Chapter 8 Municipal Securities
Municipal bonds are issued by state and local governments and by government entities
such as school districts, public works agencies, etc.
Source of cash to repay debt (bond’s security) varies widely.
Some municipals are secured by tax revenues of the issuer
Some municipals are secured by use revenue for the project financed
Some municipals are secured by other government income.
Exemption of interest from Federal income taxation is the most significant feature of
municipal bonds. The tax exempt status municipal interest income makes municipals
more attractive. However changes in the tax code can have dramatic impact on the value
of this tax exemption.
ytmmunicipal = ytmtaxable (1- t) where t is the marginal tax for investors in municipal
securities.
Individual investors are the largest single holder of municipal securities.
Federal Tax Tables
Federal Income Tax
SingleRate
$0 - $7,000 10.000%
$7,001 - $28,400 15.000%
$28,401 - $68,800 25.000%
$68,801 - $143,500 28.000%
$143,501 - $311,950 33.000%
$311,951 + 35.000%
JointRate
$0 - $14,000 10.000%
$14,001 - $56,800 15.000%
$56,801 - $114,650 25.000%
$114,651 - $174,700 28.000%
$174,701 - $311,950 33.000%
$311,951 + 35.000%
Oklahoma
SingleRate
$10,000 + 7.000%
JointRate
$21,000 + 7.000%
General obligation bonds – municipal securities secured by taxing power of the issuer.
Property tax = assessed property value * millage rate
Revenue bond –secured by revenues generated from operating project.
1
http://www.investinginbonds.com/muni_bond_prices.htm
Issuer
STILLWATER OKLA MED CTR AUTH HOSP REV FORMERLY
STILLWATER OK
Rating
BBB S
BAA2 M
CUSIP
Coupon
Maturity
860815CY3 OK
5.63%
5/15/2023
First Call
5/15/2014
5/15/2016
Price
ytm
100
5.63%
Volume of $400,000 for 3 trades.
Issuer
MBIA UNIVERSITY OKLA
REVS TULSA CAMPUS - SER
A MBIA - BOOK ENTRY ONL
Rating
AAA M
AAA F
CUSIP
Coupon
Maturity
914760ZN6 OK
4.50%
1/1/2018
Price High
Price Low
102.12
99.62
4.298
4.536
Volume of $20,000 for 2 trades
2
102
100
Redemption features of municipal bonds
-Sinking fund or serial bonds.
-Typical term maturity bonds.
Examples of large defaults
1975 State of New York’s Urban Development Corporation, $100 million
1986 Washington Public Power Supply System (WPPSS)
Credit ratings available from Moody’s and Standard and Poor’s
Chapter 10 Mortgage Loans –
A mortgage loan is a loan secured by the collateral of some specified real estate which
obliges the borrower to make a predetermined series of payments.
Conventional mortgage - loan secured by borrower’s credit and collateral
Parties to a mortgage transaction can include;
Borrower Originator Servicer Insurer -
original source of funds, application, credit evaluation, fund
transfer
record keeping, collecting, escrow account administration
guarantees repayment of a portion of loan principal
Key measures of credit quality –
Payment to Income ratio (PTI)
Loan to Value ration (LTV)
PTI is generally measured as the gross monthly payment including taxes and insurance.
LTV can be measured with the property’s market value or assessed value.
Mortgage originators –
Income – origination fees (points), application and processing fees, profit on sale.
Hold mortgage as investment
Sell mortgage to investor
Securitize mortgage
3
Mortgage servicing –
Income – servicing fee (slice of loan rate), interest earned on escrow balance, float on
monthly payment, late payment charges, marketing income.
Servicing is a part of every mortgage. The servicing fee is included in the contract rate.
The mortgage rate is 8.125% and the servicing fee is 50 basis points the net interest
received by the investor is 7.625%.
Mortgages are either conventional or insured
Government provided mortgage insurance –
Federal Housing Administration
Veterans Administration
Federal Farmer’s Administration
Private mortgage insurance Mortgage insurance – insures against default by borrower. Mortgage insurance is
usually required if LTV > 80%. Private mortgage insurance companies will insure the
amount of the mortgage above the 80% LTV ratio. For instance a borrower who has
$5,000 down payment on a $100,000 home, needs a $95,000 loan. The originator will
require the borrower to purchase mortgage insurance. The private mortgage insurance
company will guarantee $15,000 of the loan to the originator (mortgage holder). The
borrower will pay for the mortgage insurance either through a higher loan rate or a
monthly payment in addition to the loan payment, taxes and insurance. Mortgage
insurance is notoriously expensive.
Government agencies involved with secondary mortgage market
Federal National Mortgage Association (private company originally a government
sponsored enterprise)
Purchases mortgages insured by FHA, VA, Federal Farmer’s Administration and
conventional mortgages
Issues common stock, debentures, structured notes, mortgage backed securities
Holds mortgages or sells mortgage pools to private mortgage pool operators, invests in
MBS.
4
Government National Mortgage (backed by Treasury)
Purchases mortgages insured by FHA, VA, Federal Farmer’s Administration.
Holds mortgages, sells mortgage backed securities.
Federal Home Loan Mortgage Corporation (private company originally a government
sponsored enterprise)
Purchases conventional mortgages
Issues common stock, debentures, structured notes, mortgage backed securities
Holds mortgages, sells mortgages to private mortgage pool operators.
A conforming mortgage meets underwriting standards of Federal Home Loan Mortgage
Corporation (Freddie Mac) or Federal National Mortgage Corporation (Fannie Mae).
The underwriting standards include
1. Maximum PTI
2. Maximum LTV
3. Maximum loan amount
For FNMA – (2003) maximum loan limits
Loan type
Loan limits
Single family
$332,700
mortgage
Multi-family
413,100
mortgage
3-family
499,300
4-family
620,500
Second Mortg.
161,350
Maximum amount in Alaska, Hawaii, and U.S. Virgin Islands are 50% greater
Conforming mortgages can be sold to an agency. The agency then sells mortgage passthrough securities based on the mortgage pool or sells mortgage pool to private mortgage
operators.
Non-conforming mortgages are purchased by private conduits.
5
Features of state foreclosure laws that influence the likelihood and cost of loan default.
1. Foreclosure procedures (judicial or non-judicial)
2. Statutory right of redemption – window of opportunity after foreclosure for original
owner to redeem property through payment.
3. Deficiency judgement – right of lender to recover deficiencies from borrower through
lien on other personal assets.
Price
Down payment
Principal
i
Cash flow
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
$100,000
$20,000
$80,000
Fixed rate
30
12
8.00%
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
$587
Total
$211,324
interest Principal paid
$533
$54
$532.98
$54.04
$532.62
$54.40
$532.25
$54.76
$531.89
$55.12
$531.52
$55.49
$531.15
$55.86
$530.78
$56.23
$530.40
$56.61
$530.03
$56.99
$529.65
$57.37
$529.26
$57.75
$528.88
$58.13
$528.49
$58.52
$528.10
$58.91
$527.71
$59.30
$527.31
$59.70
$526.91
$60.10
$526.51
$60.50
$526.11
$60.90
$525.70
$61.31
$525.30
$61.72
$524.88
$62.13
$524.47
$62.54
Interest
$131,324
Balance
$79,946
$79,892.29
$79,837.89
$79,783.13
$79,728.01
$79,672.51
$79,616.65
$79,560.42
$79,503.81
$79,446.82
$79,389.46
$79,331.71
$79,273.58
$79,215.05
$79,156.14
$79,096.84
$79,037.14
$78,977.04
$78,916.54
$78,855.64
$78,794.34
$78,732.62
$78,670.49
$78,607.95
Fixed rate (contract rate) level payment contracts are one mortgage design –
6
LTV
0.799463
0.798923
0.798379
0.797831
0.79728
0.796725
0.796167
0.795604
0.795038
0.794468
0.793895
0.793317
0.792736
0.792151
0.791561
0.790968
0.790371
0.78977
0.789165
0.788556
0.787943
0.787326
0.786705
0.786079
1  (1  i ) n 
MB0  MP

i



Note the contract rate is adjusted by 1/12 and the number of periods is also increased
by a factor of 12 when considering a fixed rate - fixed term – monthly pay - self
amortizing loan contract.
Variable rate mortgage contract – reference rate (index), reset period, margin, periodic
caps, lifetime caps, floors.
Caps limit the possible change in the contract rate. The actual rate charge will change by
the full amount. Which can produce negative amortization.
Other mortgage contract types:
Balloon mortgage - Lender agrees to refinance the remaining balance at specified
intervals over the term of the loan.
Two-step mortgage – one reset date during life of mortgage
Growing equity mortgages
Graduated payment mortgages
Tiered payment mortgages
Fixed / adjustable rate hybrids
7
Mortgage backed securities include



Mortgage passthroughs
Collateralized mortgage obligations
Stripped mortgage backed securities
The latter two securities are created from mortgage passthrough securities.
Three government agencies issue mortgage passthrough securities – Government
National Mortgage Association (GNMA), FHLMC and FNMA. (government sponsored
enterprises)
Mortgage guarantors provide one of two guarantees
-
Fully modified – principal and interest will be paid when due.
Modified – timely payment of interest, principal will be paid when collected .
Characteristics of Agency passthroughs –
Only the guarantees of GNMA are backed by the full faith and credit of the U.S.
Treasury.
Fully modified passthroughs.
GNMA I – single lender pools, servicing spread 50 basis points, payment delay 45 days
GNMA II – multiple lender pools, servicing spread 50-150 basis points, payment delay
50 days
GNMA underwriting standards –
GNMA restricts loans purchased to those that are insured by FHA, VA or RHS.
Only new mortgages issued within last 24- months can be included
Assumable mortgages are not permitted.
8
FHLMC – issues participation certificates (PCs)
Cash program – Cash PCs – multiple lender pools
Guarantor/Swap program – Swap PCs – single and multiple lender pools
Both modified and fully modified passthroughs
Conventional mortgages - fixed rate, variable rate and balloon are used as collateral
No limits on mortgage seasoning.
No assumable mortgages permitted.
FNMA – MBS programs
Fully modified passthroughs
Only multiple lender pools
No limits on seasoning
No assumable mortgages permitted
Net interest spread can be 50 – 250 basis points.
9
Valuing a passthrough security –
The passthrough coupon rate is less than the contract rate of the mortgages in the pool by
an amount that reflects the servicing fee and guarantee fee.
Weighted average coupon rate (WAC) – Sum of the weighted contract rate of each
mortgage in the pool. Weights determined like portfolio weights - proportion of total
outstanding balance.
Weighted average maturity (WAM) – Sum of the weighted maturity of each mortgage in
the pool.
Cash flows of a mortgage passthrough security depend on the cash flows of the
underlying mortgages net of servicing fees and guarantee fees and include both scheduled
principal repayment and prepayments.
To place a value on mortgage pools it is essential to treat the expected prepayment
pattern of the mortgages in the pool. One method is the Public Securities Association
(PSA) prepayment benchmark
CPR = annual prepayment rate
SMM = Single monthly mortality rate
SMM = 1 – (1-CPR)1/12
A SMM of w% means that approximately w% of the remaining mortgage balance at the
beginning of the month, less the scheduled principal payment, will prepay that month.
Prepayment for month t = SMM x (beginning mortgage balance (t) – scheduled principal
payment (t)).
Assume a remaining balance of $290 million at the beginning of the month, a SMM of
0.5143% and a scheduled principal payment of $3,000,000.
0.005143 x (290,000,000 – 3,000,000) = $1,476,041
10
The PSA benchmark assumes the following prepayment rates for 30-year mortgages;
1. A CPR of 0.2% for the first month, increase by 0.2% per year per month for the next
30-months when it peaks at 6% per year. (if t<=30 then CPR=(6%*t)/30 .
2. 6% CPR for the remaining years. (if t >30 then CPR = 6%).
A prepayment assumption will determine the expected cash flow to be received by the
owners of the passthrough certificates. Given the projected cash flows based on some
prepayment assumption and the market price of a pass through, the yield to maturity of a
passthrough can be calculated. This is referred to as the cash flow yield.
The Wall Street Journal reports the cash flow yield on passthrough securities of all three
agencies. The Salomon Brother’s prepayment model is used (?).
Spreadsheet example of cash flow construction
Different assumptions of prepayment speed can be incorporated with adjustment to the
assumed conditional prepayment rate. Exhibit 11-4 page 244 – Average time to move
implied by PSA speed.
11