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Mortgage Markets and Mortgage Backed Securities

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Title: Mortgage Markets and Mortgage Backed Securities


1
Mortgage Markets and Mortgage Backed Securities
  •  

2
Brief History of Mortgages
  • Following the decline of Roman empire, Germanic
    law developed the idea to use land as security in
    borrowers agreements, this practice was referred
    to as a gage
  • William of Normandy introduced the Germanic gage
    system into early English law. The French word
    mort (dead or frozen) was combined with gage to
    produce a locked pledge or mort-gage on property.

3
The US mortgage market
  • Establishment of mortgage companies in the the
    1800s to finance land purchases by farmers in
    the Midwest.
  • By 1900 there were approximately 200 mortgage
    companies with outstanding loan values totaling
    4 billion
  • Early mortgages paid interest semiannually,
    nonamortizing with a balloon payment at the end
    (as short as 3 to 5 years)

4
History of US Mortgage Market 1900 - 1950
  • Fast growth form 1900 to 1930 was slowed by large
    number of foreclosures in early 1930s.
  • Federal Government started trying to support the
    mortgage market especially the secondary mortgage
    market with formation of Federal National
    Mortgage Association (Fannie Mae) in 1938
  • Post WWII fast expansion of housing market due to
    liquidity of private sector.

5
History of US Mortgage Market 1950 - 1980
  • 1954 Fannie Mae was reorganized. New charter
    made it part private part federal owned
  • 1968 Fannie Mae becomes entirely privately held.
    Ginnie Mae is established to oversee special
    assistance (FHA and VA) programs. Guarantees
    backed by full faith and credit of US Treasury.
  • 1970 Establishment of Freddie Mac
  • 1977 First private pass through issued

6
History of US Mortgage Market 1980 - 2004
  • 1980s growing use of Adjustable Rate Mortgages
  • First Collateralized Mortgage Obligations offered
  • Dramatic growth of Mortgage backed securities
    market.

7
The Current Mortgage Market
  • The Primary Market The issue of Mortgages to
    individuals by financial institutions.
  • Mortgage Originators
  • Thrifts, Commercial Banks and Mortgage Brokers

8
Origination Income
  • Origination Fee - expressed in terms of points --
    each point represents 1 of the borrowed funds --
    Origination fee of 3 points on 100,000 mortgage
    is 3,000
  • Secondary market profit -- selling the mortgage
    obligation at a price higher than it originally
    cost.
  • Servicing Fee - Collecting monthly payments,
    forwarding proceeds to owners of the loan,
    sending payment notices, maintaining records,
    furnishing tax info etc 

9
Servicing Fees
  • Servicing fees are generally a portion of the
    mortgage rate and is often referred to as
    servicing spread.

10
The mortgage origination process
  • Applicant submits info relating to the property
    and income. Originator performs credit report
    and looks at the probability of repayment. 
  • PTI -- payment to income ratio (monthly payment
    / monthly income)
  • LTV -- loan to value ratio (Loan amount /
    Valuation )
  • Commitment letter-- outlines the terms available
    for the next 30 to 60 days. The borrower pays a
    commitment fee which will be lost if no loan is
    taken out.

11
Post Loan Options
  • After making the loan the originator has one of
    three options
  • Hold the mortgage in their portfolio.
  • Sell the mortgage to an investor (who will either
    hold the mortgage or use it as collateral),
    possibly continuing to service the mortgage.
  • Use the mortgage as collateral to issue a
    security (securitizing the mortgage)

12
Origination Risks
  • Price Risk If rates increase the originator has
    already committed to charging lower rates --  
  • Can protect against price risk with a second
    commitment from a secondary market participant
    that agrees to buy the given loan at a futures
    point in time for a given price.
  • However this brings a second risk -- if rates
    decline the borrower may not close and the
    originator is locked into providing the above
    market return.
  • Fall out Risk. Risk that some individuals issued
    commitment letters will not close

13
Mortgage Construction
  • Traditional Fixed Rate Mortgage (fixed-rate
    level-payment, fully amortized mortgage)
  • Principal and interest are amortized over the
    life of the mortgage.
  • The payment is determined with the basic PV of an
    annuity formula

14
Amortization of a Loan
  • You want to borrow 1,000 and pay it off over
    three years. Assume that you are charged 6 each
    year. How much will your payment be?
  • 1,000 PV PMT ????
  • 1,000 PMT (PVIFA6,3)
  • 1,000 PMT(2.67)
  • PMT 374.11

15
Amortization
  • You pay a total of 374.11(3) 1,122.33
  • A portion of each payment represents interest
    charges.
  • You can find the amount of interest by
    multiplying the beginning balance each payment
    period by the interest rate.
  • At the beginning the balance is 1,000 so there
    is 1,000(.06) 60 in interest.

16
Amortization
  • Beginning
    Ending
  • Year Balance Payment Interest Principal
    Balance

1
1,000
374.11
60.00
314.11
685.89
2
685.89
374.11
41.15
332.96
352.93
3
352.93
374.11
21.18
352.93
0.00
17
Amortization 30 yr Mortgage150,000 5.85
  • Beginning
    Ending
  • Year Balance Payment Interest Principal
    Balance

1
150,000
884.91
731.25
153.6614
149,846.34
154.41
2
149,846
884.91
730.50
149691.93
1756.97
359
884.91
8.57
876.35
880.62
0
880.62
880.62
360
884.91
4.29
18
Servicing Fee Revisited
  • Since the servicing fee is generally a portion of
    the interest payment the actual fee income will
    decline throughout the life of the mortgage as
    interest decline.

19
Prepayments and CF Uncertainty
  • Generally there is not a penalty for prepaying
    the principle early. When a prepayment is made
    for less the entire balance it is referred to as
    a curtailment.
  • Some mortgages however do have a lock out period
    or penalty period which can limit or prohibit
    prepayment.

20
Origination Problems
  • Mismatch
  • Institutions are borrowing short and lending
    long, They must manage the different timing of
    their cash flows.
  • Tilt
  • The real burden of the loan to the borrower is
    in the early years of the loan. Since inflation
    decreases the real burden of their payments over
    time. Therefore individuals may not enter the
    market, even though they are able to given their
    future income.

21
Adjustable Rate Mortgages
  • The loan rate is reset periodically using a base
    or reference rate.
  • The rate might reset every month, year, 2 years 5
    years etc..
  • Reference Rate
  • Market determined
  • Cost of Funds

22
ARM Features
  • Usually offer an initial rate less than
    prevailing fixed rate (teaser rate).
  • At reset date reference rate plus a spread
    determines the rate.
  • There may be caps and floors on the rates, both
    periodic and lifetime.

23
Balloon Two Step Mortgages
  • Allows for rollover and renegotiation of the loan
    at periodic intervals.
  • Different from ARM the future rate is not set
    from base rate.
  • Loan is extended if certain requirements are met.
  • 30 due in 5 is a thirty year mortgage where the
    remaining principal is due (or refinanced) after
    five years.
  • Two step rates once based upon a specified rate

24
Solutions to the tilt problem
  • ARMs address the mismatch problem by allowing for
    longer term lending at a short term rate.
  • The tilt problem has creates the market for other
    types of products
  • Graduated Payment Mortgages
  • Price -level Adjusted Mortgage. 
  • Dual Rate Mortgage 

25
Graduated Payment Mortgages
  • The mortgage payment increases each year at the
    beginning of the loan then hits a level amount
    for the remainder of the loan.
  • This actually produces negative amortization
    since in the beginning the total amount does not
    cover the interest on the loan.
  • Specified in the loan are The fixed rate, the
    rate of growth for the first few years, the
    number of years over which the payment will
    increase

26
Graduated Payment Mortgages
  • Example 30 year, 10 mortgage on 100,000 with
    the payment growing at 7.5 each year for the
    first 5 years.
  • Fixed Rate payment would be 877.5715
  • GPM Payments
  • Year Payment Year Payment
  • 1 667.04 2 717.06
  • 3 770.84 4 828.66
  • 5 890.80 6-30 957.62

27
Price Level Adjusted Mortgages
  • Monthly payment is designed to be level in
    purchasing power. The fixed rate of interest is
    a real rate of interest.
  • The monthly payment is then calculated using the
    real rate just as a regular mortgage would be.
  • The actual payment is then adjusted based upon
    the rate of inflation.

28
Dual Rate Mortgages
  • Similar to the PLAM except the amount owed is
    based on a floating short term rate.
  • To establish the mortgage you need
  • the payment rte (the real rate of interest that
    is fixed for the life of the loan),
  • the effective or debiting rate that changes
    periodically and
  • the maturity of the mortgage.

29
Other plans
  • Growing Equity Mortgage Similar to the GPM
    except there is no negative amortization. The
    increase in payment will serve to pay off the
    principal quicker than a traditional mortgage.
  • Lenders will be willing to lend a t a lower rate
    (if the yield curve slopes up) and borrowers
    increase payment solving tilt problem
  • High LTV loans eliminates high down payments by
    financing up to 100 of the value of the home
    plus closing costs.

30
Other Plans
  • Alt-A loans Requires alternate documentation of
    income for special cases such as self employed
    individuals. Rtes are generally 75 basis points
    to 125 basis points above other rates
  • Sub Prime Loans Borrowers who have had credit
    problems. Rates based upon different risk grades

31
Risks Faced by Investors in the Secondary
Mortgage Market
  • Credit Risk
  • Risk of default by the borrower
  • Liquidity risk
  • Even with the secondary markets, individual
    loans are relatively illiquid
  • Price Risk
  • Value moves opposite changes in interest rates
  • Prepayment Risk
  • The borrower may prepay early

32
Mortgage Pass Through Securities
  • Interest and Principle are collected by the
    issuer of the pass through on a pool of mortgages
    who then transfers (passes through) the payments
    to the owners of new securities backed by the
    mortgages.
  • Neither the amount or timing of the cash flows
    actually matches the cash flows on the pool of
    mortgages.
  • When a mortgage is included in a pool it is said
    to be securitized.

33
Cash Flows
  • Neither the amount or timing of the cash flows
    actually matches the cash flows on the pool of
    mortgages.
  • Servicing and other fees are removed from the
    cash flows received from the mortgage prior to
    being passed through to the holder of the pass
    through security. There is also a delay in the
    pass through process.

34
Terminology
  • The pool of mortgages will have a variety of
    different rtes and maturities. Therefore, the
    description of the pass through is based upon
    weighted averages of the coupon and maturity.

35
WAC, WAM and WARM
  • WAC weighted average coupon rate
  • Weighting the mortgage rate of each mortgage in
    the pool by the outstanding principal balance
  • WAM weighted average maturity
  • Weighting the number of months to maturity of
    each mortgage in the pool by the outstanding
    principal balance
  • WARM weighted average remaining maturity
  • After prepayments have started the maturity
    changes.

36
Guarantee Types
  • Fully Modified Pass Throughs Guarantees that
    the principal and interest will be paid
    regardless of whether the borrower is late.
  • Modified Pass Through Guarantees the timely
    payment of interest, the principal is passed
    through when it is received.

37
Ginnie Mae
  • Ginnie Mae pass throughs are guaranteed by the US
    treasury.
  • Issues Mortgage backed securities which are fully
    modified pass throughs
  • All mortgages are FHA, VA or Farmers Home
    Administration loans

38
Fannie Mae
  • Sells mortgage backed securities and channels the
    funds to lenders by buying mortgages. The
    institution may continue to service the original
    mortgage.
  •  All are fully modified pass throughs, but there
    is no government guarantee of payment
  • Both Ginnie Mae and Fannie Mae securities are
    commonly referred to as Mortgage Backed
    Securities

39
Freddie Mac (FHLMC)
  • Participation Certificates sold by the agency are
    used to finance the origination of conventional
    mortgages. Usually PC only guarantee that the
    interest payment will be made. The principle
    payment is passed through as it is received. The
    guarantee is not backed by the federal government
    as is the case in Ginnie Mae.
  • Most are fully modified (new issues are)

40
 Participation Certificates
  • Two main programs
  • Cash program FHLMC buys mortgages from the issuer
    and issues PC's based on the mortgages.
  • Guarantor / Swap program -- Allows thrifts to
    swap mortgages for PC's based on the mortgages.
    The institution can swap mortgages selling below
    par for without recognizing an accounting loss!
  • The PC is then
  • Held as an investment
  • used as collateral for borrowing
  • sold

41
Comparison of rates
  • The pass through rate is less than that of the
    mortgage pool. The difference accounts for
    service and guaranteeing fees.
  • The timing is also different to allow for the
    payment of the mortgages (on the first of the
    month) prior to the pass through occurring.

42
Size of Mortgage Backed Securities Market
  • The MBS market has grown dramatically in the last
    20 years.
  • Currently there is a political debate surrounding
    whether Fannie Mae, Ginnie Mae and Freddie Mac
    are too large.
  • Part of their growth is based upon the market
    believing that all three have a government
    guarantee, even though Fannie Mae and Fredie Mac
    do not.

43
of Outstanding Debt Market
44
Average Daily Trading Volume (Billions)
45
Issuance by GSEs ( Billions)
46
Recent Study by Federal Reserve
  • Wayne Passmore, an economist at the Federal
    Reserve Bank has recently completed a study on
    the impact of GSEs
  • The GSEs have a funding advantage
  • Slightly lower mortgage rtes for a few borrowers
  • Implicit subsidy from government relationship
  • Implicit subsidy responsible for much of GSE
    Market Value
  • MBS have not increased homebuilding

47
Creation of a GNMA pass through
  • The loan pool must have standard features in
    terms of single family or mutli family, maturity
    etc.
  • The originators forward the pool to GNMA with
    supporting documentation requesting GNMA to
    guarantee the securities to be backed by the pool
  • After review a pool number is assigned if the
    pool is accepted

48
Creation of a GNMA pass through
  • The originators transfer the mortgage documents
    to custodial agents and send pool documents to
    GNMA
  • Originators look for investors (dealers,
    investment banks etc) willing to buy a given
    amount at a specified price

49
Creation continued
  • GNMA issues the guarantee following review of the
    documentation.
  • Originators continue to service the loans.
  • The GNMA MBS is not a debt of the issuer, it is a
    representation of the loan pool with payments
    guaranteed by Ginnie Mae

50
Fees for a typical GNMA pool
  • 44 basis points are retained by the servicer for
    servicing fees
  • Ginnie Mae receives 6 basis points for the
    guarantee. The issuer is guaranteeing Ginnie Mae
    against defaults by the homeowner and Ginnie Mae
    guarantees against defaults by the issuer.
  • The investor then receives approximately 50 basis
    points less than the coupon of the loan
    portfolio.

51
Price Quotes
  • GNMAs are quoted in 1/32 of a point
  • Quotes depend upon a pool factor pf(t)
    representing the of the initial mortgage pool
    balance outstanding

52
Market Value
  • Consider an investor with 20 million of a 100
    million issue with a pool factor of .9 and a
    price of 9316/32
  • Par value remaining 20 (.9) 18 million
  • The value is then price x par value x pool factor
  • Market Value (.9350) (20)(.9) 16.38 Million
  • You would need to also account for accrued
    interest to find the actual cash price.

53
Accrued interest
  • Assume a coupon rate of 9 and 20 days into the
    month

54
Trading and Settlement Procedures
  • Agency pass throughs are identified by a pool
    prefix number.
  • TBA trade a trade based on an agency pass
    through prior to the pool of mortgages being
    established. Generally, there will prior
    agreement on agency type, program, coupon rates,
    and settlement date

55
Market references
  • At a given point in time there may be many
    seasoned issues of an agency security with the
    same coupon rate.
  • For example in early 2000 there were more than
    30,000 pools of 30 year Ginnie Mae MBSs with a
    coupon rate of 9.
  • Each pool may be from a different area of the
    country or from several regions.
  • Dealers will refer to all of these as Ginnie Mae
    9s even though they have different prepayment
    characteristics. If the investor does not specify
    a pool number, the dealer has the option to
    deliver any of the pools.

56
Non Agency Pass Through Securities
  • Often non agency mortgage pass throughs will
    attempt to increase their rating
  • External Credit Enhancement
  • third party guarantees of losses up to a
    predetermined amount. Often these are in the
    form of a corporate guarantee , a letter of
    credit, pool insurance or bond insurance
  • Internal Credit Enhancement
  • Reserve funds
  • Over collateralization
  • Senior/subordinated structure

57
Prepayment conventions
  • In order to value a MBS the pattern of
    prepayments needs to be forecasted.
  • To do this the pool needs to be looked at and
    some assumptions need to be made concerning the
    payment of the pool.

58
Measuring prepayment
  • Constant Monthly Mortality
  • Assume that there is a 0.5 chance that the
    mortgage will be prepaid after the first year.
    The 0.5 is the single month mortality rate (or
    SMM)
  • Given the SMM it is easy to compute the
    probability that the mortgage will be retired in
    the next month.
  • The probability that the mortgage survived the
    first month is 1-0.005 .995 or 99.5

59
Measuring Prepayment
  • Given a 99.5 chance that the mortgage survived
    the first month, and a 0.5 SMM for the second
    month the probability that the mortgage will be
    retired in the second month is 0.50(.995)
    0.4975
  • Continuing in the same manner the yearly
    prepayment rate could be found.

60
Conditional Prepayment Rate
  • Let CPR be the conditional prepayment rate. The
    probability that the mortgage survives one year
    is (1-SMM)12 which should equal (1-CPR)
  • or
  • (1-SMM)12(1-CPR) CPR 1-(1-SMM)12
  • this assumes that prepayments will be the same
    through time which is not consistent with the
    empirical evidence

61
Conditional Prepayment Rate (CPR)
  • The industry convention is to use an annual
    prepayment rate based upon the historical
    prepayment observed by the FHA. The CPR can then
    be easily transferred back to a monthly rate (the
    single month mortality rate (SMM))
  • SMM 1 - (1-CPR)1/12
  •  
  • If the CPR is 6 the SMM is equal to
  • 1 - (1-.06)1/12 .005143

62
 Calculations
  • Prepayment based upon the SMM
  •  Estimated Prepayment for month t
  • Using the SMM above assume we own a pass through
    with a beginning balance of 290 million and
    principal repayment of 3 million scheduled
  • Estimated Prepayment would be
  • .005143(290,000,000-3,000,000)1,476,041

63
The PSA benchmark
  •  The Public Securities Association prepayment
    benchmark is expressed as a monthly series of
    conditional prepayment rates.
  • The PSA benchmark assumes that prepayments start
    slow then increase
  •  

64
Market Convention
  • The CPR has been shown to level off after thirty
    months. The standard CPR used is .2 for the
    first month then increasing at .2 each month
    until 6 is reached for the thirtieth month and
    every month thereafter.

65
100 PSA
  • 100 PSA assumes market convention speed of
    prepayment
  • Using the convention of a CPR of 0.2 for the
    first month increased by 0.2 each month for the
    next 30 months
  • After 30 periods a CPR of 6 for the remaining
    years of the mortgage
  • PSA is then expressed as a percentage of 100 PSA
    benchmark.  

66
PSA benchmark
  • For Example a PSA of 150 means that the pool
    prepays at an expected rate 1.5 times as fast as
    the PSA benchmark
  • Notice the CPR is a multiple of the PSA not the
    SMM

67
Monthly cash flow construction(See Handout)
  • Assume that you have a 400 Million 7.5 pass
    through with a WAC of 8.125 and a WAM of 357
    months assuming 100PSA
  • Note the pass through has been seasoned three
    months this makes the CPR 0.8

68
Example Continued
  • The SMM for the first month is then
  • SMM1-(1-CPR)1/121-(1-0.008)1/120.000669124
  • The scheduled mortgage payment would be
  • 400,000,000PMT(PVIFA357,8.125/12)2,975,868.24
  • (this changes with each payment due to prepayment)

69
Monthly cash flow construction
  • Interest is found from the pass through rate of
    7.5 400,000,000(.075)/12 2,500,000
  • The scheduled principal is found using the WAC
    and the payment calculated earlier.
  • Total interest scheduled from the pool is
    400,000,000(.08125)/12 2,708,333.333
  • Given a payment of 2,975,868.24 the scheduled
    principal is 2,975,868.24 - 2,708,333.333
  • 267,534.91

70
Monthly Cash Flow Construction
  • The expected prepayment for the month is then
    found using
  • For the first month this is equal to
  • .000669124(400,000,000-267,534.91)
  • 267,470.58
  • total principal is then equal to
  • 267,534.91267,470.58535,005.49

71
Monthly Cash Flow Construction
  • Total Cash Flow is then the sum of the interest
    paid to the pass through investor and the total
    principal
  • 2,500,000 535,005.493,035,005.49
  • the next months outstanding balance is then
    reduced by the amount of principal
  • 4,000,000-535,005.49 399,464,994.51
  • the next month would proceed the same way with
    the exception of the scheduled mortgage payment.

72
Note
  • The PSA convention is the result of past
    experience on FHA prepayments. The empirical
    evidence suggests a level CPR after 30 months of
    6. The first 29 months are just a linear
    approximation starting at zero months and ending
    at 29.
  • The same method is used regardless of the
    maturity of the pass through, and the rate (ARM
    or fixed.) It is at best an quick and easy
    estimate.

73
Non Agency CPR convention
  • Defaults and other problems characterize the
    nonagency pass throughs, therefore there is a PSA
    standard default assumption (SDA)
  • 0.02 fro the first month increasing by 0.02
    each month up to .6 at 30 months
  • .6 form 30 to 60 months
  • 61 months to 120 months default rates decline to
    0.03
  • 120 to maturity default rates remain at 0.03

74
Factors Affecting Prepayment
  • Prevailing Mortgage Rates
  • Characteristics of the Mortgage Pool
  • Seasonal Factors
  • General Economic Activity

75
Factors Influencing Prepayment
  • Prevailing Mortgage Rates
  • Spread between Original Rate and Prevailing rate
  • If the original rate is greater than the
    prevailing rate there is a higher probability of
    prepayment. These mortgages are often referred
    to a premium mortgages. (the opposite case would
    produce discount mortgages)
  • Path of Rates
  • If rates went up then down prepayments will be
    higher. If rates decreased then increased and
    decreased again, prepayments will not be as high
    since many took advantage the first time.

76
Factors Influencing Prepayment
  • Prevailing Mortgage Rates
  • Level of rates
  • As the level of rates declines turnover
    increases as more homes become affordable.

77
Factors Influencing Prepayment
  • Characteristics of Underlying Mortgage Loans
  • Seasonality (more in the Spring and summer less
    in the winter)
  • Age of Mortgage Prepayments are higher during the
    early stages of the mortgage and the final
    periods prior to maturity
  • Type of Loan (ARM, balloon etc)

78
Factors Influencing Prepayment
  • Seasonality (more in the Spring and summer less
    in the winter)
  • This mirrors the amount of home buying activity.
  • This results in a slight lag of the impact of
    prepayments on the MBS market since there is a
    lag in passing through the prepayments.

79
Factors Influencing Prepayment
  • General Economic Factors
  • Housing Costs
  • Geographic Location
  • Family Circumstances
  • Economic Activity

80
Extension and Contraction Risk
  • The investor is not sure of the timing of the
    cash flows since it depends upon the timing of
    the prepayments. Therefore they face other risks
  • Extension Risk there is a change in the market
    that causes fewer prepayments and the length of
    time prior to the repayment increases due to
    fewer prepayments
  • Contraction risk - Prepayments increase as rtes
    decline causing shortening of the length of the
    MBS and reinvestment risk.

81
Collateralized Mortgage Obligations.
  • Provide semiannual payments
  • The payment of principle is allocated among
    different tranches that represent the repayment
    of principle.
  • Allows investors to attempt to match their
    willingness to accept prepayment risk to a
    security
  •  

82
Average Life
  • This measure represents the average time to
    receipt of principal repayments.

83
Sequential pay CMO
  • The first Tranche receives principle until the
    total principle in the tranche is paid off. The
    CMO will be explained by a Weighted average
    maturity and a weighted average coupon that
    represents the mortgages in the CMO.
  • The actual timing of the payoff will depend upon
    the prepayment rate. The speed of prepayment can
    be estimated, but it will not be know in advance.

84
Example Same starting point as before
  • Assume that you have a 400 Million 7.5 pass
    through with a WAC of 8.125 and a WAM of 357
    months assuming 100PSA
  • Four payment tranches
  • Tranche Par Amount Coupon
  • A 194,500,000 7.5
  • B 36,000,000 7.5
  • C 96,500,000 7.5
  • D 73,000,000 7.5

85
Example continued
  • Each tranche received interest upon the
    outstanding principal in the tranche. Tranche B
    receives no principal until Tranche A has
    received all of its principal likewise tranche C
    follows B and D follows C.
  • Therefore after the fist period, tranche B
    receives 36,000,000(.075)/12 225,000
  • Tranche B continues to receive 225,000 each
    period until the principal has been paid off to
    tranche A. The pay down of principal is
    calculated as before

86
CMO
  • The CMO has allowed investors to choose a tranche
    that best matches their desire to accept
    prepayment risk (match the timing of cash flows
    to their needs).
  • However, there is still variability in the actual
    timing of the tranches since prepayments may not
    occur at the estimated speed.

87
Accrual Tranches
  • In the example all the tranches receive interest
    payments. Often this is not the case. It is
    possible for one or more tranches to be an
    accrual bond.
  • The interest that would have been paid on the
    tranche now goes to paying down the debt on the
    earlier tranche. This shortens the maturity of
    the other tranches.

88
Floating Rate Tranches
  • Any fixed rate tranche can be converted to a
    floating rte and inverse floating rate tranche
    (adding a tranche to the total structure of the
    CMO)
  • Whatever portion of the balance is not the
    floater will be the balance of the inverse
    floater.
  • You can also use only a portion of the tranche to
    create the floaters.

89
Interest Only and Principal Only
  • Another structure is to allocate only interest or
    only principal to a given tranche.
  • The IO investor will want the prepayments to be
    slow since it extends the life of the CMO. The
    PO investor will prefer that the prepayments
    arrive quickly

90
Structured IO
  • IO tranches are often referred to as structured
    IOs to distinguish them from a stripped IO.
  • In this case the coupon rate for one tranche is
    different from the coupon rate on the collateral.
    For example the rate may be less than the
    interest rate on the collateral. The excess
    interest is then allocated to a separate tranche.

91
Notional IO classes
  • This is a class that receives the excess coupon
    interest. It has no par value, only a notional
    value upon which the payments are based.

92
Planned Amortization classes
  • Includes a set principal payment schedule which
    must be followed (if the actual prepayments fall
    within a given window then a schedule of
    principal payments is followed).
  • PAC bondholders have priority over the other
    classes within a CMO. Therefore PAC bonds come
    at the expense of support or companion bonds
    which absorb the prepayment risk (they forego
    principal)   

93
Planned Amortization Class Tranche (PAC) CMOs
  • If prepayments are within a specified range, the
    cash flow pattern is known.
  • PAC bondholders have priority over the other
    tranches in the issue.
  • The non PAC bonds are termed support or companion
    bonds.
  • The minimum is based off of a range of PSA
    assumes an upper and lower collar.

94
PAC Bonds
  • The guaranteed principal payment is the minimum
    of the principal repayments of the two possible
    PSAs.
  • The prepayment can occur even if prepayment
    occurs at a rate different than the original
    collars

95
PAC bonds
  • The support bonds provide protection against both
    extension and contraction risk. Therefore the
    PAC will not shorten even outside of the initial
    PAC bands.
  • The wider band of guaranteed prepayments creates
    an effective collar in which the prepayments stay
    constant.

96
PAC Bonds
  • The support bond will not receive any principal
    until the PAC has received all of the scheduled
    prepayment.
  • If the prepayment is slower than scheduled any
    principal that might have gone to the support
    bond (if the schedule was met) will now go tot
    the PAC.

97
PAC Bonds
  • If the prepayment is faster than originally
    planned the support bond will receive faster
    prepayments, eliminating the PAC paying off
    quicker.
  • If the principal of the support bond is paid off
    early then the PAC will decrease in maturity.

98
Quick Question
  • Will the schedule of principal repayments be
    satisfied if prepayments are faster than the
    initial upper collar?
  • It depends upon when the prepayments occur. The
    initial assumption was that the support would be
    eliminated at the upper collar. It repayments
    were initially slow, there is extra support
    available.

99
Quick Question 2
  • Will the schedule of principal repayment be
    satisfied as long as prepayments stay within the
    initial collar?
  • Not always the initial structure only guarantees
    that the schedule will be met if it is at either
    of the extremes. If prepayment varies there is a
    possibility that the PAC is busted.

100
Answer continued
  • IF the PAC has been prepaying at the faster PSA
    the amount of support decreases and the lower
    collar of the effective collar increases above
    the initial collar.

101
Final Question
  • Given the first two questions does a wider
    initial collar imply that there is less risk that
    the repayment will not fit the schedule?
  • No the actual prepayment experience once the PAC
    is seasoned is what is important.
  • Given prepayment experience, the effective collar
    is what should be investigated.

102
Increasing Prepayment Protection
  • Lockout Structure Eliminating the earlier or
    shorter PAC from the package creating more
    support bonds
  • Changing the prepayment rules in the event that
    all support bonds are paid off. One possible
    structure reverse PAC -- requires any extra
    principal to go to the longer maturity PACs

103
Targeted Amortization Class
  • Instead of guaranteeing a range of rates
    initially a TAC bond guarantees a specific
    targeted rate. The bond is therefore only
    protected against contraction risk, not extension
    risk.

104
Stripped Mortgage Backs
  • 1) Synthetic coupon pass throughs
  • results in a cash flow different than the
    underlying coupon
  • 2) IO and PO strips
  • Principal is at a discount from par. IO has a
    notional value.
  • 3) CMO strips

105
Principal Only Strips
  • The principal only strip is purchased at a
    substantial discount to par value.
  • The faster the prepayments, the higher the return
    to the investor since the return is determined
    only by the speed with which the investor will
    receive the principal

106
Interest Only Strips
  • The Interest is based upon the amount of
    prepayments outstanding therefore the investor
    will hope that the prepayments will be slow.
  • It is possible for the IO investor to not recover
    the amount originally paid if prepayments are too
    fast.

107
Introduction
  • MBSs represent the largest market for assets
    which have been securitized, however many other
    similar assets exist.
  • Types of assets
  • Auto Loans Student Loans
  • Credit Card Receivables Music Royalty Receivable
  • Home Equity Loans Equipment Leases
  • Manufactured Housing Home Equity Loans
  • SBA Loans Parking Ticket Receivables

108
Outstanding Mortgage and Asset Backed Securities
in US
109
Outstanding Value ofABS by Underlying Asset
110
Issues
  • All of these assets face both credit risk and
    prepayment risk, they are often referred to as
    credit sensitive structures products.
  • Corporations offer these as a means of separating
    the assets used in the collateral from the assets
    of the firm. Often this results in a form of
    credit enhancement that can decrease borrowing
    costs, however there can also be increased costs
    that offset the decreased borrowing cost.

111
Features of an ABS
  • Amortizing vs. Nonamortizing
  • Amortizing loans such as cars and mortgages have
    a set schedule of payment of principle and
    interest. Therefore projecting prepayments is an
    important part of analyzing the cash flows
    generated.
  • Nonamortizing assets only have a minimum payment
    and there is not a schedule of principle
    repayments (credit card receivables for example).
    Therefore there is not a prepayment risk.

112
Features of ABS
  • Fixed or Floating rates
  • Generally floating rate asset backed securities
    are backed by floating rate assets. Fixed rate
    loans can also be used to create floating rate
    asst backed securities for example the floating
    tranches of a CMO.

113
Features of ABS
  • Credit Enhancements
  • External Credit Enhancements third party
    guarantees
  • Corporate guarantee
  • Letters of credit
  • Bond insurance
  • Internal Credit Enhancements
  • Reserve Funds (cash reserve or Excess servicing
    spreads)
  • Overcollateralization
  • Senior / Subordinated

114
Features of ABS
  • Pass-through
  • Each holder is entitled to a portion share of the
    cash flow from the underlying assets
  • Pay Through
  • The pool loans are split into tranches similar to
    a CMO, however a pass-through does not need to be
    created first. Often the senior tranches are
    split apart into smaller tranches. This creates
    a transfer of risk from the senior to
    subordinated tranches (credit tranching).
    Prepayment risk can also be transferred (time
    tranching or prepayment tranching)

115
Features of ABS
  • Option Clean up Call provisions
  • Percent of (collateral, bond, or tranche) call
    -- outstanding bond can be called if the
    outstanding (collateral balance, bonds
    outstanding or outstanding tranches) falls below
    a given level
  • Call on or after a specified date.
  • Auction call -- called if the collateral can be
    sold at auction at a price greater than par value
    at a given date.
  • Insurer Call Insurer can call if the
    collaterals call history reaches a predetermined
    level.

116
Differences in ABS Market
  • The cash flows from the assets are often not as
    predictable as in the case of mortgages.
  • For example Home Equity Lines of Credit
  • Borrowers have open end line of credit that can
    be accessed at any time.
  • This creates risks in the outstanding balance as
    well as prepayment.
  • Increased default risk, especially automobile
    loans, and credit card receivables.
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