Mortgage Markets and
Mortgage Backed Securities
UNIVERSITE
D’AUVERGNE
Drake
DRAKE UNIVERSITY
Brief History of Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Following the decline of Roman empire,
Germanic law developed the idea to use land as
security in borrowers agreements, this practice
was referred to as a gage
William of Normandy introduced the Germanic
gage system into early English law. The French
word mort (dead or frozen) was combined with
gage to produce a locked pledge or mort-gage
on property.
The US mortgage market
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Establishment of mortgage companies in the the
1800’s to finance land purchases by farmers in
the Midwest.
By 1900 there were approximately 200 mortgage
companies with outstanding loan values totaling
$4 billion
Early mortgages paid interest semiannually,
nonamortizing with a balloon payment at the end
(as short as 3 to 5 years)
History of US Mortgage Market
1900 - 1950
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Fast growth form 1900 to 1930 was slowed by
large number of foreclosures in early 1930’s.
Federal Government started trying to support the
mortgage market especially the secondary
mortgage market with formation of Federal
National Mortgage Association (Fannie Mae) in
1938
Post WWII fast expansion of housing market due
to liquidity of private sector.
History of US Mortgage Market
1950 - 1980
UNIVERSITE
D’AUVERGNE
Drake
Drake University
1954 Fannie Mae was reorganized. New charter
made it part private part federal owned
1968 Fannie Mae becomes entirely privately held.
Ginnie Mae is established to oversee special
assistance (FHA and VA) programs. Guarantees
backed by “full faith and credit” of US Treasury.
1970 Establishment of “Freddie Mac”
1977 First private pass through issued
History of US Mortgage Market
1980 - 2004
UNIVERSITE
D’AUVERGNE
Drake
Drake University
1980’s growing use of Adjustable Rate Mortgages
First Collateralized Mortgage Obligations offered
Dramatic growth of Mortgage backed securities
market.
The Current Mortgage Market
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The Primary Market – The issue of Mortgages to
individuals by financial institutions.
Mortgage Originators
Thrifts, Commercial Banks and Mortgage Brokers
Origination Income
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Origination Fee - expressed in terms of points -each point represents 1% of the borrowed funds
-- Origination fee of 3 points on 100,000
mortgage is $3,000
Secondary market profit -- selling the mortgage
obligation at a price higher than it originally
cost.
Servicing Fee - Collecting monthly payments,
forwarding proceeds to owners of the loan,
sending payment notices, maintaining records,
furnishing tax info etc…
Servicing Fees
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Servicing fees are generally a portion of the
mortgage rate and is often referred to as
servicing spread.
The mortgage origination
process
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Applicant submits info relating to the property and
income. Originator performs credit report and looks
at the probability of repayment.
PTI -- payment to income ratio (monthly
payment / monthly income)
LTV -- loan to value ratio (Loan amount /
Valuation )
Commitment letter-- outlines the terms available for
the next 30 to 60 days. The borrower pays a
commitment fee which will be lost if no loan is taken
out.
Post Loan Options
UNIVERSITE
D’AUVERGNE
Drake
Drake University
After making the loan the originator has one of
three options
Hold the mortgage in their portfolio.
Sell the mortgage to an investor (who will
either hold the mortgage or use it as
collateral), possibly continuing to service the
mortgage.
Use the mortgage as collateral to issue a
security (securitizing the mortgage)
Origination Risks
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Price Risk If rates increase the originator has
already committed to charging lower rates -Can protect against price risk with a second
commitment from a secondary market participant
that agrees to buy the given loan at a futures
point in time for a given price.
However this brings a second risk -- if rates
decline the borrower may not close and the
originator is locked into providing the above
market return.
Fall out Risk. Risk that some individuals issued
commitment letters will not close
Mortgage Construction
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Traditional Fixed Rate Mortgage (fixed-rate
level-payment, fully amortized mortgage)
Principal and interest are amortized over the
life of the mortgage.
The payment is determined with the basic PV
of an annuity formula
Amortization of a Loan
UNIVERSITE
D’AUVERGNE
Drake
Drake University
You want to borrow 1,000 and pay it off over three
years. Assume that you are charged 6% each
year. How much will your payment be?
1,000 = PV PMT =????
1,000 = PMT (PVIFA6%,3) =
1,000 = PMT(2.67)
PMT = 374.11
Amortization
UNIVERSITE
D’AUVERGNE
Drake
Drake University
You pay a total of 374.11(3) = $1,122.33
A portion of each payment represents interest
charges.
You can find the amount of interest by
multiplying the beginning balance each payment
period by the interest rate.
At the beginning the balance is $1,000 so there
is 1,000(.06) = 60 in interest.
UNIVERSITE
D’AUVERGNE
Amortization
Drake
Drake University
Beginning
Ending
Year Balance Payment Interest Principal Balance
1
1,000
374.11
60.00
314.11
685.89
2
685.89
374.11
41.15
332.96
352.93
3
352.93
374.11
21.18
352.93
0.00
Amortization 30 yr Mortgage
$150,000
5.85%
Beginning
Year Balance Payment
1
150,000 884.91
Interest Principal
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Ending
Balance
731.25 153.6614 149,846.34
2 149,846 884.91
730.50
154.41
149691.93
359
1756.97 884.91
8.57
876.35
880.62
360
880.62 884.91
4.29
880.62
0
Servicing Fee Revisited
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Since the servicing fee is generally a portion of
the interest payment the actual fee income will
decline throughout the life of the mortgage as
interest decline.
UNIVERSITE
D’AUVERGNE
Prepayments and CF Uncertainty
Drake
Drake University
Generally there is not a penalty for prepaying the
principle early. When a prepayment is made for
less the entire balance it is referred to as a
curtailment.
Some mortgages however do have a lock out
period or penalty period which can limit or
prohibit prepayment.
Origination Problems
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Mismatch
Institutions are borrowing short and lending
long, They must manage the different timing of
their cash flows.
Tilt
The real burden of the loan to the borrower is in
the early years of the loan. Since inflation
decreases the real burden of their payments over
time. Therefore individuals may not enter the
market, even though they are able to given their
future income.
Adjustable Rate Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The loan rate is reset periodically using a base
or reference rate.
The rate might reset every month, year, 2 years
5 years etc..
Reference Rate
Market determined
Cost of Funds
ARM Features
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Usually offer an initial rate less than prevailing
fixed rate (teaser rate).
At reset date reference rate plus a spread
determines the rate.
There may be caps and floors on the rates, both
periodic and lifetime.
Balloon & Two Step Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Allows for rollover and renegotiation of the loan at
periodic intervals.
Different from ARM the future rate is not set from
base rate.
Loan is extended if certain requirements are met.
30 due in 5 is a thirty year mortgage where the
remaining principal is due (or refinanced) after
five years.
Two step rates once based upon a specified rate
Solutions to the tilt problem:
UNIVERSITE
D’AUVERGNE
Drake
Drake University
ARMs address the mismatch problem by allowing
for longer term lending at a short term rate.
The tilt problem has creates the market for other
types of products
Graduated Payment Mortgages
Price -level Adjusted Mortgage.
Dual Rate Mortgage
Graduated Payment Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The mortgage payment increases each year at
the beginning of the loan then hits a level
amount for the remainder of the loan.
This actually produces negative amortization
since in the beginning the total amount does not
cover the interest on the loan.
Specified in the loan are The fixed rate, the rate
of growth for the first few years, the number of
years over which the payment will increase
Graduated Payment Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Example: 30 year, 10% mortgage on $100,000
with the payment growing at 7.5% each year for
the first 5 years.
Fixed Rate payment would be $877.5715
GPM
Year Payment
1
$667.04
3
$770.84
5
$890.80
Payments
Year
2
4
6-30
Payment
$717.06
$828.66
$957.62
Price Level Adjusted Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Monthly payment is designed to be level in
purchasing power. The fixed rate of interest is a
real rate of interest.
The monthly payment is then calculated using
the real rate just as a regular mortgage would
be.
The actual payment is then adjusted based upon
the rate of inflation.
Dual Rate Mortgages
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Similar to the PLAM except the amount owed is
based on a floating short term rate.
To establish the mortgage you need
1. the payment rte (the real rate of interest that is
fixed for the life of the loan),
2. the effective or debiting rate that changes
periodically and
3. the maturity of the mortgage.
Other plans
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Growing Equity Mortgage: Similar to the GPM
except there is no negative amortization. The
increase in payment will serve to pay off the
principal quicker than a traditional mortgage.
Lenders will be willing to lend a t a lower rate (if
the yield curve slopes up) and borrowers increase
payment solving tilt problem
High LTV loans eliminates high down payments
by financing up to 100% of the value of the
home plus closing costs.
Other Plans
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Alt-A loans: Requires alternate documentation of
income for special cases such as self employed
individuals. Rtes are generally 75 basis points to
125 basis points above other rates
Sub Prime Loans: Borrowers who have had
credit problems. Rates based upon different risk
grades
Risks Faced by Investors in the
Secondary Mortgage Market
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Credit Risk
Risk of default by the borrower
Liquidity risk
Even with the secondary markets, individual
loans are relatively illiquid
Price Risk
Value moves opposite changes in interest rates
Prepayment Risk
The borrower may prepay early
Mortgage Pass Through
Securities
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Interest and Principle are collected by the issuer
of the pass through on a pool of mortgages who
then transfers (passes through) the payments to
the owners of new securities backed by the
mortgages.
Neither the amount or timing of the cash flows
actually matches the cash flows on the pool of
mortgages.
When a mortgage is included in a pool it is said
to be securitized.
Cash Flows
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Neither the amount or timing of the cash flows
actually matches the cash flows on the pool of
mortgages.
Servicing and other fees are removed from the
cash flows received from the mortgage prior to
being passed through to the holder of the pass
through security. There is also a delay in the pass
through process.
Terminology
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The pool of mortgages will have a variety of
different rtes and maturities. Therefore, the
description of the pass through is based upon
weighted averages of the coupon and maturity.
WAC, WAM and WARM
UNIVERSITE
D’AUVERGNE
Drake
Drake University
WAC = weighted average coupon rate
Weighting the mortgage rate of each mortgage
in the pool by the outstanding principal balance
WAM = weighted average maturity
Weighting the number of months to maturity of
each mortgage in the pool by the outstanding
principal balance
WARM = weighted average remaining maturity
After prepayments have started the maturity
changes.
Guarantee Types
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Fully Modified Pass Throughs: Guarantees that
the principal and interest will be paid regardless
of whether the borrower is late.
Modified Pass Through: Guarantees the timely
payment of interest, the principal is passed
through when it is received.
Ginnie Mae
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Ginnie Mae pass throughs are guaranteed by the
US treasury.
Issues Mortgage backed securities which are fully
modified pass throughs
All mortgages are FHA, VA or Farmers Home
Administration loans
Fannie Mae
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Sells mortgage backed securities and channels
the funds to lenders by buying mortgages. The
institution may continue to service the original
mortgage.
All are fully modified pass throughs, but there is
no government guarantee of payment
Both Ginnie Mae and Fannie Mae securities are
commonly referred to as “Mortgage Backed
Securities”
Freddie Mac (FHLMC)
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Participation Certificates sold by the agency are
used to finance the origination of conventional
mortgages. Usually PC only guarantee that the
interest payment will be made. The principle
payment is passed through as it is received. The
guarantee is not backed by the federal
government as is the case in Ginnie Mae.
Most are fully modified (new issues are)
Participation Certificates
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Two main programs
Cash program FHLMC buys mortgages from the
issuer and issues PC's based on the mortgages.
Guarantor / Swap program -- Allows thrifts to
swap mortgages for PC's based on the
mortgages. The institution can swap mortgages
selling below par for without recognizing an
accounting loss!
The PC is then:
Held as an investment
used as collateral for borrowing
sold
Comparison of rates
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The pass through rate is less than that of the
mortgage pool. The difference accounts for
service and guaranteeing fees.
The timing is also different to allow for the
payment of the mortgages (on the first of the
month) prior to the pass through occurring.
Size of Mortgage Backed
Securities Market
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The MBS market has grown dramatically in the
last 20 years.
Currently there is a political debate surrounding
whether Fannie Mae, Ginnie Mae and Freddie
Mac are too large.
Part of their growth is based upon the market
believing that all three have a government
guarantee, even though Fannie Mae and Fredie
Mac do not.
% of Outstanding Debt Market
UNIVERSITE
D’AUVERGNE
Drake
Drake University
100%
7.8%
23.6%
8.1%
80%
60%
40%
20%
0%
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Municipal
Treasury
Corporate*
FedAgencies
MoneyMarket
Mortgage-Related
Bond Market Association 2003 is as of Sept 30,2003
Asset-Backed
UNIVERSITE
D’AUVERGNE
Average Daily Trading Volume
($Billions)
Drake
Drake University
438.60
450.00
400.00
366.40
350.00
1995
1996
MBS
1997
1999
2000
Treasuries
Bond Market Association 2003 as of Sept 30,2003
2001
154.49
2002
2003
Treasuries
1994
MBS
1993
219.23
297.90
69.47
1992
206.60
67.12
1998
12.83 17.03 22.11 30.41 29.39 38.15 47.08
1991
186.50
70.93
0.00
226.60
212.10
193.20
191.30
50.00
111.96
100.00
173.60
150.00
152.10
200.00
203.70
250.00
127.50
$ Billions
300.00
Issuance by GSE’s ($ Billions)
UNIVERSITE
D’AUVERGNE
Drake
Drake University
1800
1600
1400
$ Billions
1200
1000
800
600
400
200
0
1980
1982
1984
1986
1988
GNMA
1990
FNMA
1992
1994
1996
FHLMC
Bond Market Associattion 2003 as of Sept 30, 2003
1998
2000
2002
UNIVERSITE
D’AUVERGNE
Recent Study by Federal Reserve
Drake
Drake University
Wayne Passmore, an economist at the Federal
Reserve Bank has recently completed a study on
the impact of GSE’s
The GSE’s have a funding advantage
Slightly lower mortgage rtes for a few borrowers
Implicit subsidy from government relationship
Implicit subsidy responsible for much of GSE
Market Value
MBS have not increased homebuilding
Creation of a GNMA pass
through
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The loan pool must have standard features in
terms of single family or mutli family, maturity
etc.
The originators forward the pool to GNMA with
supporting documentation requesting GNMA to
guarantee the securities to be backed by the pool
After review a pool number is assigned if the
pool is accepted
Sundaresan 2002
Creation of a GNMA pass
through
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The originators transfer the mortgage documents
to custodial agents and send pool documents to
GNMA
Originators look for investors (dealers, investment
banks etc) willing to buy a given amount at a
specified price
Creation continued
UNIVERSITE
D’AUVERGNE
Drake
Drake University
GNMA issues the guarantee following review of
the documentation.
Originators continue to service the loans.
The GNMA MBS is not a debt of the issuer, it is a
representation of the loan pool with payments
guaranteed by Ginnie Mae
Fees for a typical GNMA pool
UNIVERSITE
D’AUVERGNE
Drake
Drake University
44 basis points are retained by the servicer for
servicing fees
Ginnie Mae receives 6 basis points for the
guarantee. The issuer is guaranteeing Ginnie
Mae against defaults by the homeowner and
Ginnie Mae guarantees against defaults by the
issuer.
The investor then receives approximately 50
basis points less than the coupon of the loan
portfolio.
Sundaresan 2002
Price Quotes
UNIVERSITE
D’AUVERGNE
Drake
Drake University
GNMA’s are quoted in 1/32 of a point
Quotes depend upon a pool factor pf(t)
representing the % of the initial mortgage pool
balance outstanding
Bt
p f (t ) 
P
where :
B t is the balance at date t
P is the original blanace
Sundaresan 2002
Market Value
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Consider an investor with $20 million of a $100
million issue with a pool factor of .9 and a price
of 9316/32
Par value remaining = 20 (.9) = 18 million
The value is then price x par value x pool factor
Market Value = (.9350) (20)(.9) = $16.38 Million
You would need to also account for accrued
interest to find the actual cash price.
Sundaresan 2002
Accrued interest
UNIVERSITE
D’AUVERGNE
Drake
Drake University
SD  M
1
ait 
c  B
30
12
where
SD  settlement Date, M is the first day of month
c  coupon rate B  balance
Assume a coupon rate of 9% and 20 days into
the month
20
1
ait  (.09) (18,000,000)  90,000
30
 12 
Sundaresan 2002
UNIVERSITE
D’AUVERGNE
Trading and Settlement Procedures
Drake
Drake University
Agency pass throughs are identified by a pool
prefix number.
TBA trade – a trade based on an agency pass
through prior to the pool of mortgages being
established. Generally, there will prior
agreement on agency type, program, coupon
rates, and settlement date
Market references
UNIVERSITE
D’AUVERGNE
Drake
Drake University
At a given point in time there may be many seasoned
issues of an agency security with the same coupon rate.
For example in early 2000 there were more than 30,000
pools of 30 year Ginnie Mae MBS’s with a coupon rate of
9%.
Each pool may be from a different area of the country or
from several regions.
Dealers will refer to all of these as Ginnie Mae 9’s even
though they have different prepayment characteristics. If
the investor does not specify a pool number, the dealer has
the option to deliver any of the pools.
Non Agency Pass
Through Securities
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Often non agency mortgage pass throughs will
attempt to increase their rating
External Credit Enhancement
third party guarantees of losses up to a
predetermined amount. Often these are in the
form of a corporate guarantee , a letter of credit,
pool insurance or bond insurance
Internal Credit Enhancement
Reserve funds
Over collateralization
Senior/subordinated structure
Prepayment conventions
UNIVERSITE
D’AUVERGNE
Drake
Drake University
In order to value a MBS the pattern of
prepayments needs to be forecasted.
To do this the pool needs to be looked at and
some assumptions need to be made concerning
the payment of the pool.
Measuring prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Constant Monthly Mortality
Assume that there is a 0.5% chance that the
mortgage will be prepaid after the first year.
The 0.5% is the single month mortality rate (or
SMM)
Given the SMM it is easy to compute the
probability that the mortgage will be retired in
the next month.
The probability that the mortgage survived the
first month is 1-0.005 = .995 or 99.5%
Measuring Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Given a 99.5% chance that the mortgage
survived the first month, and a 0.5% SMM for
the second month the probability that the
mortgage will be retired in the second month is:
0.50%(.995) = 0.4975%
Continuing in the same manner the yearly
prepayment rate could be found.
Conditional Prepayment Rate
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Let CPR be the conditional prepayment rate. The
probability that the mortgage survives one year is
(1-SMM)12 which should equal (1-CPR)
or
(1-SMM)12=(1-CPR)
CPR = 1-(1-SMM)12
this assumes that prepayments will be the same
through time which is not consistent with the
empirical evidence
Conditional Prepayment Rate
(CPR)
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The industry convention is to use an annual
prepayment rate based upon the historical
prepayment observed by the FHA. The CPR can
then be easily transferred back to a monthly rate
(the single month mortality rate (SMM))
SMM = 1 - (1-CPR)1/12
If the CPR is 6% the SMM is equal to
1 - (1-.06)1/12 =.005143
Calculations
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Prepayment based upon the SMM
Estimated Prepayment for month t
 beg mortgage balance scheduled principal
 SMM

for month t
payment for month t




Using the SMM above assume we own a pass
through with a beginning balance of 290 million
and principal repayment of 3 million scheduled
Estimated Prepayment would be:
.005143(290,000,000-3,000,000)=$1,476,041
The PSA benchmark
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The Public Securities Association prepayment
benchmark is expressed as a monthly series of
conditional prepayment rates.
The PSA benchmark assumes that prepayments
start slow then increase
Market Convention
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The CPR has been shown to level off after thirty
months. The standard CPR used is .2% for the
first month then increasing at .2% each month
until 6% is reached for the thirtieth month and
every month thereafter.
100 PSA
UNIVERSITE
D’AUVERGNE
Drake
Drake University
100 PSA assumes market convention speed of
prepayment:
Using the convention of a CPR of 0.2% for the
first month increased by 0.2% each month for
the next 30 months
After 30 periods a CPR of 6% for the remaining
years of the mortgage
PSA is then expressed as a percentage of 100 PSA
benchmark.
PSA benchmark
UNIVERSITE
D’AUVERGNE
Drake
Drake University
For Example a PSA of 150 means that the pool
prepays at an expected rate 1.5 times as fast as
the PSA benchmark
Notice the CPR is a multiple of the PSA not the
SMM
Monthly cash flow construction
(See Handout)
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Assume that you have a $400 Million 7.5% pass
through with a WAC of 8.125% and a WAM of
357 months assuming 100PSA
Note: the pass through has been seasoned three
months this makes the CPR = 0.8%
Example Continued
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The SMM for the first month is then:
SMM=1-(1-CPR)1/12=1-(1-0.008)1/12=0.000669124
The scheduled mortgage payment would be
400,000,000=PMT(PVIFA357,8.125%/12)=2,975,868.24
(this changes with each payment due to
prepayment)
Monthly cash flow construction
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Interest is found from the pass through rate of
7.5% $400,000,000(.075)/12 = $2,500,000
The scheduled principal is found using the WAC
and the payment calculated earlier.
Total interest scheduled from the pool is =
400,000,000(.08125)/12 = 2,708,333.333
Given a payment of 2,975,868.24 the scheduled
principal is: 2,975,868.24 - 2,708,333.333=
267,534.91
Monthly Cash Flow Construction
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The expected prepayment for the month is then
found using:
 beg mortgage balance scheduled principal
 SMM

for month t
payment for month t

For the first month this is equal to :
.000669124(400,000,000-267,534.91)
=267,470.58
total principal is then equal to
267,534.91+267,470.58=535,005.49



Monthly Cash Flow Construction
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Total Cash Flow is then the sum of the interest
paid to the pass through investor and the total
principal
=2,500,000+ 535,005.49=3,035,005.49
the next months outstanding balance is then
reduced by the amount of principal
=4,000,000-535,005.49 =399,464,994.51
the next month would proceed the same way with
the exception of the scheduled mortgage
payment.
Note
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The PSA convention is the result of past
experience on FHA prepayments. The empirical
evidence suggests a level CPR after 30 months of
6%. The first 29 months are just a linear
approximation starting at zero months and
ending at 29.
The same method is used regardless of the
maturity of the pass through, and the rate (ARM
or fixed.) It is at best an quick and easy
estimate.
Non Agency CPR convention
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Defaults and other problems characterize the
nonagency pass throughs, therefore there is a
PSA standard default assumption (SDA)
0.02% fro the first month increasing by 0.02%
each month up to .6% at 30 months
.6% form 30 to 60 months
61 months to 120 months default rates decline to
0.03%
120 to maturity default rates remain at 0.03%
Factors Affecting Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
1.
2.
3.
4.
Prevailing Mortgage Rates
Characteristics of the Mortgage Pool
Seasonal Factors
General Economic Activity
Factors Influencing Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Prevailing Mortgage Rates
Spread between Original Rate and Prevailing rate
If the original rate is greater than the prevailing rate there
is a higher probability of prepayment. These mortgages
are often referred to a premium mortgages. (the opposite
case would produce discount mortgages)
Path of Rates
If rates went up then down prepayments will be higher. If
rates decreased then increased and decreased again,
prepayments will not be as high since many took
advantage the first time.
Factors Influencing Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Prevailing Mortgage Rates
Level of rates
As the level of rates declines turnover increases as
more homes become affordable.
Factors Influencing Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Characteristics of Underlying Mortgage Loans
Seasonality (more in the Spring and summer less
in the winter)
Age of Mortgage Prepayments are higher during
the early stages of the mortgage and the final
periods prior to maturity
Type of Loan (ARM, balloon etc)
Factors Influencing Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Seasonality (more in the Spring and summer less
in the winter)
This mirrors the amount of home buying activity.
This results in a slight lag of the impact of
prepayments on the MBS market since there is a
lag in passing through the prepayments.
Factors Influencing Prepayment
UNIVERSITE
D’AUVERGNE
Drake
Drake University
General Economic Factors
Housing Costs
Geographic Location
Family Circumstances
Economic Activity
Extension and Contraction Risk
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The investor is not sure of the timing of the cash
flows since it depends upon the timing of the
prepayments. Therefore they face other risks
Extension Risk – there is a change in the market
that causes fewer prepayments and the length of
time prior to the repayment increases due to
fewer prepayments
Contraction risk - Prepayments increase as rtes
decline causing shortening of the length of the
MBS and reinvestment risk.
Collateralized Mortgage
Obligations.
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Provide semiannual payments
The payment of principle is allocated among
different tranches that represent the repayment
of principle.
Allows investors to attempt to match their
willingness to accept prepayment risk to a
security
Average Life
UNIVERSITE
D’AUVERGNE
Drake
Drake University
This measure represents the average time to receipt of
principal repayments.
T
t(projecte d Principal received at time t)
Average Life  
12(Total Princiapl)
t 1
Sequential pay CMO
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The first Tranche receives principle until the total
principle in the tranche is paid off. The CMO will
be explained by a Weighted average maturity
and a weighted average coupon that represents
the mortgages in the CMO.
The actual timing of the payoff will depend upon
the prepayment rate. The speed of prepayment
can be estimated, but it will not be know in
advance.
Example: Same starting point as
before
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Assume that you have a $400 Million 7.5% pass
through with a WAC of 8.125% and a WAM of
357 months assuming 100PSA
Four payment tranches
Tranche
A
B
C
D
Par Amount
Coupon
194,500,000 7.5
36,000,000
7.5
96,500,000
7.5
73,000,000
7.5
Example continued
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Each tranche received interest upon the
outstanding principal in the tranche. Tranche B
receives no principal until Tranche A has
received all of its principal likewise tranche C
follows B and D follows C.
Therefore after the fist period, tranche B
receives $36,000,000(.075)/12 = $225,000
Tranche B continues to receive 225,000 each
period until the principal has been paid off to
tranche A. The pay down of principal is
calculated as before…
CMO
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The CMO has allowed investors to choose a
tranche that best matches their desire to accept
prepayment risk (match the timing of cash flows
to their needs).
However, there is still variability in the actual
timing of the tranches since prepayments may
not occur at the estimated speed.
Accrual Tranches
UNIVERSITE
D’AUVERGNE
Drake
Drake University
In the example all the tranches receive interest
payments. Often this is not the case. It is
possible for one or more tranches to be an
accrual bond.
The interest that would have been paid on the
tranche now goes to paying down the debt on
the earlier tranche. This shortens the maturity of
the other tranches.
Floating Rate Tranches
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Any fixed rate tranche can be converted to a
floating rte and inverse floating rate tranche
(adding a tranche to the total structure of the
CMO)
Whatever portion of the balance is not the floater
will be the balance of the inverse floater.
You can also use only a portion of the tranche to
create the floaters.
Interest Only and Principal Only
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Another structure is to allocate only interest or
only principal to a given tranche.
The IO investor will want the prepayments to be
slow since it extends the life of the CMO. The PO
investor will prefer that the prepayments arrive
quickly
Structured IO
UNIVERSITE
D’AUVERGNE
Drake
Drake University
IO tranches are often referred to as structured
IO’s to distinguish them from a stripped IO.
In this case the coupon rate for one tranche is
different from the coupon rate on the collateral.
For example the rate may be less than the
interest rate on the collateral. The excess interest
is then allocated to a separate tranche.
Notional IO classes
UNIVERSITE
D’AUVERGNE
Drake
Drake University
This is a class that receives the excess coupon
interest. It has no par value, only a notional
value upon which the payments are based.
Planned Amortization classes
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Includes a set principal payment schedule which
must be followed (if the actual prepayments fall
within a given window then a schedule of
principal payments is followed).
PAC bondholders have priority over the other
classes within a CMO. Therefore PAC bonds
come at the expense of support or companion
bonds which absorb the prepayment risk (they
forego principal)
Planned Amortization Class
Tranche (PAC) CMO’s
UNIVERSITE
D’AUVERGNE
Drake
Drake University
If prepayments are within a specified range, the
cash flow pattern is known.
PAC bondholders have priority over the other
tranches in the issue.
The non PAC bonds are termed support or
companion bonds.
The minimum is based off of a range of PSA
assumes an upper and lower collar.
PAC Bonds
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The guaranteed principal payment is the
minimum of the principal repayments of the two
possible PSA’s.
The prepayment can occur even if prepayment
occurs at a rate different than the original collars
PAC bonds
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The support bonds provide protection against
both extension and contraction risk. Therefore
the PAC will not shorten even outside of the
initial PAC bands.
The wider band of guaranteed prepayments
creates an effective collar in which the
prepayments stay constant.
PAC Bonds
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The support bond will not receive any principal
until the PAC has received all of the scheduled
prepayment.
If the prepayment is slower than scheduled any
principal that might have gone to the support
bond (if the schedule was met) will now go tot
the PAC.
PAC Bonds
UNIVERSITE
D’AUVERGNE
Drake
Drake University
If the prepayment is faster than originally
planned the support bond will receive faster
prepayments, eliminating the PAC paying off
quicker.
If the principal of the support bond is paid off
early then the PAC will decrease in maturity.
Quick Question
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Will the schedule of principal repayments be
satisfied if prepayments are faster than the initial
upper collar?
It depends upon when the prepayments occur….
The initial assumption was that the support
would be eliminated at the upper collar. It
repayments were initially slow, there is extra
support available.
Quick Question 2
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Will the schedule of principal repayment be
satisfied as long as prepayments stay within the
initial collar?
Not always the initial structure only guarantees
that the schedule will be met if it is at either of
the extremes. If prepayment varies there is a
possibility that the PAC is busted.
Answer continued
UNIVERSITE
D’AUVERGNE
Drake
Drake University
IF the PAC has been prepaying at the faster PSA
the amount of support decreases and the lower
collar of the effective collar increases above the
initial collar.
Final Question
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Given the first two questions does a wider initial
collar imply that there is less risk that the
repayment will not fit the schedule?
No the actual prepayment experience once the
PAC is seasoned is what is important.
Given prepayment experience, the effective collar
is what should be investigated.
Increasing Prepayment
Protection
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Lockout Structure: Eliminating the earlier or
shorter PAC from the package creating more
support bonds
Changing the prepayment rules in the event that
all support bonds are paid off. One possible
structure: reverse PAC -- requires any extra
principal to go to the longer maturity PAC’s
Targeted Amortization Class
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Instead of guaranteeing a range of rates initially
a TAC bond guarantees a specific targeted rate.
The bond is therefore only protected against
contraction risk, not extension risk.
Stripped Mortgage Backs
UNIVERSITE
D’AUVERGNE
Drake
Drake University
1) Synthetic coupon pass throughs
results in a cash flow different than the underlying
coupon
2) IO and PO strips
Principal is at a discount from par. IO has a
notional value.
3) CMO strips
Principal Only Strips
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The principal only strip is purchased at a
substantial discount to par value.
The faster the prepayments, the higher the
return to the investor since the return is
determined only by the speed with which the
investor will receive the principal
Interest Only Strips
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The Interest is based upon the amount of
prepayments outstanding therefore the investor
will hope that the prepayments will be slow.
It is possible for the IO investor to not recover
the amount originally paid if prepayments are too
fast.
Introduction
UNIVERSITE
D’AUVERGNE
Drake
Drake University
MBS’s represent the largest market for assets which have
been securitized, however many other similar assets
exist.
Types of assets
Auto Loans
Credit Card Receivables
Home Equity Loans
Manufactured Housing
SBA Loans
Student Loans
Music Royalty Receivable
Equipment Leases
Home Equity Loans
Parking Ticket Receivables
UNIVERSITE
D’AUVERGNE
Outstanding Mortgage and Asset
Backed Securities in US
Drake
Drake University
5802.3
6000
5077.9
5000
4006.9
3536.2
4000
Billioins $
4330.4
3146.8
2840.4
2595.7
3000
2000
1000
0
1995
1996
MBS
Manufactured Housing
1997
Credit Card
Student Loans
1998
1999
2000
Auto
Equipment Leases
Securitization Davidson et al Wiley Pub. 2003
2001
2002
Home Equity Loans
Outstanding $ Value of
ABS by Underlying Asset
UNIVERSITE
D’AUVERGNE
Drake
Drake University
1800
1600
1400
$ Billions
1200
1000
800
600
400
200
0
1995
Credit Card
Auto
1996
1998
1997
Home Equity
Student Loans
2001
2000
1999
CBO / CDO
Euqipment Loans
Bond Market Association, 2003 is as of Sept 30, 2003
2003
2002
Other
Manufact. Housing
Issues
UNIVERSITE
D’AUVERGNE
Drake
Drake University
All of these assets face both credit risk and
prepayment risk, they are often referred to as
credit sensitive structures products.
Corporations offer these as a means of
separating the assets used in the collateral from
the assets of the firm. Often this results in a form
of credit enhancement that can decrease
borrowing costs, however there can also be
increased costs that offset the decreased
borrowing cost.
Features of an ABS
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Amortizing vs. Nonamortizing
Amortizing loans such as cars and mortgages have
a set schedule of payment of principle and
interest. Therefore projecting prepayments is an
important part of analyzing the cash flows
generated.
Nonamortizing assets only have a minimum
payment and there is not a schedule of principle
repayments (credit card receivables for example).
Therefore there is not a prepayment risk.
Features of ABS
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Fixed or Floating rates
Generally floating rate asset backed securities are
backed by floating rate assets. Fixed rate loans
can also be used to create floating rate asst
backed securities for example the floating
tranches of a CMO.
Features of ABS
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Credit Enhancements
External Credit Enhancements – third party
guarantees
Corporate guarantee
Letters of credit
Bond insurance
Internal Credit Enhancements
Reserve Funds (cash reserve or Excess servicing
spreads)
Overcollateralization
Senior / Subordinated
Features of ABS
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Pass-through
Each holder is entitled to a portion share of the cash flow
from the underlying assets
Pay Through
The pool loans are split into tranches similar to a CMO,
however a pass-through does not need to be created first.
Often the senior tranches are split apart into smaller
tranches. This creates a transfer of risk from the senior to
subordinated tranches (credit tranching). Prepayment risk
can also be transferred (time tranching or prepayment
tranching)
Features of ABS
UNIVERSITE
D’AUVERGNE
Drake
Drake University
Option Clean up Call provisions
Percent of (collateral, bond, or tranche) call -outstanding bond can be called if the outstanding
(collateral balance, bonds outstanding or
outstanding tranches) falls below a given level
Call on or after a specified date.
Auction call -- called if the collateral can be sold at
auction at a price greater than par value at a
given date.
Insurer Call – Insurer can call if the collateral’s call
history reaches a predetermined level.
Differences in ABS Market
UNIVERSITE
D’AUVERGNE
Drake
Drake University
The cash flows from the assets are often not as
predictable as in the case of mortgages.
For example: Home Equity Lines of Credit
Borrowers have open end line of credit that can
be accessed at any time.
This creates risks in the outstanding balance as
well as prepayment.
Increased default risk, especially automobile
loans, and credit card receivables.