Mortgage Backed Securities Mortgage Pass-Throughs

Mortgage Backed Securities Mortgage Pass-Throughs • GNMA -- a federal government agency • FNMA and FHLMC -- government sponsored enterprises. Fannie and Freddie • Pass-throughs collaterialized by pools of home mortgages • Cash Flows of a pass-through: 1. Interest 2. Scheduled repayment of principal 3. Prepayment of Principal Mortgage Backed Securities Mortgage Pass-Throughs • Total amount of payment to the investor is less: 1. Mortgage servicing fees 2. Guarantee fees paid to the issuer or guarantor • Normally investors face a delay of 15 days before receipt of payments • Payments are made monthly and include all the cash flows • Characteristics of a pass-through 1. WAC: Weighted average coupon -- mortgage interest rates weighted by remaining balance 2. WAM: Weighted average maturity -- maturity weighted by remaining balance Mortgage Pass-Throughs Factors Affecting Prepayment Rates • Difference between the prevailing market mortgage rate, yM, and contracted interest rates on the mortgages in the pool, yC. Prepayments increase as yC - yM increases • Path of mortgage rates: Refinancing burnout yM % 12 10 8 0 Refinancing No-burnout Refinancing burnout Time Mortgage Pass-Throughs Factors Affecting Prepayment Rates • Level of mortgage rates: Lower mortgage rates encourage housing turnover and refinancing because housing is more affordable. • Conventional mortgage versus FHA/VA: Conventional mortgages have higher prepayment rates. • Amount of seasoning, lower prepayments unless pent-up refinancing from persistently high interest rates Mortgage Pass-Throughs Factors Affecting Prepayment Rates • Geographic location: California has higher prepayments and housing turnover. • Type of mortgage: 30 year, 5 year balloon, floating rate, etc. • Seasonality: Home buying and selling increases in spring and peaks in late summer, then declines in fall and winter. Prepayments follow the same seasonality. Mortgage Pass-Throughs Prepayment Rate Models • Models attempt to account for the primary factors influencing prepayment rates: 1. Refinancing incentives -- yC-yM. Market interest rate factors. 2. Refinancing burnout 3. Seasoning 4. Seasonality • Prepayment rate forecasts are made for each month of the remaining life of the mortgage pool. Only a single forecast rate is usually reported and used for pricing (Bloomberg) Mortgage Pass-Throughs Pool Value and Prepayment Risk • Two components of the value of a pass-through 1. Price quoted relative to par -- 95-05 or 95 5/32 percent of par of 100. Is it possible for the price of a pass-through to be greater than par? 2. The prepayment speed or PSA value. Without an assumed prepayment speed, the price is meaningless because the rate of cash flow from the security is unspecified.(Public Securities Association) • The assumptions underlying a price quote are: 1. Reinvestment can be made at the quoted yield 2. Pass- through must be held to maturity 3. Assumed prepayment rate is constant to maturity Mortgage Pass-Throughs Prepayment Risk • Contraction Risk: Greater rates of prepayment and lower reinvestment rates when interest rates decline. Average Life Contracts Extension Risk: Slower prepayments result in increasing the amount invested funds at lower coupon rates so that reinvestment at higher market rates is foreclosed. Average Life Extends Mortgage Pass-Throughs Prepayment Risk • Prepayment risk primarily arises from interest rate changes. 1. When interest rates decline, prepayments increase reducing the value of the pass-through compared to an option-free bond. Pass-through Value, P Option-free bond Pass-through Interest rate y% Contraction 10 risk Extension Risk Mortgage Pass-Throughs Prepayment Risk • Investor Examples Depository Institutions: Banks, S&Ls and credit unions investing in passthroughs or CMOs are exposed to considerable Extension risk. Their liabilities are short-term and floating rate so that when interest rates rise, there is an increase in interest cost or cash outflow on liabilities and a reduction in cash flow from their MBS. • Pension Plans, with long-term liabilities, are exposed more to contraction risk -- an interest rate decline increases cash flows that must be reinvested at lower than expected market rates. Mortgage Pass-Throughs Maturity of a Pass-Through or CMO • Returns on pass-throughs and CMOs are commonly compared with yields on Treasuries -securities that are virtually default free. • Is the premium over a “comparable” Treasury worth accepting the prepayment risk of the passthrough or CMO? • What does “comparable” mean? Comparable coupon rate and maturity. • The actual maturity of a pass-through tells us little about the rate at which principal is repaid because of prepayment risk. Mortgage Pass-Throughs Maturity of a Pass-Through or CMO • Common measures to compare maturities of passthroughs and CMOs 1. Average life: the average time to receipt of principal. t * Pr incipal (t ) AL   t 1 12 * Total Pr incipal AL = Average life;T = remaining months to maturity. What is the average life of a Treasury bond with 10 years until maturity, $1,000 par value and coupons paid semiannually? 20 *1000 AL   10 years 2 *1000 T Mortgage Pass-Throughs Maturity of a Pass-Through or CMO • Common measures to compare maturities of passthroughs and CMOs 1. Average life: Since the Average Life varies with the rate of prepayment, under which prepayment speed should the Treasury and pass-through be compared? Example: 7.5% coupon, WAM of 357 months passthrough AL at various PSA PSA 50 100 165 200 300 400 500 600 700 AL 15.1 11.7 8.76 7.68 5.63 4.44 3.68 3.16 2.78 The Faster the Prepayment Speed, the lesser the AL. Mortgage Pass-Throughs Maturity of a Pass-Through or CMO • Common measures to compare maturities of passthroughs and CMOs 2. Macaulay’s Duration NOTE: Average life does not take into account the amount of the cash flows at each period. Clearly if a mortgage is prepaid, later principal is received earlier and all of the remaining interest is not paid. CMO Collateralized Mortgage Obligation • FFIEC “High-Risk Mortgage Security Test A “high-risk mortgage security” is a CMO tranche that, at the time of purchase or at subsequent testing dates, meets any one of the following 3 tests: 1. Average Life Test: The average life of the CMO is greater than 10 years. 2. Average Life Sensitivity Test: (a) +300 bp parallel change in yields, AL increases by more than 4 years (EXTENSION). (b) -300 bp parallel change in yields, AL decreases by more than 6 years (CONTRACTION). CMO Collateralized Mortgage Obligation • FFIEC “High-Risk Mortgage Security Test Price Sensitivity Test: Percentage change in price is greater than 17 % with a ±300 bp change in interest rates. • Assumptions: 1. Prepayment speeds are the same for each test and will change according to an accepted model as interest rates change. 2. Yields used in the shift of the yield curve are the Treasury yields with maturity equal to the AL of the CMO before the shift plus a premium that the CMO is selling for at the time of the test.