Guide to Mortgage- New York Backed Securities

Lakhbir S. Hayre

(212) 816-8327 lakhbir.s.hayre@

New York

Robert Young

(212) 816-8332 robert.a.young@

New York

See the Disclosure Appendix for the Analyst Certification and Other Disclosures.

UNITED STATES FIXED INCOME RESEARCH

Mortgage Securities

NOVEMBER 3, 2004

UNITED STATES

Guide to MortgageBacked Securities

This report can be accessed electronically via:

FI Direct

Yield Book

E-Mail Please contact your salesperson to receive fixed-income research electronically.

UNITED STATES FIXED INCOME RESEARCH

Mortgage Securities

See the Disclosure Appendix for the Analyst Certification and Other Disclosures.

NOVEMBER 3, 2004

UNITED STATES

Lakhbir S. Hayre

(212) 816-8327 lakhbir.s.hayre@

New York

Robert Young

(212) 816-8332 robert.a.young@

New York

Guide to MortgageBacked Securities

This report can be accessed electronically via:

FI Direct

Yield Book

E-Mail

Please contact your salesperson to receive fixedincome research electronically.

November 3, 2004

Contents

Guide to Mortgage-Backed Securities

I. Introduction

6

Why Mortgage Securities?................................................................................................................ 7

Outline of Paper ............................................................................................................................... 8

II. Agency Pass-Through Securities

9

Terminology .................................................................................................................................... 10

Types of Agency Pass-Through Collateral ........................................................................................ 13

Types of Pass-Through Trading........................................................................................................ 15

An Agency Pass-Through Trade ....................................................................................................... 17

Multifamily Pass-Through Programs................................................................................................. 20

III. Basics of Mortgage Security Analysis

22

Measuring Prepayments.................................................................................................................... 22

The Effect of Prepayments on MBS Cash Flows ............................................................................... 23 A Brief Primer on Prepayment Analysis and Modeling ..................................................................... 24 Yield, Average Life, and Nominal Spreads ....................................................................................... 28

IV. Option-Adjusted Analysis of Mortgage Securities

30

The Z-Spread ................................................................................................................................... 30

Option-Adjusted Spread ................................................................................................................... 31

Interest Rate Volatility and Calculation of OAS ................................................................................ 32

Option Costs and Interpretation of OAS............................................................................................ 33

Effective Duration............................................................................................................................ 35 Convexity ........................................................................................................................................ 36

V. Mortgage Securities Lending

39

Repurchase Transactions .................................................................................................................. 39

Dollar Rolls...................................................................................................................................... 42

VI. Structured Mortgage Securities

45

Development of the CMO Market..................................................................................................... 45

A CMO Trade .................................................................................................................................. 47

CMO Bond Types ............................................................................................................................ 49

Stripped Mortgage-Backed Securities ............................................................................................... 52

VII. The Nonagency Market

55

Cash Flow Structure of Nonagency Mortgage Securities ................................................................... 55

Types of Nonconforming Residential Mortgages............................................................................... 56

Commercial Mortgage-Backed Securities ......................................................................................... 59

Appendix A. Resources for MBS and ABS Investors

61

Appendix B. Glossary of Common Terms

64

Appendix C. Standard Agency Definitions of CMO Bond Types

70

Appendix D. Settlement Dates

71

Appendix E. Mortgage Mathematics

73

Appendix F. Clearance and Settlement in the Back Office

77

Appendix G. Risk-Based Capital Standards

80

4

Citigroup Global Markets

Guide to Mortgage-Backed Securities

November 3, 2004

Acknowledgments

This is the third edition of the Guide to Mortgage-Backed Securities, originally published in 1995. For this updated version, sections on MBS trade mechanics, mortgage securities lending, and a number of useful appendices have been added. We thank Ana DiStefano for her careful and patient preparation of this paper and Peg Pisani for her fine editing of all three editions. We also thank Darrell Wheeler, Ivan Gjaja, and Gaurav Bansal for their helpful comments. Last, but certainly not least, we thank Ben Hebert for his extensive help in updating this paper.

Citigroup Global Markets

5

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