Chapter 11 Mortgage Derivative Securities and Structured Finance © OnCourse Learning

Chapter 11 Learning Objectives  Understand the valuation of mortgage securities  Understand cash flows from various types of mortgage securities in terms of their amount and timing  Understand how changes in interest rates affect mortgage securities values  Understand how prepayment and default assumptions affect the cash flows of mortgage securities  Understand how mortgage securities can be used to hedge against interest rate risk © OnCourse Learning 2

Mortgage-Derivative Security  Any security for which the cash flows derived from mortgages are rearranged in terms of amount and timing  Do not include pass-throughs  Different from traditional debt securities in that:  Both the timing and the amount of future expected cash flows are dependent on changes in the rate of interest  Interest rate contingent securities  Valuation of mortgage-derivative securities more complicated 3 © OnCourse Learning

Traditional Debt Security Valuation  Typically fixed, semi-annual interest payments with face value paid at maturity  Value moves inversely with market interest rates  Yield to maturity at a given point in time is based on current market value © OnCourse Learning 4

Valuation of Traditional Debt Security - Example 5 © OnCourse Learning

Traditional Debt Securities 6 © OnCourse Learning

Mortgage-Related Security  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 © OnCourse Learning 7

Mortgage-Related Securities  Market rates rise, mortgage prepayment slows down as borrowers hold onto low-rate loans  Market rates decline, mortgage prepayment increases due to refinancing © OnCourse Learning 8

Mortgage Pass-Throughs  The rate of mortgage prepayment is crucial in pass- through valuation  Several models of expected prepayment:  FHA Twelve-Year Prepaid Life  Constant Prepayment Rate  FHA Experience © OnCourse Learning 9

Mortgage Pass-Throughs (Cont.)  Prepayment models (cont.):  Public Securities Association (PSA) Model Current industry standard Combines FHA experience with CPR model PSA benchmark assumes that the annual CPR on a monthly basis is 0.2 percent in the first month; months 2-30 increases by 0.2 percent/month; after month 30 – 6 percent  Econometric Prepayment Models  Refinancing Models Based on title search activity which precedes refinancing © OnCourse Learning 10

PSA and Multiples of PSA 11 © OnCourse Learning

Changes in Interest Rate and Prepayment Behavior  The interest rate differential between the current market rate and that on the pool is the single most important determinant of prepayments.  If current rate is above contract rate borrowers have little incentive to prepay  Regardless of the size of the positive differential, prepayment will occur at a uniformly slower pace, driven by non-economic factors (job relocation, divorce)  When market rates fall below the contract rate, prepayments accelerate until a sufficiently large negative differential is reached at which point they level off 12 © OnCourse Learning

Interest Rate Differential and Prepayment Rates 13 © OnCourse Learning

Pass-Throughs  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  If selling at a discount, accelerated (delayed) prepayment increases (decreases) the realized yield © OnCourse Learning 14

Pass-Throughs  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  High coupon pass-throughs suffer price compression due to prepayment expectations © OnCourse Learning 15

Pass-Throughs  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  The duration of pass-throughs is impossible to measure because of the uncertain prepayments  Possible to determine effective (implied) duration by observing price behaviors of various pass-throughs in response to changes in interest rates © OnCourse Learning 16

Mortgage-Backed Bonds  Cash flows are structured as traditional non-callable debt with periodic interest payments and face value at maturity  Seek to be sufficiently over collateralized  Cash flows not paid to investors are placed in a sinking fund  Financial rating based on amount of overcollateralization © OnCourse Learning 17

Mortgage-Backed Bonds  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 © OnCourse Learning 18

Collateralized Mortgage Obligations  Cash flows are made up of various tranches and residual class  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  Yield is higher on longer tranches © OnCourse Learning 19

Collateralized Mortgage Obligations  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 © OnCourse Learning 20

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  Amount of principal equals the initial pool balance but the timing is unknown © OnCourse Learning 21

Strips  If prepayment accelerates, principal is returned faster  Interest-only strips receive the interest when it is paid  Total amount of interest is not known but is based on principal outstanding  Accelerated prepayment reduces principal and reduces interest amount © OnCourse Learning 22

Strips  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 © OnCourse Learning 23

Strips  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 © OnCourse Learning 24

Floters  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  The interest rate on the floater is usually pegged to some short-term rate such as LIBOR © OnCourse Learning 25

Floters  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  Inverse floater is a bond on which the interest rate moves opposite to the market rate © OnCourse Learning 26

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 © OnCourse Learning 27

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  Costs include administrative costs and overhead © OnCourse Learning 28

Servicing Rights  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  Rates rise, discount rate goes up and prepayment accelerates. Combines to reduce the value of servicing rights © OnCourse Learning 29

Excess Servicing Rights  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  The greater the spread, the larger the excess servicing fees © OnCourse Learning 30

Reasons for Excess Servicing Rights  Mortgage-backed securities generally have coupons in one-half point intervals  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 © OnCourse Learning 31

Value Creation in MBSs  Value is created even though no additional cash flow is created  Securitization eliminates liquidity risk and makes the market larger  Securitization rearranges the cash flows into more and less risky components  Asymmetric information may distort values - lenders may have superior © OnCourse Learning 32