MortgageBacked Securities

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Mortgage-Backed Securities

• Chris Lamoureux, PhD
• Head of Finance
• Estes/Neill Professor of Finance
• University of Arizona

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Background

• A dominant aspect of the US economy is widespread
  home ownership (owner-occupied housing). In the
  2000 Census, 66.2 of American households owned
  their own home. This compares to a homeownership
  rate of less than 50 in 1890, and 43.6 in 1940.

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International Rates of Home Ownership

• US 66.2
• UK 67.9
• Japan 60.3
• France 54.3
• Germany 40.5
• Republic of Korea 53.3

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Mortgages

• US Public policy has attempted to increase
  home-ownership. Prior to the 1970s most
  mortgages were owned by the financial system
  (Banks and SLs).
• Because these loans are very standardized, they
  were the first type of securitized loans.
• A mortgage is a collateralized, amortizing loan.
• It has a prepayment option.

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MBSs

• The most basic MBS is an Agency Passthrough
  security.
• Passthrough Features
• Type of Guarantee
• Fully modified passthrough timely payment of
  both interest and principal.
• Modified passthrough timely payment of
  interest, principal passed through when collected
  (guaranteed to be no later than a pre-specified
  date).
• Number of Lenders
• Single or multiple lender (impacts extent of
  diversification).

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MBS Features (Contd.)

• Mortgage Design of loans.
• Esp. FRM vs. ARM
• Mortgage Characteristics
• Government-insured vs. Conventional
• Maximum Loan size
• Amount of Seasoning permitted
• Assumability
• Maturity
• Servicing Spread.
• Payment Procedure (Delays / Method).

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Agency Passthroughs

• Three Types
• GNMA
• Fully modified
• Only FHA, VA, and RHS (Rural Housing Service)
  loans allowed
• GNMA I only single lender pools.
• GNMA II both single- and multiple-lender pools.
• Servicing Spread
• GNMA I 50 basis points.
• GNMA II 150 basis points.

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3 Types (Contd.)

• Federal Home Loan Mortgage Corp (Freddie Mac)
  (Participation Certificate)
• Cash Program.
• Guarantor / Swap Program.
• Wide variety of pools.
• Spread 50 250 basis points.
• Federal National Mortgage Association (Fannie
  Mae)
• All are fully modified.
• Otherwise, very similar to Freddie Mac.

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CMOs

• In June, 1983, FHLMC offered the first CMO. The
  CMO is a more sophisticated way of distributing
  the cash flows from a pool of mortgages than the
  straightforward passthrough.

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CMOs (Contd.)

• The first CMOs focused on providing a variety of
  terms-to-maturity (durations) to investors.
• They are known as sequential pay structures
  (aka plain vanilla clean).
• The mortgages are pooled and the future cash
  flows are allocated according to specific classes
  or tranches.
• Example
• 1 million pool of FNMA 7.5s consistent with
  185 PSA
• Tranche A
• Receives all principal flow from Months 1 through
  64, when principal balance is 0 Stated Coupon.

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CMOs (Contd.)

• Tranche B
• Receives stated coupon all principal flow from
  Months 65 through 107, when principal balance is
  0.
• Tranche C
• Receives stated coupon all principal flow from
  Months 108 through 134, when principal balance is
  0.
• Tranche Z
• Receives no cash flows until first 3 tranches are
  retired (although face amount accrues at stated
  coupon) then all remaining principal flows.
• (Cash flows shown in Sundaresan, Figure 9-9, p.
  327.)

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CMOs (Contd.)

• In 1986, following large drops in mortgage rates,
  and increased pre-payments, issuers developed and
  issued prepayment protected bonds called planned
  amortization classes. (PACs)
• PACs have a principal payment schedule--like a
  sinking fund that can be maintained over a range
  of prepayment rates.
• The relative certainty of these PAC tranches is
  obtained by setting up a companion tranche that
  absorbs the uncertainty.

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Trading MBS 1.

• MBS do not trade in the same manner as treasuries
  or even corporate debt. Most trades are
  conducted on a TBA basis, where the basic
  structure of a security, but not the specific
  security is agreed to trade. This is meant to
  make for fungibility in the MBS market. So a
  trade specifies the WAC, WAM, prepayment history,
  and then most trades will actually comprise
  securities from several pools.

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Trading MBS 2.

• Most trading in MBS occurs according to a
  schedule established by the Public Securities
  Association. I take the following time-line
  example from Tierney Moores Chapter 5 from The
  Handbook of Mortgage-Backed Securities, (Fabozzi,
  ed.) 1995.
• On June 18, the portfolio manager calls a dealer
  and agrees to buy a 30-Yr FannieMae pass-through
  with 1 million face value, coupon 8.5. Agreed
  upon price 102 47/64 w/ no other characteristics
  specified.

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Trading MBS 3.

• On July 9 the manager receives a fax that states
  that 2 pools will be delivered in 2 days
• A new pool issued on July 1 with 1.00 factor.
• A pool issued on June 1 just beginning to pay
  principal with a factor .99.
• The dealer will deliver 98 of the requested face
  value. The settlement date is July 13, where the
  manager pays the agreed upon premium plus accrued
  interest from July 1 through July 12.

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Trading MBS 4.

• On the settlement date, the portfolio manager
  receives notice that Fedwire has credited its
  securities account and debited its cash account.
• On the last day of the month (July 31) Fedwire
  surveys all accounts and records our portfolio
  manager as the owner of record if its purchased
  MBS.
• On the 4th business day of the month (Aug. 6)
  Fannie Mae releases pool factors. Fannie Mae
  pass-throughs pay coupons on the 25th of the
  month to holders of the last record date. The
  interest and principal payment will be credited
  to the managers account via Fedwire.

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Trading MBS 5.

• The factor in this case is the remaining
  principal multiplier for the previous month.
  This is multiplied by the original principal x
  the passthrough rate x 1/12 to come up with this
  months interest cash flow.