Value of a Mortgage Back Security

Hey guys,

Sorry, noob question, but why is the value of a mortage security less than the value of a treasury security as demonstrated by:

  • Value of Mortgage Security = Value of a Treasury Security - Value of a the prepayment option

I guess my question is why are we using the Treasury Security as a starting reference point?

Thanks in advance all


Because treasuries have the least amount of risk premium (except for TIPS) and a huge liquid market so they are the most convenient benchmark. No default risk, minimal liquidity risk (for on the run issues). For zero-coupon treasuries, no reinvestment risk either.

TIPS might be even better since they have no inflation risk either, but they are too complicated with a varying principal value.

Worth noting here that the above relationship really only holds for an Agency MBS, one that is backed by the full faith and credit of the US government… ie., the only uncertainty in the stream of cash flows backing the MBS is the timing of those cash flows seeing as how the government will subsidize any defaults.

A private-label or Non-Agency MBS has credit or default risk that is not subsidized by the US government so therefore a second uncertainty is introduced when estimating cash flows in the valuation context… timing and EXTENT, which would drive the value even lower.

think Treasuries as a the plain vanilla bond

then options/features added make it as non-Treasury

in this case it is the prepayment option that makes it less than Treasuries