Securitized Products: An Overview of
Mortgage- and Asset-Backed Securities
Jim Womack, CFA
Managing Director & Principal
March 12, 2015
Monte Carlo Resort & Casino
Las Vegas, Nevada
Mortgage-Backed & Asset-Backed Securities:
What Are They and How Are They Different From Other Bonds?
Generally Speaking:
• Bonds backed by many
( thousands)
(or
th
d ) off borrowers.
b
• Credit worthiness is often
independent of the issuer.
• Significant credit support at
issuance that builds over time
• St
Strong credit
dit profile
fil nott
reliant on asset valuations.
Unique Advantages of MBS / ABS:
• Efficiently Achieve Greater Credit
and Economic Diversity
• Gain Credit Stability Through Even
the Worst of Market Conditions
• Reduce or Eliminate the Event Risk
Inherent in Single Credit Issues
• Attractive Yields vs. Other Types
of Lower Rated Bonds
-2-
High Credit Quality and Cash Flow Stability
An “Apples to Apples” Comparison of Historical Excess Returns
DURATION
ANNUAL
EXCESS
RETURN
Merrill Lynch AAA Credit Card ABS
2.3 Years*
0.89%**
Merrill Lynch 1-3 Year Agency CMO PAC
1.9 Years*
0.84%**
Merrill Lynch AAA Auto ABS
1.3 Years*
0.84%**
Merrill Lynch 1-3 Year Corporate (AAA-A)
1.9 Years*
0.75%**
Merrill Lynch 1-5
1 5 Year Corporate (AAA
(AAA-A)
A)
2.8 Years*
0.67%**
Merrill Lynch 1-3 Year Callable Agencies
1.4 Years*
0.14%***
SECTOR INDEX
*
**
***
Data as of December 31, 2014
Annualized duration adjusted excess return vs. Treasuries since December 1996 (earliest available excess return data on ABS)
Annualized duration adjusted excess return vs. Treasuries since December 1998 (earliest available excess return data on Callable Agencies)
Source: Merrill Lynch & Bloomberg
-3-
Mortgage-Backed & Asset-Backed Securities:
High Credit Quality, Low Event Risk and Stable Return Profile
‘AAA’ Securitized, ‘A’ Rated Corporate
& Agency Cumulative Excess Returns
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
1997
1999
2001
2003
2005
2007
2009
1-3
1
3 Year AAA-Rated
AAA Rated Securitized Index
1-3 Year A-Rated Industrials Index
1-3 Year Agency Index
Source: Barclays Capital, BofA Merrill Lynch
Inception of BofA Merrill Lynch Excess Return data is 12/31/1996
-4-
2011
2013
Asset-Backed Securities: The Basics
Non-Housing Related Receivables in Bankruptcy Remote Structures
AAA
Rated
ABS Trust
AA Rated
A Rated
BBB Rated
-5-
Asset-Backeds: Remembering The Great Financial Crisis
Not The Headlines You Remember!
“Most Senior GMAC prime auto ABS ratings able to withstand
‘depression’ unemployment scenario.”
- Moody
Moody’s
s Investor Service,
Service 5-12-09
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
y g collateral p
pools.”
- Moody
Moody’s
s Investor Service,
Service 8
8-21-09
21 09
“Auto-loan Backing is Popular; Investors Like These Tried and
Tested Securities
Securities”
- Headline,
Headline Wall Street Journal
Journal, 9-16-2009
“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
-6-
Asset-Backeds: How The Typical Auto Structure Works
Two Types of Credit Support: Overcollateralization & Subordination
Overcollateralization
Lesser Amount
L
A
t off
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
-7-
Asset-Backeds: How The Typical Auto Structure Works
Subordination Protects The Senior Note Holders 5 Ways
Class
Rating
Size
Percent
A1
A2-A
A2
A
A2-B
A3
A4
AAA
AAA
AAA
AAA
AAA
210,000,000
400,000,000
450,000,000
592,000,000
249,260,000
93.0%
B
AA
60,200,000 5th Loss Protection
3.0%
C
A
40,135,000 4th Loss Protection
2.0%
D
BBB
40,135,000 3th Loss Protection
2.0%
Reserve Account
2nd Loss Protection
0.8%
R
Reserve
A
Accountt
1 tL
1st
Loss Protection
P t ti
1 0%
1.0%
Total Subordination For Senior Note Holders
Overcollateralization at Origination
g
Total Credit Support to Senior Bondholders
-8-
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
1.5%
1.5%
Rolling 12-Months
Monthly
1.2%
1.2%
0.9%
0.9%
0.6%
0.6%
Source: Fitch Ratings
Class 0.2%
Rating
Size
Percent
A1
AAASource: Fitch
210,000,000
Ratings
A2-A 0.0%
AAA
400,000,000
A2-B
AAA
450,000,000
9/93 9/94592,000,000
9/95 9/96 9/97 9/98
A3
AAA
A4
AAA
93.0%
249,260,000
B
AA
60,200,000
,
,
3.0%
%
C
A
40,135,000
2.0%
D
BBB
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
0.3%
0.0%
2001
2003
14.5%
-9-
2005
2007
2009
2011
2013
Asset-Backeds: How The Typical Auto Structure Works
Natural Deleveraging: The Credit Enhancement Grows As Bonds Pay Down
AAA
Credit Support
Total Credit
Support to
Senior
Bondholders
At Origination
14.5%
15.9%
A1
AAA
0.3 Year
WAL
24.7%
A2-A
A2
A
A2-B
AAA
1.1 Year WAL
A3
AAA
2.2 Year WAL
BT
Tranche,
h AA R
Rated,
t d 4
4.4
4Y
Year WAL
14.5%
C Tranche, A Rated, 4.7 Year WAL
D Tranche, BBB Rated, 4.9 Year WAL
Reserve Accounts
- 10 -
65.2%
A4
AAA
3.8 Year WAL
Still a Need For A Structured Approach to Investing
Beyond the Rating: Ensuring High Credit Quality and Cash Flow Stability
Factors to Analyze at Purchase (e.g., New Issue):
 Overcollateralization
 Subordination
 Underlying Loan Characteristics
~ Fico Scores (Credit Profile of Borrowers)
~ Loan Terms (Length, LTV, etc.)
~ Distribution of Loan Terms
~ Geographic Distribution
 Collateral Characteristics
~ New Autos vs.
vs Used Autos
~ Cars vs. SUVs
 Sponsor/Servicer (e.g., Ford, GE, etc.)
~ Experience
E
i
((capabilities,
biliti
strategy
t t
and
d procedures
d
ffor lloss mitigation)
iti ti )
~ Financial Condition
- 11 -
Still a Need For A Structured Approach to Investing
Beyond the Rating: Ensuring High Credit Quality and Cash Flow Stability
Factors for Ongoing Analysis:
 Deal Specific Credit Metrics
~ Delinquencies (30, 60, 90+ Days)
~ Cumulative Net Losses
~ Changes in Credit Enhancement
 Economic Fundamentals
~ Collateral Values (i.e., Used Auto Prices)
~ Economic Environment (unemployment, housing, gas prices, etc.)
~ Fleet Age
 Financial Market Conditions
~ ABS Spreads (particularly on lower rated tranches)
~ Equity Performance (stock prices of issuer/servicers )
p
Debt Performance ((spreads
p
on corporate
p
debt or CDS))
~ Corporate
- 12 -
Mortgage-Backed Securities
The Mortgage Market Is One of the Deepest and Most Liquid Markets
12
Marketable Debt Outstanding
600
Average Daily Trading Volume
$11 9
$11.9
10
$505
400
$8 7
$8.7
$ Billions
$ Trillions
8
500
$7.5
6
4
2
300
200
$179
$2.1
100
$20
0
Source: The Securities Industry and Financial Markets Association
0
Data as of December 31, 2014
- 13 -
$5
Mortgage-Backeds: More Yield Than Corporates…But Why?
Comparing Yield of MBS vs. A Rated Corporate Bonds
10.0
30-Year MBS Pass-Through & Like Maturity A Rated Corporate Yields
Yield in Perrcent
8.0
6.0
4.0
2.0
0.0
1992
1994
1996
1998
2000
2002
2004
30 Year MBS Pass-through Average Yield:
2006
5.69%
AR
Rated
t d Corporate
C
t B
Bond
dA
Average Yield:
Yi ld 5.01%
5 01%
Source: Merrill Lynch, Bloomberg
Data as of December 31, 2014
- 14 -
2008
2010
2012
MBS Yield
Advantage:
2014
0 68%
0.68%
Mortgage-Backed Securities
The Traditional Mortgage Pass-Through
Homeowner
Bank
Trustees
Guaranteed Timely Principal & Interest
Government Sponsored Entity
(Ginnie Mae, Fannie Mae, Freddie Mac)
IInvestors
t
receive
i pro-rata
t share
h
off interest,
i t
t
principal, and principal prepayments.
Investors have uncertainty about when they
get principal back
back.
- 15 -
Investors
Mortgage-Backed Securities
Traditional GSE Guaranteed Mortgage-Backed Securities
Key Characteristics of MBS:
 Bonds Receive Principal and Interest Monthly
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 of Loan Prepayment 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 because
homeowners are refinancing (i.e., +200 PSA or 24CPR).
- 16 -
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%
- 17 -
Yield
Mortgage-Backed Securities
Traditional 30-Year Mortgage Lending
Key Characteristics of 30-Year Loans & MBS:
 30-Year Loans Spread
p
Payments
y
Out to Reduce Monthly
y Payment
y
 Nearly All of The Payment In The Early Years Is Interest
 The
e Interest
te est Rate
ate Level
e e Impacts
pacts The
e Monthly
o t y Payment
ay e t For
o tthe
e Borrower
o o e
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
30 Year Borrowers Are Typically Very Rate Sensitive
 Borrowers Can Repay Their Loans Without Penalty and at Any Time
 Bondholders Receive
Recei e An Attractive
Attracti e Yield Above
Abo e Treasuries,
Treas ries Agenc
Agency Iss
Issued
ed
Debentures and Other Types of Securities Because Borrowers Can Repay
Their Loans Without Penalty and at Any Time
 Agency MBS
S are Backed by The Homeowner, by The Agency, and by
The Implied Guarantee Of The Government
- 18 -
Mortgage-Backed Securities
Traditional 30-Year Mortgage Pass-Through & Cash Flow Profile
Mortgage Rates
Mortgage Rates
Mortgage Rates
HIGHER
UNCHANGED
LOWER
NO REFINANCE
LESS Trading Up
LESS Renovation
LESS
ESS Downsizing
D
i i
Get Transferred
Death, Divorce, Etc.
Trading Up
Major Renovation
Downsizing
Get Transferred
Death, Divorce, Etc.
REFINANCE
MORE Trading Up
MORE Renovation
MORE Downsizing
Get Transferred
Death, Divorce, Etc.
6% CPR
12% CPR
25% CPR
5 Year
Bond
2 Year
Bond
Per Year
Per Year
8 Year
Bond
3 Year Contraction
3 Year Extension
- 19 -
Per Year
Mortgage-Backed Securities
Traditional 15-Year and 10-Year Mortgage Lending
Key Characteristics of 15-Year & 10-Year Loans & MBS:
 15-Year & 10-Year Loans Are For People
p Who Want To Pay
y Debt Back Fast
 More of the Payment Is Principal, So The Interest Rate Has Less of an
Impact on The Monthly Payment
So 15-Year & 10-Year Borrowers Are Typically LESS Rate Sensitive
 The Shorter The Loan, The Less Variability The Cash Flows Are 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
 15-Year and 10-Year Pass-throughs Receive An Attractive Yield Above
Treasuries,, Agency
g
y Issued Debentures and Other Types
yp of Securities,,
But Less Than a 30-Year Pass-through
- 20 -
Mortgage-Backed Securities
Traditional 10-Year Mortgage Pass-Through & Cash Flow Profile
Mortgage Rates
Mortgage Rates
Mortgage Rates
HIGHER
UNCHANGED
LOWER
NO REFINANCE
LESS Trading Up
LESS Renovation
LESS Downsizing
Get Transferred
Death, Divorce, Etc.
Trading Up
Major Renovation
g
Downsizing
Get Transferred
Death, Divorce, Etc.
REFINANCE
MORE Trading Up
MORE Renovation
MORE Downsizing
D
i i
Get Transferred
Death, Divorce, Etc.
7% CPR
12% CPR
25% CPR
3.4 Year
Bond
2.9 Year
Bond
Per Year
4.0 Year
Bond
Per Year
Per Year
0.5 Year Contraction
0.6 Year Extension
- 21 -
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.
increased
$
Investors in short-term, intermediate-term
and long-term securities can now
participate in the mortgage
mortgage-backed
backed
securities market.
- 22 -
$
$
Class 1
$
$
$
Class 2
$
$
$
Class 3
Mortgage-Backed Securities
The Two Main Types of Collateralized Mortgage Obligations (CMOs)
Seqential Class CMO:
 Cash Flow Stability Improved vs. Pass-Through Since Tranches
Get Paid Back In Sequential Order
 Big Prepayment Swings Can Still Cause Some Cash Flow Variability
(e.g., A Sequential Backed By New 30 Year Loans).
 A Sequential Backed By Stable Collateral Can Greatly Improve
Cash Flow Stability (e.g., 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
 Th
The Key
K is
i to
t Analyze
A l
“Stressed”
“St
d” Prepayment
P
t Assumptions
A
ti
to
t
Ensure The Bond Will Act Like You Expect
- 23 -
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
yp
y Run “Stress Tests” To Ensure The Support
pp
Classes
Are Adequate To Provide The Required Stability For The PAC Class.
- 24 -
Mortgage-Backed Securities
The Well Structured PAC CMO Structure
Consistent Payment History Well Within Wide PAC Bands
2 Year Bond at +50 bps Over Treasuries
• Often Greater Yield and Cash Flow Stability Than Callable Agencies
• Yields Comparable or Higher than A-Rated Corporate Bonds.
Source: Bloomberg
- 25 -
Mortgage-Backed Securities
The Key Factors That Drive Cash Flow Stability
Collateral Characteristics:
L
Loan
Term:
T
Sh t Equals
Shorter
E
l More
M
Stability
St bilit
Loan Balance:
Lower Equals More Stability
Seasoning (Loan Age):
Longer Equals More Stability
Mortgage Rate:
Out-of-money Equals More Stability
S
Security
i Structure:
S
Structure Often Enhances Collateral Characteristics, But There Is
No Substitute For Careful Analysis.
y
Generally Speaking:
Pre-Planned Amortization (PAC) CMO
Sequential Amortization (SEQ) CMO
Mortgage Pass-through
- 26 -
More Stability
Some Stability
Least Stability
Mortgage-Backed Securities:
“Taper Tantrum”
Why So Much On Cash Flow Stability: Minimizing Extension (And Call) Risk
Duration:
Sample (Actual)
MBS & CMO
Portfolio
Typical
Mortgage
Collateral
2.1 Years
3.2 Years
Yield-to-Maturity:
1.3%
1.3%
Wtd. Average $ Price:
$104.2
$107.3
Wtd. Average
Original Loan Term:
16 Years
30 Years
Avg. Origination Date:
2004
2012
Current Avg
Avg. Balance:
$79K
$300K
Avg. Time to Maturity:
9 Years
Impact of 50 Basis Point
Rate Decline on Payment:
Source: Merrill Lynch, Bloomberg, Atlanta Capital
$19 / mo
Data as of September 2012
- 27 -
SHORTER
LOANS
MORE
SEASONED
30 Years
LOWER LOAN
BALANCE
$85 / mo
MORE
STRUCTURE
“Taper Tantrum”
Mortgage-Backed Securities:
Why So Much On Cash Flow Stability: Minimizing Extension (And Call) Risk
3.0
Sample (Actual) MBS & CMO Portfolio Duration Variability
0.8%
UNCHANGED
0.6%
20
2.0
0 4%
0.4%
0.2%
1.0
0.0%
Mar-12
3.0
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Merrill Lynch Callable Agency Index Duration Variability
0.8%
1.4 Years to 2.4 Years
0.6%
2.0
0.4%
0.2%
1.0
0.0%
Mar-12
3.0
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Merrill Lynch 0-3 Year CMO PAC Index Duration Variability
0.8%
1.1 Years to 2.7 Years
0.6%
2.0
0.4%
0.2%
1.0
0.0%
Mar-12
Jun-12
Source: Merrill Lynch, Bloomberg, Atlanta Capital
Sep-12
Dec-12
- 28 -
Mar-13
Jun-13
Sep-13
“Taper Tantrum”
Mortgage-Backed Securities:
Whyy So Much On Cash Flow Stability:
y Minimizing
g Extension ((And Call)) Risk
Negative Convexity (e.g., The 1-Year, Non-Call, 5-Year Callable Bond)
Purchase
Date
1 Year
5 Year
Call
Date
Maturity
D t
Date
(Yield to Call)
(Duration to Call)
May-August
Return
1-Year T-Note Index Return:
0.14%
1.0 yr
0.07%
1-Year, NC 5-Year Callable Bond:
0.97%
1.0 yr
(2.96%)
April 30 Yield Duration
Reaching for Yield
 Adding yield almost always means adding some form of risk (credit risk,
duration, negative convexity, etc.). It’s important to understand the risks
with each investment and how they impact the overall portfolio.
Source: Merrill Lynch, Bloomberg
- 29 -
“Taper Tantrum”
Mortgage-Backed Securities:
Why So Much On Cash Flow Stability: Minimizing Extension (And Call) Risk
Merrill Lynch
Mortgage Index
Merrill Lynch 1-5
Callable Index
Sample (Actual)
MBS & CMO
Portfolio
Effective
Duration (Beg)
2.4 Years
1.3 Years
2.2 Years
Market
M
k Yi
Yield
ld
To Worst (Beg)
2.60%
0.68%
1.04%
May 2013
Price Return
(1.70%)
(0.32%)
(0.36%)
Source: Merrill Lynch; Atlanta Capital; BondEdge
- 30 -
Mortgage-Backed & Asset-Backed Securities
Summary: High Yield and High Quality Are Not Mutually Exclusive
 The Mortgage-Backed and Asset-Backed Sectors Can Offer
Attractive Investments That Can Add Significant Yield and
T t l Return
Total
R t
Over
O
Time
Ti
 Premiums Are Comparable to or Higher Than Many ‘A’ Rated
Corporate Bonds and the Return Profile Is More Stable
 Traditional Mortgage Bonds and Many ABS Structures Have A
Proven Track Record of Maintaining The Highest Credit Quality
In Even The Deepest Economic Downturns
 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
- 31 -
Thank You!
- 32 -