Securitization (2nd Semester 2024) PDF

Definition of pass through prepayment and pass through  Securitization (Cornett and Saunders Chapter 26)  What is Securitization? Securitization: Packaging and selling of loans and other assets backed by securities. Many types of loans and assets are being repa...

Definition of pass through prepayment and pass through  Securitization (Cornett and Saunders Chapter 26)  What is Securitization? Securitization: Packaging and selling of loans and other assets backed by securities. Many types of loans and assets are being repackaged in this fashion including royalties on recordings ( David Bowie, Rod Stewart). Original use was to enhance the liquidity of the residential mortgage market. Three essential elements of securitization: packaging, creation of securities (ABS: asset backed security) and transfer of the ownership of securities Securitization involves packaging the loan with other loans of similar characteristics, creating credit- enhanced claims and then selling these claims to investors. While loan sale dates back to the 19 th century, securitization was invented relatively recently in 1970 when GNMA developed GNMA pass-through. These GNMA pass-through is collateralized by Federal Housing Association (FHA) and Veterans Administration (VA) single-family mortgage loans. The S&L industry has been involved in securitizing for about 25 years. On the other hand, commercial banks start securitizing businesses only after 1985. Bank of America issued the first private-sector pass- through which is backed by conventional mortgages in 1977. But, the securitizing of various types of loans started only after 1985. 3  What is Securitization? Why the process of securitization starts with packaging assets with similar characteristics? Standardization will alleviate the information gaps between investors and loan originators, reducing adverse selection costs. (HLT loan is hard to securitize.) Issuer can reduce the risk of securitized instruments by diversifying the portfolio of underlying assets. For instance, mortgagees in different geographical areas are less likely to default together. By geographically diversifying the mortgage portfolio, issuer can reduce the risk inherent in securitized instruments. By transferring the ownership of loans it has originated, a bank can reduce their interest rate exposure gaps Traditional Lending Model (Originate-to-Hold Model) Risk Originati Funding Servicing Processi Credit on (the (the (the ng (the Culture broker) lender) collector) guaranto r) Lending transaction is a bundle of following distinct services relating to credit transactions. Origination (the broker) The activities of initiating a loan to a borrower Funding (the lender) The actual extension of the loan after an affirmative decision is reached in the credit analysis Servicing (the collector) Collecting loan repayments and keeping records Risk Processing (the guarantor) Post-lending monitoring to control default risk Credit Culture The bank’s organizational design, reporting arrangements, communication practices and incentive schemes for credit officers  Traditional Lending Model (Originate-to-Hold Model) Traditionally, one bank has offered all these five activities, so that lending can be decomposed into five distinct activities has been ignored. But, it is possible that a bank is specialized in only some activities – some bank may be specialized in originating loans but do not fund the loans. Then, why banks have traditionally offered all these five activities and combine them into one activity? Funding advantage due to regulation 1. Depository institutions enjoyed an advantage in funding due to the existence of deposit interest rate ceilings, low deposit insurance premium, entry restrictions and various tax advantages. By combining funding with originating loans (funding loans they originate by deposits), banks made huge profits. 2. However, in the 1970s, high inflation increased drastically the opportunity costs of deposit holding. Households switched from deposit to money market mutual funds which yielded higher returns. 3. In the 1980s, deposit interest rate ceilings were removed. Deposit interest rate started rising. Bank’s advantage in funding was eroded. 4. Furthermore, entry barriers into the banking industry began to scramble, tax benefits began to disappear and deposit insurance premium rose and Basel Accord imposed capital requirements. All these increased bank’s funding costs. 5. On the other hand, bank’s specialized ability to originate loans is still superior to other types of financial institutions. 6. Therefore, banks are engaged in origination of loans but relegate funding of the loans to other investors or financial institutions. This leads to a different business model of banking – originate-to-distribute model. 6  Traditional Lending Model (Originate-to-Hold Model) Another factor which contributes to emergence of originate-to-distribute model is advances in information technology. To buy securitized instruments, investors must be able to access the information about payoff attributes of the loans. Advances in information technology helps reduce the information gap between investors and the originator of loans.  Traditional Lending Model (Originate-to-Hold Model) It is important to understand that lending is actually decomposable. For example, suppose a bank were to specialize in the processing of interest rate and credit risk, along with the provision of brokerage services. It could restrict itself to writing letters of credit and loan commitments, avoiding deposits and earning assets altogether.  Example: Securitization versus funding loan portfolios Suppose the North American Bank has originated a portfolio of loans. North American knows that the aggregate payoff on this portfolio will be $100 with probability 0.9 and $30 with probability 0.1. Call this portfolio A. Investors, however, are unable to distinguish between this portfolio and another loan portfolio, call it B, that has an aggregate payoff of $100 with probability 0.7 and $30 with probability 0.3. Investors believe that there is a 0.5 probability that the portfolio is A, and an equal probability that it is B. The cost to the bank of communicating the “true” value of its loan portfolio is $11. Also, North American’s net profit from loan origination and servicing is 1% of the value of the securitized loan portfolio, whereas if the loans are kept on the books and funded by the bank, the bank’s net profit is 2% of the “true” value of the loan portfolio minus a fixed cost of 99 cents associated with funding. Will North American prefer to securitize or fund its loan portfolio? Does your answer change if the communication cost drops from $11 to $2?  Example: Securitization versus funding loan portfolios Answer: First, we will show that if North American decides to sell/securitize its loan portfolio, it will prefer to do so without communicating information to investors since the cost of communication exceeds the benefits of revelation. Having shown that securitization without communication dominates securitization with communication, in Step 2 we show that North American prefers to fund the loan rather than securitize it without communication. Finally, in Step 3 we show that North American prefers to securitize with communication if the communication cost drops from $11 to $2.  Example: Securitization versus funding loan portfolios First, we compute the value of the “pooled” portfolio, that is, the price at which the bank can sell or securitize the portfolio without any information communication. Given risk neutrality, the bank offering portfolio A will be able to sell it for the average of the values of portfolios A and B, that is, at  Example: Securitization versus funding loan portfolios Then, it is apparent that it does not pay for North American to reveal its true portfolio quality to investors, since its net payoff from doing so is $93 (the privately known value of its loan portfolio) minus $11 (the cost of information communication), which equals $82, whereas the “pooling value” of its loan portfolio is $86. Thus, securitization without communication dominates securitization with communication.  Example: Securitization versus funding loan portfolios Step 2 You can see now that if North American securitizes its portfolio without communication, its net profit is 86 cents (1% of $86). But if it funds the loans, its net profit is 0.02 × $93 – 0.99 = 87 cents. Thus, the bank will prefer not to securitize when the cost of communicating the true value of its loan portfolio to investors is $11. Combining steps 1 and 2 shows that funding the loan is North American’s optimal strategy.  Example: Securitization versus funding loan portfolios Step 3 If the communication cost drops to $2, North American’s net profit from communicating and securitizing is 0.01 × $[93 – 2] = 91 cents. This exceeds both the net profit from funding the loans as well as the net profit from securitizing without communication and shows how improvements in information processing technology that reduce the costs of communicating financial information – can spur securitization. Originate-to-Distribute Model Originate-to-Distribute Model Securitization allows banks to perform credit evaluation, originate loans, fund loans and monitor and service loans without retaining credit risk exposure. Bright side: Market efficiently transfer risk across counterparties. Dark side: Moral hazard problem with banks. Banks have less incentive to perform careful credit analysis when they review loan applications, shirk monitoring and indulge in fraudulent activity. This moral hazard prevalent in the banking industry before the Subprime Mortgage Crisis was pointed out as one of the important causes of the Subprime Mortgage Crisis of 2008 – 2009.  Originate-to-Distribute Model Initially, banks applied this new business model to mortgages, credit card credits, and car and student loans. But, eventually, they applied originate-to- distribute model to corporate loans.  Mechanisms used to convert on- balance-sheet assets to a securitized asset To securitize assets, the assets need to be removed from the balance sheets of the FIs. For this purpose, FIs often create off-balance-sheet subsidiaries such as SPV (also known as SPE, special purpose entity) or SIV (structured investment vehicle). 1. SPV 1. A SPV is a bankruptcy-remote entity that a parent company uses to isolate or securitize assets and it often holds these off-balance sheet. 2. SPV is used in the more traditional form of securitization. SPV is a legal entity created for one very limited, particular task. 3. An FI selects a pool of loans and sells them to an off-balance-sheet SPV. 4. SPV does the following: Packaging the loans together / Create ABS backed by the cash flows from the underlying loan pool / Sell ABS to investors use the sales proceeds to the originating bank 5. SPV earns fees from the creation of ABS. However, ABS investors have the ownership of underlying loans. All cash flows from the loan pass through SPV to ABS security investors. 6. The life of SPV is limited to the maturity of ABS. 7. The legal form for an SPV may be a limited partnership, a limited liability company, a trust, or a corporation. Mechanisms used to convert on- balance-sheet assets to a securitized asset Traditional securitization process using SPV  Types of SPVs 1. Amortizing Structures (Pass Through) 1. They collect interest and principal payments from the underlying loans and in turn make principal and interest payments to noteholders via regular coupons until the security matures. 2. These structures return principal to the investors throughout the life of the ABS, therefore these securities are fully amortizing.  Types of SPVs 2. Revolving Structures 1. Revolving structures tend to be suitable for securitizing debts with repaid relatively quickly such as credit card receivables, trade receivables and auto loans. 2. The interest and principal of these debt contracts are usually paid within a relatively short period, commonly within three to four months. 3. This creates a maturity mismatch problem, as investors of ABS would prefer to hold their investments for over a year. 4. This structure results in a relatively predictable repayment schedule, despite the fact the collateral is non-amortizing. 5. The interest repayments are channeled to investors as coupon payments while principal repayments are then used to acquire additional assets that meet specified criteria such that the collateral is a revolving pool of assets.  Types of SPVs 2. Revolving Structures 6. Interest is paid over the life of the ABS and principal is repaid in the final period.  Types of SPVs 3. Master Trusts 1. These structures can be used by originators to execute multiple securitizations using the same SPV. 2. The originator transfers a very large pool of loans to the SPV that significantly exceeds the value of ABS issued. 3. This vehicle is relatively flexible, that is, it allows the issue of several concurrent or subsequent issues from a significantly large pool of loans. 4. The originator continuously transfers assets to this SPV and creates ABS to meet investor demand. 5. The unfunded portion of the pool (seller’s share) is typically retained by the issuer. 6. The structure decouples the payment pattern of the ABS with the payment schedule of the underlying assets. Mechanisms used to convert on- balance-sheet assets to a securitized asset 2. SIV 1. SIV was invented by Citigroup in 1988. 2. The lifespan of SIV is not limited to any security. It is a structured finance operating company. Operating companies are owned by the holding company, but are responsible for all day-to-day operations of the company. Net profits after expenses are handed over to the holding company. 3. SIV doesn’t create ABS and sell them to investors. It holds loans as its assets until maturity. In order to get cash to purchase loans from an FI, it sells commercial papers or bonds to investors. Loans held by SIV backing commercial papers SIV issues – ABCP (asset backed commercial paper). 4. In essence, SIV itself becomes ABS. 5. SIV is different from traditional banks in that SIV cannot issue deposits. Mechanisms used to convert on- balance-sheet assets to a 2. securitized asset SIV 6. SIV investors simply receive fixed payments from debt issued by SIV. They don’t have the ownership of the SIV’s assets. 7. Even though cash flows from loans are not enough to pay promised principal and interest to debt holders, SIV is responsible for paying promised principal and interest to debt holders. For this situation, SIV usually has lines of credit or loan commitments from the sponsoring bank. Ultimately, loan risk come back to the sponsoring bank’s balance sheet. 8. SIV earns a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues as long as the yield curve is upward slopping. The SIV is acting like any old fashioned spread banker, seeking to earn a spread between its income on assets and cost of funds on liabilities. It earns this spread by accepting two types of risk: a credit transformation (lending to AA borrowers while issuing AAA liabilities) and a maturity transformation (borrowing short while lending long). 9. The scale of both transformations were considerably less than traditional banks, and leverage was also typically half to a quarter of that used by banks, so the risks were less and the returns available were also much lower. 10. SIVs often employ great amounts of leverage to generate returns. 11. Even though SIV’s balance sheets are very similar to that of a traditional bank, SIV is exposed to higher liquidity risk. Mechanisms used to convert on- balance-sheet assets to a securitized asset 2. SIV 12. The profitability of securitized assets is highly determined by the SPV or SIV having a high credit rating since large institutional investors are willing to or required to buy only investment grade securities. 13. Some even criticize that SIV seeks to 'arbitrage' credit by issuing debt or debt-like liabilities and purchasing debt or debt-like assets, and earning the credit spread differential between its assets and liabilities. This was possible since rating agencies are eager to offer AAA-rating to SIVs which pay hefty fees. Rating agencies such as S&P’s seem directed at selling ratings to issuers, rather than selling information to investors through issuers. But, there is no “true” arbitrage since SIVs are exposed to high interest rate risk and liquidity risk. 14. SIVs were a form of highly-leveraged speculation, which was dependent on the assumption that the markets would always supply liquidity. Mechanisms used to convert on- balance-sheet assets to a securitized asset Traditional securitization process using SIV Mechanisms used to convert on- balance-sheet assets to a securitized asset Why ABCP carries strong credit ratings?  Their maturities are short.  The sponsors generally have very high credit ratings.  SIV has lines of credit or loan commitments from the sponsoring banks.  SIV’s loans are used as a collateral for ABCP.  Motivations for Securitization Hedge FI’s interest rate exposure gaps Allows FI asset portfolios more liquid Important source of fee income (with FIs acting a servicing agents for the assets sold) Reduce the regulatory taxes such as capital requirements, reserve requirements and deposit insurance premium. 1980: Less than 15% of residential mortgages were securitized. → 2024: 50~ 6% of all residential mortgages were securitized. 29  Three Major Forms of Asset Securitization 1. Pass-through 2. Collateralized mortgage obligation (CMO) 3. Mortgage-backed bond Even though all three forms of securitization were originated in the real estate lending market, these techniques are currently being applied to loans other than mortgages- credit card loans, auto loans, student loans and commercial and industrial (C&I) loans 30 1. Mortgage pass- through What is mortgage pass-through security? A mortgage pass-through is a securitization structure where investors directly receive cash flows generated by the underlying assets.  Three sponsoring agencies that are involved in the creation of mortgage pass- through The Federal National Mortgage Association (FNMA or Fannie Mae) The Government National Mortgage Association (GNMA or Ginnie Mae) The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)  GNMA Split off from the FNMA (the Federal National Mortgage Association) in 1968 Government-owned agency Two major functions 1. Sponsor mortgage-backed securities programs by FIs 2. Timing insurance Support only the pool of mortgage loans whose default or credit risk is insured by the Federal Housing Administration, the Veterans Administration and the Farmers Home administration. These loans are otherwise disadvantaged in the housing market such as low-income families, you families and veterans. Maximum mortgage under the GNMA securitization programs are capped. 34  GNMA Ginnie Mae stands a few steps behind the mortgage market. It neither issues sells or buys pass- through mortgage-backed securities, nor does it purchase mortgage loans. Instead, private lending institutions approved by Ginnie Mae originate eligible loans, pool them into securities, and issue mortgage-backed securities that are guaranteed by Ginnie Mae.  FNMA Also called Fannie Mae The oldest of the three mortgage-backed security sponsoring agencies. It was founded in 1938 during the Great Depression as part of the New Deal. The practice of selling conventional prime mortgages has been common since the 1930s, when the federal government established Fannie Mae to promote the flow of capital to the mortgage market. The federal government chartered Freddie Mac in 1970 to compete with Fannie Mae, which had been sold to private investors in 1968. Both firms purchase large amounts of prime mortgage loans, which they finance by selling bonds in the capital markets. Before the 1990s, Fannie Mae, Freddie Mac, and other firms rarely purchased nonprime loans. Instead, the originating lenders held most nonprime loans, which comprised a relatively small portion of the mortgage market, until they matured. A government-sponsored enterprise (GSE) federally chartered corporations that are privately owned by shareholders Quasi-government entity Now a private corporation held by stockholders, whose stock is traded on major exchanges with a lines of credit from the U.S. treasuries. More active than GNMA in creating pass-through securities Helps , rather than merely sponsors, to create pass-through. 36  FNMA FNMA creates mortgage-backed securities by purchasing packages of mortgage loans from banks and thrifts. It finances such purchasing by selling MBSs to outside investors such as life insurers and pension funds. It engages in swap transactions whereby it swaps MBSs with an FI for original mortgages. The FI can resell them on the capital market or hold them in its portfolio. Unlike GNMA, conventional mortgage loans without FHA/VA insurance are also accepted by FNMA for securitization as long as their loan-to-value is low or collateral ratios is high. If loan-to-value is high or collateral ratios of conventional mortgage loans is low, then private sector credit insurance is needed before they are accepted into FNMA securitization37  FNMA On September 7, 2008, the Federal Housing Finance Agency (FHFA) placed FNMA and Freddie Mac in conservatorship. FHFA was given full powers to control the assets and operations of the firms. Dividends to common shareholders and preferred shareholders were suspended. But, the U.S. Treasury ensures that FNMA and Freddie Mac keep their debt obligations. In 2010, Fannie Mae and Freddie Mac were delisted from NYSE. The Federal Housing Finance Agency directed the delisting after Fannie's stock traded below $1 a share for over 30 days. Since then the stocks have continued to trade on the Over-the-Counter Bulletin Board.  FHLMC Also called Freddie Mac Performs similar function to FNMA except major role has involved savings banks Stockholder owned with line of credit from the Treasury. Buys mortgage loan pools from the FIs and swaps MBSs for loans. Sponsors conventional loan pools as well as FHA/VA mortgage pools and guarantees timely payment of interest and ultimate payment of principal on the securities it issues. 39  Mortgage pass-through FIs frequently pool mortgages and other assets they originate and offer investors an interest in the pool in the form of pass-through securities. Pass-through securitization is the simplest way to securitize mortgages, by selling direct participations in the pool of assets. Pass-through security represents an ownership interest in the underlying mortgages which share similar characteristics and this in the resulting cash flow. While many different types of loans and assets are currently being securitized, the original use of securitization is a result of government- sponsored programs to enhance the liquidity of the residential mortgage market. Three government agencies are involved in the creation of mortgage- backed, pass-through securities. GNMA FNMA FHLMC 40 Mortgage pass-through Either originating FIs or third-party servicer receives principal and interest payments and pass them though to pass-through security holders.  Mortgage pass-through Each offers different guarantee. GNMA guarantees full and timely payment of principal and interest even if the underlying borrowers default. However, the guarantee does not protect against the risk of early repayments by borrowers. This guarantee carries the full faith and credit of the US. FNMA guarantees full and timely payment of principal and interest even if the underlying borrowers default. However, the guarantee does not protect against the risk of early repayments by borrowers. But, this guarantee is not explicitly backed by the Treasury. Freddie Mac guarantees full and timely payment of interest and ultimate payment of principal, even if the underlying borrowers default. However, the guarantee does not protect against the risk of early repayments by borrowers. But this guarantee is not explicitly backed by the Treasury. But, people believe that FNMA/Freddie Mac pass throughs are implicitly guaranteed by the US Treasury. Mortgage pass-through GNMA/FNMA/Freddie Mac mortgage pass throughs are credit risk-free. But, these are exposed to interest rate risk (their market values change as market interest rate fluctuates.) and prepayment risk. Mortgage pass-through: Example On October 1, 2005, Fannie Mae guaranteed a mortgage pass-through security and the prospectus supplement stated the following: “pass-through rate” or the coupon rate for the security is 5.00%. The pool number for this security is Fannie Mae pool number CL-844801. The pool number is important because it indicates the specific mortgages underlying the pass-through and the issuer of the pass-through.  Mortgage pass-through: Example If an investor purchased $15 million principal of this security and, in some month, the cash flow available to be paid to the security holders (after all fees are paid) is $12 million, how much is the investor entitled to receive? The investor owns $15 million principal of the total principal of $464,927,576. This represents $15,000,000 / $464,927,576 = 0.0322630895 or about 3.2263% of ownership. This ownership entitles the investor to 0.0322630895 × $12,000,000 = $387,157.07. Wells Fargo Bank, N.A. is identified as the seller and the servicer. What does that mean? Fannie Mae provides the guarantee, but Wells Fargo Bank, N.A., is the issuer or seller of the security. It also services the payments and in this capacity is said to be the servicer. More details are given below. Pass-through securities that carry its guarantee and bear its name are issued by lenders it approves, such as thrifts, commercial banks, and mortgage bankers. Thus, these approved entities are referred to as the “issuers.” These lenders receive approval only if the underlying loans satisfy the underwriting standards established by Fannie Mae. When it guarantees securities issued by approved lenders, Fannie Mae permits these lenders to convert illiquid individual loans into liquid securities backed by the U.S. government (in case of Ginnie Mae pass-through). In the process, Fannie Mae accomplishes its goal to supply funds to the residential mortgage market and provide an active secondary market. For the guarantee, Fannie Mae receives a fee, called the guaranty fee.  Mortgage pass-through Represent direct ownership in a portfolio of mortgage loans that share similar maturity, interest rate and quality characteristics The portfolio is placed in a guarantor trust and certificates of ownership are sold directly to investors. Each certificate represents a claim against the entire portfolio. Ownership of the loans rests with the certificate holders. Pass-through securities do not appear on the originator’s balance sheet. 46  Pass-Through Two structure used with pass-through Static pool pass-through 1. The nature of the pool of loans against which claims are sold to investors. 2. The trust in which the loans are held is tax free at the trust level. 3. Examples of static pass-through: Ginnie Mae, Fannie Mae, Freddie Mac Dynamic pool pass-through 1. The debt obligation included in the pool are usually short term, so that they turn over, implying changes in the compositions of the loan portfolio. 2. This structure- also, called revolving structure, involves a pool of loans with an average life that is shorter than the stated maturities of claims issued against the pool. 47  Pass-through Dynamic pool pass-through 3. When a loan within the pool matures, the proceeds are reinvested for a fixed period of time (the revolving period). 4. During the revolving period, only interest is paid to the certificate holders. 5. All principal repayments are reinvested to maintain the original principal amount. 6. Examples of dynamic pass-through: mostly credit card loans where repayment periods are uncertain and brief, frustrating the desire of investors to remain invested for some minimum 48  Pass-through: Example An FI is planning to issue $100 million in BB-rated commercial loans. The FI will finance the loans by issuing demand deposits. 1. What is the minimum capital required under Basle III? The minimum capital required on commercial loans = $100m x 1.0 x 0.08 = $8 million. Commercial loans belong to category 6 (100% weights). 49  Pass-through: Example 2. What is the minimum amount of demand deposits needed to fund this loan assuming there is a 10 percent average reserve requirement on demand deposits? Since there is an interaction between the demand deposits and cash reserves held, the answer requires solving the following, assuming the $8 million is funded by equity and the reserve requirements are kept as cash: DD = 92m/0.9 = $102.22 million  Pass-through: Example 3. Show a simple balance sheet with total assets, total liabilities, and equity if this is the only project funded by the bank. Assets Liabilities Cash $10.22m Demand deposits $102.22m Loan 100.00m Equity 8.00m Total $110.22m $110.22m  Pass-through: Example Consider a GNMA mortgage pool with principal of $20 million. The maturity is 30 years with a monthly mortgage payment of 10 percent per year. Assume no prepayments. 1. What is the monthly mortgage payment (100 percent amortizing) on the pool of mortgages?  Pass-through: Example 2. If the GNMA insurance fee is 6 basis points and the servicing fee is 44 basis points, what is the yield on the GNMA pass‑through?  Pass-through: Example 3. What is the monthly payment on the GNMA in part (2)?  Pass-through: Example 4. Calculate the first monthly servicing fee paid to the originating FIs.  Pass-through: Example 5. Calculate the first monthly insurance fee paid to GNMA.  Further Incentives 1. Gap exposure 2. Illiquidity exposure 3. Default risk by mortgagees 1. Credit risk is transferred to pass-through security holders. ** GNMA pass through is credit risk-free. ** 4. Default risk by bank/trustee 1. GNMA provides timing insurance to pass- through security holders. 57  Gap exposure The FI funds the 30-year mortgage portfolio with short- term demand deposits, resulting in duration mismatch. 58  Illiquidity exposure Hold very illiquid asset portfolio of long-term mortgages and no excess reserves → exposed to the potential liquidity shortages Solutions to this illiquidity exposure Issue longer-term deposits or other liability claims Interest rate swaps to transform the bank’s liabilities into those of a long-term, fixed rate nature. However, these techniques do not solve regulatory tax burdens. → GNMA pass-through can solve both problems. 59 Illiquidity exposure (Continued) The banks begins the securitization process by packaging the $100 million in mortgage loans and removing them from the balance sheet by placing them with a third-party trustee. Trustee may be another bank of high creditworthiness or a legal trustee. Bank determines that (1) GNMA will guarantee for a fee, the timing of interest and principal payments on the bonds issued to back the mortgage pool and (2) the bank itself will continue to service the pool of mortgages for a fee, even after they are placed in trust. GNMA issues pass-through securities backed by the underlying $100 million mortgages. These securities are sold to outside investors in the 60  Attractiveness of Pass-Through to Investors Before examining the mechanics of the repayment on a pass-through security, we consider the attractiveness of these security to investors. Investors are protected from the following two risks. Default risk by the mortgagees House price fall → Mortgagee walked away from the mortgage , leaving behind a low-valued house to be foreclosed at a price below the outstanding mortgage. → The mortgage bondholder is exposed to losses. → Government agencies bear the risk of default and protect the bondholders. Default risk by bank/trustee Originating banks default. → GNMA would bear the cost of making timely interest and principal payments in full and on time to GNMA bondholders. 61 Attractiveness of Pass-Through to Investors (Continued) Mortgage coupon rate = 12% Minus Servicing fee = 0.44 Minus GNMA insurance fee = 0.06 GNMA pass-through bond coupon = 11.5% 62  Bank Balance Sheet After securitization Assets Liabilities Cash $ 10.22 Demand $ 102.22 reserves Deposit Cash 100 Equity 8 proceeds from mortgage securitizatio n $ 110.22 $ 110.22 63 Bank Balance Sheet (Continued) $100 mil illiquid mortgages loans have been replaced by $100 mil cash. The duration mismatch has been reduced. The bank has reduced its regulatory taxes (capital requirements, cash reserves and deposit insurance premium) Keeping all assets in the form of liquid assets can also reduce regulatory taxes. However, smaller profits. Bank is now acting as an asset broker, rather than a traditional asset transformer. Advantage of being an asset broker → servicing fees and fees from mortgage origination Bank profits become more fee-based than interest rate spread-based. 64  Prepayment Risk on Pass- Through Securities The risk of prepay early before a mortgage matures and then refinance with a new mortgage Realized coupons/cash flows on pass-through securities can often deviate substantially from the stated or expected coupon flows in a no-prepayment world. 65  Prepayment Risk on Pass- Through Securities (Continued) To understand the effects of prepayments on pass-throughs security returns, it is necessary to understand the nature of the cash flows received by investors from the underlying portfolio of mortgages. In the U.S. most conventional mortgages are fully amortized. Mortgagees pay back to the mortgage lender the same amount of fixed money every month which includes the principal component and the interest component. As time passes, the interest component shrinks and the principal component increases. The problem for the FI is to figure a constant monthly payment that exactly pays off the mortgage loan at maturity. This constant payment is formally equivalent to a monthly annuity paid by the mortgagee. 66  Prepayment Risk on Pass- Through Securities (Continued) How to calculate monthly payment? Size of pool = $100,000,000 Maturity = 30 years (n=30) Number of monthly payments = 12 (m=12) r = annual mortgage coupon rate = 12% PMT = Constant monthly payment to pay off the mortgage over its life $100,000,000 = PMT* [1 – 1/(1+r/m)mn] ⇔ PMT = $1,028,613 Since there are 1,000 individual mortgages, $1,028.61 per mortgage rounding to the nearest cent. 67  Prepayment Risk on Pass- Through Securities (Continued) The aggregate monthly payments of $1,028,610 comprise different amounts of principal and interest each month. In month 1, the interest component = (12%/12)*$100 million (the outstanding loan balance on the mortgage pool) = $1,000,000 ⇒ $1,028,610 - $1,000,000 = $28,610 used to pay off outstanding principal on the pool ⇒ By the end of month 1, the outstanding balance on the mortgages has been reduced to $99,971,390. As times go by, the interest component decreases since smaller outstanding balance left. The remaining portion – principal component increases. 68  Prepayment Risk on Pass- Through Securities (Continued) When 12% is the coupon rate or interest rate the housebuyers pay on the mortgages, the rate passed through to GNMA investors is 11.5% after deducting 6 basis point insurance fee paid to GNMA and 44 basis point servicing fee paid to the originating bank. The servicing fees are usually paid each month (to keep banks to be an efficient collection/servicing agents). With 11.5% annual interest rate, GNMA bondholders would collectively receive $990,291 per month over the 30 years under conditions of no prepayment. The market value of the 12% mortgage coupon pool (11.5% actual coupons) = V = $990,291/(1+y/12) + $990,291/(1+y/12) 2 + … + $990,291/(1+y/12)360 If y is less than 11.5%, V > original value If y is greater than 11.5%, V < original value However, valuation is more complex because of the existence of prepayment 69  Example A bank originates a pool of 500 30-year mortgages, each averaging $150,000 with an annual mortgage coupon rate of 8 percent. If the GNMA credit risk insurance fee is 6 basis points and the bank's servicing fee is 19 basis points. 1. What is the present value of the mortgage pool? PV = $500 x $150,000 = $75 million 2. What is the monthly mortgage payment? PV = $75 million, N = 360 times, k = 0.6667%, PMT = $550.323.43  Example (Continued) 3. For the first two payments, what portion is interest and what portion is principal repayment? For the first monthly payment, the monthly interest is 0.08/12 x $75 million = $500,000. Therefore, for the first monthly mortgage payment, $50,323.43 is repayment of principal. For the second monthly payment, the principal outstanding is $75m ‑ $50,323.43 = $74,949,676.57. The monthly interest payment is $499,664.51. The principal payment in the second month is $550,323.43 ‑ $499,664.51 = $50,658.92.  Example (Continued) 4. What are the expected monthly cash flows to GNMA bondholders? The GNMA bond rate is 0.08 ‑ (6 + 19) basis points = 7.75 percent. GNMA bondholders receive monthly payments PV = $75 million, N = 360, k = 0.0064583, PMT = $537,309.18. 5. What is the present value of the GNMA pass‑through bonds? Assume that the risk adjusted market annual rate of return is 8 percent compounded monthly. The discount yield is 8% annually, compounded monthly. PMT = $537,309.18, k = 0.006667, N = 360, PV = $ 73,226,373.05  Example (Continued) 6. Would actual cash flows to GNMA bondholders deviate from expected cash flows as in part (4)? Why or why not? Actual payments will equal expected payments if and only if no prepayments are made. If any mortgages are prepaid as a result of refinancing or homeowner mobility, then the monthly payments will change. In the month in which prepayments are made, monthly payments will increase to reflect the principal repayments. In all subsequent months, monthly payments will decline to reflect the lower face value of the pass‑through bonds.  Example (Continued) 8. What are the expected monthly cash flows for the bank and GNMA? GNMA and the originating bank share the difference between the monthly mortgage payments and the GNMA pass‑through payments $550,323.43 ‑ $537,309.18 = $13,014.25. The originating bank gets 19 out of the 25 basis points (or 76 percent) for a payment of $9,890.83 monthly. GNMA receives the remaining 6 basis points (or 24 percent) for a payment of $3,123.42.  Prepayment Risk on Pass- Through Securities (Continued) Factors affecting prepayments Refinancing As coupon rates on new mortgages fall, individual mortgagee has incentives to pay off old, high-cost mortgages and refinance at lower rates. However, some factors inhibiting this refinancing Transaction costs Recontracting costs Prepayment penalty fees on the outstanding mortgage balance prepaid The cost of appraisal and credit checks 75  Prepayment Risk on Pass- Through Securities (Continued) Factors affecting prepayments Housing Turnover The decision to move or turn over a house may be due to a complex set of factors such as the level of house prices, the size of the underlying mortgage, the general health of the economy, and even the season. The sale of a house in a pool does not necessarily imply that the mortgage has to be prepaid. Most GNMA pools allow assumable mortgages (The mortgage contract is transferred to the buyer of a house from the seller of a house.) Not the case for FNMA nor FHLMC pass-throughs 76  Effects of Prepayment Since the bank has sold the mortgage cash flows to GNMA investors and must by law pass through all payments received (minus servicing and guaranty fees), investors’ cash flows directly reflect the rate of prepayment. The actual cash flows received on these securities by investors fluctuate monthly with the rate of prepayments. In a no-prepayment world, each month’s cash flows are the same. However, the effects of early payment increase monthly payments at certain months, leaving less outstanding principal and interest to be paid in later years. 77  Effects of Prepayments (Continued) Good news effects Lower market yields increase present value of cash flows. Principal received sooner. Bad news effects Fewer interest payments in total. Reinvestment at lower rates. Instead of reinvesting monthly cash flows at 12%, investors may reinvest only at lower rates such as 8%. 78  Prepayment Models Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates. To evaluate the fair value of GNMA and FNMA/FHLMC bond portfolios, managers must factor in assumptions about the prepayment behavior of mortgages. How can we quantitatively model prepayment behavior of mortgages? In this chapter, we will consider three alternative ways. Weighted-average life: 1. the weighted average of the times of the principal repayments: it's the average time until a dollar of principal is repaid. 2. reflects an assumed prepayment schedule. WAL = [ Time × Expected Principal received] Total principal outstanding 79  Prepayment Models Methods: Public Securities Association approach. Other empirical approaches. Option pricing approach. 80  PSA Model developed by the Public Securities Association empirically based model that reflects an average rate of prepayment based on the past experience of pools of FHA- insured mortgages Assumes 0.2 percent per annum in first month, increasing by 0.2 percent per month for first 30 months, until annualized prepayment rate equals 6 percent This model assumes that the prepayment rate then levels off at a 6 percent annualized rate for the remaining life of the pool Actual outcomes affected by relative coupon level, age of mortgage pool, amortization, assumability, size of pool, conventional/non-conventional, location, and demographics of mortgagees. PSA Model 82  PSA Model Issuers or investors who assume that their mortgage pool prepayments exactly match this pattern are said to assume 100 percent PSA behavior. In practice, actual outcomes affected by relative coupon level, age of mortgage pool, amortization, assumability, size of pool, conventional/non-conventional, location, and demographics of mortgagees. To adjust for these factors, one approach would be to approximately control for them by assuming some fixed deviation of any specific pool from PSA’s assumed average or benchmark pattern. For example, one pool may be assumed to be 75 percent PSA and another 125 percent PSA.  Other Empirical Models FIs that are trading, dealing, and issuing pass-throughs have also developed their own proprietary empirical models of prepayment behavior. Most empirical models are proprietary versions of the PSA model in which FIs make their own estimates of the pattern of monthly prepayments. Incorporate economic variables burn-out factor variables (Burnouts occur when the majority of borrowers refinance earlier in the interest rate drop cycle and the remainder are unable to follow suit, perhaps due to a lack of equity in the property or a reduction in their personal creditworthiness.) idiosyncratic factors 84  Other Empirical Models In constructing an empirical valuation model, FIs begin by estimating a prepayment function from observing the experience of mortgage holders prepaying during any particular period on mortgage pools similar to the one to be valued. The conditional prepayment rates in month i (pi) for similar pools would be modeled as functions of the important economic variables driving prepayment— for example, pi = f (mortgage rate spread, age, collateral, geographic factors, burn-out factor). Burn-out factor: The aggregate percent of the mortgage pool that has been prepaid prior to the month under consideration. Other Empirical Models  Other Empirical Models Once the frequency distribution of the pi s is estimated, FI can calculate the expected cash flows on the mortgage pool under consideration and estimate its fair yield given the current market price of the pool.  Option Model Approach Called option-adjusted spread (OAS) models Use option pricing theory to figure fair yield spread of pass-throughs over Treasuries. focus on the prepayment risk of pass-throughs as the essential determinant of the required yield spread of pass-through bonds over Treasuries 88  Option Model Approach Fair price on pass-through decomposable into two parts PGNMA = PTBOND - PPREPAYMENT OPTION The ability of the mortgage holder to prepay is equivalent to the bond investor writing a call option on the bond and the mortgagee owning or buying the option. YGNMA = YT-BOND + YOPTION The investors’ required yield on a GNMA should equal the yield on a similar duration T-bond plus an additional yield for writing the valuable call option. Option-adjusted spread between GNMAs and T-bonds reflects value of a call option.  Option Model Approach How to calculate the value of the option- adjusted spread on GNMAs? simplifying assumptions 1. The only reasons for prepayment are due to refinancing mortgages at lower rates. 2. The current discount (zero-coupon) yield curve for T-bonds is flat. 3. The mortgage coupon rate is 10 percent on an outstanding pool of mortgages with an outstanding principal balance of $1 million. 4. The mortgages have a three-year maturity and pay principal and interest only once at the end of each year. 5. Mortgage loans are fully amortized, and there is no servicing fee.  Option Model Approach 6. Because of prepayment penalties and other refinancing costs, mortgagees do not begin to prepay until mortgage rates, in any year, fall 3 percent or more below the mortgage coupon rate for the pool (the mortgage coupon rate is 10 percent in this example). 7. Interest rate movements over time change a maximum of 1 percent up or down each year. The time path of interest rates follows a binomial process (See the graph on the next slide.) 8. With prepayments present, cash flows in any year can be the promised payment PMT = $402,114, the promised payment (PMT) plus repayment of any outstanding principal, or zero if all mortgages have been prepaid or paid off in the previous year. Option Model Approach  Option Model Approach From the aforementioned assumptions, we can calculate PMT = $402,114 PGNMA = $1, 017, 869  Option Model Approach End of Year 1 no mortgage holder would prepay As a result, the GNMA pass-through investor could expect to receive PMT = $402,114 with certainty. Thus, CF1 = $402,114.  Option Model Approach End of Year 2 In year 2, there are three possible mortgage interest rate scenarios. However, the only one that triggers prepayment is when mortgage rates fall to 7 percent. This occurs with only a 25 percent probability. With 75 percent probability, the investor receives PMT = $402,114. If prepayment occurs with 25 percent probability, the investor receives: PMT + Principal balance remaining at end of year 2. At the end of the first year, PMT = $402,114 and the payment of interest component would be 0.10 × $1,000,000 = $100,000, and the repayment of principal component = $402,114 − $100,000 = $302,114.  Option Model Approach End of Year 2 At the end of the second year, the promised amortized payment of PMT = $402,114 can be broken down to an interest component of 10 percent × $697,886 = $69,788.6 and a principal component amount of $402,114 − $69,788.6 = $332,325.4, leaving a principal balance at the end of year 2 of $1,000,000 − $302,114 − $332,325.4 = $365,560.6. If prepayment occurs, PMT + Principal balance outstanding at end of year 2 = $402,114 + $365,560.6 = $767, 674.6 CF2 = 0.25($767,674.6) + 0.75($402,114) = $191,918.64 + 2 $301,585.5 = $493,504.15  Option Model Approach End of Year 3 CF3 = 0. 25(0) + 0.75($402,114) = $301,585.5 With the probability of 0.25, prepayment of all principal remaining has already occurred in the previous period. Therefore, no payment at all. With the probability of 0.75, promised payment of $402,114.  Option Model Approach Derivation of the Option-Adjusted Spread  Option Model Approach Derivation of the Option-Adjusted Spread Option Model Approach When prepayment risk is present, the expected cash flow yield at 8.96 percent is 4 basis points less than the required 9 percent yield on the GNMA when no prepayment occurs. The slightly lower yield results because the positive effects of early prepayment. What is collateralized mortgage obligation? A collateralized mortgage obligation (CMO) is a type of mortgage-backed security in which principal repayments are structured according to maturity and risk levels.  Collateralized Mortgage Obligation (CMO) While pass-throughs are the primary mechanism for securitization, the CMO is a second and growing vehicle for securitizing FI assets. The CMO packages the cash flows from mortgages and pass-through securities in a different fashion to attract different types of investors. 102  Collateralized Mortgage Obligation (CMO) (Continued) Introduced by Freddie Mac in June 1983. Each CMO was divided into three tranches, and each class received semiannual interest payments. The tranches are strictly prioritized for the receipt of scheduled principal and interest repayments. Class B bondholders begin to receive principal payments and any prepayments after the class A bondholders are paid off. Class B bondholders have to be completely paid off before class C bondholders can receive principal payments. The original CMO was structured so that class A bondholders were repaid within 5 years of the offering date, class B bondholders were repaid within 12 years, and class C bondholders within 20 years. All prepayments go to retiring the principal outstanding of only one class of bondholders at a time, leaving the other classes’ prepayments protected for a period of time. 103 Collateralized Mortgage Obligation (CMO) (Continued) Here is a bucket of water mixed with ink. People want either pure water or black ink. Can you separate this bucket of water into pure water and black ink? That is what CMO does.  Collateralized Mortgage Obligation (CMO) (Continued) CMO can be created either by packaging and securitizing whole mortgage loans or more usually by placing existing pass-throughs in a trust off balance sheet (double securitization). The trust holds the GNMA pass-throughs as collateral against issues of new CMO securities in three or more different classes. > : The investment bank or other issuer creates the CMO to make profit by repackaging the cash flows from the single class GNMA pass-through into cash flows more attractive to different groups of investors.  Collateralized Mortgage Obligation (CMO) (Continued) Class A would receive interest plus all of the principal payments passed through from the underlying mortgages until it is entirely paid off, while class B and class C bondholders receive only interest. While there is still variability in the rate of repayment due to the randomness in prepayment rates, the CMO structure reduces this variability by serializing cash flows this way. By investing in a CMO tranche with a sufficiently long effective maturity, the FI can reduce its exposure to prepayment risk. Prepayment risk CMOs can be used by financial institutions to facilitate asset/liability management. Suppose that S&L has 30-year fixed rate mortgages financed with liabilities of shorter maturities. Such an institution can reduce the maturity mismatching on its balance sheet by its mortgages for the shorter tranches of CMOs. 106  Creation of CMOs CMOs can be created either by packaging and securitizing whole mortgage loans or, more usually, by placing existing pass-throughs in a trust off the balance sheet. The trust or third-party FI holds the GNMA pass-through as collateral against issues of new CMO securities. The trust issues these CMOs in three or more different classes. Issuing CMOs is often equivalent to double securitization. The investment bank or other issuer creates the CMO to make a profit by repackaging the cash flows from the single-class GNMA pass- through into cash flows more attractive to different groups of investors. The sum of the prices at which the three CMO bond classes can be sold normally exceeds that of the original pass-through. 107 Example. The Value of Additivity of CMOs Suppose that an investment bank buys a $150million issue of GNMAs and places them in trust as collateral. Class A. Annual fixed coupon 7 percent, class size $50 mil Class B. Annual fixed coupon 8 percent, class size $50 mil Class C. Annual fixed coupon 9 percent, class size $50 mil Under the CMO, each class has a guaranteed or fixed coupon. By restructuring the GNMA as a CMO, the investment bank can offer investors who buy bond class C a higher degree of mortgage prepayment protection, and those who take class A virtually no prepayment protection. 108 Example. The Value of Additivity of CMOs (Continued) Each month, mortgagees in the GNMA pool pay principal and interest on their mortgages. → These cash flows are passed through the owner of the GNMA bonds. → The CMO issuer uses the cash flows to pay promised coupon interest to the three classes of CMO bondholders. Suppose that in month 1 the promised amortized cash flows (PMT) on the mortgages underlying the GNMA pass-through collateral are $1 mil, but an additional $1.5 mil cash flows results from early prepayments. The cash flows in the first month available to pay promised coupons to the three classes of bondholders would be: 109 Example. The Value of Additivity of CMOs (Continued) Trustee: Coupon payments → Each period, the trustee pays out the guaranteed coupons to the three classes of bondholders at annualized coupon rates of 7%, 8% and 9%, respectively. Given the stated principal of $50 mil, the class A bondholder receive $291,667 in coupon payments (0.007/12*$50 mil) in month 1, and the class B bondholders receive $222,222 in month 1, and class C bondholders receive $375,000 in month 1. The total promised coupon payments to the three classes amount to $1 mil = PMT with no-prepayment 110  Collateralized Mortgage Obligation (CMO) (Continued) Class A bondholders The shortest average life with a minimum of prepayment protection Investors seeking short-duration mortgage-backed assets to reduce the duration of their mortgage-related asset portfolios. Depository institutions are interested in this class. Class B bondholders Some prepayment protection and expected duration of five to seven years. Pension funds and life insurance companies primarily purchase these bonds. 111  Collateralized Mortgage Obligation (CMO) (Continued) Class C bondholders Insurance companies and pension funds seeking long-term duration assets to match their long-term duration liabilities. Provide high degree of prepayment protection. By splitting bondholders into different classes and by restructuring cash flows into forms more valued by different investors clienteles, the CMO issuer stands to make a profit. 112  Collateralized Mortgage Obligation (CMO) (Continued) Other CMP classes Class Z An accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired. Not really a zero coupon bond. Have a stated coupon and accrued interest for the bondholder on a monthly basis at this rate → The trustee does not pay this interest until all other classes of bonds are fully retired. → When all the other classes have been retired, the Z-class bondholder will receive the promised coupon and principal payments and accrued interest payments. Have the characteristics of both zero coupon bond and a regular bond. 113  Collateralized Mortgage Obligation (CMO) (Continued) Class R The residual class of a CMO giving the right to any remaining collateral in the trust after all other bond classes have been retired plus any reinvestment income earned by the trust. If prepayments are slower than expected, there is often excess collateral left over in the pool when all regular classes have been retired. Trustees often reinvest funds or cash flows received from the underlying instrument (GNMA) in the period prior to paying interest on the CMOs. The size of any excess collateral and interest on interest gets bigger when rates are high and the timing of coupon intervals is semiannual rather than monthly. High risk investment class that gives the investor the rights to the overcollateralization and reinvestment income on the cash 114 flows in the CMO trust.  Collateralized Mortgage Obligation (CMO) (Continued) Macaulay Duration calculates the weighted average time before a bondholder would receive the bond's cash flows  Collateralized Mortgage Obligation (CMO) (Continued) Securitization Coupon payment: Each month the trustee pays out the guaranteed coupons to the three classes of bondholders at annualized coupon rates of 7%, 8% and 9%.Given the stated principal of $50mil for each class, the class A bondholders receive approximately $291,667 in coupon payments in month 1, the class B receive approximately $333,333 in coupon payments in month 1 and the class C receive approximately $375,000 in coupon payments in month 1. Thus, sum of these three is $1mil. Principal payment: The trustee has $2.5mil available to pay out as a result of promised mortgage payments plus early prepayments. The trustee would pay this remaining $1.5mil to class A bondholders to retire these bondholders’ principal. This retires early some of these bondholders’ principal outstanding. At the end of month 1, only $48.5mil of class A bonds remains outstanding. Securitization Suppose that the same thing happens in month 2. The trustee will use any excess cash flows to pay off or retire the principal of Class A bondholders. Class A bonds are usually fully retired between 1.5 and 3 years. After Class A bonds are fully retired, trustee uses excess cash flows to pay off the principal of Class B bondholders. First coupon payments are made. The class B receive approximately $333,333 in coupon payments in month 2 and the class C receive approximately $375,000 in coupon payments in month 2. If trustee receives $1,208,333 from the mortgage/GNMA pool, the excess cash flows of $500,000 ($1,208,333 - $708,333) then go to retire the principal outstanding of CMO bond Class B. At the end of month 2, only $49.5mil Class B bonds outstanding. All of the $50mil principal on Class B bonds will retire – in practice, five to seven years after the CMO issue. Securitization After Class B bondholders are retired, all remaining cash flows will be dedicated to paying the promised coupon of Class C bondholders and retiring the $50mil principal on Class C bonds. In practice, Class C bonds can have an average life as long as 20 years. Risk of CMO The extent to which the tranches get their principal back depends on losses on the underlying assets. The first 5% of losses are borne by the principal of the equity tranche. If losses exceed 5%, the equity tranche loses all its principal and some losses are borne by the principal of the mezzanine tranche. If losses exceed 25%, the mezzanine tranche loses all its principal and some losses are borne by the principal of the senior tranche. The ABS is designed so that the senior tranche is rated AAA. The mezzanine tranche is typically rated BBB. The equity tranche is typically unrated. Risk of CMO The objective of the creator of the ABS is to make the senior tranche as big as possible without losing its AAA credit rating. The ABS creator examines information published by rating agencies on how tranches are rated and may present several structures to rating agencies for a preliminary evaluation before choosing the final one. A particular type of ABS is a collateralized debt obligation (CDO). This is an ABS where the underlying assets are fixed-income securities.  Risk of CMO Equity tranches were typically retained by the originator of the mortgages or sold to a hedge fund. Finding investors for the mezzanine tranches was more difficult. Financial engineers created an ABS from the mezzanine tranches of ABSs that were created from subprime mortgages. This is known as an ABS CDO or Mezz ABS CDO. The senior tranche of the ABS CDO is rated AAA. This means that the total of the AAA-rated instruments created in the example that is considered here is 90% (75% plus 75% of 20%) of the principal of the underlying mortgage portfolios.  Risk of CMO The AAA-rated tranche would receive the promised return if losses on the underlying mortgage portfolios were less than 25% because all losses of principal would then be absorbed by the more junior tranches. The AAA-rated tranche of the ABS CDO is much more risky. It will get paid the promised return if losses on the underlying portfolios are 10% or less because in that case mezzanine tranches of ABSs have to absorb losses equal to 5% of the ABS principal or less. Even though ABS CDO bonds have a AAA credit rating, it is much riskier than AAA bonds. Credit rating agencies fail to correctly evaluate the risk inherent in ABS CDO. Investors that purchase AAA ABS CDO bonds don’t quite understand this as well and just consider credit rating when they decide to purchase ABS CDO.  Risk of CMO Many banks have lost money investing in the senior tranches of ABS CDOs. The investments typically promised a return quite a bit higher than the bank’s funding cost. Because they were rated AAA, the capital requirements were minimal. Merrill Lynch is an example of a bank that lost a great deal of money from investments in ABS CDOs. In July 2008, Merrill Lynch agreed to sell senior tranches of ABS CDOs, that had previously been rated AAA and had a principal of $30.6 billion, to Lone Star Funds for 22 cents on the dollar. Risk of CMO In practice, many more tranches were created and many of the tranches were thinner (i.e., corresponded to a narrower range of losses). The risks in the AAA-rated tranches of ABSs and ABS CDOs were higher than either investors or rating agencies realized. Many analysts overlooked the fact that correlations always increase in stressed market conditions (where volatility of asset return is higher). (Issuer will try to reduce the risk of ABS CDOs by diversification of underlying assets and overcollateralization.) Many analysts assumed that the BBB-rated tranches of an ABS were equivalent in risk to BBB-rated bonds. There are important differences between the two and these differences can have a big effect on the valuation of the tranches of ABS CDOs.  Risk of CMO All BBBs Are Not the Same! When evaluating a CDO created from the mezzanine tranches, analysts tended to assume that the mezzanine tranche of an ABS, when rated BBB, can be considered to be identical to a BBB bond. The model credit rating agency employed assume that the BBB tranche of an ABS had the same probability of loss, or the same expected loss, as a BBB bond. However, as we have already examined in the previous slides, the risk of losing everything is much higher with the BBB tranches of ABSs than with a BBB-rated bond.  Example Consider $200 million of 30-year mortgages with a coupon of 10 percent per annum paid quarterly. 1. What is the quarterly mortgage payment? PV of the annuity = $200 mil, annual interest rate = 0.1, number of payments = 120, payment = $5,272,358.60  Example (Continued) 2. What are the interest repayments over the first year of life of the mortgages? What are the principal repayments?  Example (Continued) 3. Construct a 30-year CMO using this mortgage pool as collateral. The pool has three tranches, where tranche A offers the least protection against prepayment and tranche C offers the most protection against prepayment. Tranche A of $50 million receives quarterly payments at 9 percent per annum; tranche B of $100 million receives quarterly payments at 10 percent per annum; and tranche C of $50 million receives quarterly payments at 11 percent per annum. Diagram the CMO structure.  Example (Continued) 4. Assume non‑amortization of principal and no prepayments. What are the total promised coupon payments to the three classes? What are the principal payments to each of the three classes for the first year? Regular tranche A interest payments are $1.125 million quarterly. If there are no prepayments, then the regular GNMA quarterly payment of $5,272,359 is distributed among the three tranches. Five million is the total coupon interest payment for all three tranches. Therefore, $272,359 of principal is repaid each quarter. Tranche A receives all principal payments. Tranche A cash flows are $1,125,000 + $272,359 = $1,397,359 quarterly. The cash flows to tranches B and C are the scheduled interest payments. Example (Continued) Example (Continued)  Example (Continued) 5. If, over the first year, the trustee receives quarterly prepayments of $10 million on the mortgage pool, how are the funds distributed? The quarterly prepayments of $10 million will be credited entirely to tranche A until tranche A is completely retired. Then prepayments will be paid entirely to tranche B. The amortization schedule for tranche A for the first year is shown below. This amortization schedule assumes that the trustee has a quarterly payment amount from the mortgage pool of $5,272,359.  Example (Continued) However, since some of the mortgages will be paid off early, the actual payment received by the trustee from the mortgage pool will decrease each quarter. Thus, the payment for the second quarter will decrease from $5,272,359 to $5,008,381 (n = 119 quarters, i = 10 percent, mortgage principal = $189,727,641). The CMO amortization schedule for tranche A given that the mortgage payments decrease with the prepayments is given below. The revised mortgage payment for each quarter is shown in the last column.  Example (Continued) 6.How are the cash flows distributed if prepayments in the first half of the second year are $20 million quarterly? The amortization schedules for tranches A and B are shown below. Again the mortgage payments from the mortgage holders are assumed to decrease as the prepayments occur.  Example (Continued) 7. How can the CMO issuer earn a positive spread on the CMO? The way the terms of the CMO are structured, the average coupon rate on the three classes equals the mortgage coupon rate on the underlying mortgage pool. However, given the more desirable cash flow characteristics of the individual classes, the FI may be able to issue the CMO classes at lower coupon rates. The difference between the sum of all coupon payments promised on all CMO tranches and the mortgage coupon rate on the underlying mortgage pool is the FI's servicing fee. What is Mortgage-Backed Bonds (MBBs) A mortgage-backed bond is a type of asset-backed security which is secured by a mortgage or collection of mortgages.  Mortgage-Backed Bonds (MBBs) Differ from pass-throughs in that Normally remain on the balance sheet. There is no direct link between the cash flow on the mortgages backing the bond and the interest and principal payments on the MBB. Cash flow on the mortgages is just used as collateral. An FI issues an MBB to reduce risk to the MBB bondholders, who have a first claim to a segment of the FI’s mortgage assets. The FI segregates the a group of mortgage assets on its balance sheet and pledges this group as collateral against the MBB issue. A trustee normally monitors the segregation of assets and makes sure that the market value of the collateral exceeds the principal owed to MBB holders. These bonds can be sold with high credit ratings and Lower coupon payments 138 Mortgage-Backed Bonds (MBBs) Before securitization 1. To reduce duration gap and lower its funding cost, the FI can segregate $12mil of the mortgages on the asset Assets Liabilities side of the balance sheet and pledge Long- $ 20 Insured $ 10 them as collateral backing a $10mil long-term MBB issue. term deposit 2. Overcollateralization: the MBB issued mortgag by the FI cost less to issue, in terms of es the required yield. Uninsure 10 d deposit $ 20 $ 20 139 Mortgage-Backed Bonds (MBBs) After securitization 1. Overcollateralization: $10mil uninsured deposits are not backed by only $8 in unpledged assets. Because of the FDIC, insured depositors are not demanding Assets Liabilities high risk premiums to hold these risky Collatera $ 12 MBB $ 10 deposits. → The FI is gaining at the l= Issue expense of the FDIC. (market 2. Maturity of liabilities increased after value of securitization. → duration gap segregat decreased. Securitization may reduce ed duration gap by decreasing maturity of mortgag asset side items but also by increasing maturity of liabilities side items. es) Other 8 Insured 10 mortgag deposit es $ 20 $ 20 140  Costs of MBBs There are several reasons why an FI might prefer the pass-through/CMO to issuing MBB. Regulatory intervention The FI is gaining at the expense of the FDIC. The FDIC is concerned about the growing use of this MBBs by risky depository institutions. MBBs tied up mortgages on the FI’s balance sheet for a long-term. → increase illiquidity of the asset portfolio The overcollateralization is costly. By keeping mortgages on the balance sheet, the FI continues to be liable for capital adequacy and reserve requirement taxes. MBBs are the least used of the three basic vehicles of securitization. 141  Regulatory Arbitrage Many of the mortgages were originated by banks and it was banks that were the main investors in the tranches that were created from the mortgages. Why would banks choose to securitize mortgages and then buy the securitized products that were created?  Innovations in Securitization New types of securitization contracts keep appearing for three main reasons: 1. In the 1980s, low interest rates made prepayment more likely, inducing investors to devise sophisticated way of dealing with prepayment risk. New securities which facilitate the management of prepayment risk have been created. 2. There are uninformed investors and informed investors in the financial markets. Less informed investors are relative less informed about the payoff attributes of underlying assets of securitized instruments and probability distribution of future payoffs on various securities compared with informed investors. While trading with informed investors in the financial markets, less informed investors don’t want to be expropriated by informed investors and demand information- insensitive securities.  Innovations in Securitization 3. Innovation in securitization and cash-flow stripping have also facilitated the creation of securities that appeal to informed investors. A given security with some private-information can always be stripped into two securities – one of which is more information sensitive (has a greater private-information) than the original security. Investors who have superior ability to acquire information at a cost will find that the rate of return on their investment in information is greater with the more information-sensitive security. By stripping one security into several different types of securities, each different types of security with different attributes can better appeal to investors with different preferences. Thus, issuer’s revenue will increase.  Innovations in Securitization Pass-through strips Involve two classes of pass-through securities that receive different portions of principal and interest from the same pool of mortgage loans A special type of CMO which has only two classes Each period mortgagees pay the same amount of amortized money, which has both principal component and interest component. Issuer of PO/IO strips splits these two cash flows and sell them to different bond class investors.  Example An FI originates a pool of short-term real estate loans worth $20 million with maturities of five years and paying interest rates of 9 percent per annum. 1.What is the average payment received by the FI, including both principal and interest, if no prepayment is expected over the life of the loan? PV of the annuity = $20 mil, annual interest rate = 0.09, number of payments = 10, payment = $3,116,401.80  Example (continued) 2.If the loans are converted into pass-through certificates and the FI charges 50 basis points servicing fee, including insurance, what is the payment amount expected by the holders of the pass-through securities if no prepayment is expected? PV of the annuity = $20 mil, annual interest rate = 0.085, number of payments = 10, payment = $3,048,154.10  Example (continued) 3. Assume the payments are separated into interest-only (IO) and principal-only (PO) payments, that prepayments of 5 percent occur at the end of years 3 and 4, and that the payment of the remaining principal occurs at the end of year 5. What are the expected annual payments for each instrument? Assume discount rates of 9 percent.  Example (continued) 4. What is the market value of IOs and POs if the market interest rates for instruments of similar risk decline to 8 percent? The market value of the IO is found by discounting the interest payment column in part (3) at 8 percent. The PV = $6,074,497.66. The market value of the PO is found by discounting the principal payment column in part (3) at 8 percent. The PV = $14,600,446.52. Note that the PV of the total payments is $20,674,944.18 which is the sum of the PV of the IO and the PV of the PO.  Innovations in Securitization 1. PO strips: Holders of the PO strip receive nearly all of the principal payments from the securitized pool. 2. IO strips: Holders of the IO strip receive primarily interest payments from the securitized pool. Negative duration (duration = interest rate elasticity of bond price/ An increase in interest rates causes the IO strip price to increase.) → A financial institution can use IO strip for hedging against interest rate risk. Innovations in Securitization IO strips have a negative duration. Changes in interest rate affect the present value of cash flows received on mortgages. 1. Discount effect: When interest rate decreases, then present value of cash flows received on mortgages increases since discount rate decreases. Thus, market value of IO strips increases. 2. Prepayment effect: When interest rate decreases, then mortgagees will prepay their mortgages and borrow another mortgage loans at a lower interest rates. Therefore, the absolute amount of interest payment decreases. These two effects work in the opposite Thus, market value of IO strips decreases. direction. We can expect the following relationship between changes in interest rate and price of IO strip. When interest rate falls moderately, the discount effect dominates the prepayment effect. But, as interest rate keeps falling below the coupon rate, the prepayment effect dominates the discount effect (That is, interest rate and price of IO strip moves in the same direction. → IO strip has a negative duration.) Innovations in Securitization Since IO strip has a negative duration, it can be very useful for portfolio-hedging device for an FI manager. Regular bonds have a positive duration whose price always decreases when interest rate rises. But, as long as the interest rate is below the coupon rate, price of IO strip increases when interest rate rises. Therefore, when IO strips are included in a portfolio with regular bonds, net portfolio value of bonds, mortgages and IO strips tend to be stable as interest rates are below the coupon rate.  Innovations in Securitization PO strip has a positive duration. As interest rate decreases, both the discount effect and the prepayment effect point to a rise in the price of PO strip. A financial institution can use the PO strips to hedge its fixed-income liabilities. A decrease in interest rates increase the value of a PO strip. Thus, the value of a PO strip is inversely related to the values of fixed income liabilities. A financial institution which wants to increase the sensitivity of its portfolio to change in interest rate or which take a naked or speculative position regarding the future course of interest rate will find PO strip very useful for its purpose.  Innovations in Securitization Securitization of other assets Auto Loans CARDs Various receivables, loans, junk bonds, ARMs.  Costs and Benefits of Securitization The supply side of securitization: Issuer’s prospective costs 1. The primary costs of securitization to the issuer are administrative in nature including legal fees, investment banking fees and rating agencies’ fees. 2. Other costs including the costs of communicating information to investors and the cost of credit enhancement. Issuer’s prospective benefits 1. Management of interest rate risk: By securitizing some of its assets, bank can reduce the maturity gap between its assets and liabilities and reduce its exposure to prepayment risk. Furthermore, bank can lengthen the average maturity of its liabilities by issuing mortgage- backed bonds since a mortgage-backed bond has an average maturity of about 5 to 12 years.  Costs and Benefits of Securitization Issuer’s prospective benefits 2. Increased liquidity: Assets that were not traded before securitization are traded in active secondary markets after securitization. Furthermore, securitization can improves liquidity of assets even before trading by pooling a large number of assets and subsequently partitioning portfolio cash flows. For instance, private information is less important for the senior tranche of CMO, even though the total information asymmetry may not change by securitization.  Example Suppose the North American Bank has two loans, each of which is due to be repaid one period hence. The cash flows are independent and identically distributed random variables. Each loan will repay $100 to the bank with probability 0.9 and $50 with probability 0.1. However, while North American knows this, prospective investors cannot distinguish this bank’s loan portfolio from that of the Southside City Bank, which has the same number of loans, but each of its loans will repay $100 with probability 0.6 and $50 with probability 0.4. The prior belief of investors is that there is a 0.5 probability that North American has the higher-valued portfolio and a 0.5 probability that it has the lower-valued portfolio. Suppose that North American wishes to securitize these loans, and knows that if it does so without credit enhancement, the cost of communicating the true value of its loans to investors is 5% of the true value. Explore North American’s securitization alternatives. Assuming that a credit enhancer is available and that the credit enhancer could (at negligible cost) determine the true value of North American’s loan portfolio, what sort of credit enhancement should North American purchase? Assume investors are risk neutral and that the discount rate is zero.  Example (Continued) We solve this problem in four steps. Step1> We show that if North American Bank securitizes its loan portfolio as a single security (that is, without cash-flow stripping or creating tranches), it will prefer securitization with communication (investors learn true value of its loan portfolio) to securitization without communication (in which investors set a pooling price of the loan portfolio). Step2> We examine the benefits of securitizing by creating two tranches represented by two particular classes of bondholders. We show that this cash-flow partitioning benefits North American by increasing its expected revenues relative to the securitization considered in Step1. Step 3> We stipulate a specific form of credit enhancement. Step 4> We examine the net benefit of credit enhancement to North American and find that it is positive. The loan portfolio is made perfectly liquid by credit enhancement. While credit enhancement by a party that knows North American’s portfolio better than investors will always help, it helps to the maximum extent possible here due to the assumption that the credit enhancer can discover the true value of North American’s loan portfolio at negligible cost.  Example (Continued) Step 1> If North American doesn’t communicate any information to investors, the market value of its securitized loan portfolio will be 0.5*[2*(0.9*100+0.1*50)] + 0.5*[2*(0.6*100+0.4*50)] = $175. If North American knows privately that its loan portfolio is worth 2*(0.9*100+0.1*50) = $190, it will wish to communicate its private information to investors and sell its portfolio for $190 and get $190 – (0.05*$190) = $180.5. Step 2> North American can create two classes of bondholders in a “junior- senior structure.” Class A bondholders are entitled to $100 in the aggregate. After they are all paid off, Class B bondholders are entitled to $100 or the residual cash flow, whichever is smaller. North American Bank doesn’t need to communicate information about type of loans it holds to Class A bondholders. If North American chooses to communicate true value of Class bonds to investors, it will be able to sell these bonds for $90 – 0.05*$90 = $85.5. Thus, its net payoff on securitizing this way will be $100 + $85.5 = $185.5. This is greater than $180.5. So, North American Bank prefers multiple tranche securitization to single security securitization.  Example (Continued) Step 3> When North American Bank hires a credit enhancer, the credit enhancer guarantees that Class B bondholders receive $100 for sure. North American Bank doesn’t need to bear the cost of communicating information to Class B bondholders. But, how much North American Bank has to pay the credit enhancer, if the credit enhancement is competitively priced? Step 4> There are four possible states: 1) With probability of 0.81, both loans 1 and 2 pay off $100 each 2) With probability of 0.09, loan 1 pays off $100 and loan 2 pays off $50 3) With probability 0.09, loan 1 pays off $50 and loan 2 pays off $100 4) With probability 0.01, both loans 1 and 2 pay off $50 each. The expected value of the credit enhancer’s liability is 2*0.09*50 + 0.01*$100 = $10. Thus, North American’s net payoff will be $100 + $100 - $10 = $190. → The loan portfolio is perfectly liquid (North American Bank can sell its loan portfolio for its true value).  Costs and Benefits of Securitization Issuer’s prospective benefits 3. Diversification of funding sources: Securitization provides originators with funding sources other than traditional sources including deposits, federal funds, subordinated debt, preferred stock and equity. 4. Enables focus on origination, servicing and monitoring: Financial institution’s most important role is alleviating information problems. Securitization enables the bank to focus on some activities which it can perform more efficiently. However, without regulatory help, it is not clear whether the bank has any advantage in funding.  Costs and Benefits of Securitization Issuer’s prospective benefits Facilitate the avoidance of adverse selection costs: Suppose that the bank on the whole is undervalued but there is very little information asymmetry about the new loan. Then, since investors who fund new loans are purchasing claims against the banks’ entire asset portfolio, if the bank funds new loans in a conventional manner, the bank must bear the adverse selection costs, that is, the bank must bear higher cost of funding than the cost of funding in the case of no information asymmetry between the bank and investors. ← Investors who provide funding to these new loans are actually purchasing claims against the bank’s entire asset portfolio, not against just new loans. If the bank fund these new loans by securitizing them, then investors are purchasing claims only against the new loans. Therefore, if there is little information asymmetry about these new loans, there will be virtually no adverse selection cost. ← Securitization through SPCs often achieves bankruptcy remoteness of the securitized assets from the borrowing firm.  Costs and Benefits of Securitization Issuer’s prospective benefits Facilitate the avoidance of adverse selection costs: An example: Gelco Corporation, a truck-leasing company with a BB credit rating from S&P. Its commercial paper, backed by high quality leases, was rated A-1. The firm saved about 80 bp in borrowing costs by securitizing its lease receivables. Avoidance of interm