VI: Debt Market Instruments 20: Asset-Backed Securities

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Asset Backed Securities  Investment Companies  Investment Trusts  Open End Companies (Mutual Funds)  Closed End Companies  Securitization  Mortgage Backed Securities  Other Securitization

Chapter 20: Asset-Backed Securities Investment Companies © Oltheten & Waspi 2012

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Net Asset Value  Net Asset Value = Market Value of Assets Units

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Open Ended (Mutual Fund)  We can create a new partnership (unit) only if we have Open Ended Capitalization

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Open Ended (Mutual Fund)  We can destroy the partnership (unit) only if we have Open Ended Capitalization.  This can entail selling assets to realize sufficient funds to redeem the unit.

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Closed End Fund  Cannot create new partnership units  Closed End Capitalization means that the number of units are fixed)

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Investment Companies  Open Ended (Mutual) Funds  Create and destroy/redeem units as needed  Primary market only  Closed End Funds  Units are fixed  After initial offering units must be bought and sold in the secondary market where they trade just like stocks.

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Why Investment Companies  Economies of scale  Diversification  Lower transaction costs  Professional management

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Performance  Average annual return S&P Index12.3% 10.0% 7.3% Mutual Funds Mutual Fund Investor

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Performance  Average annual return © Oltheten & Waspi 2012 S&P Index8.06% 10.0% 7.3% Mutual Funds Mutual Fund Investor

Chapter 20: Asset-Backed Securities Mortgage Backed Securities © Oltheten & Waspi 2012

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Mortgages  Structured so that payments are  Monthly  Even over the life of the loan

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Mortgages  $1,000,000 principal loan  8½%  30 years

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Mortgages  $1,000,000 principal loan  8½%  30 years  Monthly mortgage payment?  How much is principal repayment  How much is interest?  After the first payment what is the loan principal?

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Mortgages  Month One:  Payment = $7,  Interest = $7,  Principal = $  Now owe $999,394.20

Chapter 20: Asset-Backed Securities Calculator Techniques  [2nd][Quit] [2nd][FV]  [2nd][P/Y] 12  [2nd][BGN]  [2nd][Quit]  [PV]  8.5[I/Y]  30 [2nd][xP/Y][N]  [CPT][PMT]  Clear  12 pmts/yr  End of Period pmts  Calculator Mode  PV=-$1m  Rate = 8.5%  N=360 months  $7,689.13

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Calculator Techniques  [2nd]Amort  [2nd][CLR WORK]  [↓]  12  Amortization  P1 = 1  P2=  P2=1  BAL = - 999,  PRN =  INT = 7, P1=1 to P2=1 means that you get month 1 only

Chapter 20: Asset-Backed Securities Mortgages © Oltheten & Waspi 2012

Chapter 20: Asset-Backed Securities Mortgages © Oltheten & Waspi 2012

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Primary Market  The bank writes 10, 30 year mortgages of $1,000,000 at 8½%  No more money

Chapter 20: Asset-Backed Securities Primary Market -> Secondary Market © Oltheten & Waspi 2012 Mortgages Secondary Market Investors $$$ Bank $$$ More Mortgages

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 The Secondary Market  If the Bank can sell the mortgages to investors then it will have capital to extend more loans.

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 The Secondary Market  Put the 10 $1m mortgages into a $10,000,000 pool (group)  Guarantee each mortgage by GNMA or FNMA

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 The Secondary Market  GNMA  Government National Mortgage Association  Wholly owned government corporation within HUD  Neither originates or purchases mortgage loans  FNMA  Federal National Mortgage Association  GSEs owned by its shareholders (until Sept 7, 2008)  In 2008 owned approx ½ of the $12 trillion mortgage market

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 The Secondary Market  Divide the pool into 1000 $10,000 units  8.0% goes to the Investor  0.1% goes to Ginnie Mae  0.4% goes to the Originating Bank (me)  I sell the units to investors through a broker

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Pass Through Securities  A pass-through security is a pro-rated ownership of all the mortgages in the pool  Each unit represents 1/1000th of each of the 10 mortgages in the pool.

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Risk  Credit Risk:  There is no credit risk because if the homeowner defaults GNMA will use its own funds to make payments until the mortgage is foreclosed and the mortgage paid off.  Prepayment or Contraction Risk:  This is the risk that the mortgage is paid off early. Prepayment risk is similar to an open call without penalty.

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 CMO  Put Through securities: all units in a pool are equal  Collateralized Mortgage Securities: units are unequal.  inventive structures  Tranches / classes

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Securitization  Securitization is the process by which loans are turned into securities for sale to investors.  The creation of this secondary market allows the primary market to function more efficiently

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012 Securitization  Mortgages  Car Loans  Consumer debt