1. Chapter 11 Valuation of Mortgage Securities

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

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

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

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

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

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

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

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

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

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

12. MORTGAGE-BACKED BONDS n Overcollateralization is related to the balance in the sinking fund n 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

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

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

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

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

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

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

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

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

21. SERVICING RIGHTS n Lenders sell off loans and often retain the servicing rights n 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

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

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

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

25. SERVICING RIGHTS n 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

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