“Mortgage Backed Securities and the Covid-19 Pandemic”

e read the HBS case “Mortgage Backed Securities and the Covid-19 Pandemic” and the
Goldman Sachs research note on Canvas. There are also links to several contemporaneous
news stories.
ˆ Question 1. Suppose you bought the particular security described in Exhibit 9a-k
of the case (whose coupon interest rate is 3%) for a price of 106% on April 1, 2020.
Because the Federal Reserve has drastically cut interest rates, a wave of refinancing by
homeowners is expected. Compute your internal rate of return under the assumption
that 1/3 of the principal is repaid by homeowners who refinance their mortgage and 1/3
is repaid by the guarantor (the government agency) because the borrowers default due
to Covid-related loss of income. Assume these repayments all happen on 10/1/2020
and that all the remaining principal is repaid on 10/1/2021 due to further refinancing
and defaults. Under this scenario, are the bonds a good investment?
NOTE: For this question, you do not need to compute the scheduled amortization payments on the loan pool. Just assume you get monthly coupon payments, with principal
repayment as described above.
ˆ Question 2. As the case describes, investors in MBS will lose money if interest rates
go up. But in early 2020 this seems unlikely for the near term, given the Fed policy.
However the case does not mention any other pandemic related mechanisms that could
affect bondholders. In what way do you think investors in April 2020 were exposed to
the direction of U.S. house prices? Can you think of other factors that may determine
the return of MBS during or after the pandemic?
ˆ Question 3. The CARES Act passed by the U.S. government in response to the
pandemic gave any homeowner with a mortgage that was held by an agency-backed
bond trust the right to 12 months of forbearance, meaning all payments of principal
and interest could be suspended without triggering default.1 Suppose you were such
a homeowner in 2020 and that the interest on your mortgage is 3.75% payable over
the next 30 years. You have not lost your job, and you do have enough income to pay
your expenses. You have an option to (i) costlessly repay your mortgage and enter in
to a new one with 2.75% interest, or (ii) put your current mortgage into forbearance.
1At the end of forbearance, the mortgage terms remain unchanged. The missed payments – both principal
and interest – have to be repaid as a lump sum at maturity, or whenever the loan is refinanced or the home
is sold.
(Assume you cannot refinance your loan while it is in forbearance. You also cannot
refinance and then put the new loan into forbearance.) How would you decide which
option to exercise?
ˆ Question 4. Now consider the bondholder in Question 1 again. Assume that all the
loans that would have otherwise defaulted in 2020 are instead put into forbearance,
and that they are all either refinanced or go into default on 10/1/2021. The guarantor
will make all scheduled payments to bond holders for loans in forbearance. What is
your internal rate of return now? In early 2021, the U.S. government was considering
extending the program for an additional 6 months. Would you favor this or oppose it?

Sample Solution