FINANCING HOME OWNERSHIP-II
Chapter 11, Real Estate Principles: A Value Approach by Ling & Archer
Chapter 10, Fixed Income Analysis by Frank J. Fabozzi
OUTLINE
•Mortgage markets – secondary
•MBS: Creation & involved parties
• MBS: Types
•MBS: Valuation
•Prepayment modelling
• Credit Default Swaps (CDS)
SECURITIZATION: SECONDARY MORTGAGE MARKET
• Securitization is a process by which intangible and illiquid assets are monetized into cash.
Various types of contractual debts such as residential mortgages, commercial mortgages,
auto loans or credit card debt obligations are pooled and sold to 3rd party investors as
securities.
• 50 years back, if you got a mortgage loan from a bank, it was very likely that the bank would
keep the loan on its balance sheet until the loan was repaid. That is no longer true. Today, the
party/bank that you deal with in order to get the loan (the originator) is highly likely to sell
the loan to a 3rd party.
• The 3rd party can be Ginnie Mae, a government agency; Fannie Mae or Freddie Mac, which are
government sponsored entities (GSEs); or a private sector financial institution (Goldman
Sachs).
SECURITIZATION: SECONDARY MORTGAGE MARKET
• The secondary mortgage market plays a key role in securitization, as it provides a platform
for the sale of mortgage-backed securities.
• Once a pool of mortgages has been securitized, the securities can be bought and sold on the
secondary market, allowing investors to trade the securities among themselves.
• The price of these securities is determined by the market, based on factors such as interest
rates, credit risk, and investor demand and depending on the prevailing economic conditions
and investor sentiment.
• However, the securitization process can also lead to problems, such as lax underwriting
standards and a lack of transparency (financial crisis of 2008).
WHY ORIGINATORS ISSUE MBS (AKA MORTGAGE PASSTHROUGH OR JUST
PASSTHROUGH)
• Transform relatively illiquid, individual financial assets into liquid and tradeable capital market
instruments.
• Allow mortgage originators to replenish their funds, which can then be used for additional
origination activities.
• Frequently a more efficient and lo3231wer cost source of financing in comparison with other
bank and capital markets financing alternatives.
• Allow issuers to diversify their financing sources, by offering alternatives to more traditional
forms of debt and equity financing.
PARTIES INVOLVED IN MBS
• Borrower. The borrower is responsible for payment on the underlying loans and therefore
ensure the ultimate performance of the asset/mortgage-backed security.
• Originator. Originators create and often service the assets that are sold or used as collateral
for asset/mortgage-backed securities.
• Special purpose entity/Trustee. The SPE/trustee is a third party retained for a fee to
administer the trust that holds the underlying assets supporting an asset-backed security.
• Acting in a fiduciary capacity, the SPE/trustee is:
o Primarily concerned with preserving the rights of the investor.
o The trustee oversees the disbursement of cash flows, and monitors compliance with
appropriate covenants by other parties to the agreement.
o The trustee is responsible that the underlying assets produce adequate cash flow to
service the securities.
o The trustee is responsible for declaring an event of default or an amortization event.
• Credit Enhancer. Credit enhancement is a method of protecting investors if cash flows from the
underlying assets are insufficient to pay the interest and principal due for the security in a
timely manner.
o Credit enhancement is used to improve the credit rating, and therefore the pricing
and marketability of the security.
• Underwriter. The asset-backed securities underwriter is responsible for advising the seller on
how to structure the security, and for pricing and marketing it to investors.
• Investors. The largest purchasers of securitized assets are typically
o pension funds, hedge funds
o insurance companies,
o fund managers, and, to a lesser degree,
o commercial banks.
• The most compelling reason for investing in asset-backed securities has been their high rate
of return relative to other assets of comparable credit risk.
MBS: PASSTHROUGH /AGENCY PASSTHROUGH SECURITIES
• Pass-Through Securities: Pass-through securities are the most basic and common type of MBS.
• They represent a direct ownership interest in a pool of mortgage loans. The cash flows from the
underlying mortgages, including principal and interest payments, are passed through to the
investors on a pro-rata basis.
• Passthrough securities are typically issued by government-sponsored enterprises (GSEs) such
as Fannie Mae and Freddie Mac in the United States.
AGENCY PASSTHROUGH
• An agency can provide one of two types of guarantees:
① One type of guarantee is the timely payment of both interest and principal even if some of
the mortgagors fail to make their monthly mortgage payments. Pass-throughs with this type
of guarantee are referred to as fully modified pass-throughs.
② The second type also guarantees both interest and principal payments, but it guarantees only
the timely payment of interest. The scheduled principal is passed through as it is collected,
with a guarantee that the scheduled payment will be made no later than a specified date.
Passthroughs with this type of guarantee are called modified passthroughs.
CASH FLOW CHARACTERISTICS OF MBS
• The cash flow of a mortgage passthrough security depends on the cash flow of the underlying
pool of mortgages.
• The cash flow consists of monthly mortgage payments representing interest, the scheduled
repayment of principal, and any prepayments.
• The passthrough rate (coupon rate) is less than the mortgage rate on the underlying pool of
mortgages by an amount equal to the servicing and guaranteeing fees.
• The monthly mortgage payment is due from each mortgagor on the first day of each month, but
there is a delay in passing through the corresponding monthly cash flow to the security holders.
CASH FLOW CHARACTERISTICS OF MBS: WAC & WAM
• Not all the mortgages that are included in a pool of mortgages that are securitized have the
same mortgage rate and the same maturity.
• Consequently, when describing a passthrough security, a weighted-average coupon rate and a
weighted-average maturity are determined.
• A weighted-average coupon rate (WAC) is found by weighting the mortgage rate of each
mortgage loan in the pool by the amount of the mortgage outstanding.
• A weighted-average maturity (WAM) is found by weighting the remaining number of months
to maturity for each mortgage loan in the pool by the amount of the mortgage outstanding.
COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS)
• Pass-throughs does not fully address the different needs of investors for instruments with
various maturities.
• While pension funds and life insurance companies looked for securities with long maturity,
banks and thrifts wanted to invest in shorter term instruments.
• As an answer to those drawbacks and the demands of different types of investors,
Collateralized Mortgage Obligations (CMOs) were created.
• The mortgage cash flows are distributed to investors by the CMO issuer based on a set of
predetermined rules. Some investors will receive their principal payments before others
according to the schedule.
CMOS TYPES: PAC
•Planned Amortization Class (PAC). A PAC tranche uses something like a sinking fund in a fixed
principal-payment schedule that directs cash-flow irregularities caused by varying
prepayments away from the PAC tranche and toward a “companion” or “support” tranche.
•PAC payment schedules are protected by priorities, which
assure investors that PAC payments are first in line to be met as principal payments are made on
the underlying mortgage loans.
•If prepayments are slow, the PAC will receive principal first and the companion will wait. If
prepayments are fast, the PAC will get only what is scheduled, and the companion class will
absorb the rest.
MBS: PAC EXAMPLE
• Suppose there is a mortgage pool with a total principal balance of $100 million. This mortgage
pool consists of 1,000 individual mortgage loans, each with a term of 30 years and an interest
rate of 4%.
• The mortgage pool is used to create a CMO with the following tranches:
• Planned Amortization Class (PAC) Tranche: This tranche is designed to provide a stable and
predictable cash flow pattern. Let's assume the PAC tranche has a total principal balance of
$80 million.
• Support Tranche: The support tranche, also known as the companion tranche, is created to
absorb prepayment and extension risk. In this example, the support tranche has a total
principal balance of $20 million.
CMO TYPES: Z TRANCHE
• A Z-tranche, also known as an accrual tranche or Z bond, is a type of collateralized mortgage
obligation (CMO).
• It receives no current cash flow in the form of interest or principal payments. Instead, it accrues
interest over time and receives its cash flow after other tranches in the CMO structure have been
paid off.
• Once all the other tranches in the CMO structure have been paid off, the cash flow stream is
directed to the Z-tranche. At this point, the accrued interest is paid first, and then the Z-tranche
begins to receive its principal payments.
• To compensate for this delay in cash flows, the z-tranche has a higher coupon rate than other
tranches.
MBS: TYPES
• Stripped Mortgage-Backed Securities: Stripped MBS are securities that separate the principal
and interest cash flows of the underlying mortgages into separate securities. The most
common types of stripped MBS include:
• Interest-Only (IO) Securities: IO securities represent the right to receive only the interest
payments from the underlying mortgages. They do not receive any principal payments.
• Principal-Only (PO) Securities: PO securities represent the right to receive only the principal
payments from the underlying mortgages. They do not receive any interest payments.
• Commercial Mortgage-Backed Securities (CMBS): CMBS are MBS backed by a pool of
commercial real estate mortgages, such as office buildings, shopping centers, or industrial
properties. CMBS allows investors to participate in the cash flows generated by the underlying
commercial mortgages.
• Residential Mortgage-Backed Securities (RMBS): RMBS are MBS backed by a pool of
residential mortgages. They can be further categorized based on the type of residential
mortgages, such as prime, subprime, or Alt-A mortgages.
VALUATION OF PASS-THROUGH SECURITIES
• Cash Flow Analysis: The cash flows generated from the underlying assets are the primary
determinant of the value of pass-through securities.
• The valuation involves projecting future cash flows based on factors such as interest rates,
prepayment rates, default rates, and recovery rates.
• These projected cash flows are then discounted to present value using an appropriate discount
rate.
• Market Comparables: Market prices and yields of similar passthrough securities can provide a
reference point for valuation.
• Prepayment: Prepayment is a significant risk in pass-through securities, as borrowers have
the option to pay off their loans early.
• Valuation models incorporate prepayment assumptions based on historical data, current
interest rates, and other relevant factors.
• Various prepayment models, such as the Single Monthly Mortality (SMM) or Conditional
Prepayment Rate (CPR), are used to estimate the timing and magnitude of prepayments.
• Credit Risk Assessment: Valuation models incorporate assumptions regarding default rates,
loss severity, and recovery rates to evaluate the credit risk exposure of the pass-through
security.
• Market Conditions: The valuation of pass-through securities is influenced by market
conditions such as interest rates, economic outlook, and liquidity. Changes in interest rates
can impact the present value of future cash flows, and market liquidity can affect the ease of
trading and pricing of the securities.
PREPAYMENT RISK FOR PASS-THROUGH SECURITIES
• If the borrower pays more than the monthly scheduled payment, the extra payment will be used
to pay down the outstanding balance faster than the original amortization schedule, resulting in
a prepayment.
• If the outstanding balance is paid off in full, the prepayment is a “complete prepayment”; if
only a portion of the outstanding balance is prepaid, the prepayment is called either a “partial
prepayment” or “curtailment.”
• A commonly used methodology for projecting prepayments and the cash flow of a pass-through
assumes that some fraction of the remaining principal in the pool is prepaid each month for the
remaining term of the mortgage.
• The prepayment rate assumed for a pool, called the conditional prepayment rate (CPR). It is
referred to as a conditional rate because it is conditional on the remaining mortgage balance.
PREPAYMENT MODELLING
• Some commonly used prepayment models to be covered in the course are:
• Single Monthly Mortality (SMM) Model: The SMM model measures the rate at which loans
within an MBS pool are expected to prepay each month. It expresses prepayment speeds as a
percentage of the outstanding mortgage pool balance.
• Conditional Prepayment Rate (CPR) Model: The CPR model is similar to the SMM model but
expresses prepayment speeds as an annualized rate.
• Public Securities Association (PSA) Model: The PSA model, is a widely used prepayment
model that provides a standard benchmark for estimating prepayment speeds. It assumes a
linear relationship between changes in interest rates and prepayment speeds.
SINGLE MONTHLY MORTALITY RATE: EXAMPLE…
•Therefore, if a mortgage loan prepaid at 1% SMM in a particular month, this means that 1% of
that month’s scheduled balance (last month’s outstanding balance minus the scheduled
principal payment) has been prepaid.
•There are two ways in which the SMM can be used.
•First, given the prepayment for a month for a mortgage pool, an investor can calculate the
SMM as we just did in our illustration.
•Second, given an assumed SMM, an investor will use it to project the prepayment for a month.
The prepayment for a month will then be used to determine the cash flow of a mortgage pool
for the month.
PREPAYMENT CALCULATION: EXAMPLE
• Mr. X is looking at the historical prepayment for a pass-through security. He finds the
following:
mortgage balance in month 42 = $260,000,000
scheduled principal payment in month 42 = $1,000,000
prepayment in month 42 = $2,450,000
a. What is the SMM for month 42?
b. How should Mr. X interpret the SMM computed?
c. What is the CPR for month 42
d. How should Mr. X interpret the CPR computed?
PSA PREPAYMENT MODEL
• The basic PSA (Public Securities Association ) model assumes that prepayment rates are low
for newly originated mortgages and high for seasoned or old mortgages.
• The PSA standard benchmark assumes the following prepayment rates for 30-year
mortgages:
o A CPR of 0.2% for the first month, increased by 0.2% per month for the next 29
months when it reaches 6% per year.
o A 6% CPR for the remaining years.
• This benchmark, referred to as “100% PSA” or simply “100 PSA.”
PSA PREPAYMENT MODEL
•Mathematically, 100 PSA can be expressed as follows:
If t ≤ 30 then CPR = 6% × (t/30)
If t > 30 then CPR = 6%
•where t is the number of months since the mortgage was originated.
•Slower or faster speeds are then referred to as some percentage of PSA. For example, 50 PSA
means one-half the CPR of the PSA benchmark prepayment rate; 150 PSA means 1.5 times the
CPR of the PSA benchmark prepayment rate.
•A ‘0’ PSA means that no prepayments are assumed.
DELINQUENCY AND DEFAULT MEASURES
• When a borrower fails to make one or more timely payments, the loan is said to be delinquent.
• When the underlying pool of assets is mortgage loans, the two commonly used methods for
classifying delinquencies are those recommended by the Office of Thrift Supervision (OTS) and
the Mortgage Bankers Association (MBA).
• The OTS method uses the following loan delinquency classifications:
‡Payment due date to 30 days late: Current
‡30–60 days late: 30 days delinquent
‡60–90 days late: 60 days delinquent
‡More than 90 days late: 90+ days delinquent
• The MBA method is a somewhat more stringent classification method, classifying a loan as 30
days delinquent once payments are not received after the due date.
CONTRACTION AND EXTENSION RISK
• The basic property of fixed-income securities that its price is negatively related to interest rate.
• When interest rate falls, the price of a bond should increase.
• But in the case of a pass-through security, the rise in price will not be as large as that of a
bond because a fall in interest rates increases the borrower’s incentive to prepay the loan and
refinance the debt at a lower rate.
• Thus, the upside price potential of a pass-through security is truncated/reduced because of
prepayments.
• The second adverse consequence is that the cash flow must be reinvested at a lower rate.
These two adverse consequences when mortgage rates decline are referred to as contraction
risk.
CONTRACTION AND EXTENSION RISK
• When the interest rate goes up price of the passthrough, like the price of any bond, will decline.
• But again, pass-through price will decline more because the higher market rates will tend to
slow down the rate of prepayment, in effect, increasing the amount invested at the coupon rate,
which is lower than the market rate.
• Prepayments will slow down because homeowners will not refinance or partially prepay their
mortgages when mortgage rates are higher than the contract rate.
• Of course, this is just the time when investors want prepayments to speed up so that they can
reinvest the prepayments at the higher market interest rate. This adverse consequence of rising
mortgage rates is called extension risk.
PASSTHROUGH VALUATION:EXAMPLE
• Let's consider an example of cash flow analysis for a passthrough security backed by a pool
of mortgage loans. Here are the details:
• Pool of Mortgage Loans:
• Total loan pool balance: $100 million
• Interest rate on loans: 4%
• Loan term: 30 years
• Monthly principal and interest payments from borrowers: $500,000
CREDIT DEFAULT SWAP (CDS)
• A credit default swap (CDS) is a derivative contract where one party (the protection buyer)
makes premium payments (spread) to another party (the protection seller) in exchange for
protection against the default of a particular debt instrument or reference entity.
• The reference entity can be a corporate bond, a loan, or even a mortgage-backed security.
• For short-dated transactions, the premium may be paid up front. Otherwise, the it is paid
over the life of the transaction.
• If a credit event occurs, such as a default or downgrade, the protection seller pays the
protection buyer a predetermined amount.
• The contract is typically specified using the confirmation document and legal definitions
produced by the International Swap and Derivatives Association (ISDA).
• Credit default swaps can be used for hedging or speculative purposes.
• Investors who hold the underlying debt instrument may use CDS to hedge against the risk of
default.
• On the other hand, speculators who do not own the underlying debt can use CDS to bet on the
creditworthiness of a particular issuer.
• They can buy or sell CDS contracts without owning the actual debt instrument, allowing them
to profit from changes in credit risk.
• CDS became popular in the early 2000s, and by 2007, the outstanding credit default swaps
value stood at $62.2 trillion.
CREDIT DEFAULT SWAP (CDS): TERMS TO KNOW
• Credit default swaps (CDS) are a type of insurance against default risk by a particular company.
The company is called the reference entity and the default is called credit event.
• Credit event: Bankruptcy, Failure to Pay, Restructuring
• Premium/Spread: The premium paid by the protection buyer to the seller, often called
“spread,” is quoted in basis points per annum of the contract’s notional value and is usually
paid quarterly.
• Size & Maturity: There are no limits on the size or maturity of CDS contracts. However, most
contracts fall between $10 million to $20 million in notional amount. Maturity usually ranges
from one to ten years, with the 5-year maturity being the most common tenor.
CREDIT EVENTS/TRIGGER EVENTS
• ISDA’s standard documents for CDS provide for six kinds of credit/trigger events. However,
market participants generally view the following three to be the most important:
• Bankruptcy, the clearest concept of all, is the reference entity’s insolvency or inability to repay
its debt.
• Failure-to-Pay occurs when the reference entity, after a certain grace period, fails to make
payment of principal or interest.
• Restructuring refers to a change in the terms of debt obligations that are adverse to the
creditors.
CDS: EXAMPLE…
• It is a $50 million, 3-year default swap linked to Ford Motors.
• The cost of the protection is 33 bp per annum paid quarterly.
• The size of cash flow per quarter (premium)
= 50 million × 0.0033 × 0.25 = 41,250.
• If default occurs and the recovery rate on the defaulted asset is 50% of the face value, then the
protection buyer receives 25 million
CREDIT DEFAULT SWAP: OVERHEDGING
• A default swap is a par product: it does totally not hedge the loss on an asset that is currently
trading away from par.
• If the asset is trading at a discount, a default swap overhedges the credit risk and vice-versa.
• This becomes especially important if the asset falls in price significantly without a credit event.
• To hedge this, the investor can purchase protection in a smaller face value or can use an
amortizing default swap in which the size of the hedge amortizes to the face value of the bond
as maturity is approached.
CDS: SETTLEMENT
• The first step taken after a credit event occurs is a delivery of a “Credit Event Notice,” either by
the protection buyer or the seller.
• Then, the compensation is to be paid by the protection seller to the buyer via either:
• Physical Settlement: In a physical settlement, the protection seller buys the distressed loan or
bond from the protection buyer at par. Here the bond or loan purchased by the seller of
protection is called the “deliverable obligation.” Physical settlement is the most common form
of settlement in the CDS market, and normally takes place within 30 days after the credit event.
• Cash Settlement: The payment from the seller of protection to the protection buyer is
determined as the difference between the notional of the CDS and the final value of the
reference obligation for the same notional.
• Cash settlement is less common because obtaining the quotes for the distressed reference credit
often turns out to be difficult. A cash settlement typically occurs no later than five business days
after the credit event.
CDS AND THE PUT OPTION
• The premium paid by the protection buyer to the seller, often called “spread,” is quoted in basis
points per annum of the contract’s notional value and is usually paid quarterly.
• Note that these spreads are NOT the same type of concept as “yield spread” of a corporate bond
to a government bond. Rather, CDS spreads are the annual price of protection quoted in bps of
the notional value, and not based on any risk-free bond or any benchmark interest rates.
• Periodic premium payments allow the protection
buyer to deliver the defaulted bond at par or to receive the difference of par and the bond’s
recovery value.
