MortgageMortgage-Backed Securities

Saurabh Jain

Its a process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors. The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgagebacked security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

Securitization

y y

Advantages to issuer Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. The difference between BB debt and AAA debt can be multiple hundreds of basis points. Reduces asset-liability mismatch: Essentially, in most banks and finance companies, the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book. Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets. Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on. Transfer risks: Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. One good example of this are catastrophe bonds.

Motives for securitization

Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. y Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. y Admissibility: Future cashflows may not get full credit in a company's accounts and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset. y Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.
y

Motives for securitization

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk. Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions. Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss.

Disadvantages to issuer

Advantages to investors y Opportunity to potentially earn a higher rate of return (on a riskadjusted basis) y Opportunity to invest in a specific pool of high quality assets: Securitizations, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options. y Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities. y Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

Advantages to the Investors

Mortgage pools are simply sets of home mortgages, which are "bonds" issued by home owners. y When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets.
y

MortgageMortgage-Backed Securities
197

Today, a mortgage originator usually sells the mortgage to a mortgage repackager, who accumulates them into mortgage pools. y Financed by mortgage-backed bonds, each mortgage pool is set up as a trust fund.
y y

A servicing agent collects the mortgage payments from the home-owners and then passes the cash flows through to the bondholders. The transformation from mortgages to mortgagebacked securities (MBSs) is called mortgage securitization.

A Brief History of MortgageMortgage-Backed Securities, Cont.

19-8

A Fixed-Rate Mortgage is a loan that specifies constant monthly payments at a fixed interest rate over the life of the mortgage. The size of the monthly payment is determined by the requirement that the present value of all monthly payments, based on the financing rate specified in the mortgage contract, be equal to the original loan amount.

FixedFixed-Rate Mortgages
19-9

The equation to calculate the payment required to retire a fixed rate mortgage is:
Monthly payment ! loan amount v r 1 1 12

1 r

12

T v12

In the equation, r is the annual mortgage financing rate, and T is the number of years in the mortgage term.

FixedFixed-Rate Mortgage, Monthly Payments

1910

Mortgage Payments, by Rate and Time

1911

Each monthly mortgage payment has two separate components:

Payment of interest on outstanding mortgage principal Pay-down, or amortization, of mortgage principal

FixedFixed-Rate Mortgage Amortization

1912

Suppose a 30-year $100,000 mortgage loan is financed at a fixed interest rate of 8%.

Monthly Payment !
y

$100,000 v .08 12 1  1   .08 12 1

30v12

! $733.76

In the first month:

Interest payment = $100,000 v .08/12 = $666.67 Principal payment = $733.76 $666.67 = $67.09 New principal = $100,000 $67.09 = $99,932.91

In the second month:

Interest payment = $99,932.91 v .08/12 = $666.22 Principal payment = $733.76 $666.22 = $67.54 New principal = $99,932.91 $67.54 = $99,865.37

Example: Fixed-Rate Mortgage FixedAmortization

1913

Mortgage amortization can be described by an amortization schedule. An amortization schedule states the scheduled principal payment, interest payment, and remaining principal owed in any month.

FixedFixed-Rate Mortgage Amortization

1914

Mortgage Amortization Schedule

1915

A mortgage borrower has the right to pay off all or part of the mortgage ahead of its amortization schedule. This is similar to the call feature of corporate bonds and is known as mortgage prepayment. During periods of falling interest rates, mortgage refinancings are an important reason for mortgage prepayments.

FixedFixed-Rate Mortgage Prepayment and Refinancing

1916

The Government National Mortgage Association (GNMA), or Ginnie Mae, is a government agency charged with the mission of promoting liquidity in the secondary market for home mortgages. GNMA mortgage pools are based on mortgages issued under programs administered by
The Federal Housing Administration (FHA) The Veterans Administration (VA), and The Farmers Home Administration (FmHA).

Government National Mortgage Association

1917

Mortgages in GNMA pools are said to be fully modified because GNMA guarantees bondholders full and timely payment of both principal and interest. Although investors in GNMA pass-throughs do not face default risk, they still face prepayment risk.
Prepayments are passed through to bondholders. If a default occurs, GNMA fully prepays the bondholders.

Government National Mortgage Association

1918

Besides GNMA, there are two other significant mortgage repackaging sponsors.
Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac, and Federal National Mortgage Association (FNMA), or Fannie Mae.

Both are government-sponsored enterprises (GSEs) and trade on the New York Stock Exchange.

GNMA Clones
1919

Mortgage prepayments are typically described by stating a prepayment rate, which is the probability that a mortgage will be prepaid in a given year. Conventional industry practice states prepayment rates using a model specified by the Public Securities Association (PSA).
Prepayment rates are stated as a percentage of a PSA benchmark.

PSA Mortgage Prepayment Model, I.

1920

In the PSA model, the rates are conditional on the age of the mortgages in the pool. They are conditional prepayment rates (CPRs). CPR is a rate at which a mortgage pool balance is assumed to be prepaid during the life of the pool For seasoned ( > 30 months old) mortgages, the CPR is constant at 6% annually for 100% of the PSA benchmark (100 PSA). For unseasoned (< 30 months old) mortgages, the CPR rises steadily in each month until it reaches an annual rate of 6% in month 30 (for 100 PSA).

PSA Mortgage Prepayment Model, II.

1921

PSA Mortgage Prepayment Model, III.

1922

By convention, the probability of prepayment in a given month is stated as a single monthly mortality (SMM). The SMM is based on the conditional prepayment rate, CPR. The equation for an SMM is:

y y y

SMM = 1 (1 CPR)1/12

An SMM of 10% implies that 10% of a pools beginning-of-month outstanding balance, less scheduled payments, will be prepaid during the month.

PSA Mortgage Prepayment Model, SMM

1923

Calculating Prepayment Amount for a month given the SMM rate

Prepaymentm = SMMm *(mortgage balance at beginning of month m scheduled principal payment for month m)

Calculating Prepayment Amount

Prevailing Mortgage Rate: a) Difference/spread between current & original mortgage rate. y Housing Turnover y Seasoning (age of the loan) y Property Location
y

Factor affecting Prepayment

Contraction Risk Shortening of the expected life of the mortgage pool due to falling interest rates and higher repayment rates. Extension Risk Risk associated with interest rate increase and falling prepayment rates.

Prepayment Risk

Given a single monthly mortality rate (SMM) of 0.45%, a mortgage pool with a $200,000 principal balance outstanding at the beginning of the 26th month, and a scheduled monthly principal payment of $60.00 for the 26th month, the estimated prepayment is: y A) $450.00. y B) $899.73. y C) $426.38.
y

Suppose that the single-monthly mortality rate (SMM) is equal to 0.004. The mortgage balance for a certain month is $100 million, and the scheduled principal payment for the same month is $2.5 million. What is the assumed prepayment amount for this month? y A) $960,000. y B) $390,000. y C) $460,000.
y

Suppose that the single-monthly mortality rate (SMM) is equal to 0.003. The mortgage balance for a certain month is $250 million, and the scheduled principal payment for the same month is $3 million. What is the assumed prepayment amount for this month? y A) $356,000. y B) $672,000. y C) $741,000.
y

y y y y y y

The single-monthly mortality rate (SMM) is equal to 0.003. The mortgage balance for March is $250 million. The scheduled principal payment is $3 million in March, and $3 million in April. The estimated April prepayment is closest to: A) $732,000. B) $741,000. C) $729,777.

The average life of a mortgage in a pool is the average time for a single mortgage in the pool to be paid off, either by prepayment or by making scheduled payments until maturity. For a pool of 30-year mortgages: Average Mortgage Life (years) 20.40 14.68 8.87 4.88

Prepayment Schedule 50 PSA 100 PSA 200 PSA 400 PSA

PSA Mortgage Prepayment Model, Average Life

1931

Contraction risk occurs as mortgage rates fall, prepayment rates increase , and the avg life of the passthrough security decreases. y Extension risk occurs as mortgage rate rise, prepayment rates slows, and the avg life of the passthrough security increases.
y

Average life of a security

Each month, GNMA mortgage-backed bond investors receive pro rata shares of cash flows derived from fully modified mortgage pools. Each monthly cash flow has three components (less the servicing and guarantee fees):
Payment of interest on outstanding mortgage principal. Scheduled amortization of mortgage principal. Mortgage principal prepayments.

Cash Flow Analysis

GNMA Fully Modified Mortgage Pools
1933

Principal and Cash Flows for a GNMA Bond

1934

The interest rate risk for a bond is often measured by Macaulay duration, which assumes a fixed schedule of cash flow payments. However, the schedule of cash flow payments for mortgage-backed bonds is not fixed.
With falling interest rates, prepayments speed up, and vice versa.

Macaulay Durations
for GNMA Mortgage-Backed Bonds Mortgage1935

Historical experience indicates that interest rates significantly affect prepayment rates, and that Macaulay duration is a very conservative measure of interest rate risk. In practice, effective duration is used to calculate predicted prices for mortgagebacked securities based on hypothetical interest rate and prepayment scenarios.

Macaulay Durations
for GNMA Mortgage-Backed Bonds Mortgage1936

 Collateralized mortgage obligations (CMOs) are securities created by splitting mortgage pool cash flows according to specific allocation rules.

The three best-known types of CMOs are:

interest-only (IOs) and principal-only (POs) strips, sequential CMOs, and protected amortization class securities (PACs).

Collateralized Mortgage Obligations

1937

Interest-only strips (IOs) pay only the interest cash flows to investors, while principal-only strips (POs) pay only the principal cash flows to investors. IO strips and PO strips behave quite differently in response to changes in prepayment rates and interest rates.
Faster prepayments imply lower IO strip values and higher PO strip values, and vice versa.

InterestInterest-Only and PrincipalPrincipalOnly Strips

1938

Cash Flows for GNMA IO and PO Strips

1939

Sequential CMOs carve a mortgage pool into a number of tranches (slices).

For example, A, B, C, and Z-tranches.

Each tranche is entitled to a share of mortgage pool principal and interest on that share of principal. However, because cash flows are distributed sequentially, this creates securities with a range of maturities.

Sequential CMOs, I.
1940

Cash flows are passed through as follows:

All principal payments goes to the topmost tranche (in alphabetical order), until all the principal in that tranche has been paid off. Except for the Z-tranche, all tranches receive proportionate interest payments, which are passed through immediately. Until all the principal in the topmost tranche has been fully paid off, interest on Z-tranche principal is paid as cash to the topmost tranche in exchange for an equal amount of principal.

Sequential CMOs, II.

1941

Sequential CMO Principal and Cash Flows

1942

Protected amortization class (PAC) bonds take priority for scheduled payments of principal. The residual cash flows are paid to PAC support (or companion) bonds. PAC cash flows are predictable as long as prepayments remain within a specified band.

Protected Amortization Class Bonds

1943

Creating a PAC bond entails three steps.

Specify two PSA prepayment schedules that form the upper and lower prepayment bounds of the PAC bond. These bounds define a PAC collar. Calculate principal-only (PO) cash flows for the two prepayment schedules specified in . On a priority basis, at any point in time, PAC bondholders receive payments of principal according to the PSA prepayment schedule with the lower PO cash flow as calculated in .

Protected Amortization Class Bonds, Cont.

1944

PAC Cash Flows and Total Cash Flows

1945

The yield to maturity for a mortgage-backed security, conditional on an assumed prepayment pattern, is called the cash flow yield. Essentially, cash flow yield is the interest rate that equates the present value of all future cash flows on the mortgage pool to the current price of the pool, assuming a particular prepayment rate.

Yields for MBSs and CMOs

1946

MBS Yields
1947

www.investinginbonds.com (for information on bonds, bonds, bonds) www.ginniemae.gov (GNMA) www.hud.gov (HUD) www.fanniemae.com (FNMA) www.freddiemac.com (FHLMC) www.bondmarkets.com (Visit the Public Securities Association)

y y y y y

Useful Websites
1948

y y

A Brief History of Mortgage-Backed Securities Fixed-Rate Mortgages

Fixed-Rate Mortgage Amortization Fixed-Rate Mortgage Prepayment and Refinancing GNMA Clones

Government National Mortgage Association Public Securities Association Mortgage Prepayment Model

Chapter Review, I.
1949

Cash Flow Analysis of GNMA Fully Modified Mortgage Pools

Macaulay Durations for GNMA Mortgage-Backed Bonds

Collateralized Mortgage Obligations

Interest-Only and Principal-Only Mortgage Strips Sequential Collateralized Mortgage Obligations Protected Amortization Class Bonds

Yields for Mortgage-Backed Securities and Collateralized Mortgage Obligations

Chapter Review, II.

1950