1. Securitization: Credit Risk Management
Copyright 2016 by Diane S. Docking

2. Lesson Objectives:
Understand the role of the Secondary Mortgage Market
Understand Securitization of Mortgages
Knowledge of:
Pass-through securities
MBS
CMOs
Copyright 2016 by Diane S. Docking

3. Subprime Mortgage Market
The Big short_Jenga
Copyright 2016 by Diane S. Docking

4. Development of a Secondary Market
U. S. Congress initiated the development of a secondary market for mortgage loans in 1934 by creating the Federal Housing Administration (FHA).
In 1938, the Federal National Mortgage Association (FNMA) which was authorized to buy FHA insured loans.
In 1968, FNMA was split up into two entities – FNMA and GNMA (Government National Mortgage Association).
GNMA was authorized by Congress to guarantees mortgage pools insured by FHA, VA and other federal agencies.
In 1970, the Federal Home Loan Mortgage Corporation (FHLMC) was created to help create a secondary market for conventional mortgages.
Copyright 2016 by Diane S. Docking

5. Copyright 2016 by Diane S. Docking
Loan Securitization
Securitization is the process of transforming loans (or other debt instruments) into marketable securities
About 50%-60% of single family mortgages are securitized
Copyright 2016 by Diane S. Docking 5

6. Securitized Mortgages
Benefits
1. Reduces the problems caused by regional lending institution’s sensitivity to local economic fluctuations.
2. Borrowers have access to a national capital market.
3. Investors have low-risk and long-term investments in mortgages without having to service the loan.
Copyright 2016 by Diane S. Docking

7. Securitization of Mortgage Loans
Copyright 2016 by Diane S. Docking

8. Securitized Mortgage-Backed Securities
Mortgage Pass-through Security (MPTS)
Collateralized Mortgage Obligation (CMO)
Stripped mortgage-backed security (SMBS)
Copyright 2016 by Diane S. Docking

9. Mortgage Pass-Through/ Mortgage-Backed Security
Definition: A security that has the borrower’s mortgage payments (P&I) pass through the trustee before being disbursed to the investors.
Issued in standard denominations
3 government agencies involved
GNMA
FNMA
Freddie Mac
Copyright 2016 by Diane S. Docking

10. Types of Pass-Through Securities
Ginnie Mae Pass-Throughs
pools of government insured (VA, FHA) mortgages.
Fannie Mae pass-throughs
pools of conventional or federally insured mortgages.
Freddie Mac Participation Certification
pools of conventional mortgages.
Issued by the Federal Home Loan Mortgage Corporation (FHLMC)
not federally insured.
GNMA
FNMA
FHLMC
Copyright 2016 by Diane S. Docking

11. Securitization Process1
Borrowers
Banks
SPE/Trust
MBS
IOU Mortgage Loan
$ Extend Credit
Sell loans $
SPE :
pools “like” mortgages,
obtains credit rating,
may seek guarantee
GNMA, FNMA,
sells to investors via
Securities Dealers
P&I payments
Investors
$ to purchase CMO,MBS
Investment return and Principal $
$ to make MORE loans 2 4 3 3 5
Mortgage Pass-Through Security
Receive P&I monthly
Copyright 2016 by Diane S. Docking

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Structure of the GNMA mortgage-backed pass-through security issuance process
SPV
Cash
Sale Proceeds
Sale Proceeds
Copyright 2016 by Diane S. Docking

13. Example: Mortgage Pass-Through Security
A bank originates 1, year mortgages, each averaging $100,000 with an annual mortgage coupon rate of 12%.
What are the accounting entries made by the bank when the loans are made?
DR) Mortgage Loans $100,000,000
CR) Cash $100,000,000
The bank decides to place these loans with a third-party trustee in a SPV. The loans will be guaranteed by GNMA for a fee of 0.06% and the bank will continue to service the loans for a fee of 0.44%.
The GNMA pass-through securities are sold to investors with a coupon rate of 11.50% and at a discount of (1% is the broker’s fee).
What are the accounting entries made by the bank when the loans are placed in the SPV?
DR) Cash $99,000,000
DR) Discount on Securitized Loans ,000,000
CR) Mortgage Loans $100,000,000
Copyright 2016 by Diane S. Docking

14. Example: Mortgage Pass-Through Security (cont.)
Assume all mortgagee’s pay on time for the first month.
What accounting entry does the bank make?
DR) Cash $1,028,612.60
CR) Payable to GNMA ,598.54
CR) Payable to SPV 990,291.43
CR) Loan Servicing Revenue 33,722.63
What are the accounting entries made by the SPV when it receives the monthly payment from the Bank?
DR) Cash $990,291.43
CR) Principal Payable to Investors ,958.10
CR) Interest Payable to Investors ,333.33
Copyright 2016 by Diane S. Docking

15. Collateralized mortgage obligation (CMO)
Definition: Security backed by a pool of mortgages and structured to fall within an estimated maturity range (tranche) based on the timing of allocated interest and principal payments on the underlying mortgages.
Tranche:
The principal amount related to a specific class of stated maturities on a collateralized mortgage obligation. The first class of bonds have the shortest maturities.
Copyright 2016 by Diane S. Docking

16. Collateralized mortgage obligation (CMO)
Collateralized mortgage obligations, CMOs, are formed by dividing the cash flow of an underlying pool of mortgages or a MBS issue into several classes, with each class having a different claim on the mortgage collateral and with each sold separately to different types of investors.
The different classes making up a CMO are called tranches or bond classes.
There are two general types of CMO tranches:
Sequential-Pay Tranches
Planned Amortization Class Tranches, PAC
Copyright 2016 by Diane S. Docking

17. Securitization Process for CMO1
Borrowers
Banks
SPE/Trust
CMO
IOU Mortgage Loan
Credit extended
Sell loans $
SPE pools like mortgages, obtains credit rating and sells to investors via Securities Dealers
P&I payments
Investors
$ to purchase CMO
Investment return and Principal 2 4 3 5
Copyright 2016 by Diane S. Docking

18. Copyright 2016 by Diane S. Docking
CMO Structure
Tranche A:
3.3%
2-yr
Tranche C:
3.6%
5-yr
Tranche Z: 5%
10-yr
All investors receive interest. Tranche A receives Principal first, then Tranche B, etc.
Copyright 2016 by Diane S. Docking

19. Sequential-Pay Tranches
A CMO with sequential-pay tranches, called a sequential-pay CMO, is divided into classes with different priority claims on the collateral's principal.
The tranche with the first priority claim has its principal paid entirely before the next priority class, which has its principal paid before the third class, and so on.
Interest payments on most CMO tranches are made until the tranche's principal is retired.
Copyright 2016 by Diane S. Docking

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Example 24-1 in text: CMO
CMO consist of three tranches, A, B, and C, formed from the collateral making up a $150M MBS. Maturity not given.
Tranche A = $50M, 7%
Tranche B = $50M, 8%
Tranche C = $50M. 9%
Book says month 1 promised cash flows = $1,000,000. Book is assuming “promised” cash flows is only the interest. This is not correct. If this were a 30 year CMO payments would be interest + principal:
Copyright 2016 by Diane S. Docking

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Example 24-1 in text: CMO
BOOK
Month 1:
Promised payment = interest only
Prepayment in month 1 = $1.5 million
Payments to Tranches in month 1:
Month 2:
Prepayment in month 2 = $1.5 million
Payments to Tranches in month 2:
Copyright 2016 by Diane S. Docking

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Example 24-1 in text: CMO
Corrected (assume 30 year maturity)
Copyright 2016 by Diane S. Docking

23. Example: Sequential-Pay Tranche – No Prepayments
A sequential-pay CMO consist of three tranches, A, B, and C, formed from the collateral making up a $100M MBS with an average coupon of 8% and 3-yr
Tranche A = $50M, 6.5%
Tranche B = $30M, 7.0%
Tranche C = $20M. 7.5%
If all goes well, what is the profit earned by the issuer of the CMO?
Weighted Average
Profit = 8% % = 1.15%
Copyright 2016 by Diane S. Docking

24. Example: Sequential-Pay Tranche – No Prepayments
Assume everyone pays as scheduled.
Assume no prepayments
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25. Example: Sequential-Pay Tranche - No Prepayments
Copyright 2016 by Diane S. Docking

26. Example: Sequential-Pay Tranche - No Prepayments
Copyright 2016 by Diane S. Docking

27. Example: Sequential-Pay Tranche
In terms of the priority disbursement rules:
Tranche A receives all principal payment from the collateral until its principal of $50M is retired. No other tranche's principal payments are disbursed until the principal on A is paid.
After tranche A's principal is retired, all principal payments from the collateral are then made to tranche B until its principal of $30M is retired.
Finally, tranche C receives the remaining principal that is equal to its par value of $20M.
Note: while the principal is paid sequentially, each tranche does receive interest each period equal to its stated PT rate (6.5%, 7%, 7.5%) times its outstanding balance at the beginning of each month.
Copyright 2016 by Diane S. Docking

28. What happens when a Borrower defaults?
Investors in Tranche A usually okay
They receive P & I
Investors in Tranche C may suffer some loss of principal
The more borrowers that default, the more losses suffered by investors in the lower tranches.
Banks suffer too
Many loans sold with recourse or provisions to repurchase if unusually fast default or contained mistakes or fraud.
Copyright 2016 by Diane S. Docking

29. Example: Sequential-Pay Tranche - Prepayments
Assume everyone pays as scheduled.
Assume prepayments of $20 million end of year 1 and 2.
Monthly Mortgage amount will adjust after prepayments.
Year 1:
Copyright 2016 by Diane S. Docking

30. Example: Sequential-Pay Tranche - Prepayments
Copyright 2016 by Diane S. Docking

31. Example: Sequential-Pay Tranche - Prepayments
Copyright 2016 by Diane S. Docking