Introduction to Bond Markets_ Analysis_ and Strategies

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					Mortgage Pass-Through

    Chapter 11
Pass-Through Securities

   created when one or more mortgage holders form a
    collection (pool) of mortgages and sell shares
    (participation certificates) in the pool
       pass-throughs are then basis for other derivatives (CMOs
        and stripped mortgage-backed securities)
   CFs come from mortgage pmts from pool of
       timing differs from mortgage pmts
       amt differs from mortgage pmts – difference due to
        servicing fees and other fees for guaranteeing issue
       CFs not known with certainty because of prepayments

   WAC – weighted-average coupon
       weight mortgage rate of each mortgage in pool by
        amt of mortgage outstanding
   WAM – weighted-average maturity
       weighting remaining # of months to maturity for
        each loan in pool by amt of mortgage outstanding
Agency Pass-Throughs

   Ginnie Mae
   Freddie Mac
   Fannie Mae
   types of guarantees
       fully-modified PTs – timely pmt of principal and
       modified PTs – guarantees interest and principal
        but only timely payment of interest
Agency Pass-Throughs

   Ginnie Mae PTs
       guaranteed by full faith and credit of US
       essentially default risk free
       Ginnie Mae guarantees security referred to as
        mortgage-backed security (MBS)
           fully modified pass-throughs
           only include mortgages guaranteed by Rural Housing
            Service, Veteran’s Association, or Farmers Home
Agency Pass-Throughs

   Freddie Mac PTs
       their pass-through is called a participation certificate
       not guaranteed by US government but …
       modified pass-throughs
       Gold PC – introduced in 1990
           fully modified PT
           eventually only PC that Freddie will issue
   Fannie Mae PTs
       MBS
       not obligation of government because government-
        sponsored agency not government agency
       fully modified pass-throughs
Non-Agency Pass-Throughs

   issued by commercial banks, thrifts, and
    private conduits
       purchase nonconforming mortgages, pool, and
        sell pass-throughs which have underlying pool as
       same thing as Agency except not guarantee of
   registered with SEC
   rated by same firms that rate debt
Credit Enhancements

   rating companies consider
       type of property
       type of loan
       term of loan
       geographical dispersion of loan
       loan size
       purpose of loan
   rating given but can be changed by credit
    enhancement (this has been key to growth of this
    type of security in market)
Credit Enhancements
   external
       3rd party guarantees that provide first-loss protection
        against losses up to a point (say 10%)
       bond insurance – same as muni bond insurance
       pool insurance – covers losses from defaults and
           usually for $ amt for life of pool
           some written so $ amt declines as pool seasons as long as
               credit performance is better than expected
               ratings agencies approve
           need additional insurance to cover losses from bankruptcy or
       rating of 3rd party must be at least as high as rating sought*
Credit Enhancements

   internal – may change CFs even with no default
       reserve funds
           cash – deposits of cash generated from issuance proceeds
           excess spread accounts – allocation of excess spread or cash
            into separate reserve account after paying net coupon
       overcollateralization
           principal amt of issue < principal amt of pool of loans
       senior/subordinate structure – most widely used
           subordinate class absorbs all losses up to amt in class
           subordinate class has higher yield
           shifting interest structure – redirects prepayments from
            subordinate class to senior class according to given schedule
            (want to maintain insurance)

   value of any security is what?
       issue for PTs why?
   prepayment speed
       CF yield – yield calculated based on projected CF
   prepayment conventions
       FHA experience – no longer used since
        prepayment rates are related to interest rate cycle
       conditional prepayment rate
       PSA prepayment benchmark
Conditional Prepayment Rate

   single-monthly mortality
       CPR is annual so convert
        to monthly rate to find
        amt of monthly
   SMM rate and
                                   SMM  1  (1  CPR)   1/ 1 2

       assume that
        approximately x% of
        remaining balance
        prepays at beginning of
PSA Prepayment Benchmark

   Public Securities Association (PSA) benchmark
       expressed as monthly series of annual prepmt rates
       assumes prepayment rate increases as loans become
        more seasoned
       assumes following CPRs for 30-year mortgages
           CPR of 0.2% for 1st month and increased by 0.2% per year
            each month for next 30 months
           6% CPR per year for remaining years
       benchmark referred to as 100 PSA
           if t<= 30, CPR = 6%(t/30)
           if t>30, CPR = 6%
PSA Benchmark

   50 PSA – assuming prepayment rate of half
    the CPR of the benchmark
   150 PSA – rate 1.5 times CPR of PSA
   SMM for month 5 assuming 100 PSA
       CPR = 6%(5/30) = 1%

           SMM  1  (1  0.01)   1/1 2

        = 0.000837
Monthly CF Construction

   assume underlying mortgages are fixed-rate
    level payment with WAC = 8.125%
       pass-through rate is 7.5% and WAM of 357
       assume 100 PSA
       in second example, assume 165 PSA
Prepayment Models

   models statistical relationships among factors
    expected to affect prepayments
   models used to view borrowers as generic
       more data available now so models are more
       models differ for agency and nonagency MBS
   book presents models developed by Bear
Agency Prepayment Models

   not as much data available on individual loans so
    models done at “pool” level
   components in Bear Stearns model
       housing turnover – existing home sales
           family relocation due to changes in employment and family
            status (change in family size, divorce)
           trade-up and trade-down activity due to changes in interest
            rates, income, and home prices
           insensitive to level of mortgage rates
       cash-out refinancing
       rate/term refinancing
Agency Prepayment Models

   cash-out refinancing
       refinancing by borrower in order to monetize the price
        appreciation of the property
       depends on increase in housing prices in region where
        property is located
       favorable tax law regarding capital gains adds incentives to
        monetize price appreciation (exempts gains up to
       may be economical even if mortgage rates are rising and
        with transaction costs
       cash-out refinancing is tied to housing prices and
        insensitive to mortgage rates
Agency Prepayment Models

   rate/term refinancing
       means borrower has gotten new mortgage on same
        property to save either on interest cost or shortening life of
        mortgage with no increase in the monthly payment
       decision whether or not to refinance is due to PV of $
        interest savings from lower rate after subtracting estimated
        costs to refinance
       proxy for rate/term refinancing for model:
           difference between prevailing rate and note rate – not good
           better on is refinancing ratio – note rate to current rate
           WAC is numerator
           ratio < 1 – note rate less than current so no incentive to
           ratio > 1 – some incentive possibly to refinance
Housing Turnover in Agency Prepayment
   factors used by Bear Stearns
       seasoning effect – (see graph on next slide)
           idea is that you must recognize the homeowner’s tenure in the
            house – may not be same as age of loan because of possible
       housing price appreciation effect
           over time LTV of home changes due to either amortization of
            loan or change in value of home – incentive to refinance if
            value of home goes up
           need to estimate prepayments due to housing appreciation
           Bear Stearns used Home Appreciation Index (HPI) – (see
       seasonality effect
           home buying increases in spring and peaks in late summer –
            buying declines in fall and winter – prepayments follow similar
            pattern but may lag a bit with peak closer to early fall
Bear Stearns Baseline HTO Prepayments
for Agency MBS
Effect of Housing Price Appreciation of
Agency Prepayments
Cash-Out Refinancing

   driven by price appreciation since loan origination –
    need proxy for this
       Bear Stearns uses HPI
       see slide to show cash-out refinancing incentives for 4
        assumed rates of appreciation
       according to Bear Stearns model, projected prepayments
        due to cash-out refinancing
           exist for all ratios greater than 0.6
           prepayments increase as the ratios increase
           the greater the price appreciation for a given ratio, the greater
            the projected prepayments
Effect of Housing Price Appreciation on
Cash-Out Refinancing on Agency
Rate/Term Refinancing Component

   decision to refinance not based totally on note rate
    relative to current rate
       S-curve for prepayments
           if totally based on ratio, why does curve flatten out (or
            prepayment rate flatten out)
               because borrowers left in pool can not get refinancing or some
                have other reasons why refinancing does not make sense
       S-curve not sufficient for modeling rate/term refinancing –
        ignores 2 things that affect decision:
           burnout effect – Bear Stearns use some pool variables as
               original term, loan purpose, WAC rate, weighted average loan
                age, loan size, rate premium over benchmark, yield curve slope
                (see slide)
           threshold media effect
Baseline Refinancing Function for Bear Stearns’ Agency
Prepayment Model for an “Ordinary” Pool of Agency Borrowers

  original loan of $125,000, age of 12 months, no rate premium at origination, no prior option to
  refinance, 3.5% annual home price appreciation
Baseline S-Curve for Agency Borrowers
Based on Loan Amount

  shows model’s S-curves for $25,000 loan size increments – relative to loans with balances less than
  $100,000, loan balances that exceed $150,000 are about 1.5 to 2.5 times more sensitive to refinancing
Nonagency Prepayment Models

   same components as in Agency models
       but more info. on these loans so prepayment model
        estimated for each type of loan (rather than for pool of
       Bear Stearns gives projected prepayment rates based on
           size of loan
           rate premium
           documentation
           occupancy status
           current LTV
Baseline Projected Prepayment Rate Across a Range of
Refinancing Incentives for 3 Loan Types
Cash Flow for Nonagency PTs

   CFs not affected by default and delinquency
    for agency PTs
   PSA has issued a standardized benchmark
    for default rates
   SDA benchmark gives annual default rate for
    a mortgage pool as a function of the
    seasoning of the mortgages
       can use multiples of default rate similar to
        prepayment benchmark – so can have 200 SDA
Cash Flow Yield
   rate that makes the PV of expected CF equal to the price
     bond-equivalent yield

           market convention for annualizing yield on fixed-income security that
            pays interest more than once a year
           found by doubling a semi-annual yield
           semi-annual yield for PT is
            semiannual cash flow yield = (1 + y M)6 – 1
            where yM is monthly interest rate that equates PV of projected monthly CF to
               price of PT
             bond-equivalent yield = 2[(1 + yM)6 – 1]

       must specifiy underlying prepayment assumption
       to realize this yield, investor must reinvest CFs at yield, investor
        must hold PT until all mortgages paid off, and assumed
        prepayment rate must actually occur
           so be careful in placing too much confidence in yields!
Average Life

   average life of MBS
       average time to receipt of principal payments
        (scheduled and prepayments) weighted by
        amount of principal expected

       average life depends on prepayment assumption
Prepayment Risk

   assume you buy 10% coupon GNMA with market
    rates of 10%
       assume rates in market fall to 6%
       consequences?? - contraction risk
           price increase but not as large as increase for option-free
               negative convexity
           CF reinvested at lower rate
       assume rates rise to 15% - extension risk
           price of PT falls but will fall more because rate increase slows
            down rate of prepayments
           problem for investor is this is exact time that they want rate of
            prepayments to increase so they have money to reinvest at
            higher market rate of 15%
Asset / Liability Management

   PTs unattractive to some institutions
       depository institutions exposed to extension risk when they
        invest – they want to lock in spread over cost of funds – PT
        is longer term than their liabilities
       life insurance companies are exposed to extension risk
        when using PTs – they might issue 4 year GIC – problem is
        uncertainty about CF from PTs that they will receive to
        have to pay off GIC
       pension fund is exposed to contraction risk using PTs –
        they have long-term liabilities and want to lock in current
        rates – exposed to risk that prepayments will speed up and
        maturity of investments will shorten (happens when rates
        fall) and they will have to reinvest prepayments at lower
Secondary Market Trading

   quoted same manner as Treasuries
       94-05 means 94 and 5/32nds of par or
        94.15625% of par
   PTs identified by pool prefix and pool number
       prefix tells type of PT – 20 for Freddie Mac PC
        means underlying pool of conventional mortgages
        with original maturity of 15 years
       prefix of AR for GNMAs means ARMs
       pool number tells specific mortgages underlying
        PT and issuer of PT

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