MATH424 Guest Lecture

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MATH424Guest Lecture

• Rouzbeh Azarbayejani

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Goals

• A better understanding of the industry
• Introduce structured finance
• Preparing for work in the industry

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Background

• BSc Electrical Engineering May 2005
• Reverse Engineering Consultant at Wells Fargo
  Corporate Trust Services
• MATH424 Fall 2005

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Outline

• The Bond Market Generally
• The Mortgage-Backed Market
• Collateralized Mortgage Obligations
• Entering the Industry

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Bond Market Generally

• A bond is a debt instrument requiring the
  issuer (borrower) to repay to the lender/investor
  the amount borrowed plus interest over a
  specified period of time
• - Fabozzi
• (Bond Markets, Analysis and Strategies,
  Prentice Hall)

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Bond Market Generally

• Example
• XYZ Inc. sells a 10-year 1000 face value bond
  with semi-annual coupon of 8

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Bond Market Generally

• Six sectors
• U.S. Treasury sector (3.2 trillion)
• Agency Sector
• Municipal Sector
• Corporate Sector (2.7 trillion)
• Asset-Backed Sector
• Mortgage Sector (3.0 trillion)

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Bond Market Generally

• Various types
• Fixed-rate
• Floating-rate
• Inverse Floaters
• Zero Coupon
• Amortizing

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Bond Market Generally

• Analyzing prices and returns
• Present Value
• Yield to Maturity
• Considering risks
• Credit Ratings

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Bond Market Generally

• Present Value
• All future cash flows from an investment can be
  discounted to its present value using a
  discounting rate

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Bond Market Generally

• Yield to Maturity
• The discount rate such that the present value of
  all cash flows equals the price

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Bond Market Generally

• Considering risks
• Call Risk
• Default Risk
• Inflation Risk
• Liquidity Risk
• Reinvestment Risk

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Bond Market Generally

• Credit Ratings
• Estimate the ability to pay interest and
  principal
• Commercial Rating Companies
• Moodys
• SP
• Fitch

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Bond Market Generally

• Credit Ratings
• Investment grade
• AAA to BBB/BAA
• Junk Bonds
• BB to D
• A high credit rating means a high sales price

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Mortgage-Backed Market

• Mortgages on the market
• Fixed
• ARM
• Option ARM
• Prepayments

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Mortgage-Backed Market

• Amortizing a mortgage
• MP monthly mortgage payment
• n number of months
• MB0 original mortgage balance
• i simple monthly interest rate

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Mortgage-Backed Market

• Mortgages on the market Fixed
• Fixed Interest rate for the life of the loan
• 1,000,000 _at_ 6 for 30 years
• gt 5,995.51 / month

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Mortgage-Backed Market

• Mortgages on the market Fixed
• 5,995.51 / month

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Mortgage-Backed Market

• Mortgages on the market Fixed IO
• Fixed Interest rate for the life of the loan
• Interest Only period (3 - 10 years)
• 1,000,000 _at_ 6.5 for 30 years, IO for 10 years
• gt 5,416.67 for 10 years
• gt 7,455.73 for 20 years

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Mortgage-Backed Market

• Mortgages on the market Fixed IO
• 5,416.67 for 10 years
• 7,455.73 for 20 years

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Mortgage-Backed Market

• Mortgages on the market ARM
• Adjustable interest rate Index Margin
• Index
• Six-month LIBOR (Bank lending rate)
• One-year COFI (Inflation)
• One-year CMT (Treasuries)
• Margin
• Depends on your credit rating (FICO, income,
  debt)
• Interest rate and payments adjusts periodically

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Mortgage-Backed Market

• Mortgages on the market ARM
• Analyze using forward rates

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Mortgage-Backed Market

• Mortgages on the market Option ARM
• Similar to IO loans borrowers have the option to
  pay less than their interest payment
• Similar to ARM loans interest rate adjusts
  periodically
• Caveat Interest rate adjusts monthly, but
  minimum payment adjusts annually
• Negatively Amortizes up to 5th year

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Mortgage-Backed Market

• Mortgages on the market Option ARM

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Mortgage-Backed Market

• Mortgages on the market Option ARM

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Mortgage-Backed Market

• Prepayments
• Borrowers usually have the right to repay the
  mortgage loan at any time. This is very different
  from bonds.
• Future cash flows are unknown because of
  prepayments
• Prepayments are usually assumed in calculating
  yields

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Mortgage-Backed Market

• Prepayments
• Single-Monthly Mortality Rate (SMM)
• SMM of x means that approximately x of the
  remaining mortgage balance at the beginning of
  the month, less the scheduled principal payment,
  will prepay this month.

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Mortgage-Backed Market

• Prepayments
• Conditional Prepayment Rate
• CPR is anualized form of the SMM
• A typical CPR is 25 CPR

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Mortgage-Backed Market

• Prepayments
• 0 CPR vs 25 CPR

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Mortgage Pass-Through Securities

• Pass-throughs are created when mortgage holders
  form a collection (pool) of mortgages and sell
  sharees in the pool.
• Two kinds
• Agency Pass-Throughs
• Fannie Mae, Freddie Mac, Ginnie Mae
• Non-Agency Pass-Throughs
• Everybody else

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Mortgage Pass-Through Securities

• Important Attributes
• Weighted-Average Coupon rate (WAC)
• Weighted-Average Maturity (WAM)
• Credit Enhancements (non-agency only)
• Internal
• External

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Mortgage Pass-Through Securities

• Weighted-Average Coupon
• Found by weighting the mortgage rate of each
  mortgage loan in the pool by the balance of the
  mortgage
• Weighted-Average Maturity
• Found by weighting the remaining months to
  maturity of each mortgage loan in the pool by the
  balance of the mortgage

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Mortgage Pass-Through Securities

• Credit Enhancements
• Help protect against losses on the certificates
• Required by investors
• Rating agencies analyze them closely
• A means of increasing bonds rating

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Mortgage Pass-Through Securities

• Credit Enhancements
• External
• Insurance
• Internal
• Reserve Fund
• Overcollateralization
• Senior/Subordinated Structure

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Mortgage Pass-Through Securities

• Senior/Sub Structure
• Senior Bonds Investment grade
• Do not take losses until subs are expired
• Subordinate Bonds lower investment grade
• Typically B1-B6
• Losses allocated in reverse sequential order

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Mortgage Pass-Through Securities

• Overcollateralization
• Like a Senior-Sub structure, OC deals also have
  Senior bonds and subordinate bonds, often split
  into mezzanine (M) and sub (B) designated bonds.
  In addition, OC deals have either excess rate
  spread, excess collateral, or both.

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Mortgage Pass-Through Securities

• Overcollateralization
• Allocating losses
• 1st loss position OC
• 2nd loss position subordinate bonds (M B)
• 3rd loss position senior bonds
• Rate spread
• collateral coupon is higher than coupon paid to
  bonds
• Balance spread
• collateral balance is higher than bond balance

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Collateralized Mortgage Obligations (CMO)

• Derivative Mortgage-Backed Securities Products
• CMO are bonds created by redirecting cash flows
  of mortgages and mortgage-backed securities to
  reduce prepayment risk
• Prepayment risk
• Extension Risk
• Contraction Risk

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Collateralized Mortgage Obligations (CMO)

• Prepayment risks
• Extension Risk
• Borrowers prepay slower in higher rate
  environments
• Contraction Risk
• Borrows prepay faster in lower rate environments

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Collateralized Mortgage Obligations (CMO)

• Just like all derivatives, CMOs cannot eliminate
  prepayment risk they can only transfer them to
  another bondholder.
• CMOs allow investors to take directed positions
  on the market

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Collateralized Mortgage Obligations (CMO)

• Typical Structures
• Sequential Pay
• Planned Amortization Classes (PAC)
• Z Bonds
• IO/PO Strip
• Ratio Strips

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Collateralized Mortgage Obligations (CMO)

• Example Sequential Pays

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Collateralized Mortgage Obligations (CMO)

• Example Planned Amortization Classes
• Have a principal payment schedule that can be
  maintained over a range of prepayment rates (PAC
  bands)
• Companions support PACs
• Fast prepayment Companions receive extra
  principal
• Slow prepayment Companions receive less
  principal

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Collateralized Mortgage Obligations (CMO)

• Example Planned Amortization Classes

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Collateralized Mortgage Obligations (CMO)

• Example Ratio-Stripping
• A pool of collateral with various rates is
  stripped to pay at an exact rate
• Fixed rate may be more attractive to some
  investors than a variable rate

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Ratio-Stripping Example _at_ 6
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Ratio-Stripping Example _at_ 6
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Ratio-Strippingn Example _at_ 6

• Originally
• 1,300,000.00 _at_ 5.53846
• Results
• 131,000.00 _at_ 0.00 (PO)
• 1,169,000.00 _at_ 6
• 1,169,000.00 (notional) _at_ 0.372000 (IO)

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Ratio-Strippingn Example _at_ 6

• Prices
• PO _at_ 80.00 (Discount)
• IO _at_ 1.200 (All Discount)

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Structuring CMOs

• Typically a pool of mortgages is structured in
  multiple ways before going to the market
• A structurer prepares different structures and
  the prices are compared

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• Fabozzi, The Handbook of Mortgage-Backed
  Securities

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(No Transcript)
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Entering the Industry

• How to prepare for a finance job
• Classes
• Resources
• Skills
• Interviews

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Entering the Industry

• Classes
• At least one two business classes
• BMGT343 - Investments
• BMGT444 - Futures and Options
• At least one economics course
• ECON200
• ECON201

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Entering the Industry

• Classes
• Math courses
• This class
• Numerical techniques (MATH/AMSC)
• Focused Research or Project (RIT, Honors)

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Entering the Industry

• Resources
• Library
• McKeldin has plenty of books on all finance
  subjects
• Student Groups
• FBIS (Finance, Banking, and Investment Society)
• Internet
• Efinancialcareers.com, i-bank web sites
• Job Fairs
• UMD (including Smith business school)
• Other local schools

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Entering the Industry

• Resources
• Library
• McKeldin has plenty of books on all finance
  subjects
• Student Groups
• FBIS (Finance, Banking, and Investment Society)
• Internet
• Efinancialcareers.com, i-bank web sites
• Job Fairs
• UMD (including Smith business school)
• Other local schools

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Entering the Industry

• Skills
• Problem Solving
• C, VBA, Matlab
• Attention to detail
• Team player

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Entering the Industry

• Interviewing
• Know about the company
• Know about the industry
• Dress well
• Prepare with interview books
• Heard on the Street Crack
• Advanced Finance and Quant Interviews - Vault

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Entering the Industry

• Books to read
• Liars Poker - Lewis
• Monkey Business - Rolfe and Troob
• When Genius Failed - Lowenstein
• Options, Futures and Other Derivatives - Hull
• The Intelligent Investor - Graham
• My Life as a Quant Derman
• Fooled by Randomness Nassim Taleb

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References

• Books
• Fabozzi, Bond Markets, Analysis and Strategies,
  Prentice Hall
• Fabozzi, The Handbook of Mortgage-Backed
  Securities, McGraw-Hill
• Hayre, Salomon Smith Barney Guide to
  Mortgage-Backed and Asset-Backed Securities,
  Wiley
• Websites
• http//www.riskglossary.com/
• http//www.investopedia.com/