Lecture #8 Mortgage-Backed Securities and Asset-Backed Securities by mmcsx


									Lecture #8 Mortgage-Backed
Securities and Asset-Backed

      Asset Securitization
Securitization Defined
 “Securitization is the
 substitution of more efficient
 public capital markets for less
 efficient, higher cost financial
 intermediaries in the funding
 of debt instruments”
– John Reed, Citibank
Securitization Began with Mortgage
– Backed Securities (MBS)
     Credit Analysis Skills – needed a fast and efficient
     method for risk rating seasoned mortgages; used
     credit card risk modeling skills
     Objectivity – used respected independent credit
     risk agencies to perform the risk analysis
     RTC – needed a fast and effective method for
     selling a large number of mortgages purchased
     from failed S& Ls
     Mortgage “Infrastructure” – Standardized and
     efficient mortgage documentation and litigation
     system in place
MBS Development,
 Computer and MIS Infrastructure – the
 ability to analyze and process a huge
 amount of financial information was also in
 New Product Development – investment
 banks in conjunction with Freddie Mac and
 Fannie Mae were anxious to introduce new
 MBS products
 Ginnie Mae – had prior experience in
 guaranteeing the payment of new
 mortgage products, and was backed by
 the full faith of the U. S. government
The Major Players in MBS
  Mortgage sellers
    RTC, specialized mortgage bankers and
    brokers, S and Ls, commercial banks, others
    Fannie Mae, Freddie Mac, private financial
    Purchase mortgages, pool mortgages into MBS,
    sell MBS with the aid of investment banks
  MBS purchasers
    Banks, insurance companies, pension funds,
    mutual funds, private individuals, foreign
    Global market
Types of MBS
  Pass–Through Securities
  Collateralized Mortgage Obligations
  Derivative Securities
    Interest-only strips (IO)
    Principal-only strips (PO)
Pass–Through Securities
 Similar to a closed-end mutual fund
   purchases and pools mortgages
   receives payment on the mortgages
     Principal and interest, monthly
     Full principal prepayment, time uncertain
   passes these payments to the holder of
   the pass-through security, quarterly
Pass–Through Securities,
   Receives payments, quarterly
   No credit risk due to:
     Insurance/guarantee against losses from mortgage
     default (VA/FHA/PMI)
     Ultimate guarantors of timely MBS payment to MBS
     purchasers (Fannie Mae/Freddie Mac/Ginnie Mae)
   Pre-payment risk
     Not sure when receive principal pre-payments
 Types of Pass-Through
            Participation               GNMA Pass-
             Certificate                  Through
             Freddie         Fannie
Issuer                                    financial
               Mac            Mae
Default       PMI           FHA/VA        FHA/VA/
Guarantor    FHA/VA           PMI           FmHA
Payment      Freddie         Fannie     Ginnie Mae
Guarantor    Mac only       Mae only     (and U. S.
Two Types of Programs
 Upon sale of a pool of mortgages to
 a conduit, seller can receive:
   Cash (cash program)
   A securitized pass through (swap
 Market for “conformable”
 passthroughs highly liquid, compete
 with gov’t bonds
   Bid –asked spread only between 1 and
Private Securitization
 For “non-conforming” mortgages
 Needed changes in gov’t regulations with
 regard to:
   S E C (lower conduit expenses)
   Purchasers – must be “investment grade”
   Tax – no double taxation
     A/B structures for tranches in a CMO
     Only B structure subject to double tax
   Ability to purchase on margin
Pre-Payment Risk, Due to
the Uncertain Timing of:
Home Sales
  When the mortgage holder sells a home, he or
  she generally pays off the mortgage
  The timing pattern of these repayments is not
  terribly difficult to estimate in advance for the
  pool as a whole
  When mortgage rates decline, many holders of
  FRMs pay off the mortgage and refinance.
  This leads to a reinvestment problem for the
  pass-through holder
  The timing pattern of these refinancing
  repayments is much more difficult to estimate
  than that associated with home sales
Collateralized Mortgage
    CMOs are designed to shift
    prepayment and reinvestment risk to
    different groups or “tranches” in
    different proportions, depending on
    the ability/desire of each tranche
    purchaser to bear the risks
    Since CMOs are complicated, credit
    “enhancers” are added to further
    guarantee payment
CMOs Continued
 Divide pool of expected cash flows into
 different tranches
 First Tranche
   First to receive payments
   Absolute certainty as to amount and timing
   Typically “AAA” rating
 Middle Tranche(s)
   Next to receive payments
   Absolute certainty as to amount, varying
   degrees of certainty as to timing
   Investment grade ratings
Last Tranche of the CMO
This bears all the residual risk as to
payment amounts (usually negligible)
and timing (can be very large,
depending on the nature of the CMO
This last tranche is more like an equity
instrument and attracts equity
This last tranche may be held by the
securitizer rather than being sold to
Value Added through MBSs
Individual Mortgages            MBS
        Illiquid                Liquid
   Valuation lacks       Market values more
continuity & precision         efficient
  Credit analysis &      Third parties assess
monitoring by lender              risk
   High operating          Lower operating
      expenses                expenses
  Limited rates and
                          Much wider range
  Local market for       National and global
      investors                 market
Evaluating MBSs – the Key Role
of the Credit Rating Agency
 Quality of the originators’ credit process
   Why does the originator want to sell?
 Quality of the underlying mortgage loans
 and homes themselves
   Loan to value ratios, location, credit scores of
   mortgage holders, default expectations
 Quality of the loan portfolio being
   Degree of diversification, portfolio default
   expectation for the portfolio as a whole under:
      A best estimate economic forecast
      A downside economic forecast
Quality and scope of the loan insurance, loan
guarantee, and MBS enhancement protection
  Will all the expected loan losses be covered by
     In a best estimate case?
     In a downside case?
Quality of the legal structure
  Who really owns and controls the underlying
Quality of the mortgage servicers
  Will the mortgage payments be collected and

Quality of the MBS structure
  What tranches have what rights? Will
  they be respected?
Quality of the rating agency itself
  Its reputation and past record
  Is it truly independent from:
    all interested private parties?
    the government?
Economics of Securitization
–Simplified Example
  30 year FRM rate = 7%,
  Weighted average CMO yield = 5%,
  Weighted average government bond
  yield = 4%
  Constant prepayments,
  15 average life for 30 year FRMs
Benefits to Mortgage Sellers, Mortgage
Borrowers and Third Parties
      Mortgage Sellers
        Sell mortgages at a profit, since “conforming”
        mortgages have a higher worth when
        Free up capital for further lending
        Gain ability to lower mortgage rates to increase
        market share
      Mortgage Borrowers
        Lower mortgage rates
        Greater funds availability
      Third Parties
Benefits to CMO Purchasers
 Higher yields than those on
 government bonds for higher tranche
 purchasers (5% for CMO versus 4%
 for government bonds)
 High expected equity-like return for
 lowest tranche holder from high
 expected residual net profit
 Tranches are customized to the
 particular needs of the purchasers
Losses to Non-Participating
Mortgage Sellers
 Lower net interest revenue from
 mortgage lending due to fall in
 mortgage rates
 Higher capital requirements for
 mortgage lending relative to
 participating sellers
 Higher costs, since under less
 pressure to modernize and
 standardize their credit evaluation
 system as required by securitizers
 and rating agencies
Mortgage Securitizers in
 KAMCO – non-performing mortgages
 acquired from troubled financial
 KoMoCo – performing mortgages
 acquired from the National Housing
 Fund operated by H&CB
 KHFC – performing mortgages
 acquired from commercial banks
Passthrough Securities
 WAC weighted-average coupon rate
  Passthrough rate is less than WAC
  Servicing and other costs/profit
 WAM, weighted average maturity
  Average life much less than WAM
Types of Passthrough
   Fannie Mae – private shareholders
   Freddie Mac – private shareholders
   Ginnie Mae – public corporation
   “Conforming mortgages” – were about 80-90% of total –
   now dropping
   Both fixed and floating rate
      No or low doc
   Issued by private financial institutions
Price Paid for Specified P-
 Amount paid =
 Price/100 x par value x pool factor

 How do you price a passthrough?
 Must know the cash flows!
Cash Flows depend on:
 Interest payments
 Scheduled principal payments
  Entire remaining principal
Terminology for Handling
 CPR = conditional prepayment rate
     = annual rate, for example, 4%/yr
     = .04
 SMM = single-monthly mortality rate
      = monthly rate
      = .003396 = .3396%/month
      = 1 –[1- CPR] to the1/12th power
PSA Prepayment Benchmark
 Starting at month = 0, the CPR
 increases .2% or .002 every month
 until the 30th month
 Then stays at 6% or .06 for every
 month there after
 This 100% PSA
 For each CPR, must convert to the
 SMM using the conversion formula
Monthly Amortization
 Cash flows to
   passthrough holder
 Explain exhibit 3 page 400
   This is the cash flow to pass through
   Also a cash flow to the servicer = to
   gross interest – net interest
Cash Flows, Continued
 Different PSA = Different cash flows
 Higher PSA = shorter average life
Determinants of PSA
 Prevailing mortgage rate relative to original
 coupon rate
   Amount of Refinancing
      Amount of difference – “incentive to refinance”
      Path dependent – “refinancing burnout”
   Housing Turnover
      Lower i = greater turnover
 Characteristics of underlying mortgages
   Type of mortgage, type of loan, pool factor,
   Location of property, and so on
Determinants of PSA,
 Seasonal Factors
 General economic activity
Current PSA Trends
 In the U.S.
   i expected to increase
   i lower than expected
   RESULT? Refinancing amount lower than
   previously but greater than anticipated
 In Korea?
   Interest only 3 year mortgages
   Fixed or floating?
   Rollover issue
Average Life
 Similar to Macaulay duration in how it
 is calculated from cash flows of
 principal payments only
 “Normal” PSA = 165, so average life =
 8.75 years, roughly similar to 10 year
Contraction and Extension
 If i goes down,
   Less increase in price than with a bond
   because more prepayment
      Similar to bonds being called
      Average remaining life decreases (contraction)
   More to reinvest, but at lower I
 If i goes up,
   Full decrease in price – similar to bond
   Less repayment, average life increases
   Less to reinvest at the higher i
Purchase passthroughs
“Structure” the cashflow from the
passthroughs into ‘tranches”
Types of tranches
  Sequential pay
  Accrual bonds
  Floating rate tranches
  Structured IO tranches
  Planned amortization class tranches - PACs
Sequential Pay
 Par value of all the tranches = par value of
 underlying collateral
 Each tranch is paid its principal in turn,
 with all the underlying principal payments
 going first to the 1st tranche, then the 2nd
 and so on.
 Each tranch gets its interest starting with
 the 1st period, is paid interest only until it
 starts receiving principal payments, then
 diminishing amounts of interest as
 principal is paid off
Sequential Pay, Continued
 Principal paydown period
 Starts at month 1 for the first tranch
 The higher the PSA, the earlier the
 beginning of the paydown period
 In effect, for any given PSA, converts from
 an average life for the entire passthrough,
 to separate and differing average lives for
 each of the tranches – see page 410
Sequential Pay, Continued
  All tranches receive payments in the
  early months, even if they do not wish to
  Average lives differ, depending on the
        Accrual Bonds
On at least one tranch, no interest is
paid until the beginning of the
paydown period
Generally true for the last, or Z,
tranche which becomes a Z bond
Floating Rate Tranches
 Create tranches that pay
  More when i goes up
  More when I goes down
  The same passthrough rate for the 2
  tranches together
  Leverage, caps and floors
Structured Interest – Only
 Pass less than passthrough rates to
 early tranches
 Pay difference in interest to notional
 IO tranche
PAC Bonds and Support
 Planned Amortization Class bonds -
 guarantee that prepayment PSA will
 be in a certain band or collar
 If outside the band, at the expense of
 the support tranches
 Less prepayment risk to PACs, more
 to support tranches
Non- Agency CMOs
 For jumbos, low docs and non-docs
 Need credit enhancement
Non- Agency Asset-Backed
 For both amortizing and non-
 amortizing financial assets
 Can be fixed or floating rate
 All require credit enhancement
   How much?
   However much that is specified by the
   rating agencies so as to get a specified
   bond rating
Types of Credit Enhancement
   Corporate guarantee
   Bank letter of credit
   Bond insurance
 Internal - next slide
 Rating Agency
   “Weakest link” rule
Internal Credit Enhancement
 Reserve funds
 Over colateralization
 Senior/subordinate structure
Complicated Structures
designed to shift
 Prepayment risk – less important than
 with mortgage-backed securities
 Credit Risk – much more important
 than mortgage-backed securities
 Junior, residual, subordinated, last
 tranches can be very risky, more risky
 than many equities
Types of ABS
 Home Equity lines of credit and loans
 Manufactured Housing
 Auto loans
 Student loans
 SBA loans
 Credit card receivables – mention LG
 Credit Card receivables’ securitization
Pricing of MBS
 Trades at a positive yield spread
 relative to Treasuries
   Prepayment risk
 Less upside price potential
 Greater downside price risk
 Overtime, decline in yield spread
 because of customizing of CLOs
Value at Risk of MBSs
 Depends on volatility of MBSs yield
 Effective duration of MBBs
 Currently more MBSs than
 government bonds

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