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MORTGAGE-BACKED SECURITIES. CHAPTER TWENTY. Practical Investment Management Robert A. Strong. Outline. Mortgages Types Mortgage Mathematics Mortgage Risk The Mortgage Backed Securities Market History Types of Securities. Outline. Considerations in Pricing Mortgage

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Mortgage backed securities

MORTGAGE-BACKED SECURITIES

CHAPTER TWENTY

Practical Investment Management

Robert A. Strong


Mortgage backed securities

Outline

  • Mortgages

    • Types

    • Mortgage Mathematics

    • Mortgage Risk

  • The Mortgage Backed Securities Market

    • History

    • Types of Securities


Mortgage backed securities

Outline

  • Considerations in Pricing Mortgage

    Backed Securities

    • The Importance of Prepayment Rates

    • The PSA Convention

    • The Risks of MBS

    • The Risk of Collateralized Mortgage Obligations

    • The Risk of Stripped Mortgage Backed Securities


Mortgage backed securities

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.

Introduction

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.


Mortgage backed securities

Mortgages: Types

  • A fixed rate mortgage is one with payments

    based on a set interest rate that does not change.

  • 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.

  • Most ARMS have an annual reset to the

    interest rate. Many also have either a cap or a floor on the interest rate.


Mortgage backed securities

Mortgages: Types

  • With a convertible mortgage, the borrower has the option to exchange it for a fixed rate at the prevailing ARM rate.

  • 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


Mortgage backed securities

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


Mortgage backed securities

Example :

A bank approves a prospective homeowner for a 30-year, $100,000 mortgage at an 8% annual rate.

Mortgage Mathematics

 There will be 30×12 = 360 monthly payments at a

monthly interest rate of 8÷12 = 0.66667%


Mortgage backed securities

For an annuity:

So:

where

C = the monthly payment

R = the monthly interest rate

N = the number of payments

 The monthly payment will be $733.76

Mortgage Mathematics


Mortgage backed securities

If the borrower pays the bank $1,500 instead of $733.76 for the thirteenth payment, how will the amortization schedule be affected?

Mortgage Mathematics

The bank considers the extra $766.24 the borrower paid a principal reduction, and the anticipated life of the loan will decrease.


Mortgage backed securities

Mortgage Risk

  • Default risk is the risk that the borrower is

    unable or unwilling to repay the debt as agreed.

  • 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.

  • 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.


Mortgage backed securities

The Mortgage Backed Securities Market

  • 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.

  • The term mortgage-backed securities refers to all products based on mortgage loans.


Mortgage backed securities

Individual Individual Individual

Mortgages Mortgages Mortgages

Mortgage Pool

Pass Through Security

Types of Securities

  • A pass-through security is a share of a pool

    of mortgages.

  • 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.


Mortgage backed securities

Types of Securities

  • Pass-through securities may be issued and guaranteed by a government agency, or they may be private label.

  • Two types of derivative securities that spring from pass-through securities are collateralized mortgage obligations and stripped mortgage-backed securities.


Mortgage backed securities

Types of Securities

  • 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.


Mortgage backed securities

Individual Individual Individual

Mortgages Mortgages Mortgages

Mortgage Pool

A Tranche B Tranche C Tranche Other Tranches

Types of Securities

Collateralized Mortgage Obligation


Mortgage backed securities

Types of Securities

Insert Table 20-3 here.


Mortgage backed securities

Types of Securities

  • With a sequential pay CMO, all the tranche

    holders receive monthly interest payments based on the principal amount outstanding in their tranche.

  • 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.


Mortgage backed securities

Types of Securities

Insert Table 20-4 here.


Mortgage backed securities

Individual Individual Individual

Mortgages Mortgages Mortgages

Mortgage Pool

Interest Only Security Principal Only Security

Types of Securities

  • There are two types of stripped mortgage

    backed securities, or strips.

  • All the interest goes to the interest only (IO)

    security holders, while the entire principal goes to the principal only (PO) holders.


Mortgage backed securities

Considerations in

Pricing Mortgage Backed Securities

  • The price risk of a MBS comes from the

    uncertainty about the timing of cash flows.

  • Prepayments can affect the realized return on

    a MBS substantially.

  • The offering memorandum for a MBS will

    state the assumptions used in estimating cash flows from the mortgage pool.

  • A benchmark assumption for the rate of

    mortgage prepayment is offered by the Public Securities Association (PSA).


Mortgage backed securities

Considerations in

Pricing Mortgage Backed Securities

Constant Prepayment Rate

  • 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.

  • The 0.2% per month prepayment assumption is called 100% PSA.


Mortgage backed securities

Riskiness of Cash Flows

Timing

Known

Timing

Unknown

variable rate

non-callable

bond

fixed rate

non-callable

bond

principal only

security

interest

only

security

$ Amount

Known

$ Amount

Unknown

Considerations in

Pricing Mortgage Backed Securities

  • A MBS has default, interest rate, and prepayment risks.


Mortgage backed securities

The Risk of Collateralized Mortgage Obligations

  • Declining interest rates will increase the

    value of a cash flow stream and will lead to prepayments.

  • 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.

  • 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.


Mortgage backed securities

The Risk of Stripped Mortgage Backed Securities

  • 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.

  • 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.


Mortgage backed securities

The Risk of Stripped Mortgage Backed Securities

Insert Table 20-6 here.


Mortgage backed securities

The Risk of Stripped Mortgage Backed Securities

Insert Table 20-7 here.


Mortgage backed securities

The Risk of Stripped Mortgage Backed Securities

Insert Table 20-8 here.


Mortgage backed securities

The Risk of Stripped Mortgage Backed Securities

Insert Table 20-9 here.


Mortgage backed securities

Review

  • Mortgages

    • Types

    • Mortgage Mathematics

    • Mortgage Risk

  • The Mortgage Backed Securities Market

    • History

    • Types of Securities


Mortgage backed securities

Review

  • Considerations in Pricing Mortgage

    Backed Securities

    • The Importance of Prepayment Rates

    • The PSA Convention

    • The Risks of MBS

    • The Risk of Collateralized Mortgage Obligations

    • The Risk of Stripped Mortgage Backed Securities


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