Securitized Products (Part 1) - Course Presentation.pdf

Securitized Products (Part 1) Course Objectives Understand what is securitization, which assets can be securitized, the structure and risks of a securitized product and why someone would securitize and invest in these products Be well-versed about the basics of individual mortgage loans and the clas...

Securitized Products (Part 1) Course Objectives Understand what is securitization, which assets can be securitized, the structure and risks of a securitized product and why someone would securitize and invest in these products Be well-versed about the basics of individual mortgage loans and the classifications of the different borrowers and loan types, as well as how these loans are pooled into MBSs Calculate prepayment speeds and use that to value MBS Know how market participants look at relative value, how they trade and how they hedge MBS securities Comprehend the role of the US GSEs in the mortgage market and the various types of MBS they offer to investors Securitization Securitization – Basics Securitization is when lenders package income producing assets into a tradeable form and sell them to investors. Originators Securitize their incomeproducing assets Corporate Finance Institute® Third Parties Asset Servicer Help guarantee the securitized assets or help sell a deal Identify, pool, monitor, and administer underlying assets Securitization – Prepayments Securitized products differ from simple amortizing bonds due to prepayments. Securitized products are priced with an assumption of prepayments. Corporate Finance Institute® Securitized products can be seen as a bond plus a call option that the investor is selling to the originator Securitization – Product Comparison Covered Bonds Have a legislated, dual-recourse framework Securitized Products do not offer such frameworks Corporate Finance Institute® Real-Estate Income Trusts (REITs) Companies that own or finance income-producing real estate REITs are more equity-like than securitized products Securitization – Income Yielding Assets Income Yielding Assets: 01 Receivables Trade, Credit Card, Utilities 02 Loans Automobiles, Corporate, Student 03 Intellectual Property Film rights, recording loyalties, trademark patent 04 05 Corporate Finance Institute® Whole Businesses (“WBS”) Wendy’s, IHOP, Taco-Bell Mortgages Mortgage-backed Securities (“MBS”) WBS: ⮚ All revenue-generating assets are being sold ⮚ Investors buy it with a higher credit rating MBS: ⮚ US MBS is the second largest pool of investable assets ⮚ Worth of $12 trillion (2019) Securitization – Income Yielding Assets 9% 2% 21% Outstanding: $44,958 Billion (2019) 37% 23% 4% 4% Corporate Bonds Mortgage-Backed Securities Asset-Backed Securities Federal Agency Securities Treasury Securities Misc Municipal Securities Corporate Finance Institute® Securitization – Securitization Process Cash Cash Special Purpose Vehicle (SPV) Originator Investors Bonds or Equity Assets Guarantor Corporate Finance Institute® Servicer Principal & Interest Guarantor Securitization – Risks 1 3 Underwriting Standards of the Assets Value of the underlying assets Corporate Finance Institute® 2 4 Rate changes > Prepayment speed > duration Default rates and lower recovery rates Securitization – Why Securitize? Why would an asset seller choose to securitize? Liquidity Corporate Finance Institute® Regulation Risk Lay-off Economic Benefits Securitization – Why Invest? Why would an investor choose to invest in securitized products? Higher Yields Corporate Finance Institute® Cash Flow Structure Access Securitization – Investors Investors with different objectives and risk tolerances Securities with different cash flows and performance Investment managers Life insurance and pension funds Banks Match with the longterm liabilities Earn a spread over the funding costs Hedge funds and private equity Access opportunities for outsized returns Corporate Finance Institute® Central Banks and official agencies Invest in secure and highest rated products Achieve excess returns Mortgage Basics Mortgage Basics - Diagram Borrower Mortgage Investor Lender Agency Corporate Finance Institute® Mortgage Basics What factors affect an individual mortgage loan? Collateral Corporate Finance Institute® Repayment Structure Credit Quality Propensity to Prepay Mortgage Basics – Property Type CMBS Corporate Finance Institute® RMBS Mortgage Basics – Single and Multi Family Mortgages Single-family Multifamily 1-4 unit homes 5 units or more Apartments, prefabs, or manufactured homes Rental apartments/buildings Corporate Finance Institute® Mortgage Basics – Government Guarantee Government Agencies VA loans for anyone who has served a minimum term in the US military; no loan limits Guarantee Required < 20% Equity Corporate Finance Institute® USDA loans are discounted rate mortgages to encourage home ownership in rural areas; no loan limits FHA offers guarantees to economically disadvantaged borrowers; limits set by HUD Mortgage Basics – Conventionals (1) Conventionals: standard loans with a small down payment and average credit histories Guarantee Required < 20% Equity Corporate Finance Institute® Private Mortgage Insurance: Genworth, MGIC, UGI, Radian, ArchMI, Essent, and NMI Mortgage Basics – Conventionals (2) Without insurance, lenders will charge a higher lending rate > 80% LTV < 20% Equity Corporate Finance Institute® Insurance is meant to protect the lender, not the borrower Mortgage Basics – Conforming Conforming Amounts Balance & Jumbo FHFA Federal Housing Finance Agency Corporate Finance Institute® US GSEs: Freddie Mac & Fannie Mae Balance conforming loan amount for 2021: $584,250 Jumbo conforming loan amount for 2021: $822,375 Mortgage Basics – Non-Conforming Non-conforming loans tend to have higher rates and fees than conforming loans. Non-conforming loans held and serviced by the lender are called portfolio loans Jumbo Exceed loan limits set by FHFA Areas of extremely high property costs Corporate Finance Institute® Other For borrowers with bad credit Also for affluent business owners or recently graduated doctors or lawyers Mortgage Basics – QM & Non-QM Loans “Lenders make a “reasonable, good faith determination of a [borrower’s] ability to repay any residential mortgage loan” Dodd-Frank Act (2010) Consumer Financial Protection Bureau (CFPB) (2014) Corporate Finance Institute® Due-diligence Origination Purpose Qualified Mortgage (QM) & Non-Qualified Mortgage (non-QM) Classification Ability -torepay (ATR) < 43% of the total income Measured by the borrower’s Debtto-income (DTI) ratio Loan rate threshold vs the average prime offer rate Mortgage Basics – QM Loans Qualified Mortgage (QM) 1 2 3 Prohibited to have certain risky loan features or reduce the monthly loan payments in early years No excessive upfront fees (“Points and Fees”) for the borrower Cannot exceed a 30-year-term loan QM ≠ Conforming Mortgage Corporate Finance Institute® Mortgage Basics – Non-QM Loans Non-Qualified Mortgage (non-QM) 1 2 Income or debt verification standards might differ May be interest-only, have a balloon payment, negative amortization features, higher DTI, or lent for “condotels” 3 Can be taken with blemished credit 4 Non-QM Lenders are generally non-bank financial companies (NBFCs) Corporate Finance Institute® Mortgage Basics – Borrower Classification Three classifications of borrowers: Prime Borrowers with strong employment and credit histories and substantial equity in the underlying property Corporate Finance Institute® Sub-Prime Alt-A Borrowers with lower income levels, fewer assets, and weaker credit histories Between Prime and SubPrime. May lack proof of steady income or assets. Loan-to-Value (LTV) Credit Score Mortgage Basics – Metrics Scores provided by a third party (FICO) Simply subtract percentage of down payment that a homebuyer puts down upon purchase Corporate Finance Institute® Scores based on payment history, credit usage, total debt, number of credit report inquiries, and length of credit history The amount of the mortgage loan as a percentage of the appraised value of the home Mortgage Basics – Documentation Documentation Full Documentation Stated No Income, No Assets (NINA) Income and assets stated by the borrower are verifiable Borrower does not need to show evidence of what was declared Borrower does not have to disclose any financial information Corporate Finance Institute® Mortgage Basics – Automatic Underwriting System AUS Automated decision-making tools that accept or classify loans based on specific risk characteristics of the loan and the borrower Automated Property Valuation Models Mortgage Scoring Model Statistical technique derived from car loan and credit card markets Streamline or waive property appraisal requirements Quantifies creditworthiness of borrowers Reduces transaction cost to borrowers and lenders Corporate Finance Institute® Mortgage Basics – Features of Mortgage Products Mortgage Rate Features Mortgage Rate Lien Ranking Occupancy Amortization Loan Balances Corporate Finance Institute® Fixed Adjusted ❑ Does not change throughout the loan term ❑ “Floating rate” or Adjusted Rate Mortgages (ARM) ❑ Not influenced by changes in prevailing market rate ❑ Have a margin (spread) over the floating interest rate benchmark ❑ Easier for investors and borrowers ❑ Ex. Constant Maturity Treasury (called CMT), the Cost of Funds Index (COFI) or LIBOR Mortgage Basics – Features of Mortgage Products Lien Ranking Features Mortgage Rate Lien Ranking Occupancy Amortization Loan Balances Corporate Finance Institute® First lien ❑ The lender has first crack at the property should the lender ever need to foreclose on the property Second lien ❑ The holder would need to wait until the first lien holder has been satisfied ❑ Recovery rates and the mortgage size are smaller Mortgage Basics – Features of Mortgage Products Occupancy Features Mortgage Rate Lien Ranking Occupancy Amortization Loan Balances Corporate Finance Institute® “Owner Occupied” ❑ Owner lives in their principal residence ❑ Safest type “Second home” ❑ Borrower has personal ties to the property and uses it himself or herself “Property as investment” ❑ The least secure option Mortgage Basics – Features of Mortgage Products Amortization Mortgage Rate Lien Ranking Occupancy Amortization Loan Balances Fully Amortizing ❑ The mortgagor pays a constant sum every month for 360 months Monthly Payment Features Interest Principal 0 Corporate Finance Institute® 120 240 Months 360 Interest-only (IO) Reverse ❑ Do not require any principal payment over the life of the loan ❑ The lender takes that advance and converts it into payments to the homeowner ❑ Reserved for those borrowers with the best credit histories ❑ Popular for seniors Mortgage Basics – Features of Mortgage Products Loan Balances Features Mortgage Rate Lien Ranking Occupancy Amortization Loan Balances Corporate Finance Institute® Low Loan Balance (LLB) ❑ Slower prepayments ❑ Borrowers do not necessarily benefit from refinancing when rates fall High Loan Balance (HLB) ❑ Faster prepayments ❑ Borrowers are more sensitive to falling rates Jumbo ❑ More concentrated in wealthier areas of the US, where default is more improbable Mortgage Basics – Prepayments Reasons for Prepayments 1 2 If the property is sold, the mortgage must be repaid If the rates fall, the mortgage may be repaid and replaced with the cheaper one 3 “Cash-out refinancing” or “cash-out refis” 4 Default of the borrower Corporate Finance Institute® Some mortgages have prepayment penalties Some mortgages allow partial repayment (curtailments) Mortgage Basics – Defaults DEFAULT Delinquency: the borrower tends to first fall behind in their mortgage payment 30-90 days 90+ days Payment is due Default: the borrower fails to find a way to remediate the loan and must sell the property to repay the lender Corporate Finance Institute® Mortgage Basics – Production Lending Institution Aggregate Raw Loans Corporate Finance Institute® Pools Mortgage Basics – Production Time to Delivery 30-60 days between borrower application and loan delivery Mortgage “Fall Off” Committed Pipeline For fixed-rate mortgages Fixed-rate guaranteed by lender When borrowers do not go through with property purchase Production is the process of a mortgage loan becoming a pool Corporate Finance Institute® Mortgage Basics – Originators Bank & Non-Bank Originators Origination Play a very large part of the origination process 6 of the top 10 mortgage loan originators in the US were non-bank 4 of the top 10 mortgage loan originators in the US Quicken Loans, United Wholesale Mortgage, and Loandepot Wells Fargo, JP Morgan Chase, Bank of America, and US Bank Corporate Finance Institute® Approval Mortgage Basics – Originators Originator must be approved by the Agency to be an originator and/or servicer Receival Transfer Originator transfers loans to the Agency Corporate Finance Institute® Agency returns MBS of equal face value Originator can choose to sell the pool in the secondary market or hold the it in its own MBS portfolio Mortgage Basics – Agency Obligation Borrower Financial Difficulty Pool given a unique pool number by issuing Agency Corporate Finance Institute® Agency will work with servicer to remediate loan May have to foreclose on property and continue to make payments to investors Mortgage Basics – Fees The cashflow from the individual mortgage makes up the cashflow of the pass-through pool BASE Base Servicing Fee Corporate Finance Institute® 25bps Guarantee Fee Also known as G-Fee Dependent on the structure of the mortgage Issued in 50bps increments to ensure uniformity Mortgage Basics – Fees Example Corporate Finance Institute® Mortgage Basics – Fees Example Loan A: 2.96% Loan B: 3.20% Base Servicing 0.25% 0.25% Guarantee Fee 0.58% 0.58% Loans Pass-Through MBS Excess Servicing Corporate Finance Institute® 2.00% 0.13% 0.37% Mortgage Basics – Current production Corporate Finance Institute® Mortgage Basics – Current Coupon Current Production Refers to the most prolific coupon being produced Usually only 3-4 coupons in active production at one time Corporate Finance Institute® Current Coupon Theoretical coupon on an MBS that would trading at par given current market prices Also defined as the coupon closest to, without exceeding, par Mortgage Basics – Pool Characteristics “Prepayment Speed”: how quickly the pool prepays versus others Corporate Finance Institute® Mortgage Basics – Pool Characteristics Negative Convexity Rates Bond duration shortens as rates fall Unfavourable for investors due to negative convexity risk Corporate Finance Institute® Not all pools prepay at the same rate Mortgage Basics – Pool Characteristics Forecast prepay speeds New Production vs Seasoned Pools LLB versus HLB Corporate Finance Institute® Mortgage Basics – Pool Characteristics Forecast prepay speeds Low WAC vs High WAC Low FICO vs High FICO Low LTV vs High LTV Corporate Finance Institute® Mortgage Basics – Pool Characteristics (qualitative) Qualitative Factors Jumbo pools tend to prepay faster Borrowers with stronger financial circumstances have higher loan balance and are more savvy Non-bank originators are more aggressive in getting borrowers to refinance when rates fall Corporate Finance Institute® MBS Statistics Weighted Average Statistics Mortgage Pools Corporate Finance Institute® Weighted average statistics vary with each pool Individual loans pay interest and principal at different rates Pool issuer provides investors with weighted average statistics Weighted Average Statistics – WAC 2.5% Pass-Through Mortgage Pool Mortgage rates of 3% and 2.5% $100 Pool WAC of 2.75% $50 Mortgage $50 Mortgage Mortgage rates of 2.75% and 2.5% WAC of 2.625% Corporate Finance Institute® Weighted Average Statistics – WAM & WALA Corporate Finance Institute® Weighted Average Maturity (WAM) Weighted Average Loan Age (WALA) Weighted average maturity of all the loans in a pool expressed in months Weighted average age of all the loans within a pool expressed in months One 30-year mortgage would have a WAM of 360 months One 30-year mortgage would have a WALA of 0 months Weighted Average Statistics – Pool Tapes Other Weighted Average Statistics Credit Scores LTV DTI Corporate Finance Institute® Weighted Average Statistics – Pool Tapes Corporate Finance Institute® Weighted Average Statistics – Pool Tapes Corporate Finance Institute® Weighted Average Statistics – Pool Tapes Corporate Finance Institute® Weighted Average Statistics – Pool Tapes Corporate Finance Institute® Prepayments Prepayment Prepayment MBS Price is a function of the market’s expectation of future prepayments Corporate Finance Institute® The effect of declining interest rates causing prepayment to increase Actual (observed) vs Market participants make their own assumptions Prepayment 60 50 40 CPR Federal Reserve Bank of New York 30 20 10 0 -150 -65 20 105 190 Incentive (WAC - Mortgage Rate, bp) Interest rates are rising right to left Corporate Finance Institute® 275 Prepayment – Good vs Bad? Good Bad Prepay speeds are not that useful by themselves. Consider current interest rate environment, housing market, and economic cycle CPR (Constant Prepayment Rate) Corporate Finance Institute® PSA (the Public Securities Association benchmark) Constant Prepayment Rate CPR Also called Conditional Prepayment Rate Projects historical prepayments into the future Needs to be converted into a monthly rate Corporate Finance Institute® Calculating SMM and CPR Total payment, including prepayments – Scheduled interest payment – Scheduled principal payment SMM [ Unpaid principal balance – Scheduled principal payment ] Example Monthly prepaid principal as a % age of the security’s outstanding balance and then annualized figure = CPR Unpaid principal balance (beg. of the month) $1,000,000 Scheduled interest payment $1,500 Principal payment expected (8,000 – 1,500 – 5,000) 0.001507 or 0.1507% (1,000,000 – 5,000) 12 1-CPR=(1-0.001507) 1 (1-0.01794) = (1 – SMM) 12 Corporate Finance Institute® 1.794% 0.001507% Actual total payments $5,000 $8,000 PSA Benchmark 100 PSA Benchmark 7.0% PSA Benchmark Prepayment rates are lower for new mortgages and will increase with seasoning CPR of 0.2% for the first month, increasing by 0.2% per year per month Levels off at 6% CPR for the rest of the mortgage’s life Annual CPR Percentage (%) 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 30 Mortgage Age (Months) Corporate Finance Institute® PSA Benchmark 100PSA, for month 20 , , 150PSA, for month 5 , Corporate Finance Institute® , Prepay Speeds, Average Life and Yield Corporate Finance Institute® Valuing MBS with prepayments % of the Current Bal Original Bal Corporate Finance Institute® Valuing MBS Valuing MBS MBS cashflows are uncertain due to prepayments The yield for an MBS is called cash flow yield Corporate Finance Institute® MBS investors are free to invest their principal more frequently than bondholders Valuing MBS – Refinitiv Corporate Finance Institute® Valuing MBS – Refinitiv Corporate Finance Institute® Valuing MBS – UST Spread Corporate Finance Institute® Valuing MBS – Z-Spread Corporate Finance Institute® Valuing MBS – Static Measurements Static Measurements Bond Equivalent Yield UST Spread Assume that interest rates and MBS cashflows remain constant Z-Spread Static measurements give yields that undervalue the MBS for investors Corporate Finance Institute® Valuing MBS with prepayments OAS Option-Adjusted Spread (OAS) The gist of OAS is found with the expected future interest rate Calculate the spread that discounts all the values Discount the cash flows based on each rate path Find a spread that equalizes the value to the first node to the PV or MBS price Corporate Finance Institute® The spread earned by the investor can be different from the OAS Interest Rate Risk MBS Interest Rate Risk Duration Approximation of how the value of a fixed income security changes as interest rates change Effective Duration = Pdown ∆i * — P0 100 Pup * 2 * 100 ∆i = Change in interest rates P0 = Initial security price Pdown = The estimated value of the security if rates are decreased by ∆i Pup = The estimated value of the security if rates are increased by ∆i Convexity Corporate Finance Institute® Measure of how duration changes as interest rates change MBS Interest Rate Risk – Refinitiv Corporate Finance Institute® MBS Interest Rate Risk – Refinitiv Corporate Finance Institute® MBS Interest Rate Risk – Refinitiv Convexity = Pup + Pdown — 2P0 2P0 * (∆i ) 2 ∆i = Change in interest rates P0 = Initial security price Pdown = The estimated value of the security if rates are decreased by ∆i Pup = The estimated value of the security if rates are increased by ∆i Corporate Finance Institute® Hedging Rate exposure Hedge Ratio T-bills equivalents MBS duration ($) Benchmark hedge ratio x MBS position Example $100 million x 0.3 = $30 million 10-year Treasuries Corporate Finance Institute® Hedging Rate exposure We buy 127% of the face amount sold in order to hedge the duration Corporate Finance Institute® Hedging Rate exposure Corporate Finance Institute® Hedging Rate Exposure – Investors Parties Hedging Rate Exposure 1. Investors Interest Rate Increase Sell US Treasuries Paying fixed interest-rate swaps 2. Originators 3. Servicers 4. GSEs Corporate Finance Institute® Interest Rate Decrease Convexity Hedging Buy US Treasuries Receive interest-rate swaps Hedging Rate Exposure – Investors Parties Hedging Rate Exposure Rate-Lock Rate hold once loan has been submitted 1. Investors 2. Originators Pull-Through Percentage of loans that need to be funded 3. Servicers 4. GSEs Securitization Funded loans held until ready to be pooled Corporate Finance Institute® Hedging Rate Exposure – Investors Parties Hedging Rate Exposure 1. Investors Interest Rate Increase MSA values rise Sell duration to hedge 2. Originators 3. Servicers 4. GSEs Corporate Finance Institute® Interest Rate Decrease MSA values fall Buy duration to hedge Hedging Rate Exposure – Investors Parties Hedging Rate Exposure 1. Investors 2. Originators 3. Servicers 4. GSEs Corporate Finance Institute® Freddie and Fannie held prime and sub-prime mortgage products