Mortgage Backed Securities

Mortgage Backed Securities MB 77

Outline • The concept of securitization • Significance of securitization • Creation of MBS • Types of MBS • Cash Flows Features and Prepayment Risk • Prepayment Convention • Prepayment Risk and Asset-Liability Management

Securitization • A framework/process in which some illiquid assets of a corporation or a financial institution are transformed into a package of securities backed by these assets, through careful packaging • Credit enhancements • Liquidity enhancements, and • Structuring

Example of Securitization • Accounts receivables constitute an important asset of most corporations. Yet, this asset has credit risk stemming from the varying credit reputations of the counterparties. • The terms of the accounts receivables could also differ from one counterparty to another counterparty, depending on the transactions. In effect, the combination of credit risk and idiosyncratic nature of each component in the accounts receivables makes them illiquid.

Motivation for Securitization • Reducing the Size of the B/S • Improving Return on Capital • Less capital requirement to meet capital requirement standards • Allows poorly rated firms to participate in certain segments of the capital market that are otherwise unavailable to them

Players in Securitization • Assets originate with some firm—often the firm whose assets back the security is referred to as the originator • Assets are acquired from the originator by the issuer • The issuer typically achieves a bankruptcy remote status by creating a special purpose vehicle (SPV). The SPV assures that the pool of assets is held distinct from the originator, so that bankruptcy or insolvency of the originator will have no consequences on the status of the pool of assets held by the SPV • A trustee will be appointed to ensure the above

Types of Pass-Through Securities • Agency Pass-Throughs • GNMA • FNMA • FHLMC • Private Label Pass-Throughs

GNMA (Ginnie-Mae) • GNMA: finances FHA and VA loans. Typically, single family, low-income loans. GNMA pass-throughs guaranteed by GNMA and are issued by GNMA approved originators and servicers. • GNMA guarantee of full and timely payment of interest and principal is backed by the full faith and credit of the U.S. Government • Historically, prepayments are less volatile relative to other agency pass-throughs

FNMA Pass-Throughs (Fannie-Mae) • Buys conventional mortgages • FNMA provides guarantee of full and timely payment of interest and principal, but this guarantee is not backed by the full faith and guarantee of the U.S. Government • Mortgage pools are much more heterogeneous when compared to the pools in the GNMA. • Pool may have mortgages with rates that vary by more than 200 basis points and the loans may be new or seasoned • FNMA covers both FHA and VA loans as well as conventional loans which have a much higher value. • Prepayments are much more volatile

FHLMC Pass-Throughs (Freddie-Mac) • Buys FHA, VA, and conventional mortgages • Guarantees full and timely payment of interest and principal, not backed by a similar guarantee of the U.S. Govt. • Diverse mortgage pool • Prepayments are much more volatile

Private Label Pass-Throughs • Non-agency pass-throughs • Create a secondary market for non-conforming loans, which are conventional loans that fail to meet the size limits and other requirements placed by the agencies • Trade at a spread over the agency pass-throughs

Cash flows of MBS • Cash flow depends on cash flows of underlying mortgages, consists of monthly mortgage payments—principal repayment, interest, and prepayments • The amount and timing of the cash flows passed through to investors are not identical • Prepayments bring uncertainty to the cash flow of a pass-through security

Prepayment Conventions and Cash Flows • To value a pass-through, we need cash flows • Prepayments make it difficult to predict cash flows • Make some assumptions about prepayments • Conditional Prepayment Rate (CPR) is a benchmark for projecting prepayments and the cash flows of a pass-through—it is the fraction of the remaining principal in the pool to be prepaid each month for the remaining term of the mortgage. • Single-Mortality Rate (SMM) SMM = 1- (1 – CPR)1/12 Prepayment rate for month t = SMM × (Beginning mortgage balance for month t – scheduled principal repayment for month t)

PSA Standard Prepayment Benchmark • Expressed as a monthly series of annual CPRs. • Assumes that prepayment rates will be low for newly originated mortgages and then will speed up as the mortgages become seasoned • If t </= 30, then CPR = (6%×t)/30 • If t > 30, then CPR = 6%, where t is the number of months since the pass-through was created • Slower or faster speeds are referred to as some percentage of PSA.

Factors Affecting Prepayment Behavior • Refinancing Incentive • Seasonality Factor • Age of the Mortgage • Family Circumstances • Housing Prices

Prepayment Risk and Asset-Liability Management • Contraction Risk • Extension Risk • Are prepayments always bad for investors in Mortgage-Backed Securities?

Collateralized Mortgage-Backed Securities and Stripped Mortgage-Backed Securities • Why and how a CMO is created? • The Structure of a CMO • CMO classes • Stripped Mortgage-Backed Securities

Types of CMO Tranches • Sequential-Pay Tranches • Accrual Bonds • Planned Amortization Class Tranches (PAC)

Stripped Mortgage-Backed Securities • Interest Only/Principal Only Strips

Principal only benefits if prepayments are faster • IO wants prepayments to be slower, because interest is based on principal amount outstanding

Mortgage Backed Securities