FIBI

1
Fixed Income Instruments 4

• Zvi Wiener
• 02-588-3049
• mswiener_at_mscc.huji.ac.il

2
Fixed Income 4

• Mortgage loans
• Pass-through securities
• Prepayments
• Agencies
• MBS
• CMO
• ABS

3
Mortgage Loans

• Mortgage is a loan secured by a specified real
  estate property.
• Conventional mortgage - credit of the borrower
  and collateral.
• Mortgage insurance - FHA, VA, FmHA guaranteed by
  US government, there are some private insurers as
  well.

4
(No Transcript)
5
Mortgage Market

• Mortgage originator - thrifts, banks
• origination fee (in points )
• PTI payment to income ratio (include tax)
• LTV loan to value ratio
• later on mortgages are securitized.

6
Mortgage Services

• Collecting payments, maintaining records
• Servicing fee - of outstanding plus some other
  benefits.
• Mortgage insurer required when LTVgt80.
• Credit life - voluntary life insurance.

7
Fixed Rate Mortgage

• A series of equal payments with PVloan.
• Example 100,000 for 20 years with 6 and equal
  monthly payments.

8
Adjustable-Rate Mortgage (ARM)

• The contract rate is reset periodically, based on
  a short term interest rate.
• Adjustment from one month to several years.
• Spread is fixed, some have caps or floors.
• Market based rates.
• Rates based on cost of funds for thrifts.
• Initially low rate is often offered teaser rate.

9
Balloon Mortgage

• One payment at the end.
• Sometimes they have renegotiation points.

10
Two-Step Mortgages

• A loan carries a fixed rate for some period
  (usually 7 years) and then reset rates.
• For example 250 basis points plus average of
  10-years Treasuries.

11
Risk in Mortgages

• Default risk
• Liquidity risk
• Interest rate risk
• Prepayment risk

12
Risk in Mortgages

• Default risk is highly affected by LTV.
• LTVgt80 in 40 of loans
• LTVgt90 in 15 of loans
• different state laws give different
• rights to lenders.

13
Prepayment Risk in Mortgages

• Sale of home
• Better interest rates
• Irrational factors

14
Mortgage Pass-Through Securities

• A group of mortgages form a pool which is
  securitized.
• Payments are pooled, service fee deducted and the
  rest divided.
• WAC weighted average coupon rate
• WAM weighted average maturity

15
Mortgage Pass-Through Securities

• Ginnie Mae Government National Mortgage
  Association, MBS - guaranteed by GNMA.
• Freddie Mac Federal Home Loan Mortgage
  Corporation, PC participation certificate.
• Fannie Mae Federal National Mortgage
  Association, MBS.

16
Role of Agencies

• guarantee timely payments
• 1. Coupon only
• 2. Both coupon and principal
• Ginnie Mae is guaranteed by the US government.
  Securities guaranteed by Ginnie Mae are called
  MBS Mortgage Backed Securities.

17
Non-Agency Pass-Through

• Credit enhancement to AA or AAA.
• Overcollateralization
• Senior/subordinated structure
• shifting interest structure
• months of prepayment to senior
• 1-60 70
• 61-72 60
• 73-84 40
• 85-96 20
• 97-108 12

18
Prepayments

• Prepayment speed, conditional prepayment rate CPR
  (prepayment rate assumed for a pool).
• Single-Monthly mortality rate SMM.
• SMM 1 - (1-CPR)1/12

19
Example of prepayments

• Example let CPR6, then
• SMM 1-(1-0.06)1/12 0.005143.
• An SMM of 0.5143 means that approximately 0.5
  of the mortgage balance will be prepaid this
  month.

20
Example of prepayments

• If the balance at the beginning of a month is
  290M, SMM 0.5143 and the scheduled principal
  payment is 3M, then the estimated repayment for
  this month is
• 0.005143 (290,000,000-3,000,000)1,476,041

21
Prepayments

• A general model should be based on a dynamic
  transition matrix, very similar to credit
  migration.
• But note the difference of a pool of not
  completely rational customers and a single firm.

22
Prepayments

• Prevailing mortgage rate relative to original.
• Path of mortgage rates.
• Level of mortgage rates.
• Seasonal factors (home buying is high in spring
  summer and low in fall, winter).
• General economic activity.

23
Bond Equivalent Yield

• Bond equivalent yield 2 (1yM)6 - 1
• Yield is based on prepayment assumptions and must
  be checked!
• PSA benchmark Public Securities Association.
  Assumes low prepayment rates for new mortgages,
  and higher rates for seasoned loans.

24
PSA prepayment benchmark

• The Public Securities Association benchmark is
  expressed as monthly series of annual prepayment
  rates.
• Low prepayment rates of new loans and higher for
  old ones.
• Assumes CPR increasing 0.2 to 6 with life of a
  loan.
• Actual rate is expressed as of PSA.

25
100 PSA
Annual CPR in
6
0.2
0 30 Age in months
26
(No Transcript)
27
(No Transcript)
28
(No Transcript)
29
(No Transcript)
30
Effective Duration
31
PSA standard default assumptions
Annual default rate (SDA) in
0.6
Month 1 - 0.02 increases by 0.02 till
30m stable at 0.6 30-60m declines by 0.01
61-120m remains at 0.03 after 120m
0.3
0.02
0 30 60 120 Age in months
32
Special Properties

• Negative convexity - if interest rates go up the
  price of a pass through security will decline
  more than a government bond due to lower
  prepayment rate.

33
CMO and stripped MBS (ch. 12)

• Collateralized Mortgage Obligations - are bond
  classes created by redirecting the cash flows of
  mortgage related products so as to mitigate
  prepayment risk.
• CMO is backed by a pool of pass-throughs, whole
  loans, or strips, structured in order to serve
  different types of clients.
• The bond classes are called tranches.

34
CMO Example

• Since 1983 - sequential-pay CMO. Each class is
  retired sequentially.
• Example collateral is a pass-through with
• par of 400M
• pass-through coupon rate 7.5
• WAC weighted average coupon 8.125
• WAM weighted average maturity 357 mo.

35
CMO Example

• 4 tranches A,B,C,D divide the whole nominal,
  coupons will be distributed proportionally, but
  principals first go to A, until repaid, then to
  B, etc.
• Another example is an accrual CMO when one of the
  tranches does not get receive current interest.
  It is accrued and added to the principal.

36
CMO Example

• Some tranches are floaters, others inverse
  floaters.
• Floater Variable Rate spread
• Inverse Floater Spread - Variable Rate
• Often LIBOR is used as variable rate.

37
Other CMOs

• PAC Planned Amortization Class,
• IO interest only,
• PO principal only,
• IO, PO strips.

38
(No Transcript)
39
(No Transcript)
40
ABS Asset-Backed Securities (13)

• Collateral,
• credit enhancement,
• Payment structure (priorities),
• legal structure (SPVspecial purpose vehicle)
• Auto loan backed securities
• Credit Card backed securities
• Home Equity loans (second lien)

41
Front office
Back office
Middle office
Institutional investor (buyer) Market Maker
(dealer)
42
Front Office

• Trade execution
• Investment decisions
• Contact with counterparties
• Real-time market monitoring

43
Middle Office

• Risk management
• Benchmark
• Valuation
• Economic forecasts
• Some investment decisions
• Internal grading, scoring
• Pricing of services
• Profitability of business lines

44
Back Office

• Trade settlement, clearing
• Margin management
• Accounting
• Administration
• Record maintenance
• Regulatory compliance
• Inventory reporting

45
Pfandbrief

• Zvi Wiener
• 02-588-3049
• http//pluto.mscc.huji.ac.il/mswiener/zvi.html

46
Pfandbrief

• Bonds issued by German banks which are subject to
  special Pfandbrief legislation. There are two
  types of Pfandbriefe depending on the collateral.
• Oeffentliche Pfandbriefe are bonds fully
  collateralized by loans to public-sector
  entities, while Hypotheken-Pfandbriefe are fully
  collateralized by residential and commercial
  mortgages, with LTVlt60.

47
Pfandbrief

• Mortgage Banks - about 20 of the business
  volume of all banking groups.
• Only few Mortgage Banks are independent, most
  belong to a larger banking group.
• residential mortgage loans
• commercial mortgage loans
• public sector lending
• refinancing through the issuing of Pfandbriefe

48
Public Sector Loans in Germany

• bn Euros 2000
• Mortgage banks 259 54.5
• Public banks 135 28.4
• Savings banks 27 5.7
• Commercial banks 30 6.3
• Cooperative banks 7.5 1.6
• Agencies 16 3.4
• Total 476 100

49
Commercial Loans in Germany

• bn Euros 2000
• Mortgage banks 110 50.4
• Public banks 35.5 16.3
• Savings banks 40 18.2
• Commercial banks 16 7.3
• Cooperative banks 16 7.4
• Others 1 0.3
• Total 218 100

50
(No Transcript)
51
The Mortgage Loan Portfolio (12/00)

• 36 commercial property
• 64 residential property
• Total Volume 342,726 million Euro
• Foreign loans 28,690 million Euro

52
Refinancing of the German Mortgage Banks

• Largest bond market in Europe
• Outstanding volume in 2000 - 1.1 trillion euro
• Gross sales 2000 - 216 billion euro
• Issuers
• private Mortgage Banks
• private ship Mortgage Banks
• public sector credit institutions

53

• Jumbo Pfandbrief above 500 million euro
• Straight bond format
• Structured Pfandbriefe
• maturities 1-10 years
• are eligible collateral

54
(No Transcript)
55
European Pfandbriefcountries
56
(No Transcript)
57
(No Transcript)
58
(No Transcript)
59
(No Transcript)
60
(No Transcript)
61
PEX ltGOgt
62
DAC

• Zvi Wiener
• 02-588-3049
• http//pluto.mscc.huji.ac.il/mswiener/zvi.html

63
Life Insurance

• yearly contribution 10,000 NIS
• yearly risk premium 2,000 NIS
• first year agents commission 3,000 NIS
• promised accumulation rate 8,000 NIS/yr
• After the first payment there is a problem of
  insufficient funds. 8,000 NIS are promised (with
  all profits) and only 5,000 NIS arrived.

64
10,000 NIS

• insufficient funds if the client leaves
• insufficient profits

65
Risk measurement

• The reason to enter this transaction is because
  of the expected future profits.
• Assume that the program is for 15 years and the
  probability of leaving such a program is ?.
• Fees are
• 0.6 of the portfolio value each year
• 15 real profit participation