Transcript Com 4FJ3 - McMaster University

Com 4FJ3
Fixed Income Analysis
Week 6
Mortgages
Residential Mortgages
• A secured loan using a residential property
as collateral
• When based on credit of purchaser and the
collateral this is a conventional mortgage
• May be insured by private company, or
government agency (FHA, VA, or FmHA in
USA, CMHC in Canada)
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Mortgage Originators
• The original lender is called the mortgage
originator, can include; banks, thrifts, trusts,
pension funds and insurance companies
– Many others in 2001-2007
• Make money through; origination fees,
application fees, processing fees, etc.
• Can make money by selling mortgage or by
holding to maturity
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Credit Approval
• 2 main ratings of the credit of an applicant
– Payment to income ratio (PTI); mortgage and
property taxes to income, the lower the better in
terms of credit quality
– Loan to Value (LTI); amount of principal
outstanding compared to the market or assessed
value of the property, the lower the better to
recover balance in default
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LTV
• The higher the LTV ratio, the higher the
probability of default
• Current LTV should be considered since
housing prices often decline in some areas
• LTVs of over 100% can be a cause for
concern, at 110% default rates can hit 10%
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The Problem
• Estimates that 5 million US households owe
25% more than value (LTV 1.33)
• 2001-2007 saw the growth of nontraditional
amortization schemes including the most
popular “Interest Only” loan
• When the real estate market crashed a large
number of mortgages went in default
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Down Payment
• For new mortgage loans, the LTV is based on the
amount paid as a down payment
– With a 15% down-payment LTV = 0.85
• In Canada; Mortgage Loan Insurance is required when
a mortgage loan is more than 80% of the purchase
price of a dwelling.
• With CMHC insurance, home buyers are able to
purchase a property with as little as 5% down.
http://www.cmhc.ca
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Securitization
• Originators can
– keep the mortgage as an investment
– sell to someone issuing a MBS
– use as security when issuing a MBS
• With the latter two options the mortgage is
said to have been securitized
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Conduits
• When an originator sells the mortgage to
someone (agency or company) who is going
to use them to back a MBS, the buyer is
called a conduit
• Private conduits include; GE Capital
Mortgage Services, Prudential Home
Mortgage, Chase Mortgage Finance, etc.
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Conforming Mortgages
• US agencies; Federal Home Loan Mortgage
Company and Federal National Mortgage
Assoc., only buy conforming mortgages
– Maximum PTI
– Maximum LTV
– Maximum dollar value of mortgage
• A non-conforming mortgage may be high
quality, but not acceptable to those agencies
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Mortgage Servicers
• Servicing includes; collecting payments,
remitting payments to the owners of the
mortgage, reminding mortgagers when
payments are overdue, maintaining records,
managing any required escrow accounts,
initiating foreclosures, etc.
• Main revenue source is servicing fees
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Mortgage Insurance
• Required in Canada if LTV is less than 80%
main insurer is CMHC
• In the US; if qualified, FHA or VA
otherwise private insurers
• Also available; credit life policies, pays off
the mortgage if the policy holder dies, term
life contract with declining value
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Mortgage Interest
• Canada Bank Act; quoted rates must be
stated on a semi-annual compounding basis
monthly rate is (1+r/2)1/6- 1
• For a 6% rate
– Monthly Rate = 0.4939%
– EAR=6.09%
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Mortgage Interest
• US practice; quoted rates are stated on a
monthly compounding basis, so the interest
charged on regular monthly payments is
1/12th of the stated rate
• For a 6% rate
– Monthly Rate = 0.5%
– EAR=6.17%
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Fixed Rate Mortgage
• Payments of a fixed amount are made over
the life of the mortgage
• Payments cover accrued interest and some
principal (proportion grows over time)
• Fully amortizes the original principal
1  1  rm  n 
P rincipal PMT 

rm


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Adjustable Rate Mortgage
• With an ARM, the interest rate is reset
periodically with respect to a reference rate
• Period can be monthly, semi-annual,
annual, or even less frequent
• Sub-prime loans often featured a teaser rate
to convince customers to sign on
• May also include caps or floors
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Balloon Mortgages
• Very common in Canada
• Amortization period is greater than the life
of the mortgage (partial amortization)
• At the end of the term of the mortgage, the
remaining balance must be paid, usually by
refinancing the mortgage
• No significant use in US until 1990s
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Partial Amortization, Mortgage
• Consider a mortgage;
•
•
•
•
$200,000 at 8% (APR semi-annual)
Amortization period of 20 years, term of 3 years,
What are the monthly payments?
What is the remaining balance?
– rm = (1 + 0.04)1/6 -1 = 0.0065582
– PVIFA(0.0065582, 240) = 120.72083
– Payment = 200,000/120.72083= 1,656.715
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Amortization Table
rate =0.6558%
APR= 8.00%
Period
Beginning
balance
interest
payment
outstanding
balance
1
2
3
200,000.00
199,654.92
199,307.58
1,311.64
1,309.38
1,307.10
1,656.72
1,656.72
1,656.72
199,654.92
199,307.58
198,957.96
1,228.56
1,225.75
1,222.93
1,656.72
1,656.72
1,656.72
186,904.17
186,473.20
186,039.41
{snip}
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35
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187,332.32
186,904.17
186,473.20
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A Second Method
• Take the future value of the loan if no
payments were made and subtract the future
value of the payments.
• FV loan = 200,000 x (1.04)6 = 253,063.80
• FV pay = 1,656.72 x FVIFA(0.0065582, 36)
= 67,024.42
• Balance = 186,039.39
– The same as the amortization table.
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Method Three
• Take the present value of the remaining 204
payments that would be required if the loan
term were 20 years.
• Due to rounding up to the next cent, the
final payment is $2.92 less, a present value
of $0.77 as of the end of year 3.
• all 3 methods give us the same value.
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Prepayments
• Typical US mortgages allow the buyer to
prepay any/all of the principal at any time
– Prepayment Penalty Mortgages (PPM) restrict
this prepayment ability
• Canadian mortgages; have more variance in
rules on prepayments;
– open vs. closed
– different rules for different mortgages
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Other Mortgages
• Growing Equity Mortgage (GEM);
payments increase over time shortening the
life of the mortgage
• Reverse mortgages; lender “pays” the
homeowner a monthly amount and collects
the house when the homeowner no longer
occupies the house
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Credit Risk
• Credit risk is not important for mortgages
insured by government agencies, since they
are fully backed by the government
• For every 1,000 mortgages issued, 10 (on
average) will go into default
• Benchmark prime loan is 30 year fixed rate
with 75-80% LTV on a single family fully
detached house
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Mortgage Risk Factors
• Mortgage term; the longer the term the
higher the default risk
• Mortgage type; fixed rate mortgages have
lower risk than ARM since payments are
known in advance
• Transaction type; initial purchase mortgages
are less risky than refinancing mortgages
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Mortgage Risk Factors
• Documentation; loans without full
documentation on the borrower’s finances
are higher risk… e.g. self-employed with
volatile income
• Occupancy status; mortgages on vacation
homes and rental properties are higher risk
than mortgages on principal residences
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Mortgage Risk Factors
• Property type; single family detached
homes are low risk, townhouses and condos
have more price risk due to development
• Size of loan; the larger the higher the risk
– to a point, very low PTIs are common
• Credit worthiness of borrower; data is often
not available to secondary buyers
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Liquidity Risk
• Although there is an active market for
mortgages, the bid/ask spread is large
• Main problem is that mortgages tend to be
large and undivisible
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Interest Rate Risk
• As with bonds, the value of a mortgage
increases with decreases in the required
yield
• Due to prepayment provisions, and “due on
sale” clauses, many (open) mortgages are
effectively bonds that are callable at par,
driving down their value
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Prepayment Risk
• Mortgages are subject to prepayment from;
– Sale of the house; can be due to change of
employment, trading up, divorce, etc.
– Refinancing to take advantage of lower rates
– Default and repossession
– Destruction of the property by fire or other
calamity
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Mortgage Pass-Throughs
• Mortgage Pass-Through Securities, a form
of Mortgage Backed Security
• A collection of mortgages bundled together
and shares of the bundle of mortgages are
sold to investors
• All principal and interest collected (after
servicing fees) is paid to the shareholders
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Sectors of the RMBS Market
• The prime sector includes
– loans that satisfy the underwriting standard of
Ginnie Mae, Fannie Mae, and Freddie Mac
(i.e., conforming loans)
– loans that fail to conform for a reason other
than credit quality or because the loan is not a
first lien on the property (i.e., nonconforming
loans).
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Sectors of the RMBS Market
• The subprime mortgage sector is the market
for loans provided to borrowers with an
impaired credit rating or where the loan is a
second lien; these loans are nonconforming
loans.
• 2001-2007 saw a rapid increase in demand
for RMBS of this type.
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Cash Flow Characteristics
• Cash flow to investors is not equal to the
cash collected since servicing and guarantee
fees are deducted before distribution
• The remaining amount is called the passthrough coupon rate
• The actual payments are not known in
advance due to prepayment provisions
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WAC and WAM
• The pooled mortgages may differ in size,
interest rate and maturity
• Weighted Average Coupon Rate (WAC) is
calculated based on the different rates
• Weighted Average Maturity (WAM) is also
calculated and reported to potential
investors
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Agency Pass Throughs
• With an agency backed security the
mortgage payments are guaranteed
• fully-modified pass throughs are guaranteed
for both interest and scheduled pricipal
• modified pass throughs only guarantee the
interest portion, principal is passed through
as collected but no later than a set date
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Main Agencies in USA
• Government National Mortgage Association
(Ginnie May) is fully federally backed
• Federal Home Mortgage Corporation
(Freddie Mac) some modified PCs outstanding
• Federal National Mortgage Association
(Fannie May)
• All currently issue fully modified MBS
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Canada
• CMHC does not directly issue MBS
• Various financial institutions are able to
issued NHA MBS, which are fully modified
due to the CMHC guarantee
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MBS Issuers
• Include financial institutions that are already
operating as Approved Lenders of NHA-insured
mortgages: banks, trust companies, insurance
companies, loan companies, credit unions and
caisses populaires.
• Other financial institutions that are not originators
of the underlying mortgages, such as investment
dealers, may become issuers. All issuers must be
approved by CMHC.
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Non-Agency Pass Throughs
• Uninsured mortgages are also bundled and
sold as MBS
• Since the mortgages are not guaranteed by
the government they are rated by the credit
rating agencies
• To ensure a AAA or AA rating the issuer
often has to perform credit enhancement
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Credit Enhancement
• External enhancement is a form of private
guarantee or insurance policy
• Weakest link; the guarantor’s credit rating
must be at least as high as the credit rating
of the MBS issue, MBS will be downgraded
if the guarantor’s credit is downgraded
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Internal Credit Enhancement
• Additional terms in the structure of the
MBS can improve the likelihood of timely
payment of interest and principal
–
–
–
–
Reserve funds
Excess servicing spread accounts
Overcollateralization
Senior/subordinated structure
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Prepayment Conventions
• The cash flow to the MBS is affected by
prepayments so the rate of prepayments
must be estimated to value this investment,
this is referred to as the prepayment speed
• Some methods of measuring speed are;
– FHA prepayment experience
– Conditional prepayment rate
– PSA prepayment benchmark
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Conditional Prepayment Rate
• A benchmark based on the characteristics of
the pool
• An annual rate of prepayments is estimated
• Single month mortality (SMM); is derived
from the CPR, similar to effective rates
SMM  1  1  CPR
1
12
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SMM and Monthly Cash Flow
• The expected principal payment can be
calculated from the SMM
• Principal payment expected =
SMM x (beginning balance - scheduled
principal payment)
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PSA Benchmark
• The Public Securities Association has also
developed a benchmark for prepayments
• The PSA prepayment benchmark, for 30
year mortgages, assumes low prepayments
is the first 5 years and a level prepayments
over the remaining 25 years
• The 100% PSA rate is 0.2% x t, to a
maximum of 6% per month
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100 PSA Benchmark
Prepayment Rate
7.5%
5.0%
2.5%
0.0%
0
60
120
180
240
300
360
Months
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Other PSAs
• The PSA benchmark can be modified
– 0 PSA means no prepayments
– 50 PSA has half the prepayment rate
– 200 PSA has double the annual prepayment
• The average time to move can be calculated
from the PSA benchmark as shown in the
text
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Monthly Cash Flows
• A chart can be built forecasting monthly
cash flows based on the SMM or PSA
benchmarks
• Example: for a 100 PSA with a WAC of
7.5% and WAM or 357 months
• Monthly cash flows peak in the 27th month
and decline over the life of the mortgage
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