Chapter 11 Valuation of Mortgage Securities

Chapter 11 Learning Objectives Understand the valuation of mortgage securities Understand the valuation of mortgage securities Understand cash flows from various types of mortgage securities Understand cash flows from various types of mortgage securities Understand how changes in interest rates affect mortgage securities values Understand how changes in interest rates affect mortgage securities values Understand mortgage securities and hedging against interest rate risk Understand mortgage securities and hedging against interest rate risk

TRADITIONAL DEBT SECURITY VALUATION Typically fixed, semi-annual interest payments with face value paid at maturity Typically fixed, semi-annual interest payments with face value paid at maturity Value moves inversely with market interest rates Value moves inversely with market interest rates Yield to maturity at a given point in time is based on current market value Yield to maturity at a given point in time is based on current market value

MORTGAGE-RELATED SECURITIES Cash flows have three components: interest, principal amortization, and prepayments Cash flows have three components: interest, principal amortization, and prepayments Total principal on mortgage pool is constant but principal payments may be accelerated or delayed based on changes in market rates Total principal on mortgage pool is constant but principal payments may be accelerated or delayed based on changes in market rates

MORTGAGE RELATED SECURITIES Market rates rise, mortgage prepayment slows down as borrowers hold onto low-rate loans Market rates rise, mortgage prepayment slows down as borrowers hold onto low-rate loans Market rates decline, mortgage prepayment increases due to refinancing Market rates decline, mortgage prepayment increases due to refinancing

PASS-THROUGHS The rate of mortgage prepayment is crucial in pass-through valuation The rate of mortgage prepayment is crucial in pass-through valuation Several models of expected prepayment: Several models of expected prepayment: FHA Twelve-Year Prepaid Life FHA Twelve-Year Prepaid Life Constant Prepayment Rate Constant Prepayment Rate FHA Experience FHA Experience

PASS-THROUGHS Prepayment models (cont.): Prepayment models (cont.): Public Securities Association (PSA) Model Public Securities Association (PSA) Model Current industry standard Current industry standard Combines FHA experience with CPR model Combines FHA experience with CPR model Econometric Prepayment Models Econometric Prepayment Models Refinancing Models Refinancing Models Based on title search activity which precedes refinancing Based on title search activity which precedes refinancing

PASS-THROUGHS No rearranging of the cash flows from the mortgage pool No rearranging of the cash flows from the mortgage pool Prepayments have a significant impact on the timing of cash flows and thus the value of those cash flows Prepayments have a significant impact on the timing of cash flows and thus the value of those cash flows If selling at a discount, accelerated (delayed) prepayment increases (decreases) the realized yield If selling at a discount, accelerated (delayed) prepayment increases (decreases) the realized yield

PASS-THROUGHS For pass-throughs selling at a premium, delayed prepayment increases yield and accelerated prepayment decreases yield For pass-throughs selling at a premium, delayed prepayment increases yield and accelerated prepayment decreases yield Coupon rates reflect market rates at time of issue Coupon rates reflect market rates at time of issue High coupon pass-throughs suffer price compression due to prepayment expectations High coupon pass-throughs suffer price compression due to prepayment expectations

PASS-THROUGHS Changes in market rates have two impacts on pass-through value: both the discount rate and the assumed prepayment will change Changes in market rates have two impacts on pass-through value: both the discount rate and the assumed prepayment will change In senior/subordinated pass-throughs the senior security has enhanced rights to cash flows and subordinated security bears all the default risk In senior/subordinated pass-throughs the senior security has enhanced rights to cash flows and subordinated security bears all the default risk

MORTGAGE-BACKED BONDS Cash flows are structured as traditional non-callable debt with periodic interest payments and face value at maturity Cash flows are structured as traditional non-callable debt with periodic interest payments and face value at maturity Seek to be sufficiently overcollateralized Seek to be sufficiently overcollateralized Cash flows not paid to investors are placed in a sinking fund Cash flows not paid to investors are placed in a sinking fund Financial rating based on amount of overcollateralization Financial rating based on amount of overcollateralization

MORTGAGE-BACKED BONDS Overcollateralization is related to the balance in the sinking fund Overcollateralization is related to the balance in the sinking fund Variables that affect the balance of the sinking fund at maturity include the mortgage prepayment rate, the reinvestment rate on the sinking fund, the initial overcollateralization, and the default rate Variables that affect the balance of the sinking fund at maturity include the mortgage prepayment rate, the reinvestment rate on the sinking fund, the initial overcollateralization, and the default rate

COLLATERALIZED MORTGAGE OBLIGATIONS Cash flows are made up of various tranches and residual class Cash flows are made up of various tranches and residual class Any mortgage prepayments are passed to bondholders thus there is no sinking fund Any mortgage prepayments are passed to bondholders thus there is no sinking fund This means that the CMO issuer faces no interest rate or reinvestment risk This means that the CMO issuer faces no interest rate or reinvestment risk Yield is higher on longer tranches Yield is higher on longer tranches

COLLATERALIZED MORTGAGE OBLIGATIONS CMOs are structured differently from pass-throughs thus prepayment behavior affects pricing and yield differently CMOs are structured differently from pass-throughs thus prepayment behavior affects pricing and yield differently Price and yield on shorter-term tranches will not vary as much with prepayment as compared to pass-throughs Price and yield on shorter-term tranches will not vary as much with prepayment as compared to pass-throughs

STRIPS Cash flows may be rearranged to produce principal-only and interest-only strips Cash flows may be rearranged to produce principal-only and interest-only strips Principal-only (PO) strips receive all principal payments when they are received Principal-only (PO) strips receive all principal payments when they are received Amount of principal equals the initial pool balance but the timing is unknown Amount of principal equals the initial pool balance but the timing is unknown

STRIPS If prepayment accelerates, principal is returned faster If prepayment accelerates, principal is returned faster Interest-only strips receive the interest when it is paid Interest-only strips receive the interest when it is paid Total amount of interest is not known but is based on principal outstanding Total amount of interest is not known but is based on principal outstanding Accelerated prepayment reduces principal and reduces interest amount Accelerated prepayment reduces principal and reduces interest amount

STRIPS Thus accelerated prepayment may be advantageous for PO investors and disadvantageous for IO investors Thus accelerated prepayment may be advantageous for PO investors and disadvantageous for IO investors A change in market interest rates changes the discount rate used to value securities and alters prepayment behavior A change in market interest rates changes the discount rate used to value securities and alters prepayment behavior

STRIPS PO Strip: Interest rate goes up, discount rate goes up, prepayment goes down and net effect is value goes down PO Strip: Interest rate goes up, discount rate goes up, prepayment goes down and net effect is value goes down IO Strip: Interest rate goes up, discount rate goes up, prepayment goes down and net effect is value goes up IO Strip: Interest rate goes up, discount rate goes up, prepayment goes down and net effect is value goes up

FLOATERS Floaters are classes of a CMO that have a rate that moves with the market Floaters are classes of a CMO that have a rate that moves with the market These are matched with an institution’s short-term liabilities that move with the market These are matched with an institution’s short-term liabilities that move with the market The interest rate on the floater is usually pegged to some short-term rate such as LIBOR The interest rate on the floater is usually pegged to some short-term rate such as LIBOR

FLOATERS Since rate is variable, there is a risk of loss if market rates risk significantly Since rate is variable, there is a risk of loss if market rates risk significantly To solve this problem an inverse floater is created out of the same tranche To solve this problem an inverse floater is created out of the same tranche Inverse floater is a bond on which the interest rate moves opposite to the market rate Inverse floater is a bond on which the interest rate moves opposite to the market rate

SERVICING RIGHTS Lenders sell off loans and often retain the servicing rights Lenders sell off loans and often retain the servicing rights Servicing includes collecting monthly payments, maintaining escrow accounts, forwarding proper payments to purchasers, sending delinquency and default notices, initiating foreclosure proceedings and collecting on PMI Servicing includes collecting monthly payments, maintaining escrow accounts, forwarding proper payments to purchasers, sending delinquency and default notices, initiating foreclosure proceedings and collecting on PMI

SERVICING RIGHTS Revenue from servicing includes the servicing fee, float on the escrow accounts, and float between receipt of monthly payments and payments to purchasers Revenue from servicing includes the servicing fee, float on the escrow accounts, and float between receipt of monthly payments and payments to purchasers Costs include administrative costs and overhead Costs include administrative costs and overhead

SERVICING RIGHTS Fee is usually between 0.25 and 0.50 percent of the mortgage balance Fee is usually between 0.25 and 0.50 percent of the mortgage balance Value is affected by interest rate changes similar to IO strips Value is affected by interest rate changes similar to IO strips Rates rise, discount rate goes up and prepayment accelerates. Combines to reduce the value of servicing rights Rates rise, discount rate goes up and prepayment accelerates. Combines to reduce the value of servicing rights

SERVICING RIGHTS Excess servicing rights are fees greater than “normal” Excess servicing rights are fees greater than “normal” Usually occurs when mortgages are sold with a promised rate less than the coupon on the mortgages Usually occurs when mortgages are sold with a promised rate less than the coupon on the mortgages The greater the spread, the larger the excess servicing fees The greater the spread, the larger the excess servicing fees

SERVICING RIGHTS Reasons for excess servicing rights Reasons for excess servicing rights Mortgage-backed securities generally have coupons in one-half point intervals Mortgage-backed securities generally have coupons in one-half point intervals Premium securities may sell at unattractive prices due to fears of prepayment Premium securities may sell at unattractive prices due to fears of prepayment Mortgage pools may contain loans with different coupons thus some loans may have excess servicing Mortgage pools may contain loans with different coupons thus some loans may have excess servicing

VALUE CREATION IN MBSs Value is created even though no additional cash flow is created Value is created even though no additional cash flow is created Securitization eliminates liquidity risk and makes the market larger Securitization eliminates liquidity risk and makes the market larger Securitization rearranges the cash flows into more and less risky components Securitization rearranges the cash flows into more and less risky components Asymmetric information may distort values - lenders may have superior Asymmetric information may distort values - lenders may have superior