Mortgage Pass-Through Securities

1. Mortgage Pass-Through Securities Chapter 11

2. 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

4. 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

5. 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

6. 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.

7. 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

8. 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

9. 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)

10. 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*

11. 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)

12. 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

13. 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

14. 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%

15. 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

16. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. Bear Stearns Baseline HTO Prepayments for Agency MBS

27. Effect of Housing Price Appreciation of Agency Prepayments

28. 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

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

30. 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

31. 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

32. 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

33. 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

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

35. 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

36. 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!

37. 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

38. 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%

39. 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

40. 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