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Fin 284 mortgage and MBS S2004

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					  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




                   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




Assume a coupon rate of 9% and 20 days into
the month




                  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



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:



 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.
                                              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.