Presentation on theme: "MORTGAGE-BACKED SECURITIES"— Presentation transcript:
1 MORTGAGE-BACKED SECURITIES CHAPTER TWENTYMORTGAGE-BACKED SECURITIESPractical Investment ManagementRobert A. Strong
2 The Mortgage Backed Securities Market OutlineMortgagesTypesMortgage MathematicsMortgage RiskThe Mortgage Backed Securities MarketHistoryTypes of Securities
3 Considerations in Pricing Mortgage Backed Securities OutlineConsiderations in Pricing MortgageBacked SecuritiesThe Importance of Prepayment RatesThe PSA ConventionThe Risks of MBSThe Risk of Collateralized Mortgage ObligationsThe Risk of Stripped Mortgage Backed Securities
4 IntroductionA mortgage is a loan with real estateas collateral. The lender, called themortgage originator, often chargespoints as a fee for preparing andplacing the mortgage.It is quite common for the lender to sell the mortgage to another party.The homeowner may be unaware of this, as the lender normally continues to be the mortgage servicer.
5 Mortgages: TypesA fixed rate mortgage is one with paymentsbased on a set interest rate that does not change.An adjustable rate mortgage (ARM), alsocalled a variable rate mortgage, has an interest rate that moves with some market interest rate, such as the Treasury bill rate.Most ARMS have an annual reset to theinterest rate. Many also have either a cap or a floor on the interest rate.
6 Mortgages: TypesWith a convertible mortgage, the borrower has the option to exchange it for a fixed rate at the prevailing ARM rate.There are other mortgage arrangements:biweekly - payments are due every two weekssemi-monthly - payments are due two times each monthgraduated payment - the monthly payments increase following a predetermined schedule
7 Mortgages: Typesshared appreciation - the borrower splits the rise in the value of the property with the lender in exchange for a reduced interest ratereverse - the homeowner sells the property to a bank and receives monthly mortgage payments
8 Mortgage Mathematics Example : A bank approves a prospective homeowner for a 30-year, $100,000 mortgage at an 8% annual rate. There will be 30×12 = 360 monthly payments at amonthly interest rate of 8÷12 = %
9 The monthly payment will be $733.76 Mortgage MathematicsFor an annuity:C = the monthly paymentR = the monthly interest rateN = the number of paymentswhereSo: The monthly payment will be $733.76
10 Mortgage MathematicsIf the borrower pays the bank $1,500 instead of $ for the thirteenth payment, how will the amortization schedule be affected?The bank considers the extra $ the borrower paid a principal reduction, and the anticipated life of the loan will decrease.
11 Mortgage RiskDefault risk is the risk that the borrower isunable or unwilling to repay the debt as agreed.Interest rate risk is the risk that the generallevel of interest rates rises, such that the value of the mortgage’s cash flow stream declines.Prepayment risk is the risk of an earlypayment of the original mortgage, such as when the home is sold or when the mortgage is refinanced at a lower rate.
12 The Mortgage Backed Securities Market The Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), & the Federal Home Loan Mortgage Corporation (Freddie Mac) support the US mortgage market by providing liquidity, buying conforming mortgages from banks across the country for resale elsewhere.The term mortgage-backed securities refers to all products based on mortgage loans.
13 A pass-through security is a share of a pool of mortgages. Types of SecuritiesA pass-through security is a share of a poolof mortgages.Individual Individual IndividualMortgages Mortgages MortgagesMortgage PoolPass-Through SecurityThe holders receive a monthly check for theirportion of the scheduled principal and interest payments, plus their share of any prepayments that may occur.
14 Types of SecuritiesPass-through securities may be issued and guaranteed by a government agency, or they may be private label.Two types of derivative securities that spring from pass-through securities are collateralized mortgage obligations and stripped mortgage-backed securities.
15 Types of SecuritiesA collateralized mortgage obligation (CMO) isa security backed by a pool of mortgages and structured to transfer prepayment or interest rate risk from one group of security holders to another.A given pool of mortgages backs two or moreclasses of securities called tranches.
16 Collateralized Mortgage Obligation Types of SecuritiesCollateralized Mortgage ObligationIndividual Individual IndividualMortgages Mortgages MortgagesMortgage PoolA Tranche B Tranche C Tranche Other Tranches
18 Types of SecuritiesWith a sequential pay CMO, all the trancheholders receive monthly interest payments based on the principal amount outstanding in their tranche.All principal payments go to the A trancheuntil the A tranche principal is completely returned. Only then will the investors in the next tranche begin to receive principal.
20 There are two types of stripped mortgage backed securities, or strips. Types of SecuritiesThere are two types of stripped mortgagebacked securities, or strips.Individual Individual IndividualMortgages Mortgages MortgagesMortgage PoolInterest Only Security Principal Only SecurityAll the interest goes to the interest only (IO)security holders, while the entire principal goes to the principal only (PO) holders.
21 Pricing Mortgage Backed Securities Considerations inPricing Mortgage Backed SecuritiesThe price risk of a MBS comes from theuncertainty about the timing of cash flows.Prepayments can affect the realized return ona M BS substantially.The offering memorandum for a M BS willstate the assumptions used in estimating cash flows from the mortgage pool.A benchmark assumption for the rate ofmortgage prepayment is offered by the Public Securities Association (PSA).
22 Pricing Mortgage Backed Securities Considerations inPricing Mortgage Backed SecuritiesConstant Prepayment RateThe standard PSA assumption is that a 30-year mortgage will see prepayments of 0.2% for the first month and that prepayments will increase by 0.2% for each of the next 29 months, after which they remain constant.The 0.2% per month prepayment assumption is called 100% PSA.
23 Pricing Mortgage Backed Securities Considerations inPricing Mortgage Backed SecuritiesA MBS has default, interest rate, and prepayment risks.Riskiness of Cash Flowsvariable ratenon-callablebondfixed rateprincipal onlysecurityinterestonly$ AmountUnknownTimingKnown
24 The Risk of Collateralized Mortgage Obligations Declining interest rates will increase thevalue of a cash flow stream and will lead to prepayments.If a mortgage pool sells at a discount,prepayments will increase the value of each of the tranches, with the higher duration tranches benefiting the most.If the pool sells at a premium, thenprepayments will reduce everyone’s yield, with the effect most pronounced for the holders of the longer duration tranches.
25 The Risk of Stripped Mortgage Backed Securities Prepayment has different consequences forIO and PO strips. An extension of the mortgage decreases the value of the principal payments but increases the value of the interest payments.Declining interest rates will increase thevalue of a series of known cash flows, as well as the likelihood of prepayment. Normally, the prepayment effect overwhelms the interest rate effect.
26 The Risk of Stripped Mortgage Backed Securities Insert Table 20-6 here.
27 The Risk of Stripped Mortgage Backed Securities Insert Table 20-7 here.
28 The Risk of Stripped Mortgage Backed Securities Insert Table 20-8 here.
29 The Risk of Stripped Mortgage Backed Securities Insert Table 20-9 here.
30 The Mortgage Backed Securities Market ReviewMortgagesTypesMortgage MathematicsMortgage RiskThe Mortgage Backed Securities MarketHistoryTypes of Securities
31 Considerations in Pricing Mortgage Backed Securities ReviewConsiderations in Pricing MortgageBacked SecuritiesThe Importance of Prepayment RatesThe PSA ConventionThe Risks of MBSThe Risk of Collateralized Mortgage ObligationsThe Risk of Stripped Mortgage Backed Securities