# 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

- Balloons

- 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
- Graphically

- 20. Mortgage Servicing
- 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

- Rise

- Fall

- 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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