Mortgage -Backed Securities

1 giddy /ABSM ortgage -Backed Securities /1 Mortgage -Backed SecuritiesProf. Ian GiddyStern School of BusinessNew York UniversityAsset -Backed SecuritiesCopyright 1999 Ian H. GiddyMortgage -Backed Securities 3 Mortgages and MBSlMortgage LoanslPass-throughsand PrepaymentslCMOslAnalysis of MBS Pricing and ConvexityGiddy/ABSM ortgage -Backed Securities /2 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 4 Structure of the US MBS MarketMortgage LoanBank ( Mortgage originator) makes a whole loanAncillary: brokers,servicers, insurersMortgage LoanBank ( Mortgage originator) makes a whole loanAncillary: brokers,servicers, insurersMortgage Pass-ThroughFNMA or GMAC (conduit) poolsmortgage loans with similar characteristicsMortgage Pass-ThroughFNMA or GMAC (conduit)

2 Poolsmortgage loans with similar characteristicsCMO or REMICT akes a Mortgage pool and makes the cash flows more predictable by assigningpriority of claims to the cash flowsCMO or REMICT akes a Mortgage pool and makes the cash flows more predictable by assigningpriority of claims to the cash flowsMBS PortfolioInstitutional investor evaluates risk/return behavior of Mortgage -Backed Securities throughoption-adjusted price and spread analysisMBS PortfolioInstitutional investor evaluates risk/return behavior of Mortgage -Backed Securities throughoption-adjusted price and spread analysisMortgage StripsInterest-Only and Principal-OnlyMortgage StripsInterest-Only and Principal-OnlyCopyright 1999 Ian H.

3 GiddyMortgage -Backed Securities 5US Mortgage -Backed SecuritiesINTERESTINTERESTPRINCIPALPRINC IPALPREPAYMENTPREPAYMENTGNMA MBS(USGovt g'tee)GNMA MBS(USGovt g'tee)INTERESTINTERESTPRINCIPALPRINCIPAL PREPAYMENTPREPAYMENTC redit enhancement:nCorpg'teenL/CnInsurance (FSA)nSenior/sub debtCredit enhancement:nCorpg'teenL/CnInsurance (FSA)nSenior/sub debtAGENCYPASS-THROUGHSPRIVATE-LABELPASS -THROUGHSGRANTOR TRUSTSTRUCTUREGRANTOR TRUSTSTRUCTUREGRANTOR TRUSTSTRUCTUREGRANTOR TRUSTSTRUCTUREFHLMC PCFNMA MBS(US Agencyg'tee)FHLMC PCFNMA MBS(US Agencyg'tee) giddy /ABSM ortgage -Backed Securities /3 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 6 Form of cash flow allocationPass-throughobligationPay-thro ughobligationDifferenttranchesPAC(planne daamortizationclass)TAC(targeted amortization plan)IO/PO stripsCopyright 1999 Ian H.

4 GiddyMortgage -Backed Securities 7 Mortgage -Backed SecuritiesprepayableEqual monthly poolsecuritynMortgage -Backed Securities areprepayable, so one cannot measure returns or values easilynThey tend to pay down early when rates fall, and later when rates Securities /4 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 8 Mortgage PrepaymentsComplexity of the option -lSystematic risk: exercise of the interest rate optionlUnsystematic risk: reasons unrelated to Mortgage interest rates (egdemographic)Copyright 1999 Ian H. GiddyMortgage -Backed Securities 9 Mortgage Pool Prepayment ConventionsTraditional method is to forecast prepayments by adjusting the PSA (Public Securities Association) benchmark of a prepayment rate that reaches 6% a year for 30 year prepayment rate (CPR):100% PSA:If t<=30 CPR=6%t/30If t>30 CPR=6%170% PSA:If t<=30 CPR=170%[6%t/30]If t>30 CPR=170%[6%]Monthly prepayment rate (SMM):SMM=[1-(1-CPR)]/12 Prepayment amount in dollars:= (Beginning Principal Balance -Scheduled Principal Repayment)*SMMG iddy/ABSM ortgage -Backed Securities /5 Copyright 1999 Ian H.

5 GiddyMortgage -Backed Securities 10 Prepayment AssignmentlConsider a $100,000 10-year, 9% Mortgage loan, with monthly equal the following calculations, using a computer spreadsheet or financial are the scheduled monthly payments? 1 month and 3 months,uWhat is the CPR and SMM, assuming 200% PSA?uWhat is scheduled principal payment?uIf it pays down at 200% PSA, what is the prepayment amount?uWhat is the remaining principal balance?Copyright 1999 Ian H. GiddyMortgage -Backed Securities 11 CMOsand StripsThe technique:lAllocate cash flows (interest & principal) of MBS to mitigate prepayment risklPay different returns based on risklThe sum of the part should be worth more than the whole : MDC Series J CMO with underlying pool WAC , 297 months final maturityGiddy/ABSM ortgage -Backed Securities /6 Copyright 1999 Ian H.

6 GiddyMortgage -Backed Securities 12 CMOsand StripslFirst-priority classeslZ-class: last to be paid offlFloating/inverse floatingCMOslPlanned Amortization Class bonds (PACs) andTACslCompanions with priority schedules (PACIIs)lVADM bonds (use early principal and interest to pay priority bondholders)lCMO residuals (collateral interest -CMO interest)lIOsand POsCopyright 1999 Ian H. GiddyMortgage -Backed Securities 13 The Negative Convexity of MBSS ecurities backed by fixed-rate mortgages have "negative convexity." This refers to the fact that when interest rates rise, the MBS behave like long-term bonds (their prices fall steeply); but when rates fall, their prices rise slowly or not at curve of 20year bond callable in 3years 20-year3-yearCallable bondGiddy/ABSM ortgage -Backed Securities /7 Copyright 1999 Ian H.

7 GiddyMortgage -Backed Securities 14 Convexity ofCallablesMortgage -Backed Securities and other callable bonds may have negative convexity which cushions a bond s price rise and accelerates its fall!PRICEYIELD100102 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 15 MBS: Fannie Mae REMIC Pass-ThroughslWhat are the underlying Mortgage pools?lLook at different asset groups:lYields on different classeslPrice risks on each classlWhat do the seller &servicergain?Group workGiddy/ABSM ortgage -Backed Securities /8 Bond Valuation,Duration and ConvexityCopyright 1999 Ian H. GiddyMortgage -Backed Securities 17 Bond ValuationThe formula for a bond s price isBIxPVIFAMxPVIFBIkMkknntntn00111=+=+++= ()()()(), giddy /ABSM ortgage -Backed Securities /9 Copyright 1999 Ian H.

8 GiddyMortgage -Backed Securities 18 TreasuriesRate6 Maturity, Mo/YrDec 97 Bid Asked99:29 99:31 Ask Notes and Bondsas quoted in the Wall Street JournalnWhen US Government bonds are stripped, the coupons and principal are separated out and sold as individual zero-coupon instrumentsnInvestment banks create Strips when the total can be sold for more than the cost of the 1999 Ian H. GiddyMortgage -Backed Securities 19 Price Risk of TreasuriesTreasuries differ:lLiquidity -traders quote wider bid-ask spreads for illiquid bondslDuration -sensitivity of price to a change in interest rates -is based on the bond s coupon levels and maturity date (low duration means less risky)lConvexity -measures how duration changes with a change in rates (high convexity is desirable) giddy /ABSM ortgage -Backed Securities /10 Copyright 1999 Ian H.

9 GiddyMortgage -Backed Securities 20 The Price-Yield RelationshipBond prices and interest rates have an inverse relationship:PRICEYIELD(RATE)9%100 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 21 The Price-Yield RelationshiplSelling at a discountis when a bond sells for less than its par value ( , the quote is <100)lSelling at premiumis when a bond sells for more than its par value ( , the quote is >100)1009%Price of a 9% bondGiddy/ABSM ortgage -Backed Securities /11 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 22 MaturityIn general, the longer the maturity, the more sensitive is a bond s price to interest-rate changes, other things being equal:PriceRequiredyield9%,5 year9%,25 year8%9%10% 1999 Ian H.

10 GiddyMortgage -Backed Securities 23 The Coupon three bonds with the samematurity can have very different sensitivities, depending on their couponlevels:PriceRequiredyield9%,5 year6%,5 year0%,5 year8%9%10% Securities /12 Copyright 1999 Ian H. GiddyMortgage -Backed Securities 24 DurationDuration measures the % price change for a given change in yield:PRICEYIELD9%100 The steeper the line, the more the price falls for a given rise in yieldCopyright 1999 Ian H. GiddyMortgage -Backed Securities 25 Greater Duration, Greater RiskDuration is measured as the PV-weighted average life, so low-coupon bonds have greater durationPRICEYIELD9%1006% BOND9% BOND0% BONDG iddy/ABSM ortgage -Backed Securities /13 Copyright 1999 Ian H.