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## Mortgage Markets and Mortgage Backed Securities

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Brief History of Mortgages

- Following the decline of Roman empire, Germanic law developed the idea to use land as security in borrowers agreements, this practice was referred to as a gage
- William of Normandy introduced the Germanic gage system into early English law. The French word mort (dead or frozen) was combined with gage to produce a locked pledge or mort-gage on property.

The US mortgage market

- Establishment of mortgage companies in the the 1800’s to finance land purchases by farmers in the Midwest.
- By 1900 there were approximately 200 mortgage companies with outstanding loan values totaling $4 billion
- Early mortgages paid interest semiannually, nonamortizing with a balloon payment at the end (as short as 3 to 5 years)

History of US Mortgage Market 1900 - 1950

- Fast growth form 1900 to 1930 was slowed by large number of foreclosures in early 1930’s.
- Federal Government started trying to support the mortgage market especially the secondary mortgage market with formation of Federal National Mortgage Association (Fannie Mae) in 1938
- Post WWII fast expansion of housing market due to liquidity of private sector.

History of US Mortgage Market 1950 - 1980

- 1954 Fannie Mae was reorganized. New charter made it part private part federal owned
- 1968 Fannie Mae becomes entirely privately held. Ginnie Mae is established to oversee special assistance (FHA and VA) programs. Guarantees backed by “full faith and credit” of US Treasury.
- 1970 Establishment of “Freddie Mac”
- 1977 First private pass through issued

History of US Mortgage Market 1980 - 2004

- 1980’s growing use of Adjustable Rate Mortgages
- First Collateralized Mortgage Obligations offered
- Dramatic growth of Mortgage backed securities market.

The Current Mortgage Market

- The Primary Market – The issue of Mortgages to individuals by financial institutions.
- Mortgage Originators
- Thrifts, Commercial Banks and Mortgage Brokers

Origination Income

- Origination Fee - expressed in terms of points -- each point represents 1% of the borrowed funds -- Origination fee of 3 points on 100,000 mortgage is $3,000
- Secondary market profit -- selling the mortgage obligation at a price higher than it originally cost.
- Servicing Fee - Collecting monthly payments, forwarding proceeds to owners of the loan, sending payment notices, maintaining records, furnishing tax info etc…

Servicing Fees

- Servicing fees are generally a portion of the mortgage rate and is often referred to as servicing spread.

The mortgage origination process

- Applicant submits info relating to the property and income. Originator performs credit report and looks at the probability of repayment.
- PTI -- payment to income ratio (monthly payment / monthly income)
- LTV -- loan to value ratio (Loan amount / Valuation )
- Commitment letter-- outlines the terms available for the next 30 to 60 days. The borrower pays a commitment fee which will be lost if no loan is taken out.

Post Loan Options

After making the loan the originator has one of three options

- Hold the mortgage in their portfolio.
- Sell the mortgage to an investor (who will either hold the mortgage or use it as collateral), possibly continuing to service the mortgage.
- Use the mortgage as collateral to issue a security (securitizing the mortgage)

Origination Risks

- Price Risk If rates increase the originator has already committed to charging lower rates --
- Can protect against price risk with a second commitment from a secondary market participant that agrees to buy the given loan at a futures point in time for a given price.
- However this brings a second risk -- if rates decline the borrower may not close and the originator is locked into providing the above market return.
- Fall out Risk. Risk that some individuals issued commitment letters will not close

Mortgage Construction

- Traditional Fixed Rate Mortgage (fixed-rate level-payment, fully amortized mortgage)
- Principal and interest are amortized over the life of the mortgage.
- The payment is determined with the basic PV of an annuity formula

Amortization of a Loan

You want to borrow 1,000 and pay it off over three years. Assume that you are charged 6% each year. How much will your payment be?

1,000 = PV PMT =????

1,000 = PMT (PVIFA6%,3) =

1,000 = PMT(2.67)

PMT = 374.11

Amortization

- You pay a total of 374.11(3) = $1,122.33
- A portion of each payment represents interest charges.
- You can find the amount of interest by multiplying the beginning balance each payment period by the interest rate.
- At the beginning the balance is $1,000 so there is 1,000(.06) = 60 in interest.

Amortization

Beginning Ending

Year Balance Payment Interest Principal Balance

1

1,000

374.11

60.00

314.11

685.89

2

685.89

374.11

41.15

332.96

352.93

3

352.93

374.11

21.18

352.93

0.00

Amortization 30 yr Mortgage$150,000 5.85%

Beginning Ending

Year Balance Payment Interest Principal Balance

150,000

884.91

731.25

153.6614

1

149,846.34

154.41

2

149,846

884.91

730.50

149691.93

1756.97

359

884.91

8.57

876.35

880.62

0

880.62

880.62

360

884.91

4.29

Servicing Fee Revisited

- Since the servicing fee is generally a portion of the interest payment the actual fee income will decline throughout the life of the mortgage as interest decline.

Prepayments and CF Uncertainty

- Generally there is not a penalty for prepaying the principle early. When a prepayment is made for less the entire balance it is referred to as a curtailment.
- Some mortgages however do have a lock out period or penalty period which can limit or prohibit prepayment.

Origination Problems

- Mismatch

Institutions are borrowing short and lending long, They must manage the different timing of their cash flows.

- Tilt

The real burden of the loan to the borrower is in the early years of the loan. Since inflation decreases the real burden of their payments over time. Therefore individuals may not enter the market, even though they are able to given their future income.

Adjustable Rate Mortgages

- The loan rate is reset periodically using a base or reference rate.
- The rate might reset every month, year, 2 years 5 years etc..
- Reference Rate
- Market determined
- Cost of Funds

ARM Features

- Usually offer an initial rate less than prevailing fixed rate (teaser rate).
- At reset date reference rate plus a spread determines the rate.
- There may be caps and floors on the rates, both periodic and lifetime.

Balloon & Two Step Mortgages

- Allows for rollover and renegotiation of the loan at periodic intervals.
- Different from ARM the future rate is not set from base rate.
- Loan is extended if certain requirements are met.
- 30 due in 5 is a thirty year mortgage where the remaining principal is due (or refinanced) after five years.
- Two step rates once based upon a specified rate

Solutions to the tilt problem:

- ARMs address the mismatch problem by allowing for longer term lending at a short term rate.
- The tilt problem has creates the market for other types of products
- Graduated Payment Mortgages
- Price -level Adjusted Mortgage.
- Dual Rate Mortgage

Graduated Payment Mortgages

- The mortgage payment increases each year at the beginning of the loan then hits a level amount for the remainder of the loan.
- This actually produces negative amortization since in the beginning the total amount does not cover the interest on the loan.
- Specified in the loan are The fixed rate, the rate of growth for the first few years, the number of years over which the payment will increase

Graduated Payment Mortgages

- Example: 30 year, 10% mortgage on $100,000 with the payment growing at 7.5% each year for the first 5 years.

Fixed Rate payment would be $877.5715

GPM Payments

Year Payment Year Payment

1 $667.04 2 $717.06

3 $770.84 4 $828.66

5 $890.80 6-30 $957.62

Price Level Adjusted Mortgages

- Monthly payment is designed to be level in purchasing power. The fixed rate of interest is a real rate of interest.
- The monthly payment is then calculated using the real rate just as a regular mortgage would be.
- The actual payment is then adjusted based upon the rate of inflation.

Dual Rate Mortgages

- Similar to the PLAM except the amount owed is based on a floating short term rate.
- To establish the mortgage you need
- the payment rte (the real rate of interest that is fixed for the life of the loan),
- the effective or debiting rate that changes periodically and
- the maturity of the mortgage.

Other plans

- Growing Equity Mortgage: Similar to the GPM except there is no negative amortization. The increase in payment will serve to pay off the principal quicker than a traditional mortgage.
- Lenders will be willing to lend a t a lower rate (if the yield curve slopes up) and borrowers increase payment solving tilt problem
- High LTV loans eliminates high down payments by financing up to 100% of the value of the home plus closing costs.

Other Plans

- Alt-A loans: Requires alternate documentation of income for special cases such as self employed individuals. Rtes are generally 75 basis points to 125 basis points above other rates
- Sub Prime Loans: Borrowers who have had credit problems. Rates based upon different risk grades

Risks Faced by Investors in the Secondary Mortgage Market

- Credit Risk

Risk of default by the borrower

- Liquidity risk

Even with the secondary markets, individual loans are relatively illiquid

- Price Risk

Value moves opposite changes in interest rates

- Prepayment Risk

The borrower may prepay early

Mortgage Pass Through Securities

- Interest and Principle are collected by the issuer of the pass through on a pool of mortgages who then transfers (passes through) the payments to the owners of new securities backed by the mortgages.
- Neither the amount or timing of the cash flows actually matches the cash flows on the pool of mortgages.
- When a mortgage is included in a pool it is said to be securitized.

Cash Flows

- Neither the amount or timing of the cash flows actually matches the cash flows on the pool of mortgages.
- Servicing and other fees are removed from the cash flows received from the mortgage prior to being passed through to the holder of the pass through security. There is also a delay in the pass through process.

Terminology

- The pool of mortgages will have a variety of different rtes and maturities. Therefore, the description of the pass through is based upon weighted averages of the coupon and maturity.

WAC, WAM and WARM

- WAC = weighted average coupon rate

Weighting the mortgage rate of each mortgage in the pool by the outstanding principal balance

- WAM = weighted average maturity

Weighting the number of months to maturity of each mortgage in the pool by the outstanding principal balance

- WARM = weighted average remaining maturity

After prepayments have started the maturity changes.

Guarantee Types

- Fully Modified Pass Throughs: Guarantees that the principal and interest will be paid regardless of whether the borrower is late.
- Modified Pass Through: Guarantees the timely payment of interest, the principal is passed through when it is received.

Ginnie Mae

- Ginnie Mae pass throughs are guaranteed by the US treasury.
- Issues Mortgage backed securities which are fully modified pass throughs
- All mortgages are FHA, VA or Farmers Home Administration loans

Fannie Mae

- Sells mortgage backed securities and channels the funds to lenders by buying mortgages. The institution may continue to service the original mortgage.
- All are fully modified pass throughs, but there is no government guarantee of payment
- Both Ginnie Mae and Fannie Mae securities are commonly referred to as “Mortgage Backed Securities”

Freddie Mac (FHLMC)

- Participation Certificates sold by the agency are used to finance the origination of conventional mortgages. Usually PC only guarantee that the interest payment will be made. The principle payment is passed through as it is received. The guarantee is not backed by the federal government as is the case in Ginnie Mae.
- Most are fully modified (new issues are)

Participation Certificates

- Two main programs
- Cash program FHLMC buys mortgages from the issuer and issues PC's based on the mortgages.
- Guarantor / Swap program -- Allows thrifts to swap mortgages for PC's based on the mortgages. The institution can swap mortgages selling below par for without recognizing an accounting loss!
- The PC is then:
- Held as an investment
- used as collateral for borrowing
- sold

Comparison of rates

- The pass through rate is less than that of the mortgage pool. The difference accounts for service and guaranteeing fees.
- The timing is also different to allow for the payment of the mortgages (on the first of the month) prior to the pass through occurring.

Size of Mortgage Backed Securities Market

- The MBS market has grown dramatically in the last 20 years.
- Currently there is a political debate surrounding whether Fannie Mae, Ginnie Mae and Freddie Mac are too large.
- Part of their growth is based upon the market believing that all three have a government guarantee, even though Fannie Mae and Fredie Mac do not.

% of Outstanding Debt Market

Bond Market Association 2003 is as of Sept 30,2003

Average Daily Trading Volume ($Billions)

Bond Market Association 2003 as of Sept 30,2003

Issuance by GSE’s ($ Billions)

Bond Market Associattion 2003 as of Sept 30, 2003

Recent Study by Federal Reserve

- Wayne Passmore, an economist at the Federal Reserve Bank has recently completed a study on the impact of GSE’s
- The GSE’s have a funding advantage
- Slightly lower mortgage rtes for a few borrowers
- Implicit subsidy from government relationship
- Implicit subsidy responsible for much of GSE Market Value
- MBS have not increased homebuilding

Creation of a GNMA pass through

- The loan pool must have standard features in terms of single family or mutli family, maturity etc.
- The originators forward the pool to GNMA with supporting documentation requesting GNMA to guarantee the securities to be backed by the pool
- After review a pool number is assigned if the pool is accepted

Sundaresan 2002

Creation of a GNMA pass through

- The originators transfer the mortgage documents to custodial agents and send pool documents to GNMA
- Originators look for investors (dealers, investment banks etc) willing to buy a given amount at a specified price

Creation continued

- GNMA issues the guarantee following review of the documentation.
- Originators continue to service the loans.
- The GNMA MBS is not a debt of the issuer, it is a representation of the loan pool with payments guaranteed by Ginnie Mae

Fees for a typical GNMA pool

- 44 basis points are retained by the servicer for servicing fees
- Ginnie Mae receives 6 basis points for the guarantee. The issuer is guaranteeing Ginnie Mae against defaults by the homeowner and Ginnie Mae guarantees against defaults by the issuer.
- The investor then receives approximately 50 basis points less than the coupon of the loan portfolio.

Sundaresan 2002

Price Quotes

- GNMA’s are quoted in 1/32 of a point
- Quotes depend upon a pool factor pf(t) representing the % of the initial mortgage pool balance outstanding

Sundaresan 2002

Market Value

- Consider an investor with $20 million of a $100 million issue with a pool factor of .9 and a price of 9316/32

Par value remaining = 20 (.9) = 18 million

The value is then price x par value x pool factor

Market Value = (.9350) (20)(.9) = $16.38 Million

You would need to also account for accrued interest to find the actual cash price.

Sundaresan 2002

Trading and Settlement Procedures

- Agency pass throughs are identified by a pool prefix number.
- TBA trade – a trade based on an agency pass through prior to the pool of mortgages being established. Generally, there will prior agreement on agency type, program, coupon rates, and settlement date

Market references

- At a given point in time there may be many seasoned issues of an agency security with the same coupon rate.
- For example in early 2000 there were more than 30,000 pools of 30 year Ginnie Mae MBS’s with a coupon rate of 9%.
- Each pool may be from a different area of the country or from several regions.
- Dealers will refer to all of these as Ginnie Mae 9’s even though they have different prepayment characteristics. If the investor does not specify a pool number, the dealer has the option to deliver any of the pools.

Non Agency Pass Through Securities

- Often non agency mortgage pass throughs will attempt to increase their rating
- External Credit Enhancement
- third party guarantees of losses up to a predetermined amount. Often these are in the form of a corporate guarantee , a letter of credit, pool insurance or bond insurance
- Internal Credit Enhancement
- Reserve funds
- Over collateralization
- Senior/subordinated structure

Prepayment conventions

- In order to value a MBS the pattern of prepayments needs to be forecasted.
- To do this the pool needs to be looked at and some assumptions need to be made concerning the payment of the pool.

Measuring prepayment

- Constant Monthly Mortality
- Assume that there is a 0.5% chance that the mortgage will be prepaid after the first year. The 0.5% is the single month mortality rate (or SMM)
- Given the SMM it is easy to compute the probability that the mortgage will be retired in the next month.
- The probability that the mortgage survived the first month is 1-0.005 = .995 or 99.5%

Measuring Prepayment

- Given a 99.5% chance that the mortgage survived the first month, and a 0.5% SMM for the second month the probability that the mortgage will be retired in the second month is: 0.50%(.995) = 0.4975%
- Continuing in the same manner the yearly prepayment rate could be found.

Conditional Prepayment Rate

- Let CPR be the conditional prepayment rate. The probability that the mortgage survives one year is (1-SMM)12 which should equal (1-CPR)

or

(1-SMM)12=(1-CPR) CPR = 1-(1-SMM)12

this assumes that prepayments will be the same through time which is not consistent with the empirical evidence

Conditional Prepayment Rate (CPR)

- The industry convention is to use an annual prepayment rate based upon the historical prepayment observed by the FHA. The CPR can then be easily transferred back to a monthly rate (the single month mortality rate (SMM))

SMM = 1 - (1-CPR)1/12

If the CPR is 6% the SMM is equal to

1 - (1-.06)1/12 =.005143

Calculations

- Prepayment based upon the SMM
- Estimated Prepayment for month t
- Using the SMM above assume we own a pass through with a beginning balance of 290 million and principal repayment of 3 million scheduled
- Estimated Prepayment would be:

.005143(290,000,000-3,000,000)=$1,476,041

The PSA benchmark

The Public Securities Association prepayment benchmark is expressed as a monthly series of conditional prepayment rates.

The PSA benchmark assumes that prepayments start slow then increase

Market Convention

- The CPR has been shown to level off after thirty months. The standard CPR used is .2% for the first month then increasing at .2% each month until 6% is reached for the thirtieth month and every month thereafter.

100 PSA

100 PSA assumes market convention speed of prepayment:

Using the convention of a CPR of 0.2% for the first month increased by 0.2% each month for the next 30 months

After 30 periods a CPR of 6% for the remaining years of the mortgage

PSA is then expressed as a percentage of 100 PSA benchmark.

PSA benchmark

- For Example a PSA of 150 means that the pool prepays at an expected rate 1.5 times as fast as the PSA benchmark
- Notice the CPR is a multiple of the PSA not the SMM

Monthly cash flow construction(See Handout)

- Assume that you have a $400 Million 7.5% pass through with a WAC of 8.125% and a WAM of 357 months assuming 100PSA
- Note: the pass through has been seasoned three months this makes the CPR = 0.8%

Example Continued

- The SMM for the first month is then:

SMM=1-(1-CPR)1/12=1-(1-0.008)1/12=0.000669124

The scheduled mortgage payment would be

400,000,000=PMT(PVIFA357,8.125%/12)=2,975,868.24

(this changes with each payment due to prepayment)

Monthly cash flow construction

- Interest is found from the pass through rate of 7.5% $400,000,000(.075)/12 = $2,500,000
- The scheduled principal is found using the WAC and the payment calculated earlier.

Total interest scheduled from the pool is = 400,000,000(.08125)/12 = 2,708,333.333

Given a payment of 2,975,868.24 the scheduled principal is: 2,975,868.24 - 2,708,333.333=

267,534.91

Monthly Cash Flow Construction

- The expected prepayment for the month is then found using:
- For the first month this is equal to :

.000669124(400,000,000-267,534.91)

=267,470.58

- total principal is then equal to

267,534.91+267,470.58=535,005.49

Monthly Cash Flow Construction

- Total Cash Flow is then the sum of the interest paid to the pass through investor and the total principal

=2,500,000+ 535,005.49=3,035,005.49

- the next months outstanding balance is then reduced by the amount of principal

=4,000,000-535,005.49 =399,464,994.51

the next month would proceed the same way with the exception of the scheduled mortgage payment.

Note

- The PSA convention is the result of past experience on FHA prepayments. The empirical evidence suggests a level CPR after 30 months of 6%. The first 29 months are just a linear approximation starting at zero months and ending at 29.
- The same method is used regardless of the maturity of the pass through, and the rate (ARM or fixed.) It is at best an quick and easy estimate.

Non Agency CPR convention

- Defaults and other problems characterize the nonagency pass throughs, therefore there is a PSA standard default assumption (SDA)
- 0.02% fro the first month increasing by 0.02% each month up to .6% at 30 months
- .6% form 30 to 60 months
- 61 months to 120 months default rates decline to 0.03%
- 120 to maturity default rates remain at 0.03%

Factors Affecting Prepayment

- Prevailing Mortgage Rates
- Characteristics of the Mortgage Pool
- Seasonal Factors
- General Economic Activity

Factors Influencing Prepayment

- Prevailing Mortgage Rates
- Spread between Original Rate and Prevailing rate

If the original rate is greater than the prevailing rate there is a higher probability of prepayment. These mortgages are often referred to a premium mortgages. (the opposite case would produce discount mortgages)

- Path of Rates

If rates went up then down prepayments will be higher. If rates decreased then increased and decreased again, prepayments will not be as high since many took advantage the first time.

Factors Influencing Prepayment

- Prevailing Mortgage Rates
- Level of rates

As the level of rates declines turnover increases as more homes become affordable.

Factors Influencing Prepayment

- Characteristics of Underlying Mortgage Loans
- Seasonality (more in the Spring and summer less in the winter)
- Age of Mortgage Prepayments are higher during the early stages of the mortgage and the final periods prior to maturity
- Type of Loan (ARM, balloon etc)

Factors Influencing Prepayment

- Seasonality (more in the Spring and summer less in the winter)
- This mirrors the amount of home buying activity.
- This results in a slight lag of the impact of prepayments on the MBS market since there is a lag in passing through the prepayments.

Factors Influencing Prepayment

- General Economic Factors
- Housing Costs
- Geographic Location
- Family Circumstances
- Economic Activity

Extension and Contraction Risk

- The investor is not sure of the timing of the cash flows since it depends upon the timing of the prepayments. Therefore they face other risks
- Extension Risk – there is a change in the market that causes fewer prepayments and the length of time prior to the repayment increases due to fewer prepayments
- Contraction risk - Prepayments increase as rtes decline causing shortening of the length of the MBS and reinvestment risk.

Collateralized Mortgage Obligations.

- Provide semiannual payments
- The payment of principle is allocated among different tranches that represent the repayment of principle.
- Allows investors to attempt to match their willingness to accept prepayment risk to a security

Average Life

- This measure represents the average time to receipt of principal repayments.

Sequential pay CMO

- The first Tranche receives principle until the total principle in the tranche is paid off. The CMO will be explained by a Weighted average maturity and a weighted average coupon that represents the mortgages in the CMO.
- The actual timing of the payoff will depend upon the prepayment rate. The speed of prepayment can be estimated, but it will not be know in advance.

Example: Same starting point as before

- Assume that you have a $400 Million 7.5% pass through with a WAC of 8.125% and a WAM of 357 months assuming 100PSA
- Four payment tranches
- Tranche Par Amount Coupon

A 194,500,000 7.5

B 36,000,000 7.5

C 96,500,000 7.5

D 73,000,000 7.5

Example continued

- Each tranche received interest upon the outstanding principal in the tranche. Tranche B receives no principal until Tranche A has received all of its principal likewise tranche C follows B and D follows C.
- Therefore after the fist period, tranche B receives $36,000,000(.075)/12 = $225,000
- Tranche B continues to receive 225,000 each period until the principal has been paid off to tranche A. The pay down of principal is calculated as before…

CMO

- The CMO has allowed investors to choose a tranche that best matches their desire to accept prepayment risk (match the timing of cash flows to their needs).
- However, there is still variability in the actual timing of the tranches since prepayments may not occur at the estimated speed.

Accrual Tranches

- In the example all the tranches receive interest payments. Often this is not the case. It is possible for one or more tranches to be an accrual bond.
- The interest that would have been paid on the tranche now goes to paying down the debt on the earlier tranche. This shortens the maturity of the other tranches.

Floating Rate Tranches

- Any fixed rate tranche can be converted to a floating rte and inverse floating rate tranche (adding a tranche to the total structure of the CMO)
- Whatever portion of the balance is not the floater will be the balance of the inverse floater.
- You can also use only a portion of the tranche to create the floaters.

Interest Only and Principal Only

- Another structure is to allocate only interest or only principal to a given tranche.
- The IO investor will want the prepayments to be slow since it extends the life of the CMO. The PO investor will prefer that the prepayments arrive quickly

Structured IO

- IO tranches are often referred to as structured IO’s to distinguish them from a stripped IO.
- In this case the coupon rate for one tranche is different from the coupon rate on the collateral. For example the rate may be less than the interest rate on the collateral. The excess interest is then allocated to a separate tranche.

Notional IO classes

- This is a class that receives the excess coupon interest. It has no par value, only a notional value upon which the payments are based.

Planned Amortization classes

- Includes a set principal payment schedule which must be followed (if the actual prepayments fall within a given window then a schedule of principal payments is followed).
- PAC bondholders have priority over the other classes within a CMO. Therefore PAC bonds come at the expense of support or companion bonds which absorb the prepayment risk (they forego principal)

Planned Amortization Class Tranche (PAC) CMO’s

- If prepayments are within a specified range, the cash flow pattern is known.
- PAC bondholders have priority over the other tranches in the issue.
- The non PAC bonds are termed support or companion bonds.
- The minimum is based off of a range of PSA assumes an upper and lower collar.

PAC Bonds

- The guaranteed principal payment is the minimum of the principal repayments of the two possible PSA’s.
- The prepayment can occur even if prepayment occurs at a rate different than the original collars

PAC bonds

- The support bonds provide protection against both extension and contraction risk. Therefore the PAC will not shorten even outside of the initial PAC bands.
- The wider band of guaranteed prepayments creates an effective collar in which the prepayments stay constant.

PAC Bonds

- The support bond will not receive any principal until the PAC has received all of the scheduled prepayment.
- If the prepayment is slower than scheduled any principal that might have gone to the support bond (if the schedule was met) will now go tot the PAC.

PAC Bonds

- If the prepayment is faster than originally planned the support bond will receive faster prepayments, eliminating the PAC paying off quicker.
- If the principal of the support bond is paid off early then the PAC will decrease in maturity.

Quick Question

- Will the schedule of principal repayments be satisfied if prepayments are faster than the initial upper collar?
- It depends upon when the prepayments occur…. The initial assumption was that the support would be eliminated at the upper collar. It repayments were initially slow, there is extra support available.

Quick Question 2

- Will the schedule of principal repayment be satisfied as long as prepayments stay within the initial collar?
- Not always the initial structure only guarantees that the schedule will be met if it is at either of the extremes. If prepayment varies there is a possibility that the PAC is busted.

Answer continued

- IF the PAC has been prepaying at the faster PSA the amount of support decreases and the lower collar of the effective collar increases above the initial collar.

Final Question

- Given the first two questions does a wider initial collar imply that there is less risk that the repayment will not fit the schedule?
- No the actual prepayment experience once the PAC is seasoned is what is important.
- Given prepayment experience, the effective collar is what should be investigated.

Increasing Prepayment Protection

- Lockout Structure: Eliminating the earlier or shorter PAC from the package creating more support bonds
- Changing the prepayment rules in the event that all support bonds are paid off. One possible structure: reverse PAC -- requires any extra principal to go to the longer maturity PAC’s

Targeted Amortization Class

- Instead of guaranteeing a range of rates initially a TAC bond guarantees a specific targeted rate. The bond is therefore only protected against contraction risk, not extension risk.

Stripped Mortgage Backs

- 1) Synthetic coupon pass throughs
- results in a cash flow different than the underlying coupon
- 2) IO and PO strips
- Principal is at a discount from par. IO has a notional value.
- 3) CMO strips

Principal Only Strips

- The principal only strip is purchased at a substantial discount to par value.
- The faster the prepayments, the higher the return to the investor since the return is determined only by the speed with which the investor will receive the principal

Interest Only Strips

- The Interest is based upon the amount of prepayments outstanding therefore the investor will hope that the prepayments will be slow.
- It is possible for the IO investor to not recover the amount originally paid if prepayments are too fast.

Introduction

- MBS’s represent the largest market for assets which have been securitized, however many other similar assets exist.
- Types of assets

Auto Loans Student Loans

Credit Card Receivables Music Royalty Receivable

Home Equity Loans Equipment Leases

Manufactured Housing Home Equity Loans

SBA Loans Parking Ticket Receivables

Outstanding Mortgage and Asset Backed Securities in US

Securitization Davidson et al Wiley Pub. 2003

Outstanding $ Value ofABS by Underlying Asset

Bond Market Association, 2003 is as of Sept 30, 2003

Issues

- All of these assets face both credit risk and prepayment risk, they are often referred to as credit sensitive structures products.
- Corporations offer these as a means of separating the assets used in the collateral from the assets of the firm. Often this results in a form of credit enhancement that can decrease borrowing costs, however there can also be increased costs that offset the decreased borrowing cost.

Features of an ABS

- Amortizing vs. Nonamortizing
- Amortizing loans such as cars and mortgages have a set schedule of payment of principle and interest. Therefore projecting prepayments is an important part of analyzing the cash flows generated.
- Nonamortizing assets only have a minimum payment and there is not a schedule of principle repayments (credit card receivables for example). Therefore there is not a prepayment risk.

Features of ABS

- Fixed or Floating rates
- Generally floating rate asset backed securities are backed by floating rate assets. Fixed rate loans can also be used to create floating rate asst backed securities for example the floating tranches of a CMO.

Features of ABS

- Credit Enhancements
- External Credit Enhancements – third party guarantees
- Corporate guarantee
- Letters of credit
- Bond insurance
- Internal Credit Enhancements
- Reserve Funds (cash reserve or Excess servicing spreads)
- Overcollateralization
- Senior / Subordinated

Features of ABS

- Pass-through
- Each holder is entitled to a portion share of the cash flow from the underlying assets
- Pay Through
- The pool loans are split into tranches similar to a CMO, however a pass-through does not need to be created first. Often the senior tranches are split apart into smaller tranches. This creates a transfer of risk from the senior to subordinated tranches (credit tranching). Prepayment risk can also be transferred (time tranching or prepayment tranching)

Features of ABS

- Option Clean up Call provisions
- Percent of (collateral, bond, or tranche) call -- outstanding bond can be called if the outstanding (collateral balance, bonds outstanding or outstanding tranches) falls below a given level
- Call on or after a specified date.
- Auction call -- called if the collateral can be sold at auction at a price greater than par value at a given date.
- Insurer Call – Insurer can call if the collateral’s call history reaches a predetermined level.

Differences in ABS Market

- The cash flows from the assets are often not as predictable as in the case of mortgages.
- For example: Home Equity Lines of Credit
- Borrowers have open end line of credit that can be accessed at any time.
- This creates risks in the outstanding balance as well as prepayment.
- Increased default risk, especially automobile loans, and credit card receivables.

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