Transcript Com 4FJ3 - McMaster University

Com 4FJ3
Fixed Income Analysis
Week 7
Mortgage Backed Securities
Monthly Cash Flows
• The forecast monthly cash flows are based
on the SMM or PSA benchmarks
• Example: on p. 239, for a 100 PSA with a
WAC or 7.5% and WAM or 357 months
• The calculations for this table are a bit
involved, because the monthly payments on
the mortgage pool decrease as prepayments
are made on some of those mortgages
2
Monthly Payments
• Calculating the scheduled monthly payment
requires keeping track of the total amount of
accumulated prepayments as a fraction of
the initial principal
• Exact formula for this calculation is not
given in this textbook
3
Principal
• The scheduled principal is the difference
between the monthly payment and the
interest on the outstanding principal
• Prepayment estimates = SMM multiplied by
(the outstanding principal less the scheduled
principal payment)
• Outstanding balance = previous balance less
scheduled principal and prepayment
4
Actual Cash Flows
• The cash flows forecast in the previous
table are just predictions
• If the estimate of 100 PSA is reasonable, the
cash flows will still be different from what
was predicted
note: most of the PSA benchmark is based on
experience, but the linear slope for the first
30 months is just an assumption
5
Prepayment Rate
• The actual rate of prepayments can vary
over time for several different reasons
– Prevailing mortgage rates; spread, path
(refinancing burnout), and level
– Characteristics of the loans
– Seasonal factors (low housing turnover in
winter months)
– General economic activity
6
Prepayment Models
• To account for the changing factors over the
life of MBS, some have built models to
predict prepayment behaviour
– From Goldman, Sachs: monthly prepayment =
(refinancing incentive)x(seasoning multiplier)
x(month multiplier)x(burnout multiplier)
• Typically not publicly reported
7
Non-Agency Pass-throughs
• Since these mortgages are not fully insured,
we need to adjust for potential defaults
• Public Securities Association has also
defined a benchmark for the default rate
• Standard Default Assumption (SDA)
• ## SDA is the relative rate of defaults
expected compared to the average (100 SDA)
8
Standard Default Assumption
0.70%
Annualized Defalut Rate
0.60%
0.50%
0.40%
0.30%
0.20%
0.10%
0.00%
0
20
40
60
80
100
120
140
160
180
200
Months
9
Cash Flow Yield
• Similar to IRR, the discount rate that sets
the present value of the forecast cash flows
equal to the price
• Market convention converts the monthly
yield into a bond equivalent basis


bond equivalent yield  2  1  ym   1
6
10
Limitations of Cash Flow Yield
• Can not be used for future value calculation
due to reinvestment risk
• Assumes security is held to maturity (price
risk)
• Prepayment rates and default/delinquency
rates must be equal to what was predicted
11
Yield Spread
• The main difference between treasury bonds
and agency (fully modified) MBS is the
prepayment risk
• What level of spread would compensate for
the added risk?
• Option pricing models have been used to
determine the appropriate spread
12
Average Life
• To which maturity treasury bond should we
compare the MBS?
• Could use Macaulay duration, but main
measure in use is average life
t  principalreceivedat timet
averagelife  12 
totalprincipal
t 1
t  timein months
n
13
Average Life vs. PSA
• The average life will be different with
different prepayment assumptions
• As prepayments increase, average life will
decrease
PSA speed
Average Life
Average Life of 357 month example
50
100
165
300
15.11
11.66
8.76
5.63
500
3.68
700
2.78
14
Negative Convexity
• Prepayments are similar to call provisions
with no call premium
• Not all mortgages will prepay since there is
a cost to the borrower to refinance
• Price increases will be limited due to the
increased likelihood of prepayments as the
interest rate declines
15
Contraction Risk
• If interest rates decrease, the amount of
prepayments will increase
• As prepayments increase, the principal will
have to be reinvested at lower rates
• Average life, and Macaulay’s duration will
decrease… this is called contraction risk
16
Extension Risk
• If interest rates rise, prepayments will
decline
• Expected cash flows will be unavailable for
reinvestment at new, higher rates
• Average life, and Macaulay’s duration will
increase… this is called extension risk
17
Asset/Liability Management
• Depository institutions are more concerned
with extension risk
• Pension funds and others with very long
investment horizons are more concerned
with contraction risk
• Synthetic securities can be built to transfer
some of these risks
18
Prepayments and Return
• Prepayments can enhance the return
compared to the cash flow yield, if the MBS
trades at a discount
• A prepayment causes the realized capital
gain to occur earlier
• If the MBS trades at a discount, its coupon
rate is lower than required, so prepayments
allow beneficial reinvestment
19
CMOs
• Collateralized Mortgage Obligations are a
variant of MBSs
• Called a pay-through structure rather than a
pass-through structure because there are
different classes of owners receiving
different cash flows, but having the same
level of seniority
• Different classes are called tranches
20
Sequential Pay Tranches
• Principal payments are directed at each
tranche in turn until that tranche is paid off
• principal pay-down window is the time
period in which that tranche is receiving
payments towards the principal
• Tranche B in example on p. 258 has a
principal pay-down window from month
81-100
21
Accrual Bonds
• A class of tranche that receives no interest
or principal until the other tranches have
been fully paid off
• The interest payments that this tranche
would have received are treated as principal
prepayments for the other tranches
22
Floating Rate Tranches
• A floating rate tranche can be created by
splitting a tranche into a floating rate
tranche and an inverse floating rate tranche
• The total interest paid to the two tranches
will be the same as the interest paid to the
original tranche
• coupon leverage will be created if the two
tranches are not of the same size
23
Planned Amortization Class
• A PAC tranche is protected from
prepayment risk because it gets principal
payments at a fixed rate
• This is accomplished by issuing support
bond tranches
• The PAC gets principal payments according
to the schedule, anything left over goes to
the support bond tranche
24
PAC Collars
• If the support bond tranche is paid off, the
PAC tranche will lose its protection
• The range of prepayment speeds that can be
handled is called the collar
• The size of the collar can change over time
based on the actual speed of prepayments
25
Targeted Amortization Class
• A TAC bond tranche is protected against
contraction risk, but not extension risk
• Prepayments in excess of a certain rate are
borne by the support bonds, but slower than
expected prepayments are shared equally
• A reverse TAC bond protects vs. extension
risk, but not contraction risk
26
VADM
• Very Accurately Determined Maturity
bonds are created much like PACs except
that there is also an accrual bond tranche
• The accrued interest for the accrual bond
tranche can be used to satisfy the scheduled
principal payments if the prepayment speed
is slower than expected
27
Support Bonds
• These bonds are the tranches that take extra
prepayment risk to allow the PAC, TAC, or
VADM to reduce that risk
• As such these bonds are very risky and
investors will demand a higher rate of return
to buy these tranches
28
Stripped MBS
• Interest only or principal only tranches
• All interest collected is paid to one tranche,
all principal payments, scheduled or
prepayments is paid to the other tranche
• Interest only tranche hurt by prepayments
• Principal only tranche gets money quicker if
prepayments increase
29
Notional Interest Only
• A tranche that is created by paying one or
more tranches lower coupon payments than
the WAC
• The excess interest is paid out to a tranche
as a percent of a notional value
– e.g. $100 m tranche receives 6%, WAC 7%
– 1% of $100 m = 5% of $20 m
– so a tranche can be created paying 5% on a
notional value of $20 m
30
Credit Risk
• A CMO is a business entity
• If issued by an agency or fully modified,
there is no credit risk
• If issued by a private conduit, the level of
credit risk must be assessed
– Private label CMO; assets are agency MBS
– Whole loan CMO; assets are mortgages
31
Appendix Subprime Meltdown
in 2007

In the summer of 2007, there was a crisis in the subprime MBS market
and this crisis, it has been argued, led to a credit and liquidity crisis that
had a rippling impact on other sectors of the credit market as well as the
equity market.

This episode is referred to as the “subprime meltdown.”

In keeping with the history of financial innovation bashing, there have
been overreactions, misinformation, and widely differing viewpoints
regarding the crisis.

Some market observers saw it as the inevitable bursting of the “housing
bubble” that had characterized the housing market in prior years.

Others viewed it as the product of unsavory practices by mortgage lenders
who deceived subprime borrowers into purchasing homes that they could
not afford.
Appendix Subprime Meltdown
in 2007 (continued)






Specific mortgage designs such as hybrid loans made it possible for a subprime
borrower to obtain a loan that could have been expected to cause financial difficulties
in the future when loan rates as part of the loan agreement were adjusted upward.
Mortgage lenders blamed borrowers for misleading them.
Another contingent laid the blame at the feet of Wall Street bankers who packaged
subprime loans into bonds and sold them to investors in the form of MBS.
Whatever the precise cause, it’s hard to deny that securitization–the financial
framework that allowed Wall Street to package these loans into RMBS–is of
enormous benefit to the economy.
Securitization has increased the supply of credit to homeowners and reduced the cost
of borrowing.
 It also spreads the risk among a larger pool of investors rather than
concentrating it in a small group of banks and thrifts.
Securitization is an important and legitimate way for the financial markets to
function more efficiently today than in the past.
Appendix Subprime Meltdown in
2007 (continued)


The securitization of subprime loans works by dividing pools of credit into classes,
or bond classes, separated by the amount of risk each class represents.
 The classes with less risk offer lower potential returns while the classes with
more risk offer higher potential returns.
 The more junior, riskier classes are purchased by sophisticated institutional
investors who understand that they may incur losses but hope for high enough
returns over a long period of time to offset possible losses.
 The demand for this product must come from investors.
In the case of RMBS backed by subprime loans, it came ultimately from hedge fund
managers.
 The major purchasers of subprime MBS were portfolio managers of
collateralized debt obligations (CDOs).
 Managers of CDOs created bond classes that were effectively leveraged
positions in a portfolio of RMBS.
 Hedge fund managers bought the bond classes that were necessary for a
transaction to get done.
Appendix Subprime Meltdown in
2007 (continued)

Rating agencies were also viewed by some market observers as being a major contributor
to the crisis.
 Recall that to aid investors in comparing the relative credit risk of securities, issuers
generally ask one or more rating agencies to assign a credit rating to the
securitization.
 The accuracy of ratings, like any other indicator of credit risk, can only be assessed
on a statistical basis over a long period of time.

What is surprising market observers is why the crisis occurred in July 2007.
 There was no new information in the market at the time.
 Investors knew well before that time all about the potential defaults.
 Moreover, since 2005, the rating agencies took action that was transparent to the
market.
 Specifically, rating agencies adjusted their criteria and assumptions regarding how
they were rating subprime MBS transactions, they downgraded some issues, and they
publicly commented on their concerns about the subprime sector.
Appendix Subprime Meltdown in
2007 (continued)
 The subprime crisis should not be minimized.
 Some homeowners have suffered from an inability to pay their
mortgage.
 Investors in some RMBS have lost real money.
 But none of this suggests that securitization created the subprime
problem.
 Instead, securitization has contributed to long-term economic
growth by getting credit to the people who really need and can use
it.