Transcript Introduction to Bond Markets, Analysis, and Strategies

Mortgage Pass-Through
Securities
Chapter 11
Pass-Through Securities
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created when one or more mortgage holders form a
collection (pool) of mortgages and sell shares
(participation certificates) in the pool
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pass-throughs are then basis for other derivatives (CMOs
and stripped mortgage-backed securities)
CFs come from mortgage pmts from pool of
mortgages
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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
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WAC – weighted-average coupon
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weight mortgage rate of each mortgage in pool by
amt of mortgage outstanding
WAM – weighted-average maturity
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weighting remaining # of months to maturity for
each loan in pool by amt of mortgage outstanding
Agency Pass-Throughs
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Ginnie Mae
Freddie Mac
Fannie Mae
types of guarantees
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fully-modified PTs – timely pmt of principal and
interest
modified PTs – guarantees interest and principal
but only timely payment of interest
Agency Pass-Throughs
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Ginnie Mae PTs
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guaranteed by full faith and credit of US
government
essentially default risk free
Ginnie Mae guarantees security referred to as
mortgage-backed security (MBS)
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fully modified pass-throughs
only include mortgages guaranteed by Rural Housing
Service, Veteran’s Association, or Farmers Home Assoc.
Agency Pass-Throughs
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Freddie Mac PTs
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their pass-through is called a participation certificate
not guaranteed by US government but …
modified pass-throughs
Gold PC – introduced in 1990
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fully modified PT
eventually only PC that Freddie will issue
Fannie Mae PTs
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MBS
not obligation of government because governmentsponsored agency not government agency
fully modified pass-throughs
Non-Agency Pass-Throughs
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issued by commercial banks, thrifts, and
private conduits
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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
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rating companies consider
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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
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external
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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
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usually for $ amt for life of pool
some written so $ amt declines as pool seasons as long as
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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
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internal – may change CFs even with no default
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reserve funds
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overcollateralization
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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
principal amt of issue < principal amt of pool of loans
senior/subordinate structure – most widely used
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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
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value of any security is what?
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prepayment speed
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issue for PTs why?
CF yield – yield calculated based on projected CF
prepayment conventions
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FHA experience – no longer used since
prepayment rates are related to interest rate cycle
conditional prepayment rate
PSA prepayment benchmark
Conditional Prepayment Rate
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single-monthly mortality
rate
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CPR is annual so convert
to monthly rate to find
amt of monthly
prepayments
SMM rate and
prepayment
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assume that
approximately x% of
remaining balance
prepays at beginning of
month
SMM  1  (1  CPR)
1 / 12
PSA Prepayment Benchmark
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Public Securities Association (PSA) benchmark
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expressed as monthly series of annual prepmt rates
assumes prepayment rate increases as loans become
more seasoned
assumes following CPRs for 30-year mortgages
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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
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if t<= 30, CPR = 6%(t/30)
if t>30, CPR = 6%
PSA Benchmark
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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
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CPR = 6%(5/30) = 1%
SMM  1  (1  0.01)
= 0.000837
1 / 12
Monthly CF Construction
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assume underlying mortgages are fixed-rate
level payment with WAC = 8.125%
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pass-through rate is 7.5% and WAM of 357
months
assume 100 PSA
in second example, assume 165 PSA
Prepayment Models
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models statistical relationships among factors
expected to affect prepayments
models used to view borrowers as generic
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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
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not as much data available on individual loans so
models done at “pool” level
components in Bear Stearns model
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housing turnover – existing home sales
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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
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cash-out refinancing
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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
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rate/term refinancing
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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:
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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
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factors used by Bear Stearns
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seasoning effect – (see graph on next slide)
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housing price appreciation effect
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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
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
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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
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driven by price appreciation since loan origination –
need proxy for this
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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
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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
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decision to refinance not based totally on note rate
relative to current rate
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S-curve for prepayments
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if totally based on ratio, why does curve flatten out (or
prepayment rate flatten out)
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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:
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burnout effect – Bear Stearns use some pool variables as
proxies:
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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
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same components as in Agency models
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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
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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
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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
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can use multiples of default rate similar to
prepayment benchmark – so can have 200 SDA
Cash Flow Yield
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rate that makes the PV of expected CF equal to the price
 bond-equivalent yield
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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]
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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
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so be careful in placing too much confidence in yields!
Average Life
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average life of MBS
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average time to receipt of principal payments
(scheduled and prepayments) weighted by
amount of principal expected
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average life depends on prepayment assumption
Prepayment Risk
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assume you buy 10% coupon GNMA with market
rates of 10%
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assume rates in market fall to 6%
consequences?? - contraction risk
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price increase but not as large as increase for option-free
bond
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negative convexity
CF reinvested at lower rate
assume rates rise to 15% - extension risk
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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
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PTs unattractive to some institutions
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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
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quoted same manner as Treasuries
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94-05 means 94 and 5/32nds of par or
94.15625% of par
PTs identified by pool prefix and pool number
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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