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Market for mortgage-backed securities

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					Market for mortgage-backed securities

Emilie Tregouet, Georg Nikisch, Jacopo Bignamini and Carlo Di Maio

2007.12.06

Mortgage-backed securities

Definitions

Mortgage backedsecurities (MBS) Creation of MBS in the market

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Mortgage-backed securities

History and foundations in the mortgage market

In 1968, Congress divided the Federal National Mortgage Association (Fannie Mae) into two organizations:
 The current Fannie Mae  The Governement National Mortgage Association (Ginnie Mae) function: use the « full faith and credit of the U.S. governement to support the Federal Housing Administration (FHA) and the Veteran Administration (VA) mortgage market.

In 1970, Congress authorized Fannie Mae to purchase conventional mortgage loans and created the Federal Home Loan Mortgage Corporation (Freddie Mac) to provide support for FHA and VA insured mortgages and conventional mortgages.

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Mortgage-backed securities

Different types of Mortgage Backed Securities
Pass-through Mortgage-Backed Securities (MBS)
 Residential Mortgage-Backed Securities (RMBS)  Commercial Mortgage-Backed Securities (CMBS)
 Multiproperty single borrower deal  Conduit-organized deal  Fusion conduit deal

Stripped MBS
 Interest-only stripped mortgage-backed securities (IO)  Principal-only stripped mortgage-backed securities (PO)

Collateralized mortgage obligation (CMO) Yields on MBS

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Mortgage pass-through securities

 The monthly payments are collected and passed through to the holders of the security.  Security created when one or more holders of mortgages form a collection (pool) and sell shares or participation certificates in the pool  They are more liquid than an individal mortgage  Fewer than 10% of multifamily unit mortgages find their way into a mortgage pool backing a mortgage pass-through securities

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Mortgage-backed securities

Issuers of mortgage-backed securities

Ginnie Mae: the largest portion of passthrough securites, Ginnie Mae securities are among the most secure investments in the global capital market, they offer the only mortgage-backed securities (MBS) carrying the full faith and credit guarantee of the United States government, which means that even in uncertain times, the investors are guaranteed payment of interest and principal

Freddie Mac: they issue securities called participation certificates (PC), certificates issued guarantee the timely payment of both interest and prinicipal, the Freddie Mac guarantee is not a guarantee by the US government, 2programs to create PCs: cash program and the Swap Program, both programs provide capital to the residential mortgage market and foster a secondary mortgage market
Mortgage-backed securities

Fannie Mae: the newest player in this market, they pool these mortgages and issue MBS, these passthroughs are guaranteed with respect to payment of interest and principal, like Freddie Mac the MBS of Fannie Mae are not obligations of the US government and their guarantee does not carry the full credit of the US government (only Ginnie Mae does carry the full faith and credit)

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Issuers of mortgage-backed securities
Nonagency pass-through securities:
the first privately pass-through securities were issued by the Bank of America in 1977 are issued by conduits of commercial banks, investment banking firms and entities not asscoiated with both (e.g. Citibank Housing or GE Capital Mortgage) agencies can purchase mortgages which confirm their underwriting standards (max. size of the loan and the max. ratio of the loan to the market value of the mortgage property) the securities are rated by rating agencies (mostly with a double A) many problems at the beginning in 1982 with the private sector:
the private pass-throughs were crowded out by agency issues private issuers faced state laws that limited the demand lack of standardization solution: several regulatory changes helped the development of the nonagency mortgage backed securities market
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Mortgage-backed securities

Differences between US market and EU market

United States Market
o Dominated by mortgage banks o Institutions remove loans from their balance sheet through securitization o Funding instrument are inexpensive o US agencies buy mortgage loans and sell them into secondary market o US government guarantee reduces funding costs

European Market
o Great diversity of mortgage lenders o Mortgage loans remain on the balance sheet of banks o Funding instruments are costly o No national european government to help lenders fund their loans o Mortgage lenders enjoy no funding advantage through government backing

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Mortgage-backed securities

European MBS market

Mortgage Backed Securities are debt securities issued off-balance sheet, which in effect means that the mortgage loans are transferred away from the bank into a Special Purpose Vehicle (SPV) which issues securities. This system is particularly common in the US and increasingly so in Europe where at present it accounts for around 5% of mortgage funding.

The development of a pan-European secondary mortgage market is a key objective in the push to integrate Europe’s mortgage markets.
More liquid funding directly sourced from capital markets through the issuance of Covered Bonds or MBS can assist in lowering funding costs and provide a wider range of funding options for lenders.

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Mortgage-backed securities

Cash flow
Loans 200,000$ each Monthly cash flow

Interest Scheduled principal repayment Prepayments

Interest Scheduled principal repayment Prepayments

Rule of destribution of cash flow pro rata basis

Interest Scheduled principal repayment Prepayments

POOLED MONTHLY CASH FLOW: INTEREST SCHEDULED PRINCIPAL REPAYMENT PREPAYMENTS

Interest Scheduled principal repayment Prepayments

Interest Scheduled principal repayment Prepayments

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Mortgage-backed securities

Prepayment risks associated with pass through securities

Prepayment risk: is the risk associated with the early unscheduled return of principal on a fixed-income security.

Contraction risk: The risk of a security shortening in duration due to the acceleration of prepayments mainly due to lowering interest rates.

Extension risk: The risk of a security lenghtening in duration due to the drop of prepayments mainly due to growing of interest rates.

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Mortgage-backed securities

Prepayment conventions
PREPAYMENT SPEED: prepayment rate assumed over the life of the underlying mortgage pool. CONDITIONAL PREPAYMENT RATE (CPR): assumes that some fraction of the remaining principal in the pool is prepaid each year for the remaining term of the mortgage. It depends on: characteristics of the pool current and the expected future economic environment it is referred as „conditional” because it is conditional on the remaining mortgage balance annual based rate

1. 2. 3. 4.

1 SINGLE-MONTHLY MORTALITY RATE (SMM): calculated as: SMM  1  (1  CPR ) 12
prepayment for month t  SMM  (beginning mortgage balance for month t - scheduled principal payment for month t)

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Mortgage-backed securities

PSA
THE PUBLIC SECURITIES ASSOCIATION prepayment benchmark is expressed as a monthly series of annual prepayment rates, it assumes that prepayment rates are low for newly originated mortgages and then speed up as the mortgage become seasoned; For instance: 30 years mortgage CPR of 0,2%, increased by 0,2% per year per month for the next 30 months till it reaches 6% year 6% CPR for the remaining years 165PSA=
 5  CPR  6%   1%  0,01  30  1 SMM  1  1  0,01 12  0,000837  20  CPR  6%   4%  0,04  30  1 SMM  1  1  0,04  12  0,003396

1. 2. 3.

100PSA= Month 5

Month 5

 5  CPR  6%   1%  0,01  30  165 PSA  1,650,01  0,0165 1 SMM  1  1  0,0165 12  0,001386  20  CPR  6%   4%  0,04  30  165 PSA  1,650,04  0,066 1 SMM  1  1  0,066  12  0,005674

Month 20

Month 20

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Mortgage-backed securities

Average life
But the stated maturity for a mortgage pass-through security because of prepayments is an inappropriate measure of the security’s life. The AVERAGE LIFE of a mortgage backed security is the average time to receipt of principal payments weighted by the amount of principal expected

Average life:

AL  
t 1

T

t  Principal received at time t 12(Total principal )

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Mortgage-backed securities

Collaterized Mortgage Obligation (CMO)
“CMO is a type of MBS with different bond classes (called tranches) issued, that receive payments according to a definied set of rules, or the required credit protection”
Credit Protection

•Credit tranching: any credit loss will first be absobed by the junior class, then by the senior •Overcollaterization: the principal value of the issued bond is less than the value of the underlying pool of mortgage •Excess spread: the issued bond pay a lower interest rate than the underlying mortgages

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Mortgage-backed securities

CMO’s Payments Tranching
•Sequential tranching: A type of collateralized mortgage obligation (CMO) in
which there are several tranches. Each tranche's holder receives interest payments as long as the tranche's principal amount has not been completely paid off. The senior tranche receives all initial principal payments until it is completely paid off, after which the next most senior tranche receives all the principle payments, and so on.

•PAC bonds:This type of tranching has a bond (often called a PAC or TAC bond)
which has even less uncertainty than a sequential bond by receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion bonds) that absorb the excess prepayments.

•VADM bonds:Very Accurately Defined Maturity (VADM) bonds are similar to
PAC bonds in that they protect against both extension and contraction risk, but their payments are supported in a different way. Instead of a support bond, they are supported by accretion of a Z bond. Because of this, a VADM tranche will receive the scheduled prepayments even if no prepayments are made on the underlying.

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Mortgage-backed securities

Subprime Mortgage Market Crisis

In the past years mortgage payments have been repackaged into a variety of complex investment securities, like MBS. Due to securitization, loans with a high risk of default could be originated, packaged and transferred to investors, strongly attracted by higher return of MBS. The risk of these was gauged by credit-rating agencies which were (are) paid by the firms that created the securities and which made (make) a lot of their money from advising on how to win the best ratings. As result, the tendency of rating agencies was to assign investment-grade ratings to MBS.
Stun the pig, hang it up by its trotters and slice it open. Decant some blood, pull out the organs and other unwanted bits, then squeeze them into a tube of scraped intestine…. Sausages are indeed harder to swallow if you know how they are made.
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Mortgage-backed securities

Conclusion

FINANCE
is NOT the DEVIL
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Mortgage-backed securities

THANK YOU!

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Mortgage-backed securities


				
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