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Chapter 11

    Securitization and
Mortgage-Backed Securities
Securitization
• Securitization refers to a process in which the
  assets of a corporation or financial institution are
  ...
Securitization
• The securitization process often involves a third-
  party trustee who ensures that the issuer complies
 ...
Securitization
• By far the largest type and the one in which the
  process of securitization has been most extensively
  ...
Mortgage-Backed Securities: Definition

• Mortgage-Backed Securities (MBS) or
  Mortgage Pass-Throughs (PT) are claims
  o...
Mortgage-Backed Securities: Creation

• Typically, the issuer of a MBS buys a portfolio or
  pool of mortgages of a certai...
Agency Pass-Throughs

• There are three federal agencies that buy certain types of
  mortgage loan portfolios (e.g., FHA- ...
Agency Pass-Throughs
  Government National Mortgage Association, GNMA
• GNMA mortgage-backed securities or pass-throughs a...
Agency Pass-Throughs
  Government National Mortgage Association, GNMA
• The mortgages underlying GNMA’s MBSs are very simi...
Agency Pass-Throughs
  Federal Home Loan Mortgage Corporation, FHLMC
• The FHLMC (Freddie Mac) issues MBSs that they refer...
Agency Pass-Throughs

  Federal Home Loan Mortgage Corporation
• Unlike GNMA’s MBSs, Freddie Mac's MBSs are
  formed with ...
Agency Pass-Throughs

  Federal National Mortgage Association, FNMA
• FNMA (Fannie Mae) offers several types of pass-
  th...
Agency Pass-Throughs

  Federal National Mortgage Association
• Like the FHLMC, FNMA's mortgages are more
  heterogeneous ...
Conventional Pass-Throughs

• Conventional pass-throughs are sold by
  commercial banks, savings and loans, other thrifts,...
Conventional Pass-Throughs

• The larger issuers of conventional MBSs
  include:
  –   Citicorp Housing
  –   Countrywide
...
Conventional Pass-Throughs

• Conventional pass-throughs are often guaranteed
  against default through external credit
  ...
Conventional Pass-Throughs
• Some conventional pass-throughs are guaranteed internally
  through the creation of senior an...
Conventional Pass-Throughs

• Conventional MBSs are rated by Moody's
  and Standard and Poor's.

• They must be registered...
Conventional Pass-Throughs
• Most financial entities that issue private-labeled MBSs or
  derivatives of MBSs are legally ...
Market
• Primary Market: Investors buy MBSs issued by
  agencies or private-label investment companies
  either directly o...
Cash Flows
• Cash flows from MBSs are generated from the
  cash flows from the underlying pool of mortgages,
  minus servi...
Cash Flows: Terms
• Weighted Average Coupon Rate, WAC: Mortgage
  portfolio's (collateral’s) weighted average rate.

• Wei...
Prepayment
• A number of prepayment models have been
  developed to try to predict the cash flows from a
  portfolio of mo...
Prepayment
  Refinancing Incentive
• The refinancing incentive is the most important
  factor influencing prepayment.

• I...
Prepayment
  Refinancing Incentive
• The refinancing incentive can be measured by the
  difference between the mortgage po...
Prepayment
  Seasoning
• A second factor determining prepayment is the age
  of the mortgage, referred to as seasoning.

•...
Prepayment
• PSA Model:



CPR (%)


     9.0                        150 PSA
     6.0                        100 PSA
   ...
Prepayment
  Seasoning
• In the standard PSA model, known as 100 PSA,
  the CPR starts at .2% for the first month and then...
Prepayment
  Seasoning
• Note that the CPR is quoted on an annual
  basis.
• The monthly prepayment rate, referred to
  as...
Prepayment
  Seasoning
• The 100 PSA model is often used as a benchmark. The
  actual aging pattern will differ depending ...
Prepayment
  Seasoning
• A current mortgage pool described by a 100 PSA
  would have a annual prepayment rate of 2% after
...
Prepayment
  Monthly Factors
• In addition to the effect of seasoning, mortgage
  prepayment rates are also influenced by ...
Prepayment
  Burnout Factors
• Many prepayment models also try to capture what
  is known as the burnout factor.

• The bu...
Cash Flow from a Mortgage Portfolio

• The cash flow from a portfolio of
  mortgages consists
  – Interest payments
  – Sc...
Cash Flow from a Mortgage Portfolio: Example 1

• Example 1: Consider a bank that has a pool
  of current fixed rate mortg...
Cash Flow from a Mortgage Portfolio: Example 1

  • For the first month, the portfolio would
    generate an aggregate mor...
Cash Flow from a Mortgage Portfolio: Example 1

   • From the $733,765 payment, $666,667 would go
     towards interest an...
Cash Flow from a Mortgage Portfolio: Example 1

• The projected first month prepaid principal can be
  estimated with a pr...
Cash Flow from a Mortgage Portfolio: Example 1

• Given the prepayment rate, the projected prepaid
  principal in the firs...
Cash Flow from a Mortgage Portfolio: Example 1

     • Thus, for the first month, the mortgage portfolio
       would gene...
Cash Flow from a Mortgage Portfolio: Example 1

• In the second month (t = 2), the projected
  payment would be $733,642 w...
Cash Flow from a Mortgage Portfolio: Example 1

• Using the 100% PSA model, the estimated
  monthly prepayment rate is .00...
Cash Flow from a Mortgage Portfolio: Example 1

    • Thus, for the second month, the mortgage portfolio
      would gener...
Cash Flow from a Mortgage Portfolio: Example 1

•   The exhibit on the next slide summarizes the
    mortgage portfolio's ...
Cash Flow from a Mortgage Portfolio: Example 1
Period    Balance    Interest     p      Sch. Prin.     SMM       Prepaid P...
Cash Flow from a MBS: Example 2

  Example 2
• The next exhibit shows the monthly cash
  flows for a MBS issue constructed...
Cash Flow from a MBS: Example 2
Period    Balance    Interest     p      Scheduled      SMM       Prepaid     Principal   ...
Cash Flow from a MBS: Example 2

    Notes:
•   The first month's CPR for the MBS issue reflects a five-
    month seasoni...
Cash Flow from a MBS: Example 2


• First Month’s Payment:
                    $100M
        p                           ...
Cash Flow from a MBS: Example 2

   • From the $736,268 payment, $625,000 would go
     towards interest and $69,601 would...
Cash Flow from a MBS: Example 2

• Using 150% PSA model and seasoning of 5
  months the first month SMM = .0015125:


    ...
Cash Flow from a MBS: Example 2

• Given the prepayment rate, the projected prepaid
  principal in the first month is $151...
Cash Flow from a MBS: Example 2

      • Thus, for the first month, the MBS would generate
        an estimated cash flow ...
Cash Flow from a MBS: Example 2

• Second Month: Payment, Interest, Scheduled Principal,
  Prepaid Principal, and Cash flo...
Market

•   As noted, investors can acquire newly issued
    mortgage-backed securities from the agencies,
    originators...
Market

•   Mortgage pass-throughs are normally sold in
    denominations ranging from $25,000 to
    $250,000, although s...
Price Quotes

•   The prices of MBSs are quoted as a percentage of
    the underlying MBS issue’s balance.
•   The mortgag...
Price Quotes

• Example: A MBS backed by a mortgage pool
  originally worth $100M, a current pf of .92, and
  quoted at 95...
Price Quotes
• The market value is the clean price; it does not take
  into account accrued interest, ai.

• For MBS, accr...
Price Quotes
• The full market value would be $88.32M:

      Full Mkt Value  $87.86M  $0.46M
                       $8...
Price Quotes
• The market price per share is the full market value
  divided by the number of shares.

• If the number of ...
Extension Risk

•   Like other fixed-income securities, the value of a
    MBS is determined by the MBS's future cash
    ...
Extension Risk

•   In contrast to other bonds, MBSs are also subject
    to prepayment risk.

•   Prepayment affects the ...
Extension Risk
• With the CF a function of rates, the value of
  a MBS is more sensitive to interest rate
  changes than t...
Extension Risk

•   If interest rates decrease, then the prices of
    MBSs, like the prices of most bonds, increase as
  ...
Extension Risk
• Rate Decrease
                                  like most bonds


   if R   lower discount rate  VM 
...
Extension Risk

• If interest rates increase, then the prices of
  MBSs will decrease as a result of higher
  discount rat...
Extension Risk
• Rate Increase
                                  like most bonds


   if R   greater discount rate  VM ...
Average Life

•    The average life of a MBS or mortgage portfolio
     is the weighted average of the security’s time
   ...
Average Life

•   The average life for the MBS issue with WAC = 8%,
    WAM = 355, PT Rate = 7.5%, and PSA = 150 is 9.18
 ...
Average Life

• The average life of a MBS depends on
  prepayment speed:
  – If the PSA speed of the $100M MBS issue
    w...
Average Life and Prepayment Risk

•   For MBSs and mortgage portfolios, prepayment risk can be
    evaluated in terms of h...
MBS Derivatives

•   One of the more creative developments in the
    security market industry over the last two decades
 ...
Collateralized Mortgage Obligations

•   Collateralized mortgage obligations, CMOs, are
    formed by dividing the cash fl...
Collateralized Mortgage Obligations

• The different classes making up a CMO are
  called tranches or bond classes.

• The...
Sequential-Pay Tranches
•   A CMO with sequential-pay tranches, called a
    sequential-pay CMO, is divided into classes w...
Sequential-Pay Tranches
•   Example: A sequential-pay CMO is shown in the
    next exhibit.

•   This CMO consist of three...
Sequential-Pay Tranches
•    In terms of the priority disbursement rules:
    – Tranche A receives all principal payment f...
Sequential-Pay Tranches
         Par = $100M Rate = 7.5%                A: Par = $50M Rate = 7.5%             B: Par =$30M...
Sequential-Pay Tranches
•   Given the assumed PSA of 150, the first month
    cash flow for tranche A consist of a princip...
Sequential-Pay Tranches
•   Based on the assumption of a 150% PSA speed, it takes 88
    months before A's principal of $5...
Sequential-Pay Tranches
  Features of Sequential-Pay CMOs
• By creating sequential-pay tranches,
  issuers of CMOs are abl...
Sequential-Pay Tranches
    Features of Sequential-Pay CMOs
•   Maturity:
    –   Collateral's maturity = 355 months (29.5...
Sequential-Pay Tranches
 Tranche    Maturity   Window Average Life
    A      88 Months 87 Months 3.69 years
    B      17...
Sequential-Pay Tranches
•   Note: A CMO tranche with a lower average life is still
    susceptible to prepayment risk.
•  ...
Sequential-Pay Tranches
• Note: Issuers of CMOs are able to offer a
  number of CMO tranches with different
  maturities a...
Different Types of Sequential-Pay Tranches

• Sequential-pay CMOs often include
  traches with special features. These
  i...
Accrual Tranche
•   Many sequential-pay CMOs have an accrual bond
    class.

•   Such a tranche, also referred to as the ...
Accrual Tranche
•   Example: suppose in our preceding equential-pay
    CMO example we make tranche C an accrual
    tranc...
Accrual Tranche
         Par = $100M Rate = 7.5%                A: Par =   $50M Rate = 7.5%      B: Par = $30M Rate = 7.5%...
Accrual Tranche
•   Since the accrual tranche's current interest of $125,000 is
    now used to pay down the other classes...
Accrual Tranche
Tranche    Window   Average Life
   A      69 Months 3.06 Years
   B      54 Months 8.23 Years
Floating-Rate Tranche
•   In order to attract investors who prefer variable
    rate securities, CMO issuers often create ...
Floating-Rate Tranche
    •     Example: Sequential-pay CMO with a floating
          and inverse floating tranches

     ...
Floating-Rate Tranche
•   The rate on the FR tranche, RFR, is set to the
    LIBOR plus 50 basis points, with the maximum
...
Floating-Rate Tranche
•   For example, if the LIBOR is 8%, then the rate on the FR
    tranche is 8.5%, the IFR tranche's ...
Notional Interest-Only Class
•   Each of the fixed-rate tranches in the previous CMOs have
    the same coupon rate as the...
Notional Interest-Only Class
•   Example: A sequential-pay CMO with a Z bond
    and notional IO tranche is shown in the n...
Notional Interest-Only Class
•   The notional IO class receives the excess interest
    on each tranche's remaining balanc...
Notional Interest-Only Class
         Collateral:   Par = $100M Rate = 7.5%   Tranche A:   Par = $50M Rate = 6%          T...
Notional Interest-Only Class
•   The IO class is described as paying 7.5% interest
    on a notional principal of $15,333,...
Notional Interest-Only Class
•    The notional principal for tranche A is
     $10,000,000, for B, $4,000,000, and for Z,
...
Planned Amortization Class, PAC
•   A CMO with a planned amortization class, PAC,
    is structured such that there is vir...
Planned Amortization Class, PAC
•   The two tranches are formed by generating two
    monthly principal payment schedules ...
Planned Amortization Class, PAC

• The PAC bond is designed to have no
  prepayment risk provided the actual
  prepayment ...
Planned Amortization Class, PAC
•   To illustrate, suppose we form PAC and support
    bonds from the $100M collateral tha...
Planned Amortization Class, PAC
•   The next exhibit shows the cash flows for the
    PAC, collateral, and support bond. T...
Planned Amortization Class, PAC
Period      Pac         Pac            Pac           Pac     Pac     Collateral Collateral...
Planned Amortization Class, PAC

• Note: For the first 98 months, the
  minimum principal payment comes from
  the 100% PS...
Planned Amortization Class, PAC

• Based on the 100-300 PSA range, a PAC
  bond can be formed that would promise to
  pay ...
Planned Amortization Class, PAC
•   The sum of the PAC's principal payments is
    $63.777M. Thus, the PAC can be describe...
Planned Amortization Class, PAC
•   The PAC bond has no prepayment risk as long as
    the actual prepayment speed is betw...
Planned Amortization Class, PAC
                    Average Life
PSA    Collateral       PAC        Support
 50      14.95...
Planned Amortization Class, PAC
    Note:
•   The PAC bond has an average life of 6.98 years
    between 100% PSA and 300%...
Other PAC-Structured CMOs
•   The PAC and support bond underlying a CMO can
    be divided into different classes. Often t...
Other PAC-Structured CMOs
•   A PAC-structured CMO can also be formed with
    PAC classes having different collars.

•   ...
Stripped MBS
•    Stripped MBSs consist of two classes:

    1. Principal-only (PO) class that receives only the
       pr...
Principal-Only Stripped MBS
•   The return on a PO MBS is greater with greater
    prepayment speed.

•   For example, a P...
Principal-Only Stripped MBS
•   Because of prepayment, the price of a PO MBS tends to be
    more responsive to interest r...
Principal-Only Stripped MBS
•   In contrast, if rates are increasing, the price of a
    PO MBS will decrease as a result ...
Principal-Only Stripped MBS
•   Thus, like most bonds, the prices of PO
    MBSs are inversely related to interest
    rat...
Interest-Only Stripped MBS
•   Cash flows from an I0 MBS come from the
    interest paid on the mortgages portfolio’s
    ...
Interest-Only Stripped MBS
•   If the mortgages underlying a $100M, 7.5% MBS with PO
    and IO classes were paid off in t...
Interest-Only Stripped MBS
•   Thus, IO MBSs are characterized by an inverse
    relationship between prepayment speed and...
IO and PO Stripped MBS
•   An example of a PO MBS and an IO MBS
    are shown in next exhibit.

•   The stripped MBSs are ...
IO and PO Stripped MBS
Period   Collateral   Collateral   Collateral   Collateral   Collateral Collateral   Stripped   Str...
IO and PO Stripped MBS
•      The table shows the values of the collateral, PO
       MBS, and IO MBS for different discou...
Other Asset-Backed Securities
•    MBSs represent the largest and most extensively
     developed asset-backed security. A...
Other Asset-Backed Securities
    Automobile Loan-Backed Securities
•   Automobile loan-backed securities are often referr...
Other Asset-Backed Securities
     Automobile Loan-Backed Securities
•    CARS differ from MBSs in that
    – they have mu...
Other Asset-Backed Securities
    Credit-Card Receivable-Backed Securities
•   Credit-card receivable-backed securities ar...
Other Asset-Backed Securities
   Credit-Card Receivable-Backed Securities
• CARDS are often structured with two periods:
 ...
Other Asset-Backed Securities
    Home Equity Loan-Backed Securities
•   Home-equity loan-backed securities are referred
 ...
Websites
•   For more information on the mortgage industry,
    statistics, trends, and rates go to www.mbaa.org

•   Mort...
Websites
•   Agency information: www.fanniemae.com,
    www.ginniemae.gov, www.freddiemac.com

•   For general information...
Evaluating Mortgage-Backed
          Securities
Monte Carlo Simulation
• Objective: Determine the MBS’s theoretical value
• Steps:
3. Simulation of interest rates: Use a ...
Step 1: Simulation of Interest Rate

• Determination of interest rate paths from a binomial
  interest rate tree.
• Exampl...
Step 1: Binomial Tree for Spot
                          and Refinancing Rates
                                           ...
Step 1: Interest Rate Paths
 Path 1       Path 2     Path 3          Path 4

6.0000%      6.0000%    6.0000%         6.000...
Step 2: Estimating Cash Flows

• The second step is to estimate the cash flow for
  each interest rate path.

• The cash f...
Step 2: Estimating Cash Flows

• To illustrate, consider a MBS formed from a
  mortgage pool with a par value of $1M, WAC ...
Step 2: Estimating Cash Flows

• The mortgage pool can be viewed as a four-year
  asset with a principal payment made at t...
Step 2: Estimating Cash Flows
     •       Mortgage Portfolio:
             – Par Value = $1M, WAC = 8%, WAM = 10 Yrs,
   ...
Step 2: Estimating Cash Flows

• Such a cash flow is, of course, unlikely
  given prepayment. A simple prepayment
  model ...
Step 2: Estimating Cash Flows
•    The prepayment model assumes:
    1. The annual CPR is equal to 5% if the mortgage pool...
Step 2: Estimating Cash Flows
       Range                   CPR
    X = WAC – Rref
    X 0                        5%
0.0...
Step 2: Estimating Cash Flows

• With this prepayment model, cash flows can
  be generated for the eight interest rate pat...
Exhibit A
Path 1      1        2                3         4          5          6            7        8          9        ...
Exhibit A
Path 5      1        2                 3        4         5           6            7         8         9        ...
Step 2: Estimating Cash Flows

  Path 1
• The cash flows for path 1 (the path with three
  consecutive decreases in rates)...
Step 2: Estimating Cash Flows
    Calculations for CF for Path 1:
•   $335,224 in year 1:
•   Interest = $80,000
•   sched...
Step 2: Estimating Cash Flows
    Calculations for CF for Path 1:
•   $324,764 in year 2:
•   Interest = $59,582
•   sched...
Step 2: Estimating Cash Flows
    Calculations for CF for Path 1:
•   $257,259 in year 3:
•   Interest = $38,368
•   sched...
Step 2: Estimating Cash Flows
    Calculations for CF for Path 1:
•   $281,560 in year 4:
•   The year 4 cash flow with th...
Step 2: Estimating Cash Flows

  Path 8
• In contrast, the cash flows for path 8 (the path with
  three consecutive intere...
Step 3: Valuing Each Path
•   Like any bond, a MBS or CMO tranche should be valued by
    discounting the cash flows by th...
Step 3: Valuing Each Path

• If we assume no default risk, then the risk-
  adjusted spot rate can be defined as


       ...
Step 3: Valuing Each Path

• The value of each path can be defined as

               T
                    CFM          C...
Step 3: Valuing Each Path

• For this example, assume the option-
  adjusted spread is 2% greater than the one-
  year, ri...
Step 3: Valuing Each Path

Binomial Tree for
                                 9.9860%
Discount Rates
                     ...
Step 3: Valuing Each Path

• From these current and future one-year spot rates,
  the current 1-year, 2-year, 3-year, and ...
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
Securitization and  Mortgage-Backed Securities
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Transcript of "Securitization and Mortgage-Backed Securities "

  1. 1. Chapter 11 Securitization and Mortgage-Backed Securities
  2. 2. Securitization • Securitization refers to a process in which the assets of a corporation or financial institution are pooled into a package of securities backed by the assets. • The process starts when an originator, who owns the assets (e.g., mortgages or accounts receivable), sells them to an issuer. • The issuer then creates a security backed by the assets called an asset-backed security or pass- through that he sells to investors.
  3. 3. Securitization • The securitization process often involves a third- party trustee who ensures that the issuer complies with the terms underlying the asset-backed security. • Many securitized assets are backed by credit enhancements, such as a third-party guarantee against the default on the underlying assets. • The most common types of asset-backed securities are those secured by mortgages, automobile loans, credit card receivables, and home equity loans.
  4. 4. Securitization • By far the largest type and the one in which the process of securitization has been most extensively applied is mortgages. • Asset-backed securities formed with mortgages are called mortgage-backed securities, MBSs, or mortgage pass-throughs.
  5. 5. Mortgage-Backed Securities: Definition • Mortgage-Backed Securities (MBS) or Mortgage Pass-Throughs (PT) are claims on a portfolio of mortgages. • The securities entitle the holder to the cash flows from a pool of mortgages.
  6. 6. Mortgage-Backed Securities: Creation • Typically, the issuer of a MBS buys a portfolio or pool of mortgages of a certain type from a mortgage originator, such as a commercial bank, savings and loan, or mortgage banker. • The issuer finances the purchase of the mortgage portfolio through the sale of the mortgage pass- throughs, which have a claim on the portfolio's cash flow. • The mortgage originator usually agrees to continue to service the loans, passing the payments on to the MBS holders.
  7. 7. Agency Pass-Throughs • There are three federal agencies that buy certain types of mortgage loan portfolios (e.g., FHA- or VA-insured mortgages) and then pool them to create MBSs to sell to investors: – Federal National Mortgage Association (FNMA) – Government National Mortgage Association (GNMA) – Federal Home Loan Mortgage Corporation (FHLMC) • Collectively, the MBSs created by these agencies are referred to as agency pass-throughs. • Agency pass-throughs are guaranteed by the agencies, and the loans they purchase must be conforming loans, meaning they meet certain standards.
  8. 8. Agency Pass-Throughs Government National Mortgage Association, GNMA • GNMA mortgage-backed securities or pass-throughs are formed with FHA- or VA-insured mortgages. • They are put together by an originator (bank, thrift, or mortgage banker), who presents a block of FHA and VA mortgages to GNMA. • If GNMA finds them in order, they will issue a guarantee and assign a pool number that identifies the MBS that is to be issued. • The originator will transfer the mortgages to a trustee, and then issue the pass-throughs, often selling them to investment bankers for distribution.
  9. 9. Agency Pass-Throughs Government National Mortgage Association, GNMA • The mortgages underlying GNMA’s MBSs are very similar (e.g., single-family, 30-year maturity, and fixed rate), with the mortgage rates usually differing by no more than 50 basis point from the average mortgage rate. • GNMA does offer programs in which the underlying mortgages are more diverse. • Note: Since GNMA is a federal agency, its guarantee of timely interest and principal payments is backed by the full faith and credit of the U.S. government -- the only MBS with this type of guarantee.
  10. 10. Agency Pass-Throughs Federal Home Loan Mortgage Corporation, FHLMC • The FHLMC (Freddie Mac) issues MBSs that they refer to as participation certificates (PCs). • The FHLMC has a regular MBS (also called a cash PC), which is backed by a pool of either conventional, FHA, or VA mortgages that the FHLMC has purchased from mortgage originators. • They also offer a pass-though formed through their Guarantor/Swap Program. In this program, mortgage originators can swap mortgages for a FMLMC pass- through.
  11. 11. Agency Pass-Throughs Federal Home Loan Mortgage Corporation • Unlike GNMA’s MBSs, Freddie Mac's MBSs are formed with more heterogeneous mortgages. • Like GNMA, the Federal Home Loan Mortgage Corporation backs the interest and principal payments of its securities, but the FHLMC's guarantee is not backed by the U.S. government.
  12. 12. Agency Pass-Throughs Federal National Mortgage Association, FNMA • FNMA (Fannie Mae) offers several types of pass- throughs, referred to as FNMA mortgage-backed securities. • Like FHLMC’s pass-throughs, FNMA’s securities are backed by the agency, but not by the government. • Like the FHLMC, FNMA buys conventional, FHA, and VA mortgages, and offers a SWAP program whereby mortgage loans can be swapped for FNMA-issued MBSs.
  13. 13. Agency Pass-Throughs Federal National Mortgage Association • Like the FHLMC, FNMA's mortgages are more heterogeneous than GNMA's mortgages, with mortgage rates in some pools differing by as much as 200 basis points from the portfolio's average mortgage rate.
  14. 14. Conventional Pass-Throughs • Conventional pass-throughs are sold by commercial banks, savings and loans, other thrifts, and mortgage bankers. • These nonagency pass-throughs, also called private labels, are often formed with nonconforming mortgages; that is, mortgages that fail to meet size limits and other requirements placed on agency pass-throughs.
  15. 15. Conventional Pass-Throughs • The larger issuers of conventional MBSs include: – Citicorp Housing – Countrywide – Prudential Home – Ryland/Saxon – G.E. Capital Mortgage
  16. 16. Conventional Pass-Throughs • Conventional pass-throughs are often guaranteed against default through external credit enhancements, such as: – Guarantee of a corporation – Bank letter of credit – Private insurance from such insurers as the Financial Guarantee Insurance Corporation (FGIC), the Capital Markets Assurance Corporation (CAPMAC), or the Financial Security Assurance Company (FSA)
  17. 17. Conventional Pass-Throughs • Some conventional pass-throughs are guaranteed internally through the creation of senior and subordinate classes of bonds with different priority claims on the pool's cash flows in the case some of the mortgages in the pool default. • Example: A conventional pass-through, known as an A/B pass-through, consists of two types of claims on the underlying pool of mortgages - senior and subordinate. – The senior claim is backed by the mortgages, while the subordinate claim is not. – The more subordinate claims sold relative to senior, the more secured the senior claims.
  18. 18. Conventional Pass-Throughs • Conventional MBSs are rated by Moody's and Standard and Poor's. • They must be registered with the SEC when they are issued.
  19. 19. Conventional Pass-Throughs • Most financial entities that issue private-labeled MBSs or derivatives of MBSs are legally set up so that they do not have to pay taxes on the interest and principal that passes through them to their MBS investors. • The requirements that MBS issuers must meet to ensure tax-exempt status are specified in the Tax Reform Act of 1983 in the section on trusts referred to as Real Estate Mortgage Investment Conduits, REMIC. • Private-labeled MBS issuers who comply with these provisions are sometimes referred to as REMICs.
  20. 20. Market • Primary Market: Investors buy MBSs issued by agencies or private-label investment companies either directly or through dealers. Many of the investors are institutional investors. Thus, the creation of MBS has provided a tool for having real estate financed more by institutions. • Secondary Market: – Existing MBS are traded by dealers on the OTC
  21. 21. Cash Flows • Cash flows from MBSs are generated from the cash flows from the underlying pool of mortgages, minus servicing and other fees. • Typically, fees for constructing, managing, and servicing the underlying mortgages (also referred to as the mortgage collateral) and the MBSs are equal to the difference between the rates associated with the mortgage pool and the rates paid on the MBS (pass-through (PT) rate).
  22. 22. Cash Flows: Terms • Weighted Average Coupon Rate, WAC: Mortgage portfolio's (collateral’s) weighted average rate. • Weighted Average Maturity, WAM: Mortgage portfolio's weighted average maturity. • Pass-Through Rate, PT Rate: Interest rate paid on the MBS; PT rate is lower than WAC -- the difference going to MBS issuer. • Prepayment Rate or Speed: Assumed prepayment rate.
  23. 23. Prepayment • A number of prepayment models have been developed to try to predict the cash flows from a portfolio of mortgages. • Most of these models estimate the prepayment rate, referred to as the prepayment speed or simply speed, in terms of four factors: – Refinancing incentive – Seasoning (the age of the mortgage) – Monthly factors – Prepayment burnout
  24. 24. Prepayment Refinancing Incentive • The refinancing incentive is the most important factor influencing prepayment. • If mortgage rates decrease below the mortgage loan rate, borrowers have a strong incentive to refinance. • This incentive increases during periods of falling interest rates, with the greatest increases occurring when borrowers determine that rates have bottomed out.
  25. 25. Prepayment Refinancing Incentive • The refinancing incentive can be measured by the difference between the mortgage portfolio's WAC and the refinancing rate, Rref. • A study by Goldman, Sachs, and Company found that the annualized prepayment speed, referred to as the conditional prepayment rate, CPR, is greater the larger the positive difference between the WAC and Rref.
  26. 26. Prepayment Seasoning • A second factor determining prepayment is the age of the mortgage, referred to as seasoning. • Prepayment tends to be greater during the early part of the loan, then stabilize after about three years. The figures on the next slide depicts a commonly referenced seasoning pattern known as the PSA model (Public Securities Association).
  27. 27. Prepayment • PSA Model: CPR (%) 9.0  150 PSA 6.0  100 PSA 3.0  50 PSA 0.2 Month 0 30 360
  28. 28. Prepayment Seasoning • In the standard PSA model, known as 100 PSA, the CPR starts at .2% for the first month and then increases at a constant rate of .2% per month to equal 6% at the 30th month; then after the 30th month the CPR stays at a constant 6%. Thus for any month t, the CPR is  t  CPR .06 , if t  30,  30  CPR  .06, if t  30
  29. 29. Prepayment Seasoning • Note that the CPR is quoted on an annual basis. • The monthly prepayment rate, referred to as the single monthly mortality rate, SMM, can be obtained given the annual CPR by using the following formula: SMM  1  [1  CPR ] 1 / 12
  30. 30. Prepayment Seasoning • The 100 PSA model is often used as a benchmark. The actual aging pattern will differ depending on where current mortgage rates are relative to the WAC. • Analysts often refer to the applicable pattern as being a certain percentage of the PSA. • For example: – If the pattern is described as being 200 PSA, then the prepayment speeds are twice the 100 PSA rates. – If the pattern is described as 50 PSA, then the CPRs are half of the 100 PSA rates (see figures on previous slide).
  31. 31. Prepayment Seasoning • A current mortgage pool described by a 100 PSA would have a annual prepayment rate of 2% after 10 months (or a monthly prepayment rate of SMM = .00168), and a premium pool described as a 150 PSA would have a 3% CPR (or SMM = .002535) after 10 months.
  32. 32. Prepayment Monthly Factors • In addition to the effect of seasoning, mortgage prepayment rates are also influenced by the month of the year, with prepayment tending to be higher during the summer months. • Monthly factors can be taken into account by multiplying the CPR by the estimated monthly multiplier to obtain a monthly-adjusted CPR. PSA provides estimates of the monthly multipliers.
  33. 33. Prepayment Burnout Factors • Many prepayment models also try to capture what is known as the burnout factor. • The burnout factor refers to the tendency for premium mortgages to hit some maximum CPR and then level off. • For example, in response to a 2% decrease in refinancing rates, a pool of premium mortgages might peak at a 40% prepayment rate after one year, then level off at approximately 25%.
  34. 34. Cash Flow from a Mortgage Portfolio • The cash flow from a portfolio of mortgages consists – Interest payments – Scheduled principal – Prepaid principal
  35. 35. Cash Flow from a Mortgage Portfolio: Example 1 • Example 1: Consider a bank that has a pool of current fixed rate mortgages that are – worth $100 million (Par, F) – yield a WAC of 8%, and – have a WAM of 360 months.
  36. 36. Cash Flow from a Mortgage Portfolio: Example 1 • For the first month, the portfolio would generate an aggregate mortgage payment of $733,765: M p $100,000,000 F0   (1  (R A / 12)) t p  $733,765 t 1 11 /(1(.08 / 12))  360 11 /(1(R A / 12)) M   .08 / 12  F0  p      R A / 12  F0 p  11 /(1( R A / 12)) M   R A / 12   
  37. 37. Cash Flow from a Mortgage Portfolio: Example 1 • From the $733,765 payment, $666,667 would go towards interest and $67,098 would go towards the scheduled principal payment:  RA   .08  Interest    F0    12  $100,000,000  $666,667    12  Scheduled Pr incipal Payment  p  Interest  $733,765  $666,667  $67,098
  38. 38. Cash Flow from a Mortgage Portfolio: Example 1 • The projected first month prepaid principal can be estimated with a prepayment model. Using the 100% PSA model, the monthly prepayment rate for the first month (t = 1) is equal to SMM = .0001668:  1  CPR   .06  .002  30  SMM  1  [1.002]1/12  .0001668
  39. 39. Cash Flow from a Mortgage Portfolio: Example 1 • Given the prepayment rate, the projected prepaid principal in the first month is found by multiplying the balance at the beginning of the month minus the scheduled principal by the SMM. • Doing this yields a projected prepaid principal of $16,671 in the first month: prepaid principal  SMM [F0  Scheduled principal ] prepaid principal  .0001668[$100,000,000  $67,098]  $16,671
  40. 40. Cash Flow from a Mortgage Portfolio: Example 1 • Thus, for the first month, the mortgage portfolio would generate an estimated cash flow of $750,435, and a balance at the beginning of the next month of $99,916,231: CF  Interest  Scheduled principal  prepaid principal CF  $666,666  $ 67,098  $16,671  $750,435 Beginning Balance for Month 2  F0  Scheduled principal  prepaid principal Beginning Balance for Month 2  $100,000,000  $67,098  $16,671  $99,916,231
  41. 41. Cash Flow from a Mortgage Portfolio: Example 1 • In the second month (t = 2), the projected payment would be $733,642 with $666,108 going to interest and $67,534 to scheduled principal: $99,916,231 p  $733,642 11 /(1(.08 / 12))  359  .08 / 12     .08  Interest   ($99,916,231)  $666,108  12  Scheduled principal  $733,642  $666,108  $67,534
  42. 42. Cash Flow from a Mortgage Portfolio: Example 1 • Using the 100% PSA model, the estimated monthly prepayment rate is .000333946, yielding a projected prepaid principal in month 2 of $33,344:  2 CPR   .06  .004  30  SMM  1  [1.004]1/12  .000333946 prepaid principal  .000333946 [$99,916,231  $67,534]  33,344
  43. 43. Cash Flow from a Mortgage Portfolio: Example 1 • Thus, for the second month, the mortgage portfolio would generate an estimated cash flow of $766,986 and have a balance at the beginning of month three of $99,815,353: CF  $666,108  $ 67,534  $33,344  $766,986 Beginning Balance for Month 3  $99,916,231  $67,534  $33,344  $99,815,353
  44. 44. Cash Flow from a Mortgage Portfolio: Example 1 • The exhibit on the next slide summarizes the mortgage portfolio's cash flow for the first two months and other selected months. • In examining the exhibit, two points should be noted: 1. Starting in month 30 the SMM remains constant at .005143; this reflects the 100% PSA model's assumption of a constant CPR of 6% starting in month 30. 2. The projected cash flows are based on a static analysis in which rates are assumed fixed over the time period.
  45. 45. Cash Flow from a Mortgage Portfolio: Example 1 Period Balance Interest p Sch. Prin. SMM Prepaid Prin. CF 100000000 1 100000000 666667 733765 67098 0.0001668 16671 750435 2 99916231 666108 733642 67534 0.0003339 33344 766986 3 99815353 665436 733397 67961 0.0005014 50011 783409 4 99697380 664649 733029 68380 0.0006691 66664 799694 5 99562336 663749 732539 68790 0.0008372 83294 815833 6 99410252 662735 731926 69191 0.0010055 99892 831817 7 99241170 661608 731190 69582 0.0011742 116449 847639 23 94291147 628608 703012 74405 0.0039166 369010 1072023 24 93847732 625652 700259 74607 0.0040908 383607 1083866 25 93389518 622597 697394 74798 0.0042653 398017 1095411 26 92916704 619445 694420 74975 0.0044402 412234 1106653 27 92429495 616197 691336 75140 0.0046154 426250 1117586 28 91928105 612854 688146 75292 0.0047909 440059 1128204 29 91412755 609418 684849 75430 0.0049668 453653 1138502 30 90883671 605891 681447 75556 0.005143 467027 1148475 31 90341088 602274 677943 75669 0.005143 464236 1142179 32 89801183 598675 674456 75781 0.005143 461459 1135915 110 54900442 366003 451112 85109 0.005143 281916 733028 111 54533417 363556 448792 85236 0.005143 280028 728820 112 54168153 361121 446484 85363 0.005143 278148 724632 113 53804641 358698 444188 85490 0.005143 276278 720466 114 53442873 356286 441903 85617 0.005143 274417 716320 115 53082839 353886 439631 85745 0.005143 272565 712195 357 496620 3311 126231 122920 0.005143 1922 128153 358 371778 2479 125582 123103 0.005143 1279 126861 359 247395 1649 124936 123287 0.005143 638 125574 360 123470 823 124293 123470 0.005143 0 124293
  46. 46. Cash Flow from a MBS: Example 2 Example 2 • The next exhibit shows the monthly cash flows for a MBS issue constructed from a $100M mortgage pool with the following features – Current balance = $100M – WAC = 8% – WAM = 355 months – PT rate = 7.5% – Prepayment speed equal to 150% of the standard PSA model: PSA = 150
  47. 47. Cash Flow from a MBS: Example 2 Period Balance Interest p Scheduled SMM Prepaid Principal CF 100000000 Principal Principal 1 100000000 625000 736268 69601 0.0015125 151147 220748 845748 2 99779252 623620 735154 69959 0.0017671 176194 246153 869773 3 99533099 622082 733855 70301 0.0020223 201148 271449 893531 4 99261650 620385 732371 70627 0.0022783 225990 296617 917002 5 98965033 618531 730702 70936 0.002535 250701 321637 940168 6 98643396 616521 728850 71227 0.0027925 275262 346489 963011 20 91641550 572760 684341 73398 0.0064757 592971 666369 1239128 21 90975181 568595 679910 73408 0.0067447 613101 686510 1255105 22 90288672 564304 675324 73399 0.0070144 632804 706204 1270508 23 89582468 559890 670587 73370 0.0072849 652066 725436 1285327 24 88857032 555356 665702 73321 0.0075563 670873 744194 1299550 25 88112838 550705 660671 73253 0.0078284 689211 762463 1313169 26 87350375 545940 655499 73164 0.0078284 683243 756406 1302346 27 86593968 541212 650368 73075 0.0078284 677322 750397 1291609 28 85843572 536522 645277 72986 0.0078284 671448 744434 1280957 29 85099137 531870 640225 72897 0.0078284 665621 738519 1270388 30 84360619 527254 635213 72809 0.0078284 659840 732649 1259903 31 83627969 522675 630240 72721 0.0078284 654106 726826 1249501 32 82901143 518132 625307 72632 0.0078284 648416 721049 1239181 33 82180094 513626 620411 72544 0.0078284 642772 715317 1228942 100 44933791 280836 366433 66874 0.0078284 351237 418111 698947 101 44515680 278223 363564 66793 0.0078284 347965 414758 692981 102 44100923 275631 360718 66712 0.0078284 344718 411430 687061 103 43689493 273059 357894 66631 0.0078284 341498 408129 681188 200 16163713 101023 166983 59225 0.0078284 126073 185298 286321 201 15978416 99865 165676 59153 0.0078284 124623 183776 283641 353 148527 928 50171 49181 0.0078284 778 49958 50887 354 98569 616 49778 49121 0.0078284 387 49508 50124 355 49061 307 49388 49061 0.0078284 0 49061 49368
  48. 48. Cash Flow from a MBS: Example 2 Notes: • The first month's CPR for the MBS issue reflects a five- month seasoning in which t = 6, and a speed that is 150% greater than the 100 PSA. For the MBS issue, this yields a first month SMM of .0015125 and a constant SMM of .0078284 starting in month 25. • The WAC of 8% is used to determine the mortgage payment and scheduled principal, while the PT rate of 7.5% is used to determine the interest. • The monthly fees implied on the MBS issue are equal to .04167% = (8% - 7.5%)/12 of the monthly balance.
  49. 49. Cash Flow from a MBS: Example 2 • First Month’s Payment: $100M p   $736,268 11 /(1(.08 / 12))  355  .08 / 12    WAC
  50. 50. Cash Flow from a MBS: Example 2 • From the $736,268 payment, $625,000 would go towards interest and $69,601 would go towards the scheduled principal payment: PT Rate WAC  RA   .075  Interest   F0    12  $100,000,000  $625,000    12  Scheduled Pr incipal Payment  p  Interest  $736,268  [(.08 / 12)($100,000,000)]  $69,601
  51. 51. Cash Flow from a MBS: Example 2 • Using 150% PSA model and seasoning of 5 months the first month SMM = .0015125:  6  CPR  1.50 .06  .018  30  SMM  1  [1.018]1/12  .0015125
  52. 52. Cash Flow from a MBS: Example 2 • Given the prepayment rate, the projected prepaid principal in the first month is $151,147 prepaid principal  SMM [F0  Scheduled principal ] prepaid principal  .0015125[$100,000,000  $69,601]  $151,147 Allow for slight rounding difference s
  53. 53. Cash Flow from a MBS: Example 2 • Thus, for the first month, the MBS would generate an estimated cash flow of $845,748 and a balance at the beginning of the next month of $99,779,252: CF  Interest  Scheduled principal  prepaid principal CF  $625,000  $ 69,601  $151,147  $845,748 Beginning Balance for Month 2  F0  Scheduled principal  prepaid principal Beginning Balance for Month 2  $100,000,000  $69,601  $151,147  $99,779,252 Allow for slight rounding difference s
  54. 54. Cash Flow from a MBS: Example 2 • Second Month: Payment, Interest, Scheduled Principal, Prepaid Principal, and Cash flow: $99,779,252 p   $735,154 11 /(1(.08 / 12))354   .08 / 12     RA   .075  Interest   F0    12  $99,779,252  $623,620    12  Scheduled Pr incipal Payment  p  Interest  $735,154  [(.08 / 12)($99,779,252)]  $69,959  7  CPR  1.50 .06  .021  30  SMM  1  [1.021]1/12  .0017671 prepaid principal  SMM [F0  Scheduled principal ] prepaid principal  .0017671 [$99,779,252  $69,959]  $176,194 CF  Interest  Scheduled principal  prepaid principal CF  $623,620  $69,959  $176,194  $869,773 Allow for slight rounding difference s
  55. 55. Market • As noted, investors can acquire newly issued mortgage-backed securities from the agencies, originators, or dealers specializing in specific pass-throughs. • There is also a secondary market consisting of dealers who operate in the OTC market as part of the Mortgage-Backed Security Dealers Association. • These dealers form the core of the secondary market for the trading of existing pass-throughs.
  56. 56. Market • Mortgage pass-throughs are normally sold in denominations ranging from $25,000 to $250,000, although some privately-placed issues are sold with denominations as high as $1 million.
  57. 57. Price Quotes • The prices of MBSs are quoted as a percentage of the underlying MBS issue’s balance. • The mortgage balance at time t, Ft, is usually calculated by the servicing institution and is quoted as a proportion of the original balance, F0. • This proportion is referred to as the pool factor, pf: Ft pf t  F0
  58. 58. Price Quotes • Example: A MBS backed by a mortgage pool originally worth $100M, a current pf of .92, and quoted at 95 - 16 (Note: 16 is 16/32) would have a market value of $87.86M: Ft  (pf t )F0  (.92)($100M )  $92M Market Value  (.9550)($92M )  $87.86M
  59. 59. Price Quotes • The market value is the clean price; it does not take into account accrued interest, ai. • For MBS, accrued interest is based on the time period from the settlement date (two days after the trade) and the first day of the next month. • Example: If the time period is 20 days, the month is 30 days, and the WAC = 9%, then ai is $.46M:  20  .09  ai     $92M  $0.46M  30  12 
  60. 60. Price Quotes • The full market value would be $88.32M: Full Mkt Value  $87.86M  $0.46M  $88.32M
  61. 61. Price Quotes • The market price per share is the full market value divided by the number of shares. • If the number of shares is 400, then the price of the MBS based on a 95 - 16 quote would be $220,800: $88.32M MBS price per share  400  $220,800
  62. 62. Extension Risk • Like other fixed-income securities, the value of a MBS is determined by the MBS's future cash flow (CF), maturity, default risk, and other features germane to fixed-income securities. M CFt VMBS   t 1 (1  R ) t VMBS  f (CFt , R )
  63. 63. Extension Risk • In contrast to other bonds, MBSs are also subject to prepayment risk. • Prepayment affects the MBS’s CF. • Prepayment, in turn, is affected by interest rates. • Thus, interest rates affects the MBS’s CFs. VMBS  f (CF, R ) CF  f (R )
  64. 64. Extension Risk • With the CF a function of rates, the value of a MBS is more sensitive to interest rate changes than those bonds whose CFs are not. • This sensitivity is known as extension risk.
  65. 65. Extension Risk • If interest rates decrease, then the prices of MBSs, like the prices of most bonds, increase as a result of the lower discount rates. • However, the decrease in rates will also augment prepayment speed, causing the earlier cash flow of the mortgages to be larger which, depending on the level of rates and the maturity remaining, could also contribute to increasing the MBS’s price.
  66. 66. Extension Risk • Rate Decrease like most bonds if R   lower discount rate  VM  if R   Increases prepayment  Earlier CFs   VM  or 
  67. 67. Extension Risk • If interest rates increase, then the prices of MBSs will decrease as a result of higher discount rates and possibly the smaller earlier cash flow resulting from lower prepayment speeds.
  68. 68. Extension Risk • Rate Increase like most bonds if R   greater discount rate  VM  if R   Decreases prepayment  Earlier CFs   VM  or 
  69. 69. Average Life • The average life of a MBS or mortgage portfolio is the weighted average of the security’s time periods, with the weights being the periodic principal payments (scheduled and prepaid principal) divided by the total principal: 1 T  principal received at t Average Life  t 12 t 1   total principal    
  70. 70. Average Life • The average life for the MBS issue with WAC = 8%, WAM = 355, PT Rate = 7.5%, and PSA = 150 is 9.18 years 1  1($220,748)  2($246,153)      355($49,061  Average Life    12  $100,000,000   9.18 years
  71. 71. Average Life • The average life of a MBS depends on prepayment speed: – If the PSA speed of the $100M MBS issue were to increase from 150 to 200, the MBS’s average life would decrease from 9.18 to 7.55, reflecting greater principal payments in the earlier years. – If the PSA speed were to decrease from 150 to 100, then the average life of the MBS would increase to 11.51.
  72. 72. Average Life and Prepayment Risk • For MBSs and mortgage portfolios, prepayment risk can be evaluated in terms of how responsive a MBS's or mortgage portfolio’s average life is to changes in prepayment speeds: Average Life prepayment risk  PSA • A MBS with an average life that did not change with PSA speeds, in turn, would have stable principal payments over time and would be absent of prepayment risk.  Av life  0  Zero prepayment risk PSA
  73. 73. MBS Derivatives • One of the more creative developments in the security market industry over the last two decades has been the creation of derivative securities formed from MBSs and mortgage portfolios that have different prepayment risk characteristics, including some that are formed that have average lives that are invariant to changes in prepayment rates. • The most popular of these derivatives are – Collateralized Mortgage Obligations, CMOs – Stripped MBS
  74. 74. Collateralized Mortgage Obligations • Collateralized mortgage obligations, CMOs, are formed by dividing the cash flow of an underlying pool of mortgages or a MBS issue into several classes, with each class having a different claim on the mortgage collateral and with each sold separately to different types of investors.
  75. 75. Collateralized Mortgage Obligations • The different classes making up a CMO are called tranches or bond classes. • There are two general types of CMO tranches: – Sequential-Pay Tranches – Planned Amortization Class Tranches, PAC
  76. 76. Sequential-Pay Tranches • A CMO with sequential-pay tranches, called a sequential-pay CMO, is divided into classes with different priority claims on the collateral's principal. • The tranche with the first priority claim has its principal paid entirely before the next priority class, which has its principal paid before the third class, and so on. • Interest payments on most CMO tranches are made until the tranche's principal is retired.
  77. 77. Sequential-Pay Tranches • Example: A sequential-pay CMO is shown in the next exhibit. • This CMO consist of three tranches, A, B, and C, formed from the collateral making up the $100M MBS in the previous example: F = $100M, WAM = 355, WAC = 8%, PT Rate = 7.5%, PSA = 150. – Tranche A = $50M – Tranche B = $30M – Tranche C = $20M
  78. 78. Sequential-Pay Tranches • In terms of the priority disbursement rules: – Tranche A receives all principal payment from the collateral until its principal of $50M is retired. No other tranche's principal payments are disbursed until the principal on A is paid. – After tranche A's principal is retired, all principal payments from the collateral are then made to tranche B until its principal of $30M is retired. – Finally, tranche C receives the remaining principal that is equal to its par value of $20M. – Note: while the principal is paid sequentially, each tranche does receive interest each period equal to its stated PT rate (7.5%) times its outstanding balance at the beginning of each month.
  79. 79. Sequential-Pay Tranches Par = $100M Rate = 7.5% A: Par = $50M Rate = 7.5% B: Par =$30M Rate = 7.5% C: Par = $20M Rate = 7.5% Period Collateral Collateral Collateral Tranch A A A Tranche B B B Tranche C C C Month Balance Interest Principal Balance Interest Principal Balance Principal Interest Balance Principal Interest 100000000 50000000 30000000 20000000 0 1 100000000 625000 220748 50000000 312500 220748 30000000 0 187500 20000000 0 125000 2 99779252 623620 246153 49779252 311120 246153 30000000 0 187500 20000000 0 125000 3 99533099 622082 271449 49533099 309582 271449 30000000 0 187500 20000000 0 125000 4 99261650 620385 296617 49261650 307885 296617 30000000 0 187500 20000000 0 125000 5 98965033 618531 321637 48965033 306031 321637 30000000 0 187500 20000000 0 125000 85 51626473 322665 471724 1626473 10165 471724 30000000 0 187500 20000000 0 125000 86 51154749 319717 467949 1154749 7217 467949 30000000 0 187500 20000000 0 125000 87 50686799 316792 464204 686799 4292 464204 30000000 0 187500 20000000 0 125000 88 50222595 313891 460488 222595 1391 222595 30000000 237893 187500 20000000 0 125000 89 49762107 311013 456802 0 0 0 29762107 456802 186013 20000000 0 125000 90 49305305 308158 453144 0 0 0 29305305 453144 183158 20000000 0 125000 91 48852161 305326 449515 0 0 0 28852161 449515 180326 20000000 0 125000 92 48402646 302517 445915 0 0 0 28402646 445915 177517 20000000 0 125000 178 20650839 129068 222016 0 0 0 650839 222016 4068 20000000 0 125000 181 19990210 124939 216625 0 0 0 0 0 0 19990210 216625 124939 182 19773585 123585 214856 0 0 0 0 0 0 19773585 214856 123585 183 19558729 122242 213101 0 0 0 0 0 0 19558729 213101 122242 184 19345627 120910 211360 0 0 0 0 0 0 19345627 211360 120910 353 148527 928 49958 0 0 0 0 0 0 148527 49958 928 354 98569 616 49508 0 0 0 0 0 0 98569 49508 616 355 49061 307 49061 0 0 0 0 0 0 49061 49061 307
  80. 80. Sequential-Pay Tranches • Given the assumed PSA of 150, the first month cash flow for tranche A consist of a principal payment (scheduled and prepaid) of $220,748 and an interest payment of $312,500: [(.075/12)($50M) = $312,500] • In month 2, tranche A receives an interest payment of $311,120 based on the balance of $49.779252M and a principal payment of $246,153.
  81. 81. Sequential-Pay Tranches • Based on the assumption of a 150% PSA speed, it takes 88 months before A's principal of $50M is retired. • During the first 88 months, the cash flows for tranches B and C consist of just the interest on their balances, with no principal payments made to them. • Starting in month 88, tranche B begins to receive the principal payment. • Tranche B is paid off in month 180, at which time principal payments begin to be paid to tranche C. • Finally, in month 355 tranche C's principal is retired.
  82. 82. Sequential-Pay Tranches Features of Sequential-Pay CMOs • By creating sequential-pay tranches, issuers of CMOs are able to offer investors maturities, principal payment periods, and average lives different from those defined by the underlying mortgage collateral.
  83. 83. Sequential-Pay Tranches Features of Sequential-Pay CMOs • Maturity: – Collateral's maturity = 355 months (29.58 years) – Tranche A’s maturity = 88 months (7.33 years) – Tranche B's maturity = 180 months (15 years) – Tranche C’s maturity = 355 months (29.58 years) • Window: The period between the beginning and ending principal payment is referred to as the principal pay-down window: – Collateral’s window = 355 months – Tranche A’s window = 87 months – Tranche B's window = 92 months – Tranche C's window =176 months • Average Life: – Collateral's average = 9.18 years – Tranche A’s average life = 3.69 years – Tranche B’s average life = 10.71 years – Tranche C’s Average life = 20.59 years
  84. 84. Sequential-Pay Tranches Tranche Maturity Window Average Life A 88 Months 87 Months 3.69 years B 179 Months 92 Months 10.71 years C 355 Months 176 Months 20.59 years Collateral 355 Months 355 Months 9.18 years
  85. 85. Sequential-Pay Tranches • Note: A CMO tranche with a lower average life is still susceptible to prepayment risk. • The average lives for the collateral and the three tranches are shown below for different PSA models • Note that the average life of each of the tranches still varies as prepayment speed changes. PSA Collateral Tranche A Tranche B Tranche C 50 14.95 7.53 19.4 26.81 100 11.51 4.92 14.18 23.99 150 9.18 3.69 10.71 9.18 200 7.55 3.01 8.51 17.46 300 5.5 2.26 6.03 12.82
  86. 86. Sequential-Pay Tranches • Note: Issuers of CMOs are able to offer a number of CMO tranches with different maturities and windows by simply creating more tranches.
  87. 87. Different Types of Sequential-Pay Tranches • Sequential-pay CMOs often include traches with special features. These include: – Accrual Bond Trache – Floating-Rate Tranche – Notional Interest-Only Tranche
  88. 88. Accrual Tranche • Many sequential-pay CMOs have an accrual bond class. • Such a tranche, also referred to as the Z bond, does not receive current interest but instead has it deferred. • The Z bond's current interest is used to pay down the principal on the other tranches, increasing their speed and reducing their average life.
  89. 89. Accrual Tranche • Example: suppose in our preceding equential-pay CMO example we make tranche C an accrual tranche in which its interest of 7.5% is to paid to the earlier tranches and its principal of $20M and accrued interest is to be paid after tranche B's principal has been retired • The next exhibit shows the principal and interest payments from the collateral and Tranches A, B, and Z.
  90. 90. Accrual Tranche Par = $100M Rate = 7.5% A: Par = $50M Rate = 7.5% B: Par = $30M Rate = 7.5% Z: Par = $20M Rate = 7.5% Period Collateral Collateral Collateral A A A B B B Z Z Z Month Balance Interest Principal Balance Interest Principal Balance Principal Interest Bal.+Cum Int Principal Interest 100000000 50000000 30000000 20000000 0 1 100000000 625000 220748 50000000 312500 345748 30000000 0 187500 20000000 0 0 2 99779252 623620 246153 49654252 310339 371153 30000000 0 187500 20125000 0 0 3 99533099 622082 271449 49283099 308019 396449 30000000 0 187500 20250000 0 0 4 99261650 620385 296617 48886650 305542 421617 30000000 0 187500 20375000 0 0 5 98965033 618531 321637 48465033 302906 446637 30000000 0 187500 20500000 0 0 68 60253239 376583 540668 1878239 11739 665668 30000000 0 187500 28375000 0 0 69 59712571 373204 536352 1212571 7579 661352 30000000 0 187500 28500000 0 0 70 59176219 369851 532069 551219 3445 551219 30000000 105850 187500 28625000 0 0 71 58644150 366526 527821 0 0 0 29894150 652821 186838 28750000 0 0 72 58116329 363227 523605 0 0 0 29241329 648605 182758 28875000 0 0 122 36470935 227943 350111 0 0 0 1345935 475111 8412 35125000 0 0 123 36120824 225755 347292 0 0 0 870824 472292 5443 35250000 0 0 125 35429038 221431 341719 0 0 0 0 0 0 35429038 341719 221431 126 35087319 219296 338966 0 0 0 0 0 0 35087319 338966 219296 354 98569 616 49508 0 0 0 0 0 0 98569 49508 616 355 49061 307 49061 0 0 0 0 0 0 49061 49061 307
  91. 91. Accrual Tranche • Since the accrual tranche's current interest of $125,000 is now used to pay down the other classes' principals, the other tranches now have lower maturities and average lives. • For example, the principal payment on tranche A is $345,748 in the first month ($220,748 of scheduled and projected prepaid principal and $125,000 of Z's interest); in contrast, the principal is only $220,748 when there is no Z bond. • As a result of the Z bond, trache A's window is reduced from 87 months to 69 months and its average life from 3.69 years to 3.06 years.
  92. 92. Accrual Tranche Tranche Window Average Life A 69 Months 3.06 Years B 54 Months 8.23 Years
  93. 93. Floating-Rate Tranche • In order to attract investors who prefer variable rate securities, CMO issuers often create floating- rate and inverse floating-rate tranches. • The monthly coupon rate on the floating-rate tranche is usually set equal to a reference rate such as the London Interbank Offer Rate, LIBOR, while the rate on the inverse floating-rate tranche is determined by a formula that is inversely related to the reference rate.
  94. 94. Floating-Rate Tranche • Example: Sequential-pay CMO with a floating and inverse floating tranches Tranche Par Value PT Rate A $50M 7.5% FR $22.5M LIBOR +50BP IFR $7.5M 28.3 – 3 LIBOR Z $20M 7.5% Total $100 7.5% • Note: The CMO is identical to our preceding CMO, except that tranche B has been replaced with a floating-rate tranche, FR, and an inverse floating-rate tranche, IFR.
  95. 95. Floating-Rate Tranche • The rate on the FR tranche, RFR, is set to the LIBOR plus 50 basis points, with the maximum rate permitted being 9.5%. • The rate on the IFR tranche, RIFR, is determined by the following formula: RIFR = 28.5 - 3 LIBOR • This formula ensures that the weighted average coupon rate (WAC) of the two tranches will be equal to the coupon rate on tranche B of 7.5%, provided the LIBOR is less than 9.5%.
  96. 96. Floating-Rate Tranche • For example, if the LIBOR is 8%, then the rate on the FR tranche is 8.5%, the IFR tranche's rate is 4.5%, and the WAC of the two tranches is 7.5%: LIBOR  8% R FR  LIBOR  50BP  8.5% R IFR  28.5  3 LIBOR  4.5% WAC  .75R FR  .25R IFR  7.5%
  97. 97. Notional Interest-Only Class • Each of the fixed-rate tranches in the previous CMOs have the same coupon rate as the collateral rate of 7.5%. • Many CMOs, though, are structured with tranches that have different rates. When CMOs are formed this way, an additional tranche, known as a notional interest-only (IO) class, is often created. • This tranche receives the excess interest on the other tranches’ principals, with the excess rate being equal to the difference in the collateral’s PT rate minus the tranches’ PT rates.
  98. 98. Notional Interest-Only Class • Example: A sequential-pay CMO with a Z bond and notional IO tranche is shown in the next exhibit. • This CMO is identical to our previous CMO with a Z bond, except that each of the tranches has a coupon rate lower than the collateral rate of 7.5% and there is a notional IO class.
  99. 99. Notional Interest-Only Class • The notional IO class receives the excess interest on each tranche's remaining balance, with the excess rate based on the collateral rate of 7.5%. • In the first month, for example, the IO class would receive interest of $87,500:  .075  .06   .075  .065  Interest   $50,000,000   $30,000,000  12   12  Interest  $62,500  $25,000  $87,500
  100. 100. Notional Interest-Only Class Collateral: Par = $100M Rate = 7.5% Tranche A: Par = $50M Rate = 6% Tranche B: Par = $30M Rate = 6.5% Tranche Z: Par = $20M Rate = 7% Notional Par = $15.333M Period Collateral Collateral Collateral A A A Notional B B B Notional Z Z Z Notional Notional Month Balance Interest Principal Balance Interest Principal Interest Balance Principal Interest Interest Balance Principal Interest Interest Total CF 100000000 50000000 0.06 0.015 30000000 0.065 0.01 20000000 0 0.07 0.005 1 100000000 625000 220748 50000000 250000 345748 62500 30000000 0 162500 25000 20000000 0 0 0 87500 2 99779252 623620 246153 49654252 248271 371153 62068 30000000 0 162500 25000 20125000 0 0 0 87068 3 99533099 622082 271449 49283099 246415 396449 61604 30000000 0 162500 25000 20250000 0 0 0 86604 4 99261650 620385 296617 48886650 244433 421617 61108 30000000 0 162500 25000 20375000 0 0 0 86108 5 98965033 618531 321637 48465033 242325 446637 60581 30000000 0 162500 25000 20500000 0 0 0 85581 70 59176219 369851 532069 551219 2756 551219 689 30000000 105850 162500 25000 28625000 0 0 0 25689 71 58644150 366526 527821 0 0 0 0 29894150 652821 161927 24912 28750000 0 0 0 24912 72 58116329 363227 523605 0 0 0 0 29241329 648605 158391 24368 28875000 0 0 0 24368 122 36470935 227943 350111 0 0 0 0 1345935 475111 7290 1122 35125000 0 0 0 1122 123 36120824 225755 347292 0 0 0 0 870824 472292 4717 726 35250000 0 0 0 726 124 35773533 223585 344494 0 0 0 0 398533 398533 2159 332 35375000 -54038 206354 14740 15072 125 35429038 221431 341719 0 0 0 0 0 0 0 0 35429038 341719 206669 14762 14762 126 35087319 219296 338966 0 0 0 0 0 0 0 0 35087319 338966 204676 14620 14620 127 34748353 217177 336235 0 0 0 0 0 0 0 0 34748353 336235 202699 14478 14478 353 148527 928 49958 0 0 0 0 0 0 0 0 148527 49958 866 62 62 354 98569 616 49508 0 0 0 0 0 0 0 0 98569 49508 575 41 41 355 49061 307 49061 0 0 0 0 0 0 0 0 49061 49061 286 20 20
  101. 101. Notional Interest-Only Class • The IO class is described as paying 7.5% interest on a notional principal of $15,333,333. • This notional principal is determined by summing each tranche's notional principal. • A tranche's notional principal is the number of dollars that makes the return on the tranche's principal equal to 7.5%.
  102. 102. Notional Interest-Only Class • The notional principal for tranche A is $10,000,000, for B, $4,000,000, and for Z, $1,333,333, yielding a total notional principal of $15,333,333: ($50,000,000)(.075  .06) A' s Notional principal   $10,000,000 .075 $30,000,000)(.075  .065) B' s Notional principal   $4,000,000 .075 ($20,000,000)(.075  .07) Z' s Notional principal   $1,333,333 .075 Total Notional Pr incipal  $15,333,333
  103. 103. Planned Amortization Class, PAC • A CMO with a planned amortization class, PAC, is structured such that there is virtually no prepayment risk. • In a PAC-structured CMO, the underlying mortgages or MBS (i.e., the collateral) is divided into two general tranches: – The PAC (also called the PAC bond) – The support class (also called the support bond or the companion bond)
  104. 104. Planned Amortization Class, PAC • The two tranches are formed by generating two monthly principal payment schedules from the collateral: – One schedule is based on assuming a relatively low PSA speed – lower collar. – The other schedule is based on assuming a relatively high PSA speed – upper collar. • The PAC bond is then set up so that it will receive a monthly principal payment schedule based on the minimum principal from the two principal payments.
  105. 105. Planned Amortization Class, PAC • The PAC bond is designed to have no prepayment risk provided the actual prepayment falls within the minimum and maximum assumed PSA speeds. • The support bond, on the other hand, receives the remaining principal balance and is therefore subject to prepayment risk.
  106. 106. Planned Amortization Class, PAC • To illustrate, suppose we form PAC and support bonds from the $100M collateral that we used to construct our sequential-pay tranches: – Underlying MBS = $100M, WAC = 8%, WAM = 355 months, and PT rate = 7.5% • To generate the minimum monthly principal payments for the PAC, assume: – Minimum speed of 100% PSA; lower collar = 100 PSA – Maximum speed of 300% PSA; upper collar = 300 PSA
  107. 107. Planned Amortization Class, PAC • The next exhibit shows the cash flows for the PAC, collateral, and support bond. The exhibit shows: – In columns 2 and 3 the principal payments (scheduled and prepaid) for selected months at both collars. – In the fourth column the minimum of the two payments. • For example, in the first month the principal payment is $170,085 for the 100% PSA and $374,456 for the 300% PSA; thus, the principal payment for the PAC would be $170,085.
  108. 108. Planned Amortization Class, PAC Period Pac Pac Pac Pac Pac Collateral Collateral Collateral Collateral Support Support Support Support Month Low PSA Pr high PSA Pr Min. Principal Int CF Balance Interest Prncipal CF Principal Balance Interest CF 100 300 0.075 100000000 Col Pr - PAC Pr 0.075 1 170085 374456 170085 398606 568692 100000000 625000 220748 845748 50662 36222970 226394 277056 2 187135 425190 187135 397543 584678 99779252 623620 246153 869773 59018 36172308 226077 285095 3 204125 475588 204125 396374 600499 99533099 622082 271449 893531 67324 36113290 225708 293032 4 221048 525572 221048 395098 616147 99261650 620385 296617 917002 75568 36045966 225287 300856 5 237895 575064 237895 393716 631612 98965033 618531 321637 940168 83742 35970398 224815 308557 98 381871 386139 381871 135237 517108 45780181 286126 424898 711025 43028 24142190 150889 193916 99 380032 379499 379499 132851 512349 45355283 283471 421491 704962 41993 24099163 150620 192613 100 378204 372970 372970 130479 503449 44933791 280836 418111 698947 45141 24057170 150357 195498 101 376384 366552 366552 128148 494700 44515680 278223 414758 692981 48205 24012029 150075 198281 102 374575 360242 360242 125857 486099 44100923 275631 411430 687061 51188 23963824 149774 200962 201 235460 61932 61932 19312 81245 15978416 99865 183776 283641 121844 12888435 80553 202396 202 234395 60806 60806 18925 79731 15794640 98716 182266 280982 121460 12766592 79791 201251 203 233336 59699 59699 18545 78244 15612374 97577 180768 278345 121069 12645131 79032 200101 204 232283 58611 58611 18172 76783 15431606 96448 179282 275729 120671 12524062 78275 198946 205 231235 57542 57542 17806 75348 15252325 95327 177807 273134 120265 12403392 77521 197786 206 230193 56492 56492 17446 73938 15074517 94216 176344 270560 119852 12283127 76770 196622 354 124660 2559 2559 32 2591 98569 616 49508 50124 46948 93517 584 47533 355 124203 2493 2493 16 2509 49061 307 49061 49368 46568 46568 291 46859 Par = 63777030 Par = 36222970
  109. 109. Planned Amortization Class, PAC • Note: For the first 98 months, the minimum principal payment comes from the 100% PSA model, and from month 99 on the minimum principal payment comes from the 300% PSA model.
  110. 110. Planned Amortization Class, PAC • Based on the 100-300 PSA range, a PAC bond can be formed that would promise to pay the principal based on the minimum principal payment schedule shown in the exhibit. • The support bond would receive any excess monthly principal payment.
  111. 111. Planned Amortization Class, PAC • The sum of the PAC's principal payments is $63.777M. Thus, the PAC can be described as having: – Par value of $63.777M – Coupon rate of 7.5% – Lower collar of 100% PSA – Upper collar of 300% PSA • The support bond, in turn, would have a par value of $36.223M ($100M - $63.777M) and pay a coupon of 7.5%.
  112. 112. Planned Amortization Class, PAC • The PAC bond has no prepayment risk as long as the actual prepayment speed is between 100 and 300. • This can be seen by calculating the PAC's average life given different prepayment rates. • The next exhibit shows the average lives for the collateral, PAC bond, and support bond for various prepayment speeds ranging from 50% PSA to 350% PSA.
  113. 113. Planned Amortization Class, PAC Average Life PSA Collateral PAC Support 50 14.95 7.90 21.50 100 11.51 6.98 19.49 150 9.18 6.98 13.05 200 7.55 6.98 8.55 250 6.37 6.98 5.31 300 5.50 6.98 2.91 350 4.84 6.34 2.71
  114. 114. Planned Amortization Class, PAC Note: • The PAC bond has an average life of 6.98 years between 100% PSA and 300% PSA; its average life does change, though, when prepayment speeds are outside the 100-300 PSA range. • In contrast, the support bond's average life changes as prepayment speed changes. • Changes in the support bond's average life due to changes in speed are greater than the underlying collateral's responsiveness.
  115. 115. Other PAC-Structured CMOs • The PAC and support bond underlying a CMO can be divided into different classes. Often the PAC bond is divided into several sequential-pay tranches, with each PAC having a different priority in principal payments over the other. • Each sequential-pay PAC, in turn, will have a constant average life if the prepayment speed is within the lower and upper collars. • In addition, it is possible that some PACs will have ranges of stability that will increase beyond the actual collar range, expanding their effective collars.
  116. 116. Other PAC-Structured CMOs • A PAC-structured CMO can also be formed with PAC classes having different collars. • Some PACs are formed with just one PSA rate. These PACs are referred to as targeted amortization class (TAC) bonds. • Different types of tranches can also be formed out of the support bond class. These include sequential-pay, floating and inverse-floating rate, and accrual bond classes.
  117. 117. Stripped MBS • Stripped MBSs consist of two classes: 1. Principal-only (PO) class that receives only the principal from the underlying mortgages. 3. Interest-only (IO) class that receives just the interest.
  118. 118. Principal-Only Stripped MBS • The return on a PO MBS is greater with greater prepayment speed. • For example, a PO class formed with $100M of mortgages (principal) and priced at $75M would yield an immediate return of $25M if the mortgage borrowers prepaid immediately. Since investors can reinvest the $25M, this early return will have a greater return per period than a $25M return that is spread out over a longer period.
  119. 119. Principal-Only Stripped MBS • Because of prepayment, the price of a PO MBS tends to be more responsive to interest rate changes than an option- free bond. • That is, if interest rates are decreasing, then like the price of most bonds, the price of a PO MBS will increase. In addition, the price of a PO MBS is also likely to increase further because of the expectation of greater earlier principal payments as a result of an increase in prepayment caused by the lower rates. (1)  prepayment  return   VPO  R (2)  lower discount rate  VPO 
  120. 120. Principal-Only Stripped MBS • In contrast, if rates are increasing, the price of a PO MBS will decrease as a result of both lower discount rates and lower returns from slower principal payments. (1)  prepayment  return   VPO  R (2)  greater discount rate  VPO 
  121. 121. Principal-Only Stripped MBS • Thus, like most bonds, the prices of PO MBSs are inversely related to interest rates, and, like other MBSs with embedded principal prepayment options, their prices tend to be more responsive to interest rate changes. VPO 0 R
  122. 122. Interest-Only Stripped MBS • Cash flows from an I0 MBS come from the interest paid on the mortgages portfolio’s principal balance. • In contrast to a PO MBS, the cash flows and the returns on an IO MBS will be greater, the slower the prepayment rate.
  123. 123. Interest-Only Stripped MBS • If the mortgages underlying a $100M, 7.5% MBS with PO and IO classes were paid off in the first year, then the IO MBS holders would receive a one-time cash flow of $7.5M: $7.5M = (.075)($100M) • If $50M of the mortgages were prepaid in the first year and the remaining $50M in the second year, then the IO MBS investors would receive an annualized cash flow over two years totaling $11.25M: $11.25M = (.075) ($100M) + (.075)($100M-$50M) • If the mortgage principal is paid down $25M per year, then the cash flow over four years would total $18.75M: $18.75M = (.075)($100M) + (.075)($100M-$25M) + (.075)($75M-$25M) + (.075)($50M-$25M))
  124. 124. Interest-Only Stripped MBS • Thus, IO MBSs are characterized by an inverse relationship between prepayment speed and returns: the slower the prepayment rate, the greater the total cash flow on an IO MBS. • Interestingly, if this relationship dominates the price and discount rate relation, then the price of an IO MBS will vary directly with interest rates. (1)  prepayment   return   VIO  R (2)  greater discount rate  VIO  VIO If 1st effect  2nd effect, then 0 R
  125. 125. IO and PO Stripped MBS • An example of a PO MBS and an IO MBS are shown in next exhibit. • The stripped MBSs are formed from collateral with – Mortgage Balance = $100M – WAC = 8% – PT Rate = 8% – WAM = 360 – PSA = 100
  126. 126. IO and PO Stripped MBS Period Collateral Collateral Collateral Collateral Collateral Collateral Stripped Stripped Month Balance Interest Scheduled Prepaid Total CF PO IO 100000000 Principal Principal Principal 1 100000000 666667 67098 16671 83769 750435 83769 666667 2 99916231 666108 67534 33344 100878 766986 100878 666108 3 99815353 665436 67961 50011 117973 783409 117973 665436 4 99697380 664649 68380 66664 135044 799694 135044 664649 5 99562336 663749 68790 83294 152084 815833 152084 663749 100 58669646 391131 83852 301307 385159 776290 385159 391131 101 58284486 388563 83977 299326 383303 771866 383303 388563 200 27947479 186317 97308 143234 240542 426858 240542 186317 201 27706937 184713 97453 141996 239449 424162 239449 184713 358 371778 2479 123103 1279 124382 126861 124382 2479 359 247395 1649 123287 638 123925 125574 123925 1649 360 123470 823 123470 0 123470 124293 123470 823
  127. 127. IO and PO Stripped MBS • The table shows the values of the collateral, PO MBS, and IO MBS for different discount rate and PSA combinations of 8% and 150, 8.5% and 125, and 9% and 100. • Note: The IO MBS is characterized by a direct relation between its value and rate of return. Discount PSA Value of Value of Value of Rate PO IO Collateral 8% 150 $54,228,764 $47,426,196 $101,654,960 8.50% 125 $49,336,738 $49,513,363 $98,850,101 9.00% 100 $44,044,300 $51,795,188 $95,799,488
  128. 128. Other Asset-Backed Securities • MBSs represent the largest and most extensively developed asset-backed security. A number of other asset- backed securities have been developed. • The three most common types are those backed by – Automobile Loans – Credit Card Receivables – Home Equity Loans • These asset-backed securities are structured as pass- throughs and many have tranches.
  129. 129. Other Asset-Backed Securities Automobile Loan-Backed Securities • Automobile loan-backed securities are often referred to as CARS (certificates for automobile receivables). • The automobile loans underlying these securities are similar to mortgages in that borrowers make regular monthly payments that include interest and a scheduled principal. • Like mortgages, automobile loans are characterized by prepayment. For such loans, prepayment can occur as a result of car sales, trade-ins, repossessions and subsequent resales, wrecks, and refinancing when rates are low. • Some CARS are structured as PACS.
  130. 130. Other Asset-Backed Securities Automobile Loan-Backed Securities • CARS differ from MBSs in that – they have much shorter lives – their prepayment rates are less influenced by interest rates than mortgage prepayment rates – they are subject to greater default risk.
  131. 131. Other Asset-Backed Securities Credit-Card Receivable-Backed Securities • Credit-card receivable-backed securities are commonly referred to as CARDS (certificates for amortizing revolving debts). • In contrast to MBSs and CARS, CARDS investors do not receive an amortorized principal payment as part of their monthly cash flow.
  132. 132. Other Asset-Backed Securities Credit-Card Receivable-Backed Securities • CARDS are often structured with two periods: – In one period, known as the lockout period, all principal payments made on the receivables are retained and either reinvested in other receivables or invested in other securities. – In the other period, known as the principal- amortization period, all current and accumulated principal payments are paid.
  133. 133. Other Asset-Backed Securities Home Equity Loan-Backed Securities • Home-equity loan-backed securities are referred to as HELS. • They are similar to MBSs in that they pay a monthly cash flow consisting of interest, scheduled principal, and prepaid principal. • In contrast to mortgages, the home equity loans securing HELS tend to have a shorter maturity and different factors influencing their prepayment rates.
  134. 134. Websites • For more information on the mortgage industry, statistics, trends, and rates go to www.mbaa.org • Mortgage rates in different geographical areas can be found by going to www.interest.com. • For historical mortgage rates go to http://research.stlouisfed.org/fred2 and click on “Interest Rates.”
  135. 135. Websites • Agency information: www.fanniemae.com, www.ginniemae.gov, www.freddiemac.com • For general information on MBS go to www.ficc.com • For information on the market for mortgage-backed securities go to www.bondmarkets.com and click on “Research Statistics and “Mortgage-Backed Securities.” For information on links to other sites click on “Gateway to Related Links.” • For information on the market for asset-backed securities go to www.bondmarkets.com and click on “Research Statistics and “Asset-Backed Securities.”
  136. 136. Evaluating Mortgage-Backed Securities
  137. 137. Monte Carlo Simulation • Objective: Determine the MBS’s theoretical value • Steps: 3. Simulation of interest rates: Use a binomial interest rate tree to generate different paths for spot rates and refinancing rates. 5. Estimate the cash flows of a mortgage portfolio, MBS, or tranche for each path given a specified prepayment model based on the spot rates 7. Determine the present values of each path. 9. Calculate the average value – theoretical value.
  138. 138. Step 1: Simulation of Interest Rate • Determination of interest rate paths from a binomial interest rate tree. • Example: – Assume three-period binomial tree of one-year spot rates (S) and refinancing rates, (Rref) where: S 0  6% R 0  8% ref u  1.1 u  1 .1 d  .9091  1 / 1.1 d  .9091  1 / 1.1 – With three periods, there are four possible rates after three periods (years) and there are eight possible paths.
  139. 139. Step 1: Binomial Tree for Spot and Refinancing Rates Su u u  7.9860 u = 1.10, d = .9091 R ref u  10.648 uu Su u  7.260 R ref  9.680 uu Su  6.600 Su u d  6.600 R ref  8.800 u R refd  8.800 uu S0  6.00% Su d  6.00 ref R 0  8.00% R ref  8.00 ud Sd  5.4546 Su d d  5.4546 R d  7.2728 ref R ref d 7.2728 ud Sd d  4.9588 R d d  6.6117 ref Sd d d  4.5080 R d d d  6.0107 ref
  140. 140. Step 1: Interest Rate Paths Path 1 Path 2 Path 3 Path 4 6.0000% 6.0000% 6.0000% 6.0000% 5.4546 5.4546 5.4546 6.6000 4.9588 4.9588 6.0000 6.0000 4.5080 5.4546 5.4546 5.4546 Path 5 Path 6 Path 7 Path 8 6.0000% 6.0000% 6.0000% 6.0000% 5.4546 6.6000 6.6000 6.6000 6.0000 6.0000 7.2600 7.2600 6.6000 6.6000 6.6000 7.9860
  141. 141. Step 2: Estimating Cash Flows • The second step is to estimate the cash flow for each interest rate path. • The cash flow depends on the prepayment rates assumed. • Most analysts use a prepayment model in which the conditional prepayment rate (CPR) is determined by the seasonality of the mortgages, and by a refinancing incentive that ties the interest rate paths to the proportion of the mortgage collateral prepaid.
  142. 142. Step 2: Estimating Cash Flows • To illustrate, consider a MBS formed from a mortgage pool with a par value of $1M, WAC = 8%, and WAM = 10 years. • To fit this example to the three-year binomial tree assume that – the mortgages in the pool all make annual cash flows (instead of monthly) – all have a balloon payment at the end of year 4 – the pass-through rate on the MBS is equal to the WAC of 8
  143. 143. Step 2: Estimating Cash Flows • The mortgage pool can be viewed as a four-year asset with a principal payment made at the end of year four that is equal to the original principal less the amount paid down. • As shown in the next exhibit, if there were no prepayments, then the pool would generate cash flows of $149,029M each year and a balloon payment of $688,946 at the end of year 4.
  144. 144. Step 2: Estimating Cash Flows • Mortgage Portfolio: – Par Value = $1M, WAC = 8%, WAM = 10 Yrs, – PT Rate = 8%, Balloon at the end of the 4th Year Year Balance P Interest Scheduled Cash Principal Flow 1 $1,000,000 $149,029 $80,000 $69,029 $149,029 2 $930,971 $149,029 $74,478 $74,552 $149,029 3 $856,419 $149,029 $68,513 $80,516 $149,029 4 $775,903 $149,029 $62,072 $86,957 $837,975 Balloon  Balance( yr4)  Sch.prin( yr4)  $775,903$86,957 $688,946 CF4  Balloon  p $688,946$149,029 $837,975 CF4  Balance( yr4)  Interest $775,903$62,072 $837,975
  145. 145. Step 2: Estimating Cash Flows • Such a cash flow is, of course, unlikely given prepayment. A simple prepayment model to apply to this mortgage pool is shown in next exhibit.
  146. 146. Step 2: Estimating Cash Flows • The prepayment model assumes: 1. The annual CPR is equal to 5% if the mortgage pool rate is at a par or discount (that is, if the current refinancing rate is equal to the WAC of 8% or greater). 3. The CPR will exceed 5% if the rate on the mortgage pool is at a premium. 5. The CPR will increase within certain ranges as the premium increases. 7. The relationship between the CPRs and the range of rates is the same in each period; that is, there is no seasoning factor.
  147. 147. Step 2: Estimating Cash Flows Range CPR X = WAC – Rref X 0 5% 0.0% < X  0.5% 10% 0.5% < X  1.0% 20% 1.0% < X  1.5% 30% 40% 1.5% < X  2.0% 50% 2.0% < X  2.5% 60% 2.5% < X  3.0% 70% X > 3.0%
  148. 148. Step 2: Estimating Cash Flows • With this prepayment model, cash flows can be generated for the eight interest rate paths. • These cash flows are shown in Exhibit A (next two slides).
  149. 149. Exhibit A Path 1 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5 2 0.066117 744776 0.08 59582 59641 0.30 205540 324764 0.074546 0.077270 279846 0.5 3 0.060107 479594 0.08 38368 45089 0.40 173802 257259 0.069588 0.074703 207255 0.5 4 260703 0.08 20856 281560 0.065080 0.072289 212972 Value = 1010465 0.125 Path 2 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5 2 0.066117 744776 0.08 59582 59641 0.30 205540 324764 0.074546 0.077270 279846 0.5 3 0.072728 479594 0.08 38368 45089 0.20 86901 170358 0.069588 0.074703 137245 0.5 4 347604 0.08 27808 375413 0.074546 0.074664 281461 Value = 1008945 0.125 Path 3 1.000000 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5 2 0.080000 744776 0.08 59582 59641 0.05 34257 153480 0.074546 0.077270 132253 0.5 3 0.072728 650878 0.08 52070 61192 0.20 117937 231200 0.080000 0.078179 184465 0.5 4 471749 0.08 37740 509489 0.074546 0.077270 378301 Value = 1005411 0.125 Path 4 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5 2 0.080000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5 3 0.072728 772918 0.08 61833 72666 0.20 140050 274550 0.080000 0.081996 216742 0.5 4 560202 0.08 44816 605018 0.074546 0.080129 444494 Value = 997720 0.125
  150. 150. Exhibit A Path 5 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.072728 1000000 0.08 80000 69029 0.20 186194 335224 0.080000 0.080000 310392 0.5 2 0.080000 744776 0.08 59582 59641 0.05 34257 153480 0.074546 0.077270 132253 0.5 3 0.088000 650878 0.08 52070 61192 0.05 29484 142747 0.080000 0.078179 113892 0.5 4 560202 0.08 44816 605018 0.086000 0.080129 444494 Value = 1001031 0.125 Path 6 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5 2 0.080000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5 3 0.088000 772918 0.08 61833 72666 0.05 35013 169512 0.080000 0.081996 133820 0.5 4 665240 0.08 53219 718459 0.086000 0.082996 522269 Value = 992574 0.125 Path 7 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5 2 0.096000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5 3 0.088000 772918 0.08 61833 72666 0.05 35013 169512 0.092600 0.086188 132277 0.5 4 665240 0.08 53219 718459 0.086000 0.086141 516247 Value = 985008 0.125 Path 8 1 2 3 4 5 6 7 8 9 10 11 Year Rref Balance WAC Interest Sch. Prin. CPR Prepaid Prin. CF Z1,t-1 Zt0 Value Prob. 1 0.088000 1000000 0.08 80000 69029 0.05 46549 195578 0.080000 0.080000 181091 0.5 2 0.096000 884422 0.08 70754 70824 0.05 40680 182258 0.086000 0.082996 155393 0.5 3 0.106480 772918 0.08 61833 72666 0.05 35013 169512 0.092600 0.086188 132277 0.5 4 665240 0.08 53219 718459 0.099860 0.089590 509741 Value = 978502 0.125 Wt. Value $997,457
  151. 151. Step 2: Estimating Cash Flows Path 1 • The cash flows for path 1 (the path with three consecutive decreases in rates) consist of – $335,224 in year 1 (interest = $80,000, scheduled principal = $69,029.49, and prepaid principal = $186,194.10, reflecting a CPR of .20) – $324,764 in year 2, with $205,540 being prepaid principal (CPR = .30) – $257,259 in year 3, with $173,802 being prepaid principal (CPR = .40) – $251,560 in year 4 • The year 4 cash flow with the balloon payment is equal to the principal balance at the beginning of the year and the 8% interest on that balance.
  152. 152. Step 2: Estimating Cash Flows Calculations for CF for Path 1: • $335,224 in year 1: • Interest = $80,000 • scheduled principal = $69,029.49 • prepaid principal = $186,194.10, reflecting a CPR of .20 $1,000,000 p  $149,029 1  (1 /(1.08)10 .08 int erest  .08($1,000,000)  $80,000 scheduled principal  $149,029  $80,000  $69,029 prepaid principal  .20($1,000,000  $69,029)  $186,194 CF1  $80,000  $69,029  $186,194  $335,224 Allow for slight rounding difference s
  153. 153. Step 2: Estimating Cash Flows Calculations for CF for Path 1: • $324,764 in year 2: • Interest = $59,582 • scheduled principal = $59,641 • prepaid principal = $205,540, reflecting a CPR of .30 Balance  $1,000,000  ($69,029  $186,194)  $744,776 $744,776 p  $119,223 1  (1 /(1.08) 9 .08 int erest  .08($744,776)  $59,582 scheduled principal  $119,223  $59,582  $59,641 prepaid principal  .30($744,776  $59,641)  $205,540 CF2  $59,582  $59,641  $205,540  $324,764 Allow for slight rounding difference s
  154. 154. Step 2: Estimating Cash Flows Calculations for CF for Path 1: • $257,259 in year 3: • Interest = $38,368 • scheduled principal = $45,089 • prepaid principal = $173,802, reflecting a CPR of .40 Balance  $744,776  ($59,641  $205,540)  $479,594 $479,594 p  $83,456 1  (1 /(1.08) 8 .08 int erest  .08($479,594)  $38,368 scheduled principal  $83,456  $38,368  $45,089 prepaid principal  .40($479,594  $45,089)  $173,802 CF3  $38,368  $45,089  $173,802  $257,259 Allow for slight rounding difference s
  155. 155. Step 2: Estimating Cash Flows Calculations for CF for Path 1: • $281,560 in year 4: • The year 4 cash flow with the balloon payment is equal to the principal balance at the beginning of the year and the 8% interest on that balance. Balance  $479,594  ($45,089  $173,802)  $260,703 int erest  .08($260,703)  $20,856 CF4  $260,703  $20,856  $281,560 Allow for slight rounding difference s
  156. 156. Step 2: Estimating Cash Flows Path 8 • In contrast, the cash flows for path 8 (the path with three consecutive interest rate increases) are smaller in the first three years and larger in year 4, reflecting the low CPR of 5% in each period.
  157. 157. Step 3: Valuing Each Path • Like any bond, a MBS or CMO tranche should be valued by discounting the cash flows by the appropriate risk-adjusted spot rates. • For a MBS or CMO tranche, the risk-adjusted spot rate, zt, is equal to the riskless spot rate, St, plus a risk premium. • If the underlying mortgages are insured against default, then the risk premium would only reflect the additional return needed to compensate investors for the prepayment risk they are assuming. • As noted in Chapter 4, this premium is referred to as the option-adjusted spread (OAS).
  158. 158. Step 3: Valuing Each Path • If we assume no default risk, then the risk- adjusted spot rate can be defined as z t  St  k t where: k = OAS
  159. 159. Step 3: Valuing Each Path • The value of each path can be defined as T CFM CF1 CF2 CF3 CFT V i Path        M 1 (1  z M ) M 1  z1 (1  z 2 ) (1  z 3 ) 2 3 (1  z T ) T where: • i = ith path • zM = spot rate on bond with M-year maturity • T = maturity of the MBS
  160. 160. Step 3: Valuing Each Path • For this example, assume the option- adjusted spread is 2% greater than the one- year, risk-free spot rates.
  161. 161. Step 3: Valuing Each Path Binomial Tree for 9.9860% Discount Rates 9.26% 8.6% 8.6% 8% 8% 7.4546% 7.4546% 6.9588% 6.5080% Z10 Z11 Z12 Z13
  162. 162. Step 3: Valuing Each Path • From these current and future one-year spot rates, the current 1-year, 2-year, 3-year, and 4-year equilibrium spot rates can be obtained for each path by using the geometric mean: z M   (1  z 10 )(1  z 11 )   (1  z 1, M 1 )  1/ M 1
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