VI: Debt Market Instruments
20: Asset-Backed Securities
Asset Backed Securities
 Investment Companies
 Investment Trusts
 Open End Companies (Mutual Funds)
 Closed End Companies
 Securitization
 Mortgage Backed Securities
 Other Securitization
Chapter 20: Asset-Backed Securities
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Investment Companies
Chapter 20: Asset-Backed Securities
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Net Asset Value
 Net Asset Value = Market Value of Assets
Units
Chapter 20: Asset-Backed Securities
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Open Ended (Mutual Fund)
 We can create a new partnership (unit) only
if we have Open Ended Capitalization
Chapter 20: Asset-Backed Securities
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Open Ended (Mutual Fund)
 We can destroy the partnership (unit) only
if we have Open Ended Capitalization.
 This can entail selling assets to realize
sufficient funds to redeem the unit.
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Closed End Fund
 Cannot create new partnership units
 Closed End Capitalization means that the
number of units are fixed)
Chapter 20: Asset-Backed Securities
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Investment Companies
 Open Ended (Mutual) Funds
 Create and destroy/redeem units as needed
 Primary market only
 Closed End Funds
 Units are fixed
 After initial offering units must be bought and
sold in the secondary market where they trade
just like stocks.
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Why Investment Companies
 Economies of scale
 Diversification
 Lower transaction costs
 Professional management
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Performance
 Average annual return 1980-2005
Mutual Fund Investor
7.3%
Mutual Funds
10.0%
S&P Index
0.00%
2.00%
Chapter 20: Asset-Backed Securities
4.00%
6.00%
8.00%
10.00%
12.3%
12.00%
14.00%
© Oltheten & Waspi 2012
Performance
 Average annual return 1980-2010
Mutual Fund Investor
7.3%
Mutual Funds
S&P Index
0.00%
2.00%
Chapter 20: Asset-Backed Securities
4.00%
6.00%
10.0%
8.06%
8.00%
10.00%
12.00%
© Oltheten
&2012
Waspi 2012
© Oltheten
& Waspi
Mortgage Backed Securities
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Mortgages
 Structured so that payments are
 Monthly
 Even over the life of the loan
Chapter 20: Asset-Backed Securities
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Mortgages
 $1,000,000 principal loan
 8½%
 30 years
 r 1  r  m 
Monthly Payment  Principal * 

m
 1  r   1
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Mortgages
 $1,000,000 principal loan
 8½%
 30 years




Monthly mortgage payment?
How much is principal repayment
How much is interest?
After the first payment what is the loan
principal?
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Mortgages
 Month One:
 Payment = $7,689.13
 Interest = $7,083.33
 Principal = $605.80
 Now owe $999,394.20
 r 1  r  m 
Payment  Principal * 

m
 1  r   1
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Calculator Techniques




[2nd][Quit] [2nd][FV]
[2nd][P/Y] 12
[2nd][BGN]
[2nd][Quit]




Clear
12 pmts/yr
End of Period pmts
Calculator Mode
 1000000 [PV]
 8.5[I/Y]
 30 [2nd][xP/Y][N]
 PV=-$1m
 Rate = 8.5%
 N=360 months
 [CPT][PMT]
 $7,689.13
Chapter 20: Asset-Backed Securities
Calculator Techniques




[2nd]Amort
[2nd][CLR WORK]
[↓]
12
P1=1 to P2=1
means that you
get month 1 only
Chapter 20: Asset-Backed Securities




Amortization
P1 = 1
P2=
P2=1
 BAL = - 999,394.20
 PRN = 605.80
 INT = 7,083.33
© Oltheten & Waspi 2012
Payment per Month
Mortgages
$9,000
$8,000
$7,000
$6,000
Interest
portion of
payment
$5,000
$4,000
$3,000
$2,000
Principal
portion of
payment
$1,000
Months
$0
0
Chapter 20: Asset-Backed Securities
60
120
180
240
300
360
© Oltheten & Waspi 2012
Remaining Principal
Mortgages
$1,200,000
$1,000,000
$800,000
$600,000
$400,000
$200,000
Months
$0
0
Chapter 20: Asset-Backed Securities
60
120
180
240
300
360
© Oltheten & Waspi 2012
Primary Market
 The bank writes 10, 30 year mortgages of
$1,000,000 at 8½%
 No more money
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Primary Market -> Secondary Market
Secondary
Market
Mortgages
More
Mortgages
$$$
$$$
Bank
Investors
Chapter 20: Asset-Backed Securities
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The Secondary Market
 If the Bank can sell the mortgages to
investors then it will have capital to extend
more loans.
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
The Secondary Market
 Put the 10 $1m mortgages into a
$10,000,000 pool (group)
 Guarantee each mortgage by GNMA or
FNMA
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
The Secondary Market
 GNMA
 Government National Mortgage Association
 Wholly owned government corporation within HUD
 Neither originates or purchases mortgage loans
 FNMA
 Federal National Mortgage Association
 GSEs owned by its shareholders (until Sept 7, 2008)
 In 2008 owned approx ½ of the $12 trillion mortgage
market
Chapter 20: Asset-Backed Securities
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The Secondary Market
 Divide the pool into 1000 $10,000 units
 8.0% goes to the Investor
 0.1% goes to Ginnie Mae
 0.4% goes to the Originating Bank (me)
 I sell the units to investors through a broker
Chapter 20: Asset-Backed Securities
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Pass Through Securities
 A pass-through security is a pro-rated
ownership of all the mortgages in the pool
 Each unit represents 1/1000th of each of the
10 mortgages in the pool.
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Risk
 Credit Risk:
 There is no credit risk because if the
homeowner defaults GNMA will use its own
funds to make payments until the mortgage is
foreclosed and the mortgage paid off.
 Prepayment or Contraction Risk:
 This is the risk that the mortgage is paid off
early. Prepayment risk is similar to an open call
without penalty.
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
CMO
 Put Through securities: all units in a pool
are equal
 Collateralized Mortgage Securities: units are
unequal.
 inventive structures
 Tranches / classes
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Securitization
 Securitization is the process by which loans
are turned into securities for sale to
investors.
 The creation of this secondary market
allows the primary market to function more
efficiently
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012
Securitization
 Mortgages
 Car Loans
 Consumer debt
Chapter 20: Asset-Backed Securities
© Oltheten & Waspi 2012