Chapter 11Chapter 11Valuation of Valuation of

Mortgage SecuritiesMortgage Securities

Chapter 11Chapter 11Learning ObjectivesLearning Objectives

Understand the valuation of Understand the valuation of mortgage securitiesmortgage securities

Understand cash flows from various Understand cash flows from various types of mortgage securitiestypes of mortgage securities

Understand how changes in interest Understand how changes in interest rates affect mortgage securities rates affect mortgage securities valuesvalues

Understand mortgage securities and Understand mortgage securities and hedging against interest rate riskhedging against interest rate risk

TRADITIONAL DEBT TRADITIONAL DEBT SECURITY VALUATIONSECURITY VALUATION

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

Value moves inversely with market Value moves inversely with market interest ratesinterest rates

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

MORTGAGE-RELATED MORTGAGE-RELATED SECURITIESSECURITIES

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

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

MORTGAGE RELATED MORTGAGE RELATED SECURITIESSECURITIES

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

Market rates decline, mortgage Market rates decline, mortgage prepayment increases due to prepayment increases due to refinancingrefinancing

PASS-THROUGHSPASS-THROUGHS

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

Several models of expected Several models of expected prepayment:prepayment: FHA Twelve-Year Prepaid LifeFHA Twelve-Year Prepaid Life Constant Prepayment RateConstant Prepayment Rate FHA ExperienceFHA Experience

PASS-THROUGHSPASS-THROUGHS

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

ModelModel Current industry standardCurrent industry standard Combines FHA experience with CPR modelCombines FHA experience with CPR model

Econometric Prepayment ModelsEconometric Prepayment Models Refinancing ModelsRefinancing Models

Based on title search activity which Based on title search activity which precedes refinancingprecedes refinancing

PASS-THROUGHSPASS-THROUGHS

No rearranging of the cash flows No rearranging of the cash flows from the mortgage poolfrom the mortgage pool

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

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

PASS-THROUGHSPASS-THROUGHS

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

Coupon rates reflect market rates Coupon rates reflect market rates at time of issueat time of issue

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

PASS-THROUGHSPASS-THROUGHS

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

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

MORTGAGE-BACKED MORTGAGE-BACKED BONDSBONDS

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

Seek to be sufficiently Seek to be sufficiently overcollateralizedovercollateralized

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

Financial rating based on amount of Financial rating based on amount of overcollateralizationovercollateralization

MORTGAGE-BACKED MORTGAGE-BACKED BONDSBONDS

Overcollateralization is related to Overcollateralization is related to the balance in the sinking fundthe balance in the sinking fund

Variables that affect the balance of Variables that affect the balance of the sinking fund at maturity include the sinking fund at maturity include the mortgage prepayment rate, the the mortgage prepayment rate, the reinvestment rate on the sinking reinvestment rate on the sinking fund, the initial overcollateralization, fund, the initial overcollateralization, and the default rateand the default rate

COLLATERALIZED COLLATERALIZED MORTGAGE OBLIGATIONSMORTGAGE OBLIGATIONS

Cash flows are made up of various Cash flows are made up of various tranches and residual classtranches and residual class

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

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

Yield is higher on longer tranchesYield is higher on longer tranches

COLLATERALIZED COLLATERALIZED MORTGAGE OBLIGATIONSMORTGAGE OBLIGATIONS

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

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

STRIPSSTRIPS

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

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

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

STRIPSSTRIPS

If prepayment accelerates, principal is If prepayment accelerates, principal is returned fasterreturned faster

Interest-only strips receive the Interest-only strips receive the interest when it is paidinterest when it is paid

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

Accelerated prepayment reduces Accelerated prepayment reduces principal and reduces interest amountprincipal and reduces interest amount

STRIPSSTRIPS

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

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

STRIPSSTRIPS

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

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

FLOATERSFLOATERS

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

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

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

FLOATERSFLOATERS

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

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

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

SERVICING RIGHTSSERVICING RIGHTS

Lenders sell off loans and often retain Lenders sell off loans and often retain the servicing rightsthe servicing rights

Servicing includes collecting monthly Servicing includes collecting monthly payments, maintaining escrow payments, maintaining escrow accounts, forwarding proper accounts, forwarding proper payments to purchasers, sending payments to purchasers, sending delinquency and default notices, delinquency and default notices, initiating foreclosure proceedings and initiating foreclosure proceedings and collecting on PMIcollecting on PMI

SERVICING RIGHTSSERVICING RIGHTS

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

Costs include administrative costs Costs include administrative costs and overheadand overhead

SERVICING RIGHTSSERVICING RIGHTS

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

Value is affected by interest rate Value is affected by interest rate changes similar to IO stripschanges similar to IO strips

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

SERVICING RIGHTSSERVICING RIGHTS

Excess servicing rights are fees Excess servicing rights are fees greater than “normal”greater than “normal”

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

The greater the spread, the larger The greater the spread, the larger the excess servicing feesthe excess servicing fees

SERVICING RIGHTSSERVICING RIGHTS

Reasons for excess servicing rightsReasons for excess servicing rights Mortgage-backed securities generally Mortgage-backed securities generally

have coupons in one-half point intervalshave coupons in one-half point intervals Premium securities may sell at Premium securities may sell at

unattractive prices due to fears of unattractive prices due to fears of prepaymentprepayment

Mortgage pools may contain loans with Mortgage pools may contain loans with different coupons thus some loans may different coupons thus some loans may have excess servicinghave excess servicing

VALUE CREATION IN MBSsVALUE CREATION IN MBSs

Value is created even though no Value is created even though no additional cash flow is createdadditional cash flow is created

Securitization eliminates liquidity risk Securitization eliminates liquidity risk and makes the market largerand makes the market larger

Securitization rearranges the cash Securitization rearranges the cash flows into more and less risky flows into more and less risky componentscomponents

Asymmetric information may distort Asymmetric information may distort values - lenders may have superiorvalues - lenders may have superior