Mortgage backed and asset backed securities high credit quality and cash flow stability
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Mortgage-Backed and Asset-Backed Securities: High Credit Quality and Cash Flow Stability. Jim Womack, CFA Managing Director & Principal March 2011. Mortgage-Backed & Asset-Backed Securities Introduction: High Credit Quality and Cash Flow Stability.

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Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed and Asset-Backed Securities: High Credit Quality and Cash Flow Stability

Jim Womack, CFA

Managing Director & Principal

March 2011


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed & Asset-Backed Securities

Introduction: High Credit Quality and Cash Flow Stability

  • For Some, A Mortgage-Backed (MBS) or Asset-Backed Security (ABS) Carries a Negative Connotation.

  • For Many More, These Sectors Provided Ultra High Credit Quality and Cash Flow Stability Even In the Height of Market Turmoil in 2008 & 2009.

  • Today, Investors Are Seeking High Quality Alternatives To Low Yielding Treasury and Agency Debentures.

  • The Market For Many Types of MBS and ABS Is Deep, Transparent, Liquid and Offers Relatively High Yields.

  • Investment Officers Can Meaningfully Raise The Yield On Their Portfolios By Selectively Including These Assets In Their Arsenal of Eligible Investments…Without Sacrificing Credit Quality or Cash Flow Stability.


Mortgage backed and asset backed securities high credit quality and cash flow stability

Asset-Backeds: How The Typical Auto Structure Works

Two Types of Credit Support: Overcollateralization & Subordination

Overcollateralization

Lesser Amount of

Bonds Backed by Loans

Pool of Auto Loans

Subordination

Still Lesser Amount

Of Senior (AAA Rated)

Bonds Backed by Loans

Lesser Amount of

Bonds Backed by Loans


Mortgage backed and asset backed securities high credit quality and cash flow stability

Asset-Backeds: How The Typical Auto Structure Works

Subordination Protects The Senior Note Holders 5 Ways

Class

Rating

Size

Percent

A1

A2-A

A2-B

A3

A4

AAA

AAA

AAA

AAA

AAA

93.0%

410,000,000

200,000,000

650,000,000

392,000,000

249,260,000

B A 60,200,0005th Loss Protection 3.0%

CBBB 40,135,0004th Loss Protection 2.0%

D BB 40,135,0003th Loss Protection 2.0%

Reserve Account2nd Loss Protection 0.8%

Reserve Account1st Loss Protection1.0%

Total Subordination For Senior Note Holders

8.8%

Overcollateralization at Origination

5.7%

Total Credit Support to Senior Bondholders

14.5%


Mortgage backed and asset backed securities high credit quality and cash flow stability

Class

Rating

Size

Percent

A1

A2-A

A2-B

A3

A4

AAA

AAA

AAA

AAA

AAA

93.0%

410,000,000

200,000,000

650,000,000

392,000,000

249,260,000

B A 60,200,000 3.0%

CBBB40,135,0002.0%

DBB40,135,0002.0%

Reserve Account 0.8%

Reserve Account 1.0%

Total Subordination For Senior Notes

8.8%

Overcollateralization at Origination

5.7%

Total Credit Support to Senior Notes

14.5%

Asset Backeds: How The Typical Auto Structure Works

Historically, Even The Lowest Rated Bonds Have Been Well Protected

Fitch Prime Auto ABS Cumulative Net Loss Index

1.4%

1.4%

1.2%

1.2%

1.0%

1.0%

0.8%

0.8%

0.6%

0.6%

0.4%

0.4%

0.2%

0.2%

Source: Fitch Ratings

0.0%

0.0%

9/93

9/94

9/95

9/96

9/97

9/98

9/99

9/00

9/01

9/02

9/03

9/04

9/05

9/06

9/07

9/08

9/09

9/10


Mortgage backed and asset backed securities high credit quality and cash flow stability

Asset-Backeds: Selected Bonds Through The CrisisIn Good Economic Times and Bad, Credit Support Increases Over Time

Auto ABS as of December 2005

Original Credit Support

Credit Support at 12-2005

Unemployment Rate

Credit Support (%)

Wachovia

Auto

04A A4

Carmax

Auto

03-2 A4

Americredit

Auto

05-AX A3

Chase

Auto

03-B A3

Wachovia

Auto

05-B A4

WFS

Auto

02-4 A4

WFS

Auto

02-2 A4

Onyx

Auto

04-C A3

Capital

Auto

03-2 A4

Auto ABS as of December 2009

Original Credit Support

Credit Support at 12-2009

Unemployment Rate

Credit Support (%)

Wachovia

Auto

05-B A4

Household

Auto

06-3 A3

Household

Auto

07-1 A3

Honda

Auto

07-1 A3

Harley

Davidson

07-2 A4

Wachovia

Auto

07-1 A3A

USAA

Auto

06-4 A3

Source: Servicer Reports


Mortgage backed and asset backed securities high credit quality and cash flow stability

Asset-Backeds: What About Insured Bonds?

Example: FGIC Takes Less Protection And a Fee to Guarantee Notes

Class

Rating

Size

Percent

A1

A2

A3-A

A3-B

A4

AAA

AAA

AAA

AAA

AAA

349,000,000

334,000,000

294,500,000

294,500,000

478,000,000

100%

Reserve AccountLoss Protection For Insurance Provider 1.5%

Overcollateralization at Origination

7.3%

Total Credit Support to FGIC Insurance Co.

9.2%

9.2% PLUS An

Insurance Policy

by AAA Rated FGIC

Total Credit Support to Senior Bondholders


Mortgage backed and asset backed securities high credit quality and cash flow stability

Asset-Backeds: Even Wrapped Issues Performed WellMany Insured Bonds Were Initially Downgraded, Then Upgraded

CREDIT RATINGS CHANGES

Reference Issue: COAFT 2006-C A4,


Mortgage backed and asset backed securities high credit quality and cash flow stability

Asset-Backeds: More Yield Than Lower Rated CorporatesComparing Yield of AAA Auto ABS vs. A Rated Corporate Bonds

Merrill Lynch AAA Rated Auto ABS & Similar Maturity A Rated Corporates

Yield in Percent

Source: Merrill Lynch and Bloomberg Data as of December 31, 2010

Since Inception

(ex 2008 & 2009)

Since Inception

4.75%

4.69%

AAA Rated Auto ABS Average Yield:

ABS +0.14%

ABS +0.28%

A Rated Corproate Average Yield:

4.61%

4.41%


Asset backeds auto loan abs was in the press too because it performed like it was supposed to

Asset-Backeds: Auto-Loan ABS Was In The Press Too! Because It Performed Like It Was Supposed To

“Most Senior GMAC prime auto ABS ratings able to withstand “depression” unemployment scenario.”

- Moody’s Investor Service, 5-12-09

“Rebound in used vehicle prices benefits auto ABS transactions.”

“Moody’s has placed fifteen tranchesfrom eight loan securitizations sponsored by Ford Motor Company in 2006 and 2007 on review for possible upgrade. The build up of credit enhancement more than offsets modest increases in lifetime cumulative losses observed in the underlying collateral pools.”

- Moody’s Investor Service, 8-21-09

“Auto-loan Backing is Popular; Investors Like These Tried and Tested Securities”

- Headline, Wall Street Journal, 9-16-2009

- Fitch Ratings, 10-15-09

“Due to available credit enhancement and structural protections, ratings for prime senior tranches of ABS auto loan transactions have remained stable year-to-date.”

- Fitch Ratings, 10-26-09


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesTraditional GSE Guaranteed Mortgage-Backed Securities

Key Features and Characteristics of MBS:

  • Bonds Receive Principal and Interest Monthly, Because Borrowers Make Monthly Mortgage Payments

  • Borrowers Can Repay Their Loans Without Penalty and at Any Time

  • People Prepay Their Mortgages For a Variety of Reasons

They Refinance, Get Transferred, Death, Divorce, Buy Bigger/Smaller Home, Etc.

  • The Speed at Which They Prepay Their Loan is Measured by PSA & CPR

PSA = Prepayment Speed Assumption, CPR = Constant Prepayment Rate

100 PSA or 100% of the PSA model rate, calls for prepayments to start slowly and build to a 6% constant prepayment rate (CPR) after 24 months.

However: If mortgage rates declined, the prepayment rate could jump to 200+

PSA and reach a 12%+ constant prepayment rate after 24 months (because homeowners are refinancing).


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesNon-Callable Bonds Have Positive Convexity

Price

Positive Convexity

+1.1%

-0.9%

Yield

-1%

+1%


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesBecause The Home Owner Can Prepay At Any Time, Mortgage-Backed Securities, Like Other Callable Bonds, Have Negative Convexity

Price

Negative Convexity

+0.8%

-1.2%

Yield

-1%

+1%


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesTraditional Mortgage Pass-Through & Cash Flow Profile

Homeowner

Bank

Trustees

Guaranteed Timely Principal & Interest

Government Sponsored Entity (Ginnie Mae, Fannie Mae, Freddie Mac)

Investors receive pro-rata share of interest, principal, and principal prepayments.

Investors have uncertainty about when they get principal back.

Investors


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesTraditional 30-Year Mortgage Lending

Key Features and Characteristics of 30-Year Loans & MBS:

  • 30-Year Loans Spread Payments Out to Reduce Monthly Payment

  • Nearly All of The Payment In The Early Years Is Interest

  • The Interest Rate Level Impacts The Monthly Payment For the Borrower on a 30-Year Loan More Than on a 15-Year or 10-Year Loan(A Key Reason Why People Don’t Refinance Their Cars)

So 30-Year Borrowers Are Typically Very Rate Sensitive

  • Borrowers Can Repay Their Loans Without Penalty and at Any Time

  • Bondholders Receive An Attractive Yield Above Treasuries, Agency Issued Debentures and Other Types of Securities Because Borrowers Can Repay Their Loans Without Penalty and at Any Time

  • Agency MBS are Backed by The Homeowner, by The Agency,

  • and by The Implied Guarantee Of The Government.


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backeds: More Yield Than Corporates…But Why? Comparing Yield of MBS vs. A Rated Corporate Bonds

30-Year Mortgage-Passthroughs & Similar Maturity A Rated Corporates

Yield in Percent

Source: Merrill Lynch and Bloomberg Data as of December 31, 2010

Since Inception

(ex 2008 & 2009)

Since Inception

6.23%

6.40%

30 Year MBS Pass-through Average Yield:

MBS +0.71%

MBS +0.74%

A Rated Corproate Average Yield:

5.52%

5.66%


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesTraditional 30-Year Mortgage Pass-Through & Cash Flow Profile

Mortgage Rates

Near Current Rates

Mortgage Rates UNCHANGED

Mortgage Rates

HIGHER

Mortgage Rates LOWER

NO REFINANCE

LESSTrading Up

LESSRenovation

LESSDownsizing

Get Transferred

Death, Divorce, Etc.

REFINANCE

MORE Trading Up

MORERenovation

MOREDownsizing

Get Transferred

Death, Divorce, Etc.

Trading Up

Major Renovation

Downsizing

Get Transferred

Death, Divorce, Etc.

OR

OR

6% CPR

Per Year

12%CPR

Per Year

25% CPR

Per Year

2 Year

Bond

8 Year

Bond

5 Year

Bond

3 Year Contraction

3 Year Extension


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesTraditional 10-Year Mortgage Lending

Key Features and Characteristics of 10-Year Loans & MBS:

  • 10-Year Loans Are Made To People Who Want To Pay Debt Back Fast

  • Most of the Payment Is Principal, So The Interest Rate Has Less of an Impact on The Monthly Payment

So 10-Year Borrowers Are NOT Typically Rate Sensitive

  • The Shorter The Loan, The Less Variability The Cash Flows At a Given Prepayment Speed

  • Borrowers Can Repay Their Loans Without Penalty and at Any Time

  • They Have The Same Credit Backing as Bonds Backed by 30-Year Loans

  • 10-Year Pass-throughs Receive An Attractive Yield Above Treasuries, Agency Issued Debentures and Other Types of Securities,

  • But Less Than a 30-Year Passthrough


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backeds: Outsized Yield Premiums For MBS NowComparing Yield of MBS vs. A Rated Corporate Bonds

10-Year Mortgage-Passthroughs & Similar Maturity A Rated Corporates

Yield in Percent

Source: RW Baird Research and Bloomberg Data as of January 31, 2011

Since Inception

(ex 2008 & 2009)

Since Inception

4.05%

3.92%

AAA Rated Auto ABS Average Yield:

MBS +0.14%

MBS +0.19%

A Rated Corproate Average Yield:

4.91%

3.73%


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesTraditional 10-Year Mortgage Pass-Through & Cash Flow Profile

Mortgage Rates

Near Current Rates

Mortgage Rates UNCHANGED

Mortgage Rates

MUCH HIGHER

Mortgage Rates

MUCH LOWER

NO REFINANCE

LESSTrading Up

LESSRenovation

LESSDownsizing

Get Transferred

Death, Divorce, Etc.

REFINANCE

MORE Trading Up

MORERenovation

MOREDownsizing

Get Transferred

Death, Divorce, Etc.

Trading Up

Major Renovation

Downsizing

Get Transferred

Death, Divorce, Etc.

OR

OR

7% CPR

Per Year

12%CPR

Per Year

25% CPR

Per Year

2.9 Year

Bond

4.0 Year

Bond

3.4 Year

Bond

0.5 Year Contraction

0.6 Year Extension


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesCollateralized Mortgage Obligations (CMOs) & Cash Flow Profile

Homeowner

Bank

Trustees

Guaranteed Timely Principal & Interest

Government Sponsored Entity (Ginnie Mae, Fannie Mae, Freddie Mac)

Classes Increase Cash Flow Certainty

Investor certainty is increased.

Investors in short-term, intermediate-term and long-term securities can now participate in the mortgage-backed securities market.

$

$

$

$

$

$

$

$

$

Class 2

Class 1

Class 3


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesThe Two Main Types of Collateralized Mortgage Obligations (CMOs)

Sequntial Class CMO:

  • Cash Flow Stability Improved vs. Pass-Through Since Tranches Get Paid Back In Sequential Order.

  • Collateral Subject to Big Prepayment Swings Can Still Cause Some Cash Flow Variability (e.g., A Sequential Backed By New 30 Year Loans).

  • A Sequential Backed By More Stable Collateral Can Greatly Improve Cash Flow Stability (e.g., A Sequential Backed By Seasoned 15 Year Loans).

Pre-Planned Ammortization Class (PAC) CMO:

  • Can Be The Most Stable Form of Mortgage-Backed Security.

  • Cash Flow Structured to Follow Pre-Planned Schedule Subject to Prepayment Speeds Remaining Within Stated Parameters (e.g., Cash Flows Unchanged Assuming PSA Between 100 and 350).

  • The Key is to Analyze “Stressed” Prepayment Assumptions to Ensure The Bond Will Act Like You Expect


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed SecuritiesAnalyzing The PAC CMO Structure

  • The PAC Can Have Stability Because Other Support Bonds Make It So.

  • If Prepayments Are Greater Than Expected, The Support Classes Will Take The Additional Prepayments So The PAC Doesn’t Have To.

  • If Prepayments Are Less Than Expected, The Support Classes Will Forego Principal So The PAC Gets The Desired Amount.

$

$

$

$

$

$

$

$

$

Support

Class 1

Support

Class 2

PAC

CMO

  • Investors Typically Run “Stress Tests” To Ensure The Support Classes Are Adequate To Provide The Required Stability For The PAC Class.


Mortgage backed and asset backed securities high credit quality and cash flow stability

Consistent Payment History Well Within Wide PAC Bands

1 Year Bond at +83 bps Over Treasuries

Mortgage-Backed SecuritiesThe Well Structured PAC CMO Structure

  • A Well Structured PAC CMO Often Provides Greater Yield and Cash Flow Stability Than Traditional Agency Callable Debentures

  • Yields On Well Structured PAC CMOs Are Comparable to A-Rated Corporates.


Mortgage backed and asset backed securities high credit quality and cash flow stability

Mortgage-Backed & Asset-Backed Securities

Summary: High Yield and High Quality Are Not Mutually Exclusive

  • Investors Are Looking For High Quality Alternatives To Low Yielding Government Debentures

  • The Mortgage-Backed and Asset-Backed Sectors Can Offer Attractive Investments That Can Add Significant Yield and Total Return Over Time.

  • Premiums Comparable to or Higher Than Many ‘A’ Rated Corporate Bonds.

  • Bonds Backed By Traditional Fixed Rate Mortgages and Auto Loans, As An Example, Have A Proven Track Record of Maintaining The Highest Credit Quality Even In The Deepest Economic Downturns.

  • Credit Quality Is Primarily Achieved By Loan Diversification, Over-Collateralization, Subordination and/or Agency Guarantees.

  • Cash Flow Stability Is Achieved Primarily By Collateral Type and Security Structure

  • When High Credit Quality and Cash Flow Stability Are Properly Combined, Event Risk Can Be All But Eliminated


Mortgage backed and asset backed securities high credit quality and cash flow stability

Thank You!


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