Mortgage-Backed and Asset-Backed Securities:
High Credit Quality and Cash Flow Stability
Jim Womack, CFA
Managing Director & Principal
March 2011
Mortgage-Backed & Asset-Backed Securities
Introduction: High Credit Quality and Cash Flow Stability
• For Some, A Mortgage-Backed (MBS) or Asset-Backed Security (ABS)
Carries a Negative Connotation.
• For Many More, These Sectors Provided Ultra High Credit Quality and
Cash Flow Stability Even In the Height of Market Turmoil in 2008 & 2009.
• Today, Investors Are Seeking High Quality Alternatives To Low Yielding
Treasury and Agency Debentures.
• The Market For Many Types of MBS and ABS Is Deep, Transparent,
Liquid and Offers Relatively High Yields.
• Investment Officers Can Meaningfully Raise The Yield On Their Portfolios
By Selectively Including These Assets In Their Arsenal of Eligible
Investments…Without Sacrificing Credit Quality or Cash Flow Stability.
-2-
Asset-Backeds: How The Typical Auto Structure Works
Two Types of Credit Support: Overcollateralization & Subordination
Overcollateralization
Lesser Amount of
Bonds Backed by Loans
Pool of Auto Loans
Subordination
Still Lesser Amount
Of Senior (AAA Rated)
Bonds Backed by Loans
Lesser Amount of
Bonds Backed by Loans
-3-
Asset-Backeds: How The Typical Auto Structure Works
Subordination Protects The Senior Note Holders 5 Ways
Class
A1
A2-A
A2-B
A3
A4
Rating
AAA
AAA
AAA
AAA
AAA
Size
Percent
410,000,000
200,000,000
650,000,000
392,000,000
249,260,000
93.0%
B
A
60,200,000
5th Loss Protection 3.0%
C
BBB
40,135,000
4th Loss Protection 2.0%
D
BB
40,135,000
3th Loss Protection 2.0%
Reserve Account
2nd Loss Protection 0.8%
Reserve Account
1st Loss Protection 1.0%
Total Subordination For Senior Note Holders
Overcollateralization at Origination
Total Credit Support to Senior Bondholders
-4-
8.8%
5.7%
14.5%
Asset Backeds: How The Typical Auto Structure Works
Historically, Even The Lowest Rated Bonds Have Been Well Protected
Fitch Prime Auto ABS Cumulative Net Loss Index
Class
A1
A2-A
A2-B
A3
A4
B
1.4%
1.4%
1.2%
1.2%
1.0%
1.0%
0.8%
0.8%
0.6%
0.6%
0.4%
0.4%
0.2%
Rating
Size
AAASource: Fitch
410,000,000
Ratings
200,000,000
0.0%AAA
AAA
650,000,000
9/93 9/94392,000,000
9/95 9/96
AAA
AAA
249,260,000
A
0.2%
Percent
0.0%
9/97 9/98 9/99 9/00 9/01 9/02 9/03 9/04 9/05 9/06 9/07 9/08 9/09 9/10
93.0%
60,200,000
3.0%
C
BBB
40,135,000
2.0%
D
BB
40,135,000
2.0%
Reserve Account
0.8%
Reserve Account
1.0%
Total Subordination For Senior Notes
Overcollateralization at Origination
8.8%
5.7%
Total Credit Support to Senior Notes
14.5%
-5-
Asset-Backeds: Selected Bonds Through The Crisis
In Good Economic Times and Bad, Credit Support Increases Over Time
Auto ABS as of December 2005
Credit Support (%)
50
45
40
35
Original Credit Support
Credit Support at 12-2005
Unemployment Rate
30
25
20
15
10
5
0
Wachovia
Auto
04A A4
Capital
Auto
03-2 A4
Carmax
Auto
03-2 A4
Chase
Auto
03-B A3
Wachovia
Auto
05-B A4
Americredit
Auto
05-AX A3
WFS
Auto
02-4 A4
WFS
Auto
02-2 A4
Onyx
Auto
04-C A3
Auto ABS as of December 2009
Credit Support (%)
50
45
40
35
Original Credit Support
Credit Support at 12-2009
Unemployment Rate
30
25
20
15
10
5
0
Wachovia
Auto
05-B A4
Source: Servicer Reports
USAA
Auto
06-4 A3
Household
Auto
06-3 A3
Household
Auto
07-1 A3
-6-
Honda
Auto
07-1 A3
Harley
Davidson
07-2 A4
Wachovia
Auto
07-1 A3A
Asset-Backeds: What About Insured Bonds?
Example: FGIC Takes Less Protection And a Fee to Guarantee Notes
Class
Rating
Size
Percent
A1
A2
A3-A
A3-B
A4
AAA
AAA
AAA
AAA
AAA
349,000,000
334,000,000
294,500,000
294,500,000
478,000,000
100%
Reserve Account
Loss Protection For Insurance Provider
1.5%
Overcollateralization at Origination
7.3%
Total Credit Support to FGIC Insurance Co.
9.2%
Total Credit Support to Senior Bondholders
-7-
9.2% PLUS An
Insurance Policy
by AAA Rated FGIC
Asset-Backeds: Even Wrapped Issues Performed Well
Many Insured Bonds Were Initially Downgraded, Then Upgraded
CREDIT RATINGS CHANGES
Reference Issue: COAFT 2006-C A4,
-8-
Asset-Backeds: More Yield Than Lower Rated Corporates
Comparing Yield of AAA Auto ABS vs. A Rated Corporate Bonds
Yield in Percent
Merrill Lynch AAA Rated Auto ABS & Similar Maturity A Rated Corporates
Source: Merrill Lynch and Bloomberg
Data as of December 31, 2010
Since Inception
AAA Rated Auto ABS Average Yield:
A Rated Corproate Average Yield:
(ex 2008 & 2009)
Since Inception
4.75%
4.69%
ABS +0.14%
ABS +0.28%
4.61%
4.41%
-9-
Asset-Backeds: Auto-Loan ABS Was In The Press Too!
Because It Performed Like It Was Supposed To
“Most Senior GMAC prime auto ABS ratings able to withstand “depression”
unemployment scenario.”
- Moody’s Investor Service, 5-12-09
“Moody’s has placed fifteen tranches from eight loan securitizations sponsored
by Ford Motor Company in 2006 and 2007 on review for possible upgrade. The
build up of credit enhancement more than offsets modest increases in lifetime
cumulative losses observed in the underlying collateral pools.”
- Moody’s Investor Service, 8-21-09
“Auto-loan Backing is Popular; Investors Like These Tried and Tested Securities”
- Headline, Wall Street Journal, 9-16-2009
“Rebound in used vehicle prices benefits auto ABS transactions.”
- Fitch Ratings, 10-15-09
“Due to available credit enhancement and structural protections, ratings for prime
senior tranches of ABS auto loan transactions have remained stable year-to-date.”
- Fitch Ratings, 10-26-09
- 10 -
Mortgage-Backed Securities
Traditional GSE Guaranteed Mortgage-Backed Securities
Key Features and Characteristics of MBS:
• Bonds Receive Principal and Interest Monthly, Because Borrowers
Make Monthly Mortgage Payments
• Borrowers Can Repay Their Loans Without Penalty and at Any Time
• People Prepay Their Mortgages For a Variety of Reasons
They Refinance, Get Transferred, Death, Divorce, Buy Bigger/Smaller Home, Etc.
• The Speed at Which They Prepay Their Loan is Measured by PSA & CPR
PSA = Prepayment Speed Assumption, CPR = Constant Prepayment Rate
100 PSA or 100% of the PSA model rate, calls for prepayments to start
slowly and build to a 6% constant prepayment rate (CPR) after 24 months.
However: If mortgage rates declined, the prepayment rate could jump to 200+
PSA and reach a 12%+ constant prepayment rate after 24 months (because
homeowners are refinancing).
- 11 -
Mortgage-Backed Securities
Non-Callable Bonds Have Positive Convexity
Price
+1.1%
Positive Convexity
-0.9%
Yield
-1% +1%
- 12 -
Mortgage-Backed Securities
Because The Home Owner Can Prepay At Any Time, Mortgage-Backed
Securities, Like Other Callable Bonds, Have Negative Convexity
Price
Negative Convexity
+0.8%
-1.2%
-1% +1%
- 13 -
Yield
Mortgage-Backed Securities
Traditional Mortgage Pass-Through & Cash Flow Profile
Homeowner
Bank
Trustees
Guaranteed Timely Principal & Interest
Government Sponsored Entity
(Ginnie Mae, Fannie Mae, Freddie Mac)
Investors receive pro-rata share of interest,
principal, and principal prepayments.
Investors have uncertainty about when they
get principal back.
- 14 -
Investors
Mortgage-Backed Securities
Traditional 30-Year Mortgage Lending
Key Features and Characteristics of 30-Year Loans & MBS:
• 30-Year Loans Spread Payments Out to Reduce Monthly Payment
• Nearly All of The Payment In The Early Years Is Interest
• The Interest Rate Level Impacts The Monthly Payment For the
Borrower on a 30-Year Loan More Than on a 15-Year or 10-Year
Loan (A Key Reason Why People Don’t Refinance Their Cars)
So 30-Year Borrowers Are Typically Very Rate Sensitive
• Borrowers Can Repay Their Loans Without Penalty and at Any Time
• Bondholders Receive An Attractive Yield Above Treasuries, Agency
Issued Debentures and Other Types of Securities Because
Borrowers Can Repay Their Loans Without Penalty and at Any Time
• Agency MBS are Backed by The Homeowner, by The Agency,
and by The Implied Guarantee Of The Government.
- 15 -
Mortgage-Backeds: More Yield Than Corporates…But Why?
Comparing Yield of MBS vs. A Rated Corporate Bonds
Yield in Percent
30-Year Mortgage-Passthroughs & Similar Maturity A Rated Corporates
Source: Merrill Lynch and Bloomberg
Data as of December 31, 2010
Since Inception
(ex 2008 & 2009)
Since Inception
6.23%
30 Year MBS Pass-through Average Yield: 6.40%
MBS +0.71%
MBS +0.74%
A Rated Corproate Average Yield: 5.66%
5.52%
- 16 -
Mortgage-Backed Securities
Traditional 30-Year Mortgage Pass-Through & Cash Flow Profile
Mortgage Rates
HIGHER
Mortgage Rates
Mortgage
Rates
Near
Current Rates
UNCHANGED
NO REFINANCE
Trading Up
LESS Trading Up
Major Renovation
LESS Renovation
Downsizing
OR
LESS Downsizing OR
Get Transferred
Get Transferred
Death, Divorce, Etc.
Death, Divorce, Etc.
6% CPR
Per Year
Mortgage Rates
LOWER
REFINANCE
MORE Trading Up
MORE Renovation
MORE Downsizing
Get Transferred
Death, Divorce, Etc.
12% CPR
25% CPR
5 Year
Bond
2 Year
Bond
Per Year
8 Year
Bond
Per Year
3 Year Contraction
3 Year Extension
- 17 -
Mortgage-Backed Securities
Traditional 10-Year Mortgage Lending
Key Features and Characteristics of 10-Year Loans & MBS:
• 10-Year Loans Are Made To People Who Want To Pay Debt Back Fast
• Most of the Payment Is Principal, So The Interest Rate Has Less of an
Impact on The Monthly Payment
So 10-Year Borrowers Are NOT Typically Rate Sensitive
• The Shorter The Loan, The Less Variability The Cash Flows At a Given
Prepayment Speed
• Borrowers Can Repay Their Loans Without Penalty and at Any Time
• They Have The Same Credit Backing as Bonds Backed by 30-Year Loans
• 10-Year Pass-throughs Receive An Attractive Yield Above
Treasuries, Agency Issued Debentures and Other Types of Securities,
But Less Than a 30-Year Passthrough
- 18 -
Mortgage-Backeds: Outsized Yield Premiums For MBS Now
Comparing Yield of MBS vs. A Rated Corporate Bonds
Yield in Percent
10-Year Mortgage-Passthroughs & Similar Maturity A Rated Corporates
Source: RW Baird Research and Bloomberg
Data as of January 31, 2011
Since Inception
AAA Rated Auto ABS Average Yield:
A Rated Corproate Average Yield:
(ex 2008 & 2009)
Since Inception
4.05%
3.92%
MBS +0.14%
MBS +0.19%
4.91%
3.73%
- 19 -
Mortgage-Backed Securities
Traditional 10-Year Mortgage Pass-Through & Cash Flow Profile
Mortgage Rates
MUCH HIGHER
Mortgage Rates
Mortgage
Rates
Near
Current Rates
UNCHANGED
NO REFINANCE
Trading Up
LESS Trading Up
Major Renovation
LESS Renovation
Downsizing
OR
LESS Downsizing OR
Get Transferred
Get Transferred
Death, Divorce, Etc.
Death, Divorce, Etc.
7% CPR
Per Year
4.0 Year
Bond
Mortgage Rates
MUCH LOWER
REFINANCE
MORE Trading Up
MORE Renovation
MORE Downsizing
Get Transferred
Death, Divorce, Etc.
12% CPR
25% CPR
3.4 Year
Bond
2.9 Year
Bond
Per Year
Per Year
0.5 Year Contraction
0.6 Year Extension
- 20 -
Mortgage-Backed Securities
Collateralized Mortgage Obligations (CMOs) & Cash Flow Profile
Homeowner
Bank
Trustees
Guaranteed Timely Principal & Interest
Government Sponsored Entity
Classes Increase Cash Flow Certainty
(Ginnie Mae, Fannie Mae, Freddie Mac)
Investor certainty is increased.
$
Investors in short-term, intermediate-term
and long-term securities can now
participate in the mortgage-backed
securities market.
- 21 -
$
$
Class 1
$
$
$
Class 2
$
$
$
Class 3
Mortgage-Backed Securities
The Two Main Types of Collateralized Mortgage Obligations (CMOs)
Sequntial Class CMO:
• Cash Flow Stability Improved vs. Pass-Through Since Tranches Get
Paid Back In Sequential Order.
• Collateral Subject to Big Prepayment Swings Can Still Cause Some Cash
Flow Variability (e.g., A Sequential Backed By New 30 Year Loans).
• A Sequential Backed By More Stable Collateral Can Greatly Improve Cash
Flow Stability (e.g., A Sequential Backed By Seasoned 15 Year Loans).
Pre-Planned Ammortization Class (PAC) CMO:
• Can Be The Most Stable Form of Mortgage-Backed Security.
• Cash Flow Structured to Follow Pre-Planned Schedule Subject to
Prepayment Speeds Remaining Within Stated Parameters (e.g., Cash
Flows Unchanged Assuming PSA Between 100 and 350).
• The Key is to Analyze “Stressed” Prepayment Assumptions to Ensure
The Bond Will Act Like You Expect
- 22 -
Mortgage-Backed Securities
Analyzing The PAC CMO Structure
• The PAC Can Have Stability Because Other Support Bonds Make It So.
• If Prepayments Are Greater Than Expected, The Support Classes Will
Take The Additional Prepayments So The PAC Doesn’t Have To.
• If Prepayments Are Less Than Expected, The Support Classes Will
Forego Principal So The PAC Gets The Desired Amount.
$
$
$
Support
Class 1
$
$
$
PAC
CMO
$
$
$
Support
Class 2
• Investors Typically Run “Stress Tests” To Ensure The Support Classes
Are Adequate To Provide The Required Stability For The PAC Class.
- 23 -
Mortgage-Backed Securities
The Well Structured PAC CMO Structure
Consistent Payment History Well Within Wide PAC Bands
1 Year Bond at +83 bps Over Treasuries
• A Well Structured PAC CMO Often Provides Greater Yield and Cash Flow
Stability Than Traditional Agency Callable Debentures
• Yields On Well Structured PAC CMOs Are Comparable to A-Rated
Corporates.
- 24 -
Mortgage-Backed & Asset-Backed Securities
Summary: High Yield and High Quality Are Not Mutually Exclusive
• Investors Are Looking For High Quality Alternatives To Low Yielding
Government Debentures
• The Mortgage-Backed and Asset-Backed Sectors Can Offer Attractive
Investments That Can Add Significant Yield and Total Return Over Time.
• Premiums Comparable to or Higher Than Many ‘A’ Rated Corporate
Bonds.
• Bonds Backed By Traditional Fixed Rate Mortgages and Auto Loans, As
An Example, Have A Proven Track Record of Maintaining The Highest
Credit Quality Even In The Deepest Economic Downturns.
• Credit Quality Is Primarily Achieved By Loan Diversification, OverCollateralization, Subordination and/or Agency Guarantees.
• Cash Flow Stability Is Achieved Primarily By Collateral Type and
Security Structure
• When High Credit Quality and Cash Flow Stability Are Properly
Combined, Event Risk Can Be All But Eliminated
- 25 -
Thank You!
- 26 -