Irwin/McGraw-Hill 1 Securitization Chapter 28 Financial Institutions Management, 3/e By Anthony Saunders

Irwin/McGraw-Hill 2 Introduction n Securitization: Packaging and selling of loans and other assets backed by securities. Many types of loans and assets are being repackaged in this fashion including royalties on recordings ( David Bowie, Rod Stewart). Original use was to enhance the liquidity of the residential mortgage market.

Irwin/McGraw-Hill 3 Securitization n Government National Mortgage Association (GNMA) Sponsors MBS programs and acts as a guarantor. Timing insurance. n FNMA actually creates MBSs by purchasing packages of mortgage loans.

Irwin/McGraw-Hill 4 Freddie Mac n Federal Home Loan Mortgage Corporation Similar function to FNMA except major role has involved savings banks. Stockholder owned with line of credit from the Treasury. Sponsors conventional loan pools as well as FHA/VA mortgage pools.

Irwin/McGraw-Hill 5 Incentives and Mechanics of Pass- Through Security Creation n Example: Create a mortgage pool from one-thousand, $100,000 mortgages (Results in $100 million). Each mortgage receives credit risk protection from FHA. Capital requirement: $4 million. Must issue more than $96 million in liabilities due to reserve requirements. (+ FDIC premia).

Irwin/McGraw-Hill 6 Further Incentives n Gap exposure n Illiquidity exposure n Default risk by mortgagees Phoenix, AZ in 1980s. n Default risk by bank/trustee

Irwin/McGraw-Hill 7 Effects of prepayments n Good news effects Lower market yields increase present value of cash flows. Principal received sooner. n Bad news effects Fewer interest payments in total. Reinvestment at lower rates.

Irwin/McGraw-Hill 8 Prepayment effects n Prepayments result of sales or refinancing. Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates. Methods: »Option pricing approach. »Public Securities Association approach. »Empirical approach.

Irwin/McGraw-Hill 9 Option Model Approach n Use option pricing theory to figure fair yield spread of pass-throughs over Treasuries. n Fair price on pass-through decomposable into two parts P GNMA = P TBOND - P PREPAYMENT OPTION n Option-adjusted spread between GNMAs and T-bonds reflects value of a call option.

Irwin/McGraw-Hill 10 Collateralized Mortgage Obligation (CMO) n CMO structure Prepayment effects differ across tranches (classes). Z-Class CMO. Improves marketability of the bonds.

Irwin/McGraw-Hill 11 Mortgage-Backed Bonds (MBBs) n Normally remain on the balance sheet. n Regulatory concerns. n Other drawbacks to MBBs.

Irwin/McGraw-Hill 12 Innovations in Securitization n Pass-through strips IO strips »Negative duration. PO strips n Securitization of other assets CARDs Various receivables, loans, junk bonds, ARMs.