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Mortgage Backed Securities – Valuation and Disclosure Considerations

Mortgage Backed Securities – Valuation and Disclosure Considerations. May 2011 Christina K. Catalina, CPA. Types of Structured Securities.

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Mortgage Backed Securities – Valuation and Disclosure Considerations

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  1. Mortgage Backed Securities – Valuation and Disclosure Considerations May 2011 Christina K. Catalina, CPA

  2. Types of Structured Securities • Asset Backed Securities (“ABS”) - a security whose value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.

  3. Types of Structured Securities, continued • Mortgage Backed Securities (“MBS”) – a type of ABS whose value and income payment is derived from and collateralized by mortgage loans. • Agency RMBS – backed by residential mortgages issued through Government Sponsored entities (i.e. Fannie Mae, Freddie Mac, Ginnie Mae) • Non-agency RMBS – back by non-conforming residential mortgages (i.e. Home Equity Lines of Credit, Subprime, Alt-A, Option ARMs (Adjustable Rate Mortgages)) • Commercial MBS (“CMBS”)– backed by mortgages on retail, office & industrial properties.

  4. How Are MBS Typically Valued? Common Valuation Methods • IDC or Bloomberg closing price if reliable and transactions are occurring at those prices • The analysis of multiple broker quotes obtained from reputable 3rd party broker dealers to determine which one, or combination of quotes should be relied on • Yield Matrix • Option adjusted spread (OSA) analysis • Monte Carlo simulation

  5. Yields for MBSs • The yield to maturity for a mortgage-backed security, conditional on an assumed prepayment pattern, is called the cash flow yield. • Essentially, cash flow yield is the interest rate that equates the present value of all future cash flows on the mortgage pool to the current price of the pool, assuming a particular prepayment rate.

  6. Pricing and Yield – other valuation considerations The price of a mortgage-backed security is determined by several factors: the type of mortgage backing the security, • the level of market interest rates, • the coupon rate on the security, • liquidity, • the prepayment assumptions used, and • the overall demand for mortgage-backed securities.

  7. Risk Factors considered in valuation of MBS • Prepayment Risk (a.k.a Extension or Contraction Risk) • Liquidity Risk • Market Risk • Interest Rate Risk • Credit Risk

  8. Valuation and Disclosure • Valuation Technique: Determine whether the valuation method is reasonable, significant inputs are disclosed and the method is consistent with FASB ASC Topic 820, Fair Value Measurements and Disclosures. • Accuracy & Classification: Ensure that the investments held as of year end are classified appropriately in the Condensed Schedule of Investments and in the ASC 820 disclosure.

  9. Residential mortgage-backed securities – valuation consideration • Junior tranche of residential mortgage-backed securities for which the credit rating has fallen between the issuance date of January 1, 20X8 and the measurement date of March 31, 20X9. Additionally, there have been few transactions of the securities between June 30, 20X8 and the measurement date compared with historical levels. In the example, the holder determines that a discount rate adjustment technique is appropriate based on the low trading volume of the securities, and applies that approach by discounting the contractual cash flows of the securities using an estimated market rate of return. • Based on its evaluation of these inputs, the entity in the example estimates that one indication of an appropriate market rate of return is 12%. However, the entity also notes that there are two recent indicative quotes for the securities that imply yields of 15% to 17%. The entity has evidence that the quotes are not based on market transactions but is not able to determine what valuation techniques or inputs were used to develop the quotes. • In the example, the entity assigns weights to the indications of the market rate of return and determines that 13% is the point within the range that is most representative of fair value under current market conditions. The entity placed more weight on the 12% estimated market rate of return because it appropriately incorporated available market data that reflected nonperformance risk and liquidity risk that market participants would consider in pricing the securities, and because the broker quotes were nonbinding and were not based on actual transactions. Furthermore, the entity was not able to determine the methods used to develop the quotes, thus lowering their reliability.

  10. Accounting Standards Update 2010-06 – update to ASC 820 “Fair Value Measurements”

  11. ASU 2010-06- Improving Disclosures about Fair Value Measurements • Fair value measurement disclosures must be presented by class of assets and liabilities. (change from “major category”) • Equity securities, segregated by any one of the following: • 1. Industry type • 2. Entity size • 3. Investment objective; • Debt securities issued by the U.S. Treasury and other U.S. government corporations and agencies; • Debt securities issued by states of the United States and political subdivisions of the states (local governments); • Debt securities issued by foreign governments; • Corporate debt securities; • Residential mortgage-backed securities; • Commercial mortgage-backed securities; • Collateralized debt obligations; • Other debt obligations (segregate by asset backed, structured, etc.) • Cash and cash equivalents • Derivatives on a gross basis ( segregated by type of underlying risk in the contract, for example: interest rate, foreign exchange, equity, commodity, credit, other, etc.) • Investment funds (segregated by type of fund)

  12. Sample disclosure : Commercial Mortgage-Backed Securities (“CMBS”) and Asset-Backed Securities (“ABS”) • CMBS and ABS may be valued based on external price/spread data. When position-specific external price data is not observable, the valuation is based on prices of comparable securities or cash flow modes that consider inputs including default rates, conditional prepayment rates, loss severities, expected yield to maturity, and other inputs specific to each security. Included in this category are certain interest-only securities which, in the absence of market prices, are valued as a function of observable whole bond prices and cash flow values of principal-only bonds using current market assumptions at the measurement date. CMBS and ABS are categorized in Level 2 of the fair value hierarchy when external pricing data is observable and in Level 3 when external pricing data is unobservable. At December 31, 2010, the Partnership had investments in ABS of $XX,XXX,XXX include in Level 3 of the fair value hierarchy. These securities represent senior tranches in various securitization trusts. The underlying loans for these securities include small business loans and credit card receivables that were originated between 200X and 201X. The underlying small business loans and credit card receivables have respective weighted-average coupon rates of X.X% and X.X% and weighted average maturities of XX and XX years. To estimate their fair value, the Partnership uses a cash flow model. The significant inputs used for the cash flow model include the following rates of inputs: • Yield to maturity: X.X-X.X% • Default rates: X.X-X.X% • Prepayment rates: X.X-X.X% • Loss severities: X.X-X.X%

  13. ASC 820 disclosures NOTE: This is an excerpt from Fair value measurements table. Determine “class” on the basis of the nature and risks of the investments - consider, for example activity or business sector, vintage, geographic concentration, credit quality, and economic characteristic In addition to nature and risks, also consider placement in fair value hierarchy (i.e., Levels 1, 2, or 3)—e.g., greater number of classes may be necessary for fair value measurements with significant unobservable inputs (Level 3) due to increased uncertainty and subjectivity.

  14. ASC 820 disclosures

  15. Original Issue Discount • Original Issue Discount (OID) on MBS and other debt securities is required to be amortized for tax and financial reporting purposes. • Investors may purchase bonds issued by a corporation at a discount. Bonds are issued at a discount when the market rate of interest exceeds the bond's coupon rate. For example, if a 10-year $100,000 bond that pays 8% interest annually is issued on 1-1-Y1 when the market rate is 10%, an investor would be willing to pay $87,706 for the bond. The investor purchases the bond at a discount to obtain an effective yield to maturity of 10%. This discount of $12,294 ($100,000 - $87,706) is known as original issue discount (OID). The OID is amortized and recognized as ordinary income over the life of the bond using the constant interest rate method. The total amount of interest income each year is found by multiplying the effective yield to maturity (i.e., the market rate) by the adjusted issue price (i.e., the adjusted basis). For Y1, the investor who purchased the above bond recognizes $8,771 ($8,000 + $771 of OID) of interest income. • The basis of the bond is increased by the amount of the OID recognized as ordinary income each year. The investor's basis for the above bond after one year is $88,477 ($87,706 + $771).

  16. Pay Down Example 1

  17. Pay Down Example 2

  18. Questions?

  19. For Further Information Tina Catalina Marcum LLP 10 Melville Park Road Melville, NY 11747 Phone: (631) 414-4414 Fax: (631) 414-4415 Email: Tina.Catalina@marcumllp.com marcumllp.com

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