Mortgage Markets and Mortgage Backed Securities

1
Mortgage Markets and Mortgage Backed Securities

•  

2
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.

3
The US mortgage market

• Establishment of mortgage companies in the the
  1800s 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)

4
History of US Mortgage Market 1900 - 1950

• Fast growth form 1900 to 1930 was slowed by large
  number of foreclosures in early 1930s.
• 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.

5
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

6
History of US Mortgage Market 1980 - 2004

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

7
The Current Mortgage Market

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

8
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 

9
Servicing Fees

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

10
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.

11
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)

12
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

13
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

14
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

15
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.

16
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
17
Amortization 30 yr Mortgage150,000 5.85

• Beginning
  Ending
• Year Balance Payment Interest Principal
  Balance

1
150,000
884.91
731.25
153.6614
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
18
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.

19
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.

20
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.

21
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

22
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.

23
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

24
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 

25
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

26
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

27
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.

28
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.

29
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.

30
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

31
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

32
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.

33
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.

34
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.

35
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.

36
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.

37
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

38
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

39
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)

40
 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

41
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.

42
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.

43
of Outstanding Debt Market
44
Average Daily Trading Volume (Billions)
45
Issuance by GSEs ( Billions)
46
Recent Study by Federal Reserve

• Wayne Passmore, an economist at the Federal
  Reserve Bank has recently completed a study on
  the impact of GSEs
• The GSEs 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

47
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

48
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

49
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

50
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.

51
Price Quotes

• GNMAs 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

52
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.

53
Accrued interest

• Assume a coupon rate of 9 and 20 days into the
  month

54
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

55
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 MBSs 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
  9s 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.

56
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

57
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.

58
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

59
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.

60
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

61
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

62
 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

63
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
•  

64
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.

65
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.  

66
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

67
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

68
Example Continued

• The SMM for the first month is then
• SMM1-(1-CPR)1/121-(1-0.008)1/120.000669124
• The scheduled mortgage payment would be
• 400,000,000PMT(PVIFA357,8.125/12)2,975,868.24
• (this changes with each payment due to prepayment)

69
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

70
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
• 267,534.91267,470.58535,005.49

71
Monthly Cash Flow Construction

• Total Cash Flow is then the sum of the interest
  paid to the pass through investor and the total
  principal
• 2,500,000 535,005.493,035,005.49
• 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.

72
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.

73
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

74
Factors Affecting Prepayment

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

75
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.

76
Factors Influencing Prepayment

• Prevailing Mortgage Rates
• Level of rates
• As the level of rates declines turnover
  increases as more homes become affordable.

77
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)

78
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.

79
Factors Influencing Prepayment

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

80
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.

81
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
•  

82
Average Life

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

83
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.

84
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

85
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

86
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.

87
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.

88
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.

89
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

90
Structured IO

• IO tranches are often referred to as structured
  IOs 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.
  

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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.

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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)   

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Planned Amortization Class Tranche (PAC) CMOs

• 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.

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PAC Bonds

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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 PACs

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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.

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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

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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

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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.

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Introduction

• MBSs 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

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Outstanding Mortgage and Asset Backed Securities
in US
109
Outstanding Value ofABS by Underlying Asset
110
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.

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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.

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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.

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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

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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)

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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
  collaterals call history reaches a predetermined
  level.

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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.