Modeling Mortgage-Backed Security Cash Flow Waterfalls
Summary
The document outlines how structured mortgage or asset-backed securities may be analyzed from the sell side, where loan-level pool data is available, and from the buy side, where investors often rely on summarized prospectus information. Its main method is to project pool cash flows, account for defaults and prepayments, apply credit enhancements and fees, then distribute remaining cash according to tranche priorities and covenants. Tranches may have different payment structures, including interest-only and principal-only claims.
The resulting waterfall supports tranche valuation and credit analysis. Weighted average term helps indicate a point on the interest-rate curve, while stressed default and prepayment assumptions inform spread and rating assessments; prepayments can have distinct effects on interest-only and principal-only tranches. The document gives a high-level workflow rather than a calibrated model or empirical results. It notes that buy-side analysis is less granular and may instead benchmark similar securities and use summary measures and default and prepayment indicators. The author also qualifies the account as based on limited experience.
Key ideas
- Loan-level asset data enables more detailed cash-flow modeling than prospectus summaries alone.
- A waterfall models pool payments after defaults, prepayments, credit enhancements, and priority fees.
- Tranche seniority and covenants determine how cash flows are allocated to liabilities.
- Stressed assumptions, weighted average term, and tranche structure inform valuation and credit assessment.
- Prepayment changes can affect interest-only and principal-only tranches differently.
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# Pricing structured products (Mortgage Backed Securities) # Pricing structured products (Mortgage Backed Securities) What would someone have to do to be able to price a structured product like Mortgage/Asset Backed Securities? ## Answer by bhutes (score 2, accepted) https://quant.stackexchange.com/a/46160 It may be a different from a buyside perspective, than from a sellside perspective. Off course, I must add a caveat that this is based on my rather limited role and experience in this domain. The sellside would have access to the complete dataset comprising the asset pool (to each single loan and mortgage). The buyside would have a prospectus containing a lot of summarized info of the asset pool, but would not have access to info at each and every loan in the pool. Cashflow Waterfall would be modelled by the sellside This would be utilized to price the individual tranches and secure the credit rating for each of the tranches. For the "cashflow waterfall", you will need to - - aggregate the raw cashflows for each period from the payment profile of the pool of underlying assets. - model defaults and prepayments. A simplistic way is to use a "Constant Default Rate" and and a "Constant Prepayment Rate" based on historical experience / statistical analysis. - compute the asset cashflows after applying defaults and prepayments - apply any credit enhancements to the cashflows - pay for priority payments, such as Trustee Fees - apply the covenants of the securitization tranches, taking seniority into account (this is the liabilities side, when you pay out of the asset cashflows period-wise). The tranches could be fixed or floating rate bonds, "Interest-Only" (IO) or "Principal-Only" (PO) tranches etc. - compute the remaining equity tranche, which constitutes the leftover cashflows after all debt obligations have been met. - compute the weighted average term of the securitization tranches. - subject the waterfall to stressed default and prepayment rates Based on 8 and 9, a credit rating is obtained, pricing proposed. Weighted average term will give a point on the interest rate curve, for the indicative coupon. Stress testing and rating will provide a basis for a spread over the risk free rate. Similarly, impact of prepayments would significantly affect the IO and PO and will be priced in. Buyside valuation assessment It will be a cruder analysis, given less detailed information than available to sell-side. Benchmark similar securities, weighted average life, default and prepayment indicators will be factored in but in a less detailed fashion than a cashflow waterfall.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.