Slides_Fundamentals of Investments - Chapter 13 doc

All rights reserved.McGraw Hill / Irwin A Brief History of Mortgage-Backed Securities Š Financed by mortgage-backed bonds also called mortgage pass-throughs, each mortgage pool is set

Valuation & Management

Charles J Corrado Bradford D.Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

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A Brief History of Mortgage-Backed Securities

Š Traditionally, local banks wrote most home

mortgages and then held the mortgages in their portfolios of interest-earning assets

Š Then, when market interest rates climbed to

near 20% in the early 1980s, bank customers flocked to withdraw funds from their savings deposits to invest in money market funds

Š Today, an originator usually sells the mortgage

to a mortgage repackager, who accumulates them into mortgage pools

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A Brief History of Mortgage-Backed Securities

Š Financed by mortgage-backed bonds (also

called mortgage pass-throughs), each

mortgage pool is set up as a trust fund A servicing agent collects the mortgage

payments and then passes the cash flows through to the bondholders.

Š The transformation from mortgages to

mortgage-backed securities (MBSs) is called mortgage securitization.

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Work the Web

 For more information on

mortgage-backed securities, visit:

http://www.investinginbonds.com

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Fixed-Rate Mortgages

Š The size of the monthly payment is determined

by the requirement that the present value of all monthly payments, based on the financing rate specified in the mortgage contract, be equal to the original loan amount

Fixed-rate mortgage

Loan that specifies constant monthly payments at a fixed interest rate over the life

of the mortgage

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Fixed-Rate Mortgages

where r = annual mortgage financing rate

T = mortgage term in years

( ) 12

121

11

12

amount

loan payment

Monthly

×+

Fixed-Rate Mortgages

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Fixed-Rate Mortgage Amortization

Š Each monthly mortgage payment has two

separate components:

cpayment of interest on outstanding mortgage

principal

dpay-down, or amortization, of mortgage principal

Š The relative amounts of each component

change throughout the life of the mortgage

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Fixed-Rate Mortgage Amortization

Š Suppose a 30-year $100,000 mortgage loan is

financed at a fixed interest rate of 8%.

— Monthly payment = 1 1 (1 08 12) $733.76

12 08 000 ,

100

$

12

30 = +

— In the second month,

Interest payment = $99,932.91 × 08/12 = $666.22 Principal payment = $733.76 – $666.22 = $67.54 New principal = $99,932.91 – $67.54 = $99,865.37

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Fixed-Rate Mortgage Amortization

Š Mortgage amortization can be described by an

amortization schedule, which states the

scheduled principal payment, interest payment, and remaining principal owed in any month

Fixed-Rate Mortgage Amortization

Fixed-Rate Mortgage Amortization

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Fixed-Rate Mortgage Prepayment & Refinancing

Š A mortgage borrower has the right to pay off

all or part of the mortgage ahead of its amortization schedule This is similar to the call feature of corporate bonds and is known as

mortgage prepayment.

Š During periods of falling interest rates,

mortgage refinancings are an important reason

for mortgage prepayments

Š Hence, mortgage investors face the risk of a

reduced rate of return

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Government National Mortgage Association

Š The Government National Mortgage

Association (GNMA), or “Ginnie Mae,” is a government agency charged with the mission

of promoting liquidity in the secondary market for home mortgages

Š GNMA mortgage pools are based on

mortgages issued under programs administered

by the Federal Housing Administration (FHA), the Veteran’s Administration (VA), and the

Farmer’s Home Administration (FmHA)

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Government National Mortgage Association

Š Mortgages in GNMA pools are said to be fully modified because GNMA guarantees

bondholders full and timely payment of both principal and interest

Š Note that although investors in GNMA

pass-throughs do not face default risk, they still face prepayment risk

Î Prepayments are passed through to bondholders.

Î If a default occurs, GNMA fully “prepays” the bondholders.

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GNMA Clones

Š Besides GNMA, there are two other significant mortgage repackaging sponsors:

cFederal Home Loan Mortgage Corporation

(FHLMC), or “Freddie Mac,” and

dFederal National Mortgage Association

(FNMA), or “Fannie Mae.”

Š Both are government-sponsored enterprises

(GSEs) and trade on the New York Stock Exchange

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GNMA Clones

Š Like GNMA, both FHLMC and FNMA

operate with qualified underwriters who accumulate mortgages into pools financed by

an issue of bonds

Š However, since FHLMC and FNMA are only GSEs, their fully modified pass-throughs do not carry the same default protection as

GNMA fully modified pass-throughs

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Work the Web

 Visit the GNMA website at:

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PSA Mortgage Prepayment Model

Š Mortgage prepayments are typically described

by stating a prepayment rate, which is the

probability that a mortgage will be prepaid in a given year

Š Conventional industry practice states

prepayment rates using a model specified by the Public Securities Association (PSA)

Î Prepayment rates are stated as a percentage of a PSA benchmark.

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PSA Mortgage Prepayment Model

Š In the PSA model, the rates are conditional on the age of the mortgages in the pool They are

conditional prepayment rates (CPRs).

Š For seasoned (> 30 months old) mortgages,

the CPR is a constant (6% annually for 100%

of the PSA benchmark (100 PSA))

Š For unseasoned (< 30 months old) mortgages,

the CPR rises steadily in each month until it reaches an annual rate of 6% (for 100 PSA) in month 30

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PSA Mortgage Prepayment Model

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PSA Mortgage Prepayment Model

Š By convention, the probability of

prepayment in a given month is stated

as a single monthly mortality (SMM).

SMM = 1 – (1 – CPR)1/12

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PSA Mortgage Prepayment Model

Š The average life of a mortgage in a pool is the

average time for a single mortgage in the pool

to be paid off, either by prepayment or by making scheduled payments until maturity

Š For a pool of 30-year mortgages,

Prepayment Schedule Average Mortgage Life (years)

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Work the Web

 Visit the Public Securities Association

at:

http://www.psa.com

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GNMA Fully Modified Mortgage Pools

Š Each month, GNMA mortgage-backed bond

investors receive pro rata shares of cash flows derived from fully modified mortgage pools

Š Each monthly cash flow has three components (less the servicing and guarantee fees):

c Payment of interest on outstanding mortgage principal.

d Scheduled amortization of mortgage principal.

e Mortgage principal prepayments.

GNMA Fully Modified Mortgage Pools

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for GNMA Mortgage-Backed Bonds

Š The interest rate risk for a bond is often

measured by Macaulay duration, which assumes a fixed schedule of cash flow payments

Š However, the schedule of cash flow payments for mortgage-backed bonds is not fixed

Î With falling interest rates, prepayments speed up, and vice versa.

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for GNMA Mortgage-Backed Bonds

Š Historical experience indicates that interest

rates significantly affect prepayment rates, and that Macaulay duration is a very conservative measure of interest rate risk

Š In practice, effective duration is used to

calculate predicted prices for mortgage-backed securities based on hypothetical interest rate

and prepayment scenarios

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Collateralized Mortgage Obligations

Š The three best-known types of CMOs are:

c interest-only (IOs) and principal-only (POs) strips,

d sequential CMOs, and

e protected amortization class securities (PACs).

Collateralized mortgage obligations (CMOs)

Securities created by splitting mortgage pool cash flows according to specific allocation rules

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Interest-Only and Principal-Only Strips

Š Interest-only strips (IOs) pay only the interest cash flows to investors, while principal-only strips (POs) pay only the principal cash flows

to investors

Š IO strips and PO strips behave quite differently

in response to changes in prepayment rates and interest rates

Î Faster prepayments imply lower IO strip values and higher PO strip values, and vice versa.

Interest-Only and Principal-Only Strips

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Sequential CMOs

Š Sequential CMOs carve a mortgage pool into a

number of tranches (slices)

Î For example, A, B, C, and Z-tranches.

Š Each tranche is entitled to a share of mortgage pool principal and interest on that share of

principal

Š However, cash flows are distributed

sequentially, so as to create securities with a range of maturities

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Sequential CMOs

Š Cash flows are passed through as follows:

Î All payments of principal will go to the topmost tranche (in alphabetical order), until all the

principal in that tranche has been paid off.

Î All tranches receive proportionate interest payments These are passed through immediately, except for the Z-tranche Interest on Z-tranche

principal is paid as cash to the topmost tranche in exchange for a transfer of an equal amount of

principal, until all the principal in the topmost tranche has been fully paid off.

Sequential CMOs

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Protected Amortization Class Bonds

Š Protected amortization class (PAC) bonds take

priority for scheduled payments of principal

The residual cash flows are paid to PAC support (or companion) bonds.

Š PAC cash flows are predictable as long as

prepayments remain within a specified band

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Protected Amortization Class Bonds

Š Creating a PAC bond entails three steps

c Specify two PSA prepayment schedules that form the upper and lower prepayment bounds of the

PAC bond These bounds define a PAC collar.

d Calculate principal-only (PO) cash flows for the two prepayment schedules specified in c.

e On a priority basis, at any point in time, PAC bondholders receive payments of principal according to the PSA prepayment schedule with the lower PO cash flow as calculated in d.

Protected Amortization Class Bonds

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Work the Web

 Check out the CMO section at:

http://www.bondresources.com

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Yields for MBSs and CMOs

Š The yield to maturity for a mortgage-backed

security conditional on an assumed

prepayment pattern is called the cash flow yield.

Š Essentially, cash flow yield is the interest rate that equates the present value of all future cash flows on the mortgage pool to the current price

of the pool, assuming a particular prepayment rate

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Chapter Review

Š A Brief History of Mortgage-Backed

Securities

Š Fixed-Rate Mortgages

Î Fixed-Rate Mortgage Amortization

Î Fixed-Rate Mortgage Prepayment and Refinancing

Š Government National Mortgage Association

Î GNMA Clones

Š Public Securities Association Mortgage

Prepayment Model

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Š Collateralized Mortgage Obligations

Î Interest-Only and Principal-Only Mortgage Strips

Î Sequential Collateralized Mortgage Obligations

Î Protected Amortization Class Bonds

Š Yields for Mortgage-Backed Securities and

Collateralized Mortgage Obligations