Introduction to Mortgage- Backed Securities

Key Players at MBS Creation Borrower Mortgage Broker –Initiate the loan with the borrower –Typically paid upfront Mortgage Banker –Issue the loan and then sell it to the dealer –Typically paid upfront Dealer –Package the loans –Typically paid upfront

Key Players at MBS Creation Rating agency –Provide information about the credit quality –Typically paid upfront Others –lawyers; accountants

Key Players During the Life of MBS Servicer –Collect payments; –Handle delinquency and foreclosure –Paid a fraction of interest payment Guarantor –Cover losses from loan defaults –Paid a fraction of interest payment Trustee –Forward payments to investor –Paid a fraction of interest payment

Key Players During the Life of MBS Investor –Compare MBS against other fixed income investment alternatives –Yield from MBS needs to cover: Funding costs Option costs (prepayment risk and default risk) Liquidity risk

How are value created Is MBS purely rent-seeking? How is value created? –Diversification –Risk-matching risk-aversion of investors are compensated –Liquidity –Standardization

Mortgage Pass-Through Securities Cash flow passed through to the investors are less than the cash flow from the underlying mortgage due to: –Servicing fees –Guaranteeing fees –Investors receive CF on a pro rata basis Characterization of MPTs –Weighted average coupon rate (WAC) –Weighted average maturity (WAM)

MPTs Agency pass-throughs –Fannie Mae –Freddie Mac –Gannie Mae Also referred to as GSE pass throughs Only conforming loans Many market participants/investors view agency pass-throughs as implicitly carrying credit guarantee of U.S. government –Low credit risk

MPTs Non-Agency pass-throughs –Commercial banks –Thrifts –Private conduits No implicit or explicit guarantees from the US government Typically rated by rating agencies

MPTs Factors affecting rating –Property types Condo; single family –Loan types Fixed rate with level payment; adjustable rate; balloon –Loan terms –Geographical dispersion –Size –Seasoning –Loan purpose (refi vs. new purchase)

MPTs Usually rated by the rating agencies –Enough internal or external credit enhancement to obtain AA or AAA ratings Internal enhancement –Reserve funds –Excess spread accounts –Overcollateralization –Senior/Subordinate structure –Shifting interest structure Redirect prepayments to senior class External enhancement –Insurance –3 rd party guarantor must have a rating higher than the pool rating

Prepayment Conventions Conditional prepayment rate (CPR) –Annual prepayment rate of the remaining outstanding principal value –On top of the scheduled principal repayment Single-Monthly Mortality Rate –Similar to CPR, but monthly Relationship 1 - CPR = (1 - SMM) 12 hence SMM = 1 – (1-CPR) 1/12 Prepayment –SMM * (OLB – Scheduled Principal PMT)

PSA Benchmark CPRs The Public Securities Association (PSA) prepayment benchmark assumes: –CPR grows 0.2% per month before the loan/pool reaches 30 month / 6% –Then CPR will stay flat at 6% for the remaining life of the loan/pool –CPR = 6% * min (t / 30, 1) The benchmark is referred to as “100%” PSA, or “100 PSA” –Slower or faster speeds of prepayment is referred to as some percentage of PSA –50 PSA; 150 PSA; 300 PSA –Just a convention of prepayment behavior

Prepayment Modeling Housing turnovers (home sales of existing houses) –Employment –Family status –Income and house price changes In general, not sensitive to mortgage rate Cash-out refi –Depend on house price appreciation and home equity accumulation Rate/term refi –Refinancing ratio = WAC / current mtg rate

Prepayment Modeling Other reasons –Curtailment / partial prepayment Does not reduce payment, but reduce loan term –Defaults Historically less than 1% of prepayment

Prepayment Modeling Variables in the prepayment “regression” –Seasoning –Seasonality –HPI –LTV –WAC / Mortgage Rate Prepayment rate picks up quickly after ratio > 0.6 Burnout effect

The PSA Standard Default Assumption SDA –0.02% in month 1 –Increase by 0.02% b/w month 1 and 30 –Default stays at 0.60% b/w month 31 and 60 –From month 61 to 120, declines from 0.60% to 0.03% –From month 120 on, remain constant at 0.03%

Mortgage Prepayment Risk Unlike treasuries, mortgage payment is uncertain –Contraction risk –Extension risk Macauley duration –Weighted average term to maturity Weight is the present value of the CF in total PV Average life –Average time to receipt of principal payment Weighted by the amount of principal expected

An Excel Example WAC = 8.125% WAM = 357 Month Coupon rate for MPT = 7.5% Fees =.625% Pool balance = $400,000,000