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Mortgage-Backed Securities

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  1. Mortgage-Backed Securities Chris Lamoureux, PhD Head of Finance Estes/Neill Professor of Finance University of Arizona

  2. Background A dominant aspect of the US economy is widespread home ownership (owner-occupied housing). In the 2000 Census, 66.2% of American households owned their own home. This compares to a homeownership rate of less than 50% in 1890, and 43.6% in 1940. Mortgage Backed Securities

  3. International Rates of Home Ownership US: 66.2% UK: 67.9% Japan: 60.3% France: 54.3% Germany: 40.5% Republic of Korea: 53.3% Mortgage Backed Securities

  4. Mortgages US Public policy has attempted to increase home-ownership. Prior to the 1970’s most mortgages were owned by the financial system (Banks and S&Ls). Because these loans are very standardized, they were the first type of securitized loans. A mortgage is a collateralized, amortizing loan. It has a prepayment option. Mortgage Backed Securities

  5. MBS’s The most basic MBS is an Agency Passthrough security. Passthrough Features: • Type of Guarantee • Fully modified passthrough – timely payment of both interest and principal. • Modified passthrough – timely payment of interest, principal passed through when collected (guaranteed to be no later than a pre-specified date). • Number of Lenders Single or multiple lender (impacts extent of diversification). Mortgage Backed Securities

  6. MBS Features (Cont’d.) • Mortgage Design of loans. Esp. FRM vs. ARM • Mortgage Characteristics • Government-insured vs. Conventional • Maximum Loan size • Amount of Seasoning permitted • Assumability • Maturity • Servicing Spread. • Payment Procedure (Delays / Method). Mortgage Backed Securities

  7. Agency Passthroughs Three Types: • GNMA • Fully modified • Only FHA, VA, and RHS (Rural Housing Service) loans allowed • GNMA I – only single lender pools. • GNMA II – both single- and multiple-lender pools. • Servicing Spread: • GNMA I: 50 basis points. • GNMA II: 150 basis points. Mortgage Backed Securities

  8. 3 Types (Cont’d.) • Federal Home Loan Mortgage Corp (Freddie Mac) (Participation Certificate) • Cash Program. • Guarantor / Swap Program. • Wide variety of pools. • Spread: 50 – 250 basis points. • Federal National Mortgage Association (Fannie Mae) • All are fully modified. • Otherwise, very similar to Freddie Mac. Mortgage Backed Securities

  9. CMOs In June, 1983, FHLMC offered the first CMO. The CMO is a more sophisticated way of distributing the cash flows from a pool of mortgages than the straightforward passthrough. Mortgage Backed Securities

  10. CMOs (Cont’d.) The first CMOs focused on providing a variety of terms-to-maturity (durations) to investors. They are known as sequential pay structures (aka: plain vanilla; clean). The mortgages are pooled and the future cash flows are allocated according to specific classes or tranches. Example: $1 million pool of FNMA 7.5%s consistent with 185% PSA: Tranche A: Receives all principal flow from Months 1 through 64, when principal balance is 0 + Stated Coupon. Mortgage Backed Securities

  11. CMOs (Cont’d.) Tranche B: Receives stated coupon + all principal flow from Months 65 through 107, when principal balance is 0. Tranche C: Receives stated coupon + all principal flow from Months 108 through 134, when principal balance is 0. Tranche Z: Receives no cash flows until first 3 tranches are retired (although face amount accrues at stated coupon) then all remaining principal flows. (Cash flows shown in Sundaresan, Figure 9-9, p. 327.) Mortgage Backed Securities

  12. CMOs (Cont’d.) In 1986, following large drops in mortgage rates, and increased pre-payments, issuers developed and issued prepayment protected bonds called planned amortization classes. (PACs) PACs have a principal payment schedule--like a sinking fund that can be maintained over a range of prepayment rates. The relative certainty of these PAC tranches is obtained by setting up a companion tranche that absorbs the uncertainty. Mortgage Backed Securities

  13. Trading MBS 1. MBS do not trade in the same manner as treasuries or even corporate debt. Most trades are conducted on a TBA basis, where the basic structure of a security, but not the specific security is agreed to trade. This is meant to make for fungibility in the MBS market. So a trade specifies the WAC, WAM, prepayment history, and then most trades will actually comprise securities from several pools. Mortgage Backed Securities

  14. Trading MBS 2. Most trading in MBS occurs according to a schedule established by the Public Securities Association. I take the following time-line example from Tierney & Moore’s Chapter 5 from The Handbook of Mortgage-Backed Securities, (Fabozzi, ed.) 1995. On June 18, the portfolio manager calls a dealer and agrees to buy a 30-Yr FannieMae pass-through with $1 million face value, coupon 8.5%. Agreed upon price: 102 47/64 w/ no other characteristics specified. Mortgage Backed Securities

  15. Trading MBS 3. On July 9 the manager receives a fax that states that 2 pools will be delivered in 2 days: • A new pool issued on July 1 with 1.00 factor. • A pool issued on June 1 –just beginning to pay principal with a factor .99. The dealer will deliver 98% of the requested face value. The settlement date is July 13, where the manager pays the agreed upon premium plus accrued interest from July 1 through July 12. Mortgage Backed Securities

  16. Trading MBS 4. On the settlement date, the portfolio manager receives notice that Fedwire has credited its securities account and debited its cash account. On the last day of the month (July 31) Fedwire surveys all accounts and records our portfolio manager as the owner of record if its purchased MBS. On the 4th business day of the month (Aug. 6) Fannie Mae releases pool factors. Fannie Mae pass-throughs pay coupons on the 25th of the month to holders of the last record date. The interest and principal payment will be credited to the manager’s account via Fedwire. Mortgage Backed Securities

  17. Trading MBS 5. The “factor” in this case is the remaining principal multiplier for the previous month. This is multiplied by the original principal x the passthrough rate x 1/12 to come up with this month’s interest cash flow. Mortgage Backed Securities