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

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

Subprime Mortgage Market The Big short_Jenga https://www.youtube.com/watch?v=juNFglL8LdU Copyright 2016 by Diane S. Docking

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

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

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

Securitization of Mortgage Loans Copyright 2016 by Diane S. Docking

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

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

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 www.ginniemae.gov FNMA www.fanniemae.com FHLMC www.freddiemac.com Copyright 2016 by Diane S. Docking

Securitization Process 1 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

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

Example: Mortgage Pass-Through Security A bank originates 1,000 30-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 99.00.(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 1,000,000 CR) Mortgage Loans $100,000,000 Copyright 2016 by Diane S. Docking

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 4,598.54 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 31,958.10 CR) Interest Payable to Investors 958,333.33 Copyright 2016 by Diane S. Docking

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

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

Securitization Process for CMO 1 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

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

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

Copyright 2016 by Diane S. Docking 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

Copyright 2016 by Diane S. Docking 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

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

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% - 6.85% = 1.15% Copyright 2016 by Diane S. Docking

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

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

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

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

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

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

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

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