CHAPTER EIGHTEEN

MORTGAGE BACKED SECURITIES

© 2001 South-Western College Publishing

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Outline

Mortgages Types Mortgage Mathematics Mortgage Risk

The Mortgage Backed Securities Market History Types of Securities

3

Outline

Considerations in Pricing MortgageBacked Securities The Importance of Prepayment Rates The PSA Convention The Risks of MBS The Risk of Collateralized Mortgage Obligations The Risk of Stripped Mortgage Backed Securities

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Introduction

A mortgage is a loan with real estate as collateral. The lender, called the mortgage originator, often charges points as a fee for preparing and placing the mortgage.

It is quite common for the lender to sell the mortgage to another party.

The homeowner may be unaware of this, as the lender normally continues to be the mortgage servicer.

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Mortgages: Types

A fixed rate mortgage is one with payments based on a set interest rate that does not change.

An adjustable rate mortgage (ARM), also called a variable rate mortgage, has an interest rate that moves with some market interest rate, such as the Treasury bill rate.

Most ARMS have an annual reset to the interest rate. Many also have either a cap or a floor on the interest rate.

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Mortgages: Types

With a convertible mortgage, the borrower has the option to exchange it for a fixed rate at the prevailing ARM rate.

There are other mortgage arrangements: biweekly - payments are due every two weekssemi-monthly - payments are due two times each monthgraduated payment - the monthly payments increase following a predetermined schedule

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Mortgages: Types

shared appreciation - the borrower splits the rise in the value of the property with the lender in exchange for a reduced interest ratereverse - the homeowner sells the property to a bank and receives monthly mortgage payments

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Mortgage Mathematics

There will be 30×12 = 360 monthly payments at a monthly interest rate of 8÷12 = 0.66667%

Example :

A bank approves a prospective homeowner for a 30-year, $100,000 mortgage at an 8% annual rate.

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Mortgage Mathematics

So:

36066667.0166667.0

1

66667.0

1000,100$ C

The monthly payment will be $733.76

For an annuity:

NRRR

C1

11value present

C = the monthly paymentR = the monthly interest rateN = the number of payments

where

Mortgage Amortization Schedule

$733.76$733.76$733.76$733.76$733.76$733.76$733.76$733.76$733.76$733.76$733.76$733.76

$8805.12

123456789

101112

Total

$666.67$666.22$665.77$665.32$664.86$664.40$663.94$663.47$663.00$662.53$662.06$661.58

$7969.82

$67.09$67.54$67.99$68.44$68.90$69.36$69.82$70.29$70.76$71.23$71.70$72.18

$835.30

$100,000.00$99,932.91$99,865.37$99,797.38$99,728.94$99,660.04$99,590.68$99,520.86$99,450.57$99,379.81$99,308.58$99,236.88$99,164.70

PaymentAmount Interest Principal

RemainingBalance

PaymentNumber

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Mortgage Mathematics

If the borrower pays the bank $1,500 instead of $733.76 for the thirteenth payment, how will the amortization schedule be affected?

The bank considers the extra $766.24 the borrower paid a principal reduction, and the anticipated life of the loan will decrease.

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Mortgage Risk

Default risk is the risk that the borrower is unable or unwilling to repay the debt as agreed.

Interest rate risk is the risk that the general level of interest rates rises, such that the value of the mortgage’s cash flow stream declines.

Prepayment risk is the risk of an early payment of the original mortgage, such as when the home is sold or when the mortgage is refinanced at a lower rate.

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The Mortgage Backed Securities Market

The Federal National Mortgage Assoc. (Fannie Mae), the Gov’t National Mortgage Assoc. (Ginnie Mae), & the Federal Home Loan Mortgage Corp. (Freddie Mac) support the US mortgage market by providing liquidity, buying conforming mortgages from banks across the country for resale elsewhere.

The term mortgage-backed securities refers to all products based on mortgage loans.

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Types of Securities

A pass-through security is a share of a poolof mortgages.

The holders receive a monthly check for theirportion of the scheduled principal and interest payments, plus their share of any prepayments that may occur.

Individual Individual Individual Mortgages Mortgages Mortgages

Mortgage Pool

Pass Through Security

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Types of Securities

A collateralized mortgage obligation (CMO) isa security backed by a pool of mortgages and structured to transfer prepayment or interest rate risk from one group of security holders to another.

A given pool of mortgages backs two or moreclasses of securities called tranches.

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Types of Securities

Individual Individual Individual Mortgages Mortgages Mortgages

Mortgage Pool

A Tranche B Tranche C Tranche Other Tranches

Collateralized Mortgage Obligation

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Types of Securities

With a sequential pay CMO, all the tranche holders receive monthly interest payments based on the principal amount outstanding in their tranche.

All principal payments go to the A tranche until the A tranche principal is completely returned. Only then will the investors in the next tranche begin to receive principal.

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Types of Securities

There are two types of stripped mortgage backed securities, or strips.

All the interest goes to the interest only (IO)security holders, while the entire principal goes to the principal only (PO) holders.

Individual Individual Individual Mortgages Mortgages Mortgages

Mortgage Pool

Interest Only Security Principal Only Security

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Considerations in Pricing Mortgage Backed Securities

The price risk of a MBS comes from the uncertainty about the timing of cash flows.

Prepayments can affect the realized return on a MBS substantially.

The offering memorandum for a MBS will state the assumptions used in estimating cash flows from the mortgage pool.

A benchmark assumption for the rate of mortgage prepayment is offered by the Public Securities Association (PSA).

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Considerations in Pricing Mortgage Backed Securities

A MBS has default, interest rate, and prepayment risks.

Riskiness of Cash Flows

variable ratenon-callable

bond

fixed ratenon-callable

bond

principal only

security

interestonly

security

$ AmountUnknown

TimingKnown

$ AmountKnown

TimingUnknown

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Declining interest rates will increase thevalue of a cash flow stream and will lead to prepayments.

If a mortgage pool sells at a discount,prepayments will increase the value of each of the tranches, with the higher duration tranches benefiting the most.

If the pool sells at a premium, thenprepayments will reduce everyone’s yield, with the effect most pronounced for the holders of the longer duration tranches.

The Risk of Collateralized Mortgage Obligations

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The Risk of Stripped Mortgage Backed Securities

Prepayment has different consequences forIO and PO strips. An extension of the mortgage decreases the value of the principal payments but increases the value of the interest payments.

Declining interest rates will increase thevalue of a series of known cash flows, as well as the likelihood of prepayment. Normally, the prepayment effect overwhelms the interest rate effect.

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Review

Mortgages Types Mortgage Mathematics Mortgage Risk

The Mortgage Backed Securities Market History Types of Securities

24

Review

Considerations in Pricing MortgageBacked Securities The Importance of Prepayment Rates The PSA Convention The Risks of MBS The Risk of Collateralized Mortgage Obligations The Risk of Stripped Mortgage Backed Securities