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BUS424 (Ch 10&11&13) 1
Mortgages and Mortgage Pass-through
1. Mortgages
2. Mortgage Pass-through Securities
BUS424 (Ch 10&11&13) 2
Mortgage
A loan secured by the collateral of specified real estate property, which obligates the borrower to make a predetermined series of payments. (page 214-215)
Terms: (1) Mortgage originator
(2) Payment-to-income (PTI) ratio
(3) Loan-to-value (LTV) ratio
(4) Contract rate
(5) Conduit
(6) PMI (page 221)
BUS424 (Ch 10&11&13) 3
Lien Status
The lien status of a loan indicates the loan’s seniority in event of the forced liquidation of the property due to default of the obligor.
(page 216)
• First lien
• Second lien (junior lien)
BUS424 (Ch 10&11&13) 4
Credit Classification
Prime loan: A loan that is originated where the borrower is viewed to have high credit quality.
Subprime loan: A loan that is originated where the borrower is viewed to have low credit quality.
Alternative-A loan: in between
(page 216)
BUS424 (Ch 10&11&13) 5
Interest Rate Types
Fixed rate mortgage (FRM)
Adjustable rate mortgage (FRM)
• Periodical rate cap
• Lifetime rate cap and floor
• Hybrid ARM
BUS424 (Ch 10&11&13) 6
Level-payment fixed-rate mortgage
Each monthly mortgage payment for a level-payment mortgage is due on the first of each month and consist of
(1) Interest of 1/12 of fixed annual interest rate times the amount of the outstanding mortgage balance at the beginning at the beginning of the previous month
(2) A repayment of a portion of the outstanding mortgage balance (principal)
Monthly payment: page 219
BUS424 (Ch 10&11&13) 7
Example (Amortization Schedule)Replicate the numbers for month 4 (page 219)
Month payment
Monthly interest
Scheduled principal payment
Ending mortgage balance
BUS424 (Ch 10&11&13) 8
Other Issues
Recasting a loan: resetting the mortgage payment for an ARM.
Lockup period: during which only interest is paid (IO product)
Prepayment and prepayment penalty – page 222
BUS424 (Ch 10&11&13) 9
Confirming Loan
Definition: Conventional loans that meets the underwriting standard of Fannie Mae and Freddie Mac.
Conventional loans: as opposed to government loans, with explicit guarantee from the federal government, e.g., Veterans Administration (VA) loans
Freddi Mac and Fannie Mae: government sponsored enterprises whose mission to provide liquidity and support to mortgage market. They receive a chapter from the federal government.
Agency MBS use confirming loans as collateral.
BUS424 (Ch 10&11&13) 10
Risks Associated with Investing in Mortgages
• Credit risk: homeowner/borrower will default
• Liquidity risk
• Interest risk
• Prepayment risk
BUS424 (Ch 10&11&13) 11
Mortgage Example
Say you are interested in buying a 2-bedroom condo in Boston. The price is $300,000. You have a 30-year 3.5% APR mortgage with 20% down payment.
(1)What would be the monthly mortgage payment?
(2)What if you have 15-year mortgage with the same APR?
(3)Suppose you could rent the place out and the rent you collect will cover your mortgage payment. What would be the annual return of your investment if the condo value stays constant.
BUS424 (Ch 10&11&13) 12
Mortgage example solution
(1)$1077.71
(2) $1715.72
(3) with the 15-year mortgage, investment return is 11.33%
BUS424 (Ch 10&11&13) 13
Mortgage Pass-through Securities
One or more mortgage holders form a collection of mortgage and sell shares or participation certificates in the pool. There are two derivatives from pass-through:
BUS424 (Ch 10&11&13) 14
Alternative Features
Pass-through rate: less than the underlying pool of mortgage loan by an amount equal to the servicing and guaranteeing fees
WAC
WAM
BUS424 (Ch 10&11&13) 15
Agency Pass-throughGinnie Mae -- MBS
Freddi Mac – participation certificate (PC)
Frannie Mae -- MBS
Fully modified pass-throughs
Modified pass-throughs
Feature: default risk free.
BUS424 (Ch 10&11&13) 16
What Determined Projected Cash Flow
Projected cash flow
Pass-through rate
Prepayment speed
Cash yield
-- the most important factor is the expected prepayment rate
BUS424 (Ch 10&11&13) 17
Alternative Prepayment Rates
(1) FHA prepayment experience approach: assuming no prepayment in the first 12 years, then all the mortgage in the pool prepay
BUS424 (Ch 10&11&13) 18
Alternative Prepayment Rates
(2) Conditional Prepayment RateBased on the characteristics of the pool (including its
historical prepayment experience) and current and expected future economic environment. Conditioned on remaining mortgage balance.
Single-month mortality rate (SMM)SMM=1-(1-CPR)1/12
Monthly Prepayment: SMM x (beginning balance for t– scheduled principal payment for t)
BUS424 (Ch 10&11&13) 19
PSA Prepayment Benchmark
(3) PSA Prepayment Benchmark published by Public Securities Association
A monthly series of annual prepayment rates. Assumes that prepayment rates are low for newly originated mortgage and then will speed up as the mortgages become seasoned.
BUS424 (Ch 10&11&13) 20
Standard Benchmark (100 PSA)
CPRs for a 30-year mortgage:(1) 0.2% per year for the first month, increased by
0.2% per month per month for the next 30 months
(2) 6% CPR for the remaining yearsIf t<=30: CPR=6%*(t/30)If t>30: CPR=6% Slower or faster speeds: 50 PSA or 300 PSAP 240
BUS424 (Ch 10&11&13) 21
Examples (page 241)
The SMMs for month 5, month 20, month 31 through 360 assuming 100 PSA
The SMMs for month 5, month 20, month 31 through 360 assuming 165 PSA
BUS424 (Ch 10&11&13) 22
Monthly Cash Flow Construction
• Objective: obtain cash flow
• Key steps:– Interest – scheduled principal– prepayment
BUS424 (Ch 10&11&13) 23
Example 1
Monthly cash flow for a $400 million 7.5% pass-through rate with a WAC of 8.125% and WAM of 357 months assuming 100 PSA.
(exhibit 11-6, page 242)
BUS424 (Ch 10&11&13) 24
Example 1 (do month 1)(1) Find SMMSMM for month 1 = (SMM for month 27)=(2) Find mortgage payment
N I/Y PV PMT FV (using WAC here)
(3) Interest: pass-through rate/12*beg balance (4) Scheduled principal payment=monthly mortgage payment –
gross coupon interest, where gross coupon interest = WAC*outstanding mortgage balance/12.
BUS424 (Ch 10&11&13) 25
Example 1 (solution)
(5) Prepayment = SMM x (beginning mortgage balance – scheduled principal payment)
= 0.00067*(400,000,000-267,535)
(6) Total principal
= 267,535+267,470
(7) Cash flow
=2,500,000+535,005
BUS424 (Ch 10&11&13) 26
Example 1 (Solution)(1) Find SMMSMM for month 1 = 0.00067(SMM for month 27)= 0.00514(2) Find mortgage payment
N I/Y PV PMT FV357 0.6771 -400000000 ? 0
(3) Interest: pass-through rate/12*beg balance =7.5%/12*400,000,000
(4) Scheduled principal payment=monthly mortgage payment – gross coupon interest, where gross coupon interest = WAC*outstanding mortgage balance/12.
= 2975,868-8.125%/12*400,000,000
BUS424 (Ch 10&11&13) 27
Example 1
(5) Prepayment = SMM x (beginning mortgage balance – scheduled principal payment)
(6) Total principal
(7) Cash flow
BUS424 (Ch 10&11&13) 28
Question
How much does the pass-through issuer earn?
BUS424 (Ch 10&11&13) 29
Example 2Monthly cash flow for $400 million 7.5%
pass-through rate with a WAC of 8.125% and WAM of 357 months assuming 165 PSA
BUS424 (Ch 10&11&13) 30
Factors Affecting Prepayment Behavior
Prevailing mortgage rate
Characteristics of the underlying mortgage loans
Seasonal factors
Home buying peak in summer, decline in fall and winter. Repayment peak in fall, low in winter
General economic activities
Prepayment models
BUS424 (Ch 10&11&13) 31
Cash Flow for Nonagency Pass-throughs
The PSA standard default assumption (SDA) benchmark gives the annual default rate for a mortgage pool as a function of the seasoning of the mortgages.
See page 309 – assumptions on default rate
BUS424 (Ch 10&11&13) 32
Cash Flow Yield
Bond-equivalent yield=2[(1+yM)6-1]
• Limitation: rely on assumptions• Based on PSA prepayment assumption
BUS424 (Ch 10&11&13) 33
Average Life
Average time to receipt of principal payment (scheduled principal payment + projected prepayments)
T
t principaltotal
ttimeatreceivedincipaltlifeAverage
1 _*12
____Pr*_
BUS424 (Ch 10&11&13) 34
Yield Spread to Treasuries
Page 251
• Spread of agency pass through to treasuries
• Spread of private-label pass through securities and treasuries
BUS424 (Ch 10&11&13) 35
Prepayment Risk to Investors
When mortgage rate decreases (contraction Risk)• prepayment risk • Lower reinvestment return
When mortgage rate increases (Extension Risk)• Price risk• High mortgage rate slows down repayment
(the basic idea is mortgage risk will be transferred to pass through investors)
BUS424 (Ch 10&11&13) 36
Asset/Liability Management Implications
What kind of liabilities do banks borrow? What kind of assets do banks hold?
So, thrifts and commercial banks are more concerned of extension risks.
Insurance companies have the similar problem when their liabilities are short term
Pension fund managers may concern of the risk from pass through’s fast prepayments
BUS424 (Ch 10&11&13) 37
Secondary Market TradingQuoted in the same manner as Treasury coupon
bonds
Pass-through securities are identified by a pool prefix and pool number provided by the agency
TBA: many trades occur while a pool is still unspecified
Quotes: see “Mortgage-backed securities” under “Bond Market Data Bank”
BUS424 (Ch 10&11&13) 38
Nonagency Pass-through
Issued by commercial banks, thrifts, and private conduits
No guarantees of default risk free
Registered with SEC
Function: credit enhancement
BUS424 (Ch 10&11&13) 39
Credit Enhancement
Structural Credit Enhancement
Shifting Interest Mechanism in a Senior-Subordinated Structure
Originator/Sell-Provided Credit Enhancement
BUS424 (Ch 10&11&13) 40
Summary of Important PointsMortgage rate
Pass-through rates
Cash flow yield
Conditional prepayment rate (CPR)
Single-Monthly Mortality Rate (SMM)
Scheduled principal payment
Unscheduled (prepaid) principal payment
Cash flow
Nonagency passthrough
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