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Introduction to Mortgage. Backed Securities Introduction to Mortgage. Backed Securities

Key Players at MBS Creation • Borrower • Mortgage Broker – Initiate the loan Key Players at MBS Creation • Borrower • Mortgage Broker – Initiate the loan with the borrower – Typically paid upfront • Mortgage Banker – Issue the loan and then sell it to the dealer – Typically paid upfront • Dealer – Package the loans – Typically paid upfront

Key Players at MBS Creation • Rating agency – Provide information about the credit Key Players at MBS Creation • Rating agency – Provide information about the credit quality – Typically paid upfront • Others – lawyers; accountants

Key Players During the Life of MBS • Servicer – Collect payments; – Handle Key Players During the Life of MBS • Servicer – Collect payments; – Handle delinquency and foreclosure – Paid a fraction of interest payment • Guarantor – Cover losses from loan defaults – Paid a fraction of interest payment • Trustee – Forward payments to investor – Paid a fraction of interest payment

Key Players During the Life of MBS • Investor – Compare MBS against other Key Players During the Life of MBS • Investor – Compare MBS against other fixed income investment alternatives – Yield from MBS needs to cover: • Funding costs • Option costs (prepayment risk and default risk) • Liquidity risk

How are value created • Is MBS purely rent-seeking? • How is value created? How are value created • Is MBS purely rent-seeking? • How is value created? – Diversification – Risk-matching • risk-aversion of investors are compensated – Liquidity – Standardization

Mortgage Pass-Through Securities • Cash flow passed through to the investors are less than Mortgage Pass-Through Securities • Cash flow passed through to the investors are less than the cash flow from the underlying mortgage due to: – Servicing fees – Guaranteeing fees – Investors receive CF on a pro rata basis • Characterization of MPTs – Weighted average coupon rate (WAC) – Weighted average maturity (WAM)

MPTs • Agency pass-throughs – Fannie Mae – Freddie Mac – Gannie Mae Also MPTs • Agency pass-throughs – Fannie Mae – Freddie Mac – Gannie Mae Also referred to as GSE pass throughs • Only conforming loans • Many market participants/investors view agency pass-throughs as implicitly carrying credit guarantee of U. S. government – Low credit risk

MPTs • Non-Agency pass-throughs – Commercial banks – Thrifts – Private conduits • No MPTs • Non-Agency pass-throughs – Commercial banks – Thrifts – Private conduits • No implicit or explicit guarantees from the US government • Typically rated by rating agencies

MPTs • Factors affecting rating – Property types • Condo; single family – Loan MPTs • Factors affecting rating – Property types • Condo; single family – Loan types • Fixed rate with level payment; adjustable rate; balloon – Loan terms – Geographical dispersion – Size – Seasoning – Loan purpose (refi vs. new purchase)

MPTs • Usually rated by the rating agencies – Enough internal or external credit MPTs • Usually rated by the rating agencies – Enough internal or external credit enhancement to obtain AA or AAA ratings • Internal enhancement – – – Reserve funds Excess spread accounts Overcollateralization Senior/Subordinate structure Shifting interest structure • Redirect prepayments to senior class • External enhancement – Insurance – 3 rd party guarantor must have a rating higher than the pool rating

Prepayment Conventions • Conditional prepayment rate (CPR) – Annual prepayment rate of the remaining Prepayment Conventions • Conditional prepayment rate (CPR) – Annual prepayment rate of the remaining outstanding principal value – On top of the scheduled principal repayment • Single-Monthly Mortality Rate – Similar to CPR, but monthly • Relationship 1 - CPR = (1 - SMM)12 hence SMM = 1 – (1 -CPR)1/12 • Prepayment – SMM * (OLB – Scheduled Principal PMT)

PSA Benchmark CPRs • The Public Securities Association (PSA) prepayment benchmark assumes: – CPR PSA Benchmark CPRs • The Public Securities Association (PSA) prepayment benchmark assumes: – CPR grows 0. 2% per month before the loan/pool reaches 30 month / 6% – Then CPR will stay flat at 6% for the remaining life of the loan/pool – CPR = 6% * min (t / 30, 1) • The benchmark is referred to as “ 100%” PSA, or “ 100 PSA” – Slower or faster speeds of prepayment is referred to as some percentage of PSA – 50 PSA; 150 PSA; 300 PSA – Just a convention of prepayment behavior

Prepayment Modeling • Housing turnovers (home sales of existing houses) – Employment – Family Prepayment Modeling • Housing turnovers (home sales of existing houses) – Employment – Family status – Income and house price changes In general, not sensitive to mortgage rate • Cash-out refi – Depend on house price appreciation and home equity accumulation • Rate/term refi – Refinancing ratio = WAC / current mtg rate

Prepayment Modeling • Other reasons – Curtailment / partial prepayment • Does not reduce Prepayment Modeling • Other reasons – Curtailment / partial prepayment • Does not reduce payment, but reduce loan term – Defaults • Historically less than 1% of prepayment

Prepayment Modeling • Variables in the prepayment “regression” – Seasoning – Seasonality – HPI Prepayment Modeling • Variables in the prepayment “regression” – Seasoning – Seasonality – HPI – LTV – WAC / Mortgage Rate • Prepayment rate picks up quickly after ratio > 0. 6 • Burnout effect

The PSA Standard Default Assumption • SDA – 0. 02% in month 1 – The PSA Standard Default Assumption • SDA – 0. 02% in month 1 – Increase by 0. 02% b/w month 1 and 30 – Default stays at 0. 60% b/w month 31 and 60 – From month 61 to 120, declines from 0. 60% to 0. 03% – From month 120 on, remain constant at 0. 03%

Mortgage Prepayment Risk • Unlike treasuries, mortgage payment is uncertain – Contraction risk – Mortgage Prepayment Risk • Unlike treasuries, mortgage payment is uncertain – Contraction risk – Extension risk • Macauley duration – Weighted average term to maturity • Weight is the present value of the CF in total PV • Average life – Average time to receipt of principal payment • Weighted by the amount of principal expected

An Excel Example • • • WAC = 8. 125% WAM = 357 Month An Excel Example • • • WAC = 8. 125% WAM = 357 Month Coupon rate for MPT = 7. 5% Fees =. 625% Pool balance = $400, 000