Mortgage

Backed
Valuation

Harvey Stein
Outline
Customary
market size 1 Customary market size comments
comments

Mortgage 2 Mortgage market structure

market structure

Prepayment 3 Prepayment modeling

modeling

Yield and OAS 4 Yield and OAS

The Legality of
Prepayment
5 The Legality of Prepayment Modeling
Modeling

Data and
6 Data and calibration
calibration

Interest rate
7 Interest rate models
models
8 Index projection
Index projection

Monte Carlo 9 Monte Carlo analysis

analysis

Greeks 10 Greeks
Validation
11 Validation
Robust
parallelization
12 Robust parallelization
Summary
13 Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Size of mortgage market
Customary
market size
comments

Mortgage
market structure
• The Case for U.S. Mortgage-Backed Securities for Global
Prepayment
modeling
Investors, Michael Wands, CFA, Head of U.S. Fixed Income,
Yield and OAS
Global Fixed Income, State Street Global Advisors:
The Legality of • Lehman U.S. Aggregate Index - 2002
Prepayment
Modeling
• MBS — 35%
• U.S. Credit — 27%
Data and
calibration • U.S. Treasury — 22%
Interest rate • U.S. Agency — 12%
models • ABS — 2%
Index projection • CMBS — 2%
Monte Carlo
analysis
• The U.S. Mortgage Market, Fannie Mae, and Freddie Mac — An
Greeks IMF Study:
Validation • March 2003 — $3.2 trillion in mortgage-backed issuance by
Robust Fannie and Freddie.
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Outstanding debt
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Size over time
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS issuance
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
CMO issuance
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling
Mortgage market structure:
Yield and OAS • Mortgages
The Legality of
Prepayment • MBS pools
Modeling

Data and • CMOs

calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
The subatomic particles -
Customary
market size
comments
mortgages
Mortgage
market structure

Prepayment
People take out loans (mortgages) to buy homes.
modeling
• Fixed rate mortgages — fixed coupon, monthly payments, self
Yield and OAS

The Legality of
amortizing, paying principal down to zero at maturity (15-30
Prepayment
Modeling
years).
Data and • Balloons – amortize on a 30 year basis, but expire in 5 or 7 years
calibration
with payment of the remaining outstanding balance.
Interest rate
models
• Adjustable rate mortgages (ARMS) — floating coupon based on
Index projection
an index (LIBOR, treasury rates, . . . ), typically with protection
Monte Carlo
analysis clauses against overly large coupon changes (lifetime and
Greeks periodic caps, annual resets, . . . ).
Validation
Low interest rates in recent years have sparked innovation — floating
Robust
parallelization rate balloons with interest only payments, various sorts of built in
Summary protections, option ARMs, . . .

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 Mortgage
Backed
Valuation

Harvey Stein
Mortgage behavior
Customary
market size
comments

Mortgage
market structure

Prepayment While it looks like ARM valuation might require some work, in that
modeling

Yield and OAS

they have embedded caps and ratchets and potentially float on a
The Legality of
CMS rate, one might think that at least fixed rate mortgages would
Prepayment
Modeling
be easily valued.
Data and With fixed monthly payments, monthly interest payments at a rate of
calibration
C on the outstanding balance, N monthly payments and an initial
Interest rate
models balance of B, then monthly payments are:
Index projection

Monte Carlo C (1 + C )N B
analysis .
Greeks
(1 + C )N − 1
Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Mortgage cash flows
Customary
market size Graphically, our cash flows look like:
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

so why not just discount and be done?

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 Mortgage
Backed
Valuation

Harvey Stein
The painful intervention of reality
Customary
market size
comments

Mortgage
market structure
The problem with discounting the scheduled payments is that
Prepayment
modeling • People move,
Yield and OAS
• refinance,
The Legality of
Prepayment
Modeling • default,
Data and
calibration
• make excess payments to pay off principal faster.
Interest rate
models
So, principal arrives randomly, or perhaps not at all (in default of
Index projection
uninsured loans).
Monte Carlo
Payments above the scheduled payments pay down the principal and
analysis
are known as prepayment.
Greeks
One of the major components of mortgage analysis is in modeling
Validation
prepayment behavior.
Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Impact of prepayment on cash
Customary
market size
comments
flows
Mortgage Thus, our simple mortgage, instead of having fixed cash flows, has
market structure
cash flows that are dependent on prepayment rates. Under one
Prepayment
modeling prepayment assumption, we have:
Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Impact of prepayment on cash
Customary
market size
comments
flows
Mortgage Under a model that projects prepayments based on interest rates and
market structure
loan characteristics, we see a different cash flow structure for each
Prepayment
modeling rate path. One example is:
Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
The atoms — MBS Pools
Customary
market size
comments

Mortgage
market structure In 1938, the collapse of the national housing market led to the federal
Prepayment
modeling
government’s formation of the Federal National Mortgage
Yield and OAS
Association, AKA “Fannie Mae”. Now, we have Fannie Mae, Freddie
The Legality of
Mac (The Federal Home Loan Mortgage Corporation), and Ginnie
Prepayment
Modeling
Mae The Government National Mortgage Association.
Data and
calibration
• Banks make mortgages.
Interest rate • Government insures conforming mortgages.
models

Index projection • Agencies buy conforming mortgages.

Monte Carlo
analysis
• Banks have money to make more mortgages.
Greeks • Agencies sell shares of mortgages on secondary market.
Validation

Robust
Ginnie, Fannie and Freddie — three sets of rules for conforming loans.
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS secondary market - pools
Customary
market size The agencies (Fannie, Freddie and Ginnie) buy mortgages, pool them
comments
together into MBS pools and sell shares. Pools are pass-through
Mortgage
market structure securities, in that the cash flows from the underlying collateral is
Prepayment
modeling
passed through to the shareholder, minus a service fee.
Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics -
Customary
market size
comments
Geographic data
Mortgage These days, there’s substantial information available about pool
market structure

Prepayment
composition, such as geographic data:
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics -
Customary
market size
comments
Loan purpose
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics -
Customary
market size
comments
Loan to value ratio and credit
Mortgage
market structure
ratings
Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics -
Customary
market size
comments
loan rate distribution
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
LTV distribution
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
Loan size distribution
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
Maturity distribution
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
Age distribution
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
Credit rating distribution
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
Servicers
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS pool fine characteristics
Customary
market size
comments
Sellers
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS secondary market - TBAs
Customary
market size
comments Pools are also sold before being created, trading as TBAs:
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Pool analysis
Customary
market size
comments

Mortgage
market structure
Pool analysis is like mortgage analysis, except that it benefits from
Prepayment
safety in numbers.
modeling

Yield and OAS

• Backed by a substantial number of individual loans, so variance is
The Legality of reduced.
Prepayment
Modeling
While it used to be the case that this was at the cost of only knowing
Data and
calibration gross aggregate data about the pool, these days the fine structure of
Interest rate the pool is often disclosed as well, telling us:
models

Index projection
• Location of individual loans,
Monte Carlo • Size of individual loans,
analysis

Greeks • LTV,
Validation
• and credit ratings.
Robust
parallelization The only thing missing is individual borrower details.
Summary

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 Mortgage
Backed
Valuation

Harvey Stein
The molecules — CMOs
Customary
market size
comments

Mortgage
market structure
In 1983, Solomon Brothers and First Boston created the first
Prepayment
Collateralized Mortgage Obligation (CMO).
modeling They realized that more pools could be sold if the pool cash flows
Yield and OAS
were carved up to stratify risk.
The Legality of
Prepayment CMOs are:
Modeling

Data and
• Backed by pools or directly by mortgages (whole loans),
calibration
sometimes by as many as 20,000 of them.
Interest rate
models • Split up cash flows of underlying collateral into a number of
Index projection “bonds” or “tranches”.
Monte Carlo
analysis • By creating desirable risk structures, tranches can be sold to a
Greeks wider audience, and at a profit.
Validation
CMOs are essentially arbitrary structured notes backed by mortgage
Robust
parallelization collateral.
Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Tranche types
Customary
market size
comments
Tranches vary by how the principal and interest are carved up.
Mortgage • Interest handling:
market structure
• Fixed cpn — Can behave like a pool or very differently,
Prepayment
modeling depending on how principal is paid.
Yield and OAS • POs — Only principal payments from underlying collateral.
The Legality of • IOs — Only interest payments.
Prepayment
Modeling • Floaters — Where there’s a floater, there’s an inverse floater
Data and (when you have fixed rate collateral).
calibration
• Inverse floaters.
Interest rate
models • Principal handling:
Index projection
• Sequential Pay — Sequence of tranches. First gets principal until
Monte Carlo
analysis paid, then 2nd gets principal, etc. Last one is most prepayment
Greeks protected and behaves most like an ordinary bond.
Validation • PACs — Scheduled principal will be payed as long as prepayment
Robust remains in a specified band.
parallelization
• TACs — Scheduled principal will be payed when prepayment is at
Summary
a specified level.
• Etc.

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 Mortgage
Backed
Valuation

Harvey Stein
Example CMO
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Example CMO tranche
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Example CMO collateral
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
CMO modeling
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment Computing the cash flows of a CMO tranche requires modeling the
Modeling

Data and
CMO, i.e. — converting the prospectus into a mathematical
calibration specification of the tranche payouts as a function of collateral cash
Interest rate
models
flows.
Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
CMO cash flow engine
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling
The cash flow engine computes CMO cash flows for each scenario.
Yield and OAS
Inputs:
The Legality of
Prepayment
Modeling
• CMO deal specification.
Data and • Index projections.
calibration

Interest rate • Current outstanding balance of each piece of collateral.

models

Index projection
Given the above inputs, the cash flow engine parses and evaluates the
Monte Carlo deal specification, using the cash flows generated from running the
analysis
prepayment model on each piece of collateral and amortizing it.
Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment modeling
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Prepayment speeds
Customary
market size
comments

Mortgage
market structure Prepayment speeds are to prepayment modeling what yield
Prepayment
modeling
calculations are to interest rate modeling.
Yield and OAS • SMM — Percentage of remaining balance above scheduled paid:
The Legality of Pi′ −Pi
Prepayment 100 Bi .
Modeling

• CPR — SMM annualized: 100(1 − (1 − SMM 12

Data and
calibration
100 ) ).
Interest rate
• PSA — “Prepayment Speed Assumption”: 0.2% initially,
models
increasing by 0.2% each month for the first 30 months, and 6.0%
Index projection
until the loan pays off. 200 PSA is double this rate, etc.
Monte Carlo
analysis
• MHP — PSA for manufactured housing (ABS, not MBS).
Greeks

Validation Looking at the value of a pool or CMO as a function of prepayment

Robust level is a useful analysis tool.
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Prepayment speed graph
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Prepayment modeling
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

Prepayment modeling is a major component of MBS and CMO
The Legality of valuation. In some sense, CMO and MBS valuation is Monte Carlo
Prepayment
Modeling analysis of the prepayment model.
Data and In prepayment modeling:
calibration

Interest rate
• Salient features of prepayment are proposed.
models
• Evidence is collected statistically.
Index projection

Monte Carlo • Models are developed for these relationships.

analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Major prepayment components
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling
• Housing turnover.
Data and • Refinancing.
calibration

Interest rate • Curtailment and Default.

models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Housing turnover
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling • Appears as relatively constant baseline level of prepayment =
Yield and OAS total (existing) home sales divided by total housing stock.
The Legality of
Prepayment • Seasonality — Less movement in the winter.
Modeling

Data and
• Seasoning — Chances of moving increase with age of mortgage,
calibration
but tend to level off. A function of WAM, loan type, and
Interest rate
models prepayment incentive.
Index projection • Lock-in effect — High rates relative to mortgage coupon are a
Monte Carlo
analysis
disincentive to moving when LTV is high.
Greeks • Rarely over 10% CPR.
Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Housing turnover illustration
Customary
market size Housing turnover behavior typically dominates prepayment when rates
comments
are low.
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Refinancing
Customary
market size Refinancing is the major interest rate dependent component.
comments
• “S-curve” — Zero when rates are above the mortgage coupon,
Mortgage
market structure picks up as rates drop and tops out at some maximum level (not
Prepayment
modeling
everyone can refinance).
Yield and OAS
• Aging — New loans less likely to be refinanced due to refi costs,
The Legality of but mitigated by high refi incentive.
Prepayment
Modeling • Credit quality — Lower credit quality less likely to refi. Can use
Data and level of cpn above mortgage rates at issuance in lieu of FICO
calibration
score.
Interest rate
models • Burnout — As borrowers refinance out of a pool, the remaining
Index projection borrowers are less likely to refinance (unaware or unable).
Monte Carlo
analysis
• Media effect — Prepayments tend to surge around multi-year
Greeks lows, presumably induced by press coverage encouraging
Validation refinancing.
Robust • Pipeline effect — Prepayment rate spikes are asymmetric.
parallelization

Summary
Prepayment drops slower than it grew. Due to mortgage broker
capacity limits causing refi applications to back up.
• Lagged effects.
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 Mortgage
Backed
Valuation

Harvey Stein
Refinancing S-curve
Customary
market size Sample refi S-curves for normal credit and poor credit:
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Curtailment and Default
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling
Default results in return of outstanding principal when property is
Yield and OAS
sold.
The Legality of
Curtailment is the reduction in maturity due to additional partial
Prepayment
Modeling
payment of principal. Without reamortization, results in additional
Data and principal pay downs on a monthly basis. Can also be from paying off
calibration
remainder of an old mortgage.
Interest rate
models
• Tend to be independent of interest rates.
Index projection

Monte Carlo
• Default risk grows and then drops as LTV decreases.
analysis

Greeks
• Curtailment picks up towards end of mortgage life.
Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Curtailment and Default graph
Customary
market size These considerations lead to the following typical curtailment and
comments
default graph.
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Loan level characteristics
Customary
market size
comments

Mortgage
market structure

Prepayment Increased disclosure allows improved prepayment modeling.

modeling
Primary loan attributes:
Yield and OAS

The Legality of
• LTV
Prepayment
Modeling • FICO score
Data and
calibration • loan size
Interest rate
models
Secondary loan attributes:
Index projection • occupancy
Monte Carlo
analysis • property type
Greeks • loan purpose
Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Yield calculations
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

49 / 119
 Mortgage
Backed
Valuation

Harvey Stein
Yield calculations
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling Internal rate of return at a given price assuming a particular
Yield and OAS
prepayment rate.
The Legality of
Prepayment • Pick a prepayment speed.
Modeling

Data and • Generate cash flows.

calibration

Interest rate
• Solve for internal rate of return that gives quoted price.
models

Index projection
Conceptually simple, but computationally intensive and involved when
Monte Carlo
trying to value a CMO backed by 20,000 pools, with cash flows
analysis carved up across 100 tranches.
Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Yield example — PSA
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

51 / 119
 Mortgage
Backed
Valuation

Harvey Stein
Yield example — BPM
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

52 / 119
 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
OAS Analysis
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

53 / 119
 Mortgage
Backed
Valuation

Harvey Stein
From Yield to OAS
Customary
market size
Consider a semi-annual bond with cash flows Ci at times ti (with
comments
principal payment included in CN ) and (dirty) price P. When the
Mortgage
market structure bond is not callable, OAS is basically Z-spread, which is basically a
Prepayment spread over a set of bonds which is basically a difference in yields.
modeling

Yield and OAS

The Legality of N
Prepayment
X Ci
Modeling P ≈ Yield
Data and 1
(1 + Y2 )2ti
calibration
N
Interest rate X Ci
models P ≈ R+S 2ti
Spread
Index projection
1
(1 + 2 )
Monte Carlo
N
analysis X Ci
Greeks P ≈ Yi +S 2ti
Z-Spread
Validation 1
(1 + 2 )
Robust N
parallelization
X Ci
P ≈ Yi +S 2ti
OAS
Summary
1
(1 + 2 )

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 Mortgage
Backed
Valuation

Harvey Stein
Optionality in OAS
Customary
market size When the bond has embedded optionality, OAS attempts to value the
comments
optionality. Doing this requires some assumptions regarding the
Mortgage
market structure evolution of interest rates:
Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
MBS and CMO OAS
Customary
market size
Compute average value under a large set of realistic scenarios. The
comments
OAS is the shift in the discount rates needed to arrive at a specified
Mortgage
market structure price.
Prepayment Because of the complexity and path dependency of the prepayment
modeling
model and the CMO tranche calculations, OAS analysis is done via
Yield and OAS

The Legality of
Monte Carlo.
Prepayment
Modeling • Calibrate interest rate model.
Data and
calibration
• Generate interest rate scenarios — discount rates, longer tenor
Interest rate rates, par rates.
models

Index projection
• Generate indices — current coupons, district 11 cost of funds,
Monte Carlo
and whatever else is needed.
analysis
• For each scenario:
Greeks

Validation
• Compute prepayments for each piece of collateral.
Robust
• Amortize each piece of collateral.
parallelization • Compute tranche cash flows.
Summary • Discount cash flows at specified OAS to generate scenario price.
• Average of scenario prices is the price at the specified OAS.
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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
The Legality of Prepayment Modeling
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Prepayment as determining a
Customary
market size
comments
contingent claim
Mortgage How can it be OK to introduce historical analysis (prepayment
market structure

Prepayment
modeling) into a risk neutral valuation (OAS calculation)?
modeling
• Consider a population holding European options with a common
Yield and OAS
(unknown) strike and varying maturity dates.
The Legality of
Prepayment • Consider an historical study of the payoff of these options when
Modeling
exercised.
Data and
calibration • The historical analysis would yield a discrete, random sampling of
Interest rate
models
max(S − K , 0), where K is the common strike.
Index projection
• Historical analysis of the payoff would yield a good
Monte Carlo characterization of the actual payoff function.
analysis
• Using the historically estimated payoff function in option pricing
Greeks
would be perfectly correct. No risk neutral adjustment need be
Validation

Robust
applied.
parallelization
To the extent that prepayment is truly a contingent claim on interest
Summary
rates (i.e. — that prepayment behavior is a function of interest
rates), then there is no logical inconsistency in deducing it via
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historical analysis and using it directly in OAS analysis.
 Mortgage
Backed
Valuation

Harvey Stein
Problems with prepayment
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of Problems with the above analysis:

Prepayment
Modeling
• Errors in deducing historical behavior.
Data and
calibration • Aggregation of behavior.
Interest rate
models • Behavior independent of rates — hedgeable?
Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Data and calibration
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Data importance
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling Data:
Yield and OAS
• Most critical component of interest rate modeling.
The Legality of
Prepayment
Modeling • Simple model calibrated to good data is far better than a
Data and sophisticated model calibrated to the wrong data.
calibration

Interest rate
• Data must have good pricing and capture risks of securities being
models
valued.
Index projection

Monte Carlo
• Characterizing risk in terms of related liquid instruments will help
analysis
to answer the question of which interest rate model to use.
Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Discounting component
Customary
market size Traditionally, the treasury curve. Thought to be closest in risk to
comments
agency default risk (i.e. negligible), but:
Mortgage
market structure • Heterogeneous — coupon bonds, some liquid and some illiquid.
Prepayment
modeling • Sparse data — large gaps between maturities leaves interim
Yield and OAS pricing unknown (subject to interpolation method).
The Legality of
Prepayment
• Market price of conditional cash flows (i.e. option prices =
Modeling Volatility data) unavailable.
Data and
calibration Newer market standard — calibrate to the swap curve.
Interest rate • Denser data — monthly at short end, annually further out. Less
models

Index projection
subject to interpretation.
Monte Carlo • Homogeneous — cash rates and par rates, not bond prices at
analysis
varying coupons. Mostly on a clean, nominal basis.
Greeks

Validation
• Rich volatility data — ATM and OTM caps and floors are well
Robust known. ATM swaptions of various tenors and maturities are well
parallelization
known. Only OTM swaption pricing is subject to discussion.
Summary
• Hedging — swap market often used to hedge MBSs. Calibrating
to it makes calculating appropriate hedges easier.
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 Mortgage
Backed
Valuation

Harvey Stein
Volatility calibration
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling What to calibrate to?
Yield and OAS
• Calibrate to full volatility cube? Too expensive to hedge.
The Legality of
Prepayment • Calibrate to one volatility? Which one?
Modeling

Data and Compromise 1: Two year and ten year swaptions are commonly used
calibration

Interest rate
for hedging, so calibrate to them.
models Compromise 2: Rather than calibrating to the entire smile, calibrate
Index projection to the ATMs and pick a model which does a reasonable job of
Monte Carlo
analysis
capturing the overall smile. This is also good because OTM swaption
Greeks data is hard to come by.
Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Interest rate models
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Popular short rate models
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Log normal short rate models have been popular for many years in the
Modeling fixed income markets.
Data and
calibration • Simple and intuitive.
Interest rate
models • A priori, rates shouldn’t go negative.
Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
A log normal short rate model
Customary
market size
comments
(LNMR)
Mortgage
market structure

Prepayment
modeling One example is the first model we used for mortgage valuation. The
Yield and OAS short rate process is rt , where:
The Legality of
Prepayment
Modeling

Data and rt = e Rt +θt

calibration

Interest rate dRt = −aRt dt + σdWt ,

models

Index projection

Monte Carlo
analysis with a and σ constants, θt is a function of time and chosen to
Greeks
calibrate the model to the discount curve. Under this model Rt is a
Validation
Gaussian process mean reverting to zero, and rt is log normal and
Robust
parallelization mean reverting as well.
Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Drawbacks of 1 factor LNMR
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS • Model skew is flat in log normal terms, which is not what’s
The Legality of observed in the market today.
Prepayment
Modeling • Correlated rates.
Data and
calibration • Calibration rigidity — can calibrate to the yield curve and two
Interest rate
models
option prices. Mean reversion is known to be hard to calibrate.
Index projection
However, greater flexibility can be introduced with time
Monte Carlo dependent volatility (Black-Derman-Toy).
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
US skews 1 year out
Customary
market size It always pays to look at the data. Here are cap and swaption implied
comments
volatilities from the US market. The skew is substantial across
Mortgage
market structure maturities.
Prepayment
modeling

Yield and OAS

45
The Legality of
Prepayment 40
Modeling
35
Data and
calibration 30 1y2y
Interest rate 25 1y5y
models 1y10y
20
Index projection 1y caplet (CFIR)
15 1y caplet (ICPL)
Monte Carlo
analysis 10
Greeks
5
Validation
0
Robust -5 -4 -3 -2 -1 0 1 2 3 4
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
US skews 5 years out
Customary
market size The five year tenors are skewed as well.
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS 45

The Legality of 40
Prepayment
Modeling 35
Data and
30 5y2y
calibration
25 5y5y
Interest rate
5y10y
models
20 5y caplet (CFIR)
Index projection
15 5y caplet (ICPL)
Monte Carlo
analysis 10

Greeks 5

Validation 0
-5 -4 -3 -2 -1 0 1 2 3 4
Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
How normal is it?
Customary
market size
Fitting the CEV model (dr = σr β dW ) to caplet skews shows that the
comments
US market is fairly close to normal (β close to zero).
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment 1.2
Modeling
1
Data and
calibration 0.8 USD
0.6 EUR
Interest rate
models 0.4 JPY

Index projection 0.2

Monte Carlo 0
analysis 0 5 10 15 20 25 30 35
Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
How normal is it?
Customary
market size
Fitting errors for the CEV model to the US market aren’t too large, so
comments
above betas are reasonable.
Mortgage
market structure

Prepayment
modeling

Yield and OAS

14%
The Legality of
Prepayment 12%
Modeling 10%
USD
Data and 8%
EUR
calibration 6%
JPY
Interest rate 4%
models
2%
Index projection 0%
Monte Carlo 0 2 4 6 8 10 12
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
LGM
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling The Linear Gaussian Markovian models (AKA Hull-White models) are
Yield and OAS a family of extremely tractable models. The two factor form is:
The Legality of
Prepayment
Modeling rt = θt + Xt + Yt
Data and
calibration dXt = −aX Xt dt + σX (t)dW1
Interest rate
models
dYt = −aY Yt dt + σY (t)dW2
Index projection dW1 dW2 = ρdt
Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
LGM advantages
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling
• Fits overall historical behavior well with fixed mean reversion and
Yield and OAS

The Legality of
correlation (ax = 0.03, ay = 0.5, ρ = −0.7).
Prepayment
Modeling • Can be calibrated to two term structures of volatility.
Data and
calibration
• Very tractable — Don’t underestimate the value of closed form
Interest rate solutions (or decent approximations) for bond prices, caplet
models
prices,and swaption prices and swap rates as a function of
Index projection
(Xt , Yt ).
Monte Carlo
analysis
• Much closer to market skew than log normal models.
Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
LGM behavior
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

• High mean reversion factor dampens long term effect of that
The Legality of
Prepayment parameter, leaving long tenor volatility mostly determined by low
Modeling
mean reversion factor.
Data and
calibration • Both factors impact short tenor volatility.
Interest rate
models • Negative correlation reduces volatility of short maturities relative
Index projection to long maturities and allows this behavior to persist in time.
Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Market volatility term structure
Customary
market size
comments 24
1−year
Mortgage 2−year
market structure 3−year
23
4−year
Prepayment 5−year
modeling 7−year
22 10−year
Yield and OAS Black Swaption Vols (%)

The Legality of 21
Prepayment
Modeling
20
Data and
calibration

Interest rate 19
models

Index projection 18

Monte Carlo
analysis 17

Greeks
16
Validation 0 20 40 60 80 100 120
Swaption expiries (months)
Robust
parallelization

Summary Swaption term structure — implied volatilities as a function of

maturity for various tenors.
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 Mortgage
Backed
Valuation

Harvey Stein
LGM volatility term structure
Customary
market size
comments 24
1−year
Mortgage 2−year
market structure 23 3−year
4−year
Prepayment 5−year
modeling 22 7−year
10−year
Yield and OAS
21
Black Swaption Vols (%)

The Legality of
Prepayment
Modeling 20

Data and
calibration 19

Interest rate
models 18

Index projection
17
Monte Carlo
analysis
16
Greeks
15
Validation 0 20 40 60 80 100 120
Swaption expiries (months)
Robust
parallelization

Summary LGM model’s swaption term structure — implied volatilities produced

by the model, as a function of maturity for various tenors.
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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Index projection
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

77 / 119
 Mortgage
Backed
Valuation

Harvey Stein
Index projection problem
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of • Prepayment model needs appropriate inputs (such as monthly

Prepayment
Modeling mortgage refi rates).
Data and
calibration • Floater indices (such as D11COFI) need to modeled.
Interest rate
models
• Neither need be discount rates, and hence, can’t be read directly
Index projection
from model.
Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Index projection solutions
Customary
market size
comments

Mortgage
market structure • Not a problem for discount rates (LIBOR, swap rates, etc).
Prepayment
modeling
Compute from model:
Yield and OAS
• For one factor log normal — build lattice and compute future
The Legality of
implied long tenor rates for each month as a function of the short
Prepayment
Modeling
rate.
• For 2 factor LGM — rates are given by formulas.
Data and
calibration
• Avoid problem — calibrate prepayment model directly to
Interest rate
models discount rates (LIBOR, swap rates, etc).
Index projection
• Simplify — to first order can ignore volatility of index relative to
Monte Carlo
analysis discount rates. How different can refi rates be on two different
Greeks dates that have the same swap curve? Regress and model as a
Validation function of the rates. Or get fancy and take vol into account as
Robust
parallelization
well.
Summary

79 / 119
 Mortgage
Backed
Valuation

Harvey Stein
Chosen solution
Customary
market size
comments We chose simple:
Mortgage
market structure • Treat implied rates as a function of swap rates.
Prepayment
modeling • Regress — proxy the current coupon for each collateral type as a
Yield and OAS weighted average of the 2 year and 10 year rates.
The Legality of
Prepayment
• Adjust for current actual value of current coupons.
Modeling
• Adjust in prepayment model for fact that a proxy for the refi rate
Data and
calibration is being used.
Interest rate
models • Potentially use lagged data (e.g. - D11COFI in ARM Wrestling:
Index projection Valuing Adjustable Rate Mortgages Indexed to the Eleventh
Monte Carlo
analysis
District Cost of Funds, by Stanton and Wallace: If Di is the
Greeks
index in month i, and Ti is the 6 month treasury rate, then the
Validation model sets
Robust
parallelization
Di = 0.889 ∗ Di−1 + 0.112 ∗ Ti + 5.6bp.
Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Monte Carlo analysis
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

81 / 119
 Mortgage
Backed
Valuation

Harvey Stein
The need for speed
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS With 20,000 pieces of collateral, interpreted rules for paying out cash
The Legality of
Prepayment
flows and time consuming prepayment projection calculations, running
Modeling
the 100,000 scenarios necessary for accurate valuation will take some
Data and
calibration time. If a scenario takes 0.0001 seconds on one piece of collateral,
Interest rate then we’ll have to wait 2.3 days. 100 scenarios would take 3.3
models
minutes.
Index projection

Monte Carlo
So, it pays to reduce the number of scenarios needed.
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
1 factor pseudo Monte Carlo
Customary
market size
comments

Mortgage
market structure
In the one factor case, the method we developed is the bifurcation
Prepayment
modeling tree approach.
Yield and OAS
• Begin with two paths starting at the current short rate.
The Legality of
Prepayment
Modeling
• Evolve them to match the moments of the model relative to the
Data and last common point.
calibration

Interest rate
• Periodically allow the paths to split:
models

Index projection
p
Monte Carlo
Ru = E[Rt |Rb = R] + Var[Rt |Rb = R]
analysis d
p
R = E[Rt |Rb = R] − Var[Rt |Rb = R]
Greeks

Validation

Robust
parallelization

Summary

83 / 119
 Mortgage
Backed
Valuation

Harvey Stein
1 factor LNMR
Customary
market size
comments

Mortgage
market structure

Prepayment
E[Rt |Rb = R] and Var[Rt |Rb = R] can be computed from the SDE
modeling
for Rt by using e at as an integrating factor, yielding:
Yield and OAS

The Legality of
Z t
Prepayment
Modeling Rt = e a(b−t) Rb + σe a(s−t) dWs ,
b
Data and
calibration
so
Interest rate
models E[Rt |Rb ] = Rb e −a(t−b) ,
Index projection

Monte Carlo
and
analysis σ2
Var[Rt |Rb ] = (1 − e −2a(t−b) ).
Greeks
2a
Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
1 factor pseudo Monte Carlo
Customary
market size
comments
The end result, with 5 selected bifurcation maturities, is the following
Mortgage
market structure tree:
Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Bifurcation tree behavior
Customary
market size
comments

Mortgage
market structure

Prepayment Advantages:
modeling

Yield and OAS

• Reasonably straight forward.
The Legality of • Conditional mean and variance of underlying R process is
Prepayment
Modeling matched at bifurcation points.
Data and
calibration • Results look reasonable with fairly small numbers of paths.
Interest rate
models
Disadvantages:
Index projection • Variability is coarse (semiannual steps).
Monte Carlo
analysis • Unclear that overall variance is captured.
Greeks
• Doesn’t extend well to the multi-factor case.
Validation

Robust
parallelization

Summary

86 / 119
 Mortgage
Backed
Valuation

Harvey Stein
LGM — VR1 — Numeraire
Customary
market size
comments
considerations
Mortgage
market structure

Prepayment
modeling
We’ve investigated a variety of variance reduction techniques for the 2
Yield and OAS

The Legality of
factor LGM model.
Prepayment
Modeling
The first is to recognize that the choice of numeraire has a major
Data and
impact on Monte Carlo efficiency.
calibration Consider valuation of a price process V under two different
Interest rate
models
numeraires N and N ′ , and corresponding equivalent martingale
Index projection measures Q and Q ′ .
Monte Carlo
analysis Vt ′ Vt

Greeks
V0 = N0 E Q [ ] = N0′ E Q [ ′ ]
Nt Nt
Validation

Robust
parallelization

Summary

87 / 119
 Mortgage
Backed
Valuation

Harvey Stein
LGM — VR1 — Numeraire
Customary
market size
comments
considerations
Mortgage
market structure

Prepayment
modeling
The relationship between N, N ′ , Q and Q ′ is that
Yield and OAS

The Legality of
Prepayment
Nt /N0 dQ
Modeling = ,
Nt /N0
′ ′ dQ ′
Data and
calibration

Interest rate where dQ/dQ ′ is the Radon-Nikodym derivative of Q with respect to

models
Q ′.
Index projection
So, a numeraire that’s higher on high rates will have an equivalent
Monte Carlo
analysis martingale measure that’s correspondingly higher as well, and thus
Greeks the Monte Carlo associated with the higher numeraire will sample
Validation
more heavily from this region.
Robust
parallelization

Summary

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Valuation

Harvey Stein
LGM — VR1 — Numeraire
Customary
market size
comments
considerations
Mortgage
market structure

Prepayment
MBS gross behavior:
modeling
• High rates — Low prepayment — MBS behavior becomes more
Yield and OAS

The Legality of
stable.
Prepayment
Modeling • Low rates — High prepayment — MBS behavior more
Data and interesting.
calibration

Interest rate Numeraire selection — Choose numeraire that’s low for high rates
models
and high for low rates:
Index projection

Monte Carlo
• Integrated form of LGM is very convenient — simplifies formulas.
analysis
But, numeraire is low for low rate paths, causing poor Monte
Greeks
Carlo behavior.
Validation

Robust
• Standard money market numeraire is much better. Harder to
parallelization
work with, but does better importance sampling.
Summary

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 Mortgage
Backed
Valuation

Harvey Stein
LGM — VR2 — path shifting
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling
Adjust paths so that sample at least captures yield curve.
Yield and OAS

The Legality of • Similar to doing control variate on the discount rates.

Prepayment
Modeling • rt = θt + Xt + Yt , and Xt and Yt are Gaussian and symmetric
Data and
calibration
around zero, so just compute a new θ to get discounting correct
Interest rate for chosen path set.
models

Index projection
VR1 + VR2 yields pricing standard deviation of about 1bp for 2,000
Monte Carlo
paths, or ≤ 1 bp error ≈ 30% of the time, and ≤ 2 bp error ≈ 66% of
analysis
the time.
Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
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Valuation

Harvey Stein
LGM — VR3 — PCA
Customary
market size
comments
• Randomly sample paths P = (Xt1 , . . . Xtn , Yt1 , . . . Ytn )
Mortgage
market structure • Xti and Yti are jointly distributed as a 2n dimensional Gaussian
Prepayment
modeling
with zero mean.
Yield and OAS • Let C be the covariance matrix of these 2n random variables.
The Legality of
Prepayment • If Z = (z1 , ..., z2n )t , and the zi are IID N(0, 1), and C = AAt ,
Modeling
then AZ has the same distribution as P.
Data and
calibration • Choose A to be the matrix whose columns are the eigenvectors
Interest rate
models of C , scaled by the square roots of their eigenvalues. Then
Index projection C = AAt .
Monte Carlo
analysis
• The best k factor approximation to P is given by using the first
Greeks k columns of A.
Validation • Small number of vectors capture most of variance.
Robust
parallelization • In 1 factor LGM — 7 vectors out of 360 for 95% of variance.
Summary
• In 2 factor LGM — 9 vectors out of 720 for 95% of variance.

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Valuation

Harvey Stein
PCA impact - Low mr factor
Customary
market size
comments
The eigenvectors can be inspected by graphing the values for each
Mortgage
factor separately. The first eigenvector for the low mean reversion
market structure factor captures the overall volatility. Subsequent eigenvalues capture
Prepayment
modeling
higher and higher frequency changes.
Yield and OAS
The first 5 eigenvectors (first factor)
The Legality of 0.1
Prepayment eigenvector 1
eigenvector 2
Modeling eigenvector 3
eigenvector 4
Data and eigenvector 5
calibration
0.05
Interest rate
models

Index projection
0
Monte Carlo
analysis

Greeks
-0.05
Validation

Robust
parallelization

Summary -0.1
60 120 180 240 300 360
Time (month)

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Valuation

Harvey Stein
PCA impact - High mr factor
Customary
market size
comments

Mortgage The high mean reversion factor’s eigenvectors are harder to interpret
market structure

Prepayment The first 5 eigenvectors (second factor)

modeling 0.04
eigenvector 1
Yield and OAS eigenvector 2
eigenvector 3
0.03 eigenvector 4
The Legality of eigenvector 5
Prepayment
Modeling 0.02

Data and 0.01

calibration

Interest rate 0
models

Index projection -0.01

Monte Carlo
-0.02
analysis

Greeks -0.03

Validation
-0.04
60 120 180 240 300 360
Robust
Time (month)
parallelization

Summary

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Backed
Valuation

Harvey Stein
LGM — VR4 — Weighted PCA
Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of • Most of action in pool is up front, both because of prepayment

Prepayment
Modeling and because of discounting.
Data and
calibration
• Weight PCA with e −αt to effect this.
Interest rate • Weight two factors differently as well (High MR factor doesn’t
models

Index projection
have as big an impact on MBS pricing as low MR factor).
Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Weighted PCA impact - Low mr
Customary
market size
comments
factor
Mortgage
market structure
As is expected, the impact of weighting is to capture more up front
Prepayment volatility at the cost of long term volatility:
modeling

Yield and OAS The first 5 eigenvectors (first factor)

0.15
The Legality of eigenvector 1
Prepayment eigenvector 2
eigenvector 3
Modeling eigenvector 4
0.1 eigenvector 5
Data and
calibration
0.05
Interest rate
models

Index projection 0

Monte Carlo
analysis
-0.05

Greeks

Validation -0.1

Robust
parallelization
-0.15
60 120 180 240 300 360
Summary
Time (month)

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 Mortgage
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Valuation

Harvey Stein
Weighted PCA impact - High mr
Customary
market size
comments
factor
Mortgage
market structure Weighting dampens out much of the long term behavior of the high
Prepayment mean reversion factor:
modeling

Yield and OAS The first 5 eigenvectors (second factor)

0.15
The Legality of eigenvector 1
eigenvector 2
Prepayment eigenvector 3
Modeling eigenvector 4
0.1 eigenvector 5
Data and
calibration
0.05
Interest rate
models

Index projection 0

Monte Carlo
analysis -0.05

Greeks

Validation -0.1

Robust
parallelization
-0.15
60 120 180 240 300 360
Summary Time (month)

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 Mortgage
Backed
Valuation

Harvey Stein
LGM — VR5 — Local antithetic
Customary
market size
comments
sampling
Mortgage
market structure

Prepayment
modeling

Yield and OAS

• Pure antithetic just makes sure sample mean is correct.
The Legality of
Prepayment
Modeling • Not so effective in interest rate MC.
Data and • Do local antithetic instead (”uniform sampling with antithetic
calibration

Interest rate
noise” (UWAN)) - Dupire and Savine:
models • Build a grid.
Index projection
• Pick antithetic pairs from each box.
Monte Carlo
analysis
• Uses MC to eliminate convexity caused bias.
Greeks • Done on first few eigenvectors.
Validation

Robust
parallelization

Summary

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Valuation

Harvey Stein
LGM — VR1+VR2+VR4+VR5 —
Customary
market size
comments
Weighted PCA with local
Mortgage
market structure
antithetic sampling
Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling
Combine methods:
Data and • VR1 — Money market numeraire.
calibration

Interest rate
• VR2 — Path shifting.
models
• VR4 — Weighted PCA.
Index projection

Monte Carlo • VR5 — Local antithetic sampling.

analysis

Greeks VR1+VR2+VR4+VR5 = standard deviation of 300 paths is lower

Validation than 5000 for VR1+VR2.
Robust
parallelization

Summary

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Backed
Valuation

Harvey Stein
LGM — VR1+VR2+VR4 with
Customary
market size
comments
Sobol sequences
Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Prepayment
Modeling

Data and
Adding Sobol sequences to the mix:
calibration
• Use Sobol sequences to randomly scale eigenvectors.
Interest rate
models • Further reduces variance.
Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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Valuation

Harvey Stein
Results
Customary
market size
comments

Mortgage 0.0037
market structure FWD
PC UWAN1
Prepayment PC UWAN2
modeling PC UWAN3
0.002 PC Sobol
Yield and OAS WPC UWAN1
WPC UWAN2
WPC UWAN3
The Legality of WPC Sobol
Prepayment 0.0011
Modeling

Data and
RMSE

calibration 0.0006

Interest rate
models
0.0003
Index projection

Monte Carlo
analysis 0.0002

Greeks

Validation
0.0001
128 256 512 1024 2048 4096
Robust Number of Paths
parallelization

Summary

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Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Greeks
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

101 / 119
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Valuation

Harvey Stein
Greek errors
Customary
market size
Greeks magnify pricing errors.
comments
dP P(S + h) − P(S − h)
Mortgage ≈
market structure
dS 2h
Prepayment
modeling If P(S) is the true model price, and P̃(S) is what we compute, then
Yield and OAS the error is ǫ(S) = P̃(S) − P(S).
The Legality of
Prepayment 1 1
Modeling P(S + h) = P(S) + P ′ (S)h + P ′′ (S)h2 + P ′′′ (S)h3 + . . .
Data and
2 3!
calibration so
Interest rate P(S + h) − P(S − h) 1
models = P ′ (S) + h2 ( P ′′′ (S) + . . .)
Index projection
2h 3!
Monte Carlo
and
analysis
P̃(S + h) − P̃(S − h) P(S + h) + ǫ(S + h) − (P(S − h) + ǫ(S − h
Greeks =
Validation
2h 2h
2 1 3
Robust
parallelization
= dP/dS + h ( d P/dS 3 + . . .) + ∆ǫ/2h
3!
Summary

The error in the calculation is the error from dropping the higher
102 / 119 order terms and from the change in error with respect to h.
 Mortgage
Backed
Valuation

Harvey Stein
Limits of computation
Customary
market size To see the magnitude of the problem, consider computing the
comments

Mortgage
derivative of the cumulative normal distribution by finite difference.
market structure Even with a computation as accurate as this, one should not exceed a
Prepayment
modeling
step size of 10−5 .
Yield and OAS

The Legality of 3e-10

Prepayment normal - delta f, h=10^-6
Modeling 2e-10 normal - delta f, h=10^-5
normal - delta f, h=10^-4
Data and 1e-10
calibration
0
Interest rate
models -1e-10
Index projection
-2e-10
Monte Carlo
analysis -3e-10
Greeks -4e-10
Validation -5e-10
Robust
parallelization -6e-10
Summary -7e-10
-3 -2 -1 0 1 2 3

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 Mortgage
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Valuation

Harvey Stein
Greek errors
Customary
market size
Errors in derivative are caused by:
comments
• High order terms corrupting finite difference (“convexity”).
Mortgage
market structure • Pricing error.
Prepayment
modeling
Error control:
Yield and OAS • Small h reduces Greek error from convexity.
The Legality of • Large h reduces Greek error from pricing error.
Prepayment p
Modeling • Balance is needed — h ≈ 3 3αf /f ′′′ if α is the relative error
Data and
calibration
≈ 10−5 for machine precision calculations with 64 bit doubles
Interest rate when f /f ′′′ ≈ 1.
models
Pricing error issues:
Index projection

Monte Carlo
• Finite difference — ǫ flat, minimal problems.
analysis
• Monte Carlo — ǫ large and random — error goes to ∞ as h → 0.
Greeks

Validation
Solution for Monte Carlo:
Robust • Make ǫ less random — Use the same paths, or the same random
parallelization
number seed.
Summary
• Accurate duration with 25bp shift, even when pricing variance is
as large as 6bp.
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Valuation

Harvey Stein
Which Greeks?
Customary
market size
comments

Mortgage
market structure

Prepayment To compute duration, rates are shifted while other inputs are held
modeling
constant. How should the option data be held constant?
Yield and OAS

The Legality of • Hold prices constant — Doesn’t make sense. Option prices have
Prepayment
Modeling to change as rates make them more or less in the money.
Data and
calibration
• Hold vol constant — Vol is a log normal vol, but LGM model is
Interest rate
normal. If vol is held constant, then model volatility will change
models
when the rates are shifted.
Index projection

Monte Carlo
• Hold normal vol constant — Most consistent with LGM model.
analysis
The situation between normal vol and log normal vol is reversed for
Greeks

Validation
the LNMR model.
Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Validation
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

106 / 119
 Mortgage
Backed
Valuation

Harvey Stein
Validation
Customary
market size
comments
How to make sure entire process works?
Mortgage
market structure General methods:
Prepayment
modeling
• Results are stable over time. Jumps can be explained by
Yield and OAS occurrence of a change in the market.
The Legality of
Prepayment
• Fitted parameters stable over time as well.
Modeling
• Prices and OASs behave appropriately
Data and
calibration • Flat in neighborhood of current cpn.
Interest rate • Expected relationships between different securities hold.
models
• Prices and OASs move as expected when input parameters are
Index projection
changed:
Monte Carlo
analysis
• Yield curve shifts.
• Volatility shifts.
Greeks
• Shifts of current index values.
Validation

Robust Mortgage specific:

parallelization

Summary
• Compare to empirical durations.

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 Mortgage
Backed
Valuation

Harvey Stein
OAS stability
Customary
market size
comments

Mortgage
market structure OASs are stable, but related to the current coupons, indicating a lack
Prepayment of linearity — the market demands a higher OAS when rates drop.
modeling
OAS (April 2006)
Yield and OAS 25 6.4
FNCL 5
FNCL 6
The Legality of FNCL 7
20 MTGEFNCL 6.3
Prepayment
Modeling
15 6.2
Data and

Current Coupon (percent)

calibration
10 6.1
Interest rate
OAS (bps)

models 5 6

Index projection
0 5.9
Monte Carlo
analysis
-5 5.8
Greeks
-10 5.7
Validation

Robust -15 5.6

parallelization 04/08 04/15 04/22
Date
Summary

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 Mortgage
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Valuation

Harvey Stein
Duration stability
Customary
market size
comments Durations are stable as well, and exhibit the appropriate relationship
Mortgage
market structure
to the current coupon. Durations drop when rates drop, with the
Prepayment
largest impact on coupons near but below the current coupon.
modeling

Yield and OAS OAS (April 2006)

25 6.4
The Legality of FNCL 5
FNCL 6
Prepayment FNCL 7
20 MTGEFNCL 6.3
Modeling

Data and 15 6.2

calibration

Current Coupon (percent)

Interest rate 10 6.1
models
OAS (bps)

5 6
Index projection

Monte Carlo 0 5.9

analysis

Greeks -5 5.8

Validation
-10 5.7
Robust
parallelization -15 5.6
04/08 04/15 04/22
Summary Date

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 Mortgage
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Valuation

Harvey Stein
Convexity stability
Customary
market size
comments Convexities also become more negative when the current coupon
Mortgage
market structure
drops because heightened prepayment causes the pool to behave less
Prepayment
bond-like.
modeling

Yield and OAS Effective Convexity (April 2006)

-0.5 6.4
FNCL 5
The Legality of FNCL 6
Prepayment FNCL 7
MTGEFNCL 6.3
Modeling

Data and -1 6.2

calibration

Current Coupon (percent)

Effective Convexity

Interest rate 6.1

models
-1.5 6
Index projection

Monte Carlo 5.9

analysis

Greeks -2 5.8

Validation
5.7
Robust
parallelization -2.5 5.6
04/08 04/15 04/22
Summary Date

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 Mortgage
Backed
Valuation

Harvey Stein

Customary
market size
comments

Mortgage
market structure

Prepayment
modeling

Yield and OAS

The Legality of
Robust parallelization
Prepayment
Modeling

Data and
calibration

Interest rate
models

Index projection

Monte Carlo
analysis

Greeks

Validation

Robust
parallelization

Summary

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Valuation

Harvey Stein
Parallelization
Customary
market size
comments
Variance reduction alone is insufficient to compute OASs in real time.
Mortgage
market structure Parallelization is needed.
Prepayment
modeling • Linux clusters.
Yield and OAS
• 6 clusters, 50 dual CPU PCs each = 100 CPUs per cluster
The Legality of
Prepayment • Embarrassingly parallel sometimes isn’t
Modeling

Data and
• Communication costs to farm out results and get back can render
calibration parallelization useless.
Interest rate • Old cluster - 750 MHZ, 100 MBPS ethernet — 60 seconds, 6 in
models

Index projection
parallel.
• New cluster - 3.0 GHZ, 100 MBPS ethernet — 15 seconds, 4
Monte Carlo
analysis seconds in parallel.
Greeks
• Data dissemination problem — 2 GB of deal and collateral
Validation

Robust
specifications.
parallelization
• PCA parallelization — compute time vs communication speed.
Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Request flow
Customary
market size
comments • User hits <go>
Mortgage • Computation data is assembled:
market structure

Prepayment
• Current values.
modeling • User selected values.
Yield and OAS
• Request sent to dispatcher.
The Legality of
Prepayment
Modeling • Dispatcher queues until an idle server is available. Retries failed
Data and requests.
calibration

Interest rate
• Server receives request.
models
• Explodes base calculation into individual path requests.
Index projection

Monte Carlo • Farms them out across the cluster.

analysis
• Redundancy and robustness.
Greeks

Validation • Assembles the result.

Robust
parallelization
• Farms out remaining requests.
Summary • Assembles results.
• Replies to client.
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 Mortgage
Backed
Valuation

Harvey Stein
Data dissemination
Customary
market size
comments

Mortgage
market structure
How to keep 2gb current on 300 machines?
Prepayment
modeling
• Layered approach.
Yield and OAS

The Legality of
• Source keeps head machines up to date.
Prepayment
Modeling • Head machines update remainder of cluster.
Data and
calibration
• Distribute within cluster in a tree fashion:
Interest rate • Copy from head to 4 children.
models
• Each time a node is updated, it starts updating 4 new nodes, and
Index projection
its updater starts updating a new node.
Monte Carlo
analysis
• Utilizes full bandwidth of ethernet switch — 100 MBPS from
Greeks each machine to switch, but independent pairs of machines can
Validation sustain this up until the switch’s backplane capacity.
Robust
parallelization

Summary

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 Mortgage
Backed
Valuation

Harvey Stein
Parallelization robustness
Customary
market size Preventing machine problems from causing calculation failures.
comments

Mortgage
Errors encountered:
market structure
• Unstripable curves.
Prepayment
modeling • Overheating machines.
Yield and OAS

The Legality of
• Flakey hard disks.
Prepayment
Modeling • Data unavailable.
Data and
calibration
• Bad data supplied.
Interest rate
models
Layered approach:
Index projection • Requests -> dispatcher -> OAS server -> slaves.
Monte Carlo
analysis
• If dispatcher gets an error (on a full request), it resends (up to
Greeks the retry limit).
Validation • If OAS server gets an error (on a path), it marks the slave as bad
Robust
parallelization and tries again. If it gets confirmation of the error, the slave is
Summary marked good and the path is listed as bad. If not, the slave is no
longer used.
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 Mortgage
Backed
Valuation

Harvey Stein
Parallelization issues
Customary
market size
comments

Mortgage
market structure
Even embarrassingly parallel problems might have trouble
Prepayment parallelizing.
modeling

Yield and OAS

• Even the simplest variance reduction adds up startup costs and
The Legality of communication overhead.
Prepayment
Modeling • If startup costs can’t be distributed as well, then they yield a
Data and
calibration
hard limit on parallelization speedup.
Interest rate • PCA analysis is slow enough that it’s hard to make it actually
models
save time.
Index projection
• Compression of data being distributed.
Monte Carlo
analysis • Tree distribution of data.
Greeks • Optimize PCA.
Validation • Parallelize PCA.
Robust • Partial PCA.
parallelization

Summary

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Valuation

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Effectiveness — pools
Customary
market size Parallelization is most effective when the ratio of scenario
comments
computation to communication is high. This is not the case for pools,
Mortgage
market structure where only one amortization and one prepayment model call are
Prepayment
modeling
needed for each scenario, and there are no tranche cash flow
Yield and OAS
calculations. But even with low efficiency, parallelization is effective in
The Legality of reducing run time.
Prepayment
Modeling Parallization Gain on a MBS
25 100
Data and Time
calibration Efficiency
20
Interest rate 75
models
15
Index projection

Relative efficiency (%)

Execution time (sec)

Monte Carlo
50
analysis
10
Greeks

Validation

Robust
parallelization 6

Summary 25

4
1 2 3 4 5 10 20
Number of slaves
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 Mortgage
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Valuation

Harvey Stein
Effectiveness – CMOs
Customary
market size
comments CMOs are quite another story. With large collateral sets and complex
Mortgage rules, each scenario can be quite intensive, so parallelization at the
market structure
path level is far more effective
Prepayment
modeling

Yield and OAS Parallization Gain on a CMO

550 100
480 Time
The Legality of Efficiency
Prepayment
Modeling

Data and
calibration 240
95

Relative efficiency (%)

Execution time (sec)

Interest rate
models

Index projection 120

Monte Carlo
90
analysis

Greeks 60

Validation

Robust
parallelization 30 85
1 2 3 4 5 10 20
Summary Number of slaves

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 Mortgage
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Valuation

Harvey Stein
Summary
Customary
market size CMO valuation is big science — lots of moving parts, with each one
comments
drawing on a different area:
Mortgage
market structure • Prepayment modeling:
Prepayment • Statistical validation and modeling of economic and behavioral
modeling
analysis.
Yield and OAS
• Data selection:
The Legality of
Prepayment • Risk analysis.
Modeling
• Interest rate modeling:
Data and
calibration • Classic arbitrage pricing theory.
Interest rate • Index projection:
models
• Statistical analysis.
Index projection
• Monte Carlo analysis:
Monte Carlo
analysis • Numerical methods.
Greeks • Variance reduction techniques.
Validation • Parallelization:
Robust • Building computation clusters.
parallelization
• Analysis and optimization of parallel algorithms.
Summary
As Emanuel Derman says, the best quants are interdisciplinarians.
CMO valuation is one area that requires it.
119 / 119
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