THE HANDBOOK OF MORTGAGE BACKED SECURITIES sixth edition

Biby, Srinivas Modukuri, and Brian Hargrave TBA Trading: Turning Pool-Specific Securities into Generic Securities 81 Settlement Procedures for Agency Pass-Throughs 82 BMA Good Delivery G

THE HANDBOOK OF MORTGAGE-BACKED

SECURITIES

THE HANDBOOK OF MORTGAGE-BACKED

Copyright © 2006, 2001, 1995 by Frank J Fabozzi All rights reserved Printed in the United States of America Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data- base or retrieval system, without the prior written permission of the publisher.

1 2 3 4 5 6 7 8 9 0 DOC/DOC 0 9 8 7 6 5

ISBN 0-07-146074-8

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, futures/securities trading, or other professional service If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

—From a Declaration of Principles jointly adopted by a Committee

of the American Bar Association and a Committee of Publishers.

McGraw-Hill books are available at special quantity discounts to use as premiums and sales promotions,

or for use in corporate training programs For more information, please write to the Director of Special Sales, Professional Publishing, McGraw-Hill, Two Penn Plaza, New York, NY 10121-2298 Or contact your local bookstore.

This book is printed on recycled, acid-free paper containing a minimum of 50% recycled, de-inked fiber.

Library of Congress Cataloging-in-Publication Data

The handbook of mortgage-backed securities / [edited] by Frank J Fabozzi.––6th ed.

p cm.

Includes bibliographical references and index.

ISBN 0-07-146074-8 (hardcover : alk paper)

1 Mortgage-backed securities—United States 2 Portfolio management—United States I Fabozzi, Frank J

HG4655.H36 2005

332.63 ′23––dc22

2005017828

An Overview of Mortgages and the Mortgage Market 3

Anand K Bhattacharya, Frank J Fabozzi, and William S Berliner

Product Definition and Terms 4

Mortgage-Loan Mechanics 9

The Mortgage Industry 15

The Loan Underwriting Process 17

Generation of Mortgage Lending Rates 20

Risks Associated with Mortgages and MBS 27

The Evolving Roles of the GSEs 32

Chapter 2

MBS Investors 35

Steven Abrahams

The Sources of Competitive Advantage in Investing in MBS 35

Fannie Mae and Freddie Mac 39

Insurers 41

Total-Return Portfolios 42

Change in the Competitive Landscape 44

The Portfolio Meets the Market 44

Chapter 3

Linda Lowell and Michael Corsi

Federally Sponsored Mortgage Pass-Through Programs 46

Pass-Through Cash Flows 52

Impact of Cash-Flow Variability on Yield and Average Life 58

Determinants of Prepayment Speeds 62

Gauging a Pool’s Prepayment Risk 68

Anatomy of the Pass-Through Market 74

Chapter 4

Trading, Settlement, and Clearing Procedures for

Jeffrey D Biby, Srinivas Modukuri, and Brian Hargrave

TBA Trading: Turning Pool-Specific Securities into

Generic Securities 81

Settlement Procedures for Agency Pass-Throughs 82

BMA Good Delivery Guidelines 83

Evolution of Loan and Borrower Characteristics 104

Credit and Prepayment Performance 106

Agency Expansion into Nonagency Zones 111

Summary 111

Chapter 6

Frank J Fabozzi

External Credit Enhancements 113

Internal Credit Enhancements 116

Use of Interest-Rate Derivative Instruments 122

Chapter 7

David M Lukach, Yogesh Gupta, Thomas Knox, and John Gibson

Securities Act Registration Statements: The Disclosure Framework 128

Disclosures for Form S-3 Registered MBS Offerings 129

Typical Sections of a Prospectus and Prospectus Supplement 132

Conclusion 156

Chapter 8

Alexander Batchvarov, William Davies, and Altynay Davletova

General Forms of Waterfalls 157

Variations in European RMBS Waterfalls by Country 159

Combined or Split RMBS Waterfalls: Compare and Contrast 165

Summary 168

SECTION TWO

ALTERNATIVE MORTGAGE PRODUCTS

Chapter 9

Exploring the MBS/ABS Continuum: The Growth and

Satish Mansukhani

Exploring the MBS/ABS Continuum: Defining the Risk Space 172

The MBS/ABS Continuum in the Hybrid Sector 173

Prepayment and Credit Performance Follow Relative Placement

along the Continuum 175 Deal Structures also Mirror Relative Placement along the Continuum 179

Sufficient Credit Enhancement to Withstand Multiples of Default Frequency

Experienced on Weaker Subprime Mortgages 180 The Value of Available Funds CAPS 183

Chapter 10

Anand K Bhattacharya, William S Berliner, and Jonathan Lieber

Background 187

Loan-Level Characteristics 190

Factors Underlying Prepayment Behavior 192

Empirical Prepayment Performance 200

Recent Developments 204

Chapter 11

Satish Mansukhani, Arjune Budhram, and Mu’taz Qubbaj

Fixed-Rate Alt-A Collateral 208

Alt-A Prepayments 222

Historical Drivers of Prepayments and Defaults 228

Credit Performance and Enhancement 234

Practical Portfolio Manager Opportunities and Considerations 252

Chapter 12

Anand K Bhattacharya, Steve Banerjee, Ricardo Horowicz, and Wei Wang

Popularity and Issuance of Hybrid ARMs 260

Characteristics of Hybrid ARM Loans 261

Hybrid ARM Refinance Incentive 266

Comparing Hybrid ARM S-Curves 272

Comparing Hybrid ARM Seasoning Curves 275

Loan-Level Drivers of Hybrid ARMs 277

Interest-Only (IO) Hybrid ARMs 282

Jumbo Hybrid ARM Credit Performance 284

Conclusions 285

Chapter 13

Hybrids: Product, Performance, Investor Base, and Frameworks to

Satish Mansukhani, Adama Kah, and Mu’taz Qubbaj

Hybrid Origination and Issuance 288

Securitization of Hybrids 290

The Hybrid Borrower 291

Prepayment Profiles of Hybrids 295

Trading Conventions in the Hybrid Market 311

Investors in the Hybrid Secondary Markets 314

A Conceptual Framework for Relative-Value Assessments of Hybrids 316

Cap Valuations on Hybrids 319

Index Levels: Implied Forwards and Historical Peaks 319

Relative Value of Hybrids 320

Identifying Characteristics/Features of Hybrids 327

Anand K Bhattacharya and Paul Jacob

Historical Perspective 389

Major Categories of Customized MBS 391

Determinants of Market Payups 397

Evaluation of Customized Pools: Current-Yield Approach 400

Evaluation of Customized Pools: Option-Adjusted Spread Analysis 401

Measuring the Duration of a Customized Pool 407

Challenges and Issues in Customized MBS Valuation 410

Chapter 17

The Prepayment and Credit Characteristics of Reperforming

FHA/VA Loans 413

Anand K Bhattacharya, William S Berliner, and Jonathan Lieber

The Process of Delinquency Curing 414

Prepayments 416

Credit Fundamentals: Overview 426

Chapter 18

Prepayment-Penalty Mortgage-Backed Securities 441

Anand K Bhattacharya, William S Berliner, and Jonathan Lieber

Legal Framework for Imposition of Prepayment Penalties 442

Prepayment-Penalty Loan Structures 443

The Dynamics of the Prepayment Penalty 448

Borrower and Lender Dynamics 449

Prepayment Behavior of Prepayment-Penalty Loans 452

The Impact of Prepayment Penalties on Security Performance and Duration 458 Conclusions 462

SECTION THREE

MORTGAGE DERIVATIVES: CMOs AND STRIPPED MBS

Chapter 19

Stripped Mortgage-Backed Securities 465

Cyrus Mohebbi, Gary Li, and Todd White

Overview of the SMBS Market 466

Investment Characteristics 470

Summary 480

Chapter 20

PAC Bond Features and Performance 481

Linda Lowell and Michael Corsi

Collars 482

Effective Collars 484

PAC Collar Drift 485

How Likely Is Breaking the PAC Bands? 486

Pay Order and Average Life Stability 488

Average-Life Profile versus Option-Pricing Models 490

Wide Window versus Tight Window 491

Conclusion 493

Chapter 21

Linda Lowell

The Basic Accrual Structure 495

How the Z Interacts with Other Bonds in the Structure 499

Accretion-Directed or VADM Bonds 503

Z Bonds in PAC Companion Structures 503

Cyrus Mohebbi and Raymond Yu

Overview of Recent Prepayment Behavior and Advances in Its

Michael Bykhovsky

Generic Model 536

Modeling Reliability and Accuracy 548

Overview of Valuation of the Prepayment Option 549

The GNMA Sector: Special Modeling Considerations 590

Putting It All Together: The Case of the 1992 FNMA 7.5% 596

The Value of Attribute-Sensitive Prepayment Models 598

Appendix: Mortgage-Rate Prediction 600

Chapter 26

Anand K Bhattacharya and Steve Banerjee

Minimizing Loan Dispersion 604

The Full Picture 605

Loan-Level Modeling 614

Predictive Strength of Loan-Level Models 617

Appendix: Use of Survival Analysis in Loan-Level Modeling 619

Chapter 27

Analyzing Specified MBS Pools Using Agency Enhanced Data and

Dan Szakallas, Alexander Levin, and Andrew Davidson

Prepayment Modeling Using Active-Passive Decomposition 624

Enhanced Agency Data and Prepayment Modeling 630

Valuation Consequence: A Payup 637

Chapter 28

Dale Westhoff and V S Srinivasan

Innovative Features: A True Loan-Level Implementation 646

The Bear, Stearns Nonagency Prepayment Database 647

The Impact of the Agencies on Nonagency Prepayment Behavior 648

Defining the Subsectors within the Nonagency Market 649

Deconstructing Our Nonagency Prepayment Forecast 652

Defining the Baseline Nonagency Refinancing Profile 653

Understanding Borrower Self-Selection and Burnout 654

Modeling Borrower Refinancing Intensity 656

The Impact of Loan Size on Nonagency Refinancing Behavior 659

Credit Quality 666

Rate Premium 669

Secondary Refinancing Effects: Documentation, Loan Purpose,

Occupancy Status 671 The Yield Curve and Refinancing Transitions 674

The Value of Updated LTV Ratio Information 676

Housing Turnover Prepayments: Seasoning and Lock-In 677

Seasonality 680

Adverse Selection in Housing Turnover Prepayments 682

Involuntary Prepayments and Curtailments 682

Refinancing Efficiency: The Next Frontier 683

Modeling the Mortgage Rate Process 685

Model Testing 687

Conclusion 688

Appendix: Model Projected versus Actual Results for Representative Deals 689

Chapter 29

Dale Westhoff and V S Srinivasan

Market Background 693

Modeling Hybrid Prepayments 703

Summary and Valuation Implications 716

Other Factors Influencing Prepayments 739

Collateral Credit Performance 744

Involuntary Prepayments 747

Loss Severity and Cumulative Losses 752

Summary 753

SECTION FIVE

PORTFOLIO MANAGEMENT TOOLS AND TECHNIQUES

Chapter 31

Frank J Fabozzi, Scott F Richard, and David S Horowitz

Alexander Levin and Andrew Davidson

Prepayment Risk and OAS 784

Equivalent Risk-Neutral Prepay Model 786

Stochastic Property of Prepay Risk Factors 788

A prOAS Pricing Model with Refinancing and Turnover Risk 789

Determining Prices of Risk: Calibration to TBAs 791

Valuation of MBS Strips with prOAS 794

Modernized Greeks 796

Concluding Remarks 798

Chapter 33

Andrew Kalotay, Deane Yang, and Frank J Fabozzi

Traditional Approaches to MBS Valuation 800

An Option-Based Prepayment Model for Mortgages 801

What Do We Mean by the Term Duration? 825

Current Approaches to Measuring Mortgage Durations 832

Comparison of Alternative Duration Measures 851

Future Approaches to Mortgage Durations 852

Implications for Investors 855

Chapter 35

David P Jacob and Tim Lu

Review of Duration and Convexity for Treasuries 858

Evolution of Average Life for CMOs 859

Implications for Performance and Risk Management 861

The Lehman MBS Index and Index Pricing 883

Calculating the Index Price 885

Chapter 38

Frank J Fabozzi and Steven V Mann

Determination of the Financing Cost 932

Illustrations of Dollar Roll Agreements 933

Risks in a Dollar Roll From the Investor’s Perspective 937

MBS Dollar-Roll Automation 938

Chapter 39

Steven Abrahams and Adam Rilander

Uncovering the Risk-Adjusted Carry in TBA 944

Start with Carry, and Hedge Duration 944

Move on to Hedging Convexity 945

Finish with Hedging Long-Term Volatility 946

The Art of Interpreting the Risk-Adjusted Carry 948

Summary 948

Chapter 40

Thomas Zimmerman and Laurent Gauthier

Delinquencies and Defaults 952

Loss Severity and Losses 970

Summary 977

Chapter 41

Laurie S Goodman

Specified Pool Payups 979

Prepayment Protection: The Data 980

Credit Curing 983

Prepayment Protection: The Ranking 989

Extension Protection: The Data 990

Ranking Extension Protection 993

Nonagency Investor Pools 994

Nonagency Call Exercises 999

Call Decisions by Issuer 1000

Call Decision Timing 1001

SECTION SIX

HEDGING TOOLS AND APPROACHES

Chapter 43

Kenneth B Dunn, Frank J Fabozzi, Michael M Luo, and Roberto M Sella

Yield-Curve Risk and Key Rate Duration 1009

How Interest Rates Change Over Time 1012

How to Implement Three-Factor Hedging 1013

Summary 1022

Chapter 44

Joseph R Prendergast

Mortgage Option Markets 1023

Mortgage Option Users 1024

Pricing Mortgage Options 1029

Mortgage Option Risk Characteristics 1032

Conclusion 1037

Appendix: Decomposing Mortgage Option Duration and Convexity 1037

Chapter 45

Andrew Aymen Samawi

Prepayment Derivatives History and Products 1042

Prepayment Derivatives Hedging Applications 1045

Auction Announcements 1051

Conclusion 1052

Chapter 46

William L Smith, Jr and Laurie S Goodman

Growth—Mortgage Servicing Industry 1054

Difficulties in Hedging IOs and MSRs 1054

Hedge Instruments 1056

Hedge Correlations 1057

Measuring Hedge Effectiveness 1060

Empirical Hedge Results 1060

Hedging with TBAs 1062

Use of Options 1064

A Few Additional Comments 1065

Thoughts On Servicing Models 1067

Bennett W Golub and Sree Sudha Yerneni

Approach to Back Testing 1074

Extending the Analysis to Servicing 1087

Alternative Hedge Methodology (“Swap + Mortgage” Hedge) 1089

Conclusion 1095

Appendix A: Monthly Durations and Prepayment Speeds 1097

Appendix B: OAS, Spreads, and Yields Used in Computing

Themes and Variations 1105

Why Will Prepayment-Linked Notes Gain Popularity? 1107

The Underlying Loan Portfolio 1125

The Role of the Servicer 1129

Loan Origination, the Lemons Market, and the Pricing of CMBS 1131

Summary 1132

Chapter 50

David P Jacob, James M Manzi, and Frank J Fabozzi

Loan Cash Flow: The Raw Material for CMBS 1136

CMBS Structures 1141

The Impact of Maturity Dispersion 1145

The Impact of Coupon Dispersion 1146

The Impact of Prepayments 1147

The Impact of Defaults 1149

Sample Default Scenarios 1150

Effects of Servicer Modifications on CMBS 1151

Summary 1155

Chapter 51

Arthur Q Frank and Tim Lu

A Brief History of GNMA Multifamily Pools 1157

Major FHA Project Loan Insurance Programs 1158

Prepayment Behavior of GNMA Multifamily Pools 1163

Default Behavior of GNMA Multifamily Pools 1175

Cumulative Defaults by Production Year and the GNMA Project

Loan Default Curve 1176 Recent Breakdown of GNMA Multifamily Prepayments into Defaults,

Refinancings with Penalties, and Refinancings without Penalties 1181

The Refinancing History of Health Care Loans Compared

with Apartment Complexes 1181

On the Investment Characteristics of GNMA Multifamily Pools and REMICs 1185

Chapter 52

Philip O Obazee and Duane C Hewlett

Mortgage Loan Default Rates and Loss Severities 1187

Factors Influencing Default Rates and Loss Severity 1190

Age 1193

Default Rate, Loss Severity, and Valuation Issues 1193

Conclusion 1198

Chapter 53

Philip O Obazee and Duane C Hewlett

Value Drivers of CMBS IOs 1200

CMBS IO Relative Value 1205

Conclusion 1208

Chapter 54

Peter Leffler, John Malysa, Jennifer Story, and Susan S Merrick

Capital Structure 1210

Reinvestment (or Revolving) Period 1213

Cash-Flow Diversion Tests 1214

Preferred-Share Caps and Reverse Turbos 1215

Interest-Rate Hedging 1215

Conclusion 1216

P R E F A C E

The sixth edition of The Handbook of Mortgage-Backed Securities is designed to

provide not only the fundamentals of these securities and the investment istics that make them attractive to a broad range of investors but also extensivecoverage on state-of-the-art strategies for capitalizing on the opportunities in thismarket The book is intended for both individual investors and professionalmanagers

character-To be effective, a book of this nature should offer a broad perspective Theexperience of a wide range of experts is more informative than that of a singleexpert, particularly because of the diversity of opinion on some issues I havechosen some of the best-known practitioners to contribute to this book Mosthave been actively involved in the evolution of the mortgage-backed securitiesmarket

DIFFERENCES BETWEEN THE FIFTH AND

SIXTH EDITIONSMoney managers must justify their management and transaction costs to clients.Consequently, all money managers eventually must demonstrate to their clients

how much value they have added to portfolio performance above and beyond

what could have been achieved by employing a lower-cost buy-and-hold strategy

As the editor of The Handbook of Mortgage-Backed Securities, I am effectively

the portfolio manager of the assets of this book—the chapters The sixth editionmust justify to my current clients (those who purchased the fifth edition of the

Handbook) why they should not follow a buy-and-hold strategy of simply

continu-ing to use the fifth edition and reduce advisory fees and transaction costs (i.e., thecost of this book) In short: What value has been added to the fifth edition?The differences between the fifth and sixth editions are summarized in thefollowing section The number of chapters has been increased from 42 to 54.Thirty-six chapters are new Consequently, this book can be characterized as anew book, reflective of the dynamic changes that have occurred in this market in

terms of new product development (particularly nonagency mortgage-backedsecurities) and advances in technologies since the publication of the fifth edition

1 Mortgages and Pass-Through Securities

2 Stripped Mortgage-Backed Securities and Collateralized Mortgage

6 Commercial Mortgage-Backed Securities

7 Non-U.S Mortgage-Backed Products

The sixth edition has 54 chapters divided into the following seven sections:

1 Mortgage-Backed Securities (MBS) Products and the Mortgage Market

2 Alternative Mortgage Products

3 Mortgage Derivatives: CMOs and Stripped MBS

4 Prepayment Models and Behavior

5 Portfolio Management Tools and Techniques

6 Hedging Tools and Approaches

7 Commercial Mortgage-Backed Securities

The following 37 chapters are new:

2 MBS Investors

5 Defining Nonagency MBS

6 Credit Enhancements for Nonagency MBS Products

7 Understanding the Prospectus and Prospectus Supplement

8 Waterfall Cash-Flow Mechanics in European RMBS

9 Exploring the MBS/ABS Continuum: The Growth and Tiering of the

Alt-A Hybrid Sector

10 Alt-A Mortgages and MBS

11 Fixed-Rate Alt-A MBS

12 Hybrid Adjustable-Rate Mortgages (ARMs)

13 Hybrids: Product, Performance, Investor Base, and Frameworks to

Assess Relative Value

14 Interest-Only ARMs

15 Residential Asset-Backed Securities

16 Customized Mortgage-Backed Securities

17 The Prepayment and Credit Characteristics of Reperforming FHA/VA

Loans

25 Agency Prepayment Model: Modeling the Dynamics of Borrower

Attributes

26 Loan-Level Prepayment Models

27 Analyzing Specified MBS Pools Using Agency Enhanced Data and

Active-Passive Decomposition

29 A Prepayment Model for Hybrid Mortgages

30 Modeling Nonprime Mortgage Prepayment, Delinquency,

and Default

32 Risk-Neutral Prepayment Modeling and Valuation with prOAS

33 An Option-Theoretic Approach to MBS Valuation

36 Managing Against the Lehman Brothers MBS Index: MBS Index

Prices

37 Managing Against the Lehman Brothers MBS Index: MBS Index

Returns

38 Dollar Rolls

39 Uncovering the Risk-Adjusted Carry in MBS

40 Mortgage Credit Quantified

41 Specified Pool Trades: Ranking the Alternatives

42 Analysis of Cleanup Calls

43 A Three-Factor Approach for Hedging Mortgage-Backed Securities

44 Mortgage Options

45 Mortgage Prepayment Derivatives

47 Mark-to-Market Methodology, Mortgage Servicing Rights, and

Hedging Effectiveness

48 Prepayment-Linked Notes

50 The Impact of Structuring on CMBS Bond Class Performance

51 Investment Characteristics of GNMA Project Loan Securities

54 Cash-Flow CDOs for CMBS Investors

The following five chapters were substantially revised:

1 An Overview of Mortgages and the Mortgage Market

18 Prepayment-Penalty Mortgage-Backed Securities

34 Approaches for Measuring the Duration of Mortgage-Related

Securities

35 Duration and Average-Life Drift of CMOs

46 Hedging IOs and Mortgage Servicing

Frank J Fabozzi, Ph.D., CFA, CPA

Merrill Lynch International

Jeffrey D Biby

Managing Director Lehman Brothers Inc.

Arjune Budhram

Associate Credit Suisse First Boston

Altynay Davletova

Vice President International Structured Product Research Merrill Lynch International

Arthur Q Frank

Director, MBS Research Nomura Securities International, Inc.

Laurent Gauthier

Executive Director Morgan Stanley

John Gibson

Director Structured Finance Group PricewaterhouseCoopers

Bennett W Golub

Managing Director BlackRock, Inc.

Laurie S Goodman

Co-Head of Global Fixed Income Research UBS

Vice President, Fixed Income Research

Countrywide Securities Corporation

Executive Vice President

Countrywide Securities Corporation

Director, Valuation Development

Andrew Davidson & Co., Inc.

Gary Li

Senior Vice President

HSBC

Jonathan Lieber

Senior Vice President

Countrywide Securities Corporation

David M Lukach

Partner Structured Finance Group PricewaterhouseCoopers

Michael M Luo

Executive Director Morgan Stanley

John Malysa

FitchRatings Credit Products

Steven V Mann

Professor of Finance Moore School of Management University of South Carolina

Satish Mansukhani

Director Credit Suisse First Boston

Adjunct Professor New York University

Christopher Muth

Research Analyst J.P Morgan Securities, Inc.

Philip O Obazee

Vice President Delaware Investment Advisers

Mu’taz Qubbaj

Associate Credit Suisse First Boston

Scott F Richard

Managing Director Morgan Stanley Asset Management

Adam Rilander

Vice President Bear, Stearns & Co.

Andrew Aymen Samawi

Chief Executive Officer BroadReach Financial Group

Roberto M Sella

Managing Director Morgan Stanley

Deane Yang

Professor Polytechnic University

Sree Sudha Yerneni

Managing Director BlackRock, Inc.

Raymond Yu

Portfolio Manager Providence Investment Management

Thomas Zimmerman

Executive Director Mortgage Strategy Group UBS

THE HANDBOOK OF MORTGAGE-BACKED

SECURITIES

ONE

MORTGAGE-BACKED SECURITIES (MBS) PRODUCTS AND THE MORTGAGE MARKET

ONE

AN OVERVIEW OF MORTGAGES AND THE MORTGAGE MARKET

Managing Director Countrywide Securities Corporation

Frederick Frank Adjunct Professor of Finance

School of Management Yale University

of the outstanding balance securitized into a variety of investment vehicles By way

of comparison, at the same point in time, the outstanding amount of U.S Treasurynotes and bonds totaled $3.9 trillion.1For a variety of reasons, such as product inno-vation, technological advancement, and demographic and cultural changes, thecomposition of the primary mortgage market is evolving at a rapid rate––older con-cepts are being updated while a host of new products is also being developed andmarketed Consequently, the mortgage lending paradigm continues to be refined

in ways that have allowed lenders to offer a large variety of products designed toappeal to consumer needs and tastes This evolution has been facilitated by atten-dant increased sophistication in pricing that has allowed for the quantification ofthe inherent risks in such loans

The purpose of this chapter is to provide a general framework for standing the overall nature and structure of the mortgage market The various prod-ucts originated in the mortgage markets are summarized, and the ongoing evolution

under-in the development of such products is discussed Additionally, the process ofdetermining mortgage-lending rates is also outlined, along with an evaluation ofthe risks associated with such mortgage products

3

1 Source: Federal Reserve.

PRODUCT DEFINITION AND TERMS

A mortgage is a loan that is secured by an underlying asset that can be

repos-sessed in the event of default For the purposes of this chapter, a mortgage isdefined as a loan made to the owner of a one- to four-family residential dwellingand secured by the underlying property Such loans traditionally have been level-pay “fully amortizing” mortgages, indicating that principal and interest paymentsare calculated in equal increments to pay off the loan over the stated term Thereare, however, a number of key characteristics differentiated along the followingattributes that are considered critical in understanding these instruments

Lien Status

The lien status dictates the seniority of the loan in the event of forced liquidation of

the property owing to default by the obligor Most mortgage loans that are originatedhave first-lien status, implying that the lender would have first call on the proceeds

of the liquidation of the property if it were to be repossessed A second lien, by trast, suggests that the creditor has access to the proceeds of liquidation only whenthe first-lien balance is extinguished Second liens can either be closed-end loans thatamortize over a given term or can be structured as home equity lines of credit(HELOCs) that are revolving debts similar in concept to credit card accounts.Borrowers often use second-lien loans as a means of liquefying the equity

con-in a home for the purpose of expenditures (such as medical bills or college tuition)

or investments (such as home improvements) A second-lien loan also may beoriginated simultaneously with the first lien in order to maintain the first lien loan-to-value (LTV) ratio below a certain level (typically 80%) This allows the obligor

to avoid the need for mortgage insurance, which is required for loans with LTVsgreater than 80% (and hence increases the monthly payment) This type of trans-action (often referred to as a “piggyback loan”) has become increasingly com-monplace since 2000 The mortgage insurance payment either may be an “add-on”amount to the mortgage payment or may take the form of a higher interest rate Tothe extent that the mortgage insurance payment is an add-on amount to the mort-gage payment, it is not a tax-deductible payment

Original Loan TermMost mortgage loans are originated with 30-year original terms and amortize on amonthly basis Loans with stated shorter terms ranging from 10, 15, and 20 yearsare also used by borrowers motivated by the desire to build equity more quickly.Among these mortgages, where the monthly mortgage payment is inversely related

to the term of the loan, the 15-year mortgage is the most common instrument Note

that a borrower always can make a partial prepayment (a curtailment) to reduce the

loan balance and build equity Other structures used include:

• Loans with balloon payments, which amortize over a 30-year term

However, at a preset point in time (the balloon date, generally five or

seven years after issuance) the borrower must pay the full balance of theloan.

• Biweekly loans, where the borrower makes a payment every two weeks.Using this payment structure, the borrower makes 26 payments peryear; the two additional payments are treated as a partial prepayment(or, as discussed later in this chapter, a curtailment), resulting in fasteramortization of the principal

Interest-Rate Type (Fixed versus Adjustable Rate)

As indicated by the nomenclature, fixed-rate mortgages have an interest rate that

is set at the closing of the loan (or, more accurately, when the rate is locked) and

is constant for the term of the loan Based on the loan balance, interest rate, andterm, a payment schedule effective over the life of the loan is calculated to amor-tize the principal balance Note that while the monthly payment is constant overthe life of the loan, the allocation of the payment into interest and principal changesover time As discussed later in this chapter, the level mortgage payment consistsmainly of interest immediately after closing but largely of principal later in the life

of the loan

Adjustable-rate mortgages (ARMs), as the name implies, have note ratesthat are subject to change over the life of the loan The vast majority of adjustable-rate loans have 30-year terms The periodic contractual rate is based on both the

movement of an underlying rate (the index) and the spread over the index (the margin) required for the particular loan program A number of different indices,

such as the one-year constant-maturity Treasury (CMT), the London InterbankOffered Rate (LIBOR), and the less popular 11th District Cost of Funds (COFI),can be used as reference rates

ARMs typically adjust or reset annually, although instruments with one- and

six-month resets also are originated Often, because of competitive considerations,the initial rate is somewhat lower than the so-called fully indexed rate In this case,the initial rate is referred to as a “teaser rate.” The note rate is subject to a series ofcaps and floors that limit the extent to which the note rate can change at reset.Structurally, the cap serves to protect the consumer from the payment shock thatmight occur in a regime of rising rates, whereas the floor acts to protect the inter-ests of the holder of the loan by preventing the note rate from dropping below pre-defined levels

A recent innovation in the ARM arena is the fixed-period or hybrid ARM.This type of loan has fixed rates that are effective for longer periods of time, such

as 3, 5, 7, and 10 years after funding.2At the end of the period, the loans reset in a

2 While the hybrid ARM is a fairly recent innovation in the prime mortgage world, this product design

is very popular in subprime lending, which refers to mortgage loans made to borrowers with

impaired credit In the subprime world, the manifestation of this product is typically a fixed period

of either two or three years, leading to the descriptive nomenclature of 2/28 or 3/27 mortgages.

fashion very similar to that of more traditional ARM loans Hybrid ARMs appeal

to borrowers who desire a loan with lower initial payments because ARM rates erally are lower than rates for 30-year fixed-rate loans At the same time, the bor-rower is insulated from some of the payment and interest rate uncertainty to whichmore frequently resetting ARMs are exposed

gen-Within the aggregate classification of ARMs, there are a number of variations

on product design that allow borrowers to further reduce monthly payments Onesuch variation is the interest-only (IO) hybrid ARM, which is a mortgage thatrequires only payment of the interest associated with the loan until the reset date.While the interest-only option is also available with fixed-rate mortgages, most ofthe current interest-only production is in hybrid ARMs At the end of the fixedperiod, the principal is amortized at a floating rate over the remaining life of theloan Since such mortgages involve initial lower monthly payments, obligors use

IO hybrid ARMs both as a vehicle to purchase more expensive properties and a nancing instrument to lower mortgage payments on their current dwelling.Another such instrument is the negative-amortization or payment-optionloan, which is limited to adjustable-rate loans Such products begin with a very lowteaser rate While the rate adjusts monthly, the payment is only adjusted on an annualbasis and is subject to a payment cap In instances where the payment is not suffi-cient to cover the interest due on the loan, the balance increases or is subject to neg-ative amortization, the extent of which is limited The mechanics of these loans arediscussed later in this chapter

refi-Credit GuaranteesWhile our discussion has centered on the fundamentals of mortgage loans, one ofthe considerations that also distinguishes various mortgages is the form of theeventual credit support required to enhance the liquidity of the loan While a com-plete discussion of secondary markets is beyond the scope of this chapter, the abil-ity of mortgage banks to continually originate mortgages is heavily dependent onthe ability to create fungible assets from a disparate group of loans made to a mul-titude of individual obligors Therefore, mortgage loans can be classified furtherbased on whether the loan is underwritten and funded under the premise that someform of governmental or quasi-governmental credit guaranty is associated with theloan Alternatively, to the extent that the loan does not qualify for such guarantees,the liquidity enhancement process may involve credit insurance obtained from pri-vate entities or may be structurally enhanced through cash-flow subordination

In the case where a guaranty at the loan level is used, one of the dimensions

along which loans can be classified is along the nomenclature of government versus conventional loans As part of housing policy considerations, the Department of

Housing and Urban Development (HUD) oversees two agencies, the FederalHousing Administration (FHA) and the Department of Veterans Affairs (VA), thatsupport housing credit for qualifying borrowers The FHA provides loan guaranteesfor borrowers with very low down payments and/or relatively low levels of income

The VA guarantees loans made to veterans, allowing such obligors to receive able loan terms Typically, FHA and VA loans are securitized under the aegis of pro-grams offered by the Government National Mortgage Association (“Ginnie Mae,”

favor-or GNMA), which is a department of HUD Since these guarantees are backed bythe U.S Treasury, these loans are collateralized by the “full faith and credit” of the

U.S government GNMA loans are referenced under the generic term of ment loans, as opposed to such loans that are not associated with explicit govern- ment guarantees and are categorized as conventional loans.

govern-Conventional loans can be securitized either as pools guaranteed by the two

“government-sponsored enterprises” (GSEs), namely, the Federal Home LoanMortgage Corporation (FHLMC, or “Freddie Mac”) and Federal National MortgageAssociation (FNMA, or “Fannie Mae”), or as private-label securities The GSEs areshareholder-owned corporations that were created by Congress to support housingactivity.3As we will discuss later in this chapter, such loans are insured through themechanism of pooling, where part of the interest is paid to the relevant GSE in the

form of a guaranty fee A private-label securitization, by contrast, does not use

guaranties from either the government or the GSEs Rather, the loans are creditenhanced either through private insurance or, more commonly, through the use ofcash-flow subordination.4The actual choice of the vehicle (GSE versus private label)used to securitize a particular loan depends on a number of factors, such as confor-mance of obligor credit attributes and property features to GSE loan requirements,the cost of credit enhancement, and loan balance.5

Loan Balance (Conforming versus Nonconforming)

As noted previously, mortgage balance often determines the vehicle used to ritize a loan This is due to the fact that the agencies have limits on the loan bal-ance that can be included in agency-guaranteed pools The maximum loan sizes forone- to four-family homes effective for the following calendar year (also referred

secu-to as the “conforming balance limit”) are adjusted every November based on theone-year change (October to October) in the average home purchase price as

3 As of this writing, the GSEs are regulated by the Office of Federal Housing Enterprise Oversight (OFHEO), which is also under the aegis of HUD The issue of GSE regulation is currently a matter of significant debate and is potentially subject to change, particularly with respect to whether the regulatory umbrella remains with HUD or is moved to a different department However, any potential changes with respect to the regulatory framework are unlikely to affect the secondary market funding activities of the GSEs.

4 The so-called senior/subordinate structure involves prioritizing the cash flows of the senior bonds; losses are deducted from the balance of the subordinate classes as they accrue, protecting the senior bonds from losses.

5 A note with respect to terminology used in this chapter: The term agencies is used to refer to Freddie Mac, Fannie Mae, and Ginnie Mae, whereas the term GSEs refers to Freddie Mac and

Fannie Mae only.

reported in the monthly interest-rate survey of the Federal Housing Finance Board(FHFB).6Since the inception of the GSEs, pools issued by Freddie Mac and FannieMae have had identical loan limits because such bounds are dictated by the samestatute The GSEs’ conforming limits for 2005 for one- to four-family homes are

at 95% of that area’s median home price, subject to a ceiling of 87% and a floor

of 48% of the GSEs’ national limits For 2005, the maximum allowable size ofFHA loans in high- and low-cost areas is $312,895 and $172,632, respectively

By contrast, the VA changes its limit periodically This limit was last changed tive for 2002, when the VA maximum loan balance was changed to $300,700 tomatch the prevailing GSE limit Prior to this change, the previous VA limit was

effec-$203,000, and had not changed for a number of years

Loans larger than the conforming limit (and thus ineligible for inclusion in

agency pools) are classified as jumbo loans and are securitized in private-label

trans-actions (along with loans, conforming-balance or otherwise, that do not meet theGSEs’ required credit or documentation standards) While the size of the private-label sector is significant (as of the fourth quarter of 2004, approximately $1.1 trillionwas outstanding), it is dwarfed by the market for agency pools, which is over 3.5 times

as large Moreover, over the years, as the conforming-balance limits have increasedowing to robust real estate appreciation, the market share of agency pools relative

to private-label deals has grown, especially for fixed-rate loans

Loan Credit and Documentation CharacteristicsMortgage lending traditionally has focused on borrowers of strong credit qualitywho were able (or willing) to provide extensive documentation of their incomeand assets However, owing to technological and methodological advances withrespect to pricing the inherent risk in mortgage loans, the industry increasinglyhas expanded product offerings to consumers who have been outside the boundaries

6 The FHFB’s monthly report can be accessed at www.fhfb.gov/mirs/mirstbl1.xls.

of the traditional credit paradigm For instance, some of the fastest-growing sectors

of the mortgage markets are the so-called subprime and alternative-A (alt-A)

sec-tors Subprime refers to borrowers whose credit has been impaired, in some cases

owing to life events such as unemployment or illness, while generally having ficient equity in their homes to mitigate the credit exposure This allows the lender

suf-to place less weight on the credit profile in making the lending decision The

alt-A category refers to loans made to borrowers who generally have high credit scores

but who have variable incomes, are unable or unwilling to document a stableincome history, or are buying second homes or investment properties The distinctionbetween these categories, however, is becoming somewhat fuzzy At this writing,for example, a fast-growing product area consists of loans to borrowers with bothmodestly impaired credit and less rigorous documentation, categorized under the

general umbrella of alt-B.

As the underwriting process for these loans continues to be refined, these egories of mortgages increasingly are becoming important parts of the primary mort-gage market However, the ability of the mortgage banking community to originatesuch products has been facilitated by the investor acceptance of securitized struc-tures collateralized by such loans The securitization vehicle used depends on thecharacteristics of the loans in question Generally speaking, however, subprime loans(which are predominantly adjustable-rate in nature) are securitized as short- andintermediate-duration securities popular with banks and depositories Alt-A loansappeal to investors because of the perceived reduced sensitivity to prepayment riskand are securitized in a number of different structural forms

cat-MORTGAGE-LOAN MECHANICSMortgage loans traditionally are structured as immediately and fully amortizing debtinstruments, where the principal balance is paid off over the life of the loan As notedpreviously, fixed-rate loans generally have a monthly payment that is fixed for thelife of the loan, based on loan balance, term, and interest rate A fixed-rate loan’s

monthly payment can be calculated by first computing the mortgage payment factor using the following formula:

Note that the interest rate in question is the monthly rate, i.e., the annual ratedivided by 12

The monthly payment is calculated by multiplying the mortgage paymentfactor by the original mortgage balance For example, consider the followingsample loan:

Loan balance: $100,000Annual rate: 6.0%

Mortgage payment factor interest rate (1 interest rate)

(1 interest rate)

loan term loan term

Monthly rate: 0.50% = 0.005

Loan term: 30 years (360 months)

The monthly payment factor is calculated as follows:

Therefore, the monthly payment on the subject loan is $599.55, as shownbelow:

$100,000 × 0.0059955 = $599.55

An examination of the allocation of principal and interest over time providesinsights with respect to the buildup of owner equity As an example, Exhibit 1–1shows the total payment and the amount of principal and interest for a $100,000

loan with a 6.0% interest rate (or note rate, as it is often called) for the first 60

months

The exhibit shows that the payment is comprised mostly of interest in the earlyperiod of the loan Since interest is calculated from a progressively declining bal-ance, the amount of interest paid declines over time In this calculation, since theaggregate payment is fixed, the principal component consequently increases overtime In fact, the exhibit shows that the unpaid principal balance in month 60 is

$93,054, which means that only $6,946 of the $35,973 in payments made by theborrower up to that point in time consisted of principal However, as the loan sea-sons, the payment is increasingly allocated to principal The crossover point in the

0 05 1 005

360 360

Monthly Interest

example (i.e., where the principal and interest components of the payment areequal) for this loan occurs in month 222.

Loans with shorter amortization schedules (e.g., 15-year loans) allow forbuildup of equity at a much faster rate Exhibit 1–2 shows the outstanding balance

of a $100,000 loan with a 6.0% note rate using 30-, 20-, and 15-year amortizationterms Note that while 50% of the 30-year loan balance is paid off in month 252,the halfway mark is reached in month 154 with a 20-year term, and month 110 for

a 15-year loan In the case of balloon loans, the monthly payments are calculated

to amortize the principal balance over a 360-month term The balloon paymentoccurs at either month 60 (for a 5-year balloon) or month 84 (for 7-year balloonloans) and refers to the unpaid principal balance at the balloon date

Patterns of building borrower equity owing to amortization are important inunderstanding the credit attributes of interest-only loans, currently a fast-growing seg-ment of the market As an example, Exhibit 1–3 compares the payment and balanceschedules for two $100,000 loans with 6% note rates over the first 70 months Oneloan has a fully-amortizing schedule, while the other is a 5-year interest-only loan inwhich the borrower pays only interest for the first 60 months A fully amortizing loanwould have a monthly payment of $599.95 and would, as noted previously, pay down

$6,946 of the loan’s balance at the end of 5 years The interest-only loan, by definition,would amortize none of the principal over the same period However, the monthlypayment on the interest-only loan would increase from $500 to $644 after month 60,amortizing the loan over the remaining 300 months With the higher payment, theremaining balance of the interest-only loan amortizes faster than a fully amortizing loan,although the balance of the IO loan remains higher for the remainder of the loan’s life

A chart showing the remaining balances of the two loans is presented in Exhibit 1–4

E X H I B I T 1–2

Balance of $100,000 Loan Over Different Original Terms (6% Rate)

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 100,000

15-year Term

20-year Term 30-year Term

E X H I B I T 1–3

Fully-Amortizing Loan 5-Year Interest-Only Loan

E X H I B I T 1–3

(Continued)

Fully-Amortizing Loan 5-Year Interest-Only Loan

Monthly Remaining Monthly Remaining