Mortgage-Backed Securities

1. Mortgage-Backed Securities • MBS deserve much of the credit for our very efficient secondary mortgage market • The next section will discuss the operation of the major mortgage-backed security programs in detail • Prepayment remains the major source of risk and return in MBS

2. Mortgage-Backed Securities • A mortgage-backed security is a financial asset promising a stream of future payments to the holder. • A “pool” or group of individual mortgage loans serve as the collateral for the financial asset. • Mortgage pass-through securities are financial assets that pay the holder a pro-rata share of the cash flows from a pool of mortgages

3. How an MBS is Created • Mortgage originators process applications and originate new loans • The originator uses its own funds or funds it has borrowed from a bank to fund the loans and hold them in the “warehouse” . • After the originator has accumulated enough loans for an MBS, the originator contacts FNMA/GNMA/FHLMC and provides information describing the individual loans. • A pool can be as small as 20-50 loans ($2-5 million) • lenders must have previously established a relationship with the agency and followed the “guide” for originating loans • Information is submitted electronically

4. How an MBS is Created • The agency reviews the information on the loans and approves or rejects the loans • For lender’s with established track records, the agency depends on lender’s representations and warranties combined with after-the-fact spot checks • Repurchases • Automated underwriting systems now expedite the process by assuring lender and agency that the loan meets the requirements and automatically transmitting the information about the loans • The agency “buys” the loans by exchanging an MBS security with a particular coupon rate and face value equal to the sum of the principal of all loans.in return for ownership of the loans

5. How an MBS is Created • The originator sells the MBS just like any security. • Investment banks and commercial banks make a market • Typically the originator has a commitment to buy the MBS as he is originating the loans. • Knows what yield he must achieve on originations

6. How an MBS is Created • The originating lender promises to service the loans • Responsibilities can vary from program to program • GNMA servicers promise to advance interest and scheduled principal payments during process of foreclosure • FNMA/FHLMC servicers typically do not

7. How an MBS is Created • Lenders look to the MBS prices quoted every day by investors • For example, based on the prices from Bloomberg, the originator might see that investment bankers are bidding a price of 99 for a 5.5% MBS delivered in January

8. MoneyLine V3.0X SPS2 11/11 10:43 EST 11/11/97 [STREET PRICING SERVICE] 1-212-922-0500 FNMA 30 YEAR FIXED RATE MORTGAGE BACKED SECURITIES FNMA DELIV BID ASK BIDYLD FNMA DELIV BID ASK BIDYLD 6.000 11/97 95:30 96:00 6.70 | 8.500 01/98 104:08 104:10 7.02 6.000 12/97 95:26 95:28 6.73 | 9.000 11/97 106:12 106:14 6.52 6.000 01/98 95:20 95:22 6.76 | 9.000 12/97 106:07 106:09 6.56 6.500 11/97 98:03 98:05 6.83 | 9.000 01/98 106:02 106:04 6.59 6.500 12/97 97:31 98:01 6.85 | 9.500 11/97 107:13 107:15 6.81 6.500 01/98 97:27 97:29 6.87 | 9.500 12/97 107:10 107:12 6.84 7.000 11/97 100:06 100:08 6.99 | 10.000 11/97 108:22 108:24 7.12 7.000 12/97 100:02 100:04 7.01 | 10.000 12/97 108:19 108:21 7.15 7.000 01/98 99:29 99:31 7.03 | 10.500 11/97 109:26 109:28 7.25 7.500 11/97 102:04 102:06 7.10 | 10.500 12/97 109:23 109:25 7.28 7.500 12/97 101:31 102:01 7.13 | 11.000 11/97 111:09 111:11 7.23 7.500 01/98 101:25 101:27 7.16 | 11.000 12/97 111:06 111:08 7.26 8.000 11/97 103:17 103:19 7.14 | 8.000 12/97 103:12 103:14 7.17 | 8.000 01/98 103:06 103:08 7.21 | 8.500 11/97 104:19 104:21 6.94 | 8.500 12/97 104:14 104:16 6.98 | Type <Return> to update the screen; <Down> or <Up> Key to Scroll

9. How an MBS is Created • The lender could promise to sell for January delivery in an amount equal to $10 million • The lender now needs to originate mortgage loans with coupons between 6.0% and 8.0% • Assume he originates $10 million of loans with 6.0% coupons and charges 2 point. Further assume that his costs of origination are 1 point • Lender advances $ 9.8 million ($ 10 million less 2 points) but incurs costs of $.1 million

10. How an MBS is Created • Once the pool is created, he contacts FNMA and swaps his loans for a 5.5% MBS • Commits to pay 15-20 bp to FNMA for Guarantee fee • Guarantee fees are negotiated between lender and FNMA based on lender’s past performance. • Generally between 15 and 25 bp • Delivers the MBS to Investment Banker for a price of 9.9 million. • The remainder of the 50 bp difference between the coupon rates on the loans and the coupon rate on the MBS is “servicing fee” • In this case: 30-35 bp

11. How an MBS is Created • Issues that can arise: • What if the originator cannot originate $10 million of loans in the next few months? • He has made a “firm commitment” • What if markets rates fall and the lender cannot originate loans with coupons of at least 6%? • What if borrowers do not close the loans they committed to ? • What if rates rise and the lender originates 7-8% loans instead of 6% loans?

12. How an MBS is Created • There are other ways to create an MBS • FNMA/FHLMC could buy loans for cash from a large number of small originators • Combine these loans into single large pools of several hundred million • Portfolio lenders could ask to “securitize” their existing portfolios of older loans • These transactions are called portfolio swaps

13. How Does an MBS Originator Earn Money? • Three sources: • Charge more fees that exceed costs • Achieve a larger servicing spread than its costs to service the loans • Servicing costs $50-100/year/loan • 10 bp on a $100,000 loan generates revenue of $100 in the first year • declines every year thereafter • ignores value of escrows • Sell the loans for a higher price • If the lender could originate 6.5% loans with one point fees it could sell a 6.0% MBS at a price of 101-06

14. Portfolio Lender v. MBS Originator • Portfolio lenders • profit is primarily earned from the spread between coupon rate and the cost of money • volume is limited by the amount of lendable funds • MBS Originators • profit is earned from fees for services • originating • servicing • volume is limited by the overall demand for new loans and my ability to compete

15. Mortgage-Backed Securities • Ignoring default problems, Mortgage pass through securities simply aggregate cash flows from a number of different mortgages and pass them through • They would provide diversification of prepayment risk • Consider the case of 100 investors each owning 1 mortgage v. owning 1% of a pool of 100 mortgages.

16. Dealing with Default Risk • Starting with GNMA MBS the major programs all provide the investor solid protection against default risk. • If a mortgagor stops making monthly payments, the guarantor must advance the monthly payment to the investors while the servicer tries to collect on the loan • If there is a deficiency after foreclosure, the guarantor must pay to the investor

17. Dealing With Prepayment Risk • Because MBS programs “pass-through” all prepayments, they do not eliminate investor concerns about prepayment risk • MBS aggregate many mortgages so that prepayment risk is not “all or nothing” as it is with an individual loan • Nevertheless, because prepayments are highly correlated across loans with similar characteristics, diversification is less valuable here than it would be in insurance for example. • As we saw earlier in the course, with prepayment uncertainty, it becomes very difficult to estimate what yield you will earn on a loan you purchase with a price different than par.

18. Prepayment Risk • When purchasing a single loan, lenders ( in the early days of the secondary market) used the “prepay in twelve” convention for pricing loans • Based on a single loans • Assume regular payments are made as scheduled for 12 years and then the remaining balance is paid in full. • Works reasonably well for small differences between coupons and required yields • Recall that for a loan purchased at par, the time to prepay makes no difference in the yield earned by the lender • Most buyers refused to pay above par for a loan • Resulted in faster than expected prepayments providing higher than expected yields.

19. Prepayment Risk • With wide variations in interest rates, the weaknesses of the prepaid in twelve rule became very apparent • Yields are very sensitive to prepay assumption when yield and coupon are significantly different

21. New Tool for Measuring Prepay Speed • FHA had been insuring loans since 1934. • Accumulated a lot of data on how many claims it paid and how many loans survived and paid premiums • Sorted its data by year of origination of the insurance contract

22. Measuring FHA Experience

23. Table of FHA Experience

25. FHA Experience • Note that the sum of the probabilities over the thirty years exceeds 100% • The probabilities are conditional on survival to that year. Thus they apply to the declining balance • Think of a series of steps each moving halfway to the door. Each subsequent step gets smaller. • We can use these probabilities to estimate cash flows from prepays

26. FHA Experience • Investors could purchase MBS based on an assumed prepayment “speed” expressed as a multiple of the base FHA experience • The actual experience of different pools could be reported and used by investors to estimate the correct speed to use for pricing.

27. PSA Base • Dealers and Investors were troubled by the fact that FHA experience kept changing over time as new data was entered and older data dropped • These frequent changes never changed the general pattern-- only the minor ups and downs that no one put much faith in • Consequently, the PSA adopted a “smoothed” FHA experience curve which is now called the PSA curve.

29. CPR • CPR stands for conditional prepayment rate. • FHA historical experience showed that after a period of “seasoning”, mortgage loans experienced about a 6% annual prepayment rate • In any given year, 6% of the remaining loans would prepay or otherwise disappear from the pool. • For a while, let us ignore the seasoning period and the “random” fluctuations around 6% • If 6% of the loans prepay in a year, then .514% prepay in a month • With a monthly rate of .514%, there will be 5% fewer loans at the end of the year than at the start. • We call this monthly rate, Single Monthly Mortality or SMM for short

36. 0% CPR

37. 0% CPR

38. 0% CPR

39. 0% CPR

40. 6% CPR

41. 6% CPR

42. 6% CPR

43. 15 % CPR (Moderately Fast)

44. Various CPR Speeds

45. Outstanding Mortgage securities by Type

47. Growth of MBS • There were several reasons for the rapid growth of MBS in the 1980’s • Provides lenders liquidity • portfolio restructuring • collateral for short term borrowing • Favorable capital treatment • 4% capital for whole loans • 1.6% capital for agency MBS

48. But,... • The MBS structure did not alter the nature of the underlying mortgage cash flows • MBS pay principal and interest monthly • bonds pay interest only semiannually • MBS cash flows fluctuate from month to month • regular payment on $5 million MBS with 10% coupon is approximately $44,000/month. If two loans prepay, the monthly payment could jump to more than $250,000 • The duration of the mortgage investment is unknown. • 0% CPR-- 10 years • 6% CPR -- 6 years • 15% CPR -- 3 years