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notional value.

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1. Notional Value of an MBS

Definition: The notional value of a mortgage-backed security (MBS) is the face value of the underlying pool of mortgages. It’s basically the sum of the principal amounts that the borrowers owe.

Purpose: It’s a contractual number used to calculate interest payments, prepayments, and cash flows.

Key point: It does not reflect actual risk; it just represents the “amount of debt the security is based on.”

Example:

Suppose an MBS pools 1,000 mortgages of $300,000 each.

Notional value = 1,000 × 300,000 = $300,000,000.

That $300M is what interest and principal repayments are calculated on.

2. Actual Risk

Definition: Actual risk is the probability and magnitude of loss due to defaults, prepayments, interest rate changes, or other market factors.

Components of risk in MBS:

Credit risk: Borrowers might default.

Prepayment risk: Borrowers pay off mortgages early (affects cash flows).

Interest rate risk: Rates fluctuate, affecting the MBS market price.

Liquidity risk: Difficulty selling the MBS at fair value.

Key point: Actual risk is often much lower or higher than notional depending on the quality of the underlying loans, credit enhancements, tranche seniority, and market conditions.

Example:

That $300M MBS might have:

80% prime borrowers → low default risk.

Tranches structured so senior tranches are protected.

Actual expected loss might be only $5M, not anywhere near $300M.

3. Why the Gap Exists

Notional is static; risk is dynamic.

Notional doesn’t change if a borrower prepays early or defaults partially.

Risk changes with economic conditions, interest rates, and borrower behavior.

Tranching and credit enhancements

Senior tranches may have nearly zero expected loss despite high notional.

Equity/subordinate tranches may be tiny in notional but extremely risky.

Market pricing vs contractual math

The market value of the MBS reflects discounted expected cash flows, not the full notional.

Risk-adjusted pricing is often far lower than notional for high-quality mortgages.

4. Rule of Thumb

Notional = “face value for calculations.”
Actual risk = “expected exposure to loss.”

A $100M notional MBS can have actual risk of $1M or $50M depending on loan quality, tranche position, and market conditions.