Securitization

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Chapter 28

• Securitization

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Overview

• Securitization is another mechanism that may be
  employed by FIs to hedge their interest rate
  exposure. This chapter explores the role of
  securitization in improving the risk-return
  trade-off. The three major forms of asset
  securitization, and its mortgage lending origins
  are also explained.

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Introduction

• Securitization Packaging and selling of loans
  and other assets backed by securities.
• Many types of loans and assets are being
  repackaged in this fashion including royalties on
  recordings ( David Bowie, Rod Stewart).
• Original use was to enhance the liquidity of the
  residential mortgage market.

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The Pass-Through Security

• Government National Mortgage Association (GNMA)
• Sponsors MBS programs and acts as a guarantor.
• Timing insurance.
• FNMA actually creates MBSs by purchasing packages
  of mortgage loans.

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Freddie Mac

• Federal Home Loan Mortgage Corporation
• Similar function to FNMA except major role has
  involved savings banks.
• Stockholder owned with line of credit from the
  Treasury.
• Sponsors conventional loan pools as well as
  FHA/VA mortgage pools.

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FNMA and FHLMC Concerns

• Concern that FNMA and FHLMC have gained too much
  market share and pose a serious risk to financial
  system
• Excessive interest rate risk exposure FNMA
• Overcharging lenders
• Passed through as higher mortgage rates
• Freddie Mac misstatement of earnings
• FNMA 1.1 billion restatement of equity
• Regulatory changes
• Signal that agencies not fully guaranteed

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Web Resources

• GNMA www.ginniemae.gov
• FNMA www.fanniemae.com
• FHLMC www.freddiemac.com

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Incentives Mechanics of Pass-Through Security
Creation

• Example
• Create a mortgage pool from one-thousand,
  100,000 mortgages (Results in 100 million).
• Each mortgage receives credit risk protection
  from FHA.
• Capital requirement 4 million.
• Must issue more than 96 million in liabilities
  due to reserve requirements ( FDIC premia).

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Further Incentives

• Gap exposure
• Illiquidity exposure
• Default risk by mortgagees
• Phoenix, AZ in 1980s.
• Default risk by bank/trustee

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Effects of Prepayments

• Good news effects
• Lower market yields increase present value of
  cash flows.
• Principal received sooner.
• Bad news effects
• Fewer interest payments in total.
• Reinvestment at lower rates.

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Prepayment effects

• Prepayments result of
• Refinancing
• Housing Turnover
• Most GNMA pools allow assumable mortgages
• Not the case for FNMA nor FHLMC pass-throughs

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Prepayments

• Since prepayment affects the cash flows to MBS,
  pricing models require estimates of the
  prepayment rates.
• Weighted-average life
• WAL ? Time Expected Principal received
  Total principal outstanding

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Prepayment Models

• Methods
• Public Securities Association approach.
• Other empirical approaches.
• Option pricing approach.

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Web Resources

• Prepayment model information
• Bear Stearns www.bearstearns.com

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PSA Model

• Assumes 0.2 percent per annum in first month,
  increasing by 0.2 percent per month for first 30
  months, until annualized prepayment rate equals 6
  percent
• Actual outcomes affected by relative coupon
  level, age of mortgage pool, amortization,
  assumability, size of pool, conventional/non-conve
  ntional, location, and demographics of mortgagees.

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Other Empirical Models

• Generally proprietary variants of PSA model
• Incorporate
• economic variables
• burn-out factor variables
• idiosyncratic factors

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Option Model Approach

• Use option pricing theory to figure fair yield
  spread of pass-throughs over Treasuries.
• Fair price on pass-through decomposable into two
  parts
• PGNMA PTBOND - PPREPAYMENT OPTION
• Option-adjusted spread between GNMAs and T-bonds
  reflects value of a call option.

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Collateralized Mortgage Obligation (CMO)

• CMO structure
• Prepayment effects differ across tranches
  (classes)
• Z-Class CMO
• R Class
• Improves marketability of the bonds

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Mortgage-Backed Bonds (MBBs)

• Normally remain on the balance sheet.
• Regulatory concerns.
• Other drawbacks to MBBs.

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Innovations in Securitization

• Pass-through strips
• IO strips
• Negative duration.
• PO strips
• Securitization of other assets
• CARDs
• Various receivables, loans, junk bonds, ARMs.

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Pertinent Websites

• Bear Stearns www.bearstearns.com
• Fed. Reserve www.federalreserve.gov
• FHLMC www.freddiemac.com
• FNMA www.fanniemae.com
• GNMA www.ginniemae.gov
• Bond Market Association www.bondmarkets.com