Securitization

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Securitization

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

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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 Pass-Through
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)). ( FDIC premia).

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II. Incentives and Mechanics of Pass-Through
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.

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II. Incentives and Mechanics of Pass-Through
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
• __________________________________________________
  ______

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II. Incentives and Mechanics of Pass-Through
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 re-
  contracting 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.

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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.
• 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 ()
125 PSA 100 PSA 75 PSA
7 ½ 6 4 /2
360 Months
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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 option-adjusted
  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 R401,114 with certainty.

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III. Effects of Prepayments Option Model Approach

• End of Year 2There 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

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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) E(CF2) E(CF3)
• P ------------ ------------- --------------
• (1d1Os) (1d2Os)2 (1d3Os)3

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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
• 401,114 493,504 301,585
• P ------------ ------------- --------------
• (1.08Os) (1.08 Os)2 (1.08
  Os)3
• 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-1.5m48.5m.
• 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.

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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.

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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 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 offbalance-sheet, the issuer
• on reserve requirements, deposit
• insurance premiums, and capital
• adequacy requirements
• __________________________________________________
  _________