mortgage-backed securities -...

Introduction to Mortgage-Backed Securities (MBS)and Other Securitized Assets

Mortgage-Backed SecuritiesPRIMER

Executive Summary

A large and diverse market

The US mortgage market, with $7.2 trillion in mortgage-related debt outstanding, has developed into oneof the largest segments of the US bond market, surpassing both the US Treasury and US corporate sectors.1

The MBS sector offers investors diverse investment options and tools for evaluating mortgage securities.

Mortgage passthrough securities

Agency mortgage passthrough securities, issued by US Federal Housing Agencies, are the most commontype of mortgages. Agencies create pools of mortgages by purchasing mortgage collateral andrepackaging it for resale in the securities market. The cash flows of the underlying mortgages in the pool‘pass through’ to the holders of the mortgage securities. Cash flows are based on the interest rates,maturities and payment schedules of the underlying mortgages.

One of the most important aspects of the underlying mortgage is the embedded prepayment option,where the buyer can accelerate the prepayment of principal beyond what is set by the payment schedule.Since borrowers will tend to prepay in falling rate environments, and they ultimately benefit at theexpense of the lender, the prepayment option exposes the mortgage securities holder to risks associatedwith changing prepayments rates. Mortgage passthrough securities are also subject to additional risks,such as interest rate risk, spread risk and model risk.

When valuing a mortgage, it is critical to consider its underlying prepayment option. To most accuratelydetermine the value of mortgage securities, the option-adjusted spread model was developed. Thisvaluable tool takes into account the embedded option.

Diversity of investment options

The introduction of collateralized mortgage obligations (CMOs) in the early 1980s widened investorparticipation in the mortgages market by creating securities with a broad range of risk/return profiles.Other investment options introduced to the mortgage/securitized market were commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS). CMBS, which are backed by pools ofcommercial mortgage loans, differ from agency passthroughs in prepayment risk and structure. ABSdiffer from traditional residential mortgages, as their cash flows tend to be much less sensitive to interestrates and are, thus, more stable.

Why include securitized assets in a US Treasury portfolio?

We believe investors have the opportunity to significantly improve their risk/return profile by strategicallyallocating a portion of their portfolio to the MBS/securitized sector for two important reasons: 1) the historically attractive risk/return profile of the securitized sector and attractive yield opportunitiesrelative to Treasuries and 2) the diversification benefits from introducing new sources of risk andpotential return to the portfolio.

1 As of December 2007. Includes GNMA, FNMA and FHLMC mortgage-backed and CMOs and private label MBS/CMOs.

Introduction to Mortgage-Backed Securities and Other Securitized Assets

2 | Goldman Sachs Asset Management

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and shouldnot be construed as research or investment advice. Please see additional disclosures.

1930sPrior to the mid 1930s, most mortgages were balloons with the entire principal due at once. During the GreatDepression, these mortgages were adversely affected by the lack of liquidity in the capital markets and contributed tothe high level of defaults.

1934Congress passes the National Housing Act. This act establishes the Federal Housing Authority (FHA) and what is tobecome the Federal National Mortgage Association (Fannie Mae). FHA is intended to provide mortgage insurance andFNMA to provide liquidity to the mortgage market.

1968Federal National Mortgage Association breaks into Fannie Mae and the Government National Mortgage Association(Ginnie Mae). Fannie Mae becomes privately owned, while Ginnie Mae is wholly owned by the US government.

1970US government establishes Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae starts its mortgagepassthrough program.

EARLY 1980sFirst collateralized mortgage obligation (CMO) deals are issued.

1986Lehman Brothers launches the Aggregate Index that includes MBS Agency passthroughs for the first time. The initialmarket capitalization of these mortgages is $300 billion.

1992Lehman Brothers adds asset-backed securities (ABS) to the Aggregate Index.

Late 1990sThe ease of refinancing via the internet leads to more rapid refinancing.

1999Lehman Brothers adds commercial mortgage-backed securities (CMBS) to the Aggregate Index.

2003-2006A boom in housing market and strong originations lead to rapid growth of the mortgage market. The mortgage marketreaches $6.5 trillion in 2006.

2007Lehman Brothers adds adjustable rate mortgages (ARMs) to the Lehman Aggregate Bond Index.

2008The market capitalization of passthroughs in the Lehman Brothers Aggregate index is $3.7 trillion, the largest componentof the Index. The overall mortgage market (including Agency and Non-agency mortgages) surpasses $7 trillion.

Milestones in the Mortgage Market


Goldman Sachs Asset Management | 3

I. Introduction and Historical Perspective

What is a mortgage?

A mortgage loan is a debt instrument by which a borrower gives the lender a lien on real property assecurity for a repayment of the loan. The borrower has the use of the property and the lien is removedwhen the obligation is fully paid.

What is a mortgage-backed security?

Mortgage-backed securities (MBS) are bonds that are secured by a collection of underlying mortgageloans. The mortgage payments of the individual real estate assets are used to pay interest and principalon the bonds.

The development of today’s mortgage-backed securities market

Prior to the 1970s, the US mortgage market was largely a primary market. Financial institutions, suchas thrifts and commercial banks, would make residential loans directly to individuals and then holdthese mortgages on their balance sheets until maturity. Due to the lack of a robust secondary market,individual financial institutions were limited in the number of mortgages they could extend and this, inturn, limited the size of the overall mortgage market.

Financial institutions were restricted in mortgage lending in terms of their level of capital and risk intheir loan portfolio. For instance, since many thrifts were local in nature, collecting deposits from alocal community and making loans to this same community could create imbalances. If in aggregate,the community wanted to borrow more than save, the thrift would not be able to meet the demand formortgages and not everyone would be able to borrow. Also, if a bank thought that its portfolio hadbecome too risky due to either credit or liquidity concerns, the bank might choose to reduce this risk byextending fewer mortgages.

During the 1970s and 1980s, the US government, through its agencies and enterprises, began toestablish an active secondary mortgage market by introducing the concept of securitization. Theagencies would pool individual residential mortgage loans originated by the private sector, issuesecurities against the pool and provide some guarantee for the payments expected from these securities.These newly created securities were called mortgage passthrough securities.

The introduction of securitization provided great benefits to the marketplace. On the supply side, itprovided greater flexibility to financial institutions originating mortgage loans by removing theconstraints mentioned earlier. On the demand side, it introduced many new investors, such as pensionfunds, to the mortgage marketplace. These benefits helped the market grow significantly in size anddiversity of securities since the 1970s. Alongside this growth, there have been significant developmentsin the investment technology used to value these securities and measure their risk.

Prior to the 1970s, the

mortgage market was

largely a primary market.

During the 1970s, the US

government established an

active secondary market by

introducing securitization.

This development led to

significant growth in the

market’s size and the

diversity of securities

available for investment.



II. The US Agencies and their Role in the Mortgage Market

Three US Federal Housing Agencies account for nearly all the mortgage passthrough issuance in the USmortgage market. These agencies are formally known as the Government National Mortgage Association(GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan MortgageCorporation (FHLMC), though they are usually referred to by their nicknames. GNMA differs fromFNMA and FHLMC in several important ways.

YearFormal Name Nickname Abbreviation Established Tie to Federal Government

Government National Ginnie Mae GNMA 1968 Backed by full mortgage faithAssociation and credit of the US Government

Federal National Fannie Mae FNMA 1938 Line of credit Mortgage Association to the US Treasury

Federal Home Loan Freddie Mac FHLMC 1970 Line of creditMortgage Corporation to the US Treasury

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and shouldnot be construed as research or investment advice. Please see additional disclosures. Source: Goldman Sachs Asset Management

Explicit versus implicit backing of the US federal government

First, while GNMA is explicitly backed by the full faith and credit of the federal government, the othertwo agencies are not. FNMA and FHLMC only have the implicit backing of the federal government.This difference is very important and in recent years the marketplace has become more focused on itspractical implications. If, due to some financial crisis, GNMA were hampered from honoring itsguarantees, the law would require that the federal government honor the agency’s obligations for them.The federal government does not have such an explicit legal responsibility in the case of FNMA orFHLMC. However, many marketplace participants believe that although there is not an explicitobligation, the federal government would nonetheless take action in a crisis, since these two agenciesare so important to the mortgage market and the US economy.

Agencies as quasi-public corporations

Second, GNMA is a public federal agency whereas FNMA and FHLMC are federally chartered,publicly owned corporations. This means that one of FNMA’s and FHLMC’s primary goals is toproduce a profit for shareholders. These two agencies are accountable, not only to the federalgovernment, but also to their shareholders.

The Government National

Mortgage Association

(GNMA), the Federal

National Mortgage

Association (FNMA) and

the Federal Home Loan

Mortgage Corporation

(FHLMC) are the main

government issuers of

mortgage passthroughs.

While GNMA is explicitly

backed by the full faith

and credit of the US

government, FNMA and

FHLMC are not. FNMA

and FHLMC only have an

implicit backing from the

US government.



III. Mortgage Passthrough Securities

Agency mortgage passthrough securities are the most common type of mortgage and represent one ofthe largest capital markets in the world. To gain a better understanding of how these securities behave,it is useful to study the characteristics of the underlying mortgage loans.

The creation of mortgage passthroughs

As outlined earlier, the agencies create passthrough securities by securitizing residential mortgages. Theagencies create pools of mortgages that are underwritten by the private sector and provide a creditenhancement to these pools. The diagram below illustrates the flow of this process.

The resulting passthrough securities represent a pro-rata share of the underlying pool of individualmortgages and receive a proportionate amount of the pool’s net cash flows. These cash flows are thepayments made by borrowers into the pool less the fees associated with servicing (the processing of themortgage payments), agency guarantees and any other costs. These resulting cash flows ‘pass through’to the holders of the mortgage securities.

Mortgage characteristics

To understand how these cash flows behave and, consequently, how the passthrough security behaves,it is helpful to understand the structure of the underlying mortgages in the pool. The agencies havesimplified their passthrough securities by only pooling together mortgages with similar structures. Thisunderlying homogeneity eases some of the complexity in analyzing these securities and thissimplification has led to increased trading and market liquidity.

Rate

Mortgages may have either a fixed rate or a floating rate. A fixed rate mortgage charges a fixed rate ofinterest over the life of the mortgage, while a floating rate mortgage does not. The interest charged on afloating rate mortgage will reset periodically according to some preset formula. The formula used todetermine the newly set rate is usually a fixed basis point spread over the yield of a specified short debtinstrument (e.g., Treasury bill rate or LIBOR rate).

Another important attribute of a mortgage is the interest rate that the borrowers pay. The coupon ofthe passthrough security will be a function of the interest that the borrowers are paying less the feesmentioned earlier. The higher the interest rate, the higher the coupon the investor in the passthroughwill receive. When the agencies pool the individual mortgages, they will ensure that only mortgageswith approximately similar interest rates are aggregated in the same pool.

Mortgages areloans secured byreal property.

100% of thecollateral consistsof residential realestate, with singlefamily homesrepresenting 70% ofthe total.

Pools of individualmortgages, nowpackaged in astandard, diversifiedform, are sold toinstitutional investors.These includepension funds, banks,governments,corporations andinsurance companies.

Commercial banks,savings and loans andinsurance companieslend moneycollateralized by theproperty directly tothe home owner.

Two mortgage loanstructures are mostcommon:

Fixed Rate andAdjustable Rate.

In both cases,principal and interestare typically repaid inequal installmentsover 15-30 years.

GNMA, FNMA andFHLMC aregovernmentalagencies that provideliquidity and creditenhancement in themortgage market.They purchaseconforming mortgagecollateral andrepackage it forresale in thesecurities market.

��

Individual Home Mortgage Deed Financial Institution US Agency Investor

��

One widely used measure of the interest rate paid by the underlying mortgages is the weighted average coupon (WAC). This measure is the interest rate of each individual mortgage weighted by itsoutstanding balance. The coupon represents the interest that flows through to the passthrough investor(the WAC less any fees). Depending on the level of the coupon relative to the market, the bond willeither be trading at a premium, at par or at a discount.

Level of the Coupon Price Name

Above the Market Premium (above $100) Premium Coupon

At the Market Par ($100) Current Coupon

Below the Market Discount (below $100) Discount Coupon

Source: Goldman Sachs Asset Management

Bonds that are trading very close to par (typically with coupons either 100 bps below or 50 bps abovethe current coupon) are often referred to as cusp coupons. Given the relatively small changes in rates,their prepayment speeds can change significantly.

Term

Another important feature of a mortgage is its term (also called maturity) and its payment scheduleover its term. The most common mortgage terms are 15-year and 30-year. When creating a passthroughsecurity, the agencies will only pool mortgages with similar terms together.

Payment schedule

When a fixed rate mortgage is originated, a set payment schedule is established. Most mortgages do nothave a single bullet payment of principal at maturity, but rather, are amortizing. These amortizingmortgages will pay back principal over the entire life of the loan. Another market convention is that thepayments on the fixed rate mortgage are constant over time–that is, all the periodic scheduled paymentsare an equal dollar amount.

Each payment will represent interest on the outstanding principal and a paydown of principal.Payments made early in the life of the mortgage will represent mostly interest, as the outstandingprincipal is high. Payments made late in the life of the mortgage will represent mostly principal, as theoutstanding principal is much lower. The figure below illustrates how the composition between interestand principal varies over time for the net cash flows of a mortgage pool with no prepayments.



To understand how an

Agency passthrough

behaves, an investor

should be familiar with

the underlying mortgage

loans. Some important

characteristics of the

individual loans are:

• Fixed or floating

interest rate charged to

the borrower

• Term or maturity (15-

year and 30-year

maturities are most

common)

• Payment schedule over

the term

• Prepayment option

0

$100

$200

$300

$400

$500

$600

$700

$800

InterestPrincipal

Paym

ent

Years

0 5 10 15 20 25 30

For illustrative purposes only.Source: Goldman Sachs Asset Management

Payments on a Pool of 30 Year 8% $100,000 Mortgages with no Prepayments



Prepayment options

One of the most critical aspects of the underlying mortgages is the embedded prepayment option. Eachindividual borrower has the option to accelerate the payment of principal beyond what is required bythe set payment schedule. When exercising this option, the borrower has the right to pay down aportion of the outstanding principal or all of the outstanding principal. These prepayments can occurfor a number of reasons:

• Buyer sells home: If a home owner chooses to relocate to another home, the owner will probably sellhis current house and entirely prepay the home’s current mortgage. The one exception to this occurswhen the mortgage is ‘assumable.’ With an assumable mortgage, the buyer can assume theobligations of the previous mortgage. The mortgage, along with the house, is passed from the sellerto the new buyer. This assumption option is particularly attractive when rates have risen and theproperty has not appreciated significantly. Only Federal Housing Administration (FHA) or theVeterans Administration (VA) loans securitized by GNMA passthroughs have this assumable option.

• Buyer refinances: When rates fall, a home owner will consider closing his current mortgage andtaking out a new mortgage at a lower rate.

• Borrower defaults: In a passthrough security, any defaults will be treated as prepayment of principalthat is guaranteed by the agencies. The impact of these defaults is relatively small.

Quantifying prepayments: CPR and PSA

For a pool of mortgages, the level of prepayments is typically based on housing turnover or, in fallingrate environments, refinancing activity. One of the most widely used measures to quantify the impact ofprepayment is the Constant Prepayment Rate (CPR). This metric expresses prepayments on anannualized basis as a percentage of principal outstanding. For instance, if the historical CPR were 5%over the past two years, this means that each year the borrowers prepaid 5% of the outstandingprincipal in addition to the scheduled principal payments. CPR can be used to quote realized historicalexperience or to quantify future expected experience.

Another prepayment measure sometimes used by the market is the Public Securities Association (PSA)standard. This measure, developed in the mid 1980s, was designed to reflect the gradual ramp-up inmortgage prepayments experienced by new mortgages, an effect called seasoning. Newly issuedmortgages tend to have lower initial prepayments because new home owners will usually live for severalyears in a house before moving. However, after several years, the expected housing turnoverexperienced by the pool will rise as people may move to larger houses or to a new community, andprepayments will rise accordingly.

One of the most

critical aspects of the

underlying mortgages

is the embedded

prepayment option,

which allows a

borrower to accelerate

the payment of

principal beyond what

is required.

0

2

4

6

8

10

150% PSA

100% PSA

50% PSA

Months

CPR

(%)

0 60 120 180 240 300 360


CPR Vector Implied by Different PSA Levels



The benchmark PSA curve, or 100% PSA, assumes that the CPR gradually ramps up from 0% to 6%over 30 months and then levels off at 6%. These assumptions are based on historical numbers andactual experience may differ. The measure is flexible, as it can be quoted as varying percentages of thebase case. For instance, 200% PSA would mean that over 30 months, the CPR ramps up to 12%instead of 6%. This flexibility permits mortgage portfolio managers to use the PSA curve to 1) reflecttheir best estimate of future prepayments or 2) analyze the sensitivity of the mortgages to changes inprepayment rates.

Prepayments will affect the cash flow composition between interest and principal and the level of overallpayments that are passed through the pool to the investor. With greater prepayments, a greater portionof the principal will be returned early in the life of the security and the later total payments will decrease.The graph below depicts how, under an assumption of 100% PSA, principal payments are front-loadedin the life of a mortgage passthrough security and in later years the overall payments decline.

The embedded option is

always going to benefit

the borrower at the

expense of the lender.

InterestPrincipal

Years

Paym

ent

0

$200

$400

$600

$800

$1000

$1200

0 5 10 15 20 25 30


Payments on a $100,000 Pool of 30 Year 8% Mortgages at 100% PSA

The embedded option is always going to benefit the borrower at the expense of the lender. Theborrower has received a valuable option from the lender in exchange for agreeing to a relatively highnominal yield. A simple example might be helpful to illustrate how this option would work against thelender. A borrower who takes out a mortgage at an 8% interest rate may choose to refinance if ratesfall to 6%. This is a very attractive for the borrower, as it will significantly lower his monthly payment;now he is paying only 6% interest instead of 8%. However, it is unattractive to the lender who mustnow reinvest the returned principal at 6%, well below the 8% rate he previously enjoyed.

The risk of receiving principal back at an inopportune time (i.e., a lower rate environment) is calledprepayment risk. The prepayment risk associated with the individual mortgages will pass through to the holder of a mortgage security, as prepayments are shared across all the mortgage securities on apro-rata basis.

Path dependency and prepayments

The level of future expected prepayments is a function of historical interest rates. For instance, a mortgagesecurity may be issued in a high rate environment and experience significant refinancing when rates fall.The more informed borrowers will refinance quickly, but others may lag because they are less aware ofthe refinancing opportunity or they are constrained from refinancing. A potential refinancing constraintmay be that the borrowers’ credit-worthiness has fallen and they cannot refinance or, perhaps, the valueof their home has fallen making refinancing difficult. After this initial wave of refinancing, the passthroughis backed by mortgages of borrowers that are less likely to refinance. This effect is called ‘burnout.’ So,if rates move back up and then come down again, the increase in prepayments will be much less in thissecond cycle than it was when rates dropped initially. This aspect of prepayment risk is called pathdependency and it makes modeling and understanding how mortgages behave much more challenging.



Trading conventions

Trading conventions in the mortgage market have developed over many years as the market tends to bequite technical from an operational standpoint. Operational challenges have deterred non-US assetmanagers from entering the market, despite the large weight of passthroughs in the Lehman BrothersGlobal Aggregate Index.

Most passthrough securities are traded on a To Be Allocated (TBA) basis. An investor does not knowthe specific security he will receive, only its general characteristics, e.g., GNMA 6% 30 year. All theTBA trades of a similar type settle on one specified day each month. Securities can also be purchasedon an individual pool basis, ‘specified pools,’ but this is less common. The TBA market, like manyother forward and future markets, allows an investor to gain economic exposure to an asset classwithout necessarily taking delivery of actual securities.

The Non-Agency Mortgage Market

While the three housing agencies account for the majority of MBS issuance, private companies alsoissue MBS. The housing agencies are limited to the types of mortgages they can securitize. Agenciessecuritize “conforming” mortgage loans, i.e., the borrower credit and loan characteristics must meet theagencies’ underwriting standards. Non-conforming loans do not meet agency underwriting standardsdue to one or a combination of the following factors: mortgage balance exceeds the amount permittedby the agencies, borrower and loan characteristics fail to meet the underwriting standards establishedby the agencies, and/or loan documentation required by the agencies is not complete due to either theborrower’s inability to provide or the lender’s decision to waive.

“Private-label” MBS, or non-agency MBS, are typically issued by homebuilders or financial institutionsthrough subsidiaries and are backed by residential loans that do not conform to the agencies’underwriting standards. Non-agency issued mortgage-backed securities are now a major component ofthe MBS market.

Below, we have provided a description of the general “sectors” of the agency and non-agency mortgagemarkets and the typical characteristics of the collateral type which falls under each of those sectors.

Mortgage collateral

Mortgage securities can be backed by a wide variety of loans with different borrower characteristics butthe market is generally divided into four main sectors: agency mortgages, prime jumbo mortgages, Alt-A mortgages and subprime mortgages.

• Agency mortgages: Must conform to the agencies’ standards in terms of loan size, the borrower’scredit score and documentation, and the loan amount relative to the value of the home (loan-to-valueratio). Other types of mortgages do not comply with these standards for one or more reasons.

• Prime Jumbo: Exceed the agency maximum loan size (traditionally $417,000 but the maximum wasraised to $729,000 through 2008), but borrowers generally have high credit scores.

• Alt-A: Generally conform with agency standards in terms of loan size and borrower credit score, buthave other features that do not conform, such as low documentation.

• Subprime: Do not conform with agency standards primarily due to lower credit scores (generally605-640 out of a possible 850, compared to 680-730 for agency mortgages as measured by FICO)and higher borrower leverage (as measured by the debt-to-income ratio, typically 40% for subprimeborrowers). Documentation on subprime mortgages also tends to be significantly lower than agencystandards, but may actually be higher than documentation on an Alt-A mortgage.

Option-adjusted duration

measures the interest rate

risk of mortgages by taking

into account the changes in

prepayments that occur at

different interest rate levels.



IV. Risks of Mortgage Passthrough Securities

The main risks of mortgage passthroughs are interest rate risk, convexity/volatility risk due toprepayments, spread risk, credit risk and model risk.

Interest rate risk

The main risk of agency passthroughs is interest rate risk. Just like other fixed income securities, whenyields rise, passthrough prices fall; and when yields fall, passthrough prices rise. However, due to theembedded options in these agency passthroughs, traditional measures such as Macaulay duration andmodified duration are not appropriate for measuring the interest rate risk of mortgages. To address thisissue, option-adjusted duration, a new measure of interest rate risk that incorporates the impact ofembedded options, was developed.

Option-adjusted duration will take into account the changes in prepayments that occur at differentinterest rate levels. For instance, when rates rise, the expected cash flows for the passthrough will tendto extend; borrowers are less likely to refinance at higher rates. When rates fall, the expected cash flowsfor the passthrough will tend to shorten; borrowers are more likely to refinance since lower rates aremore attractive.

The option-adjusted duration captures these effects by shocking the yield curve up and down by equalamounts and recalculating the security’s price in each scenario, given the new expected cash flows. Theprice changes that result from these shocks are then used to estimate the security’s sensitivity to changesin interest rates. This sensitivity is the option-adjusted duration.

There are other measures of interest rate sensitivity that the market will sometimes quote, but they arenot as useful as an option-adjusted duration estimate. These other measures include weighted averagelife (WAL), which is an average time to receive back principal on the underlying loans and weightedaverage maturity (WAM), which is weighted average maturity of the underlying loans.

Convexity/volatility risk due to prepayments

For non-callable securities (plain vanilla bonds), duration measures underestimate price gains andoverestimate price losses. This estimation error (the curvature of the price/yield relationship) is calledconvexity and, in the case of a non-callable bond, it favors the investor and is called positive convexity.The opposite occurs for mortgages with prepayment risk. Duration measures overestimate price gainsand underestimate price losses. In this case, the estimation error is called negative convexity and willalways work against the investor. The more prepayment risk a security has, the worse the estimationerror will be and, in turn, the more negative its convexity will be.

Unlike non-callable

bonds, mortgages have

negative convexity, which

works against the

investor. Convexity

becomes more negative,

as the prepayment risk of

the security increases.

88

93

98

103

108Price change estimated by durationActual price change

Example: Conventional 30 year

Duration overestimatesthe price appreciation

Duration underestimatesthe price appreciation

Pric

e ($

)

-200 -150 -100 -50 0 50 100 150 200


Negative Convexity



Many managers will adjust their mortgage hedges frequently. This practice of constantly hedging theportfolio is called ‘dynamically hedging.’ The cost of this practice reflects the portfolio’s negativeconvexity. Whenever prices go down (rates up), the manager has to sell securities and whenever pricesgo up (rates down), the manager has to buy securities. In very volatile markets, the cost of negativeconvexity becomes expensive, reflecting the increased value of the options that the manager is short.Investors in mortgages are often said to be short volatility because when volatility increases, a mortgageinvestor loses as the cost of hedging rises (i.e., the cost of the negative convexity rises).

If a portfolio manager decides not to hedge, the portfolio’s duration will tend to drift. In rallyingmarkets, the portfolio will become shorter and in sell-offs, the portfolio will become longer. In trendingmarkets, this could lead to significant underperformance. Additionally, if liabilities are being matchedwith these securities, it may lead to an asset/liability mismatch.

Spread risk

The mark-to-market risk of mortgages may be broken into several components. The most volatilecomponent of this risk is Treasury interest rate risk, which was described earlier. This risk may behedged by taking short positions on US Treasuries or more easily by selling US Treasury interest rate futures.

The other two components of mark to market risk are associated with the swap spreads (the yielddifference between swap rates and Treasury rates) and the mortgage/swap basis (the yield differential,adjusted for embedded options, between mortgage rates and swap rates). These two risks are oftenreferred to as ‘spread risk’: the risk that a change in either of these two spreads will lead to a change in price.

Many investors will use swaps or eurodollar contracts to hedge any unwanted swap risk in theirportfolios. As swap spreads are positive in the US, most managers will want to be exposed to this typeof risk. However, if the manager thinks that the portfolio has too much swap spread risk or themanager has a negative tactical view on swap spreads, then he will hedge back this risk. This type ofhedging became more common after the second half of 1998.

A major component of

mark-to-market risk is

referred to as ‘spread

risk.’ This risk is driven

by swap spreads and the

mortgage/swap basis.

The chart below illustrates that as yields move, negative convexity becomes more costly. Since thisnegative convexity is tied to prepayment risk, this relationship should make sense. When markets arevery volatile, the prepayment option is worth more and, as a result, the security’s performance relativeto non-callable securities suffers more.

-200

0

-1

-2

-3

-4-150 -100 -50 0 50 100 150 200

Loss

fro

mC

onve

xity

($)

* Assumes no dynamic hedging. For illustrative purposes only.Source: Goldman Sachs Asset Management

Price Performance vs. Treasury*



Typically, most managers do not hedge the mortgage/swap basis risk for two reasons. First, mostmanagers do not have the ability to hedge this risk because it requires carrying short mortgagepositions which are usually not permitted. Second, many managers do not wish to hedge this risk as therisk may be embedded in their benchmark or the managers view the risk as attractive.

Estimated VolatilitySource of Mark to Market Risk Definition of spread/rate Hedging Vehicles

MBS/Swap Basis MBS Spread 30-50 bps Shorting other mortgages(adjusted for option)less Swap Spreads

Swap Spread Swap rates less 20-30 bps Selling interest rate swapsTreasury rates or eurodollar contracts

Treasury Rates Treasury rates 100-110 bps Selling Treasury interest ratecontracts or shorting Treasuries


Credit risk

The credit risk in agency passthrough securities is fairly minimal. In the case of GNMA passthroughs,the investor may view these bonds as secure as US Treasuries since they carry an explicit federalguarantee. In the case of FNMA and FHLMC passthroughs, though there is not an explicit guaranteeupon which to rely, there are several other sources of credit support. First, there is the credit-worthinessof the two agencies themselves. Even without federal support, the market considers these agenciesfinancially sound. Second, there is an implicit guarantee. It is thought by many market participants thatif the agencies were in financial trouble, the federal government would assist them. Finally, thesepassthrough securities are not general obligations of the agencies but are collateralized by theunderlying pool of mortgages.

Credit risk resides primarily in the non-agency mortgage market. As mentioned above, for agency MBS,agency guarantees assure investors that they will receive timely payment of interest and principal,regardless of the delinquency or default rates on the underlying loans. Because non-agency MBS haveno such guarantees, some other form of protection is needed to shield investors from borrowerdelinquencies.

Private-label MBS are rated by rating agencies and often feature credit enhancements, such assubordination and overcollateralization, that are designed to help protect investors from delinquenciesor losses on the underlying loans.

Modeling the aggregate

behavior of many

individual residential

mortgage borrowers is

extremely challenging

and, as a result, models

may not be perfectly

reliable.



A typical capital structure will include investment grade bonds, as well as “junk” or unrated bonds.The senior bonds are rated AAA and have first priority on cash flow. The investment gradesubordinates are rated AA to BBB and have a lower priority on cash flow. At the bottom of the creditstack are the non-investment grade subordinates. These bonds are rated BB+ or lower and aresignificantly exposed to losses from the underlying mortgage loans.

Model risk

A final risk to investing in mortgages is the reliability of the quantitative model used to predictprepayments. For most callable securities, such as agency or corporate callables, there is littleuncertainty about how the borrowers will behave. They will nearly always call the bonds if it isattractive to call them or will not call them if it is unattractive to call them.

On the other hand, not every individual residential borrower may refinance when it looks as if theyshould. This behavior may be driven by economic constraints or a lack of information on the individualborrower’s part. It is more difficult to predict the aggregate decisions of many individual borrowersthan it is to predict the decision of a single corporation. A model must attempt to predict this overallbehavior of borrowers and the model may not always be successful in this attempt.

One way to manage this model risk is to stress test the assumptions underlying the model and see howmuch the model’s results change as a result of varying assumptions. For instance, if normal housingturnover were 25% greater or less than the model’s base case, what happens to the model’s output? It isimportant to understand the sensitivities of models and not treat them as a perfectly reliable black box.

Cash Flow Mechanics

MortgageLoans

LossPriority

PrincipalPayments

Generic DealStructure

First Loss

Pool ofMortgageLoans

Loss

Pos

ition

Cash

Flo

w

AAA / Aa

UnratedB / B

BB / BaBBB / Baa

A / AAA / Aaa

Subordination

Senior-subordinated credit structures are created with single or multiple subordinated credit classes. Inthese structures, the “junior” tranches are subordinated to the “senior” tranches in terms of theprioritization of principal cash flows. In addition, the subordinate tranches are designed to absorblosses before they are allocated to senior tranches. In other words, these designated junior securitiesprovide the credit support to the senior securities.

The diagram below illustrates a typical mortgage pool capital structure:



V. Relative Value in Mortgage Passthrough Securities

In many fixed income markets, a primary driver in valuing a security is its nominal spread relative to a comparable maturity Treasury. Typically, nominal spreads of mortgages relative to Treasuries tend to be very high and would suggest that mortgages are very attractive. However, nominal spreadanalysis, as an indicator of relative value, is not complete in the case of mortgages and will yieldmisleading conclusions.

Option-adjusted spread

The reason that nominal spreads are a misleading indictor of value with respect to mortgages is thatmortgages are composed of two separate underlying investment positions. The investor is long a set offixed cash flows but is also short an option. The nominal yield does not incorporate the value of theoption that the investor has sold to the borrowers and, thus, this yield tends to overstate a mortgage’sattractiveness. As a result of this shortcoming, option-adjusted spread (OAS) models were developed tocreate a measure of valuation that accounts for the embedded short option. This type of model adjuststhe nominal spread to account for the option value and provides a better indicator of relative value.This same model is also used for calculating the option adjusted duration discussed earlier.

Interest rate and prepayment models

An OAS model is based upon two submodels: an interest rate model and a prepayment model. Theinterest rate model is a tool that will simulate future, potential interest rate paths.

One of the critical inputs into the interest rate model is the level of volatility. The level of volatility usedcan potentially make the OAS look attractive or unattractive. The more volatile interest rates areexpected to be, the more valuable the embedded option will be and the lower the OAS will be, if allelse is equal. This occurs because more volatile markets are more likely to create refinancingopportunities for borrowers. The less volatile interest rates are expected to be, the less valuable theembedded option will be and the higher the OAS will be. At the extreme, if volatility were zero, thereceases to be any uncertainty regarding the option and the time premium of the option is zero.

The prepayment model predicts how individuals behave regarding prepayments. It predicts prepaymentsstemming from normal housing turnover, interest rate shifts and any other factor deemed relevant. Topredict housing turnover, modelers will examine factors such as historical experience, demographictrends and any recent changes to the tax law. Even the impact of the internet has been incorporatedinto these models.

Predicting refinancing activity due to interest rate shifts is very important as this suggests howefficiently the borrower’s option will be used against the lender. Predicting how a corporation willbehave when it has a refinancing opportunity is usually fairly simple. If it is profitable to refinance, acompany will usually do so. This is not the case with home owners. While some may be quite efficientin refinancing, others may not be. Some may only refinance after the opportunity has existed for awhile and some may not refinance at all. Generally, individuals have become more efficient atrefinancing due to the internet, which has improved the flow of information and market access and hasmade refinancing easier. The outputs of different OAS models can vary a great deal. When examiningthe output of an OAS model, it is important to understand the model’s biases and limitations. It alsomakes sense to stress test the model and understand how it behaves under different assumptions.Mortgage traders regularly use these models as a tool in managing mortgage positions but should notuse them as black boxes.

The option-adjusted spread

model is a helpful indicator

of relative value because it

takes into account the short

embedded option.



VI. Other Types of Mortgage-Backed Securities

This introduction to mortgage-backed securities has focused entirely on agency mortgage passthroughs.Passthroughs are the most basic type of mortgage-backed security. One of the unique aspects of themortgage market is the diversity of instruments and products available to market participants. We havehighlighted below some other types of residential mortgage-backed securities:

Adjustable Rate Mortgage (ARM)

A passthrough security that has predetermined adjustments of the interest rate at specific intervals.Mortgage payments are tied to varying indices, such as the interest rate on US Treasury bills, LIBOR orthe average national mortgage rate. Adjustments are made regularly, usually at intervals of one, three,or five years. Different types of ARMs, include Hybrid ARMs, where the interest rate on the note isfixed for a period of time and then floats thereafter, as well as Option ARMs, where the borrower hasthe option to make minimal payments which allow for negative amortization or to make fullyamortizing payments.

Collateralized Mortgage Obligations (CMOs)

One disadvantage of standard agency passthrough securities is that their durations often do not matchthe duration of the investor’s liabilities. The introduction of CMOs in the early 1980s solved thisproblem and increased the investment universe for mortgage securities.

The most basic CMO structure is called a ‘sequential.’ This structure breaks an agency passthroughinto multiple bonds or tranches. Instead of passing through all cash flows on a pro-rata basis to thesenew securities, principal payments are paid in sequential order. A simple deal might be broken intothree tranches with principal payments being sequentially paid to only one tranche at a time. Once thefirst tranche has been completely paid down, principal payments would be directed towards the secondtranche. Once the second tranche has been completely paid down, principal payments would bedirected towards the third tranche. This methodology would break the passthrough into three securitieswith varying interest rate risk: a short duration tranche, an intermediate duration tranche and a longduration tranche. The securities created from this type of structure would be called ‘sequentials.’ Thefigure below illustrates how the principal would be directed in this type of sequential structure:

0

$100

$200

$300

$400

$500

$600Tranche A (Weighted-Average Life 3.5)

Tranche B (Weighted-Average Life 10.1)

Tranche C (Weighted-Average Life 20.5)

Year0 5 10 15 20 25 30

Prin

cipa

l Pay

men

t


Sequential Structure at 100% PSA

The introduction of

CMOs in the early 1980s

increased the mortgage

investor base by

broadening the range of

MBS investment options

available.



By using a CMO structure to break up an agency passthrough in this way, many investors, who mightnot normally purchase mortgages, may now find opportunities in the mortgage market given thebroader range of investments available. Since the early 1980s, CMO deals have become increasinglycomplex as a wide variety of CMOs were created in response to the needs of individual investor bases.CMOs may be created from either agency passthroughs or from pools of non-agency mortgages. The CMOs created with non-agency collateral are often referred to as ‘private label’ and most tranchesare AAA-rated. CMOs are not included in the Lehman Aggregate Index since the agency mortgagepassthroughs that are backing many of these structures are already included in the index.

VII. Non-Residential Securitized Assets

So far, we have focused only on residential mortgage-backed securities. However, there are other sectorsof the market that are interesting in the current environment. These include commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS). CMBS are bonds backed by pools ofmortgages on commercial mortgage loans. ABS are one of the most diverse sectors in the global fixedincome markets, but have one trait in common: they are backed by a pool of homogeneous assets.

Commercial Mortgage-Backed Securities (CMBS)

CMBS are securities backed by pools of commercial mortgage loans. These loans are typically securedby commercial property, such as apartment buildings, shopping malls, warehouse facilities, hotels andoffice buildings. This asset class emerged in the early 1990s as a result of the weak commercial realestate market. This weak market caused many traditional lenders, such as banks, insurance companiesand pensions funds making direct loans, to exit the market. The CMBS market replaced some of thistraditional lending and began to grow significantly in the late 1990s. Though CMBS share manysimilarities with residential passthroughs, there are many differences as well.

Lower prepayment risk

CMBS have much less prepayment risk than agency passthroughs. This lower level of risk is a result ofprepayment lockouts and prepayment penalties embedded in the underlying commercial loans. Alockout prevents any prepayments over a particular specified time period, while a prepayment penaltyreduces the economic benefit of refinancing as interest rates fall.

Credit enhancement in CMBS

There is no government guarantee for securities in the CMBS market as the housing agencies do nothave the mandate to offer such credit support. However, the majority of the market is AAA-rated.CMBS securities achieve a AAA-rating through senior/subordinated structuring. In each deal, a certainamount of the securities will be junior to the AAA-rated bonds and will absorb losses prior to thesenior bonds. The deals are often broken into four credit classes of bonds:

• Senior bonds: Nearly always AAA-rated

• Mezzanine bonds: Investment grade, but subordinated to senior bonds

• Junior bonds (or B-pieces): Below investment grade with significant credit exposure

• First loss piece: Most junior class and likely to experience complete loss if there is a significant credit event.

CMBS, which are backed

by pools of commercial

mortgage loans, differ from

agency passthroughs in

prepayment risk, credit

quality and structure.



Balloon structures

Unlike residential mortgages that are typically fully amortizing, loans in the commercial real estatemarket usually have a balloon structure with a 5- to 10-year term. In a balloon structure there is a largepayment of principal (often called a bullet) at the end of the loan’s term. This balloon structureintroduces the risk that the borrower may not be able to refinance their loan at the end of its term,often called ‘balloon extension risk.’ However, this risk is primarily borne by the subordinatebondholders.

Deal types

CMBS deal types are generally classified by the level of diversification of the underlying collateral. Themost common deal type is collateralized by loans originated in a securitization conduit. The conduitenables an investment bank to originate and securitize commercial loans while minimizing balance sheetexposure to the loans. This strategy differs from that of banks and insurance companies, whichtypically originate and retain commercial mortgages. The loans in these conduits tend to be very welldiversified with multiple borrowers, property types and locations and are typically backed by a hundredor more loans. The originators strive for this diversification because it is favorably looked upon by therating agencies. The good credit ratings that come from strong diversification are important to theoriginator as they make the economics of the deal much more attractive and the deal more profitable.

Many investors prefer these diversified conduit deals to other deals with more concentrated real estaterisk as extensive real estate experience may not give an investor a significant advantage over otherinvestors. For example, an isolated default on a $5 million loan will not jeopardize a senior bondholder in a $1 billion deal. The most important skill in these deals is an understanding of the structure,the credit enhancement and the overall quality of the loan underwriting procedures. Other deal typesthat are less common are single asset/borrower deals, large loan deals and fusion deals. Singleasset/borrower and large loan deals have more concentrated real estate risk. Understanding the qualityof each of the underlying loans and related real estate collateral becomes more important.

Asset-Backed Securities (ABS)

Asset-backed securities can represent attractive, conservative core portfolio holdings due to their cashflow stability and strong structural credit support. Unlike traditional residential mortgages, ABS cashflows are relatively insensitive to changes in interest rates and display much greater cash flow stabilitythan typical passthroughs. From a credit perspective, ABS are secured by diversified pools of obligorsand due to various potential credit enhancements, are often rated AAA. These credit enhancements mayinclude insurance wrappers, junior/senior structures and certain performance triggers that dynamicallyadjust the level of protection based on actual credit performance. The ABS sector is comprised of manycollateral subtypes, including credit card, auto, home equity, manufactured housing and utility rate-reduction receivables.

Adding MBS, CMBS and

ABS to a 100% US

Treasury portfolio can

increase the portfolio’s

return without

increasing its risk.



VIII. Why Do Investors Buy Mortgages?

A question of interest to a high credit quality investor is whether to include mortgages in theirinvestment universe. Historically, mortgages have offered investors attractive yield pick-up versusTreasuries with little credit risk:

Spre

ad v

s. Tr

easu

ries

0

50

100

150

200

250

300

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

As May 28, 2008Source: Lehman Brothers

Agency Mortgage Spreads (vs. Treasuries)

We believe that inclusion of the securitized sector in a fixed income portfolio can offer very attractiveadvantages:

• Historically, the securitized sectors have been very attractive on a risk/return basis. Althoughmortgage passthrough securities are short prepayment options, the incremental yield advantage ofthese securities has more than made up for the cost of these embedded options.

• Adding these other sectors to a fixed income portfolio should provide diversification benefits to theportfolio. Though mortgages, like Treasuries, have exposure to general interest rate risk, they alsohave potential exposure to many other risks (described earlier) that do not affect Treasuries.



VIII. Conclusion

Since the introduction of the first agency passthrough securities over thirty years ago, themortgage/securitized market has grown significantly in size, diversity of investment options, andcapacity of investment tools.

• Size: The US mortgage market has developed into the largest fixed income market in the UnitedStates, with a market capitalization of $7.2 trillion. Additionally, the success of securitization in theagency passthrough market has given rise to other securitized markets such as the CMO, CMBS andABS markets.

• Diversity: As the secondary passthrough market matured, the diversity of investment options in thesecuritized market increased. The introduction of CMOs in the early 1980s made it possible to createsecurities with a broad range of risk/return profiles. This innovation increased the number of marketparticipants as some investors, previously not active in the passthrough market, could now findinvestments suitable for their portfolios. The development of the CMBS and ABS markets alsointroduced further investment options to the market.

• Credit quality and depth: Agency market is AAA, and senior/subordinated credit enhancement allowsAAA creation from non-agency mortgage loans. While the bulk of the mortgage universe is highlyrated, equity-like risk is available in credit tranching whole loans (passthroughs not wrapped by theagencies) and commercial mortgages.

• Investment tools: Alongside this growing market, the investment community has increased andrefined its understanding of these securities and has developed tools to evaluate their distinctiverisk/return profiles. Such tools include option-adjusted spread and option-adjusted durationtechnology. Given the risk/return profile of the securitized sector, fixed income investors shouldconsider a strategic allocation to it.

The inclusion of the securitized sector as a strategic asset class has largely been embraced by fixedincome investors in the US, and is becoming a growing part of fixed income portfolios of globalinvestors. This adoption is apparent in the widespread use of the Lehman Aggregate Index (whichincludes the securitized sectors) over the older Lehman Government Corporate Index. A similar trend isemerging globally as fixed income investors outside of the United States also begin to embrace thesecuritized sector on a strategic basis. This trend is apparent in the growing popularity of the LehmanGlobal Aggregate (which includes the securitized sectors) at the expense of older, traditional all-government benchmarks. This trend will gain momentum as these global investors increase theirunderstanding of this market and how it can play a beneficial role in their portfolios.

Copyright © 2008 Goldman, Sachs & Co. All Rights Reserved. (9530.SA) MBSPRIMER/05-08

These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. This material is provided foreducational purposes only and should not be construed as investment advice or an offer to sell, or the solicitation of offers to buy, any security. This material has been prepared byGSAM and is not a product of the Goldman Sachs Global Investment Research (GIR) Department. The views and opinions expressed may differ from those of the GIR Department orother departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This informationmay not be current and GSAM has no obligation to provide any updates or changes.

The strategy discussed herein may include the use of derivatives. Derivatives often involve a high degree of financial risk because a relatively small movement in the price of theunderlying security or benchmark may result in a disproportionately large movement, unfavorable or favorable, in the price of the derivative instrument.

Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without Goldman Sachs Asset Management’s prior written consent,be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient. Pastperformance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are notguaranteed, and a loss of principal may occur.

This presentation has been communicated in Canada by GSAM LP, which is registered as a non-resident adviser under securities legislation in certain provinces of Canada and as a non-resident commodity trading manager under the commodity futures legislation of Ontario. In other provinces, GSAM LP conducts its activities under exemptions from the adviserregistration requirements. In certain provinces GSAM LP is not registered to provide investment advisory or portfolio management services in respect of exchange-traded futures oroptions contracts and is not offering to provide such investment advisory or portfolio management services in such provinces by delivery of this material.

This presentation has been issued or approved for use in or from Hong Kong by Goldman Sachs (Asia) L.L.C. This presentation has been communicated in the United Kingdom byGoldman Sachs Asset Management International which is authorized and regulated by the Financial Services Authority (FSA). This presentation has been issued or approved for use in orfrom Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W. With specific regard to the distribution of this document in Asia ex-Japan, please note that thismaterial can only be provided to GSAM's third party distributors (for their internal use only), prospects in Hong Kong and Singapore and existing clients in the referenced strategy in theAsia ex-Japan region.

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