1. Mortgage Risk Management Blackwell, Griffiths and Winters Chapter 14 and other material

2. Learning Objectives Understand the primary risks of mortgages
Understand the process of securitization in the mortgage markets
Understand mortgage-backed securities (MBS)
Understand interest-rate risk management in the mortgage market

3. Risks of Investing in Whole Mortgages
Liquidity risk: whole mortgages are highly illiquid for the following reasons:
Current mortgage owner may engage in cherry-picking the portfolio (sell bad mortgages while keeping good ones);
The cost of analyzing whole mortgages is high relative to their size;
There is no established secondary market for whole mortgages.
Interest-rate risk: mortgage values are sensitive to interest rate changes because:
Mortgages are fixed-income securities, and their values are inversely related to interest rates.
Mortgage prepayment rates change inversely with interest rates.

4. Risks of Investing in Whole Mortgages (cont.)
Default risk: most mortgages have low default risk because of:
Overcollateralization
Rising property values
Declining loan balances
Tax and insurance escrows
Private mortgage insurance
When defaults do occur, investors suffer a significant loss of value.
Geographic concentration risk: Traditionally, many banks and thrifts held mortgage portfolios secured by property located in a single geographic region and guaranteed by borrowers who lived and worked in the same region. This exposed institutions to additional default risk due to dependence on the local economy.

5. Mortgages Securitization General Background
In the securitization process, a large number of similar, illiquid loans (such as mortgages) are bundled together in an asset pool.
Mortgage-backed securities (MBS) are the dominating type of asset-backed securities (ABS) in the U.S.
Securitization allows for unbundling of the three major activities of the mortgage business – origination, servicing, and investment.

6. Mortgages Securitization Steps in Creating a Mortgage Pool
- The institution that intends to issue MBS assembles a pool of relatively similar mortgages (e.g., in terms of maturity and coupon rate);
- A trustee is hired to verify the existence of the mortgages and to ensure that they are not sold after the MBS are issued;
- The pool is insured by a third party;
- The responsibility for servicing the mortgage is transferred to an independent servicer;
- MBS are issued and sold to investors.

7. Mortgages Securitization Mortgage Servicing
Responsibilities of the servicer:
Collecting payments from borrowers and transferring those funds to the mortgage pool;
Collecting taxes and insurance escrow payments;
Interacting with borrowers, answering questions and resolving problems;
Pursuing delinquent payments and forcing foreclosure in the case of default;
Servicing business has become highly automated; it is characterized by economies-of-scale.
Servicer may have little incentive to provide high quality services to the borrower.

8. Mortgages Securitization The Mortgage-Backed Security
The issuer starts with the expected cash flows of the pool and sets the rules that govern how these cash flows will be distributed among investors.
The goal of the MBS issuer is to create a set of securities that have the highest possible value to investors.
The issuer’s profit comes from selling the MBS for more money than was spent to assemble the pool, design the MBS, and market them to investors.
MBS are owned by various investors.

9. MBS Issuers
Ginnie Mae (GNMA) provides guarantees against default losses for mortgages that are used to back privately issued MBS.
Fannie Mae (FNMA) and Freddie Mac (FHLMC) are largest issuers of MBS.
Ginnie, Fannie, and Freddie are agencies that were established to create and develop the secondary market in mortgages. They hold or insure about $4.1 trillion in mortgages, almost 44% of the market.
MBS backed by mortgages that do not conform to agency standards offer higher returns than those issued or insured by the agencies.

10. MBS Secondary Market OTC market;
Many MBS are held as long-term investments and rarely trade;
When comparing ask prices, it is important to recognize that different dealers may be quoting prices for different securities.

11. Impact of Securitization on Risk
Liquidity risk: MBS are much more liquid than whole mortgages. Increased liquidity is not costless. Result, yield is less than aw mortgages
Interest-rate risk of the underlying mortgages is not reduced. But, it is possible to create securities which have different levels of interest-rate risk from the underlying pool.
Default risk: Most securitized mortgages are essentially free from default risk.
Geographic Concentration risk: Widespread securitization virtually eliminates problems of geographic concentration.

12. Impact of Securitization on Risk
Systemic risk – the risk that the market as a whole will experience a breakdown. It is possible because the market is dominated by a small group of participants.
Servicer risk. If the servicer does a poor job interacting with borrowers, it may influence the borrowers’ repayment or prepayment decisions.
Model risk. Automated models are used to make the initial lending decision and valuation models are used to price MBS. There is always the risk that the model is inaccurate.

13. Managing MBS Interest-rate Risk
Because of prepayments, the duration of a mortgage portfolio changes as interest rates change.
These changes in duration suggest that mortgages have very different risk characteristics in rising and falling rate environments.
This instability makes interest-rate risk management difficult for mortgage portfolios and MBS.
More on managing interest rate risk in slides 30 to 32

14. Market Price of Mortgage-Backed Instruments
The price is of an asset is the PV of the expected cash flows
However, for mortgages, the expected cash flow is not certain due to prepayment of the principal
Prepayment occurs through:
New home purchase through relocation
New home purchase without moving
Death
Change in economic conditions
Refinancing
Other

15. No Prepayment VS Prepayment with No Change in Rates Environment

16. Estimating Prepayments and The Conditional Cash Flow in a MBS
Suppose that
A $250 million pool of mortgage is assembled and a MBS is issued against those mortgages
Suppose that the average rate on the mortgage in that pool is around 8%
Effect of interest rate changes on the conditional cash flow
If interest rates should rise above 8%, individuals will prepay the pool of mortgages slower; and it will take longer for the mortgages to be fully paid
If interest rates should fall below 8%, the prepayment will speed up; and the mortgages will be fuller paid sooner

17. Conditional Cash Flows PSA Rate of 100 VS Rate of 400

18. Effects of Changes in Interest Rates
The principal takes longer to pay if current mortgage rates are higher than the average rate on the mortgages in the pool
The higher the rate the slower the payoff
Effect is for periodic cash flow to last longer, the higher are mortgage rates
The principal pays off faster, if the current mortgage rate is lower than the average rate on the pool
The lower the rate, the faster the payoff
Effect is for periodic cash flow to end sooner, the lower are mortgage rates
If rates far far enough fast enough, the cash flow could disappear so fast that the value of the bond falls as interest rates fall

19. Numerical Example of SMM and Prepayment
SMM = 1- (1-CPR)^(1/12) Prepayment = SMM * (Balance at start of month less scheduled principle payment) Suppose balance is 255,235,555 scheduled payment 1,222,857 PSA 1.75 CPR 4%

20. Estimating Prepayments
The process starts with a standard prepayment rate that reflects factors other than interest rates
The process then adjusts this standard prepayment rate to reflect current interest rate conditions
The adjusted prepayment rate is then used to formulate and expected cash flow path of interest and principal that reflects both the interest rate environment and other factors
The conditional cash flow path is used to calculate the price of a MBS, CMO or, REMIC

21. MBS Structures
The MBS structure is a set of rules that define which investors receive the cash flows that come to the pool.
Servicing, trustee, and insurance fees are paid out of interest.
1) Passthroughs. The cash flows from the pool are divided evenly between a fixed number of shares. Every dollar received by the pool (net of fees) passes through to the investors on a pro rata basis.

22. MBS Structures (cont.)
2) IO strips and PO strips. Must be created together.
Interest payments are divided evenly among IO strip shares and principal payments divided among the PO strip shares.
If interest rates fall, mortgage prepayments rise. Higher prepayments benefit PO investors and hurt IO investors.
As a result, PO investors like falling rates and dislike increasing rates, while IO investors react in the opposite way.
A combination of an IO and a PO strip is a simple passthrough.

23. MBS Structures (cont.) 3) CMOs
A generic CMO contains three types of tranches:
a) Sequential tranches are divided into a number of identical shares and have a principal balance and fixed coupon rate associated with them.
b) A zero-coupon tranche has an initial principal balance and an earnings rate. As long as tranches ahead of it are still being repaid, the Z-tranche receives no cash flows.
c) A residual tranche gets any cash flow that doesn’t contractually belong to another tranche.

24. Cash Flows from Sequential-Pay CMO Collateral: Balance = $100m, WAM = 355 Months, WAC = 8%, PT Rate = 7.5%, Prepayment: 150 PSA, Tranches: A: $50 million, B = $30 million, C = $20 million

25. More Complex MBS Structures
Planned Amortization Class (PAC) plus companion bond PAC has a promised prepayment rate. When prepayments are higher than the PAC’s promised prepayment rate, the companion bond gets the extra prepayments. When pool prepayments are lower, the PAC gets part of the companion’s prepayments. This CMO structure reallocates prepayment risk across investors.
Floater plus inverse floater A floater is a sequential tranche with an adjustable coupon rate tied to some market rate. The coupon rate on an inverse floater is equal to a fixed rate minus an index. Putting the coupon rates of the floater and inverse floater together gives a fixed-rate sequential tranche. Splitting them creates securities that appeal to two sets of investors, those who think interest rates will rise and those who think they will fall.

26. Prepayments and MBSs, CMOs, and REMICs
The price of structured mortgage products depends upon the expected cash flow
Realized cash flows depend upon the prepayment rate
The expected cash flows depend upon the assumed cash flow stream
The expected cash flow stream is known as the conditional cash flow stream because it is conditional on materialization of the assumed condition
The Public Securities Association has developed method of developing the expected cash flow for mortgage pools

27. More Complex Structured Securities Collateralized Debt and Loan Obligation
A type of asset backed security in which a special purpose vehicle owns a portfolio of wide variety of fixed-income assets
The SPV issues bonds to pay for these assets
These bonds have a ratings depending upon their claim against the cash flow from the vehicle’s assets
senior tranches (AAA)
mezzanine tranches (AA to BB)
equity tranches (unrated)
Losses are applied in reverse order of seniority
junior tranches offer higher coupons to compensate for the higher default risk

28. More Complex Structured Securities Other Collateralized Obligation
Collateralized Bond Obligations (CBO) Collateralized Loan Obligation (CLO) Collateralized Debt Obligations (CDO) Collateralized Fund Obligations (CFO) These are similar in structure, except that the holdings of each SPV each is limited to the type of assets in its name CDOs, in contrast, can hold almost any type of debt as an asset in the SPV

29. Credit Enhancements to Private MBS
Subordination or credit tranching Over collateralization Excess spread External Enhancements Surety Bond Wrapped security – a security insured by a third party LOC Cash collateral

30. Managing MBS Interest-rate Risk
A perfect hedge will always gain in value exactly what the investment portfolio loses and vice versa.
Creating a perfect hedge is equivalent of targeting duration of zero (i.e., the goal is complete insensitivity to changes in interest rates).

31. Managing MBS Interest-rate Risk (cont.)
An alternative goal might be to reduce the risk to an acceptable level, called target duration.
That is, an investor wants to take on less interest-rate risk but not zero interest-rate risk.

32. Managing MBS Interest-rate Risk (cont.)
Hedging MBS
with Treasury forwards
with Options
with Treasury Futures
Preference is for Treasury futures
Duration of Treasury bond is calculated the same as the duration of a bond in the cash market
Most MBS have a positive duration and the investor will need a short position to neutralize interest rate (price ) risk.
Because the correct hedge amount will change with interest rates, this is a dynamic hedge.
In contrast, a static hedge does not need to be adjusted as interest rates change.

33. Basis Risk
Basis risk is a possibility of the price of the risky security (an MBS) and the value of the hedge changing in an unexpected way.
When hedges are designed, the assumption generally made is that changes in the value of the hedge will exactly offset changes in the value of the risky security.
There may be a time when a risky security loses value and the hedge position doesn’t gain enough to make up for the loss.
No hedge is perfect!