Mortgage Pass-Through Securities

Chapter 11

Pass-Through Securities

created when one or more mortgage holders form a collection (pool) of mortgages and sell shares (participation certificates) in the pool pass-throughs are then basis for other derivatives (CMOs

and stripped mortgage-backed securities) CFs come from mortgage pmts from pool of

mortgages timing differs from mortgage pmts amt differs from mortgage pmts – difference due to

servicing fees and other fees for guaranteeing issue CFs not known with certainty because of prepayments

WAC and WAM

WAC – weighted-average coupon weight mortgage rate of each mortgage in pool by

amt of mortgage outstanding WAM – weighted-average maturity

weighting remaining # of months to maturity for each loan in pool by amt of mortgage outstanding

Agency Pass-Throughs

Ginnie Mae Freddie Mac Fannie Mae types of guarantees

fully-modified PTs – timely pmt of principal and interest

modified PTs – guarantees interest and principal but only timely payment of interest

Agency Pass-Throughs

Ginnie Mae PTs guaranteed by full faith and credit of US

government essentially default risk free Ginnie Mae guarantees security referred to as

mortgage-backed security (MBS) fully modified pass-throughs only include mortgages guaranteed by Rural Housing

Service, Veteran’s Association, or Farmers Home Assoc.

Agency Pass-Throughs

Freddie Mac PTs their pass-through is called a participation certificate not guaranteed by US government but … modified pass-throughs Gold PC – introduced in 1990

fully modified PT eventually only PC that Freddie will issue

Fannie Mae PTs MBS not obligation of government because government-

sponsored agency not government agency fully modified pass-throughs

Non-Agency Pass-Throughs

issued by commercial banks, thrifts, and private conduits purchase nonconforming mortgages, pool, and

sell pass-throughs which have underlying pool as collateral

same thing as Agency except not guarantee of government

registered with SEC rated by same firms that rate debt

Credit Enhancements

rating companies consider type of property type of loan term of loan geographical dispersion of loan loan size purpose of loan

rating given but can be changed by credit enhancement (this has been key to growth of this type of security in market)

Credit Enhancements external

3rd party guarantees that provide first-loss protection against losses up to a point (say 10%)

bond insurance – same as muni bond insurance pool insurance – covers losses from defaults and foreclosures

usually for $ amt for life of pool some written so $ amt declines as pool seasons as long as

credit performance is better than expected ratings agencies approve

need additional insurance to cover losses from bankruptcy or fraud

rating of 3rd party must be at least as high as rating sought*

Credit Enhancements

internal – may change CFs even with no default reserve funds

cash – deposits of cash generated from issuance proceeds excess spread accounts – allocation of excess spread or cash

into separate reserve account after paying net coupon overcollateralization

principal amt of issue < principal amt of pool of loans senior/subordinate structure – most widely used

subordinate class absorbs all losses up to amt in class subordinate class has higher yield shifting interest structure – redirects prepayments from

subordinate class to senior class according to given schedule (want to maintain insurance)

Prepayment

value of any security is what? issue for PTs why?

prepayment speed CF yield – yield calculated based on projected CF

prepayment conventions FHA experience – no longer used since

prepayment rates are related to interest rate cycle conditional prepayment rate PSA prepayment benchmark

Conditional Prepayment Rate

single-monthly mortality rate CPR is annual so convert

to monthly rate to find amt of monthly prepayments

SMM rate and prepayment assume that

approximately x% of remaining balance prepays at beginning of month

12/1)1(1 CPRSMM

PSA Prepayment Benchmark

Public Securities Association (PSA) benchmark expressed as monthly series of annual prepmt rates assumes prepayment rate increases as loans become

more seasoned assumes following CPRs for 30-year mortgages

CPR of 0.2% for 1st month and increased by 0.2% per year each month for next 30 months

6% CPR per year for remaining years benchmark referred to as 100 PSA

if t<= 30, CPR = 6%(t/30) if t>30, CPR = 6%

PSA Benchmark

50 PSA – assuming prepayment rate of half the CPR of the benchmark

150 PSA – rate 1.5 times CPR of PSA benchmark

SMM for month 5 assuming 100 PSA CPR = 6%(5/30) = 1%

= 0.000837

12/1)01.01(1 SMM

Monthly CF Construction

assume underlying mortgages are fixed-rate level payment with WAC = 8.125% pass-through rate is 7.5% and WAM of 357

months assume 100 PSA in second example, assume 165 PSA

Prepayment Models

models statistical relationships among factors expected to affect prepayments

models used to view borrowers as generic more data available now so models are more

complex models differ for agency and nonagency MBS

book presents models developed by Bear Stearns

Agency Prepayment Models

not as much data available on individual loans so models done at “pool” level

components in Bear Stearns model housing turnover – existing home sales

family relocation due to changes in employment and family status (change in family size, divorce)

trade-up and trade-down activity due to changes in interest rates, income, and home prices

insensitive to level of mortgage rates cash-out refinancing rate/term refinancing

Agency Prepayment Models

cash-out refinancing refinancing by borrower in order to monetize the price

appreciation of the property depends on increase in housing prices in region where

property is located favorable tax law regarding capital gains adds incentives to

monetize price appreciation (exempts gains up to $500,000)

may be economical even if mortgage rates are rising and with transaction costs

cash-out refinancing is tied to housing prices and insensitive to mortgage rates

Agency Prepayment Models

rate/term refinancing means borrower has gotten new mortgage on same

property to save either on interest cost or shortening life of mortgage with no increase in the monthly payment

decision whether or not to refinance is due to PV of $ interest savings from lower rate after subtracting estimated costs to refinance

proxy for rate/term refinancing for model: difference between prevailing rate and note rate – not good

proxy better on is refinancing ratio – note rate to current rate WAC is numerator ratio < 1 – note rate less than current so no incentive to

refinance ratio > 1 – some incentive possibly to refinance

Housing Turnover in Agency Prepayment Models factors used by Bear Stearns

seasoning effect – (see graph on next slide) idea is that you must recognize the homeowner’s tenure in the

house – may not be same as age of loan because of possible refinancing

housing price appreciation effect over time LTV of home changes due to either amortization of

loan or change in value of home – incentive to refinance if value of home goes up

need to estimate prepayments due to housing appreciation Bear Stearns used Home Appreciation Index (HPI) – (see

slide) seasonality effect

home buying increases in spring and peaks in late summer – buying declines in fall and winter – prepayments follow similar pattern but may lag a bit with peak closer to early fall

Bear Stearns Baseline HTO Prepayments for Agency MBS

Effect of Housing Price Appreciation of Agency Prepayments

Cash-Out Refinancing

driven by price appreciation since loan origination – need proxy for this Bear Stearns uses HPI see slide to show cash-out refinancing incentives for 4

assumed rates of appreciation according to Bear Stearns model, projected prepayments

due to cash-out refinancing exist for all ratios greater than 0.6 prepayments increase as the ratios increase the greater the price appreciation for a given ratio, the greater

the projected prepayments

Effect of Housing Price Appreciation on Cash-Out Refinancing on Agency Prepayments

Rate/Term Refinancing Component decision to refinance not based totally on note rate

relative to current rate S-curve for prepayments

if totally based on ratio, why does curve flatten out (or prepayment rate flatten out) because borrowers left in pool can not get refinancing or some

have other reasons why refinancing does not make sense S-curve not sufficient for modeling rate/term refinancing –

ignores 2 things that affect decision: burnout effect – Bear Stearns use some pool variables as

proxies: original term, loan purpose, WAC rate, weighted average loan age,

loan size, rate premium over benchmark, yield curve slope (see slide)

threshold media effect

Baseline Refinancing Function for Bear Stearns’ Agency Prepayment Model for an “Ordinary” Pool of Agency Borrowers

original loan of $125,000, age of 12 months, no rate premium at origination, no prior option to refinance, 3.5% annual home price appreciation

Baseline S-Curve for Agency Borrowers Based on Loan Amount

shows model’s S-curves for $25,000 loan size increments – relative to loans with balances less than$100,000, loan balances that exceed $150,000 are about 1.5 to 2.5 times more sensitive to refinancing

Nonagency Prepayment Models same components as in Agency models

but more info. on these loans so prepayment model estimated for each type of loan (rather than for pool of loans)

Bear Stearns gives projected prepayment rates based on size of loan rate premium documentation occupancy status current LTV

Baseline Projected Prepayment Rate Across a Range of Refinancing Incentives for 3 Loan Types

Cash Flow for Nonagency PTs CFs not affected by default and delinquency

for agency PTs PSA has issued a standardized benchmark

for default rates SDA benchmark gives annual default rate for

a mortgage pool as a function of the seasoning of the mortgages can use multiples of default rate similar to

prepayment benchmark – so can have 200 SDA

Cash Flow Yield

rate that makes the PV of expected CF equal to the price bond-equivalent yield

market convention for annualizing yield on fixed-income security that pays interest more than once a year

found by doubling a semi-annual yield semi-annual yield for PT is

semiannual cash flow yield = (1 + y M)6 – 1

where yM is monthly interest rate that equates PV of projected monthly CF to price of PT

bond-equivalent yield = 2[(1 + yM)6 – 1] must specifiy underlying prepayment assumption to realize this yield, investor must reinvest CFs at yield, investor

must hold PT until all mortgages paid off, and assumed prepayment rate must actually occur so be careful in placing too much confidence in yields!

Average Life

average life of MBS average time to receipt of principal payments

(scheduled and prepayments) weighted by amount of principal expected

average life depends on prepayment assumption

Prepayment Risk

assume you buy 10% coupon GNMA with market rates of 10% assume rates in market fall to 6% consequences?? - contraction risk

price increase but not as large as increase for option-free bond negative convexity

CF reinvested at lower rate assume rates rise to 15% - extension risk

price of PT falls but will fall more because rate increase slows down rate of prepayments

problem for investor is this is exact time that they want rate of prepayments to increase so they have money to reinvest at higher market rate of 15%

Asset / Liability Management

PTs unattractive to some institutions depository institutions exposed to extension risk when they

invest – they want to lock in spread over cost of funds – PT is longer term than their liabilities

life insurance companies are exposed to extension risk when using PTs – they might issue 4 year GIC – problem is uncertainty about CF from PTs that they will receive to have to pay off GIC

pension fund is exposed to contraction risk using PTs – they have long-term liabilities and want to lock in current rates – exposed to risk that prepayments will speed up and maturity of investments will shorten (happens when rates fall) and they will have to reinvest prepayments at lower rate

Secondary Market Trading

quoted same manner as Treasuries 94-05 means 94 and 5/32nds of par or

94.15625% of par PTs identified by pool prefix and pool number

prefix tells type of PT – 20 for Freddie Mac PC means underlying pool of conventional mortgages with original maturity of 15 years

prefix of AR for GNMAs means ARMs pool number tells specific mortgages underlying

PT and issuer of PT