Mortgage Pass-Through Securities

1. Mortgage Pass-Through Securities

2. Mortgage Pass-Through Securities • Cash flow passed through to the investors are less than the cash flow from the underlying mortgage due to: • Servicing fees • Guaranteeing fees • Investors receive CF on a pro rata basis • Weighted average coupon rate (WAC) • Weighted average maturity (WAM)

3. MPTs • Agency pass-throughs • Fannie Mae • Freddie mac • Gannie Mae Also referred to as GSE pass throughs • Only conforming loans • Many market participants/investors will agency pass-throughs as implicitly carrying credit guarantee of U.S. government • Low credit risk

4. MPTs • Non-Agency pass-throughs • Commercial banks • Thrifts • Private conduits • No implicit or explicit guarantees from the US government • Typically rated by rating agencies

5. MPTs • Factors affecting rating • Property types • Condo; single family • Loan types • Fixed rate with level payment; adjustable rate; balloon • Loan terms • Geographical dispersion • Size • Seasoning • Purpose (refi vs. new purchase)

6. MPTs • Usually rated by the rating agencies • Enough internal or external credit enhancement to obtain AA or AAA ratings • Internal enhancement • Reserve funds • Excess spread accounts • Overcollateralization • Senior/Subordinate structure • Shifting interest structure • Redirect prepayments to senior class • External enhancement • Insurance • 3rd party guarantor must have a rating higher than the pool rating

7. Prepayment Conventions • Conditional prepayment rate (CPR) • Annual prepayment of the remaining outstanding principal value • On top of the scheduled principal payment • Single-Monthly Mortality Rate • Similar to CPR, but monthly • Relationship 1 - CPR = (1 - SMM)12 hence SMM = 1 – (1-CPR)1/12 • Prepayment • SMM * (OLB – Scheduled Principal PMT)

8. PSA Benchmark CPRs • The Public Securities Association (PSA) prepayment benchmark assumes: • CPR grows 0.2% per month before the loan/pool reaches 30 month / 6% • Then CPR will stay flat at 6% for the remaining life of the loan/pool • CPR = 6% * min (t / 30, 1) • The benchmark is referred to as “100%” PSA, or “100 PSA” • Slower or faster speeds of prepayment is referred to as some percentage of PSA • 50 PSA; 150 PSA; 300 PSA • Just a convention of prepayment behavior

9. An Excel Example • WAC = 8.125% • WAM = 357 Month • Coupon rate for MPT = 7.5% • Fees = .625% • Pool balance = $400,000,000

10. Prepayment Modeling • Housing turnovers (home sales of existing houses) • Employment • Family status • Income and house price changes In general, not sensitive to mortgage rate • Cash-out refi • Depend on house price appreciation and home equity accumulation • Rate/term refi • Refinancing ratio = WAC / current mtg rate

11. Prepayment Modeling • Other reasons • Curtailment / partial prepayment • Defaults • Historically less than 1% of prepayment

12. Prepayment Modeling • Variables in the prepayment “regression” • Seasoning • Seasonality • HPI • LTV • WAC / Mortgage Rate • Pick up after ratio > 0.6 • Burnout effect

13. The PSA Standard Default Assumption • SDA • 0.02% in month 1 • Increase by 0.02% b/w month 1 and 30 • Default stays at 0.60% b/w month 31 and 60 • From month 61 to 120, declines from 0.6^ to 0.03% • From month 120 on, remain constant at 0.03%

14. Mortgage Prepayment Risk • Unlike treasuries, mortgage payment is uncertain • Contraction risk • Extension risk • Macauley duration • Weighted average term to maturity • Weight is the present value of the CF in total PV • Average life • Average time to receipt of principal payment • Weighted by the amount of principal expected