Valuation of Mortgage Securities

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Chapter 11

• Valuation of Mortgage Securities

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Chapter 11Learning Objectives

• Understand the valuation of mortgage securities
• Understand cash flows from various types of
  mortgage securities
• Understand how changes in interest rates affect
  mortgage securities values
• Understand mortgage securities and hedging
  against interest rate risk

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TRADITIONAL DEBT SECURITY VALUATION

• Typically fixed, semi-annual interest payments
  with face value paid at maturity
• Value moves inversely with market interest rates
• Yield to maturity at a given point in time is
  based on current market value

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MORTGAGE-RELATED SECURITIES

• Cash flows have three components interest,
  principal amortization, and prepayments
• Total principal on mortgage pool is constant but
  principal payments may be accelerated or delayed
  based on changes in market rates

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MORTGAGE RELATED SECURITIES

• Market rates rise, mortgage prepayment slows down
  as borrowers hold onto low-rate loans
• Market rates decline, mortgage prepayment
  increases due to refinancing

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PASS-THROUGHS

• The rate of mortgage prepayment is crucial in
  pass-through valuation
• Several models of expected prepayment
• FHA Twelve-Year Prepaid Life
• Constant Prepayment Rate
• FHA Experience

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PASS-THROUGHS

• Prepayment models (cont.)
• Public Securities Association (PSA) Model
• Current industry standard
• Combines FHA experience with CPR model
• Econometric Prepayment Models
• Refinancing Models
• Based on title search activity which precedes
  refinancing

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PASS-THROUGHS

• No rearranging of the cash flows from the
  mortgage pool
• Prepayments have a significant impact on the
  timing of cash flows and thus the value of those
  cash flows
• If selling at a discount, accelerated (delayed)
  prepayment increases (decreases) the realized
  yield

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PASS-THROUGHS

• For pass-throughs selling at a premium, delayed
  prepayment increases yield and accelerated
  prepayment decreases yield
• Coupon rates reflect market rates at time of
  issue
• High coupon pass-throughs suffer price
  compression due to prepayment expectations

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PASS-THROUGHS

• Changes in market rates have two impacts on
  pass-through value both the discount rate and
  the assumed prepayment will change
• In senior/subordinated pass-throughs the senior
  security has enhanced rights to cash flows and
  subordinated security bears all the default risk

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MORTGAGE-BACKED BONDS

• Cash flows are structured as traditional
  non-callable debt with periodic interest payments
  and face value at maturity
• Seek to be sufficiently overcollateralized
• Cash flows not paid to investors are placed in a
  sinking fund
• Financial rating based on amount of
  overcollateralization

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MORTGAGE-BACKED BONDS

• Overcollateralization is related to the balance
  in the sinking fund
• Variables that affect the balance of the sinking
  fund at maturity include the mortgage prepayment
  rate, the reinvestment rate on the sinking fund,
  the initial overcollateralization, and the
  default rate

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COLLATERALIZED MORTGAGE OBLIGATIONS

• Cash flows are made up of various tranches and
  residual class
• Any mortgage prepayments are passed to
  bondholders thus there is no sinking fund
• This means that the CMO issuer faces no interest
  rate or reinvestment risk
• Yield is higher on longer tranches

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COLLATERALIZED MORTGAGE OBLIGATIONS

• CMOs are structured differently from
  pass-throughs thus prepayment behavior affects
  pricing and yield differently
• Price and yield on shorter-term tranches will not
  vary as much with prepayment as compared to
  pass-throughs

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STRIPS

• Cash flows may be rearranged to produce
  principal-only and interest-only strips
• Principal-only (PO) strips receive all principal
  payments when they are received
• Amount of principal equals the initial pool
  balance but the timing is unknown

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STRIPS

• If prepayment accelerates, principal is returned
  faster
• Interest-only strips receive the interest when it
  is paid
• Total amount of interest is not known but is
  based on principal outstanding
• Accelerated prepayment reduces principal and
  reduces interest amount

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STRIPS

• Thus accelerated prepayment may be advantageous
  for PO investors and disadvantageous for IO
  investors
• A change in market interest rates changes the
  discount rate used to value securities and alters
  prepayment behavior

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STRIPS

• PO Strip Interest rate goes up, discount rate
  goes up, prepayment goes down and net effect is
  value goes down
• IO Strip Interest rate goes up, discount rate
  goes up, prepayment goes down and net effect is
  value goes up

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FLOATERS

• Floaters are classes of a CMO that have a rate
  that moves with the market
• These are matched with an institutions
  short-term liabilities that move with the market
• The interest rate on the floater is usually
  pegged to some short-term rate such as LIBOR

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FLOATERS

• Since rate is variable, there is a risk of loss
  if market rates risk significantly
• To solve this problem an inverse floater is
  created out of the same tranche
• Inverse floater is a bond on which the interest
  rate moves opposite to the market rate

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SERVICING RIGHTS

• Lenders sell off loans and often retain the
  servicing rights
• Servicing includes collecting monthly payments,
  maintaining escrow accounts, forwarding proper
  payments to purchasers, sending delinquency and
  default notices, initiating foreclosure
  proceedings and collecting on PMI

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SERVICING RIGHTS

• Revenue from servicing includes the servicing
  fee, float on the escrow accounts, and float
  between receipt of monthly payments and payments
  to purchasers
• Costs include administrative costs and overhead

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SERVICING RIGHTS

• Fee is usually between 0.25 and 0.50 percent of
  the mortgage balance
• Value is affected by interest rate changes
  similar to IO strips
• Rates rise, discount rate goes up and prepayment
  accelerates. Combines to reduce the value of
  servicing rights

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SERVICING RIGHTS

• Excess servicing rights are fees greater than
  normal
• Usually occurs when mortgages are sold with a
  promised rate less than the coupon on the
  mortgages
• The greater the spread, the larger the excess
  servicing fees

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SERVICING RIGHTS

• Reasons for excess servicing rights
• Mortgage-backed securities generally have coupons
  in one-half point intervals
• Premium securities may sell at unattractive
  prices due to fears of prepayment
• Mortgage pools may contain loans with different
  coupons thus some loans may have excess servicing

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VALUE CREATION IN MBSs

• Value is created even though no additional cash
  flow is created
• Securitization eliminates liquidity risk and
  makes the market larger
• Securitization rearranges the cash flows into
  more and less risky components
• Asymmetric information may distort values -
  lenders may have superior