Residential Mortgages and Mortgage-Backed Securities

1
Residential Mortgages and Mortgage-Backed
Securities
2
Mortgage-Backed Securities
3
Mortgage-Backed Securities

• A mortgage originator with a pool of mortgages
  has the option of holding the portfolio, selling
  it, or selling it to be used to securitize a MBS
  issue or deal.
• Depending on the types of mortgages, the
  originator who sells mortgages to become a
  securitized asset can sell them to one of the
  three agencies (Fannie Mae, Ginnie Mae, or
  Freddie Mac) or to a private-sector conduit.
• As noted in Chapter 7, Fannie Mae and Freddie Mac
  are Government-sponsored enterprises (GSEs),
  whereas Ginnie Mae is a federal agency. In our
  discussion of MBSs, we will refer to all three as
  being agencies.

4
Mortgage-Backed Securities

• Agency MBSs are MBSs created by one of the
  agencies they are collectively referred to as
  agency MBSs,
• Nonagenecy MBS are MBS created by private
  conduits also called private labels.

5
Mortgage-Backed Securities

• Residential mortgages can be divided into prime
  and subprime mortgages.
• Prime mortgages include those that are both
  conforming (meet the agencys underwriting
  standards) and nonconforming but still meeting
  credit quality standards.
• Subprime mortgages include those with low credit
  ratings.

6
Mortgage-Backed Securities

• Note
• Typically, agency residential MBSs are created
  from conforming loans.
• In more recent periods, though, agency MBS issues
  backed by pools of lower quality mortgages were
  issued.
• All other mortgages that are securitized are
  nonagency MBS.

7
Mortgage-Backed Securities

• After the mortgages are sold to an agency or
  private conduit, the originator typically
  continues to service the loan for a service fee
  (that is, collect payments, maintain records,
  forward tax information, and the like).
• The service fee is typically a fixed percentage
  (25 to 100 basis points) of the outstanding
  balance.
• The originator can also sell the servicing to
  another party.
• Investors who buy the MBSs receive a pro rata
  share from the cash flow of the pool of
  mortgages.

8
Ginnie Mae Mortgage-Backed Securities

• Ginnie Mae (Government National Mortgage
  Association's (GNMA)) is a true federal agency.
• As such, the MBSs that it guarantees are backed
  by the full faith and credit of the U.S.
  government.

9
Ginnie Mae Mortgage-Backed Securities

• Creation
• Ginnie Mae MBSs are put together by a
  lender/originator (bank, thrift, or mortgage
  banker), who presents a block of mortgages that
  meets Ginnie Maes underwriting standards.
• If Ginnie Mae finds them in order, it will issue
  a guarantee and assign a pool number that
  identifies the MBS that is to be issued.
• The lender will then transfer the mortgages to a
  trustee, and then issue the pass-through
  securities as a Ginnie Mae pass-through security.

10
Ginnie Mae Mortgage-Backed Securities

• Features
• Ginnie Mae provides the guarantee, but does not
  issue the Ginnie Mae MBS.
• Thus, different from the standard MBS that is
  issued by the other agencies or a conduit, Ginnie
  Mae MBSs are issued by the lenders.
• The minimum denomination on a Ginnie Mae
  pass-through is 25,000 and the minimum pool is
  1 million.

11
Ginnie Mae Mortgage-Backed Securities

• Types
• The mortgages underlying Ginnie Mae MBSs can be
  grouped into one of two Ginnie Mae MBS programs
  Ginnie Mae I and Ginnie Mae II.
• The Ginnie Mae I program consists of MBSs backed
  by single-family and multifamily mortgage loans
  that have a fixed note rate and are sold by only
  one issuer.
• The Ginnie Mae II program consists of just
  single-family mortgage loans that can have either
  fixed or adjustable rates and have multiple
  issuers.

12
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

• Fannie Mae and Freddie Mac are Government-sponsore
  d enterprises (GSE) initially created to provide
  a secondary market for mortgages.
• Today, there activities include not only the
  buying and selling of mortgages, but also
  creating and guaranteeing mortgage-backed
  pass-through securities, as well as buying MBSs.

13
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

• Note
• Both GSEs are regulated by the Office of Federal
  Housing Enterprise Oversight (OFHEO) and both
  were placed in conservatorship in September 2008.
  
• Prior to being placed in conservatorship, the
  Fannie Mae and Freddie Mac MBSs were guarantee by
  each of the companies, but not the government.
• As part of the banking bailout in 2008, though,
  government backing was provided to their MBSs.

14
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

• Freddie Mac issues MBSs that it refers to as
  participation certificates (PCs).
• Freddie Mac and Fannie Mae have regular MBSs
  (also called a cash PC), which are backed by a
  pool of conforming mortgages that they have
  purchased from mortgage originators.
• They also offer a pass-though formed through
  their Guarantor/Swap Program. In this program,
  mortgage originators can swap mortgages for a
  Fannie Mae or Freddie Mac pass-through.

15
Fannie Mae and Freddie Mac Mortgage-Backed
Securities

• Unlike Ginnie Mae, Fannie Maes and Freddie Mac's
  MBSs are formed with more heterogeneous
  mortgages.
• The minimum denomination on a Freddie Mac and
  Fannie Mae pass-through is 100,000 and their
  mortgage pools range up to several hundred
  million dollars.

16
Nonagency MBS

• Nonagency pass-throughs or private labels are
  sold by commercial banks, investment banks, other
  thrifts, and mortgage bankers.
• As noted, nonagency pass-throughs are often
  formed with prime or subprime nonconforming
  mortgages.
• Larger issuers of nonagency MBSs include
  Citigroup, Bank of America, and G.E. Capital
  Mortgage.

17
Nonagency MBS

• Features
• Nonagency MBSs are often guaranteed against
  default through external credit enhancements,
  such as the guarantee of a corporation or a bank
  letter of credit or by private insurance from a
  monocline insurer.
• Many are also guaranteed internally through the
  creation of senior and subordinate classes of
  bonds with different priority claims on the
  pool's cash flows in the case some of the
  mortgages in the pool default.
• The more subordinate claims sold relative to the
  senior claims, the more secure the senior claims.

18
Nonagency MBS

• Features
• Nonagency MBSs are rated by Moody's and Standard
  and Poor's.
• They must be registered with the SEC when they
  are issued.

19
Nonagency MBS

• Features
• Most financial entities that issue private-label
  MBSs or derivatives of MBSs are legally set up so
  that they do not have to pay taxes on the
  interest and principal that passes through them
  to their MBS investors.
• The requirements that MBS issuers must meet to
  ensure tax-exempt status are specified in the Tax
  Reform Act of 1983 in the section on trusts
  referred to as Real Estate Mortgage Investment
  Conduits, REMIC.
• Private-labeled MBS issuers who comply with these
  provisions are sometimes referred to as REMICs.

20
Nonagency MBS

• Features
• Nonagency residential MBSs differ fundamentally
  from agency MBSs in that their cash flows are
  subject to default risk, whereas agency MBSs with
  their government and agency guarantees are
  considered default free.

21
Cash Flows

• Cash flows from MBSs are generated from the cash
  flows from the underlying pool of mortgages,
  minus servicing and other fees.
• Typically, fees for constructing, managing, and
  servicing the underlying mortgages (also referred
  to as the mortgage collateral) and the MBSs are
  equal to the difference between the rates
  associated with the mortgage pool and the rate
  that is paid to the MBS investors (pass-through
  (PT) rate).

22
Cash Flows Terms

1. Weighted Average Coupon Rate, WAC Mortgage
   portfolio's (collaterals) weighted average rate.
2. Weighted Average Maturity, WAM Mortgage
   portfolio's weighted average maturity.
3. Pass-Through Rate, PT Rate Interest rate paid on
   the MBS PT rate is lower than WACthe difference
   going to the MBS issuer.
4. Prepayment Rate or Speed Assumed prepayment rate.

23
Cash Flow from a MBS

• Example
• The next slide shows the monthly cash flows for
  a MBS issue constructed from a 100 million
  mortgage pool with the following features
• Current balance 100 million
• WAC 8
• WAM 355 months
• PT rate 7.5
• Prepayment speed equal to 150 of the standard
  PSA model PSA 150

24
Projected Cash Flows from an Agency MBS
IssueMortgage Portfolio 100,000,000, WAC
8, WAM 355 Months, PT Rate 7.5, Prepayment
150 PSA
25
Cash Flow from a MBS

• Notes
• The first month's CPR for the MBS issue reflects
  a 5-month seasoning in which t 6, and a speed
  that is 150 greater than the 100 PSA. For the
  MBS issue, this yields a first month SMM of
  .0015125 and a constant SMM of .0078284 starting
  in month 25.
• The WAC of 8 is used to determine the mortgage
  payment and scheduled principal, whereas the PT
  rate of 7.5 is used to determine the interest.
• The monthly fees implied on the MBS issue are
  equal to .04167 (8 - 7.5)/12 of the monthly
  balance.

26
Cash Flow from a MBS

• First Months Payment

27
Cash Flow from a MBS

• From the 736,268 payment, 625,000 would go
  towards interest and 69,601 would go towards the
  scheduled principal payment

28
Cash Flow from a MBS

• Using 150 PSA model and seasoning of 5 months
  the first month SMM .0015125

29
Cash Flow from a MBS

• Given the prepayment rate, the projected prepaid
  principal in the first month is 151,147

30
Cash Flow from a MBS

• Thus, for the first month, the MBS would generate
  an estimated cash flow of 845,748 and a balance
  at the beginning of the next month of 99,779,252

31
Cash Flow from a MBS

• Second Month Payment, Interest, Scheduled
  Principal, Prepaid Principal, and Cash flow

32
Market

• As noted, investors can acquire newly issued
  mortgage-backed securities from the agencies,
  originators, or dealers specializing in specific
  pass-through.
• There is also a secondary market consisting of
  dealers who operate in the OTC market as part of
  the Mortgage-Backed Security Dealers Association.
  
• These dealers form the core of the secondary
  market for the trading of existing pass-through.

33
Market

• MBSs are normally sold in denominations ranging
  from 25,000 to 250,000, although some
  privately-placed issues are sold with
  denominations as high as 1 million.

34
Price Quotes

• The prices of MBSs are quoted as a percentage of
  the underlying MBS issues balance.
• The mortgage balance at time t, Ft, is usually
  calculated by the servicing institution and is
  quoted as a proportion of the original balance,
  F0.
• This proportion is referred to as the pool
  factor, pf

35
Price Quotes

• Example
• A MBS backed by a mortgage pool originally worth
  100 million
• Current pf of 0.92
• quoted at 95 - 16 (Note 16 is 16/32)
• The current balance, Ft, would be 92 million
  and the market value would be 87.86 million

36
Price Quotes

• Note
• The market value is the clean price it does not
  take into account accrued interest.
• For MBS, accrued interest is based on the time
  period from the settlement date (typically two
  days after the trade) and the first day of the
  next month.

37
Price Quotes

• Example
• If the time period is 20 days, the month is 30
  days, and the WAC 9, then the accrued interest
  is 460,000
• The full market value (clean price plus accrued
  interest) would be 88,320,000

38
Price Quotes

• The market price per share is the full market
  value divided by the number of shares.
• Example
• If the number of shares is 400, then the price of
  the MBS based on a 95 - 16 quote would be
  220,800

39
Extension Risk

• Like other fixed-income securities, the value of
  a MBS is determined by the MBS's future cash flow
  (CF), maturity, default risk, and other features
  germane to fixed-income securities.

40
Extension Risk

• In contrast to other bonds, MBSs are also subject
  to prepayment risk.
• Prepayment affects the MBSs CF.
• Prepayment, in turn, is affected by interest
  rates.

41
Extension Risk

• Thus, interest rates affects the MBSs CFs

42
Extension Risk

• With the CF a function of rates, the value of a
  MBS is more sensitive to interest rate changes
  than those bonds whose CFs are not.
• This sensitivity is known as extension risk.

43
Extension Risk

• If interest rates decrease, then the prices of
  MBSs, like the prices of most bonds, would
  increase as a result of the lower discount rates.
  
• However, the decrease in rates will also augment
  prepayment speed, causing the earlier cash flow
  of the mortgages to be larger which, depending on
  the level of rates and the maturity remaining,
  could also contribute to increasing the MBSs
  price.

44
Extension Risk

• Rate Decrease

45
Extension Risk

• If interest rates increase, then the prices of
  MBSs will decrease as a result of higher discount
  rates and possibly the smaller earlier cash flow
  resulting from lower prepayment speeds.

46
Extension Risk

• Rate Increase

47
Average Life

• The average life of a MBS or mortgage portfolio
  is the weighted average of the securitys time
  periods, with the weights being the periodic
  principal payments (scheduled and prepaid
  principal) divided by the total principal

48
Average Life

• The average life for the MBS issue with WAC 8,
  WAM 355, PT Rate 7.5, and PSA 150 is 9.18
  years

49
Average Life

• The average life of a MBS depends on prepayment
  speed
• If the PSA speed of the 100 million MBS issue
  were to increase from 150 to 200, the MBSs
  average life would decrease from 9.18 to 7.55,
  reflecting greater principal payments in the
  earlier years.
• If the PSA speed were to decrease from 150 to
  100, then the average life of the MBS would
  increase to 11.51.

50
Average Life and Prepayment Risk

• For MBSs and mortgage portfolios, prepayment risk
  can be evaluated in terms of how responsive a
  MBS's or mortgage portfolios average life is to
  changes in prepayment speeds

51
Average Life and Prepayment Risk

• A MBS with an average life that did not change
  with PSA speeds, in turn, would have stable
  principal payments over time and would be absent
  of prepayment risk.

52
MBS Derivatives
53
MBS Derivatives

• One of the more creative developments in the
  security market industry over the last three
  decades has been the creation of derivative
  securities formed from MBSs and mortgage
  portfolios that have different prepayment risk
  characteristics, including some that are formed
  that have average lives that are invariant to
  changes in prepayment rates.
• The most popular of these derivatives are
• Collateralized Mortgage Obligations, CMOs
• Stripped MBS

54
Collateralized Mortgage Obligations

• Collateralized mortgage obligations, CMOs, are
  formed by dividing the cash flow of an underlying
  pool of mortgages or a MBS issue into several
  classes, with each class having a different claim
  on the mortgage collateral and with each sold
  separately to different types of investors.

55
Collateralized Mortgage Obligations

• The different classes making up a CMO are called
  tranches or bond classes.
• There are two general types of CMO tranches
• Sequential-Pay Tranches
• Planned Amortization Class Tranches, PAC

56
Sequential-Pay Tranches

• A CMO with sequential-pay tranches, called a
  sequential-pay CMO, is divided into classes with
  different priority claims on the collateral's
  principal.
• The tranche with the first priority claim has its
  principal paid entirely before the next priority
  class, which has its principal paid before the
  third class, and so on.
• Interest payments on most CMO tranches are made
  until the tranche's principal is retired.

57
Sequential-Pay Tranches

• Example
• A sequential-pay CMO is shown in Slide 59.
• This CMO consist of three tranches, A, B, and C,
  formed from the collateral making up the 100
  million MBS in the previous example F 100
  million, WAM 355, WAC 8, PT Rate 7.5, PSA
  150.
• Tranche A 50 million
• Tranche B 30 million
• Tranche C 20 million

58
Sequential-Pay Tranches

• Priority Disbursement Rules
• Tranche A receives all principal payment from the
  collateral until its principal of 50 million is
  retired. No other tranche's principal payments
  are disbursed until the principal on A is paid.
• After tranche A's principal is retired, all
  principal payments from the collateral are then
  made to tranche B until its principal of 30
  million is retired.
• Finally, tranche C receives the remaining
  principal that is equal to its par value of 20
  million.
• Although the principal is paid sequentially, each
  tranche does receive interest each period equal
  to its stated PT rate (7.5) times its
  outstanding balance at the beginning of each
  month.

59
Cash Flows from Sequential-Pay CMOCollateral
Balance 100m, WAM 355 Months, WAC 8, PT
Rate 7.5, Prepayment 150 PSA, Tranches A
50 million, B 30 million, C 20 million
60
Sequential-Pay Tranches

• Given the assumed PSA of 150, the first month
  cash flow for tranche A consist of a principal
  payment (scheduled and prepaid) of 220,748 and
  an interest payment of 312,500
• Interest (.075/12)(50,000,000)
  312,500
• In month 2, tranche A receives an interest
  payment of 311,120 based on the balance of
  49,779, 252 and a principal payment of 246,153.

61
Sequential-Pay Tranches

• Based on the assumption of a 150 PSA speed, it
  takes 88 months before A's principal of 50M is
  retired.
• During the first 88 months, the cash flows for
  tranches B and C consist of just the interest on
  their balances, with no principal payments made
  to them.
• Starting in month 88, tranche B begins to receive
  the principal payment.
• Tranche B is paid off in month 180, at which time
  principal payments begin to be paid to tranche C.
  
• Finally, in month 355 tranche C's principal is
  retired.

62
Sequential-Pay Tranches

• Features of Sequential-Pay CMOs
• By creating sequential-pay tranches, issuers of
  CMOs are able to offer investors maturities,
  principal payment periods, and average lives
  different from those defined by the underlying
  mortgage collateral.

63
Sequential-Pay Tranches

• Features of Sequential-Pay CMOs
• Maturity
• Collateral's maturity 355 months (29.58 years)
• Tranche As maturity 88 months (7.33 years)
• Tranche B's maturity 180 months (15 years)
• Tranche Cs maturity 355 months (29.58 years)
• Window The period between the beginning and
  ending principal payment is referred to as the
  principal pay-down window
• Collaterals window 355 months
• Tranche As window 87 months
• Tranche B's window 92 months
• Tranche C's window 176 months
• Average Life
• Collateral's average 9.18 years
• Tranche As average life 3.69 years
• Tranche Bs average life 10.71 years
• Tranche Cs Average life 20.59 years

64
Sequential-Pay Tranches

• Features of Sequential-Pay CMOs
• A CMO tranche with a lower average life is still
  susceptible to prepayment risk.
• The average life of each of the tranches still
  varies as prepayment speed changes.

65
Sequential-Pay Tranches

• Note
• Issuers of CMOs are able to offer a number of CMO
  tranches with different maturities and windows by
  simply creating more tranches.

66
Different Types of Sequential-Pay Tranches

• Sequential-pay CMOs often include tranches with
  special features. These include
• Accrual Bond Tranche
• Floating-Rate Tranche
• Notional Interest-Only Tranche

67
Accrual Tranche

• Many sequential-pay CMOs have an accrual bond
  class.
• Such a tranche, also referred to as the Z bond,
  does not receive current interest but instead has
  it deferred.
• The Z bond's current interest is used to pay down
  the principal on the other tranches, increasing
  their speed and reducing their average life.

68
Accrual Tranche

• Example
• Suppose in our preceding sequential-pay CMO
  example we make tranche C an accrual tranche in
  which its interest of 7.5 is to paid to the
  earlier tranches and its principal of 20 million
  and accrued interest is to be paid after tranche
  B's principal has been retired
• Slide 69 shows the principal and interest
  payments from the collateral and Tranches A, B,
  and Z.

69
Cash Flows From Sequential-Pay CMO with Z
TrancheCollateral Balance 100M, WAM 355
Months, WAC 8, PT Rate 7.5, Prepayment 150
PSA, Tranches A 50M, B 30M, C 20M
70
Accrual Tranche

• Features
• Since the accrual tranche's current interest of
  125,000 is now used to pay down the other
  classes' principals, the other tranches now have
  lower maturities and average lives.
• For example, the principal payment on tranche A
  is 345,748 in the first month (220,748 of
  scheduled and projected prepaid principal and
  125,000 of Z's interest) in contrast, the
  principal is only 220,748 when there is no Z
  bond.
• As a result of the Z bond, tranche A's window is
  reduced from 87 months to 69 months and its
  average life from 3.69 years to 3.06 years.

71
Floating-Rate Tranche

• In order to attract investors who prefer
  floating-rate securities, CMO issuers often
  create floating-rate and inverse floating-rate
  tranches.
• The monthly coupon rate on the floating-rate
  tranche is usually set equal to a reference rate
  such as the London Interbank Offer Rate, LIBOR,
  while the rate on the inverse floating-rate
  tranche is determined by a formula that is
  inversely related to the reference rate.

72
Floating-Rate Tranche

• Example Sequential-pay CMO with a floating and
  inverse floating tranches
• Note The CMO is identical to the preceding
  CMO, except that tranche B has been replaced with
  a floating-rate tranche, FR, and an inverse
  floating-rate tranche, IFR.

Tranche Par Value PT Rate
A FR IFR Z 50 million 22.5 million 7.5 million 20 million 7.5 LIBOR 50bp 28.3 3 LIBOR 7.5
Total 100 million 7.5
73
Floating-Rate Tranche

• The rate on the FR tranche, RFR, is set to the
  LIBOR plus 50 basis points, with the maximum rate
  permitted being 10.
• The rate on the IFR tranche, RIFR, is determined
  by the following formula
• This formula ensures that the weighted average
  coupon rate (WAC) of the two tranches will be
  equal to the coupon rate on tranche B of 7.5,
  provided the LIBOR is less than 9.5.

RIFR 28.5 - 3 LIBOR
74
Floating-Rate Tranche

• Example If the LIBOR is 8, then the rate on
  the FR tranche is 8.5, the IFR tranche's rate is
  4.5, and the WAC of the two tranches is 7.5

75
Notional Interest-Only Class

• Each of the fixed-rate tranches in the previous
  CMOs have the same coupon rate as the collateral
  rate of 7.5.
• Many CMOs are structured with tranches that have
  different rates.
• When CMOs are formed this way, an additional
  tranche, known as a notional interest-only (IO)
  class, is often created.
• The notional interest-only tranche receives the
  excess interest on the other tranches
  principals, with the excess rate being equal to
  the difference in the collaterals PT rate minus
  the tranches PT rates.

76
Notional Interest-Only Class

• Example
• A sequential-pay CMO with a Z bond and notional
  IO tranche is shown in the next slide.
• This CMO is identical to the previous CMO with a
  Z bond, except that each of the tranches has a
  rate lower than the collateral rate of 7.5 and
  there is a notional IO class.

77
Sequential-Pay CMO with Notional IO
TrancheCollateral Balance 100m, WAM 355
Months, WAC 8, PT Rate 7.5, Prepayment 150
PSA, Tranches A 50m, B 30m, Z 20m,
Notional IO 15.333333m
78
Notional Interest-Only Class

• The notional IO class receives the excess
  interest on each tranche's remaining balance,
  with the excess rate based on the collateral rate
  of 7.5.
• In the first month, for example, the IO class
  would receive interest of 87,500

79
Notional Interest-Only Class

• The IO class is described as paying 7.5 interest
  on a notional principal of 15,333,333.
• This notional principal is determined by summing
  each tranche's notional principal.
• A tranche's notional principal is the number of
  dollars that makes the return on the tranche's
  principal equal to 7.5.

80
Notional Interest-Only Class

• The notional principal for tranche A is
  10,000,000, for B, 4,000,000, and for Z,
  1,333,333, yielding a total notional principal
  of 15,333,333

81
Planned Amortization Class, PAC

• A CMO with a planned amortization class, PAC, is
  structured such that there is virtually no
  prepayment risk.
• In a PAC-structured CMO, the underlying mortgages
  or MBS (i.e., the collateral) is divided into two
  general tranches
• The PAC (also called the PAC bond)
• The support class (also called the support bond
  or the companion bond)

82
Planned Amortization Class, PAC

• The two tranches are formed by generating two
  monthly principal payment schedules from the
  collateral
• One schedule is based on assuming a relatively
  low PSA speed lower collar.
• The other schedule is based on assuming a
  relatively high PSA speed upper collar.
• The PAC bond is then set up so that it will
  receive a monthly principal payment schedule
  based on the minimum principal from the two
  principal payments.

83
Planned Amortization Class, PAC

• The PAC bond is designed to have no prepayment
  risk provided the actual prepayment falls within
  the minimum and maximum assumed PSA speeds.
• The support bond, on the other hand, receives the
  remaining principal balance and is therefore
  subject to prepayment risk.

84
Planned Amortization Class, PAC

• Example
• PAC and support bond formed from the 100
  million collateral with WAC 8, WAM 355
  months, and PT rate 7.5
• Minimum monthly principal payments for the PAC
  generated using 100 and 300 collars
• Lower Collar 100 PSA Minimum speed of 100
  PSA
• Upper Collar 300 PSA Maximum speed of 300 PSA

85
Planned Amortization Class, PAC

• The next slide shows the cash flows for the PAC,
  collateral, and support bond. The exhibit shows
  
• In columns 2 and 3 the principal payments
  (scheduled and prepaid) for selected months at
  both collars.
• In the fourth column the minimum of the two
  payments.
• For example, in the first month the principal
  payment is 170,085 for the 100 PSA and 374,456
  for the 300 PSA thus, the principal payment for
  the PAC would be 170,085.

86
PAC And Support BondsPAC formed 100 and 300 PSA
ModelCollateral Balance 100m, WAM 355
Months, WAC 8, PT Rate 7.5, Prepayment
150 PSA
87
Planned Amortization Class, PAC

• Note
• For the first 98 months, the minimum principal
  payment comes from the 100 PSA collar, and from
  month 99 on the minimum principal payment comes
  from the 300 PSA collar.

88
Planned Amortization Class, PAC

• Based on the 100-300 PSA range, a PAC bond can be
  formed that would promise to pay the principal
  based on the minimum principal payment schedule
  shown in the exhibit.
• The support bond would receive any excess monthly
  principal payment.

89
Planned Amortization Class, PAC

• The sum of the PAC's principal payments is
  63.777 million. Thus, the PAC can be described
  as having
• Par value of 63.777 million
• Coupon rate of 7.5
• Lower collar of 100 PSA
• Upper collar of 300 PSA
• The support bond, in turn, would have a par value
  of 36.223 million (100 million - 63.777
  million) and pay a coupon of 7.5.

90
Planned Amortization Class, PAC

• The PAC bond has no prepayment risk as long as
  the actual prepayment speed is between 100 and
  300.
• This can be seen by calculating the PAC's average
  life given different prepayment rates.
• The next exhibit shows the average lives for the
  collateral, PAC bond, and support bond for
  various prepayment speeds ranging from 50 PSA to
  350 PSA.

91
Planned Amortization Class, PAC

• The average lives for the collateral, PAC bond,
  and support bond for various prepayment speeds
  ranging from 50 PSA to 350 PSA.

92
Planned Amortization Class, PAC

• Features
• The PAC bond has an average life of 6.98 years
  between 100 PSA and 300 PSA its average life
  does change, though, when prepayment speeds are
  outside the 100-300 PSA range.
• In contrast, the support bond's average life
  changes as prepayment speed changes.
• Changes in the support bond's average life due to
  changes in speed are greater than the underlying
  collateral's responsiveness.

93
Other PAC-Structured CMOs

• The PAC and support bonds can be divided into
  different classes.
• Often the PAC bond is divided into several
  sequential-pay tranches, with each PAC having a
  different priority in principal payments over the
  other.
• Each sequential-pay PAC, in turn, will have a
  constant average life if the prepayment speed is
  within the lower and upper collars.
• In addition, it is possible that some PACs will
  have ranges of stability that will increase
  beyond the actual collar range, expanding their
  effective collars.

94
Other PAC-Structured CMOs

• A PAC-structured CMO can also be formed with PAC
  classes having different collars.
• Some PACs are formed with just one PSA rate.
  These PACs are referred to as targeted
  amortization class (TAC) bonds.
• Different types of tranches can also be formed
  out of the support bond class. These include
  sequential-pay, floating and inverse-floating
  rate, and accrual bond classes.

95
Stripped MBS

• Stripped MBSs consist of two classes
• Principal-only (PO) class that receives only the
  principal from the underlying mortgages.
• Interest-only (IO) class that receives just the
  interest.

96
Principal-Only Stripped MBS

• The return on a PO MBS is greater with greater
  prepayment speed.
• For example, a PO class formed with 100 million
  of mortgages (principal) and priced at 75
  million would yield an immediate return of 25
  million if the mortgage borrowers prepaid
  immediately. Since investors can reinvest the
  25 million, this early return will have a
  greater return per period than a 25 million
  return that is spread out over a longer period.

97
Principal-Only Stripped MBS

• Because of prepayment, the price of a PO MBS
  tends to be more responsive to interest rate
  changes than an option-free bond.

98
Principal-Only Stripped MBS

• If interest rates are decreasing, then like the
  price of most bonds, the price of a PO MBS will
  increase.
• In addition, the price of a PO MBS is also
  likely to increase further because of the
  expectation of greater earlier principal payments
  as a result of an increase in prepayment caused
  by the lower rates.

99
Principal-Only Stripped MBS

• If rates are increasing, the price of a PO MBS
  will decrease as a result of both lower discount
  rates and lower returns from slower principal
  payments.

100
Principal-Only Stripped MBS

• Thus, like most bonds, the prices of PO MBSs are
  inversely related to interest rates, and, like
  other MBSs with embedded principal prepayment
  options, their prices tend to be more responsive
  to interest rate changes.

101
Interest-Only Stripped MBS

• Cash flows from an I0 MBS come from the interest
  paid on the mortgages portfolios principal
  balance.
• In contrast to a PO MBS, the cash flows and the
  returns on an IO MBS will be greater, the slower
  the prepayment rate.

102
Interest-Only Stripped MBS

• If the mortgages underlying a 100 million, 7.5
  MBS with PO and IO classes were paid off in the
  first year, then the IO MBS holders would receive
  a one-time cash flow of 7.5 million
• If 50 million of the mortgages were prepaid in
  the first year and the remaining 50 million in
  the second year, then the IO MBS investors would
  receive an annualized cash flow over two years
  totaling 11.25 million
• If the mortgage principal is paid down 25
  million per year, then the cash flow over four
  years would total 18.75 million

7.5m (.075)(100m)
11.25m (.075) (100m) (.075)(100m - 50m)
18.75m (.075)(100m) (.075)(100m - 25m)
(.075)(75m - 25m)
(.075)(50m - 25m)
103
Interest-Only Stripped MBS

• Thus, IO MBSs are characterized by an inverse
  relationship between prepayment speed and
  returns the slower the prepayment rate, the
  greater the total cash flow on an IO MBS.

104
Interest-Only Stripped MBS

• Note
• If inverse relationship between prepayment speed
  and returns dominates the price and discount rate
  relation, then the price of an IO MBS will vary
  directly with interest rates.

105
IO and PO Stripped MBS

• An example of a PO MBS and an IO MBS are shown in
  the next slide.
• The stripped MBSs are formed from collateral
  with
• Mortgage Balance 100 million
• WAC 8
• PT Rate 8
• WAM 360
• PSA 100

106
Projected Cash Flows for Stripped PO and
IOCollateral Mortgage Portfolio 100 million,
WAC 8, WAM 360 Months, Prepayment 100 PSA
107
IO and PO Stripped MBS

• The table shows the values of the collateral, PO
  MBS, and IO MBS for different discount rate and
  PSA combinations of 8 and 150, 8.5 and 125, and
  9 and 100.
• Note The IO MBS is characterized by a direct
  relation between its value and rate of return.

  Price Sensitivity    
Discount PSA Value of Value of Value of
Rate   PO IO Collateral
8.00 150 54,228,764 47,426,196 101,654,960
8.50 125 49,336,738 49,513,363 98,850,101
9.00 100 44,044,300 51,795,188 95,799,488
108

• Evaluating Mortgage-Backed Securities

109
Evaluating Mortgage-Backed Securities

• Like all securities, MBSs can be evaluated in
  terms of their characteristics.
• With MBSs, such an evaluation is more complex
  because of the difficulty in estimating cash
  flows due to prepayment.
• One approached used to evaluate MBS and CMO
  tranches is yield analysis.

110
Yield Analysis

• Yield analysis involves calculating the yields on
  MBSs or CMO tranches given different prices and
  prepayment speed assumptions or alternatively
  calculating the values on MBSs or tranches given
  different rates and speeds.

111
Yield Analysis

• Example
• Suppose an institutional investor is interested
  in buying a MBS issue that has a par value of
  100 million, WAC 8, WAM 355 months, and a
  PT rate of 7.5.
• The value, as well as average life, maturity,
  duration, and other characteristics of this
  security would depend on the rate the investor
  requires on the MBS and the prepayment speed she
  estimates.

112
Yield Analysis

• If the investors required return on the MBS is
  9 and her estimate of the PSA speed is 150, then
  she would value the MBS issue at 93,702,142.
• At that rate and speed, the MBS would have an
  average life of 9.18 years.
• Whether a purchase of the MBS issue at
  93,702,142 to yield 9 represents a good
  investment depends, in part, on rates for other
  securities with similar maturities, durations,
  and risk, and in part, on how good the prepayment
  rate assumption is.
• For example, if the investor felt that the
  prepayment rate should be 100 PSA and her
  required rate with that level of prepayment is
  9, then she would price the MBS issue at
  92,732,145 and the average life would be 11.51
  years.

113
Yield Analysis

• In general, for many institutional investors the
  decision on whether or not to invest in a
  particular MBS or tranche depends on the price
  the institution can command.
• For example, based on an expectation of a 100
  PSA, our investor might conclude that a yield of
  9 on the MBS would make it a good investment.
• In this case, the investor would be willing to
  offer no more than 92,732,145 for the MBS issue.

114
Yield Analysis

• One common approach used in conducting a yield
  analysis is to generate a matrix of different
  yields by varying the prices and prepayment
  speeds.
• The next slide shows the different values for our
  illustrative MBS given different required rates
  and different prepayment speeds.
• Using this matrix, an investor could determine,
  for a given price and assumed speed, the
  estimated yield, or determine, for a given speed
  and yield, the price. Using this approach, an
  investor can also evaluate for each price the
  average yield and standard deviation over a range
  of PSA speeds.

115
Yield and Vector Analysis Mortgage Portfolio
100M, WAC 8, WAM 355 Months, PT Rate 7.5
Rate/PSA 50 100 150
7 8 9 10 Average Life Rate 7 8 9 10 Value 106,039,631 98,251,269 91,442,890 85,457,483 14.95 Vector Month Range PSA 1-50 200 51-150 250 151-250 150 251-355 200 Value 103,729,227 98,893,974 94,465,328 90,395,704 Value 105,043,489 98,526,830 92,732,145 87,554,145 11.51 Vector Month Range PSA 1-50 200 51-150 300 151-250 350 251-355 400 Value 103,473,139 98,964,637 94,794,856 90,929,474 Value 104,309,207 98,732,083 93,702,142 89,146,871 9.18 Vector Month Range PSA 1-50 200 51-150 150 151-250 100 251-355 50 Value 104,229,758 98,756,370 93,826,053 89,,364,229
116
Yield Analysis

• One of the limitations of the above yield
  analysis is the assumption that the PSA speed
  used to estimate the yield is constant during the
  life of the MBS.
• In fact, such an analysis is sometimes referred
  to as static yield analysis.
• In practice, prepayment speeds change over the
  life of a MBS as interest rates change in the
  market.

117
Vector Analysis

• A more dynamic yield analysis, known as vector
  analysis, can be used.
• In applying vector analysis, PSA speeds are
  assumed to change over time.
• In the above case, a matrix of values for
  different rates can be obtained for different
  PSA vectors formed by dividing the total period
  into a number of periods with different PSA
  speeds assumed for each period.
• A vector analysis example is also shown at the
  bottom of the last exhibit slide.

118
Web Sites

• MBS Price Information
•  Wall Street Journal
• Go to http//online.wsj.com/public/us, Market,
  Bonds, Rates, Credit Markets, and
  Mortgage-Backed Securities, CMO.
• Investinginbonds.com
• MBS Price Index The Merrill Lynch
  Mortgage-Backed Securities (MBS) Index is a
  statistical composite tracking the overall
  performance of the mortgage-backed securities
  market over time. The index includes U.S.
  dollar-denominated 30-year, 15-year and balloon
  pass-through mortgage securities.
• Go to http//investinginbonds.com/ click
  MBS/ABS Market At-A-Glance.

119
Web Sites

• Agency MBS Prospectus and other information
• Fannie Mae Information and Prospectus
• Use Advance Search to find a MBS and its pool
  number
• Go to Fannie Mae www.fanniemae.com Site Map
  Mortgage-Backed Securities More Search
  Options.
• Or go to http//sls.fanniemae.com/slsSearch/Home.d
  o
• Use pool number to find information on Fannie Mae
  MBS
• Information includes Prospectus and Common Pool
  Information

120
Web Sites

• Agency MBS Prospectus and other information
• Ginnie Mae Information and Prospectus
• Go to Ginnie Mae www.ginniemae.gov
• To find pool number, look for Multiple Issue
  Pool Number found under Issuer
• To find prospectus on MBS, look for REMIC
  Offering Circulars under Investors
• Or go to http//www.ginniemae.gov/investors/prosp
  ectus.asp?SectionInvestors

121
Web Sites

• Agency MBS Prospectus and other information
• Freddie Mae Information on types of MBS
• www.freddiemac.com
• Go to Mortgage Securities

122
Web Sites

• For Moodys information on MBS
• www.moodys.com
• Search for structured finance, historical
  performance, and structured finance default
  studies.

123
Web Sites

•  
• Office of Federal Housing Enterprise Oversight
  www.ficc.com
•  
• Rating Agencies
• www.moodys.com
• www.standardandpoors.com
• http//reports.fitchratings.com