1,019 billion

2003: USD 2,131 billion

2002: USD 1,444 billion

2001: USD 1,093 billion


The high liquidity (???) of most mortgage-backed securities means that any investor wishing to take a position need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread


/see: http://en.wikipedia.org/wiki/Mortgage-backed_security


Share this post

Link to post
Share on other sites

The problem with understanding credit derivatives is that, unless you work in the industry or are an economic expert then, its so difficult to get a basic grasp of what people are talking about and how they work without having a good grounding in the technical jargon that is used to explain them, especially for most lay people and amateur investors like myself.


The simplest and most effective explanation of the basic concepts of Mortgage Backed Securities (MBS) I have seen are in this 3 part collection of short Youtube videos by The Khan Academy. It defiantly helps to explain things by going over the mechanism that traditional mortgages work before starting to talk about the securitization process and I find it helps having a visual picture/model of the tranches to match the jargon to and how the process works.



Mortgage-Backed Securities I



Mortgage-Backed Securities II



Mortgage-Backed Securities III




Collateralized Debt Obligation (CDO)




Later in his series on the Bail Out (1-15) it explains how the toxic debts, affect individual banks and the entire banking system and shows what the bail out is intended to do and why it won't work.


More Khan Academy videos here






If the above videos are a bit to simplistic and people want a more indepth explanation , then Krassimir Petrov has a series of five hour long lectures on Credit Derivatives. I did watch these video lectures first but found them a little to technical for me to get a basic grounding in the subject, I understood it but couldn't put it into words as concisely as the Khan videos do.


Structured Finance, Lecture 1 - The Alphabet Soup of the Credit Crisis - 62 min



I feel explaining some of the Jargon as Krassimir does in the above video could be useful in writing an article, though perhaps it may be best to just explain the basic and most commonly used acronyms rather than all of them which could cause confusion.


Structured Finance, Lecture 2 - Credit Derivatives - Part 1 - 71 min



Structured Finance, Lecture 3 - Credit Derivatives, Part 2 - 71 min



Structured Finance, Lecture 4 - Credit Default Swaps - 69 min



Structured Finance, Lecture 5 - Securitization - 66 min



More Krassimir Petrov lectures here



I'm not quite sure if this was the sort of thing you were looking for in this thread DrBubb, these are just the best resources I have found that put the concepts across to me. It may be a little simplistic but I feel its good to start with the basic concepts before getting into a discussion about the complexities and implications of derivatives that can only be discussed effectively using technical jargon. It would be good if others could post articles, videos, podcasts, links to books or websites that they found explains the subject and this thread could become a valuable resource for MBS information.


I suppose it depends on who you are writing the article for, beginners? intermediate/amateur investors or as a more advanced article on the mechanisms and how they will affect investments? I don't think it would be possible to write an article that could effectively cover all three without confusing the beginners or dumbing it down for the professionals, perhaps it may be better to do a two or three part article.

Share this post

Link to post
Share on other sites



Structured Finance, Lecture 1 - The Alphabet Soup of the Credit Crisis


Introduces the alphabet soup (CDO, CMO, ABS, CLO, MBS, CDS, CBO, CPDO, LBO, MBO, CP, ABCP, etc.)

of structured finance and other instruments that contributed to the current Credit Crisis




"Wall Street takes debts and converts it into Treasure."

Junk sub-prime mortgages packaged, and packaged into securities with triple-A ratings


ABS : Asset-Backed Securities

CDO : Collateralised Debt Obligation


CMO : Collateralised Mortgage Obligations (package of mortgages) "mortgage bonds" - pass-through

CBO : Collateralised Bond Obligations (composed of bonds)

CLO : Collateralised Loan Obligation (composed of loans) -

- - - "not yet bust": car loans, student loans, credit card loans


CDS : Credit Default Swap : protection, in case a specific bond goes bad: buyer gets principle, seller gets bond


Pool for Securitisation :


Tranche : layers or levels of the pool. Seniority determines where flows are paid


THIS is what I was looking for - 27 minutes in...




Structured Finance, Lecture 5 - Securitization





I have the basic lingo now.

What I want to concentrate on are CMO's and how they might be unwound.

That will be difficult to achieve because each CMO is supported by payments from a pool.

But all the payments of a particular mortgage may not go into a single pool, it might get "sliced and diced"

into different levels and layers. So it will be very difficult to separate out of different pools, the flows

associated with a particular home.


What a mess!


I was hoping their would be potential to Brady-ise these bonds, and then use the bonds for swap

transactions. But how can you negotiate with thousands of individual homeowners !

Share this post

Link to post
Share on other sites

HOW THEY WERE meant to work...


In the mainstream press, “CDO” (Collateralized Debt Obligations) is often used to refer to Collateralized Mortgage Obligations. But there are important differences between these.


(a) The underlying pool of a CMO consists entirely of mortgage bonds — that is, Asset-Backed Securities (ABS) the underlying assets of which are mortgage loans (and perhaps long-term commercial leases). The acronym “MBS” is used (Mortgage-Backed Securities) for this subset of ABS.


In contrast, the underlying pool of a CDO (at least all I’ve ever laid eyes on) is diversified. E.g., most deals I drafted restricted MBS to 2 to 4% of the pool.


(B) The differences noted are important when one turns to the now-crucial notion of “market value.”


(i) CMOs — because their pools are homogenous and because their raison d’etre is truly public (to distribute the risks and rewards of mortgage lending to the wide world) — trade fairly efficiently (ahem: they used to trade …) in the secondary market.


That is: The mortgage loans underlying an MBS, and the MBS under a CMO, are packaged and rated in a roughly standardized way throughout the industry. They tend to be “cookie cutter” deals. One AA-rated Midprime MBS was not thought much different from the next.


(Note: They are NOT HOMOGENOUS, are they!

A CMO backed by mortgages in a "Stranded Suburbs" area will be worth less than one in a better connected area.)


MORE: http://newcombat.net/Conversation/credit-c...m-market-value/


- - -


Further, all the CDO deals I was close to (as primary drafter: on emails and phone calls with bank, rating agency, portfolio manager and perhaps investors) were entered into with little notion of secondary trading:


– The aim (again) was to solve a guy’s problem — not to extend the credit business of a particular industry to the four corners of the globe.


– And the third-party investors in the CDO tranches weren’t looking for liquid assets, but rather something like a CD. Something that would pay attractive interest for a fixed period of time and then expire.


(CDOs were almost always wound up within 2 to 4 years — much much sooner than their (20 to 30-year “stated maturities.”)


(iv) AND SO. Today, as investors and regulators worldwide demand to know the market value of their CDO tranches, the answer unfortunately is that they weren’t built to support the notion of market value, and never traded efficiently in the best of times.

They weren’t really bonds, one might say. They had the form of bonds, but the underlying economic reality was rather different.



Share this post

Link to post
Share on other sites

Given the case of the MiniBonds from Lehman Brothers are they worth anything? I would think there is no market for these structured products.

Share this post

Link to post
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now