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# CHAPTER 10: MORTGAGE-BACKED AND ASSET-BACKED

## PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. Suppose ABC Bank has a fixed-rate mortgage portfolio with the following features:
Mortgage portfolio balance = \$100,000,000
Weighted Average coupon rate (WAC) = 8%
Weighted average maturity (WAM) = 360 months
Estimated prepayment speed = 150 PSA

## Item Month 1 Month 2

Balance 100,000,000
Interest 666,667
p 733,765
Scheduled Principal
CPR
SMM
Prepaid Principal
Total Principal
Cash Flow

## Item Month 1 Month 2

Balance 100,000,000 99,907,884
Interest 666,667 666,053
p 733,765 733,581
Scheduled Principal 67,098 67,528
CPR .003 .006
SMM .0002503 .0005014
Prepaid Principal 25,018 50,058
Total Principal 92,116 117,586
Cash Flow 758,782 783,639

2. Suppose ABC Bank in Question 1 sells mortgage-backed securities backed by its \$100
million portfolio of fixed-rate mortgages with the MBSs having the following features:
Mortgage Collateral = \$100,000,000
Weighted average coupon rate (WAC) = 8%
Weighted average maturity (WAM) = 360 months
Estimated prepayment speed = 150 PSA
MBS pass-through rate = PT Rate = 7%
ABC will service the mortgage portfolio

a. Show in the table the first two months of cash flows going to the MBS investors.

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Item Month 1 Month 2
Balance 100,000,000
Interest 583,333
p 733,765
Scheduled Principal
CPR
SMM
Prepaid Principal
Total Principal
Cash Flow

a.

## Item Month 1 Month 2

Balance 100,000,000 99,907,884
Interest 583,333 582,796
p 733,765 733,581
Scheduled Principal 67,098 67,528
CPR .003 .006
SMM .0002503 .0005014
Prepaid Principal 25,018 50,058
Total Principal 92,116 117,586
Cash Flow 675,449 700,382

b. Typically, fees for constructing, managing, and servicing the underlying mortgages and the
MBSs are equal to the difference between the WAC associated with the mortgage pool and
the MBS pass-through (PT) rate. The monthly fees on the MBS issue are equal to .08333% =
(8% 7%)/12 of the monthly balance. In the first month this is \$83,333 and the second
month it is \$83,257. This is also equal to the differences in cash flows from the banks cash
flows before selling the MBS (Question 1) and the cash flows the MBS holders receive.

3. Explain some of the factors that determine the prepayment speed on a mortgage portfolio.

The refinancing incentive is the most important factor influencing prepayment. If mortgage
rates decrease below the mortgage loan rate, borrowers have a strong incentive to prepay. This
incentive increases during periods of falling interest rates, with the greatest increases occurring
when borrowers determine that rates have bottomed out. A second factor determining
prepayment is the age of the mortgage, referred to as seasoning. Prepayment tends to be greater
during the early part of the loan, and then stabilize after a certain elapse of time. Mortgage
prepayment rates are also influenced by the month of the year, with prepayment tending to be
higher during the summer months. Finally, there is the burnout factor. The burnout factor refers

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to the tendency for premium mortgages to hit some maximum prepayment rate and then level
off. In addition to these factors prepayment is also influences by secular variations, types of
mortgages, and the original terms of the mortgage.

## 4. Define agency pass-throughs and describe some of their features.

Agency pass-throughs are MBSs created by federal agencies: Federal National Mortgage
Association (Fannie Mae, FNMA), the Government National Mortgage Association (Ginnie
Mae, GNMA), and the Federal Home Loan Mortgage Corporation (Freddie Mac, FHLMC).
These agencies buy certain types of mortgage loan portfolios and then pool them to create MBSs
to sell to investors.

Ginnie Mae
Ginnie Mae is a true federal agency. As such, the MBSs that it guarantees are backed by the full
faith and credit of the U.S. government. Ginnie Mae MBSs are put together by a
lender/originator (bank, thrift, or mortgage banker), who presents a block of mortgages that
meets Ginnie Maes underwriting standards. If Ginnie Mae finds them in order, it will issue a
guarantee and assign a pool number that identifies the MBS that is to be issued. The lender will
then transfer the mortgages to a trustee, and then issue the pass-through securities as a Ginnie
Mae pass-through security. Ginnie Mae, therefore, provides the guarantee, but does not issue the
Ginnie Mae MBS. Thus, different from the standard MBS that is issued by the other agencies or
a conduit, Ginnie Mae MBSs are issued by the lenders. The mortgages underlying Ginnie Mae
MBSs can be grouped into one of two Ginnie Mae MBS programs: Ginnie Mae I and Ginnie
Mae II. The Ginnie Mae I program consists of MBSs backed by single-family and multifamily
mortgage loans that have a fixed note rate and are sold by only one issuer. The Ginnie Mae II
program consists of just single-family mortgage loans that can have either fixed or adjustable
rates and have multiple issuers. The minimum denomination on a Ginnie Mae pass-through is
\$25,000 and the minimum pool is \$1 million.

## Fannie Mae and Freddie Mac Mortgage-Backed Securities

Fannie Mae and Freddie Mac are Government-sponsored enterprises (GSE) initially created to
provide a secondary market for mortgages. Today, there activities include not only the buying
and selling of mortgages, but also creating and guaranteeing mortgage-backed pass-through
securities, as well as buying MBSs. Both GSEs are regulated by the Office of Federal Housing
Enterprise Oversight (OFHEO) and both were placed in conservatorship in September 2008.
Prior to being placed in conservatorship, the Fannie Mae and Freddie Mac MBSs were guarantee
by each of the companies, but not the government. As part of the banking bailout in 2008,
though, government backing was provided to their MBSs.
Freddie Mac issues MBSs that it refers to as participation certificates (PCs). Freddie Mac
and Fannie Mae have regular MBSs (also called a cash PC), which are backed by a pool of
conforming mortgages that they have purchased from mortgage originators. They also offer a
pass-though formed through their Guarantor/Swap Program. In this program, mortgage
originators can swap mortgages for a FMLMC pass-through. Unlike Ginnie Mae, Fannie Maes
and Freddie Mac's MBSs are formed with more heterogeneous mortgages. The minimum
denomination on a Freddie Mac and Fannie Mae pass-through is \$100,000 and their mortgage
pools range up to several hundred million dollars.

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5. Define conventional private-label pass-throughs and describe some of their features.

Private labels or nonagency pass-throughs are sold by commercial banks, investment banks,
other thrifts, and mortgage bankers. Nonagency pass-throughs are often formed with prime or
subprime nonconforming mortgages. Larger issuers of nonagency MBSs include Citigroup, Bank
of America, and G.E. Capital Mortgage. Their pass-throughs are often guaranteed against default
through external credit enhancements, such as the guarantee of a corporation or a bank letter of
credit or by private insurance from a monocline insurer. Many are also guaranteed internally
through the creation of senior and subordinate classes of bonds with different priority claims on
the pool's cash flows in the case some of the mortgages in the pool default. The more
subordinate claims sold relative to the senior claims, the more secure the senior claims. Because
of their credit risk, nonagency MBSs are rated by Moody's and Standard and Poor's, and, unlike
agency pass-throughs, they must be registered with the SEC when they are issued.
Nonagency residential MBSs differ fundamentally from agency MBSs in that their cash
flows are subject to default risk, whereas agency MBSs with their government and agency
guarantees are considered default free.

6. What is the market value (clean price) of an 8% MBS issue backed by a mortgage pool
with an original par value of \$100 million, if its price is quoted at 105-16 with a pool
factor of .95?

An MBS issue backed by a mortgage pool with an original par value of \$100 million and
currently priced at 105-16 (105.5% of par) with a pool factor of .95 would have a market value
\$100,225,000:

## Par Value Remaining = (\$100,000,000) (.95) = \$95,000,000

Market Value = (\$95,000,000) (1.055) = \$100,225,000

7. Explain the relationship between extension risk, prepayment risk, and average life.

The effect of an interest rate increase in lowering the price of the bond by decreasing the value of
its cash flows is known as extension risk. Extension risk can be described in terms of the
relationship between interest rates and the MBS's average life. The average life of a MBS is the
weighted average of securitys time periods, with the weights being the periodic principal
payments (scheduled and prepaid principal) divided by the total principal. Thus, if the
prepayment speed were to increase as a result of lower interest rates, then the average life of the
MBS will decrease, indicating greater principal payments in the earlier years.

8. Explain how the following CMOs are constructed and their features:
a. Sequential-pay tranche
b. Sequential-pay tranches with an accrual bond tranche
c. Floating-rate and inverse floating-rate tranches
d. Notional IO tranche
e. PAC and support bonds
f. Sequential-pay PAC

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a. Sequential-pay tranche: A CMO with sequential-pay tranches is divided into classes with
different priority claims on the collateral's principal. The tranche with the first priority claim
has its principal paid entirely before the next priority class, which has its principal paid
before the third class, and so on. Interest payments on most of the CMO tranches are made
until the tranche's principal is retired. Sequential-pay tranches have maturities, principal
payment periods, and average lives different from those defined by the underlying mortgage
collateral. Some of the tranches will have an average life that is less than the collateral's
average life. In general, a CMO tranche with a lower average life is less susceptible to
prepayment risk. Such risk, though, is not eliminated.

b. Sequential-pay tranches with an accrual bond tranche: An accrual bond class included
with a sequential-pay CMO does not receive interest until its principal payments are made.
Its interest, though, does accrue.

c. Floating-rate and inverse floating-rate tranches: These tranches are created from a fixed-
rate tranche. The monthly coupon rate on the floating-rate tranche is usually set equal to a
reference rate such as the London Interbank Offer Rate, whereas the rate on the inverse
floating-rate tranche is determined by a formula that is inversely related to the reference rate.
The tranches are attractive to investors who prefer floating rate securities.

d. Notional IO tranche: When CMOs are structured with tranches that have different rates, a
notional interest-only class is often created. This tranche receives the excess interest on the
other tranche's principal, with the excess rate being equal to the difference in the collateral
rate minus the tranche's coupon rate.

e. PAC and support bonds: In a PAC-structured CMO, the underlying mortgages collateral is
divided into two general tranches: the PAC tranche and the support tranche. The two tranches
are formed by generating two monthly principal payment schedules from the collateral; one
schedule is based on assuming a relatively low PSA speed, whereas the other is obtained by
assuming a relatively high PSA speed. The PAC bond is then set up so that it will receive a
monthly principal payment schedule based on the minimum principal from the two principal
payments. Thus, the PAC bond is designed to have no prepayment risk provided the actual
prepayment falls within the minimum and maximum assumed PSA speeds. The support
bond, on the other hand, receives the remaining principal balance and is therefore subject to
prepayment risk.

f. Sequential-pay PAC: This is formed by dividing a PAC into several sequential-pay tranches,
with each PAC having a different priority in principal payments over the other tranches. Each
sequential-pay PAC, in turn, will have a constant average life if the prepayment speed is
within the lower and upper collars. In addition, it is possible that some of the PACs' range of
stability will increase beyond the actual collar range, expanding the effective collars on some
tranches.

9. Explain the interest rate and value relation for a principal-only stripped MBS and an
interest-only stripped MBS.

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Principal-only (PO) stripped mortgage-backed securities receive only the principal from the
underlying mortgages. The return on a PO MBS is greater with greater prepayment speed. For
example, a PO class formed with \$100 million mortgages (principal) and priced at \$75 million
would yield an immediate return of \$25 million if the mortgage borrowers prepaid immediately.
Since investors can reinvest the \$25 million, this early return will have a greater return per period
than a \$25 million return that is spread out over a 30-year period. Because of prepayment, the
price of a PO MBS tends to be more responsive to interest rate changes than other option-free
bonds. That is, if interest rates are decreasing, then like the price of most bonds, the price of a
PO MBS will increase. In addition, the price of a PO MBS is also likely to increase further
because of the expectation of greater earlier principal payments as a result of an increase in
prepayment caused by the lower rates. Thus, like most bonds, the prices of PO MBS are
inversely related to interest rates. Like other MBS with embedded principal prepayment options,
PO MBS prices tend to be more responsive to interest rate changes.

Interest-only (IO) stripped MBSs receive only the interest from the underlying mortgages. Cash
flows from an I0 come from interest paid on the mortgages pools principal balance. In contrast
to a PO MBS, the cash flows and the returns on an IO MBS will be greater, the slower the
prepayment rate. Thus, IO MBSs are characterized by an inverse relationship between
prepayment speed and cash flows: the slower the prepayment rate, the greater the total cash
flows on an IO MBS. Interestingly, if this inverse relationship is relatively large, then it is
possible that the price of an IO MBS could vary directly with interest rates.

## 10. What is yield analysis?

Yield analysis involves calculating the yields on MBSs or CMO tranches given different prices
and prepayment speed assumptions or alternatively calculating the values on MBSs or tranches
given different rates and speeds. One common approach is to generate a matrix of different
yields by varying the prices and prepayment speeds. Using this matrix, an investor could
determine for a given price and speed, the estimated yield, or determine for a given speed and
yield, the price.

11. Explain the difference between static yield analysis and vector analysis.

In a static yield analysis, the PSA speed used to estimate yields given prices, or prices given
yields, is assumed to be constant during the life of the MBS. Vector analysis is a more dynamic
analysis in which the PSA speeds are assumed to change over time. Such analysis involves
generating a matrix of values for different rates given different PSA vectors with each vector
having different PSA speeds assumed for each period.

12. Using the MBScollateral Excel program available on the website, create an Excel table for
the following agency MBS:
Mortgage Collateral = \$50,000,000
WAC = 7%
PT rate = 6.5
WAM = 350

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Seasoning = 10
PSA = 75%

Note: In your table, you may want to hide many of the rows and some of the columns. Do
keep columns for period, balance, interest, scheduled principal, prepaid principal, and
cash flow.

13. Using the MBScollateral program (on text website), determine (for the MBS in Question
12) the values and average lives for the following yield analysis matrix:

Value Value
5%
6%
7%
8%

Average Life

## Discount Rate/PSA 50 150

Value Value
5% \$57,565,779 \$55,167,657
6% \$52,884,127 \$52,005,608
7% \$48,833,080 49,174,840
8% \$45,306,641 46,629,042

## Average Life 14.28 8.74

14. Using the MBScollateral Excel program (on text website), create an Excel table for a
principal-only stripped MBS and interest-only stripped MBS formed from the MBS
described in Question 12. In your table, hide many of the rows and hide all columns except
the ones for period, collateral balance, collateral interest, collateral principal, cash flow

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for PO strip, and cash flow for IO strip.

## 15. Given the following mortgage collateral and PAC:

Mortgage Collateral = \$100,000,000
Weighted average coupon rate (WAC) = 7%
Weighted average maturity (WAM) = 350 months
Seasoning = 10 months
Estimated prepayment speed = 150 PSA
MBS pass-through rate = PT Rate = 6.5%
PAC formed from the collateral with a lower collar of 100 and upper collar of 300
Support bond receiving the residual principal

a. Using the MBSpac Excel program (on the text website), create an Excel table for
the CMO. In your table, hide many of the rows and hide all columns except for the
following: period, the balance, interest, and principal for the collateral, the interest,
lower collar principal, upper collar principal, PAC principal, and cash flow for the
PAC bond, and principal, interest, and cash flow for the support bond.
b. Using the MBSpac Excel program, determine the average life for collateral, PAC
bond, and support bond given the PSA speeds shown in the table:

## PSA Collateral PAC Support

Average Life Average Life Average Life
50
100
150
200
250
300
350

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c. Comment on the PACs average life given the different PSA speeds.

a.

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b.
PSA Collateral PAC Support
Average Life Average Life Average Life
50 14.28 7.48 20.86
100 10.98 6.60 18.89
150 8.74 6.60 12.59
200 7.16 6.60 8.17
250 6.01 6.60 4.96
300 5.16 6.60 2.58
350 4.51 5.97 2.39

c. Comment: The PACs average life is constant at 6.60 for PSA speeds between the 100 and
300 collars. This indicates there is no prepayment risk on the PAC provided the actual PSA
speed is between the upper and lower collars.

16. Suppose the collateral backing a nonagency MBS consists of a fixed-rate residential
mortgage portfolio with the following features:
Mortgage Portfolio Balance = \$500,000,000
Weighted Average Coupon Rate (WAC) = 6%
Weighted Average Maturity (WAM) = 360 months
No Prepayment

Using the MBS Collateral with Default Loss Excel Program (on text website), determine
the following:
a. The cumulative default rates after months 30, 60, 120, and 360 for SDAs of 100,
200, and 300.
b. Graph the cumulative default rates from the beginning to maturity (360 th month)
for SDAs of 100, 200, and 300.
a.

b.

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17. Suppose a conduit was structuring a senior-subordinate structured MBS deal based on the
collateral described in Question 16. Determine the allocations of the \$500 million
principal for the senior and subordinate classes that the conduit would need if he wanted
to eliminate the projected default losses based on SDAs of 100, 200, and 300.

## SDA Senior Principal Subordinate

100 \$480,965,975 \$19,034,124
200 \$462,613,559 \$37,386,441
300 \$444,920,709 \$55,079,291

18. The table below shows a \$300 million senior-subordinate structured MBS with one Senior
Bond Class and four subordinate classes:

## Senior-Subordinated Structured MBS

Bond Class Tranche Principal Credit Ratings

## Senior 1 \$250 million AAA

Subordinate 2 \$30 million AA
Subordinate 3 \$10 million A
Subordinate 4 \$5 million BBB
Subordinate 5 \$5 million B

a. What is the senior interest?
b. What is the subordinate interest?
c. If the default losses on the collateral totaled \$17 million, what trances would
absorb the loss.

## a. Senior Interest = 83.33%.

b. Subordinate Interest = 16.67%.
c. Tranches 4 and 5 would absorb \$10 million (100% of their principal) and Tranche 3
would absorb \$7 million (70% of their principal).

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19. Determine the percentage of prepayment that would go to the senior and subordinate
classes described in Question 18 given the following Shifting Interest Schedule.

1-7 100%
8 80%
9 60%
10 40%
After 10 0%

## Years after Issuance Shifting Interest % Prepayment to

Percentage Senior Tranche
1-7 100% 100%
8 80% 96.67%
9 60% 93.33%
10 40% 90.00
After 10 0% 83.33%

## 20. Explain what is meant by a step-down provision as it relates to the shifting-interest

schedule in Question 19.

In a senior-subordinated structured deal, the step-down provision allows for reductions in the
credit support over time provided there is no deterioration in the credit quality of the collateral.
For a shifting interest schedule in Question 19, the shift-down of credit starts in Year 8 when the
percentage of interest on the prepayment to senior goes down from 100% in Year 7 to 80% in
Year 8; in Year 9 from 80% to 60%; in Year 10 from 60% to 40%; and after Year 10 from 40%
to 0. A step down provision would, in turn, prohibit the step downs if the credit quality of the
collateral, as measured by certain tests (e.g., principal-loss test or delinquency test), is not met.

21. Explain how excess interest is set up with an interest-only account to provide a credit
enhancement to a nonagency MBS.

Excess spread (or excess interest) is the interest from the collateral that is not being used to meet
liabilities (pass-through rate) and fees (mortgage servicing and administrative services). The
excess spread is used to offset any default losses from the collateral. If the excess spread is
retained in the structure rather than paid out, it can be accumulated in a reserve account and used
to offset current and futures losses. Excess interest could be set up as an excess interest-only (IO)
class, with the proceeds going to a reserve account and paid out to IO holders at some future date
if there is an excess.

## 22. Explain some of the features that characterize commercial mortgages.

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(1) Commercial loans are non-recourse. This means that the lender can only look to the
income-producing property backing the loan for interest and principal. As a result, the
lender monitors the credit performance in terms of key ratios such as the debt-to-service
ratio and the loan-to-value ratio.

(2) Commercial mortgages often have call or prepayment protection, such as prepayment
penalties, and defeasance (contractual agreement that requires that the borrowers to invest
in Treasury securities that would replicate the cash flows from of a projected prepayment
schedule.

(3) Commercial mortgage loans are typically balloon loans. At the balloon date, the borrower
must pay of the remaining balance. This is typically done by refinancing.

## 23. Explain the two types of commercial MBS deals.

Two types are commercial MBS deals are single borrower/multiproperty deals and conduit deals.
A single borrower/multiproperty deal involves one borrower, such as a developer, who has
multiple development properties that are collectively financed by the commercial MBS issue. In
a conduit deal, there is one conduit and a number of originators with different types of properties
and from different geographical areas.

24. What is the important principle analysts must adhere to when examining commercial MBS
deals?

## Credit analysis should be performed on a loan-by-loan basis and on an ongoing basis.

25. XYZ Inc. manufactures and sells machine tools with a large part of its sales coming from
installment sales contracts. XYZs credit department makes decisions on extending credit,
originating loans, and servicing them. XYZ has \$500 million installment sales contracts. It
also would like to raise \$500 million in new funds. Explain how XYZ would set up a
special purchase vehicle to securitize its sales contracts as an alternative to issuing a \$500
million debt issue. What are the advantages of the SPV securitization by an SPV over
issuing debt?

XYZ could set up a Special Purpose Vehicle (SPV)XYZ Trust. XYX Inc. would then sell XYZ
Trust \$500 million of installment loans for \$500 million cash. XYZ Trust would then sell \$500
million in securities backed by the \$500 million in loans.

XYZ Inc. alternatively could have raised \$500 million by issuing corporate bonds, either as a
debenture or collateralized by the installment loans. If XYZ were to default, all of its creditors
would be able to go after all of its assets. If XYZ Inc. sells the installment loans to its SPV, XYZ
Trust, then XXZ Trust owns the loans/assets and not XYX Inc.. If XYZ Inc. were forced into
bankruptcy, the creditors of XYX Inc. would not be able to recover the installment loans of XYZ
Trust. When XYZ Trust issues ABS, the investors will look only at the credit risk associated with
the installment loans; i.e., credit risk is based only on that collateral. As a result, by financing

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with securitization via a SPV, the bonds or ABS may have a better credit rating and lower rate
than would XYZ Inc. bonds.

26. What is the main structural difference between an ABS formed with automobile loans,
home equity loans, or residential mortgage loans and those formed with credit card
receivables?

The collateral backing an ABS are car loans or home equity loans in which the principal is
amortized. As a result, the principal is paid off to the ABS holders. In contrast, the collateral
backing an ABS is not amortized. Amortized ABSs are, in turn, subject to prepayment risk,
whereas Non-amortized ABSs are not.

27. How is the payment of principal on an ABS backed by credit card receivables typically
structured?

Because the payment of principal on non-amortized ABSs does not follow a specified schedule,
principal payments are managed by setting up periods when principal received from the
collateral is invested (lockout period) and periods when the principal is paid to ABS holder
(amortizing period).

28. How do ABSs backed by automobile loans (CARS) differ from MBS?

CARS differ from MBSs in that they have much shorter lives, their prepayment rates are less
influenced by interest rates than mortgage prepayment rates, and they can include more credit
enhancements.

29. Suppose the estimate absolute prepayment speed (APS) on pool of automobile loans is
2.5%. What would the monthly prepayment rate be for the mortgage pool in month 15?

APS
SMM
1 ( APS)(M 1)
.025
SMM .038462
1 (.025)(15 1)

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