Final Exam FIN 4550, Wednesday 12/15/04 2:00-3:50
Chapters from Fabbozi:
Chapter 7: Corporate Debt Instruments
Chapter 8: Municipal Securities
Chapter 10: Residential Mortgages
Chapter 11: Mortgage Pass-Through Securities
Chapter 12: Collateralized Mortgage Obligations
Segments of the bond market ranked by size of outstanding face value 2nd quarter 2004:
Mortgage related, Corporate, U.S. Treasury, Asset backed, Federal Agencies, Money
market, Municipal, Asset backed.
http://www.bondmarkets.com/
http://www.sec.gov/Archives/edgar/
Important legal frameworks in corporate debt markets
Securities Act of 1933 – SEC registration and reporting requirements (public markets)
Trust Indenture Act of 1939 – Trustee appointed to represent interests of
bondholders
Priority rules:
Debenture bonds
Subordinated debenture bonds
Senior bonds
Mortgage bonds
Equipment Trust Certificates –
Trust Originated Preferred Securities (TOPRS)
Income Bonds
Guaranteed bonds
Private placements;
Rule 144A
Financial Distress
Chapter 7 bankruptcy
Chapter 11 bankruptcy
Day count conventions:
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Full Price = Clean Price + AI
Invoice Amount = Quoted Price + AI
actual/actual (US Treasury) and 30/360(Corporate and Municipal)
Interest accrues on a coupon security from and including the last-coupon-day (LCD) up to
but excluding the settlement date (SD).
Provisions for paying off bonds prior to maturity date
Call provisions
Call protection vs. refunding protection.
Bullet bonds.
Sinking fund provisions
Credit ratings
Financial ratios by credit rating
Cumulative default rates by credit rating
Secondary market for corporate bonds
Municipal bonds are issued by state and local governments and by government entities such
as school districts, public works agencies, etc.
General obligation bonds
Revenue bond
Exemption of interest from Federal income taxation
ytmmunicipal = ytmtaxable (1- t) where t is the marginal tax for investors in municipal
securities.
Early redemption features of municipal bonds
-Sinking fund or serial bonds.
-Typical term maturity bonds.
Conventional mortgage
Parties to a mortgage transaction:
Borrower
Originator
Servicer
Insurer
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Measures of credit quality –
Payment to Income ratio (PTI)
Loan to Value ration (LTV)
Government provided mortgage insurance
Federal Housing Administration
Veterans Administration
Federal Farmer’s Administration
Private mortgage insurance
Government agencies involved with secondary mortgage market
Federal National Mortgage Association (FNMA)
http://www.fanniemae.com/
Government National Mortgage (GNMA) (backed by Treasury)
http://www.ginniemae.gov/
Federal Home Loan Mortgage Corporation (FHLMC – Freddie Mac) (private company
originally a government sponsored enterprise)
http://www.freddiemac.com/
Conforming mortgage
1. Maximum PTI
2. Maximum LTV
3. Maximum loan amount
Non-conforming mortgages
Features of state foreclosure laws
Fixed rate (contract rate) level payment contracts are one mortgage design –
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.
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Variable rate mortgage contract – reference rate (index), reset period, margin, periodic caps,
lifetime caps, floors.
Negative amortization.
Balloon mortgage
Two-step mortgage
Growing equity mortgages
Graduated payment mortgages
Tiered payment mortgages
Fixed / adjustable rate hybrids
Reverse mortgages
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.
FHLMC – issues participation certificates (PCs)
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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.
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
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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 30months 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.
Mortgage.xls
Exhibit 11-4 page 244
Exhibit 12-2 page 258
Exhibit 12-5 page 262
T t * totalPRN
t
Life = Average life = 
12 * MB0
Cash flow yield = ytm = discount rate that makes present value of expected cash flows equal
price
ytm 6
) )  1)
BEY = 2  ((1 
12
t 1
Principal pay-down window
Negative convexity
Extension risk
Contraction risk
Collateralized Mortgage Obligations:
Sequential pay trances
Accrual bonds
Floating rate tranches
Inverse floating rate tranches
PAC bonds
Support bonds
Principal only strips
Interest only strips
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