fixed income securities and their derivatives
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- 1. Fixed Income Securities and their Derivatives
- 2. Asset-Backed Securities
- 3. Asset-Backed Securities
- ABS derive their cash flows from a pool of underlying assets
- MBS = mortgage backed securities
- CARS = certificates for automobile receivables
- CARDS = certificates for amortizing revolving debts
- HELS = home equity loan securities
- 4. Asset-Backed Securities
- The underlying assets generate cash flows of principal and interest which can be repackaged and sold to investors.
- 5. Asset-Backed Securities
- In ABS, the underlying assets are collected into a pool .
- Pool assets are standardized .
- The asset pool is placed in trust.
- Claims on the cash flows generated by the asset pool are structured:
- Pass-through structures
- Multi-class structures
- Securities representing these claims are sold.
- 6. Securitization
- By pooling and repackaging cash flows, ABS issuers can convert illiquid fixed income assets into marketable bonds.
- Requires trust structure to hold underlying assets, and
- Credit enhancement to achieve investment grade bond rating
- External: guarantees
- Internal: over-collateralization.
- 7. Issuers
- Mortgage related agencies
- Ginnie Mae (pass-thoughs)
- Freddie Mac (PCs)
- Fannie Mae (MBS)
- Private label MBS
- Citi, GE, Prudential
- Private label ABS
- GMAC and other auto companies
- Finance companies
- Credit card issuers
- 8. Investors
- Insurance companies
- Pension funds
- Mutual funds
- Wealthy individuals
- 9. MBS
- Backed by mortgage loans.
- A mortgage loan is a loan secured by real estate
- The mortgage is a security agreement that gives the lender the right to seize by foreclosure the property securing the loan if the borrower defaults
- Mortgage loans are originated by banks and other financial firms.
- Once originated, a mortgage loan may be held, sold to an investor for cash, or pooled and securitized.
- 10. Mortgage Loan Types
- Fixed-rate, level pay (plain vanilla)
- Term of loan is fixed (30 years is common in US)
- Contract rate of interest is fixed for the life of the loan.
- Payments (usually monthly) are constant for the term of the loan
- The payments fully amortize the loan.
- FHA, conventional, conforming, nonconforming, jumbo
- 11. Mortgage Loan Types
- Graduated payment loans (GPMs)
- Low initial payments and period of negative amortization
- Graduated equity loans (GEMs)
- Fixed coupon with growing payments
- Adjustable rate mortgages (ARMs)
- Various index rates
- Caps and collars
- 12. Mortgage Loan Payments
- The payments on a plain vanilla mortgage are determined by
- 13. For Example
- The monthly payments on a $187,000 loan written at 10% for 15 years is
- 14. Mortgage Loan Payments
- Each payment consists of
- interest equal to i /12 times the amount of principal owing at the time the payment is due, and
- scheduled principal repayment
- Payments are calculated such that the interest due is paid first and then the remainder of the payment is used to reduce the principal owed.
- A table listing the payments and how they are divided between interest and principal is called an amortization schedule.
- 15. Amortization Schedule
- For example, here are the first few lines of an amortization schedule for a 15-year, 10% fixed rate loan with an initial principal of $187,000
- 16. Amortization Schedule
- A better way to visualize the amortization process is to look at a graph of the payments
- 17. Amortization Schedule
- The principal balance remaining after any number of payments can be determined by constructing an amortization schedule or by employing the formula
- 18. Amortization Schedule
- The logic of this formula is that the principal balance remaining after s payments is always the present value of the remaining 12T-s payments discounted at the contract rate of interest
- 19. Amortization Schedule
- 20. Mortgage Servicing
- Collection and forwarding of payments
- Administration of escrow accounts
- Servicing fees
- Typically 50 basis points
- Right to service loan is sold by owner of mortgage loan
- 21. Mortgage Servicing
- For example
- 22. Prepayments
- Payments made by borrowers in excess of their scheduled loan payments.
- Entire (as when the house is sold or refinanced)
- Partial (accelerated principal repayment)
- Most prepayments are optional to the borrower
- put option
- Borrower incentives when rates
- 23. For Example
- Consider a mortgage thats been outstanding for two years and rates have fallen 2%
- 24. Prepayments
- To the extent that prepayments cannot be perfectly predicted, they create uncertainty about the term of mortgage loa
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