1. Mortgage Pass-Through Securities
Chapter 11

2. Pass-Through Securities
created when one or more mortgage holders form a collection (pool) of mortgages and sell shares (participation certificates) in the pool
pass-throughs are then basis for other derivatives (CMOs and stripped mortgage-backed securities)
CFs come from mortgage pmts from pool of mortgages
timing differs from mortgage pmts
amt differs from mortgage pmts – difference due to servicing fees and other fees for guaranteeing issue
CFs not known with certainty because of prepayments

4. WAC and WAM WAC – weighted-average coupon
weight mortgage rate of each mortgage in pool by amt of mortgage outstanding
WAM – weighted-average maturity
weighting remaining # of months to maturity for each loan in pool by amt of mortgage outstanding

5. Agency Pass-Throughs Ginnie Mae Freddie Mac Fannie Mae
types of guarantees
fully-modified PTs – timely pmt of principal and interest
modified PTs – guarantees interest and principal but only timely payment of interest

6. Agency Pass-Throughs Ginnie Mae PTs
guaranteed by full faith and credit of US government
essentially default risk free
Ginnie Mae guarantees security referred to as mortgage-backed security (MBS)
fully modified pass-throughs
only include mortgages guaranteed by Rural Housing Service, Veteran’s Association, or Farmers Home Assoc.

7. Agency Pass-Throughs Freddie Mac PTs Fannie Mae PTs
their pass-through is called a participation certificate
not guaranteed by US government but …
modified pass-throughs
Gold PC – introduced in 1990
fully modified PT
eventually only PC that Freddie will issue
Fannie Mae PTs
MBS
not obligation of government because government-sponsored agency not government agency
fully modified pass-throughs

8. Non-Agency Pass-Throughs
issued by commercial banks, thrifts, and private conduits
purchase nonconforming mortgages, pool, and sell pass-throughs which have underlying pool as collateral
same thing as Agency except not guarantee of government
registered with SEC
rated by same firms that rate debt

9. Credit Enhancements rating companies consider
type of property
type of loan
term of loan
geographical dispersion of loan
loan size
purpose of loan
rating given but can be changed by credit enhancement (this has been key to growth of this type of security in market)

10. Credit Enhancements external
3rd party guarantees that provide first-loss protection against losses up to a point (say 10%)
bond insurance – same as muni bond insurance
pool insurance – covers losses from defaults and foreclosures
usually for $ amt for life of pool
some written so $ amt declines as pool seasons as long as
credit performance is better than expected
ratings agencies approve
need additional insurance to cover losses from bankruptcy or fraud
rating of 3rd party must be at least as high as rating sought*
*important for investor to do credit analysis on 3rd party guarantor because if their rating is downgraded, security’s rating probably will be too

11. Credit Enhancements internal – may change CFs even with no default
reserve funds
cash – deposits of cash generated from issuance proceeds
excess spread accounts – allocation of excess spread or cash into separate reserve account after paying net coupon
overcollateralization
principal amt of issue < principal amt of pool of loans
senior/subordinate structure – most widely used
subordinate class absorbs all losses up to amt in class
subordinate class has higher yield
shifting interest structure – redirects prepayments from subordinate class to senior class according to given schedule (want to maintain insurance)

12. Prepayment value of any security is what? prepayment speed
issue for PTs why?
prepayment speed
CF yield – yield calculated based on projected CF
prepayment conventions
FHA experience – no longer used since prepayment rates are related to interest rate cycle
conditional prepayment rate
PSA prepayment benchmark
conditional prepayment rate – assume that a certain % of mortgages will be prepaid each month for rest of term
based on characteristics of pool and current and expected interest rate environment
annual prepayment rate

13. Conditional Prepayment Rate
single-monthly mortality rate
CPR is annual so convert to monthly rate to find amt of monthly prepayments
SMM rate and prepayment
assume that approximately x% of remaining balance prepays at beginning of month

14. PSA Prepayment Benchmark
Public Securities Association (PSA) benchmark
expressed as monthly series of annual prepmt rates
assumes prepayment rate increases as loans become more seasoned
assumes following CPRs for 30-year mortgages
CPR of 0.2% for 1st month and increased by 0.2% per year each month for next 30 months
6% CPR per year for remaining years
benchmark referred to as 100 PSA
if t<= 30, CPR = 6%(t/30)
if t>30, CPR = 6%

15. PSA Benchmark
50 PSA – assuming prepayment rate of half the CPR of the benchmark
150 PSA – rate 1.5 times CPR of PSA benchmark
SMM for month 5 assuming 100 PSA
CPR = 6%(5/30) = 1% =

16. Monthly CF Construction
assume underlying mortgages are fixed-rate level payment with WAC = 8.125%
pass-through rate is 7.5% and WAM of 357 months
assume 100 PSA
in second example, assume 165 PSA

21. Prepayment Models
models statistical relationships among factors expected to affect prepayments
models used to view borrowers as generic
more data available now so models are more complex
models differ for agency and nonagency MBS
book presents models developed by Bear Stearns

22. Agency Prepayment Models
not as much data available on individual loans so models done at “pool” level
components in Bear Stearns model
housing turnover – existing home sales
family relocation due to changes in employment and family status (change in family size, divorce)
trade-up and trade-down activity due to changes in interest rates, income, and home prices
insensitive to level of mortgage rates
cash-out refinancing
rate/term refinancing

23. Agency Prepayment Models
cash-out refinancing
refinancing by borrower in order to monetize the price appreciation of the property
depends on increase in housing prices in region where property is located
favorable tax law regarding capital gains adds incentives to monetize price appreciation (exempts gains up to $500,000)
may be economical even if mortgage rates are rising and with transaction costs
cash-out refinancing is tied to housing prices and insensitive to mortgage rates

24. Agency Prepayment Models
rate/term refinancing
means borrower has gotten new mortgage on same property to save either on interest cost or shortening life of mortgage with no increase in the monthly payment
decision whether or not to refinance is due to PV of $ interest savings from lower rate after subtracting estimated costs to refinance
proxy for rate/term refinancing for model:
difference between prevailing rate and note rate – not good proxy
better on is refinancing ratio – note rate to current rate
WAC is numerator
ratio < 1 – note rate less than current so no incentive to refinance
ratio > 1 – some incentive possibly to refinance

25. Housing Turnover in Agency Prepayment Models
factors used by Bear Stearns
seasoning effect – (see graph on next slide)
idea is that you must recognize the homeowner’s tenure in the house – may not be same as age of loan because of possible refinancing
housing price appreciation effect
over time LTV of home changes due to either amortization of loan or change in value of home – incentive to refinance if value of home goes up
need to estimate prepayments due to housing appreciation
Bear Stearns used Home Appreciation Index (HPI) – (see slide)
seasonality effect
home buying increases in spring and peaks in late summer – buying declines in fall and winter – prepayments follow similar pattern but may lag a bit with peak closer to early fall

26. Bear Stearns Baseline HTO Prepayments for Agency MBS

27. Effect of Housing Price Appreciation of Agency Prepayments

28. Cash-Out Refinancing
driven by price appreciation since loan origination – need proxy for this
Bear Stearns uses HPI
see slide to show cash-out refinancing incentives for 4 assumed rates of appreciation
according to Bear Stearns model, projected prepayments due to cash-out refinancing
exist for all ratios greater than 0.6
prepayments increase as the ratios increase
the greater the price appreciation for a given ratio, the greater the projected prepayments

29. Effect of Housing Price Appreciation on Cash-Out Refinancing on Agency Prepayments

30. Rate/Term Refinancing Component
decision to refinance not based totally on note rate relative to current rate
S-curve for prepayments
if totally based on ratio, why does curve flatten out (or prepayment rate flatten out)
because borrowers left in pool can not get refinancing or some have other reasons why refinancing does not make sense
S-curve not sufficient for modeling rate/term refinancing – ignores 2 things that affect decision:
burnout effect – Bear Stearns use some pool variables as proxies:
original term, loan purpose, WAC rate, weighted average loan age, loan size, rate premium over benchmark, yield curve slope (see slide)
threshold media effect

31. Baseline Refinancing Function for Bear Stearns’ Agency Prepayment Model for an “Ordinary” Pool of Agency Borrowers
original loan of $125,000, age of 12 months, no rate premium at origination, no prior option to
refinance, 3.5% annual home price appreciation

32. Baseline S-Curve for Agency Borrowers Based on Loan Amount
shows model’s S-curves for $25,000 loan size increments – relative to loans with balances less than
$100,000, loan balances that exceed $150,000 are about 1.5 to 2.5 times more sensitive to refinancing

33. Nonagency Prepayment Models
same components as in Agency models
but more info. on these loans so prepayment model estimated for each type of loan (rather than for pool of loans)
Bear Stearns gives projected prepayment rates based on
size of loan
rate premium
documentation
occupancy status
current LTV

34. Baseline Projected Prepayment Rate Across a Range of Refinancing Incentives for 3 Loan Types

35. Cash Flow for Nonagency PTs
CFs not affected by default and delinquency for agency PTs
PSA has issued a standardized benchmark for default rates
SDA benchmark gives annual default rate for a mortgage pool as a function of the seasoning of the mortgages
can use multiples of default rate similar to prepayment benchmark – so can have 200 SDA

36. Cash Flow Yield
rate that makes the PV of expected CF equal to the price
bond-equivalent yield
market convention for annualizing yield on fixed-income security that pays interest more than once a year
found by doubling a semi-annual yield
semi-annual yield for PT is
semiannual cash flow yield = (1 + y M)6 – 1
where yM is monthly interest rate that equates PV of projected monthly CF to price of PT
bond-equivalent yield = 2[(1 + yM)6 – 1]
must specifiy underlying prepayment assumption
to realize this yield, investor must reinvest CFs at yield, investor must hold PT until all mortgages paid off, and assumed prepayment rate must actually occur
so be careful in placing too much confidence in yields!

37. Average Life average life of MBS
average time to receipt of principal payments (scheduled and prepayments) weighted by amount of principal expected
average life depends on prepayment assumption

38. Prepayment Risk
assume you buy 10% coupon GNMA with market rates of 10%
assume rates in market fall to 6%
consequences?? - contraction risk
price increase but not as large as increase for option-free bond
negative convexity
CF reinvested at lower rate
assume rates rise to 15% - extension risk
price of PT falls but will fall more because rate increase slows down rate of prepayments
problem for investor is this is exact time that they want rate of prepayments to increase so they have money to reinvest at higher market rate of 15%

39. Asset / Liability Management
PTs unattractive to some institutions
depository institutions exposed to extension risk when they invest – they want to lock in spread over cost of funds – PT is longer term than their liabilities
life insurance companies are exposed to extension risk when using PTs – they might issue 4 year GIC – problem is uncertainty about CF from PTs that they will receive to have to pay off GIC
pension fund is exposed to contraction risk using PTs – they have long-term liabilities and want to lock in current rates – exposed to risk that prepayments will speed up and maturity of investments will shorten (happens when rates fall) and they will have to reinvest prepayments at lower rate

40. Secondary Market Trading
quoted same manner as Treasuries
94-05 means 94 and 5/32nds of par or % of par
PTs identified by pool prefix and pool number
prefix tells type of PT – 20 for Freddie Mac PC means underlying pool of conventional mortgages with original maturity of 15 years
prefix of AR for GNMAs means ARMs
pool number tells specific mortgages underlying PT and issuer of PT