18 - Mortgage-Backed Securities I

Abstract

This chapter explains the mortgage-backed securities, which are the largest of the asset-backed bond markets. A mortgage is a loan made for the purpose of purchasing property, which in turn is used as the security for the loan itself. The mortgage-backed market in the United States is the largest in the world and has witnessed phenomenal growth in 1990. In the U.S. market, the terms of a conventional mortgage—known as a level-payment fixed-rate mortgage—state the interest rate payable on the loan, the term of the loan, and the frequency of payment. Although mortgage contracts are typically long-term loan contracts running usually for 20–30 years or even longer, there is no limitation on the amount of the principal that may be repaid at any one time. The most common approach used by the market is to assume a fixed prepayment rate at the time of issue and to use this to project the cash flows. The term of maturity of a bond also gives an indication of its sensitivity to changes in market interest rates.