Mortgage-Backed Securities

1. Mortgage-Backed Securities • MBS deserve much of the credit for our very efficient secondary mortgage market • Has enabled homebuyers to tap broad national and even international sources of capital • “Agency” MBS have not been a default problem • Even though sellers have no residual interest in the loans they sell, it is a “repeated game” with the two GSEs and a lender who wants to continue to play is evaluated by the quality of the loans sold • Locking up mortgages in an MBS does create problems for those who want to modify loan terms • Not such a big issue for Agency pass-through MBS • Mostly backed by FRMs where modification is less of an issue • The next section will discuss the operation of the major agency mortgage-backed security programs in detail • From an investor’s perspective, these securities eliminate default risk • Prepayment risk is unaffected by MBS structure and is the major source of risk and return in Agency MBS

2. Mortgage-Backed Securities • A mortgage-backed security is a financial asset promising a stream of future payments to the holder. • A “pool” or group of individual mortgage loans serve as the collateral for the financial asset. • Mortgage pass-through securities are financial assets that pay the holder a pro-rata share of the cash flows from a pool of mortgages

3. Agency Mortgage Securitization Channels Conventional Financing Government Financing Conforming Loans FHA Loans VA Loans Non-Conforming Loans Subprime Loans “Alt” A Loans Jumbo Loans Agency Channel Government Channel Private Conduits • Commercial Banks • Insurance Companies • Ginnie Mae • Fannie Mae • Freddie Mac * Fannie Mae and Freddie Mac are also minor players in the government financing market segment * Private Conduits may also issue securities based on conforming loans

4. How an MBS is Created • Mortgage originators process applications and originate new loans • The originator uses its own funds or funds it has borrowed from a bank to fund the loans and hold them in the “warehouse” . • After the originator has accumulated enough loans for an MBS, the originator contacts FNMA/GNMA/FHLMC and provides information describing the individual loans. • A pool can be as small as 20-50 loans ($2-5 million) • lenders must have previously established a relationship with the agency and followed the “guide” for originating loans • Information is submitted electronically

5. How an MBS is Created • The agency reviews the information on the loans and approves or rejects the loans • For lender’s with established track records, the agency depends on lender’s representations and warranties combined with after-the-fact spot checks • Repurchases • Automated underwriting systems now expedite the process by assuring lender and agency that the loan meets the requirements and automatically transmitting the information about the loans • The agency “buys” the loans by exchanging a guaranteed MBS security with a particular coupon rate and “face value” equal to the sum of the principal of all loans. • Although technically the GSE “buys” the loans, the real economic event is that the GSE “guarantees” the security.

6. How an MBS is Created • The originator sells the MBS just like any security. • Investment banks and commercial banks make a market • Typically the originator has a commitment to buy the MBS as he is originating the loans. • Knows what yield he must achieve on originations

7. Features and Benefits of Pass-Through Securities General Description $175,000 Interest and Scheduled Principal Loan #1 Passthrough: $1 million par Avg loan: $250,000 $250,000 Interest and Scheduled Principal Loan #2 • Pooled Monthly Cashflow: • Interest • Scheduled Principal • Prepayments $350,000 Interest and Scheduled Principal Loan #3 Rule for distribution of cash flow: pro rata basis $225,000 Interest and Scheduled Principal Loan #4 Avg loan is $250,000 Total Pool Amount: $1 Million

8. $$ Monthly P&I Payment All Monthly Principal plus interest at pass-through rate $$ Monthly P&I Payment Less servicing spread Paying Agent Capital Market Investor Borrower Servicer deducts Servicing Spread • Cash flows include: • Scheduled interest • Scheduled principal repayments • Unscheduled payments • (including partial prepayments and prepayment of the entire outstanding balance of the loan) 7.00% (.25%) 6.75% (.25%) 6.50% Gross Mortgage Coupon (Note Rate) Servicing Fee to Issuer (Servicer) Guaranty Fee (GSE) Pass-Through Coupon to Investor Features and Benefits of Pass-Through Securities Cash Flow Characteristics • Cash flows generated by mortgage pool are passed on to the investor net the servicing spread Pass-Through Coupon = Gross Mortgage Coupon - Servicing Spread Servicing Spread = Servicing Fee + Guaranty Fee

9. Features and Benefits of Pass-Through Securities Cash Flow Characteristics • Servicing fee provides compensation to the issuer (or servicer) for assuming loan administration responsibilities including: • Record maintenance and custody • Cash management and accounting • Collections and delinquency management • Investor reporting (as required) Servicing Fees in U.S. Market Agency Conduits ( Fannie Mae & Freddie Mac ) Government Conduit ( Ginnie Mae ) • Typically range between 25 and 37 basis points depending on loan and servicer characteristics • Higher servicing fee for adjustable rate loans due to increased complexity with cash management responsibilities • Negotiable with agency -- servicers with strong relationship and high servicing standards can receive reduced servicing fees • Generally 44 basis points (can vary in special programs)

10. Features and Benefits of Pass-Through Securities Cash Flow Characteristics • Guaranty fee is compensation provided to the financial guarantor for: • 100% guaranty of timely payment of principal and interest to investors • Used to cover issuer credit risk in the event of default by issuer/servicer • Assumption of most of the credit risk associated with underlying assets • Servicer retains certain obligations related to defaulted loans Guaranty Fees in U.S. Market Agency Conduits ( Fannie Mae & Freddie Mac ) Government Conduit ( Ginnie Mae ) • Typically under 25 basis points • Negotiable with agency -- originators with high underwriting standards and clean delinquency history can typically negotiate a guaranty fee well under 25 basis points • In return the issuer receives an “implicit government guaranty” given the government charter of the agencies • Generally 6 basis points • Both the underlying loans and the securities are backed by the full faith and credit of the U.S. government

11. Features and Benefits of Pass-Through Securities Pro Rata Distribution Example: If 1,000 certificates are issued relative to a mortgage pool, each certificate would represent the right to 1/1000 of each payment of principal and interest on each mortgage in the pool. • Pass-through securities are issued as a single class with each investor having a pro-rata interest in the total mortgage pool: Investor receives principal and interest on a monthly basis in an amount equal to its proportionate share of the security If a loan in the pool defaults, the investor receives a “Prepayment” equal to the principal amount of the defaulted loan For GNMA securities, prepayment occurs after the foreclosure is complete For FNMA/FHLMC securities, it generally occurs about 90-120 days after the initial default

12. How an MBS is Created • Typically the issuer promises to service the loans/MBS • Combines self-originated loans with loans acquired from other lenders and brokers • Servicing responsibilities can vary from program to program • GNMA servicers promise to advance interest and scheduled principal payments during process of foreclosure • FNMA/FHLMC servicers typically do not • Smaller loan originators can either sell the loans to another lender who becomes the MBS issuer or arranges to sell the servicing rights and obligations to an entity that specializes in servicing.

13. “Pass – Through Securities” • The major Agency MBS programs (GNMA/FNMA/FHLMC) are all “pass-through” programs. • In a “pass-through” security, essentially all the payments received from borrowers in a month are simply “passed through” or paid to the investors who purchased the MBS. • All regularly scheduled payments that are made by borrowers are passed on to the investors • If some borrowers prepay (either in full or partially), the extra payments are passed through to the investors • If a borrower fails to make a payment, the “guarantor” must deposit an advance equal to the missing payment. • In general, the originator/issuer must make the advances related to delinquencies - at least for a while • If a loan is terminated because of a default, the “guarantor” must deposit an advance equal to the unpaid loan balance, which is then passed on to the investor. • In general, the FNMA/FHLMC “buy out” loans from the pool when they become seriously delinquent • In GNMA pools, the servicer must advance delinquent payments until the default is resolved via sale of the property and collection from FHA or VA is received.

14. Key Terms • WAC: Weighted average coupon of the individual loans in a pool • WAM: Weighted average remaining maturity of the loans in a pool • Servicing Fee: Fees paid to the loan servicer for servicing the pool of loans plus guarantee fees paid to the guaranteeing agency • GNMA pools have standard servicing fee of 50 basis points • FNMA/FHLMC servicing fee is the difference between the WAC and the Pass-Through Rate • Pass Through Rate: The rate of interest promised to the purchasers of the MBS • Example: GNMA pools backed by 6% mortgages will have a pass through rate of 5.5% • FNMA/FHLMC: If a pool of loans has a WAC of 7.75%, the issuer can assign a pass-through rate of 7% and earn a 75 basis point servicing fee. • Or they could assign a pass-through rate of 7.25% and earn a 50 basis point servicing fee. • The pass-through rate must be set below the lowest coupon rate on any individual loan by enough to cover the guarantee fee and a minimum servicing fee for the loan. • Note that the WAC-Servicing Fee= Pass-through rate ALWAYS!

15. Key Terms (continued) • WALA: Weighted Average Loan Age • Note: WAM can differ from 360-WALA because of partial repayments which shorten the remaining maturity • Pool Factor: The proportion of the original principal balance outstanding as of the stated factor date • TBA: “To Be Announced” Trading in MBS is generally for forward delivery with settlement for each type of MBS occurring once per month. In TBA trading, the purchaser does not know the specific pools being delivered until just before settlement • Purchaser only knows the guarantor (GNMA/FNMA/FHLMC), the pass-through rate, the type of MBS and the seasoning (new, moderately seasoned, seasoned) • E.g., New 6% FNMA 30 year MBS

16. Different MBS Programs

17. How an MBS is Created • Lenders look to the MBS prices quoted every day by investors • For example, based on the prices from Bloomberg, the originator might see that investment bankers are bidding a price of 98-30 for a 5.0% MBS delivered in January. • (Based on Bloomberg Bid for FHLMC Gold shown on next page)

19. How an MBS is Created • The lender could promise to sell for Jan delivery an amount equal to $10 million • The lender now needs to originate mortgage loans with coupons between 5.5% and 7.5% • Assume he originates $10 million of loans with 5.50% coupons and charges 2.5 points. (Consistent with then current Countrywide Pricing). Further assume that his costs of origination are 1 point. • Lender advances $ 9.750 million ($ 10 million less 2.5 points) and incurs costs of $.1 million • Total out of pocket: $9.85 million

20. How an MBS is Created • Once the pool is created, he contacts FHLMC and swaps his loans for a 5.0% MBS • Commits to pay 15-20 bp to FHLMC for Guarantee fee • Guarantee fees are negotiated between lender and FNMA or FHLMC based on lender’s past performance. • Generally between 15 and 25 bp • Delivers the MBS to Investment Banker for a price of $9.89375 million. • Profit on Sale:9.89375-9.85=43,750 or just less than ½ point on the face value of the loans • The remainder of the 50 bp difference between the coupon rates on the loans and the coupon rate on the MBS is “servicing fee” • In this case: 30-35 bp • This servicing contract could also be sold to enhance profit today.

21. How an MBS is Created • Issues that can arise: • What if the originator cannot originate $10 million of loans in the next few months? • He has made a “firm commitment” to deliver an MBS • What if market rates fall and the lender cannot originate loans with coupons of at least 5.5%? • What if borrowers do not close the loans they committed to ? • What if rates rise and the lender originates 6-7% loans instead of 5.5% loans?

22. Let’s Look at One Possibility • Suppose that customers object to paying 2.5 points and instead, most take out 6% loans with 0 points. • Lender now advances $10 million ($10 million less 0 points) and incurs $.1 million in costs • Lender still sells the 5% MBS at 98-30 and receives $9.89375 in cash from dealer • Profit from sale: $9.89375-10-.1=-206,250 • But, the lender now has a servicing contract that pays (after guarantee fees) a total of 80-85 bp instead of 30-35 bp • The cost of servicing a 6% mortgage is pretty much the same as the cost to service a 5.5% mortgage. • Say servicing costs 10-15 bp on average • This leaves a stream of “excess” servicing fees of approximately 70 bp

23. What’s this Worth? • We can use our old friend to estimate the value contingent on the duration

24. What’s This Worth? • Option A: originate 5.5% loans with 2.5 points and sell the servicing • Option B: originate 6.0% loans with 0 point and sell the servicing

25. How Does an MBS Originator Earn Money? • Three sources: • Charge fees that exceed costs and discount • Achieve a larger servicing spread than it costs to service the loans • Servicing costs $50-100/year/loan • 10 bp on a $100,000 loan generates revenue of $100 in the first year • declines every year thereafter • ignores value of escrows • Sell the loans for a higher price than it advances • Note 1 & 3 are close to equivalent

26. How an MBS is Created • There are other ways to create an MBS • FNMA/FHLMC could buy loans for cash from a large number of small originators • Combine these loans into single large pools of several hundred million • Portfolio lenders could ask to “securitize” their existing portfolios of older loans • These transactions are called portfolio swaps

27. Portfolio Lender v. MBS Originator • Portfolio lenders • profit is primarily earned from the spread between coupon rate and the cost of money • volume is limited by the amount of lendable funds • MBS Originators • profit is earned from fees for services • originating • servicing • volume is limited by the overall demand for new loans and ability to compete

28. Mortgage-Backed Securities • Two Major Risks of Mortgages: • Default Risk • For agency pass-through MBS, this is taken on by agency guarantor • Prepayment Risk: • mortgage pass-through securities simply aggregate cash flows from a number of different mortgages and pass them through • This aggregation provides diversification of prepayment risk– but does not eliminate it. • Consider the case of 100 investors each owning 1 mortgage v. owning 1% of a pool of 100 mortgages.

29. Dealing with Default Risk • Starting with GNMA MBS the major programs all provide the investor solid protection against default risk. • If a mortgagor stops making monthly payments, the guarantor must advance the monthly payment to the investors while the servicer tries to collect on the loan • If there is a deficiency after foreclosure, the guarantor must pay to the investor

30. Dealing With Prepayment Risk • Because MBS programs “pass-through” all prepayments, they do not eliminate investor concerns about prepayment risk • MBS aggregate many mortgages so that prepayment risk is not “all or nothing” as it is with an individual loan • Nevertheless, because prepayments are highly correlated across loans with similar characteristics, diversification is less valuable here than it would be in insurance for example. • As we saw earlier in the course, with prepayment uncertainty, it becomes very difficult to estimate what yield you will earn on a loan you purchase with a price different than par.

31. Prepayment Risk • When purchasing a single loan, lenders ( in the early days of the secondary market) used the “prepay in twelve” convention for pricing loans • Based on a single loans • Assume regular payments are made as scheduled for 12 years and then the remaining balance is paid in full. • Works reasonably well for small differences between coupons and required yields • Recall that for a loan purchased at par, the time to prepay makes no difference in the yield earned by the lender • Most buyers refused to pay above par for a loan • Resulted in faster than expected prepayments providing higher than expected yields.

32. Prepayment Risk • With wide variations in interest rates, the weaknesses of the prepaid in twelve rule became very apparent • Yields are very sensitive to prepay assumption when yield and coupon are significantly different

34. New Tool for Measuring Prepay Speed • FHA had been insuring loans since 1934. • Accumulated a lot of data on how many claims it paid and how many loans survived and paid premiums • Sorted its data by year of origination of the insurance contract

35. Measuring FHA Experience

36. Table of FHA Experience

38. FHA Experience • Note that the sum of the probabilities over the thirty years exceeds 100% • The probabilities are conditional on survival to that year. Thus they apply to the declining balance • Think of a series of steps each moving halfway to the door. Each subsequent step gets smaller. • We can use these probabilities to estimate cash flows from prepays

39. FHA Experience • Investors could purchase MBS based on an assumed prepayment “speed” expressed as a multiple of the base FHA experience • The actual experience of different pools could be reported and used by investors to estimate the correct speed to use for pricing.

40. PSA Base • Dealers and Investors were troubled by the fact that FHA experience kept changing over time as new data was entered and older data dropped • These frequent changes never changed the general pattern-- only the minor ups and downs that no one put much faith in • Consequently, the PSA adopted a “smoothed” FHA experience curve which is now called the PSA curve.

42. CPR • CPR stands for constant (conditional) prepayment rate. • FHA historical experience showed that after a period of “seasoning”, mortgage loans experienced about a 6% annual prepayment rate • In any given year, 6% of the remaining loans would prepay or otherwise disappear from the pool. • For a while, let us ignore the seasoning period and the “random” fluctuations around 6% • If 6% of the loans prepay in a year, then .514% prepay in a month • With a monthly rate of .514%, there will be 6% fewer loans at the end of the year than at the start. • We call this monthly rate, Single Monthly Mortality or SMM for short

49. 0% CPR

50. 0% CPR