MBS MODULE MODULE 7

Mortgage-Backed Security Markets -- Secondary Mortgage Markets Mortgage Related Securities Mortgage Collateral Why Should There Be a Secondary Market?

Originator Buys Mortgages Cash Secondary Mortgage Market Sells MRS Cash Investor Originator Mortgage (-) Cash (+) AgencyInvestor Mortgage (+)MRS (+) Cash (-)

MRS: Basic Characteristics Credit Enhancement Avoid Double Taxation and Bankruptcy Tailor Cash Flows from Mortgages to Investors

MRS: Phylum -- Flora & Fauna Mortgage Pass-Through Securities Mortgage-Backed Bonds Mortgage Pay-through Bonds Collateralized Mortgage Obligations

Credit Enhancement Techniques Pass-Through -- FHA/VA Loans Mortgage-Backed Bonds -- Agency Equity or Pool Revenue Mortgage Pay- -- Agency Equity Through Bonds Pool Insurance Collateralized -- Agency Equity Pool Mortgage Obligations Insurance Letter of Credit Debts of Agency -- FHA/VA Loans in Pool

Mortgage-Backed Bond: Cash- flows Originator Buys Mortgages Cash $125 Firm Sells MBB Cash $100 Investor Firm $125 Mortgages MBB $100 Equity $25

CMO Structure Maturity Coupon $ Total $ Assets Mortgages % 106 Total Assets 106 Liabilities A % 30 B % 30 C % 25 Z % 15 Liabilities 100 Equity 6 Total 106

Tax and Accounting for MRS - Guarantor Trust -- Avoids Double Taxation 1. Limited Life 2. Self-Liquidating 3. No Asset Management

REMIC Cash Flow Structure Originator Buys Mortgages Cash Secondary Market Agency Sells Cash Investor Transfers or Sells Mortgages “off balance” Sheet Trust or Separate Accounting Activity REMIC

Secondary Market Players - FNMA - GNMA - FHLMC

Secondary Market Players - Federal Credit Agencies  Farm Credit system  Farm Credit Assistance Financial Corp.  Federal Agricultural Mortgage Corp. (Farmer Mae)  Farmers Home Administration (FmHA)  Financing Corp. (FICO)  Federal Financing Bank (FFB)  State and Local Credit Agencies - HFA’s - Private Sector Firms - First Boston, et. al. - “RTC” Paper

Regulation of GSE’s FNMA/FHLMC Capital Requirements - Interest Risks - Default Risks - Management and Operating Risks

Valuation of MRS Mortgage Derivative Securities Interest Rates Affect both Amounts of Cash Flows and Time Value of Cash Flows MRS are Interest-Contingent Securities

MRS Fundamentals 1. Principal of Pool is Fixed in Total (No Defaults) 2. Interest Payments Depend Upon Past Amortization 3. Changes in Interest Rates Affect Timing of Prepayments

Pass-Throughs and Prepayment Rates 1. Twelve Year Prepaid Life 2. Constant Prepayment Rate (CPR) 3. FHA Experience 4. Public Securities Association (PSA) 5. Econometric Prepayment Models

PSA Model 6%100% PSA 30 Time

Econometric Models Age of Mortgage Seasonal Current and Projected Interest Rate Relative to Mortgage Coupon Geography Borrower Characteristics - Age - Income - Wealth

Interest Rates and Prepay Behavior o 100%. Differential Between Market and Coupon + -

SWAPS - Mortgage Pools for MRS - Used by S&L’s Because of Liquidity