Overview

2. 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.

3. 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.

4. 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. • Fully guarantees the securities

5. 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.

6. Web Resources GNMA www.ginniemae.gov FNMA www.fanniemae.com FHLMC www.freddiemac.com

7. 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).

8. Further Incentives • Gap exposure • Illiquidity exposure • Default risk by mortgagees • Phoenix, AZ in 1980s. • Default risk by bank/trustee

9. Present value of a mortgage • For monthly payments (PMT), the monthly interest rate equals r/m, where r is the APR and m=12 months. For a mortgage with a remaining time to maturity of n years, the present value is calculated as: • Which is recognizable as the product of PMT and PVAF

10. Present Value of the Pass-through • Because of the servicing fees, the present value of the payments to the holder of the pass-through will be less than the present value of the underlying mortgage payments, assuming zero prepayments.

11. Prepayment effects • Prepayments result of • Refinancing • Prepayment penalties and points • Housing Turnover • Most GNMA pools allow assumable mortgages • Not the case for FNMA nor FHLMC pass-throughs

12. 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.

13. 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

14. Prepayment Models • Methods: • Public Securities Association approach. • Other empirical approaches. • Option pricing approach.

15. Web Resources Prepayment model information: Bear Stearns www.bearstearns.com

16. 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.

17. Other Empirical Models • Generally proprietary variants of PSA model • Incorporate • economic variables • burn-out factor variables • idiosyncratic factors

18. 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

19. Option Adjusted Spread • Within the binary tree structure, the option adjusted spread can be calculated as the spread over the Treasury security term structure needed to equate the present value of the cash flows with the observed price of the security. • Value of the prepayment option: • Option-adjusted spread between GNMAs and T-bonds reflects value of a call option.

20. FNMA and FHLMC Concerns • Concern that FNMA and FHLMC have gained too much market share and pose a serious risk to financial system • Credit losses and high debt to equity • 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

21. Collateralized Mortgage Obligation (CMO) • CMO structure • Prepayment effects differ across tranches (classes) • Z-Class CMO • R Class • Improves marketability of the bonds

22. Mortgage-Backed Bonds (MBBs) • Normally remain on the balance sheet. • Regulatory concerns. • Other drawbacks to MBBs.

23. Innovations in Securitization • Pass-through strips • IO strips • Negative duration. • PO strips

24. Securitization of Other Assets • Securitization of other assets • CARDs • Various receivables, loans, junk bonds, ARMs. • Bounds on securitization: • Degree of homogeneity of underlying assets • Credit quality of underlying assets • If difficult to value, costs of securitizing are higher

25. 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