Korea Capital Market Institute

We examine the primary market of the mortgage-backed securities issued by the Korea Housing Finance Corporation (KHFC). Since its inception in 2004 as a government sponsored housing finance enterprise (GSE), KHFC has been issuing multi-class mortgage-backed securities with maturities ranging from 1 to 20 years about 6 times a year. All classes backed by the homogeneous pool of mortgages are standard bonds with bullet principal payments and differ primarily in maturities. However, all classes with the exception of the bullet maturity tranche are callable subjecting the bond investors to a measure of prepayment risk. That is, the issuer has the option to call the bond after the call protection period, passing the prepayment risk to the bond investors. The coupons, which are paid quarterly, are paid sequentially from the lowest maturity class down to the longest maturity class each payment period. The KHFC MBS had an average legal maturity of 8.5 years, which has declined to 5.9 years in 2007. Bonds with maturities 5 years or longer account for well over half of the bonds issued showing that the KHFC has become an established supplier of intermediate-term and long-term fixed income securities to institutional investors in the Korean bond market. We find that the spread on the KHFC MBS is within 27 basis points relative to the government bonds, suggesting that the issue market is very efficient. Pricing the KHFC MBS, a highly complex product, by valuing the embedded options is clearly very difficult. We price the mortgage-backed securities issued by the Korea Housing Finance Corporation using the OAS (option-adjusted spread) method. In order to price the bonds using the OAS method, we first develop a series of prepayment models. We first build the prepayment model similar to the PSA model for the US mortgages. We find that the conditional prepayment rate (CPR) of the Korean mortgages start at about 6%, rise 1.1% a month to about 17% before leveling off after about 10 months. We conclude that the Korean mortgages season fast and rise to a high conditional prepayment rate before leveling off. Using pool level data, we find that the CPR is positively related to the spread between the MBS coupon interest rate and the current market mortgage rate, a few seasonal dummies, loan-to-value (LTV) ratio, and inversely related to the excessive LTV dummy. The OAS method is modular in design in which appropriate interest term structure models as well as appropriate prepayment models can be implemented independent of one another. Once an interest term structure model and a prepayment model have been chosen, Monte Carlo simulation generates cashflows to bondholders. The cashflows to various classes are discounted using the discount rate, which is typically estimated as the sum of the risk-free rate and the OAS. We have conducted the sensitivity analysis of tranche prices in regard to simulation counts, OAS, interest rate volatility, riks-free rate and the coefficient of the interest spread and find that the direction of sensitivities are as expected. We find that actual lives as well as durations as determined through simulations are much shorter than the expected lives based on legal maturities. We interpret this as arising mainly from the fact that the house prices in Seoul went up steeply during the study period causing a surge of mobility related refinancing. The KHFC MBS is rarely traded in Korea. Therefore, the applicability of the OAS method is currently limited in Korea since the OAS method requires the OAS observed in the market as an input. Our research makes a contribution to the further development of the MBS market in Korea by analyzing and pricing the KHFC MBS, thus adding to the knowledge base of the MBS product. We propose that the market participants in the Korean MBS market produce the daily quotes of the market consensus PSA/CPR/OAS for the KHFC MBS making it easier for the global fixed income securities communities