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Securitization

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Title: Securitization


1
Securitization
2
I.1 Secondary Mortgage Market
  • Primary Mortgage Market Lender deals directly
    with the borrower for underwriting (risk analysis
    to determine if the loan should be made), and
    origination of the loan (direct interaction with
    the borrower).
  • Secondary Mortgage Market Mortgage loans and
    securities backed by mortgage loans are sold to
    investors, typically through intermediaries, for
    inclusion as part of the investors portfolio of
    assets.

3
I.1 Secondary Mortgage Market
  • Evolution of the Secondary Mortgage Market
  • 1. Early Market Development 1930 1969
  • 2. Introduction of Mortgage-backed Securities
    1970 1980
  • 3. Initial reaction to interest rate volatility,
    and prepayment risk 1980 1986
  • 4. Growth in derivative mortgage-backed
    securities and opening new market areas 1987
    the present

4
I.1 Secondary Mortgage Market
  • Early Development
  • Prior to the 1930s there was no organized
    secondary mortgage market.
  • Development was part of President Roosevelts
    New Deal program to lift the U.S. economy out
    of the Great Depression. It was one element of
    a multi-faceted plan to encourage homeownership
    and stimulate mortgage lending.
  • Aside Other elements of the plan
  • 1. Development of Federal Home-Loan Bank system
  • 2. Inception of government mortgage insurance
    programs (VA and FHA)
  • 3. Insurance of Savings Deposits (FDIC, FSLIC)
  • 4. Fixed payment fully amortized mortgage
    introduced.

5
I.1 Secondary Mortgage Market
  • Federal National Mortgage Association (Fannie
    Mae)
  • Created in 1938 first federal government
    secondary market agency
  • Goals for Fannie Mae and the Secondary Mortgage
    Market
  • 1. To provide liquidity for mortgage originators
    and investors
  • 2. Integrate local mortgage markets with national
    capital markets
  • 3. Transfer funds from capital surplus to capital
    shortage areas
  • 4. To provide special assistance to the federal
    government in implementing housing and mortgage
    market policies

6
I.1 Secondary Mortgage Market
  • Surge of Growth in secondary market after WWII
    for two reasons
  • 1. Great demand for VA guaranteed loans
  • 2. Growth in demand for long-term investments by
    pension funds and life insurance companies.
  • Grow makes problems of secondary market apparent
  • 1. No secondary market for privately insured
    loans, so integration of local mortgage and
    national capital markets ineffective
  • 2. Many potential investors not interested in
    direct mortgage investment

7
I.1 Secondary Mortgage Market
  • Monumental Changes in the Mortgage-backed
    Securities Market
  • 1. 1968 Government National Mortgage
    Association (Ginnie Mae) created
  • a. First mortgage-backed securities issued under
    Ginnie Mae guarantee program
  • b. Takes over special assistance function from
    Fannie Mae
  • 2. 1970 Act of Congress creates Federal Home
    Loan Mortgage Corporation (Freddie Mac)
  • For the first time privately insured mortgages
    are traded in the secondary mortgage market

8
I.2 Mortgage-Backed Securities
  • Mortgage-backed securities or "MBS" are a type of
    fixed income investment. The main feature that
    distinguishes MBS from other fixed income
    investments is prepayment risk.
  • Because of prepayment risk, MBS usually offer
    higher yields than otherwise-comparable fixed
    income securities.

9
I.2 Mortgage-Backed Securities
10
I.2 Mortgage-Backed Securities
  • A simple "pass-through" security that represents
    ownership of an underlying "pool" of mortgage
    loans. An investor who owns the MBS is entitled
    to receive collections of interest and principal,
    including prepayments. In MBS jargon, the
    payments on the loans are "passed-through" to the
    investors.
  • A small portion of the interest collections is
    not passed through to cover expenses. Thus, an
    MBS has a "pass-through rate, which is the net
    rate at which investors receive interest on the
    balance of the mortgage loans backing the
    security.
  • For example, if the mortgage loans backing an MBS
    have interest rates of 6.5, the MBS might have a
    pass-through rate of 6. The difference, 0.5,
    covers expenses.

11
I.2 Mortgage-Backed Securities
  • Most MBS are issued or guaranteed by one of the
    three mortgage-related "agencies" or "government
    sponsored enterprises" (GSEs) (1) Ginnie Mae,
    (2) Fannie Mae, and (3) Freddie Mac.
  • Each "agency MBS" has the benefits of a credit
    guarantee from its related agency. Those
    guarantees insulate MBS investors from credit
    risk on the underlying loans.
  • The federal government backs Ginnie Mae's
    guarantee. The guarantees of the other two
    agencies do not have federal backing, but
    professionals generally view those agencies as
    having extremely high credit quality.

12
I.2 Mortgage-Backed Securities
  • Private sector entities also issue MBS. Those are
    called "private label MBS. Private label MBS do
    not carry guarantees from the GSEs and,
    therefore, use other forms of credit enhancement
    to counter-balance the credit risk of their
    underlying mortgage loans.

13
I.2 Mortgage-Backed Securities
  • The loans backing an agency MBS are similar to
    each other.
  • For example, a given agency MBS could be backed
    either by fixed-rate mortgage loans (FRMs) or by
    ARMs, but not by both.
  • In the case of agency MBS composed of FRMs, all
    the loans would have interest rates close
    together.
  • For some kinds of agency MBS, all the FRMs must
    have exactly the same interest rate. In other
    agency MBS, the interest rates on the FRMs can
    vary by as much as 1.75.

14
I.2 Mortgage-Backed Securities
  • In the case of an agency MBS backed by ARMs, the
    interest rate adjustment mechanism in all the
    loans must be based on the same index.
  • For example, all the ARMs backing an agency MBS
    could have adjustment formulas tied to LIBOR.
  • Alternatively, all the ARMs could have formulas
    tied to the one-year Treasury constant maturity
    index (CMT). However, an agency MBS could not be
    backed by a mixture of LIBOR-based and CMT-based
    ARMs.
  • A given agency MBS would have roughly similar
    maturities.
  • An agency MBS would not be backed by a mixture of
    loans having both 30-year and 15-year final
    maturities.

15
I.2 Mortgage-Backed Securities
  • Professionals tend to group agency MBS into large
    categories and often treat the securities as
    fungible within each category.
  • For example, one category would be all the Fannie
    Mae MBS with pass-through rates of 6 and backed
    by 30-year FRMs. Another category would be all
    Ginnie Mae MBS with 5½ pass-through rates and
    backed by 15-year FRMs.

16
II.1 Mortgage-Backed Securities
  • Mortgage-Backed Securities
  • Definition A financial instrument whose interest
    and principal payments are either derived
    directly from the cash flows of an underlying
    pool of mortgages (e.g., pass throughs) or are
    collateralized by such a pool (e.g.,
    mortgage-backed bonds).

17
II.1 Mortgage-Backed Securities
  • Why investors prefer mortgage-backed securities
    to investment in whole mortgage loans?
  • 1. Separates ownership of cash flows from
    origination and servicing functions
  • 2. Provides small investor with the ability to
    diversify across a pool of loans
  • 3. Provides an extra layer of security from
    default
  • a. government guarantees
  • b. private pool insurance
  • c. over collateralization of the pool
  • 4. Good information about the characteristics of
    the mortgages in the pool
  • 5. Ability to restructure cash flows from the
    pool
  • 6. Increases liquidity through standardization
    and good information

18
II.1 Mortgage-Backed Securities
  • Three Major of Mortgage-backed securities
  • Pass-through securitization
  • Collateralized mortgage obligations
  • Mortgage-backed bonds

19
II.2 Pass-Through Securities
  • The pass through or participation certification
    (PCs) is the most common structure for
    mortgage-backed securities.
  • The MBS acquires mortgages from original mortgage
    lenders.
  • The agency then examines mortgage at to ensure
    that they meet the credit-quality guidelines.
  • Loans with similar characteristics and maturity)
    are pooled together and the servicer passes
    through a pro rata share of all interest and
    principal payments to the investors.
  • For example if an investor owns 2 of the pool,
    she would receive 2 of all the payments of
    interest and principal received by e pool less
    fees.

20
II.2 Pass-Through Securities
  • The actual packaging or pooling can be done by
    the government sponsored enterprises Ginnie Mae,
    Fannie Mae and Freddie Mac, or by private
    enterprises.
  • Payments to investors are made on a monthly
    basis. Since not all the mortgages in a pool have
    the exact same mortgage rate and maturity, a
    weighted-average coupon (WAC) is calculated for
    the pool of mortgages backing the pass-through.
    However, investors receive what is called net
    coupon which is the WAC less the fees that the
    MBS issuer charges for guaranteeing

21
II.2 Pass-Through Securities
  • Credit Risk
  • Like any debt instrument, mortgages involve
    credit risk. Credit risk arises from uncertainty
    over whether the borrower will perform as
    required to fulfill interest and principal
    payments. In order to reduce that risk on
    mortgages, the conventional mortgage contract,
    which was developed by Fannie Mae in the 1930s,
    requires borrowers to put down 20 of the house
    price as down payment. This is expressed as 80
    loan-to-value ratio when value refers to the
    market price of the home. Thus the collateral for
    the mortgage, the value of home, amounts to 125
    of the debt principal.
  • Mortgage insurance is provided by several federal
    government programs as well as by private
    mortgage insurance companies

22
II.2 Pass-Through Securities
  • Credit Risk
  • The The Federal Housing Administration (FHA) was
    created under the National Housing Act of 1934.
    It insures mortgages of low- and moderate-income
    families to promote ownership for those people.
    The FHA insurance covers the whole amount of the
    loan, but there is a limit to what the size of
    the loan could be. If the borrower with FHA
    insurance defaults insurance, the FHA has two
    options. It can pay the lender the insured amount
    and let the lender take the title of the house.
    The FHA can reimburse the lender for the entire
    loan amount and take the title of the house.
  • The Department of Veterans Affairs (VA) offers
    insurance on mortgages for veterans. Unlike the
    FHA, the VA insurance covers only a certain
    percentage of the loan, up to 25.

23
II.2 Pass-Through Securities
  • Credit Risk
  • Most loans are not insured by the government
    agencies like FHA, VA, or RHS. These are called
    conventional mortgages. Private lenders
    investing in these mortgages often require
    private mortgage insurance (PMI) if the
    loan-to-value ratio exceeds 80 (that is, if the
    home buyer puts down less than 20). Such
    insurance can be obtained from a mortgage
    insurance company (MIC). The MIC industry was
    created in 1920s but collapsed in the 1930s. It
    gained popularity again in the 1950s. Recently,
    private insurers have been accused of abuses such
    as repeated sale of PMI insurance policies to
    borrowers with enough equity to not require
    mortgage insurance.

24
II.2 Pass-Through Securities
  • Credit Risk
  • Most Investors in MBSs do not want to hold credit
    risk on the underlying mortgages, so MBS issuers
    provide guarantees. When Fannie Mae and Freddie
    Mac issue MBSa, they charge a guarantee fee that
    is currently between 20-30 basis points. This is
    taken from the gross yield on the loan so it is
    netted to the investor. These corporations are
    able reduce their risk of mortgage default by
    diversifying their large portfolios across the
    nation. Investors in these MBS thus have not the
    individual borrower, but Fannie Mae and Freddie
    Mac as a counter party to their credit risk.
    Therefore the credit risk of mortgage-backed
    securities issued by Fannie Mae and Freddie Mac
    reflects the credit rating of those corporations.

25
II.2 Pass-Through Securities
  • Ginnie Mae Pass-through programs
  • Ginnie Mae offers three pass-through programs
    Ginnie Mae I, Ginnie Mae II and Ginnie Mae
    Platinum.
  • These programs are backed by the full faith and
    credit of the US government. Therefore, they have
    virtually the same risk as US treasury securities
    except for the prepayment risk.
  • Ginnie Mae pass-throughs are backed by newly
    originated FHA and VA insured mortgages and their
    credit is further enhanced by Ginnie Maes
    guarantee.

26
II.2 Pass-Through Securities
  • Ginnie Mae I has the lowest servicing spread with
    6 basis points for guarantee fee and 44 basis
    points for servicing fees. The majority of Ginnie
    Mae pass-throughs are issued under Ginnie Mae I,
    where the securities are backed by single-family
    fixed-rate 30- or 15-year mortgages and one-year
    adjustable rate mortgages.

27
II.2 Pass-Through Securities
  • Freddie Mac
  • Freddie Mac offers a pass-through program that
    offers full and timely payment of interest and
    principal.
  • Like Freddie Mac notes and bonds, these
    pass-throughs are not guaranteed by the full
    faith and credit of the US government. However,
    some market participants view them as similar in
    credit worthiness to Ginnie Mae pass-throughs.
  • Freddie Macs pass-through pools consist of
    conventional mortgages as well as those from FHA
    and VA mortgages. Freddie Mac charges guarantee
    fee under 25 basis points and a servicing fee
    between 25-37 basis points. Freddie Mac has
    implemented a contract feature that adjusts the
    guarantee fee up or down relative to the current
    level of security price spreads.

28
II.2 Pass-Through Securities
  • Fannie Mae
  • Fannie Mae offers a pass-through program which,
    like Fannie Mae notes and bonds, is not backed by
    the full faith and credit of the US government.
  • Fannie Maes pass-through pools consist of
    conventional mortgages as well as those from FHA
    and VA mortgages.
  • Fannie Maes have similar fees as Freddie Macs
    guarantee fee 25 basis points and servicing fee
    of 25 to 37 basis points. In 2003, the average
    effective guarantee fee that Fannie Mae reported
    was 20.2 basis points

29
II.3 Incentives and Mechanics of Pass-Through
Security Creation
  • 1. To Reduce Regulatory Taxes
  • Create a mortgage pool from one-thousand,
    100,000 mortgages (for a 100 m mortgage pool)
    with 30 years in maturity and 12 percent interest
    rate.
  • Each mortgage receives credit risk protection
    from FHA.
  • Capital requirement 100m .05 .08 4
    million (the risk-adjusted value of residential
    mortgages is 50 of face value and the risk-based
    capital requirement is 8).
  • Must issue more than 96 million in liabilities
    due to a 10 reserve requirements. ( FDIC
    premia).

30
II.3 Incentives and Mechanics of Pass-Through
Security Creation
  • Reserve requirement 10 106.6 10.66m,
    leaves 96m to fund the mortgages.
  • FDIC insurance premium 106.66m .0027
    287,982
  • The three levels of regulatory taxes
  • 1. Capital requirements
  • 2. Reserve requirements
  • 3. FDIC insurance premiums.

31
II.3 Incentives and Mechanics of Pass-Through
Security Creation
  • Bank Balance Sheet Before Securitization
  • Assets Liabilities
  • __________________________________________________
    ______
  • Cash reserves 10.66 Demand Deposits 106.6
  • Long-term mortgage 100.00 Capital 4.00
  • __________________________________________________
    ______
  • Bank Balance Sheet After Securitization
  • __________________________________________________
    ______
  • Cash reserves 10.66 Demand Deposits 106.6
  • Cash proceeds from 100.00 Capital 4.00
  • mortgage securitization
  • __________________________________________________
    ______

32
II.3 Further Incentives
  • 2. To Reduce Gap exposure The FI funds the
    30-year mortgages out of short-term deposits
    thus has a duration mismatch.
  • 3. To Reduce Illiquidity exposure illiquid
    portfolio of long term mortgages.
  • Creating GNMA pass-through securities can largely
    resolve the duration and illiquidity risk
    problems on the one hand and reduce the burden of
    regulatory taxes on the other.

33
II.3 Further Incentives
  • Investors of GNMA securities are protected
    against two levels of default risks
  • 1. Default Risk by the Mortgages
  • Phoenix, AZ in 1980s.
  • Through FHA/VA housing insurance, government
    agencies bear the risk of default.
  • 2. Default Risk by Bank/Trustee GNMA would bear
    the cost of making the promising payments in full
    and on time to GNMA bondholders.

34
II.3 Further Incentives
  • Given the default protection, the returns to GNMA
    bondholders
  • _______________________________________
  • Mortgage coupon rate 12
  • - Service fee (to the bank) 0.44
  • - GNMA insurance fee 0.06
  • GNMA pass-through bond coupon 11.50
  • ________________________________________

35
II.3 Further Incentives
  • Bank Balance Sheet after Securitization
  • Assets Liabilities
  • __________________________________________________
    ______
  • Cash reserves 10.66 Demand Deposits 106.6
  • Cash proceeds from 100.00 Capital 4.00
  • mortgage securitization
  • __________________________________________________
    ______
  • A dramatic change in the balance sheet exposure
    of the bank
  • 1. 100m illiquid mortgage loans have been
    replaced by 100m cash
  • 2. The duration mismatch has been reduced
  • 3. The bank has an enhanced ability to deal with
    and reduce its regulatory taxes.

36
III. Effects of Prepayments
  • Prepayment Risk Makes Mortgage-Backed Securities
    Unique
  • Prepayment gives mortgage holders a very valuable
    call option on the mortgage when this option is
    in the money.
  • The effect is to lower dramatically the principal
    and interest cash flows received in the later
    months of the pools life.
  • There are two reasons for prepayment by
    borrowers
  • 1. Adjustment in housing consumption
  • 2. Changes in market interest rates

37
III. Effects of Prepayments
  • Effects of prepayments
  • 1. Good news effects
  • Lower market yields increase present value of
    cash flows.
  • Principal received sooner.
  • 2. Bad news effects
  • Fewer interest payments in total.
  • Reinvestment at lower rates.

38
III. Effects of Prepayments
  • Measuring Prepayments
  • A specialized vocabulary for describing and
    measuring prepayments A "prepayment speed" or
    "prepayment rate" describes the pace at which
    borrowers prepay their mortgage loans.
  • Professionals often use two standardized models.
    The first, called "constant prepayment rate" or
    CPR, expresses the pace of prepayments in terms
    of a constant annual rate of prepayment.
  • For example, 10 CPR refers to a constant annual
    rate of prepayment such that borrowers prepay 10
    of the balance of a pool of loans each year.

39
III. Effects of Prepayments
  • A prepayment rate of "10 CPR" corresponds to a
    monthly prepayment rate (i.e., single monthly
    mortality or SMM) of approximately 0.8742,
    calculated as follows

40
III. Effects of Prepayments
  • Exhibit 5 shows the monthly level of principal
    cash flow on the pool of mortgage loans (100
    million, 30-year, 7, fixed rate). The shaded
    portions of the four panels have different
    shapes, but all have the same area. That is
    because the total amount of principal cash flows
    remains the same under all prepayment scenarios
    only the timing of the principal cash flows
    changes. At higher CPR prepayment speeds, more of
    the principal cash flow comes in the early years
    of the life of the pool. For example, at a
    prepayment speed of 6 CPR, the weighted average
    life or "WAL" of the pool is 10.8 years.25 At a
    slower prepayment speed of 3 CPR, the WAL is
    somewhat longer 14.4 years. Conversely, at a
    fast prepayment rate of 24, the WAL is just 3.5
    years. In graphical terms, the WAL corresponding
    to given CPR is roughly the point along the
    x-axis that divides the shaded area in half.

41
III. Effects of Prepayments
42
III. Effects of Prepayments
  • The second commonly used prepayment model is
    called PSA. The PSA model is based on the CPR
    model. It's like the CPR model except that
    prepayments start slowly and rise to their
    ultimate rate over a period of 2½ years (30
    months). More precisely, the base case of the PSA
    model (i.e., "100 PSA") is defined as follows
    prepayments are 0.2 CPR in the first month
    following origination of a pool of mortgage loans
    and increase by 0.2 CPR per month until they
    reach a steady-state rate of 6 CPR in the 30th
    month. Multiples of the base case, such as 200
    PSA, refer to situations where prepayments in
    each month are at a level corresponding to a
    multiple of the 100 PSA scenario.

43
III. Effects of Prepayments
  • Exhibit 7 shows the principal cash flows on our
    hypothetical pool of mortgage loans at various
    PSA prepayment speeds. Each panel in Exhibit 7
    shows the cash flows at a PSA prepayment speed
    that relates to the corresponding CPR speed in
    Exhibit 6. For example, the top left panel in
    Exhibit 7 shows the 100 PSA scenario, which
    corresponds to the 6 CPR scenario in Exhibit 6.
    Likewise, the 400 PSA scenario in Exhibit 7
    corresponds to the 24 CPR scenario in Exhibit
    6.

44
III. Effects of Prepayments
45
III. Effects of Prepayments
  • Prepayment in the Real World
  • Prepayments in the real world do not adhere to
    steady patterns like those embodied in the CPR
    and PSA models. Instead, prepayments are erratic
    and jumpy. All other things being equal, an
    environment of low interest rates motivates more
    borrowers to refinance their loans, producing
    higher prepayment speeds. Similarly, loans with
    higher interest rates tend to experience faster
    prepayments because the borrowers get favorable
    refinancing opportunities more frequently.

46
III. Effects of Prepayments
  • Exhibit 8 shows the reported prepayment speeds on
    loans backing two cohorts of Fannie Mae MBS
    those with pass-through rates of 5 and 6.5,
    respectively. The chart shows that the prepayment
    speed on the 6.5 MBS is consistently faster than
    the prepayment speed on the 5 MBS. In addition,
    the chart shows that the prepayment speeds of
    both cohorts rise and fall over time as interest
    rates fluctuate.

47
III. Effects of Prepayments
48
III. Effects of Prepayments
  • Prepayments result of sales or refinancing.
  • Since prepayment affects the cash flows to MBS,
    pricing models require estimates of the
    prepayment rates.
  • Methods
  • Option pricing approach.
  • Public Securities Association approach.
  • Empirical approach.

49
III. Effects of Prepayments PSA Model
  • The PSA (Public Securities Association) model
    assumes that the prepayment rate starts at 0.2
    per annum in the first month, increasing by 0.2
    per month for the first 30 months, until
    prepayment rate then levels off at a 6
    annualized rate for the remaining life of the
    pool.
  • Issuers or investors who assume that their
    mortgage pool prepayment exactly match this
    pattern are said to assume 100 percent PSA
    behavior.

50
III. Effects of Prepayments PSA Model
  • Actual prepayment rate may differ from PSAs
    assumed pattern
  • The level of the pools coupon relative to the
    current mortgage coupon rate
  • The age of the mortgage pool
  • Whether the payments are fully amortized
  • Assumability of mortgages in the pool.
  • Size of the pool
  • Conventional or nonconventional mortgages
  • Geographical location
  • Age and job status of mortgagees in the pool.

51
III. Effects of Prepayments PSA Model
  • On approach to control these factors is by
    assuming some fixed deviation of any specific
    pool from PSAs assumed average or benchmark
    pattern. E.g., one pool may be assumed to be 75
    PSA, and another 125 PSA. The formal has a
    lower prepayment rate than historically
    experienced the latter, a faster rate.

52
III. Effects of Prepayments PSA Model
Prepayment rate ()
125 PSA
7.5
100 PSA
6.0
4.5
75 PSA
Months
30
360
53
III. Effects of Prepayments Other Empirical
Models
  • Most empirical models are proprietary versions of
    the PSA model in which FIs make their own
    estimates of the pattern on monthly prepayments.
  • FIs begin by estimating a prepayment function
    from observing the experience of mortgage holders
    prepaying during any particular period on
    mortgage pools.

54
III. Effects of Prepayments Other Empirical
Models
  • The conditional prepayment rates in month i for
    similar pools would be modeled as functions of
    economic variables driving prepayment e.g.,
  • pi f(mortgage rate spread, age,
    collateral,
  • geographic factors, burn-out
    factor).
  • Once the frequency distribution of the pis is
    estimated, the bank can calculate the expected
    cash flows on the mortgage pool under
    consideration and estimate its fair yield given
    the current market price of the pool.

55
III. Effects of Prepayments Option Model Approach
  • Fair price on pass-through decomposable into two
    parts
  • PGNMA PTBOND - PPREPAYMENT OPTION
  • Option-adjusted spread between GNMAs and T-bonds
    reflects value of a call option. Specifically,
    the ability of the mortgage holder to prepay is
    equivalent to the bond investor writing a call
    option on the bond and the mortgagee owning or
    buying the option. If interest rates fall, the
    option becomes more valuable as it moves into the
    money and more mortgages are prepaid early by
    having the bond called or the prepayment option
    exercised.

56
III. Effects of Prepayments Option Model Approach
  • In the yield dimension
  • YGNMA YTBOND YPREPAYMENT OPTION
  • That is, the fair yield spread or option-adjusted
    spread (OAS) between GNMAs and T-bonds plus an
    additional yield for writing the valuable call
    option.

57
III. Effects of Prepayments Option Model Approach
  • Example Smiths Model
  • Assumptions
  • 1. The only reasons for prepayment are due to
    refinancing mortgage at lower rates
  • 2. The current discount (zero-coupon) yield curve
    for T-bonds is flat
  • 3. The mortgage coupon rate is 10 on an
    outstanding pool of mortgages with an outstanding
    principal balance of 1,000,000
  • 4. The mortgages have a 3-year maturity and pay
    principal and interest only once at the end of
    each year.
  • 5. Mortgage loans are fully amortized, and there
    is no service fee.

58
III. Effects of Prepayments Option Model Approach
  • Thus the annually fully amortized payment under
    no prepayment conditions is
  • R 1,000,000/(PVIFA 10, 3 yrs) 402,114.
  • At the current mortgage rate of 9, the GNMA
    bond would be selling at
  • P 402,114 (PVIFA 9, 3 yrs) 1,017,869.

59
III. Effects of Prepayments Option Model Approach
  • 6. Because of prepayment penalties and
    refinancing costs, mortgagees do not begin to
    prepay until mortgage rates fall 3 or more below
    the mortgage coupon rat
  • 7. Interest rate movements over time change a
    maximum of 1 up or down each year. The time
    path of interest rates follows a binomial
    process.
  • 8. With prepayment present, cash flows in any
    year can be the promised payment R 402,411,
    the promised payment (R) plus repayment of any
    outstanding principal, or zero in all mortgages
    have been prepaid or paid off in the previous
    year.

60
III. Effects of Prepayments Option Model Approach
  • End of Year 1 since interest rates can change up
    or down by 1 per annum, mortgages are not
    prepaid. GNMA bondholders receive the promised
    payment R401,114 with certainty.

61
III. Effects of Prepayments Option Model Approach
  • End of Year 2There are three possible mortgage
    rates 11, 9, and 7 with 25, 50, and 25 of
    probability.
  • If prepayment occurs, the investor receives
  • R principal balance remaining at the end of yr
    2
  • 402,114 365,561 767,675
  • Thus CF2 .25(767,675) .75(402,114)
    493,504.15

62
III. Effects of Prepayments Option Model Approach
  • End of Year 3 since there is a 25 probability
    that mortgages are prepaid in yr 2, the investor
    will receive no cash flows at the end of yr 3.
    However, there is also a 75 probability that
    mortgages will not be prepaid in yr 2, the
    investor will receive the promised payment R
    402,114.
  • CF3 .25(0) .75(402,114) 301,586

63
III. Effects of Prepayments Option Model Approach
  • Deviation of the Option-Adjusted Spread
  • The required yield on a GNMA with prepayment risk
    is divided into the required yield on T-bond plus
    a required spread for the prepayment call option
    given to the mortgage holders
  • E(CF1) E(CF2) E(CF3)
  • P ------------ -------------
    --------------
  • (1d1Os) (1d2Os)2 (1d3Os)3

64
III. Effects of Prepayments Option Model Approach
  • Assume that the T-bond yield curve is flat, so
    that d1 d2 d3 8 then
  • 401,114 493,504 301,585
  • P ------------ -------------
    --------------
  • (1.08Os) (1.08 Os)2 (1.08 Os)3
  • Os 0.96 and
  • YGNMA YTBOND Os
  • 8 0.96 8.96

65
IV. Collateralized Mortgage Obligation (CMO)
  • Definition A mortgage-backed pay-through Bond
    that categorized investors into groups
    (traunches) who were designated to receive
    repayment of principal in the pool in a
    sequential manner, rather than the traditional
    pro-rata share.
  • Initial CMO was issued by Freddie Mac in 1983
    note that prepayment risk was a big concern at
    this time because interest rates had been
    relatively volatile, moving up very rapidly to
    unanticipated heights during the preceding decade.

66
IV. Collateralized Mortgage Obligation (CMO)
  • CMO structure
  • CMOs can be created either by packaging and
    securitizing whole mortgage loans or by placing
    existing pass-throughs in a trust.
  • The investment bank or issuer creates the CMO to
    make a profit. The sum of the prices at which the
    CMO bond classes can be sold normally exceeds
    that of the original pass-throughs.
  • Prepayment effects differ across tranches.
  • Improves marketability of the bonds.

67
IV. Collateralized Mortgage Obligation (CMO)
68
IV. Collateralized Mortgage Obligation (CMO)
  • Other classes
  • Class Z is the last regular class. After the
    other classes have been retired, Z-class
    bondholder receives the promised coupon and
    principal payments
  • Class R Garbage class is the residual class
    giving the owner the right to any remaining
    collateral in the trust after all other bond
    classes have been retired any reinvestment
    income earned by the trust.

69
IV. Collateralized Mortgage Obligation (CMO)
  • The Value Additivity of CMOs
  • Suppose an investment bank buys a 150m issue of
    GNMAs and places them in trust as collateral. It
    then issues a CMO with
  • Class A Annual fixed coupon 7, class size 50m
  • Class B Annual fixed coupon 8, class size 50m
  • Class C Annual fixed coupon 9, class size 50m

70
IV. Collateralized Mortgage Obligation (CMO)
  • Assume that in month 1 the promised amortized
    cash flows on the mortgages are 1m but there is
    an additional 1.5m cash flows as a result of
    early prepayment. These are distributed to CMO
    holders as
  • Coupon payments
  • Class A (7) 291,667
  • Class B (8) 333,333
  • Class C (9) 375,000

71
IV. Collateralized Mortgage Obligation (CMO)
  • Principal Payments
  • The 1.5m cash flows remaining will be paid to
    Class A holders to reduce its principal
    outstanding to 50m-1.5m48.5m.
  • Between 1.5 to 3 years after issue, Class A will
    be fully retired. The trust will continue to pay
    Class B and C holders the promised coupon
    payments of 333,333 and 375,000 monthly. Any
    cash flows over the promised coupons will be paid
    to retire Class B CMOs.

72
IV. Collateralized Mortgage Obligation (CMO)
  • Class Z This class has a stated coupon, such as
    10, and accrues interest for the bondholders on
    a monthly basis at this rate. The trust does not
    pay this interest, however, until all other
    classes are fully retired. Then Z-class holders
    received coupon and principal payments plus
    accrued interest payments. Thus, Z-class has
    characteristics of both a zero-coupon bond and a
    regular bond.

73
IV. Collateralized Mortgage Obligation (CMO)
  • Class R CMOs tend to be over-collaterized
  • CMO issuers normally uses very conservative
    prepayment assumptions. If prepayments are
    slower than expected, there is often excess
    collateral left over when all regular classes are
    retired.
  • Trustees often reinvest cash flows in the period
    prior to paying interest on the CMOs. The higher
    the interest rate and the timing of coupon
    intervals is semiannual rather than monthly, the
    larger the excess collateral.

74
IV. Collateralized Mortgage Obligation (CMO)
  • This residual R-class is a high-risk investment
    class that gives the investor the rights to the
    overcollateralization and reinvestment income on
    the cash flows in the CMO trust.
  • Because the value of the returns in this bond
    increases when interest rates rise, while normal
    bond values fall with interest rate increases,
    Class R often has a negative duration.

75
V. Mortgage-Backed Bonds (MBBs)
  • Definition This security represents a general
    obligation of the issuing entity. The payments
    are collateralized by and derived from an
    underlying pool of mortgages.
  • Ways that the bond differs from the pass-through
    security
  • 1. Prepayment risk is absorbed by the issuer
  • This is handled through over collateralization of
    the pool
  • (range 120 to 240 of the mortgages needed to
    handle
  • the cash flows)

76
V. Mortgage-Backed Bonds (MBBs)
  • 2. Typically issued by private mortgage
    originators. Therefore government guarantees are
    replaced with private pool insurance and/or
    ratings by bond rating agencies (e.g., Standard
    and Poors or Moodys)
  • 3. Sale of securities not treated as an asset
    sale to the issuer.
  • 4. Cash flows can be restructured to meet the
    needs of the investor because mortgage payments
    are not being directly passed through.

77
V. Mortgage-Backed Bonds (MBBs)
  • Differs from pass-throughs and CMOs in two key
    dimensions
  • 1. While pass-throughs and CMOs remove mortgages
    from balance sheets, MBBs normally remain on the
    balance sheet.
  • 2. Pass-throughs and CMOs have a direct link
    between the cash flow on the underlying
    mortgages, with MBBs the relationship is one of
    collateralization.

78
V. Mortgage-Backed Bonds (MBBs)
  • Normally remain on the balance sheet and
    over-collaterized to reduce funding costs.
  • __________________________________________________
    ________________
  • Assets Liabilities
  • __________________________________________________
    ________________
  • Long-term Mortgages 20 Insurance
    Deposits 10
  • Uninsured Deposits 10
  • __________________________________________________
    ________________
  • Collateral 12 MBB 10
  • Other Mortgages 8 Insured Deposits
    10
  • __________________________________________________
    ________________

79
V. Mortgage-Backed Bonds (MBBs)
  • Regulatory concerns the bank gains only because
    the FDIC is willing to bear enhanced credit risk
    through its insurance guarantees to depositors.

80
V. Mortgage-Backed Bonds (MBBs)
  • Other drawbacks to MBBs
  • MBB ties up mortgages on the balance sheet.
  • The need to overcollaterize to ensure a
    high-quality credit risk rating.
  • By keeping mortgages on the balance sheet, the
    bank continues to be liable for capital adequacy
    and reserve requirement taxes.

81
VI. Innovations in Securitization
  • IO/PO Stripped Securities
  • Definition Mortgage-backed securities in which
    the payments from a mortgage are split (stripped)
    into two securities.
  • Investors in the interest only portion (IO)
    receive only the interest payments from the pool
    of mortgages. Investors in the principal only
    portion (PO) receive all principal repaid
    including amortization and prepayment.
  • The change in the value of these two components
    is very different when interest rates change.

82
VI. Innovations in Securitization
  • For a decline in interest rates
  • 1. The price of the PO strip security increases
    there is rapid prepayment of most principal and
    discount rates drop. The combined effect is to
    increase the value of these securities
  • 2. The price of an IO strip security decreases
    the rapid prepayment rate truncates the interest
    payment stream so severely that the value goes
    almost to zero.

83
VI. Innovations in Securitization
  • For an increase in interest rates
  • 1. The price of the PO strip security decreases
    the repayment of principal further in the future
    and the increasing discount rate causes this
    securitys value to decrease.
  • 2. The price of the IO strip may increase or
    decrease the payment stream is increasing as
    the prepayment rate is reduced, thereby
    increasing value. However, increases in the
    discount rate will decrease the value.
  • These two effects would offset one another and we
    would expect there to be relatively little impact
    on value.

84
VI. Innovations in Securitization
  • Pass-through strips
  • IO strips The owner of an IO strip has a claim
    to the present value of interest payments by the
    mortgagees. When interest rates change, they
    affect the cash flows received on mortgages
  • Discount Effect As interest rates fall, the
    present value of any cash flows received on the
    strip rises, increasing the value of the IO
    strips.
  • Prepayment Effect As interest rates fall,
    mortgagees prepay their mortgages. The number of
    IO payments the investor receives is likely to
    shrink, which reduces the value of IO bonds.

85
VI. Innovations in Securitization
  • IO Strip (continued)
  • Specifically, one can expect that as interest
    rates fall below the mortgage coupon rate, the
    prepayment effect gradually dominates the
    discount effect, so that over some range of the
    price or value of IO bond falls as interest rates
    fall (negative duration).
  • The negative duration IO bond is a very valuable
    asset as a portfolio-hedging device.

86
VI. Innovations in Securitization
  • PO strip the mortgage principal components of
    each monthly payment, which include the monthly
    amortized payment and any early prepayments.
  • Discount Effect As yields fall, the present
    value of any principal payments must increase and
    the value of the PO strip rises.
  • Prepayment Effect As yields fall, the mortgage
    holders pay off principal early. The PO bond
    holders received the fixed principal balance
    outstanding earlier than stated. This works to
    increase the value of the PO strip.

87
VI. Innovations in Securitization
  • PO Strip (Continued)
  • As interest rates fall, both the discount and
    prepayment effects point to a rise in the value
    of PO strip. The price-yield curve reflects an
    inverse relationship, but with a steeper slope
    than for normal bonds I.e., PO strip bond values
    are very interest rate sensitive, especially for
    yields below the stated mortgage coupon rate.

88
VI. Innovations in Securitization
  • Securitization of other assets
  • CARDs (Certificates of Amortized Revolving
    Debts)
  • Various receivables, loans, junk bonds, ARMs.

89
VII. Can All Assets Be Securitized?
  • Benefits Costs
  • __________________________________________________
    _________
  • 1 New funding source 1. Cost of public/private
    credit risk
  • insurance and guarantees
  • 2. Increased liquidity of bank loans 2. Cost of
    overcollateralization
  • 3. Enhanced ability to manage the 3. Valuation
    and packaging costs
  • duration gap (the cost of asset heterogeneity)
  • 4. If offbalance-sheet, the issuer
  • on reserve requirements, deposit
  • insurance premiums, and capital
  • adequacy requirements
  • __________________________________________________
    _________
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