Securitization and the Mortgage Backed Securities Topic 11

1. Securitization and the Mortgage Backed Securities Topic 11

2. Securitization and the Mortgage Backed Securities

3. Federal Agencies and their backing from government

4. Government Sponsored Enterprises GSEsTaken from Ben Bernanke – “GSE Portfolios, Systemic Risk, and Affordable Housing,” March 6, 2007 • The Congress chartered these two companies with the goal of expanding the amount of capital available to the residential mortgage market, thereby promoting homeownership, particularly among low- and middle-income households.  • Although they retain their government charters, Fannie and Freddie were converted (in 1968 and 1989, respectively) to private, publicly traded, for-profit companies. • Fannie and Freddie are regulated by the Office of Federal Housing Enterprise Oversight (OFHEO), with additional oversight by the Department of Housing and Urban Development (HUD).  The regulatory framework under which the GSEs operate has two principal objectives: first, to support the GSEs’ mission of promoting homeownership, especially access to affordable housing; and second, to ensure that these two companies operate in a financially prudent manner.

5. Government Sponsored Enterprises GSEs • Fannie Mae and Freddie Mac each run two lines of business.  Their • first line of business involves purchasing mortgages from primary • mortgage originators, such as community bankers; packaging them into • securities known as mortgage-backed securities (MBS); enhancing • these MBS with credit guarantees; and then selling the guaranteed • securities.  Through this process, securities that trade readily in • public debt markets are created.   • This activity, known as securitization, increases the liquidity of the • residential mortgage market.  In particular, the securitization of mortgages • extended to low- and middle-income home purchasers likely has made • mortgage credit more widely available.  

6. Government Sponsored Enterprises GSEs • Their second line of business involves the purchase of mortgage-backed • securities and other types of assets for their own investment portfolios.   • This line of business has raised public concern because its fundamental • source of profitability is the widespread perception by investors that • the U.S. government would not allow a GSE to fail, notwithstanding the • fact that--as numerous government officials have asserted--the • government has given no such guarantees.  • The perception of government backing allows Fannie and Freddie to • borrow in open capital markets at an interest rate only slightly above • that paid by the U.S. Treasury and below that paid by other private • participants in mortgage markets.  By borrowing at this preferential rate • and purchasing assets (including MBS) that pay returns considerably • greater than the Treasury rate, the GSEs can enjoy profits of an • effectively unlimited scale. 

7. Government Sponsored Enterprises GSEs • Consequently, the GSEs’ ability to borrow at a preferential rate • provides them with strong incentives both to expand the range of assets • that they acquire and to increase the size of their portfolios to the • greatest extent possible. • Arguments for GSEs • GSE portfolios may serve to enhance liquidity and reduce costs • in the mortgage market in some circumstances.  • In particular, the GSE portfolio purchases may create benefits for • home purchase mortgages extended to lower-income households, • to low- and moderate-income first-time homebuyers, and to buyers • of homes in lower-income neighborhoods.  • These are all mortgage markets in which the private sector might have • greater difficulties making mortgage credit more widely available and • thus for which the case for government support may be stronger.

8. Government Sponsored Enterprises GSEs Arguments against GSEs • Two factors underlie many financial crises: First, major crises usually • involve financial institutions or markets that are either very large or • play some critical role in the financial system.  Second, the origins of • most financial crises (excluding, perhaps, those attributable to natural • disasters, war, and other nonfinancial events) can be traced to failures • of due diligence or "market discipline" by an important group of • market participants. • GSEs satisfy both these conditions! • The activities of the GSEs are not confined to debt markets; because • the GSEs engage in extensive hedging activities, these companies are • among the most active users of derivative instruments.  Thus, by any • measure, the GSEs have a significant presence in U.S. financial markets

9. Government Sponsored Enterprises GSEs Arguments against GSEs • In most situations, policymakers can rely on market forces to • constrain the risk-taking behavior of privately owned financial • organizations.  Market discipline is effective because, normally, the • creditors of private firms have powerful incentives to monitor the • risk-taking and risk-management activities conducted by these • organizations.  These market responses act as a brake on an organization’s • risk-taking behavior and consequently reduce the likelihood that the • company will fail. • Unlike other private firms, however, the GSEs face little or no • market discipline from their senior debt holders because of the • belief among market participants that the U.S. government will back • these institutions under almost any circumstances.  As a result, • increased risk-taking by the GSEs does not significantly increase their • cost of funding or reduce their access to credit, as it would for • other private firms. 

10. Government Sponsored Enterprises GSEs Reform agenda for GSEs – Capital Requirements • The concentrated and potentially volatile nature of the GSEs’ portfolios, • together with the lack of market discipline on GSE activities, makes • ensuring adequate capital--the first element--especially important.  • To ensure the safety and soundness of the GSEs and to reduce systemic • risks, the GSE regulator should have capital authority that is on a par • with that of the bank regulators.  • For example, the GSE regulator should have clear authority to establish • and modify both the minimum and the risk-based capital standards • for the GSEs.  A strong capital base would significantly reduce the • implicit subsidy and incentive problems that now distort GSE • investment decisions.

11. Government Sponsored Enterprises GSEs Reform agenda for GSEs – Orderly receivership process • Reform legislation should establish (1) a well-defined and mandatory • process for placing a GSE in receivership and (2) a method for resolving • a GSE once it is placed in receivership.  • Both parts are necessary for the receivership process to be meaningful • and credible.  Market participants should clearly understand that, once • certain conditions arise, regulatory forbearance will be impermissible • and a GSE receivership will be established.   • Importantly, the GSE receivership process should include a mechanism • for ensuring that both the shareholders and creditors of a failed GSE will • bear financial losses.  Only if GSE debt holders are persuaded that the • failure of a GSE will subject them to losses will they have an incentive to • exert market discipline.

12. Government Sponsored Enterprises GSEs Reform agenda for GSEs – Link portfolio to public policy goals • Tying the portfolios to a purpose that provides measurable benefits • to the public would help to ensure that society in general--not just • GSE shareholders--receives a meaningful return in exchange for • accepting the risks inherent in the portfolios.  • Moreover, defining the scope and purpose of the portfolios in this • way would reduce the potential for unbridled growth in those portfolios • while avoiding the imposition of arbitrary limits or caps.

13. Market conventions in measuring prepayments

14. Mortgage Cash flows with prepayments Useful formulas Single monthly mortality: Survival factor:

15. Mortgage Cash flows with prepayments Useful formulas Scheduled monthly payment: Scheduled principal payment: Scheduled interest payment: Principal pre-payment:

16. Effects of prepayments on Principal remaining

17. Effects of prepayments on monthly cash flows

18. Effects of prepayments on monthly cash flows

19. Effects of prepayments on monthly cash flows

20. Effects of prepayments on monthly cash flows

21. Effect of Refinancing rates on prepayments

22. Seasonality and Prepayments

23. Seasoning and Prepayments

24. MBS Cash Flow Conventions

25. MBS Cash Flow Conventions

26. Traditional Yield Measures • Nominal spread • Static (z) spread • Yield to worst, i.e., smallest of: • Yield to maturity • All yields to calls and puts • These measures do not consider the effect of embedded options (reinvestment or call features).

27. Traditional Yield Measures

28. Nominal Yield Spread • The nominal spread is the difference between a non-Treasury bond’s yield and the YTM for a benchmark Treasury coupon security. • The nominal yield spread measures the compensation for the additional credit risk, option risk, and liquidity risk an investor is exposed to by investing in a non-Treasury security with the same maturity.

29. Zero-Volatility Spread • The zero-volatility or Z- spread is a measure of the spread the investor would realize over the entire Treasury spot rate curve if the bond is held to maturity. • It is not the spread off of one point on the Treasury yield curve (nominal spread), it is an average over all spot rates. • The Z-spread is also called a static spread – and is calculated as the spread which will make the present value of the cash flows from the non-Treasury bond, when discounted at the Treasury spot rate plus the spread, equal to the non-Treasury bond’s price. • Trial and error is used to determine the Z-spread.

30. What is the best spread?Option Adjusted Spread (OAS) • The Z-spread, which looks at measuring the spread over a spot rate curve, has a problem in that it fails to take future interest rate volatility into consideration – which could change the cash flows for bonds with embedded options. • The option-adjusted spread (OAS) was developed to take the dollar difference between the fair valuation and the market price and convert it to a yield spread measure. • The OAS is used to reconcile the fair price (value) and the market price by finding a return (spread) that will equate the two. • The spread is measured in basis points.

31. Option Adjusted Spread (OAS) • The option-adjusted spread is a spread after adjusting for the option risk. • Depending on the benchmark interest rates used to generate the interest rate tree, the option-adjusted spread may or may not capture credit risk. • The option-adjusted spread is not a spread off of one maturity of the benchmark interest rates; rather, it is a spread over the forward rates in the interest rate tree that were constructed from the benchmark interest rates.

32. Option-Adjusted Spread • In addition to valuation, the binomial tree also can be used to estimate the option spread. • The simplest way to estimate the option spread is to estimate the YTM for a bond with an option given the bond’s values as determined by the binomial model, then subtract that rate from the YTM of an otherwise identical option-free bond.

33. Option-Adjusted Spread • Example: In the previous example the value of the three-year, 9% callable was 96.2584, while the equilibrium price of the noncallable was 96.9521. Using these prices, the YTM on the callable is 10.51832% and the YTM on the noncallable is 10.2306, yielding an option spread of .28772%:

34. Option Adjusted Spreads (OAS)

35. Option Adjusted Spreads (OAS)

36. Option Adjusted Spreads (OAS)

37. Option Adjusted Spreads (OAS)

38. Option Adjusted Spreads (OAS) If π > 0 , the model price is higher than the market value. This indicates that the security is cheap, according to the model. To make the model produce a value equal to V , we need to increase the discount factor. So, we select a z > 0 such that the model produces a price equal to the market value. This factor z is referred to as the option-adjusted spread (OAS). A positive OAS indicates that the security is cheap.

39. Relationship Between the Benchmark, OAS, and Relative Value

40. Option Adjusted Spreads (OAS)

41. Session - Conclusions/Main insights • Mortgage market is a big part of capital markets. Both FRM and ARM are used in the US. • Mortgage cash flows are monthly and consist of scheduled interest, scheduled principal and prepayments. • Federal Agencies play a very big part in securitizing mortgages and creating mortgage backed securities. • Many factors determine prepayments, including refinancing rates, seasoning, seasonality, housing prices, etc. • Option adjusted spreads (OAS) are used to trade MBS in capital markets.