Mortgage Pass-Through Securities

1. Mortgage Pass-Through Securities Fabozzi—Chapter 11

2. Introduction – pg 244 • What is a mortgage pass-through security? • A security comprised of a pool (portfolio) of residential mortgages. • All monthly interest and principal payments made by homeowners are passed through to the security holders (less fees). • Not all of the mortgages in the pool have the same maturity or interest rate. So pass-throughs use: • Weighted-Average Coupon Rate (WAC). • Weighted-Average Maturity (WAM). • WAC and WAM weight the coupon or maturity by outstanding amount of mortgage.

3. Diagram Of A Pass-Through Pooled Monthly Cash Flow: -Pooled Interest-Pooled Principal-Pooled Prepays Each Homeowner Pays:-Interest-Scheduled principal-Prepayments Pass-through coupon paid to investors

4. Agency Pass-Throughs • Pass-throughs guaranteed by government-sponsored agencies. There are three types: • Ginnie Mae (Government National Mortgage Association): Backed by full faith and credit of US Government. • Freddie Mac (Federal Home Loan Mortgage Corporation): Not guaranteed by US Government. But most consider it very low risk. • Fannie Mae (Federal National Mortgage Association): Not guaranteed by US Government, but considered low risk. • Types of guarantees: • Fully modified pass-throughs: guarantee timely payment of interest and principal even if mortgager fails to pay. • Modified pass-throughs: both interest and principal and interest are guaranteed, but only interest is guaranteed to be timely. Principal payment occurs when collected, but no later than a specified date.

5. Nonagency Pass-Throughs* • Issued by commercial banks, thrifts, and private conduits: • They have no guarantees by the U.S. Government. • Success of this market has been driven by credit enhancements. • External Credit Enhancements: Third-party guarantees losses up to specific level (usually 10% loss). (See Page 247) • Bond insurance – Guarantees interest and principal when due. • Pool insurance** – Covers losses from defaults and foreclosures. • Internal Credit Enhancements: • Reserve funds – cash reserve acct for payment of interest and principal. • Excess Spread Accounts*** – gradually increase as pass through seasons • Overcollateralization – Principal amount of mortgages paying into pool exceeds principal amount issued by pool. • Senior/Subordinate structure – by far most common enhancement. • See next slide for example on Senior/Subordinate structure

6. Senior/Subordinate Structure • Securities sold against the pool of mortgages are classified according senior/subordinate credit: • Subordinate class absorbs first losses on underlying mortgages. • Example: $100 million security is divided into two classes: • $90 million senior class and $10 million subordinate class. • The subordinate class will absorb all losses up to $10 million. • Senior class experiences no losses until losses exceed $10 million. • Obviously subordinate bondholders will require a much higher yield than senior bondholders.

7. Valuing a Mortgage Pass-Through • To value a pass-through it’s necessary to project its cash flow. This can be difficult: • Interest payment – easy • Scheduled principal payment – easy • Prepayment – difficult • To value a pass-through assumptions must be made about the prepayment rate in the underlying mortgage pool: • The prepayment rate assumed is called the prepayment speed or speed. • The yield calculated based on the projected cash flow is called a cash flow yield.

8. How To Estimate Cash Flow • *In the early days the market used a naïve approach: • Assumed no prepayments during the first 12 years. • After 12 years, all mortgages were assumed to prepay. • *This was replaced by FHA Prepayment Experience: • Prepayment rates were derived from historical data from the FHA (Federal Housing Administration). • FHA experience is not necessarily accurate for all mortgage pools. • This is no longer used. • Another benchmark for prepayment is called the Conditional Prepayment Rate (CPR): • CPR is proportion of the remaining principal in pool that will be repaid for the remaining term of the mortgage. • CPR is an annual rate based on the characteristics of the mortgage pool and future expected economic environment.

9. Prepayments Using CPR • Since CPR is an annual rate, it has to be converted to a monthly rate, called the single-monthly mortality rate (SMM): • Formula 11.1 • An SMM of x% means: • Approximately x% of remaining mortgage balance at the beginning of the month (less scheduled principal payment) will prepay that month: • Formula 11.2 • One model that uses the CPR/SMM to estimate prepayment CFs is the Public Securities Association Prepayment Model (PSA Prepayment Model).

10. PSA Prepayment Model • Is a series of monthly annual prepayment rates: • Assumes prepayments are low for new mortgages and will speed up as the mortgages become seasoned*. • PSA Model for 30-year mortgages: • CPR of 0.2% for first month increasing 0.2% each month for next 30 months (this is called seasoning). • When CPR reaches 6%, assume 6% per year for remaining years. • This is referred to as the 100 PSA Model (or 100% PSA Model). • Mathematically: (where t = # months since mtg originated) • Slower or faster speeds can be considered: • 50 PSA means 0.5 CPR, 150 PSA means 1.5 CPR, etc.

11. 100 PSA Model Graphically • Why does seasoning occur for 30 months? • Few people prepay when first purchasing a home. • However, the longer someone lives in a home the more likely someone may sell it (and thus prepay).

12. Example of 100 PSA Model • 100 PSA Model: page 251 • Month 5: • CPR = 6%  (5/30) = 1% or 0.01 • SMM = 1 – (1 – 0.01)1/12 = 0.000837 • Month 20: • CPR = 6%  (20/30) = 4% or 0.04 • SMM = 1 – (1 – 0.04)1/12 = 0.003396 • Month 31-360: • CPR = 6% or 0.06 • SMM = 1 – (1 – 0.06)1/12 = 0.005143

13. Example of 165 PSA Model • 165 PSA Model – Multiply CPR by 1.65: pg 251 • Month 5: • CPR = 1.65  6  (5/30) = 1.65% or 0.0165 • SMM = 1 – (1 – 0.0165)1/12 = 0.001386 • Month 20: • CPR = 1.65  6  (20/30) = 6.6% or 0.066 • SMM = 1 – (1 – 0.066)1/12 = 0.005674 • Month 31-360: • CPR = 1.65  9.9% or 0.099 • SMM = 1 – (1 – 0.099)1/12 = 0.007828

14. Cautions Using PSA Model • Calling PSA Model a “model” may be a bit strong. It is really more market convention: • It is not based on rigorous statistical modeling of particular pool of mortgages. • Your text refers to it as the PSA Benchmark. • PSA Model is based on a study by PSA on FHA prepayment experience. • Using CPR is useful, but it does have many limitations*.

15. Factors Affecting Prepayments and Prepayment Modeling • A prepayment model is a statistical model used to forecast prepayments. • Wall Street firms and research firms have developed different prepayment models. • Firms usually use different models for agency and nonagency pass-throughs. • We will consider a prepayment model developed by Bear Stearns, (once) a major dealer in the mortgage market: • We will use this model to see if we can determine some factors that affect prepayment.

16. The Bear Stearns Model • The Bear Stearns Model is an agency prepayment model. • The model consists of three components: • Housing turnover. • Cash-out refinancing. • Rate/term refinancing.

17. Housing Turnover • Refers to existing home sales (not newly constructed homes) • 3 factors forecast prepayment due to housing turnover: • Seasoning effect • Housing price appreciation effect • Seasonality effect • *Seasoning effect: • B/S model suggests seasoning occurs much fast than PSA Model indicates (prepayments reach 6% CPR in 15 months, not 30 months) • Why? Refinancing waves. Age of loan < length of time owning home. • **Housing price appreciation effect: • As house prices increase there is greater incentive for cash-out refinancing. • Seasonality effect: • Home buying increases in spring and peaks in late summer (low in winter). • Prepayments follow this pattern because home sales cause prepayments.

18. Cash-Out Refinancing • Cash-out refinancing occurs when house prices increase: • Homeowners refinance not to get a better interest rate, but to get cash from equity of their home. • However, the rate of refinancing will depend not only on house prices, but also on the interest rate of new mortgages. • Bear Stearns model compares the pool’s WAC with the prevailing mortgage rates. The model suggests: • *Prepayments exist for WAC/Prevailing mortgage rate > 0.60. • Prepayments increase as WAC/Prevailing mortgage rate increases. • **The greater the price appreciation for a given ratio the greater the project prepayments.

19. Rate/Term Refinancing • Not all investors refinance to get cash out: • Some refinance to get a lower interest rate or a shorter term on their mortgage. • To capture this, the Bear Stearns model captures two potentially important dynamics: • Burnout effect – The fact that the lower interest rates go, eventually the slower the rate of refinancing (eventually everyone who can refinance has refinanced). • Threshold-media effect – as mortgage rates drop to historic levels, borrowers become more aware of these opportunities due to advertisements and media (again, eventually every who can refinance will, as rates decline).

20. Non-Agency CF Estimation • Non-agency CF estimation must consider all of the attributes of agency CF estimation: • *However, one more issue must be considered: • Default and delinquencies (i.e., late payments). • A benchmark for default rates has been introduced by the PSA: • Called the PSA Standard Default Assumption (SDA) benchmark.

21. 100 SDA (std default assumption) • From month 1-30: • Default rate in month one is 0.02% • Default rate increases 0.02% each month for 30 months (when default rate is 0.60%). • From month 30-60: • Default rate remains at 0.60%. • From month 61-120: • Default rated declines linearly from 0.60% to 0.03% • From month 121 on: • Default rate remains constant at 0.03. • Note, can also consider 200 SDA, 50 SDA, etc.

22. 100 SDA Graphically

23. Cash Flow Yield • Once a projected CF and pass-through price is calculated, its yield can also be calculated. • Recall from chapter 3 that the yield is the interest rate that makes the PV of the expected CFs equal the asset’s price: • A mortgage pass-through has a monthly yield which has to be annualized. • Recall that market convention dictates using the bond equivalent yield (i.e., multiplying the semiannual yield by 2). • However, mortgage pass-throughs have monthly yields, so to make them comparable to yields on semiannual yielding bonds we must: semiannual cash flow yield

24. Caution Using CF Yield • Remember that CF yield is based on prepayment assumptions that may or may not be accurate. • Even if the assumptions are accurate, the CF yield will be realized yield only if the following are true: • Investor reinvests all CFs at the CF yield. • Investor must hold the pass-through security until all the mortgages have been paid off.

25. Prepayment Risks • Suppose an investor buys a 10% Ginnie Mae when mortgage rates are 10% and later mortgage rates decline to 6%. • Prepayments will increase. This creates two adverse consequences: • First, the Ginnie Mae price will rise, but not as much as an option-free bond would. That is the upside potential is truncated. • Second, the cash flow must be reinvested at a lower rate • Taken together these adverse effects are referred to as contraction risk. • Suppose mortgage rates increase from 10% to 15%: • Ginnie Mae will decline in price almost as much as an option-free bond (although not quite as much) because prepayments slow down. • Investors wish prepayments would increase and be reinvested at a higher rate. • Taken together these are known as extension risk. • Note: prepayments can sometimes enhance investor performance if bonds were purchased at a discount (see pp. 268-269)

26. Secondary Market Quotes of Mortgage Pass-Throughs • Pass-throughs are quoted in same manner as Treasury securities: • For example: 94-05 means 94 and 5/32 percent of face value.