Chapter 11

Mortgage Derivative Securities and Structured

Finance

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Chapter 11 Learning Objectives

Understand the valuation of mortgage securities

Understand cash flows from various types of mortgage securities in terms of their amount and timing

Understand how changes in interest rates affect mortgage securities values

Understand how prepayment and default assumptions affect the cash flows of mortgage securities

Understand how mortgage securities can be used to hedge against interest rate risk

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Mortgage-Derivative Security Any security for which the cash flows derived from

mortgages are rearranged in terms of amount and timing Do not include pass-throughs Different from traditional debt securities in that:

Both the timing and the amount of future expected cash flows are dependent on changes in the rate of interest

Interest rate contingent securities Valuation of mortgage-derivative securities more complicated

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Traditional Debt Security Valuation

Typically fixed, semi-annual interest payments with face value paid at maturity

Value moves inversely with market interest rates

Yield to maturity at a given point in time is based on current market value

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Valuation of Traditional Debt Security - Example

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Traditional Debt Securities Sensitivity of prices to changes in interest rates are

measured by the security’s duration Duration (D) given by the following relationship

The principles of valuation, YTM, and sensitivity of prices to changes in interest rates can be very different fro MRSs

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Mortgage-Related Security

Cash flows have three components: interest, principal amortization, and prepayments

Total principal on mortgage pool is constant but principal payments may be accelerated or delayed based on changes in market rates

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Mortgage-Related Securities

Market rates rise, mortgage prepayment slows down as borrowers hold onto low-rate loans

Market rates decline, mortgage prepayment increases due to refinancing

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Mortgage Pass-Throughs

The rate of mortgage prepayment is crucial in pass-through valuation

Several models of expected prepayment: FHA Twelve-Year Prepaid Life

Constant Prepayment Rate

FHA Experience

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Mortgage Pass-Throughs (Cont.)

Prepayment models (cont.): Public Securities Association (PSA) Model

Current industry standard

Combines FHA experience with CPR model

PSA benchmark assumes that the annual CPR on a monthly basis is 0.2 percent in the first month; months 2-30 increases by 0.2 percent/month; after month 30 – 6 percent

Econometric Prepayment Models

Refinancing Models

Based on title search activity which precedes refinancing

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PSA and Multiples of PSA

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Changes in Interest Rate and Prepayment Behavior The interest rate differential between the current market rate

and that on the pool is the single most important determinant of prepayments.

If current rate is above contract rate borrowers have little incentive to prepay

Regardless of the size of the positive differential, prepayment will occur at a uniformly slower pace, driven by non-economic factors (job relocation, divorce)

When market rates fall below the contract rate, prepayments accelerate until a sufficiently large negative differential is reached at which point they level off

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Interest Rate Differential and Prepayment Rates

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Pass-Throughs

No rearranging of the cash flows from the mortgage pool

Prepayments have a significant impact on the timing of cash flows and thus the value of those cash flows

If selling at a discount, accelerated (delayed) prepayment increases (decreases) the realized yield

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Pass-Throughs

For pass-throughs selling at a premium, delayed prepayment increases yield and accelerated prepayment decreases yield

Coupon rates reflect market rates at time of issue

High coupon pass-throughs suffer price compression due to prepayment expectations

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Pass-Throughs

Changes in market rates have two impacts on pass-through value: both the discount rate and the assumed prepayment will change

In senior/subordinated pass-throughs the senior security has enhanced rights to cash flows and subordinated security bears all the default risk

The duration of pass-throughs is impossible to measure because of the uncertain prepayments Possible to determine effective (implied) duration by observing price behaviors of various

pass-throughs in response to changes in interest rates

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Mortgage-Backed Bonds

Cash flows are structured as traditional non-callable debt with periodic interest payments and face value at maturity

Seek to be sufficiently over collateralized

Cash flows not paid to investors are placed in a sinking fund

Financial rating based on amount of overcollateralization

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Mortgage-Backed Bonds

Overcollateralization is related to the balance in the sinking fund

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

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Collateralized Mortgage Obligations

Cash flows are made up of various tranches and residual class

Any mortgage prepayments are passed to bondholders thus there is no sinking fund

This means that the CMO issuer faces no interest rate or reinvestment risk

Yield is higher on longer tranches

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Collateralized Mortgage Obligations

CMOs are structured differently from pass-throughs thus prepayment behavior affects pricing and yield differently

Price and yield on shorter-term tranches will not vary as much with prepayment as compared to pass-throughs

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Strips

Cash flows may be rearranged to produce principal-only and interest-only strips

Principal-only (PO) strips receive all principal payments when they are received

Amount of principal equals the initial pool balance but the timing is unknown

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Strips

If prepayment accelerates, principal is returned faster

Interest-only strips receive the interest when it is paid

Total amount of interest is not known but is based on principal outstanding

Accelerated prepayment reduces principal and reduces interest amount

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Strips

Thus accelerated prepayment may be advantageous for PO investors and disadvantageous for IO investors

A change in market interest rates changes the discount rate used to value securities and alters prepayment behavior

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Strips

PO Strip: Interest rate goes up, discount rate goes up, prepayment goes down and net effect is value goes down

IO Strip: Interest rate goes up, discount rate goes up, prepayment goes down and net effect is value goes up

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Floters

Floaters are classes of a CMO that have a rate that moves with the market

These are matched with an institution’s short-term liabilities that move with the market

The interest rate on the floater is usually pegged to some short-term rate such as LIBOR

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Floters

Since rate is variable, there is a risk of loss if market rates risk significantly

To solve this problem an inverse floater is created out of the same tranche

Inverse floater is a bond on which the interest rate moves opposite to the market rate

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Servicing Rights

Lenders sell off loans and often retain the servicing rights

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

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Servicing Rights

Revenue from servicing includes the servicing fee, float on the escrow accounts, and float between receipt of monthly payments and payments to purchasers

Costs include administrative costs and overhead

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Servicing Rights

Fee is usually between 0.25 and 0.50 percent of the mortgage balance

Value is affected by interest rate changes similar to IO strips

Rates rise, discount rate goes up and prepayment accelerates. Combines to reduce the value of servicing rights

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Excess Servicing Rights

Excess servicing rights are fees greater than “normal”

Usually occurs when mortgages are sold with a promised rate less than the coupon on the mortgages

The greater the spread, the larger the excess servicing fees

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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

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Value Creation in MBSs

Value is created even though no additional cash flow is created

Securitization eliminates liquidity risk and makes the market larger

Securitization rearranges the cash flows into more and less risky components

Asymmetric information may distort values - lenders may have superior

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