Securitization Chapter 28

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SecuritizationChapter 28

• Financial Institutions Management, 3/e
• By Anthony Saunders

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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.

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Securitization

• Government National Mortgage Association (GNMA)
• Sponsors MBS programs and acts as a guarantor.
• Timing insurance.
• FNMA actually creates MBSs by purchasing packages
  of mortgage loans.

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Freddie Mac

• 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.
• Sponsors conventional loan pools as well as
  FHA/VA mortgage pools.

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Incentives and Mechanics of Pass-Through Security
Creation

• Example
• Create a mortgage pool from one-thousand,
  100,000 mortgages (Results in 100 million).
• Each mortgage receives credit risk protection
  from FHA.
• Capital requirement 4 million.
• Must issue more than 96 million in liabilities
  due to reserve requirements. ( FDIC premia).

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Further Incentives

• Gap exposure
• Illiquidity exposure
• Default risk by mortgagees
• Phoenix, AZ in 1980s.
• Default risk by bank/trustee

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Effects of prepayments

• 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.

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Prepayment effects

• 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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Option Model Approach

• Use option pricing theory to figure fair yield
  spread of pass-throughs over Treasuries.
• 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.

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Collateralized Mortgage Obligation (CMO)

• CMO structure
• Prepayment effects differ across tranches
  (classes).
• Z-Class CMO.
• Improves marketability of the bonds.

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Mortgage-Backed Bonds (MBBs)

• Normally remain on the balance sheet.
• Regulatory concerns.
• Other drawbacks to MBBs.

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Innovations in Securitization

• Pass-through strips
• IO strips
• Negative duration.
• PO strips
• Securitization of other assets
• CARDs
• Various receivables, loans, junk bonds, ARMs.