Fixed Income Final
What is meant by a derivative mortgage-backed security?
A derivative is a financial contract or instrument that derives its value from an underlying asset. Thus, by a derivative mortgage-backed security we mean a security that is created and that derives its value from an underlying mortgage asset. In terms of the agency MBS market, an agency collateralized mortgage obligation (CMO) and an agency stripped MBS are derivatives because they derive their value from agency mortgage pass-through securities.
What is an FHA-insured loan?
An FHA-insured loan is a government loan by virtue of being backed by an agency of the federal government. As such it is guaranteed by the U.S. government. FHA provides loan guarantees for those borrowers who can afford only a low down payment and generally also have relatively low levels of income.
What are contraction risk and extension risk?
Contraction risk is the adverse result when mortgage rates decline, while extension risk is the adverse consequence when mortgage rates rise.
How are FICO scores used in classifying loans?
In assessing the credit quality of a mortgage applicant, lenders look at a FICO score in order to a classify loan. A FICO score refers to how financial institutions rank the credit worthiness of a borrower. FICO scores range from 350 to 850. There is an inverse relation between a FICO score and a firm's credit risk. Thus, if a firm receives a high FICO score this means it has low credit risk. The credit score is the primary attribute used to characterize loans as either prime or subprime. Prime (or A-grade) loans generally have FICO scores of 660 or higher, front and back ratios with the above-noted maximum of 28% and 36%, and LTVs less than 95%. Alt-A loans may vary in a number of important ways. While subprime loans typically have FICO scores below 660, the loan programs and grades are highly lender-specific. One lender might consider a loan with a 620 FICO score to be a "B-rated loan," while another lender would grade the same loan higher or lower, especially if the other attributes of the loan (such as the LTV) are higher or lower than average levels.
What is a conventional loan?
In contrast to government loans, there are loans that have no explicit guarantee from the federal government. Such loans are obtained from "conventional financing" and therefore are referred to in the market as conventional loans. Although a conventional loan may not be insured when it is originated, a loan may qualify to be insured when it is included in a pool of mortgage loans that backs a mortgage-backed security (MBS).
Why are prepayments attributable to housing turnover likely to be insensitive to changes in mortgage rates?
In general, housing turnover is insensitive to the level of mortgage rates. This is because housing turnover is driven largely by family relocation due to changes in employment and family status as well as changes in income and the housing market. None of these factors are necessarily related to the level of mortgage rates.
What are the WAC and WAM of a pass-through security?
Not all of the mortgages that are included in a pool of mortgages that are securitized have the same mortgage rate and the same maturity. Consequently, when describing a pass through security, a weighted average coupon rate and a weighted-average maturity are determined. A weighted-average coupon rate (WAC) is found by weighting the mortgage rate of each mortgage loan in the pool by the amount of the mortgage outstanding. A weighted average maturity (WAM) is found by weighting the remaining number of months to maturity for each mortgage loan in the pool by the amount of the mortgage outstanding.
What does a conditional prepayment rate of 8% mean?
One benchmark for projecting prepayments and the cash flow of a pass-through requires that one assumes some fraction of the remaining principal in the pool is prepaid each month for the remaining term of the mortgage. The prepayment rate assumed for a pool, called the conditional prepayment rate (CPR), is based on the characteristics of the pool (including its historical prepayment experience) and the current and expected future economic environment. It is referred to as a conditional rate because it is conditional on the remaining mortgage balance. The CPR is an annual prepayment rate.
How does the guarantee for a Ginnie Mae mortgage-backed security differ from that of a mortgage-backed security issued by Fannie Mae and Freddie Mac?
Ginnie Mae, unlike Fannie Mae and Freddie Mac, are guaranteed by the full faith and credit of the U.S. government. Ginnie Mae is a federally related institution because it is part of the Department of Housing and Urban Development. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs).
What is meant by prepayments due to housing turnover?
Housing turnover means existing home sales. The two factors that impact existing home sales include (1) family relocation due to changes in employment and family status (e.g., change in family size, divorce), and (2) trade-up and trade-down activity attributable to changes in interest rates, income, and home prices. In general, housing turnover is insensitive to the level of mortgage rates.
What is the difference between a prime loan and a subprime loan?
A loan that is originated where the borrower is viewed to have a high credit quality (i.e., where the borrower has strong employment and credit histories, income sufficient to pay the loan obligation without compromising the borrower's creditworthiness, and substantial equity in the underlying property) is classified as a prime loan. A loan that is originated where the borrower is of lower credit quality or where the loan is not a first lien on the property is classified as a subprime loan.
What is the average life of a pass-through, and what does it depend on?
A measure commonly used to estimate the life of a pass-through is its average life. Consider a mortgage-back security guaranteed by Ginnie Mae, which is a fully modified pass-throughs. The average life of a mortgage-backed security is the average time to receipt of principal payments (scheduled principal payments and projected prepayments), weighted by the amount of principal expected.
What is a mortgage pass-through security?
A mortgage pass-through security, or simply a pass-through, is a security that results when one or more mortgage holders form a collection (pool) of mortgages and sell shares or participation certificates in the pool. From the pass-through, two further derivative mortgage-backed securities are created: collateralized mortgage obligations and stripped mortgage-backed securities.
What is a home equity loan?
A popular mortgage product backed by residential property that is classified as a subprime mortgage loan is the home equity loan (HEL). Typically the borrower has either an impaired credit history and/or the payment-to-income ratio is too high for the loan to qualify as a conforming loan for securitization by Ginnie Mae, Fannie Mae, or Freddie Mac.
What is the current LTV of a mortgage loan?
The current LTV is the LTV based on the current unpaid mortgage balance and the estimated current market value of the property.
What is the problem with using the original LTV to assess the likelihood that a seasoned mortgage will default?
At one time, investors considered only the original LTV in their analysis of credit risk. Because of periods in which there has been a decline in housing prices, the current LTV has become the focus of attention. The current LTV is the LTV based on the current unpaid mortgage balance and the estimated current market value of the property. Specifically, the concern is that a decline in housing prices can result in a current LTV that is considerably greater than the original LTV. This would result in greater credit risk for such mortgage loans than at the time of origination. Thus, the current LTV (as opposed to the original LTV) is much better equipped to assess the likelihood that a seasoned mortgage will default.
What is an alternative-A loan?
Between the prime and subprime sector is a somewhat nebulous category referred to as an alternative-A loan or, more commonly, alt-A-loan. These loans are considered to be prime loans (the "A" refers to the A grade assigned by underwriting systems), but they have some attributes that either increase their perceived credit riskiness or cause them to be difficult to categorize and evaluate.
Explain what is meant by a residential mortgage-backed security.
By a residential mortgage-backed security (RMBS), we mean a security that is created when residential mortgages are packaged together to form a pool of mortgage loans and then one or more debt obligations are issued backed by the cash flow generated from the pool of mortgage loans. "Backed" means that the principal and interest due to the investors in an RMBS come from the principal and interest payments made by the borrowers whose loans are part of the pool of mortgages. A mortgage loan that is included in an RMBS is said to be securitized, and the process of creating an RMBS is referred to as securitization.
In a discussion of the CMO market, the popular press sometimes refers to this sector of the mortgage-backed securities market as the riskiest sector and the pass-through sector as the safest sector. Comment.
Collateralized mortgage obligations derive their cash flow from underlying mortgage collateral such as pass-throughs or a pool of whole loans. Thus, CMOs can be referred to as a derivative mortgage-backed securities product. The popular press does not always distinguish between the speculative and hedging nature of derivates but perceive derivatives as riskier due to greater variability in outcomes that often result. On the other hand, many pass-throughs are sponsored by government agencies and thus perceived as being safe. Thus, the popular press can erroneously mistake differences in overall or total risk when speaking of the CMO sector and the pass-through sector. The fact is CMOs are backed by pass-throughs and thus the total risk of each sector should be the same.
What is a jumbo loan?
For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The loan limits, referred to as conforming limits, for Freddie Mac and Fannie Mae are identical because they are specified by the same statute. Loans larger than the conforming limit for a given property type are referred to as jumbo loans.
What is meant by conforming limits?
For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The maximum loan size for one- to four-family homes changes every year. The change is based on the percentage change in the average home price published by the Federal Housing Finance Board. The loan limits, referred to as conforming limits, for Freddie Mac and Fannie Mae are identical because they are specified by the same statute. It can also be noted that one of the underwriting standards is the loan balance at the time of origination. Conventional loans that meet the underwriting standards of the two government-sponsored enterprises (GSEs) are called conforming limits. But there are other important underwriting standards that must be satisfied such as the type of property, loan type, transaction type, loan-to-value ratio by loan type, loan-to-value ratio by loan type and transaction type, borrower credit history, and documentation.
While it is often stated that Ginnie Mae issues mortgage-backed securities, why is that technically incorrect?
It is not technically correct to say that Ginnie Mae is an issuer of pass-through securities. Ginnie Mae provides the guarantee, but it is not the issuer. Pass-through securities that carry its guarantee and bear its name are issued by lenders it approves, such as thrifts, commercial banks, and mortgage bankers. Thus, these approved entities are referred to as the "issuers."
In what sense has the investor in a residential mortgage loan granted the borrower (homeowner) a loan similar to a callable bond?
Prepayment risk is the risk associated with a mortgage's cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan's note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan. The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par.
Why would a pass-through with a WAM of 350 months be an unattractive investment for a savings and loan association?
Prepayment risk makes pass-through securities unattractive for certain financial institutions to hold from an asset-liability perspective. Thrifts and commercial banks want to lock in a spread over their cost of funds. Their funds are raised on a short-term basis. If they invest in fixed-rate pass-through securities with a WAM of 350 months (over 29 years), they will be mismatched because a pass-through is a longer term security. In particular, a savings and loan association and other depository institutions are exposed to extension risk when they invest in pass-through securities. When interest rates rise investors will not refinance their homes.
How does a CMO alter the cash flow from mortgages so as to shift the prepayment risk across various classes of bondholders?
Prepayment risk refers to the risk associated with the early unscheduled return of principal on a fixed-income security. Collateralized mortgage obligations (CMOs) redirect cash flows from a pass-through security to various bond classes making it possible to redistribute prepayment risk for investors who want to reduce their exposure to prepayment risk. Because the total prepayment risk of a pass-through will not be changed by altering the cash flows, other investors must be found who are willing to accept the unwanted prepayment risk.
What are the two types of private-label MBS?
Private label MBS are nonagency loans. Some private institutions, such as subsidiaries of investment banks, financial institutions, and home builders, also issue mortgage securities. When issuing mortgage securities, they may issue either agency or non-agency mortgage pass-through securities; however, their underlying collateral will more often include different or specialized types of mortgage loans or mortgage loan pools that do not qualify for agency securities. The transactions may use alternative credit enhancements such as letters of credit. These non-agency or so-called private-label mortgage securities are the sole obligation of their issuer and are not guaranteed by one of the GSEs or the U.S. Government. Private-label mortgage securities are assigned credit ratings by independent credit agencies based on their structure, issuer, collateral, and any guarantees or other factors.
What is meant by prepayments due to rate/term refinancing?
Rate/term refinancing means that the borrower has obtained a new mortgage on the existing property to save either on interest cost or shortening the life of the mortgage with no increase in the monthly payment. The homeowner's incentive to refinance is based on the projected present value of the dollar interest savings from the lower mortgage rate after deducting the estimated transaction costs to refinance.
Describe the cash flow of a mortgage pass-through security.
The cash flow of a mortgage pass-through security depends on the cash flow of the underlying mortgages. The cash flow consists of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments. Payments are made to security holders each month. Neither the amount nor the timing, however, of the cash flow from the pool of mortgages is identical to that of the cash flow passed through to investors.
In a CMO structure with several PAC bonds, explain why, when the support bonds are paid off, the structure will be just like a sequential-pay CMO.
The PAC bonds and support bonds are formed from the sequential-pay CMO. If the support bonds are paid off earlier than expected, then the structure reverts to a sequential-pay CMO. The first CMO was created in 1983 and was structured so that each class of bond would be retired sequentially. Such structures are referred to as sequential-pay CMOs. The payment rules dictate that each tranche receives periodic coupon interest payments based on the amount of the outstanding balance at the beginning of the month. However, the disbursement of the principal is made in a special way. A tranche is not entitled to receive principal until the entire principal of the preceding tranche has been paid off. More specifically, the first tranche receives all the principal payments until the entire principal amount owed to that bond class is paid off; then the next tranche begins to receive principal and continues to do so until it is paid off in entirety.
Indicate whether you agree or disagree with the following statement: "The PSA prepayment benchmark is a model for forecasting prepayments for a pass-through security."
The Public Securities Association (PSA) prepayment benchmark is expressed as a monthly series of annual prepayment rates. This benchmark is commonly referred to as a prepayment model, suggesting that it can be used to estimate prepayments. Characterization of this benchmark as a prepayment model is inappropriate. It is simply a market convention of prepayment behavior. The PSA benchmark assumes that prepayment rates are low for newly originated mortgages and then will speed up as the mortgages become seasoned.
What is the S-curve for prepayments? Explain the reason for the shape.
The S-curve for prepayment is a graph where values for the "CPR%" are given along the vertical line and values for the "WAC/Mortgage Rate" ratio are found along the horizontal axis. The reason for the observed S-curve for prepayments is that as the rate ratio increases, the CPR (i.e., prepayment rate) increases. There is some level of the rate ratio, however, at which the prepayment rate tends to level off. The reason for this leveling of the prepayment rate is because the only borrowers remaining in the pool are those that cannot obtain refinancing or those who have other reasons why refinancing does not make sense. The S-curve is not sufficient for modeling the refinancing rate/term refinancing. This is because the S-curve fails to adequately account for two dynamics of borrower attributes that impact refinancing decisions: (1) the burnout effect and the threshold media effect.
What types of investors would be attracted to an accrual bond?
The accrual bond has appeal to investors who are concerned with reinvestment risk. Because there are no coupon payments to reinvest, reinvestment risk is eliminated until all the other tranches are paid off.
What is the advantage of a prepayment penalty mortgage from the perspective of the lender?
The advantage of a prepayment penalty mortgage from the perspective of the lender is that the lender can reduce losses if the borrower chooses to pay off the mortgage when rates fall. More details are given below. Effectively, the borrower's right to prepay a loan in whole or in part without a penalty is a called an option. A mortgage design that mitigates the borrower's right to prepay is the prepayment penalty mortgage. This mortgage design imposes penalties if borrowers prepay. The penalties are designed to discourage refinancing activity and require a fee to be paid if the loan is prepaid within a certain amount of time after funding. Penalties are typically structured to allow borrowers to partially prepay up to 20% of their loan each year the penalty is in effect and charge the borrower six months of interest for prepayments on the remaining 80% of their balance. Some penalties are waived if the home is sold and are described as "soft" penalties; hard penalties require the penalty to be paid even if the prepayment occurs as the sale of the underlying property.
Explain the effect on the average lives of sequential-pay structures of including an accrual tranche in a CMO structure.
The effect of an accrual tranche is to decrease the average lives of the other tranches at the expense of the accrual tranche. The payment rules for interest provide for all tranches to be paid interest each month. In many sequential-pay CMO structures, at least one tranche does not receive current interest. Instead, the interest for that tranche would accrue and be added to the principal balance. Such a bond class is commonly referred to as an accrual tranche or a Z bond (because the bond is similar to a zero-coupon bond). The interest that would have been paid to the accrual bond class is then used to speed up or pay down of the principal balance of earlier bond classes. Thus, the average lives for the other tranches become shorter because of the inclusion of the accrual bond.
What is the impact of a prepayment that is less than the amount required to completely pay off a loan?
The impact on the borrower is that the principal (or amount required to completely pay off a loan) is reduced by the amount paid off that period that goes beyond the interest due. The impact on the lender can involve risk and is captured by the concept of prepayment risk, which is the risk associated with a mortgage's cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan's note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan. The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par value. The exception, of course, is if the loan is a prepayment penalty mortgage loan.
Explain why the higher the loan-to-value ratio is, the greater the credit risk is to which the lender is exposed.
The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property. The higher this ratio is, the less the protection (and the greater the credit risk) for the lender if the applicant defaults on the payments and the lender must repossess and sell the property. The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default. They will either try to protect this equity by remaining current or, if they fail, sell the house or refinance it to unlock the equity. In any case, the lender is protected by the buyer's self-interest. On the other hand, if the borrower has little or no equity in the property, the value of the default option is much greater.
What was the motivation for the creation of PAC bonds?
The motivation for the creation of PAC bonds was to diminish the uncertainty in cash flows including prepayment risk. The greater predictability of the cash flow for these classes of bonds, now referred to exclusively as PAC bonds, occurs because there is a principal repayment schedule that must be satisfied. PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds. It is these bonds that absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.
What is the original LTV of a mortgage loan?
The original LTV of a mortgage loan is the LTV at the time of origination. The LTV is the ratio of the amount of the loan to the market (or appraised) value of the property. The lower this ratio, the more protection the lender has if the applicant defaults and the property must be repossessed and sold.
What are subprime mortgage-backed securities?
The subprime mortgage sector is the market for loans provided to borrowers with an impaired credit rating or where the loan is a second lien; these loans are nonconforming loans. All of these loans can be securitized in different sectors of the RMBS market. Loans that satisfy the underwriting standard of the agencies are typically used to create RMBS that are referred to as agency mortgage-backed securities (MBS). All other loans are included in what is referred to generically as nonagency MBS. In turn, this subsector is classified into private label MBS, where prime loans are the collateral, and subprime MBS, where subprime loans are the collateral. The names given to the nonagency MBS are arbitrarily assigned. Some market participants refer to private label MBS as "residential deals" or "prime deals." Subprime MBS are also referred to as "mortgage-related asset-backed securities." In fact, market participants often classify agency MBS and private label MBS as part of the RMBS market and subprime MBS as part of the market for asset-backed securities. This classification is somewhat arbitrary.
Explain the role of a support bond in a CMO structure.
The support bond class in a CMO structure provides for the prepayment protection for the other bond classes. It is the support bonds that forego principal payments if the collateral prepayments are slow. The support bonds can be thought of as bodyguards for the PAC bondholders. When the bullets fly (i.e., prepayments occur) it is the bodyguards that get killed off first. The bodyguards are there to absorb the bullets. When all the bodyguards are killed off (i.e., the support bonds paid off with faster-than-expected prepayments), the PAC bonds must fend for themselves: they are exposed to all the bullets.
What are the two primary factors in determining whether or not funds will be lent to an applicant for residential mortgage loan?
The two primary factors are the Payment to Interest (PTI) Ratio and Loan to Value (LTV) Ratio. PTI measures ability of the applicant to make monthly payments. The lower the LTV ratio, the more protection the lender has if the applicant defaults and the property must be repossessed and sold.
Why is the cash flow of a residential mortgage loan unknown?
There are many factors that can affect the cash flow of a residential mortgage unknown. These include: (1) credit risk, (2) liquidity risk, (3) price risk, and (4) prepayment risk. Credit risk is the risk that the homeowner/borrower will default. Liquidity risk refers to the degree of liquidity in the secondary market for mortgage loans where the bid-ask spreads are large compared to other debt instruments. Price risk refers to the fact that the price of a fixed-income instrument will move in an opposite direction from market interest rates. Thus, a rise in interest rates will decrease the price of a mortgage loan. Prepayment risk is the risk associated with a mortgage's cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan's note rate.
When a prepayment is made that is less than the full amount to completely pay off the loan, what happens to future monthly mortgage payments for a fixed-rate mortgage loan?
This type of prepayment in which the entire mortgage balance is not paid off is called a partial payment or curtailment. When a curtailment is made, the loan is not recast. Instead, the borrower continues to make the same monthly mortgage payment. The effect of the prepayment is that more of the subsequent monthly mortgage payment is applied to the principal. The net effect of the prepayment is that the loan is paid off faster than the scheduled maturity date. That is, the maturity of the loan is "curtailed."
Why is an assumed prepayment speed necessary to project the cash flow of a pass-through?
To value a pass-through security, it is necessary to project its cash flow. The difficulty is that the cash flow is unknown because of prepayments. The only way to project a cash flow is to make some assumption about the prepayment rate over the life of the underlying mortgage pool. The prepayment rate assumed is called the prepayment speed or, simply, speed. If the assumed prepayment rate is inaccurate or misleading, the resulting cash flow is not meaningful for valuing pass-throughs.
Describe the sectors of the residential mortgage-backed securities market.
Two subsectors based on the credit quality of the borrower: prime mortgage market and subprime mortgage market. The prime sector includes (1) loans that satisfy the underwriting standard of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., conforming loans); and (2) loans that fail to conform for a reason other than credit quality or because the loan is not a first lien on the property (i.e., nonconforming loans). The subprime mortgage sector is the market for loans provided to borrowers with an impaired credit rating or where the loan is a second lien; these loans are nonconforming loans.
What is the difference between a cash-out refinancing and a rate-and-term refinancing?
When a lender is evaluating an application from a borrower who is refinancing, the loan-to-value ratio (LTV) is dependent upon the requested amount of the new loan and the market value of the property as determined by an appraisal. When the loan amount requested exceeds the original loan amount, the transaction is referred to as a cash-out-refinancing. If instead, there is financing where the loan balance remains unchanged, the transaction is said to be a rate-and-term refinancing or no-cash refinancing. That is, the purpose of refinancing the loan is to either obtain a better note rate or change the term of the loan.
Explain why, in a fixed-rate mortgage, the amount of the mortgage payment applied to interest declines over time, while the amount applied to the repayment of principal increases.
With each monthly payment, an excess above the interest owed is paid. This extra serves to reduce the outstanding principal (or balance owed). With a reduced balance owed, the next monthly mortgage payment will consist of a lower amount of interest paid since the interest rate is multiplied times a lower balance. Since the payment is fixed, this means that more of the fixed payment can be applied to lower the principal. Hence, the monthly interest declines over time, while an increasing amount is applied to the repayment of the principal.
