CHAPTER TWENTY MORTGAGEBACKED SECURITIES Practical Investment Management Robert

CHAPTER TWENTY MORTGAGE-BACKED SECURITIES Practical Investment Management Robert A. Strong

Outline u Mortgages Types u Mortgage Mathematics u Mortgage Risk u u The Mortgage

Outline u Considerations in Pricing Mortgage Backed Securities The Importance of Prepayment Rates u The PSA Convention u The Risks of MBS u The Risk of Collateralized Mortgage Obligations u The Risk of Stripped Mortgage Backed Securities u South-Western / Thomson Learning © 2004 20 - 3

Introduction A mortgage is a loan with real estate as collateral. The lender, called the mortgage originator, often charges points as a fee for preparing and placing the mortgage. It is quite common for the lender to sell the mortgage to another party. The homeowner may be unaware of this, as the lender normally continues to be the mortgage servicer. South-Western / Thomson Learning © 2004 20 - 4

Mortgages: Types u A fixed rate mortgage is one with payments based on a set interest rate that does not change. u An adjustable rate mortgage (ARM), also called a variable rate mortgage, has an interest rate that moves with some market interest rate, such as the Treasury bill rate. u Most ARMS have an annual reset to the interest rate. Many also have either a cap or a floor on the interest rate. South-Western / Thomson Learning © 2004 20 - 5

Mortgages: Types u With a convertible mortgage, the borrower has the option to exchange it for a fixed rate at the prevailing ARM rate. u There are other mortgage arrangements: biweekly - payments are due every two weeks semi-monthly - payments are due two times each month graduated payment - the monthly payments increase following a predetermined schedule South-Western / Thomson Learning © 2004 20 - 6

Mortgages: Types shared appreciation - the borrower splits the rise in the value of the property with the lender in exchange for a reduced interest rate reverse - the homeowner sells the property to a bank and receives monthly mortgage payments South-Western / Thomson Learning © 2004 20 - 7

Mortgage Mathematics Example : A bank approves a prospective homeowner for a 30 -year, $100, 000 mortgage at an 8% annual rate. There will be 30× 12 = 360 monthly payments at a monthly interest rate of 8÷ 12 = 0. 66667% South-Western / Thomson Learning © 2004 20 - 8

Mortgage Mathematics For an annuity: where C = the monthly payment R = the monthly interest rate N = the number of payments So: The monthly payment will be $733. 76 South-Western / Thomson Learning © 2004 20 - 9

Mortgage Mathematics If the borrower pays the bank $1, 500 instead of $733. 76 for the thirteenth payment, how will the amortization schedule be affected? The bank considers the extra $766. 24 the borrower paid a principal reduction, and the anticipated life of the loan will decrease. South-Western / Thomson Learning © 2004 20 - 10

Mortgage Risk u Default risk is the risk that the borrower is unable or unwilling to repay the debt as agreed. u Interest rate risk is the risk that the general level of interest rates rises, such that the value of the mortgage’s cash flow stream declines. u Prepayment risk is the risk of an early payment of the original mortgage, such as when the home is sold or when the mortgage is refinanced at a lower rate. South-Western / Thomson Learning © 2004 20 - 11

The Mortgage Backed Securities Market u The Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), & the Federal Home Loan Mortgage Corporation (Freddie Mac) support the US mortgage market by providing liquidity, buying conforming mortgages from banks across the country for resale elsewhere. u The term mortgage-backed securities refers to all products based on mortgage loans. South-Western / Thomson Learning © 2004 20 - 12

Types of Securities u A pass-through security is a share of a pool of mortgages. Individual Mortgages Mortgage Pool Pass-Through Security u The holders receive a monthly check for their portion of the scheduled principal and interest payments, plus their share of any prepayments that may occur. South-Western / Thomson Learning © 2004 20 - 13

Types of Securities w Pass-through securities may be issued and guaranteed by a government agency, or they may be private label. w Two types of derivative securities that spring from pass-through securities are collateralized mortgage obligations and stripped mortgage-backed securities. South-Western / Thomson Learning © 2004 20 - 14

Types of Securities u A collateralized mortgage obligation (CMO) is a security backed by a pool of mortgages and structured to transfer prepayment or interest rate risk from one group of security holders to another. A given pool of mortgages backs two or more classes of securities called tranches. u South-Western / Thomson Learning © 2004 20 - 15

Types of Securities Collateralized Mortgage Obligation Individual Mortgages Mortgage Pool A Tranche B Tranche

Types of Securities Insert Table 20 -3 here. South-Western / Thomson Learning © 2004

Types of Securities u With a sequential pay CMO, all the tranche holders receive monthly interest payments based on the principal amount outstanding in their tranche. u All principal payments go to the A tranche until the A tranche principal is completely returned. Only then will the investors in the next tranche begin to receive principal. South-Western / Thomson Learning © 2004 20 - 18

Types of Securities Insert Table 20 -4 here. South-Western / Thomson Learning © 2004

Types of Securities u There are two types of stripped mortgage backed securities, or strips. Individual Mortgages Mortgage Pool Interest Only Security u Principal Only Security All the interest goes to the interest only (IO) security holders, while the entire principal goes to the principal only (PO) holders. South-Western / Thomson Learning © 2004 20 - 20

Considerations in Pricing Mortgage Backed Securities u The price risk of a MBS comes from the uncertainty about the timing of cash flows. u Prepayments can affect the realized return on a M BS substantially. u The offering memorandum for a M BS will state the assumptions used in estimating cash flows from the mortgage pool. u A benchmark assumption for the rate of mortgage prepayment is offered by the Public Securities Association (PSA). South-Western / Thomson Learning © 2004 20 - 21

Considerations in Pricing Mortgage Backed Securities Constant Prepayment Rate w The standard PSA assumption is that a 30 year mortgage will see prepayments of 0. 2% for the first month and that prepayments will increase by 0. 2% for each of the next 29 months, after which they remain constant. w The 0. 2% per month prepayment assumption is called 100% PSA. South-Western / Thomson Learning © 2004 20 - 22

Considerations in Pricing Mortgage Backed Securities A MBS has default, interest rate, and prepayment risks. u Riskiness of Cash Flows Timing Known Timing Unknown $ Amount Known fixed rate non-callable bond principal only security $ Amount Unknown variable rate non-callable bond interest only security South-Western / Thomson Learning © 2004 20 - 23

The Risk of Collateralized Mortgage Obligations u Declining interest rates will increase the value of a cash flow stream and will lead to prepayments. u If a mortgage pool sells at a discount, prepayments will increase the value of each of the tranches, with the higher duration tranches benefiting the most. u If the pool sells at a premium, then prepayments will reduce everyone’s yield, with the effect most pronounced for the holders of the longer duration tranches. South-Western / Thomson Learning © 2004 20 - 24

The Risk of Stripped Mortgage Backed Securities u Prepayment has different consequences for IO and PO strips. An extension of the mortgage decreases the value of the principal payments but increases the value of the interest payments. u Declining interest rates will increase the value of a series of known cash flows, as well as the likelihood of prepayment. Normally, the prepayment effect overwhelms the interest rate effect. South-Western / Thomson Learning © 2004 20 - 25

The Risk of Stripped Mortgage Backed Securities Insert Table 20 -6 here. South-Western /

The Risk of Stripped Mortgage Backed Securities Insert Table 20 -7 here. South-Western /

The Risk of Stripped Mortgage Backed Securities Insert Table 20 -8 here. South-Western /

The Risk of Stripped Mortgage Backed Securities Insert Table 20 -9 here. South-Western /

Review u Mortgages Types u Mortgage Mathematics u Mortgage Risk u u The Mortgage

Review u Considerations in Pricing Mortgage Backed Securities The Importance of Prepayment Rates u The PSA Convention u The Risks of MBS u The Risk of Collateralized Mortgage Obligations u The Risk of Stripped Mortgage Backed Securities u South-Western / Thomson Learning © 2004 20 - 31