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Securitization Chapter 28

Securitization Chapter 28. Financial Institutions Management, 3/e By Anthony Saunders. Introduction. Securitization: Packaging and selling of loans and other assets backed by securities.

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Securitization Chapter 28

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  1. SecuritizationChapter 28 Financial Institutions Management, 3/e By Anthony Saunders

  2. Introduction • Securitization: Packaging and selling of loans and other assets backed by securities. • Many types of loans and assets are being repackaged in this fashion including royalties on recordings ( David Bowie, Rod Stewart). • Original use was to enhance the liquidity of the residential mortgage market.

  3. Securitization • Government National Mortgage Association (GNMA) • Sponsors MBS programs and acts as a guarantor. • Timing insurance. • FNMA actually creates MBSs by purchasing packages of mortgage loans.

  4. Freddie Mac • Federal Home Loan Mortgage Corporation • Similar function to FNMA except major role has involved savings banks. • Stockholder owned with line of credit from the Treasury. • Sponsors conventional loan pools as well as FHA/VA mortgage pools.

  5. Incentives and Mechanics of Pass-Through Security Creation • Example: • Create a mortgage pool from one-thousand, $100,000 mortgages (Results in $100 million). • Each mortgage receives credit risk protection from FHA. • Capital requirement: $4 million. • Must issue more than $96 million in liabilities due to reserve requirements. (+ FDIC premia).

  6. Further Incentives • Gap exposure • Illiquidity exposure • Default risk by mortgagees • Phoenix, AZ in 1980s. • Default risk by bank/trustee

  7. Effects of prepayments • Good news effects • Lower market yields increase present value of cash flows. • Principal received sooner. • Bad news effects • Fewer interest payments in total. • Reinvestment at lower rates.

  8. Prepayment effects • Prepayments result of sales or refinancing. • Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates. • Methods: • Option pricing approach. • Public Securities Association approach. • Empirical approach.

  9. Option Model Approach • Use option pricing theory to figure fair yield spread of pass-throughs over Treasuries. • Fair price on pass-through decomposable into two parts • PGNMA = PTBOND - PPREPAYMENT OPTION • Option-adjusted spread between GNMAs and T-bonds reflects value of a call option.

  10. Collateralized Mortgage Obligation (CMO) • CMO structure • Prepayment effects differ across tranches (classes). • Z-Class CMO. • Improves marketability of the bonds.

  11. Mortgage-Backed Bonds (MBBs) • Normally remain on the balance sheet. • Regulatory concerns. • Other drawbacks to MBBs.

  12. Innovations in Securitization • Pass-through strips • IO strips • Negative duration. • PO strips • Securitization of other assets • CARDs • Various receivables, loans, junk bonds, ARMs.

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