Mortgage Markets and Mortgage Backed Securities Finance 284 Drake Fin 284 DRAKE UNIVERSITY Drake Brief History of Mortgages Drake University Fin 284 5,000 years ago Babylonians used land as security to encourage the building of dikes and dams Egyptians used surveys to describe land plots ranked by fertility from flooding of the Nile Romans introduced the fiducia a document that was a title to land. Roman Law defined a hypotheca or “pledge” that resembled lien theory today History info from "Mortgage Backed Securites: by William Bartlett Drake Brief History of Mortgages Drake University Fin 284 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. Drake The US mortgage market Drake University Fin 284 Establishment of mortgage companies in the the 1800’s 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) History of Mortgage Market Drake Drake University 1910-1925 Fin 284 Farm Mortgage Bankers Association formed in 1914. Became Mortgage Bankers Association in 1923 as markets expanded into more urban settings. During 1920’s a secondary mortgage market started to form. Mortgage companies issued mortgage participation bonds that guaranteed payment of principal and interest to the owners (backed by the mortgages) History of Mortgage Market Drake Drake University 1925-1930 Fin 284 Early 1920’s fast appreciation of land value (50 to 75% annually). Assumption was that inflation would help bail out poor loans and that boom in prices assured payments. 1929 stock market crash spilled over to mortgage market. A majority of the mortgage companies went out of business. Foreclosures brought about a surplus of real estate and values decreased to half of their high during 1927 and 28. History of Mortgage Market Drake Drake University 1930-1935 Fin 284 Majority of foreclosures were on second and third mortgages. From 1931 to 1935 foreclosures averaged 250,000 annually. Moratoriums on foreclosures provided some relief in the Midwest states where farms were also experiencing the dust bowl. Feb 8, 1933 Iowa issued first law suspending foreclosures (for 2 years), within 18 month 27 other states had enacted similar laws. History of Mortgage Market Drake Drake University 1930-1935 Fin 284 1933 Home Owners Loan Corporation was formed by the federal government. Used proceeds of government bond sales to refinance homeowners mortgages. The HOLC acquired defaulted mortgages, refinanced them and put the loans on a monthly payment schedule Refinanced over 1 million homes in first three years. History of Mortgage Market Drake Drake University 1930-1935 Fin 284 1934 Federal Housing Administration was formed Primary objectives The improvement of the nations housing standards To provide an adequate home financing system To be a stabilizing influence on residential mortgage markets. Furthered the concept of amortizing loans and provided intermediary to channel funds to needed areas History of Mortgage Market Drake Drake University 1930-1940 Fin 284 FHA – insured mortgages provided dependability and transferability to the market and reduced risk. 1938 Federal National Mortgage Association (Fannie Mae) was formed to provide a secondary market for FHA insured loans. History of Mortgage Market Drake Drake University Post WWII Fin 284 After WWII The government established the Veterans Administration which helped fuel a housing boom. The VA offered veterans financing for homes with little or no down payment. Private sector was very liquid and wanted to increase return form bond holdings that had been purchased to fund the war. Mortgages were a perfect vehicle to do this. Drake History of Mortgage Market Drake University Fin 284 1948 Fannie Mae completes first secondary market transaction with the purchase of VA loans. 1949 Prudential Federal, Salt Lake City sells $1.5 million in FHA/VA loans to First Federal in NY – First private secondary market transaction 1954 Fannie Mae was reorganized. New charter made it part private part federal owned Drake History of Mortgage Market Drake University Fin 284 1963 FHLB and FSLIC issue nationwide regulations permitting S&L’s to purchase conventional residential loans (Up to 3% of Assets) S&L’s allowed to make loans to non association members History of Mortgage Market Drake Drake University 1968 Fin 284 Fannie Mae becomes entirely privately held Ginnie Mae is established to oversee special assistance (FHA and VA) programs Ginnie Mae has authority to guarantee timely payments of P&I on securities issued by lenders of FHA and VA loans. Guarantees backed by “full faith and credit” of US Treasury. History of Mortgage Market Drake Drake University 1970 Fin 284 Ginnie Mae guarantees first issuance of mortgage pass throughs backed by FHA and VA mortgages State of New Jersey pension fund was the buyer. Federal Home Loan Mortgage Corporation (Freddie Mac) chartered as secondary marketing arm of FHLB, issues first participation certificate in 1971 Fannie Mae granted authority to purchase conventional mortgages History of Mortgage Market Drake Drake University 1970’s Fin 284 1971 – Fannie Mae and Freddie Mac issue uniform loan documents. 1972 Fannie Mae and Freddie Mac start purchasing conventional single family mortgages 1975 CBOT offers futures trading on Ginnie Mae MBS’s 1976 total secondary market exceed $43 Million 1977 First Private pass-throughs issued by Bank of America San Francisco and First Federal Chicago History of Mortgage Market Drake Drake University 1980’s Fin 284 1981 Freddie Mac and Fannie Mae institute loan swap programs – allowing S&L’s to exchange loans held in portfolio for MBS A large quantity of adjustable rate mortgage products enter the market 1983 Freddie Mac issues first CMO Ginnie Mae introduces GNMA-II program to attract pension fund money Freddie Mac and Fannie maw attempt to standardize ARM’s that they will use. History of Mortgage Market Drake Drake University 1980’s Fin 284 1984 ARM half of all residential loans closed. CBOT initiates GNMA-II futures contracts Ginnie Mae MBS issuance hits $200 Billion Ginnie Mae issues first ARM MBS backed by FHA insured ARM loans Congress passes legislation to tax Freddie Mac 1986 Fannie Mae issues its first stripped securities A record $48 billion CMO’s are offered First CMO by Freddie Mac based on 15 year mortgages Drake The Mortgage Market Drake University Fin 284 The Primary Market Mortgage Originators Thrifts, Commercial banks and mortgage brokers Drake Origination income Drake University Fin 284 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… Drake Servicing Fees Drake University Fin 284 Servicing fees are generally a portion of the mortgage rate and is often referred to as servicing spread. The mortgage origination Drake Drake University process Fin 284 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. Drake Post Loan Options Drake University Fin 284 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) Drake Origination Risks Drake University Fin 284 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 Drake Mortgage Construction Drake University Fin 284 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 Drake Amortization of a Loan Drake University Fin 284 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 Drake Amortization Drake University Fin 284 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. Drake Amortization Drake University Fin 284 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 Amortization 30 yr Mortgage Drake Drake University $150,000 5.85% Fin 284 Beginning Ending Year Balance Payment Interest Principal Balance 1 150,000 884.91 731.25 153.6614 149,846.34 2 149,846 884.91 730.50 154.41 149691.93 359 1756.97 884.91 8.57 876.35 880.62 360 880.62 884.91 4.29 880.62 0 Drake Servicing Fee Revisited Drake University Fin 284 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. Drake Prepayments and CF Uncertainty Drake University Fin 284 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. Drake Origination Problems Drake University Fin 284 Mismatch Institutions are borrowing short and lending long) 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. Drake Adjustable Rate Mortgages Drake University Fin 284 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 Drake ARM Features Drake University Fin 284 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. Drake Balloon & Two Step Mortgages Drake University Fin 284 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 Drake Solutions to the tilt problem: Drake University Fin 284 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 Drake Graduated Payment Mortgages Drake University Fin 284 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 Drake Graduated Payment Mortgages Drake University Fin 284 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 Drake Price Level Adjusted Mortgages Drake University Fin 284 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. Drake Dual Rate Mortgages Drake University Fin 284 Similar to the PLAM except the amount owed is based on a floating short term rate. To establish the mortgage you need 1. the payment rte (the real rate of interest that is fixed for the life of the loan), 2. the effective or debiting rate that changes periodically and 3. the maturity of the mortgage. Drake Other plans Drake University Fin 284 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. Drake Other Plans Drake University Fin 284 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 Risks Faced by Mortgage Drake Drake University Investors Fin 284 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 Mortgage Pass Through Drake Drake University Securities Fin 284 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. Drake Cash Flows Drake University Fin 284 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. Drake Terminology Drake University Fin 284 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. Drake WAC, WAM and WARM Drake University Fin 284 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. Drake Guarantee Types Drake University Fin 284 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. Drake Ginnie Mae Drake University Fin 284 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 Drake Fannie Mae Drake University Fin 284 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” Drake Freddie Mac (FHLMC) Drake University Fin 284 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) Drake Participation Certificates Drake University Fin 284 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 Drake Comparison of rates Drake University Fin 284 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. Creation of a GNMA pass Drake Drake University through Fin 284 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 Sundaresan 2002 Creation of a GNMA pass Drake Drake University through Fin 284 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 Drake Creation continued Drake University Fin 284 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 Drake Fees for a typical GNMA pool Drake University Fin 284 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. Sundaresan 2002 Drake Price Quotes Drake University Fin 284 GNMA’s 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 Bt p f (t ) P where : B t is the balance at date t P is the original blanace Sundaresan 2002 Drake Market Value Drake University Fin 284 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. Sundaresan 2002 Drake Accrued interest Drake University Fin 284 SD M 1 ait c B 30 12 where SD settlement Date, M is the first day of month c coupon rate B balance Assume a coupon rate of 9% and 20 days into the month 20 1 ait (.09) (18,000,000) 90,000 30 12 Sundaresan 2002 Drake Trading and Settlement Procedures Drake University Fin 284 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 Drake Market references Drake University Fin 284 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 MBS’s 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 9’s 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. Non Agency Pass Drake Drake University Through Securities Fin 284 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 Drake Prepayment conventions Drake University Fin 284 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. Drake Measuring prepayment Drake University Fin 284 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% Drake Measuring Prepayment Drake University Fin 284 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. Drake Conditional Prepayment Rate Drake University Fin 284 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 Conditional Prepayment Rate Drake Drake University (CPR) Fin 284 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 Drake Calculations Drake University Fin 284 Prepayment based upon the SMM Estimated Prepayment for month t beg mortgage balance scheduled principal SMM for month t payment 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 Drake The PSA benchmark Drake University Fin 284 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 Drake Market Convention Drake University Fin 284 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. Drake 100 PSA Drake University Fin 284 100 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. Drake PSA benchmark Drake University Fin 284 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 Monthly cash flow construction Drake Drake University (exhibit 3 in book) Fin 284 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% Drake Exhibit 3 Drake University Fin 284 The SMM for the first month is then: SMM=1-(1-CPR)1/12=1-(1-0.008)1/12=0.000669124 The scheduled mortgage payment would be 400,000,000=PMT(PVIFA357,8.125%/12)=2,975,868.24 (this changes with each payment due to prepayment) Drake Monthly cash flow construction Drake University Fin 284 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 Drake Monthly Cash Flow Construction Drake University Fin 284 The expected prepayment for the month is then found using: beg mortgage balance scheduled principal SMM for month t payment for month t For the first month this is equal to : .000669124(400,000,000-267,534.91) =267,470.58 total principal is then equal to 267,534.91+267,470.58=535,005.49 Drake Monthly Cash Flow Construction Drake University Fin 284 Total Cash Flow is then the sum of the interest paid to the pass through investor and the total principal =2,500,000+ 535,005.49=3,035,005.49 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. Drake Note Drake University Fin 284 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. Drake Non Agency CPR convention Drake University Fin 284 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% Drake Factors Affecting Prepayment Drake University Fin 284 1) Prevailing Mortgage Rates 2) Characteristics of the Mortgage Pool 3) Seasonal Factors 4) General Economic Activity Drake Factors Influencing Prepayment Drake University Fin 284 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. Drake Factors Influencing Prepayment Drake University Fin 284 Prevailing Mortgage Rates Level of rates As the level of rates declines turnover increases as more homes become affordable. Drake Factors Influencing Prepayment Drake University Fin 284 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) Drake Factors Influencing Prepayment Drake University Fin 284 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. Drake Factors Influencing Prepayment Drake University Fin 284 General Economic Factors Housing Costs Geographic Location Family Circumstances Economic Activity Drake Extension and Contraction Risk Drake University Fin 284 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. Collateralized Mortgage Drake Drake University Obligations. Fin 284 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 Drake Average Life Drake University Fin 284 This measure represents the average time to receipt of principal repayments. T t(projecte d Principal received at time t) Average Life t 1 12(Total Princiapl) Drake Sequential pay CMO Drake University Fin 284 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. Example: Same starting point as Drake Drake University before Fin 284 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 Drake Example continued Drake University Fin 284 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… Drake CMO Drake University Fin 284 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. Drake Accrual Tranches Drake University Fin 284 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. Drake Floating Rate Tranches Drake University Fin 284 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. Drake Interest Only and Principal Only Drake University Fin 284 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 Drake Structured IO Drake University Fin 284 IO tranches are often referred to as structured IO’s 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. Drake Notional IO classes Drake University Fin 284 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. Drake Planned Amortization classes Drake University Fin 284 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) Planned Amortization Class Drake Drake University Tranche (PAC) CMO’s Fin 284 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. Drake PAC Bonds Drake University Fin 284 The guaranteed principal payment is the minimum of the principal repayments of the two possible PSA’s. The prepayment can occur even if prepayment occurs at a rate different than the original collars Drake PAC bonds Drake University Fin 284 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. Drake PAC Bonds Drake University Fin 284 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. Drake PAC Bonds Drake University Fin 284 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. Drake Quick Question Drake University Fin 284 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. Drake Quick Question 2 Drake University Fin 284 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. Drake Answer continued Drake University Fin 284 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. Drake Final Question Drake University Fin 284 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. Increasing Prepayment Drake Drake University Protection Fin 284 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 PAC’s Drake Targeted Amortization Class Drake University Fin 284 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. Drake Stripped Mortgage Backs Drake University Fin 284 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 Drake Principal Only Strips Drake University Fin 284 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 Drake Interest Only Strips Drake University Fin 284 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.
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