Mortgage -Backed Securities

Giddy/ABS

Mortgage-Backed Securities/1

Asset-Backed Securities

Mortgage-Backed Securities

Prof. Ian Giddy

Stern School of Business

New York University

Mortgages and MBS

Mortgage Loans

l Pass-throughs and Prepayments

l CMOs

l Analysis of MBS Pricing and Convexity

l

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 3

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Structure of the US MBS Market

Mortgage

MortgageLoan

Loan

Bank

Bank(mortgage

(mortgageoriginator)

originator)makes

makesaawhole

wholeloan

loan

Ancillary:

brokers,

servicers,

insurers

Ancillary: brokers, servicers, insurers

Mortgage

MortgagePass-Through

Pass-Through

FNMA

FNMAor

orGMAC

GMAC(conduit)

(conduit)pools

pools

mortgage

loans

with

similar

mortgage loans with similarcharacteristics

characteristics

Mortgage

MortgageStrips

Strips

Interest-Only

Interest-Onlyand

andPrincipal-Only

Principal-Only

CMO

CMOor

orREMIC

REMIC

Takes

Takesaamortgage

mortgagepool

pooland

andmakes

makesthe

the

cash

flows

more

predictable

by

cash flows more predictable byassigning

assigning

priority

priorityofofclaims

claimstotothe

thecash

cashflows

flows

MBS

MBSPortfolio

Portfolio

Institutional

Institutionalinvestor

investorevaluates

evaluatesrisk/return

risk/return

behavior

behaviorofofmortgage-backed

mortgage-backedsecurities

securitiesthrough

through

option-adjusted

option-adjustedprice

priceand

andspread

spreadanalysis

analysis

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 4

US Mortgage-Backed Securities

AGENCY

PASS-THROUGHS

PRIVATE-LABEL

PASS-THROUGHS

INTEREST

INTEREST

INTEREST

INTEREST

PRINCIPAL

PRINCIPAL

PRINCIPAL

PRINCIPAL

PREPAYMENT

PREPAYMENT

PREPAYMENT

PREPAYMENT

GRANTOR

GRANTORTRUST

TRUST

STRUCTURE

STRUCTURE

GRANTOR

GRANTORTRUST

TRUST

STRUCTURE

STRUCTURE

GNMA

GNMAMBS

MBS

(US

(USGovt

Govtg'tee)

g'tee)

Copyright ?1999 Ian H. Giddy

FHLMC

FHLMCPC

PC

FNMA

FNMAMBS

MBS

(US

(USAgency

Agencyg'tee)

g'tee)

Credit

Creditenhancement:

enhancement:

n Corp g'tee

n Corp g'tee

n L/C

n L/C

n Insurance (FSA)

n Insurance (FSA)

n Senior/sub debt

n Senior/sub debt

Mortgage-Backed Securities 5

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Form of cash flow allocation

Pay-through

obligation

Different tranches

Pass-through

obligation

PAC

(planned aamortization class)

TAC

(targeted amortization plan)

IO/PO strips

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 6

Mortgage-Backed Securities

GNMA

mortgage pool

security

Mortgage

1

Mortgage

2

...

Mortgage

n

Equal monthly payments

prepayable

Mortgage-backed securities are prepayable,

so one cannot measure returns or values

easily

n They tend to pay down early when rates fall,

and later when rates rise.

n

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 7

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Mortgage Prepayments

Complexity of the option l Systematic risk: exercise of the interest

rate option

l Unsystematic risk: reasons unrelated to

mortgage interest rates (eg

demographic)

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 8

Mortgage Pool Prepayment Conventions

Traditional method is to forecast prepayments by adjusting the PSA

(Public Securities Association) benchmark of a prepayment rate that

reaches 6% a year for 30 year mortgages.

Annual prepayment rate (CPR):

100% PSA:

If t30 CPR=6%

170% PSA:

If t30 CPR=170%[6%]

Monthly prepayment rate (SMM):

SMM=[1-(1-CPR)]/12

Prepayment amount in dollars:

= (Beginning Principal Balance - Scheduled Principal Repayment)*SMM

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 9

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Prepayment Assignment

Consider a $100,000 10-year, 9% mortgage loan,

with monthly equal payments.

l Make the following calculations, using a computer

spreadsheet or financial calculator:

1. What are the scheduled monthly payments?

2. After 1 month and 3 months,

u What is the CPR and SMM, assuming 200% PSA?

u What is scheduled principal payment?

u If it pays down at 200% PSA, what is the

prepayment amount?

u What is the remaining principal balance?

l

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 10

CMOs and Strips

The technique:

l Allocate cash flows (interest & principal)

of MBS to mitigate prepayment risk

l Pay different returns based on risk

l The sum of the part should be worth

more than the whole alone.

Example: MDC Series J CMO with

underlying pool WAC 9.5%, 297 months

final maturity

Copyright ?1999 Ian H. Giddy

Mortgage-Backed Securities 11

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