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Overview Securitization is another mechanism that may be employed by FIs to hedge their interest rate exposure. This chapter explores the role of securitization in improving the risk-return trade-off. The three major forms of asset securitization, and its mortgage lending origins are also explained.
Introduction • Securitization: Packaging and selling of loans and other assets backed by securities. • Many types of loans and assets are being repackaged in this fashion including royalties on recordings ( David Bowie, Rod Stewart). • Original use was to enhance the liquidity of the residential mortgage market.
The Pass-Through Security • Government National Mortgage Association (GNMA) • Sponsors MBS programs and acts as a guarantor. • Timing insurance. • FNMA actually creates MBSs by purchasing packages of mortgage loans.
Freddie Mac • Federal Home Loan Mortgage Corporation • Similar function to FNMA except major role has involved savings banks. • Stockholder owned with line of credit from the Treasury. • Sponsors conventional loan pools as well as FHA/VA mortgage pools.
FNMA and FHLMC Concerns • Concern that FNMA and FHLMC have gained too much market share and pose a serious risk to financial system • Excessive interest rate risk exposure FNMA • Overcharging lenders • Passed through as higher mortgage rates • Freddie Mac misstatement of earnings • FNMA $1.1 billion restatement of equity • Regulatory changes • Signal that agencies not fully guaranteed
Web Resources GNMA www.ginniemae.gov FNMA www.fanniemae.com FHLMC www.freddiemac.com
Incentives & Mechanics of Pass-Through Security Creation • Example: • Create a mortgage pool from one-thousand, $100,000 mortgages (Results in $100 million). • Each mortgage receives credit risk protection from FHA. • Capital requirement: $4 million. • Must issue more than $96 million in liabilities due to reserve requirements (+ FDIC premia).
Further Incentives • Gap exposure • Illiquidity exposure • Default risk by mortgagees • Phoenix, AZ in 1980s. • Default risk by bank/trustee
Effects of Prepayments • Good news effects • Lower market yields increase present value of cash flows. • Principal received sooner. • Bad news effects • Fewer interest payments in total. • Reinvestment at lower rates.
Prepayment effects • Prepayments result of • Refinancing • Housing Turnover • Most GNMA pools allow assumable mortgages • Not the case for FNMA nor FHLMC pass-throughs
Prepayments • Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates. • Weighted-average life WAL = [ Time × Expected Principal received] Total principal outstanding
Prepayment Models • Methods: • Public Securities Association approach. • Other empirical approaches. • Option pricing approach.
Web Resources Prepayment model information: Bear Stearns www.bearstearns.com
PSA Model • Assumes 0.2 percent per annum in first month, increasing by 0.2 percent per month for first 30 months, until annualized prepayment rate equals 6 percent • Actual outcomes affected by relative coupon level, age of mortgage pool, amortization, assumability, size of pool, conventional/non-conventional, location, and demographics of mortgagees.
Other Empirical Models • Generally proprietary variants of PSA model • Incorporate • economic variables • burn-out factor variables • idiosyncratic factors
Option Model Approach • Use option pricing theory to figure fair yield spread of pass-throughs over Treasuries. • Fair price on pass-through decomposable into two parts • PGNMA = PTBOND - PPREPAYMENT OPTION • Option-adjusted spread between GNMAs and T-bonds reflects value of a call option.
Collateralized Mortgage Obligation (CMO) • CMO structure • Prepayment effects differ across tranches (classes) • Z-Class CMO • R Class • Improves marketability of the bonds
Mortgage-Backed Bonds (MBBs) • Normally remain on the balance sheet. • Regulatory concerns. • Other drawbacks to MBBs.
Innovations in Securitization • Pass-through strips • IO strips • Negative duration. • PO strips • Securitization of other assets • CARDs • Various receivables, loans, junk bonds, ARMs.
Pertinent Websites Bear Stearns www.bearstearns.com Fed. Reserve www.federalreserve.gov FHLMC www.freddiemac.com FNMA www.fanniemae.com GNMA www.ginniemae.gov Bond Market Association www.bondmarkets.com