Securitization

Financial Institutions Management, 3/e By Anthony Saunders

Irwin/McGraw-Hill

I. Introduction


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, and provide a source of fee income. It also helps to reduce the effect of regulatory taxes such as capital requirements, reserve requirements, and deposit insurance premiums.
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I. Introduction: Pass-Through Securities



Government National Mortgage Association (GNMA)

Sponsors MBS programs by FIs. Act as a guarantor to investors, i.e., it provides timing insurance.
GNMA supports only those pools of mortgages that comprise mortgage loans whose default or credit risk is insured by one of three government agencies: VA, FHA, and FHMA.

FNMA actually creates MBSs by purchasing and holding packages of mortgages on its balance sheet; it also issues bonds directly to finance those purchases.
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I. Introduction: Pass-Through Securities



Federal Home Loan Mortgage Corporation

Similar function to FNMA except major role has involved savings banks. Stockholder owned with line of credit from the Treasury. It buys mortgage loans from FIs and swaps MBSs for loans. It also sponsors conventional loan pools as well as FHA/VA mortgage pools and guarantees timely payment of interest and principal on the securities it issues.
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II. Incentives and Mechanics of PassThrough Security Creation



1. To Reduce Regulatory Taxes:

Create a mortgage pool from one-thousand, $100,000 mortgages (Results in $100 million) with 30 years in maturity and 12 percent interest rate. Each mortgage receives credit risk protection from FHA. Capital requirement = $100m * .05 * .08 = $4 million (the risk-adjusted value of residential mortgages is 50% of face value and the risk-based capital requirement is 8%). Must issue more than $96 million in liabilities due to a 10% reserve requirements (106.67m = $96m/(1-0.1)). Irwin/McGraw-Hill (+ FDIC premia).

II. Incentives and Mechanics of PassThrough Security Creation

Reserve requirement = 10% * $106.67 = $10.67m, leaves $96m to fund the mortgages. FDIC insurance premium = $106.66m * .0027 = $287,982 The three levels of regulatory taxes:
1. Capital requirements; 2. Reserve requirements; 3. FDIC insurance premiums.
Irwin/McGraw-Hill

II. Incentives and Mechanics of PassThrough Security Creation

Bank Balance Sheet Before Securitization:
Assets Liabilities ________________________________________________________ Cash reserves $10.66 Demand Deposits$106.6 Long-term mortgage $100.00 Capital $ 4.00 ________________________________________________________

Irwin/McGraw-Hill

II. Incentives and Mechanics of PassThrough Security Creation

Bank Balance Sheet after Securitization
Assets Liabilities ________________________________________________________ Cash reserves $10.66 Demand Deposits$106.6 Cash proceeds from $100.00 Capital $ 4.00 mortgage securitization ________________________________________________________ A dramatic change in the balance sheet exposure of the bank: 1. $100m illiquid mortgage loans have been replaced by $100m cash; 2. The duration mismatch has been reduced; 3. The bank has an enhanced ability to deal with and reduce its regulatory taxes.

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II. Further Incentives



Two additional risks arise from mortgage origination:

2. To Reduce Gap exposure: The FI funds the 30-year mortgages out of short-term deposits; thus has a duration mismatch. 3. To Reduce Illiquidity exposure: illiquid portfolio of long term mortgages.

Creating GNMA pass-through securities can largely resolve the duration and illiquidity risk problems on the one hand and reduce the burden of regulatory taxes on the other.
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II. Further Incentives



Investors of GNMA securities are protected against two levels of default risks:  1. Default Risk by the Mortgages
Through FHA/VA housing insurance, government agencies bear the risk of default.  2. Default Risk by Bank/Trustee: GNMA would bear the cost of making the promising payments in full and on time to GNMA bondholders.
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II. Further Incentives



Given the default protection, the returns to GNMA bondholders:

_______________________________________ Mortgage coupon rate = 12% - Service fee (to the bank) = 0.44 - GNMA insurance fee = 0.06 GNMA pass-through bond coupon = 11.50% ________________________________________
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III. Effects of Prepayments

 

Sources of prepayment risk: 1. Refinancing:

For individuals in the pool to pay off old high-cost mortgages and refinance at lower rates. Refinancing involves transaction costs and recontracting costs.

 

2. Housing Turnover:
Due to a complex set of factors.

Prepayment gives mortgage holders a very valuable call option on the mortgage when this option is in the money. Irwin/McGraw-Hill

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III. Effects of Prepayments

The effect is to lower dramatically the principal and interest cash flows received in the later months of the pools life.  Good news effects


Lower market yields increase present value of cash flows. Principal received sooner.


Bad news effects

Fewer interest payments in total. Irwin/McGraw-Hill Reinvestment at lower rates.
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III. Effects of Prepayments



Prepayments result of sales or refinancing.

Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates. Methods:
Option pricing approach. Public Securities Association approach. Empirical approach.
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III. Effects of Prepayments: PSA Model



The PSA (Public Securities Association) model assumes that the prepayment rate starts at 0.2% per annum in the first month, increasing by 0.2% per month for the first 30 months, until prepayment rate then levels off at a 6 % annualized rate for the remaining life of the pool. Issuers or investors who assume that their mortgage pool prepayment exactly match this pattern are said to assume 100 percent PSA behavior.
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III. Effects of Prepayments: PSA Model

Monthly prepayment rate (%)

7 %
6% 4 /2%

125% PSA 100% PSA 75% PSA

360 Months

30
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III. Effects of Prepayments: PSA Model



Actual prepayment rate may differ from PSAs assumed pattern:

The level of the pools coupon relative to the current mortgage coupon rate; The age of the mortgage pool; Whether the payments are fully amortized; Assumability of mortgages in the pool. Size of the pool; Conventional or nonconventional mortgages; Geographical location; Age and job status of mortgagees in the pool.
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III. Effects of Prepayments: PSA Model



On approach to control these factors is by assuming some fixed deviation of any specific pool from PSAs assumed average or benchmark pattern. E.g., one pool may be assumed to be 75% PSA, and another 125% PSA. The formal has a lower prepayment rate than historically experienced; the latter, a faster rate.
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III. Effects of Prepayments: Other Empirical Models

Most empirical models are proprietary versions of the PSA model in which FIs make their own estimates of the pattern on monthly prepayments.  FIs begin by estimating a prepayment function from observing the experience of mortgage holders prepaying during any particular period on mortgage pools.

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III. Effects of Prepayments: Other Empirical Models



The conditional prepayment rates in month i for similar pools would be modeled as functions of economic variables driving prepayment; e.g., pi = f(mortgage rate spread, age, collateral, geographic factors, burn-out factor). Once the frequency distribution of the pis is estimated, the bank 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.
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III. Effects of Prepayments: Option Model Approach

 

Fair price on pass-through decomposable into two parts

PGNMA = PTBOND - PPREPAYMENT OPTION

Option-adjusted spread between GNMAs and T-bonds reflects value of a call option. Specifically, 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. If interest rates fall, the option becomes more valuable as it moves into the money and more mortgages are prepaid early by having the bond called or the prepayment option exercised.
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III. Effects of Prepayments: Option Model Approach



In the yield dimension:

YGNMA = YTBOND + YPREPAYMENT OPTION

That is, the fair yield spread or optionadjusted spread (OAS) between GNMAs and T-bonds plus an additional yield for writing the valuable call option.
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III. Effects of Prepayments: Option Model Approach

Example: Smiths Model  Assumptions:

1. The only reasons for prepayment are due to refinancing mortgage at lower rates; 2. The current discount (zero-coupon) yield curve for T-bonds is flat; 3. The mortgage coupon rate is 10% on an outstanding pool of mortgages with an outstanding principal balance of $1,000,000; 4. The mortgages have a 3-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 service fee.

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III. Effects of Prepayments: Option Model Approach

Thus the annually fully amortized payment under no prepayment conditions is:
R = $1,000,000/(PVIFA 10%, 3 yrs) = $402,114. At the current mortgage rate of 9%, the GNMA bond would be selling at: P = $402,114 * (PVIFA 9%, 3 yrs) = $1,017,869.
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III. Effects of Prepayments: Option Model Approach



6. Because of prepayment penalties and refinancing costs, mortgagees do not begin to prepay until mortgage rates fall 3% or more below the mortgage coupon rate. 7. Interest rate movements over time change a maximum of 1% up or down each year. The time path of interest rates follows a binomial process. 8. With prepayment present, cash flows in any year can be the promised payment R = $402,411, the promised payment (R) plus repayment of any outstanding principal, or zero in all mortgages have been prepaid or paid off in the previous year.
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III. Effects of Prepayments: Option Model Approach



End of Year 1: since interest rates can change up or down by 1% per annum, mortgages are not prepaid. GNMA bondholders receive the promised payment R=$401,114 with certainty.

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III. Effects of Prepayments: Option Model Approach



End of Year 2:There are three possible mortgage rates; 11%, 9%, and 7% with 25%, 50%, and 25% of probability.

If prepayment occurs, the investor receives: R + principal balance remaining at the end of yr 2 = $402,114 + $365,561 = $767,675 Thus CF2 = .25($767,675) + .75($402,114) = $493,504.15
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III. Effects of Prepayments: Option Model Approach

Where the principal balance remaining at the end of yr 2 is calculated as:
Year Total Payment Interest Payment Principal Payment Remaining Principal

1 2 3

402,114 402,114 402,114

100,000 69,789 36,556

302,113 332,325 365,561

697,886 365,561 0

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III. Effects of Prepayments: Option Model Approach

End of Year 3: since there is a 25% probability that mortgages are prepaid in yr 2, the investor will receive no cash flows at the end of yr 3. However, there is also a 75% probability that mortgages will not be prepaid in yr 2, the investor will receive the promised payment R = $402,114.  CF3 = .25($0) + .75($402,114) = $301,586

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III. Effects of Prepayments: Option Model Approach

Deviation of the Option-Adjusted Spread:  The required yield on a GNMA with prepayment risk is divided into the required yield on T-bond plus a required spread for the prepayment call option given to the mortgage holders:


E(CF1)
(1+d1+Os)
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E(CF2)
(1+d2+Os)2

E(CF3)
(1+d3Os)3
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P = ------------ + ------------- + --------------

III. Effects of Prepayments: Option Model Approach

Deviation of the Option-Adjusted Spread:  Where  P= Price of GNMA  d1 = discount rate on 1-yr, zero T-bonds  d2 = discount rate on 2-yr, zeroT-bonds  d3 = discount rate on 3-yr, zeroT- bonds  Os = option-adjusted spread on GNMA

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III. Effects of Prepayments: Option Model Approach



Assume that the T-bond yield curve is flat, so that d1 = d2= d3 = 8%; then
$401,114 $493,504 (1+.08+ Os)2 $301,585 (1+.08+ Os)3

P = ------------ + ------------- + ------------- (1+.08+Os)

  

Os = 0.96%; and YGNMA = YTBOND + Os = 8% + 0.96% = 8.96%

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IV. Collateralized Mortgage Obligation (CMO)



CMO structure
CMOs can be created either by packaging and securitizing whole mortgage loans or by placing existing pass-throughs in a trust. The investment bank or issuer creates the CMO to make a profit. The sum of the prices at which the CMO bond classes can be sold normally exceeds that of the original pass-throughs. Prepayment effects differ across tranches. Improves marketability of the bonds.
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IV. Collateralized Mortgage Obligation (CMO)

The Value Additivity of CMOs:  Suppose an investment bank buys a $150m issue of GNMAs and places them in trust as collateral. It then issues a CMO with:


Class A: Annual fixed coupon 7%, class size $50m Class B: Annual fixed coupon 8%, class size 50m Class C: Annual fixed coupon 9%, class size $50m

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IV. Collateralized Mortgage Obligation (CMO)



Assume that in month 1 the promised amortized cash flows on the mortgages are $1m but there is an additional $1.5m cash flows as a result of early prepayment. These are distributed to CMO holders as:
Coupon payments:
Class A (7%): $291,667 Class B (8%): $333,333 Class C (9%): $375,000
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IV. Collateralized Mortgage Obligation (CMO)



Principal Payments:
The $1.5m cash flows remaining will be paid to Class A holders to reduce its principal outstanding to $50m-$1.5m=$48.5m. Between 1.5 to 3 years after issue, Class A will be fully retired. The trust will continue to pay Class B and C holders the promised coupon payments of $333,333 and $375,000 monthly. Any cash flows over the promised coupons will be paid to retire Class B CMOs. Irwin/McGraw-Hill
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IV. Collateralized Mortgage Obligation (CMO)



Class Z: This class has a stated coupon, such as 10%, and accrues interest for the bondholders on a monthly basis at this rate. The trust does not pay this interest, however, until all other classes are fully retired. Then Z-class holders received coupon and principal payments plus accrued interest payments. Thus, Z-class has characteristics of both a zero-coupon bond and a regular bond.
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IV. Collateralized Mortgage Obligation (CMO)



Class R: CMOs tend to be over-collaterized:

CMO issuers normally uses very conservative prepayment assumptions. If prepayments are slower than expected, there is often excess collateral left over when all regular classes are retired. Trustees often reinvest cash flows in the period prior to paying interest on the CMOs. The higher the interest rate and the timing of coupon intervals is semiannual rather than monthly, the larger the excess collateral. Irwin/McGraw-Hill
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IV. Collateralized Mortgage Obligation (CMO)



This residual R-class is a high-risk investment class that gives the investor the rights to the overcollateralization and reinvestment income on the cash flows in the CMO trust.  Because the value of the returns in this bond increases when interest rates rise, while normal bond values fall with interest rate increases, Class R often has a negative duration.
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V. Mortgage-Backed Bonds (MBBs)



Differs from pass-throughs and CMOs in two key dimensions:

1. While pass-throughs and CMOs remove mortgages from balance sheets, MBBs normally remain on the balance sheet. 2. Pass-throughs and CMOs have a direct link between the cash flow on the underlying mortgages, with MBBs the relationship is one of collateralization.
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V. Mortgage-Backed Bonds (MBBs)



Normally remain on the balance sheet and over-collaterized to reduce funding costs.

__________________________________________________________________ Assets Liabilities __________________________________________________________________ Long-term Mortgages $20 Insurance Deposits $10 Uninsured Deposits $10 __________________________________________________________________ Collateral $12 MBB $10 Other Mortgages $ 8 Insured Deposits $10 __________________________________________________________________
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V. Mortgage-Backed Bonds (MBBs)



Regulatory concerns: the bank gains only because the FDIC is willing to bear enhanced credit risk through its insurance guarantees to depositors.

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V. Mortgage-Backed Bonds (MBBs)



Other drawbacks to MBBs:

MBB ties up mortgages on the balance sheet. The need to overcollaterize to ensure a high-quality credit risk rating. By keeping mortgages on the balance sheet, the bank continues to be liable for capital adequacy and reserve requirement taxes.

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VI. Innovations in Securitization



Pass-through strips
IO strips: The owner of an IO strip has a claim to the present value of interest payments by the mortgagees. When interest rates change, they affect the cash flows received on mortgages:
Discount Effect: As interest rates fall, the present value of any cash flows received on the strip rises, increasing the value of the IO strips. Prepayment Effect: As interest rates fall, mortgagees prepay their mortgages. The number of IO payments the investor receives is likely to shrink, which reduces the Irwin/McGraw-Hill value of IO bonds.

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VI. Innovations in Securitization

IO Strip (continued):
Specifically, one can expect that as interest rates fall below the mortgage coupon rate, the prepayment effect gradually dominates the discount effect, so that over some range of the price or value of IO bond falls as interest rates fall (negative duration). The negative duration IO bond is a very valuable asset as a portfolio-hedging device.

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VI. Innovations in Securitization

PO strip: the mortgage principal components of each monthly payment, which include the monthly amortized payment and any early prepayments.
Discount Effect: As yields fall, the present value of any principal payments must increase and the value of the PO strip rises. Prepayment Effect: As yields fall, the mortgage holders pay off principal early. The PO bond holders received the fixed principal balance outstanding earlier than stated. This works to increase the value of the PO strip.
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VI. Innovations in Securitization



PO Strip (Continued):
As interest rates fall, both the discount and prepayment effects point to a rise in the value of PO strip. The price-yield curve reflects an inverse relationship, but with a steeper slope than for normal bonds; I.e., PO strip bond values are very interest rate sensitive, especially for yields below the stated mortgage coupon rate.
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VI. Innovations in Securitization



Securitization of other assets

CARDs (Certificates of Amortized Revolving Debts) Various receivables, loans, junk bonds, ARMs.

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VII. Can All Assets Be Securitized?

Benefits Costs ___________________________________________________________ 1 New funding source 1. Cost of public/private credit risk insurance and guarantees 2. Increased liquidity of bank loans 2. Cost of overcollateralization 3. Enhanced ability to manage the 3. Valuation and packaging costs duration gap (the cost of asset heterogeneity) 4. If off=balance-sheet, the issuer on reserve requirements, deposit insurance premiums, and capital adequacy requirements ___________________________________________________________
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