Mortgages and Mortgage Pass-through

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. . Mortgage. A loan secured by the collateral of specified real estate property, which obligates the borrower to make a predetermined series of payments. (page 225-227)Terms: (1) Mortgage originator (2) Payment-to-income (PTI) ratio (3) Loan-to-value (LTV) ratio (4) Conforming mortg

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Mortgages and Mortgage Pass-through

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1. Mortgages and Mortgage Pass-through

3. Mortgage Mortgage Servicers Servicing fees Mortgage insurers PMI Credit life (continuation of mortgage payments after the death of the insured person)

4. Lien Status The lien status of a loan indicates the loan’s seniority in event of the forced liquidation of the property due to default of the obligor. First lien Second lien (junior lien)

5. Credit Classification Prime loan: A loan that is originated where the borrower is viewed to have high credit quality. Subprime loan: A loan that is originated where the borrower is viewed to have low credit quality. Alternative-A loan: in between (page 228)

6. Interest Rate Types Fixed rate mortgage (FRM) Adjustable rate mortgage (FRM) Periodical rate cap Lifetime rate cap and floor Hybrid ARM

7. Level-payment fixed-rate mortgage Each monthly mortgage payment for a level-payment mortgage is due on the first of each month and consist of Interest of 1/12 of fixed annual interest rate times the amount of the outstanding mortgage balance at the beginning at the beginning of the previous month A repayment of a portion of the outstanding mortgage balance (principal) Monthly payment: page 231

8. Example Replicate the numbers for month 25 (page 231-232) Month payment Monthly interest Scheduled principal payment Ending mortgage balance

9. Other Issues Prepayment and prepayment mortgage – page 234-235 Conforming loans – page 235

10. Risks Associated with Investing in Mortgages Credit risk: homeowner/borrower will default Liquidity risk Interest risk Prepayment risk

11. Mortgage Pass-through Securities One or more mortgage holders form a collection of mortgage and sell shares or participation certificates in the pool. There are two derivatives from pass-through: Exhibit 11-1: Mortgage Loans and RMBS Cash flows: see Exhibit 11-2 on page 243.

12. Alternative Features Pass-through rate: less than the underlying pool of mortgage loan by an amount equal to the servicing and guaranteeing fees WAC WAM

13. Agency Pass-through Ginnie Mae -- MBS Freddi Mac – participation certificate (PC) Frannie Mae -- MBS Fully modified pass-throughs Modified pass-throughs Feature: default risk free.

14. What Determined Projected Cash Flow Projected cash flow Pass-through rate Prepayment speed Cash yield -- the most important factor is the expected prepayment rate

15. Alternative Prepayment Rates (1) FHA prepayment experience approach: assuming no prepayment in the first 12 years, then all the mortgage in the pool prepay

16. Alternative Prepayment Rates (2) Conditional Prepayment Rate Based on the characteristics of the pool (including its historical prepayment experience) and current and expected future economic environment. Conditioned on remaining mortgage balance. Single-month mortality rate (SMM) SMM=1-(1-CPR)1/12 Monthly Prepayment: SMM x (beginning balance for t– scheduled principal payment for t)

17. PSA Prepayment Benchmark (3) PSA Prepayment Benchmark published by Public Securities Association A monthly series of annual prepayment rates. Assumes that prepayment rates are low for newly originated mortgage and then will speed up as the mortgages become seasoned.

18. Standard Benchmark (100 PSA) CPRs for a 30-year mortgage: 0.2% per year for the first month, increased by 0.2% per month per month for the next 30 months (2) 6% CPR for the remaining years If t<=30: CPR=6%*(t/30) If t>30: CPR=6% Slower or faster speeds: 50 PSA or 300 PSA P 253

19. Examples (page 251) The SMMs for month 5, month 20, month 31 through 360 assuming 100 PSA The SMMs for month 5, month 20, month 31 through 360 assuming 165 PSA

20. Monthly Cash Flow Construction Objective: obtain cash flow Key steps: Interest scheduled principal prepayment

21. Example 1 Monthly cash flow for a $400 million 7.5% pass-through rate with a WAC of 8.125% and WAM of 357 months assuming 100 PSA. (exhibit 11-3, page 254)

22. Example 1 (do month 1) (1) Find SMM SMM for month 1 = (SMM for month 27)= (2) Find mortgage payment N I/Y PV PMT FV (using WAC here) (3) Interest: pass-through rate/12*beg balance (4) Scheduled principal payment=monthly mortgage payment – gross coupon interest, where gross coupon interest = WAC*outstanding mortgage balance/12.

23. Example 1 (solution) (5) Prepayment = SMM x (beginning mortgage balance – scheduled principal payment) = 0.00067*(400,000,000-267,535) (6) Total principal = 267,535+267,470 (7) Cash flow =2,500,000+535,005

26. A Tricky Question How much does the pass-through issuer earn?

27. Example 2 Monthly cash flow for $400 million 7.5% pass-through rate with a WAC of 8.125% and WAM of 357 months assuming 165 PSA

28. Factors Affecting Prepayment Behavior

29. Cash Flow for Nonagency Pass-throughs The PSA standard default assumption (SDA) benchmark gives the annual default rate for a mortgage pool as a function of the seasoning of the mortgages. See page 264 – assumptions on default rate

30. Cash Flow Yield Bond-equivalent yield=2[(1+yM)6-1] Limitation: rely on assumption Based on PSA assumption Other conditions: see page 266

31. Average Life Average time to receipt of principal payment (scheduled principal payment + projected prepayments)

32. Yield Spread to Treasuries Page 267 Spread of agency pass through to treasuries Spread of private-label pass through securities and treasuries

33. Prepayment Risk to Investors When mortgage rate decreases (contraction Risk) prepayment risk Lower reinvestment return When mortgage rate increases (Extension Risk) Price risk High mortgage rate slows down repayment (the basic idea is mortgage risk will be transferred to pass through investors)

34. Asset/Liability Management Implications Thrifts and commercial banks are more concerned of extension risks. Insurance companies have the similar problem when their liabilities are short term Pension fund managers may concern of the risk from pass through’s fast prepayments

35. Secondary Market Trading Quotes: see “Mortgage-backed securities” under “Bond Market Data Bank”

36. Nonagency Pass-through Issued by commercial banks, thrifts, and private conduits No guarantees Registered with SEC Function: credit enhancement

37. Credit Enhancement A. External credit enhancements – come in the form of third-party guarantees that provide for first-loss protection against losses up to a specified level Corporate guarantee A letter of credit Pool insurance Bond insurance The rating of the third-party guarantor must be at least as high as the rating sought.

38. Credit Enhancements B. Internal Credit Enhancement Reserve funds: straight deposits of cash generated from issuance proceeds. Excess service spread accounts: excess spread or cash into a separate reserve account after paying out the net coupon, servicing fee and all other expenses. Overcollateralization: a pool of assets with a greater principal amount than the principal amount of pool of mortgage loans. Senior/subordinated structure: most often used.

39. Senior/Subordinated Structure Subordinated class is the first piece to absorb losses Example: $100 million deal: $92.5m and $7.75m, i.e., subordination level of 7.75%. What are the loss ratios of both bonds: (1) if loss is $5m, and (2) if loss is $10m Why are subordinated class investors willing to take the losses ? high return Shifting interest structure – page 248.

40. Summary of Important Points Mortgage rate Pass-through rates Cash flow yield Conditional prepayment rate (CPR) Single-Monthly Mortality Rate (SMM) Scheduled principal payment Unscheduled (prepaid) principal payment Cash flow Nonagency passthrough

41. Exercises Questions 14, 15, and 20

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