Mortgage Pass-Through Securities

1. Mortgage Pass-Through Securities • MPS is created as a portfolio of single or multi family mortgages from which shares or participation certificates are sold. The size and timing of the cash flows from the pool of mortgages( portfolio) is different to that of the cash flows passed through to investors. The monthly cash flow of the MPS is less than the cash flow of the pooled mortgage by an amount equal to service fees and guarantee fees. The cash flow for the MPS is uncertain due to prepayments.

3. Types of MPS • Agency MPS are Ginnie Mae, FreddieMac and Fannie Mae. • Fully modified pass-throughs guarantee both interest and principal, while Modified pass-throughs guarantees interest only. • Ginnie Mae pass-throughs are risk free, since they are the obligation of the US government. • Freddie Mac issues a pass through called PC and Gold PC. • Freddie Mac and Fannie Mae issues are not the obligation of the US Government.

4. Credit Enhancement • Factors considered by rating agencies to assign a rating to non-agency pass throughs are: type of property, type of loan, the term, the geographic dispersion of the loan, the size, the amount of the seasoning of the loans and the purpose of the loan. • External Credit Enhancement: for protection against specific amount of loss.,i.e ,15% they are : corporate guarantee, a letter of credit , pool insurance and bond insurance. • Pool insurance cover losses steming from default and forclusure. • Bond insurance provides supllemental insurance.

5. Collateralized Mortgage Obligations CMO • To mitigate prepayment risk, a class of derivative securities is created by redirecting the interest and principal from the pass-throughs and pool of whole loans such that the new derivative class will have different coupon rate and varying risk return profile that meets the needs and expectation of investors, thus broadening the appeal of the mortgage backed securities. • When CMO created this way, it has more than one class of bond holders at a given level of credit priority known as pay-through structure.

6. Sequential pay Tranches • Each class is retired sequentially • Accrual Bonds • PAC, protected from both contraction and extension risk, providing two-sided prepayment protection. • TAC, while PAC provides protection against both contraction and extension risk over a wide range of PSA, TAC bond has a single PSA rate from which the schedule of principal repayment is protected, therefore, the prepayment protection

7. afforded the TAC bond is less than that of a PAC bond. • Lockouts and reverse PAC created to provide greater protection for PAC bonds. A CMO structure with no principal payments to a PAC class is referred to as a lockout structure.

8. Shift to Securitization in 1980 • Deterioration of the credit quality of the major banks portfolio as a result of less developing countries’ LDC debt crisis of 1982. • Mushrooming innovative products induced by liberalization of regulatory landscape that transferred risk from banks & other intermediaries to ultimate investors. • Return to a more favorable macro-economic conditions, i.e., reappearance of positive real interest rates and upward sloping yield curves • Disintermediation of credits induced through securitization

9. Prepayment Risk • Extension risk • Contraction risk

10. Extension Risk • Extension risk arises as the pass-through underlying mortgage pays slowly as interest rates rise. When interest rates rise, prepayments decline, as prepaying mortgages does not pay off. Rather, mortgagors find it more attractive to invest their funds rather than prepay.

11. Contraction Risk • Contraction risk arises in the event of falling interest rates, as prepayments speed up. The fall in interest rates makes refinancing attractive for mortgagors or individuals relocating and selling property. The pass-through life therefore shortens and subjects investors to contraction risk.

12. Factors Affecting Refinancing • Age (seasoning) of the loan. • The spread between the mortgage rate and prevailing rate. • Refinancing incentives. • Previous path of interest rates, if the rates were high in the past, slowing prepayment, path dependence is referred to refinancing burnout. • Level of mortgage rate. • Economic activity • Seasonal factor

13. PO & IO Derivatives • Stripped mortgage-backed securities issued in early 1987 separated coupons from the corpus of the underlying pool of mortgages into a class of securities known as: • Interest-only (IO) securities, with all of the principal going to another class known as • Principal-only (PO) securities.

14. Example • Suppose the pass-through underlying the collateral is $200 million mortgage securities with 6.5 percent coupon and priced at par with maturity of 25 years. • The PO backed by this pass-through is worth $50 million, since it is a deep-discount bond. The PO investors (who receive no coupon interest) will receive a dollar return of $150 million ($200 million principal less initial investment of $50 million) over 25 years, or 5.7 percent annualized return.

15. Operational Risk • The Basle Committee on Banking Supervision BCBS reported recently that, “An informal survey …highlights the growing significance of risks other than credit and market risks, such as operational risk, which have been at the heart of some important banking problems in recent years.” • Few definitions: • Any financial risk other than credit and market risk, • Risk arising from operation, such as back office problems, failure in processing transactions and in systems, and technology breakdown, • The risk of loss from failed internal processes, people, and systems, or from external events

16. Market Risk • Risk of sudden shock, which could damage the financial system that the wider economy would suffer is an example of systematic or market risk. • Contagious transmission of the shock due to actual or suspected exposure to a failing bank or banks. Followed by flight to quality. • Panicky behavior of depositors or investors or • Interruption in the payment system

17. Breakdown of Financial risks Commercial Investment Treasury Retail Asset Banking Banking Management Management Management operational Credit Market Source: Robert Gescke