Mortgage Backed Securities
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Outline
The concept of securitization
Significance of securitization
Creation of MBS
Types of MBS
Cash Flows Features and Prepayment Risk
Prepayment Convention
Prepayment Risk and Asset-Liability Management
Securitization
A framework/process in which some illiquid
assets of a corporation or a financial
institution are transformed into a package of
securities backed by these assets, through
careful packaging
Credit enhancements
Liquidity enhancements, and
Structuring
Example of Securitization
Accounts receivables constitute an important asset
of most corporations. Yet, this asset has credit risk
stemming from the varying credit reputations of
the counterparties.
The terms of the accounts receivables could also
differ from one counterparty to another
counterparty, depending on the transactions. In
effect, the combination of credit risk and
idiosyncratic nature of each component in the
accounts receivables makes them illiquid.
Motivation for Securitization
Reducing the Size of the B/S
Improving Return on Capital
Less capital requirement to meet capital
requirement standards
Allows poorly rated firms to participate in
certain segments of the capital market that
are otherwise unavailable to them
Players in Securitization
Assets originate with some firm—often the firm whose
assets back the security is referred to as the originator
Assets are acquired from the originator by the issuer
The issuer typically achieves a bankruptcy remote status
by creating a special purpose vehicle (SPV). The SPV
assures that the pool of assets is held distinct from the
originator, so that bankruptcy or insolvency of the
originator will have no consequences on the status of the
pool of assets held by the SPV
A trustee will be appointed to ensure the above
Types of Pass-Through Securities
Agency Pass-Throughs
GNMA
FNMA
FHLMC
Private Label Pass-Throughs
GNMA (Ginnie-Mae)
GNMA: finances FHA and VA loans. Typically,
single family, low-income loans. GNMA passthroughs guaranteed by GNMA and are issued by
GNMA approved originators and servicers.
GNMA guarantee of full and timely payment of
interest and principal is backed by the full faith
and credit of the U.S. Government
Historically, prepayments are less volatile relative
to other agency pass-throughs
FNMA Pass-Throughs
(Fannie-Mae)
Buys conventional mortgages
FNMA provides guarantee of full and timely payment of
interest and principal, but this guarantee is not backed by
the full faith and guarantee of the U.S. Government
Mortgage pools are much more heterogeneous when
compared to the pools in the GNMA.
Pool may have mortgages with rates that vary by more
than 200 basis points and the loans may be new or
seasoned
FNMA covers both FHA and VA loans as well as
conventional loans which have a much higher value.
Prepayments are much more volatile
FHLMC Pass-Throughs
(Freddie-Mac)
Buys FHA, VA, and conventional
mortgages
Guarantees full and timely payment of
interest and principal, not backed by a
similar guarantee of the U.S. Govt.
Diverse mortgage pool
Prepayments are much more volatile
Private Label Pass-Throughs
Non-agency pass-throughs
Create a secondary market for nonconforming loans, which are conventional
loans that fail to meet the size limits and
other requirements placed by the agencies
Trade at a spread over the agency passthroughs
Cash flows of MBS
Cash flow depends on cash flows of
underlying mortgages, consists of monthly
mortgage payments—principal repayment,
interest, and prepayments
The amount and timing of the cash flows
passed through to investors are not identical
Prepayments bring uncertainty to the cash
flow of a pass-through security
Prepayment Conventions and
Cash Flows
To value a pass-through, we need cash flows
Prepayments make it difficult to predict cash flows
Make some assumptions about prepayments
Conditional Prepayment Rate (CPR) is a benchmark for projecting
prepayments and the cash flows of a pass-through—it is the fraction of
the remaining principal in the pool to be prepaid each month for the
remaining term of the mortgage.
Single-Mortality Rate (SMM)
SMM = 1- (1 – CPR)1/12
Prepayment rate for month t = SMM × (Beginning mortgage balance for
month t – scheduled principal repayment for month t)
PSA Standard Prepayment
Benchmark
Expressed as a monthly series of annual CPRs.
Assumes that prepayment rates will be low for
newly originated mortgages and then will speed
up as the mortgages become seasoned
If t </= 30, then CPR = (6%×t)/30
If t > 30, then CPR = 6%, where t is the number of
months since the pass-through was created
Slower or faster speeds are referred to as some
percentage of PSA.
Factors Affecting Prepayment
Behavior
Refinancing Incentive
Seasonality Factor
Age of the Mortgage
Family Circumstances
Housing Prices
Prepayment Risk and AssetLiability Management
Contraction Risk
Extension Risk
Are prepayments always bad for investors
in Mortgage-Backed Securities?
Collateralized Mortgage-Backed
Securities and Stripped
Mortgage-Backed Securities
Why and how a CMO is created?
The Structure of a CMO
CMO classes
Stripped Mortgage-Backed Securities
Types of CMO Tranches
Sequential-Pay Tranches
Accrual Bonds
Planned Amortization Class Tranches (PAC)
Stripped Mortgage-Backed
Securities
Interest Only/Principal Only Strips
Principal only benefits if prepayments are
faster
IO wants prepayments to be slower, because
interest is based on principal amount
outstanding