C19 MORTGAGES & MORTGAGE-BACKED SECURITIES

RESEDENTIAL MORTGAGE PRODUCTS #

LIEN STATUS

Whether the mortgage is a first lien, a second lien, or a subsequent lien will greatly impact the lender’s ability to recover the balance owed in the event of default.

ORIGINAL LOAN TERM

Mortgage terms of 10 to 30 years are common, with the most popular being 30 years (long term).

CREDIT CLASSIFICATION

Classifying loans between prime and subprime is determined mainly by credit score

• Prime (A-grade) loans have low rates of delinquency and default as a result of low loan-to-value (LTV) ratios, borrowers with stable and sufficient income, and a strong history of repayments.
• Subprime (B-grade) loans have higher rates of delinquency and default compared to prime loans.
• Alternative-A loans are the loans in between prime and subprime.

INTEREST RATE TYPES

Fixed-rate mortgages have a set rate of interest for the term of the mortgage. Payments are constant for the term and consist of blended amounts of interest and principal.

Adjustable-rate mortgages (ARMs) have rate changes throughout the term of the mortgage. The rate is usually based on a base rate (e.g., prime rate, LIBOR) plus a spread.

PREPAYMENTS & PREPAYMENTS PENALTIES

Prepayments reduce the mortgage balance and amortization period.

To counteract the negative effects of prepayments, many loans contain prepayment penalties. They are amounts payable to the servicer for prepayments within a certain time and/or over a certain amount. Soft penalties are those that may be waived on the sale of the home; hard penalties may not be waived.

CREDIT GUARANTEES

The ability to create mortgage-backed securities requires loans that have credit guarantees.

Government loans are those that are backed by federal government agencies .

Conventional loans could be securitized by either government-sponsored enterprises (GSEs): Federal Home Loan Mortgage Corporation (FHLMC) or Federal National Mortgage Association.

PREPAYMENTS #

Mortgage prepayments come in two forms: (1) increasing the frequency or amount of payments and (2) repaying/refinancing the entire outstanding balance. Prepayments are much more likely to occur when market interest rates fall and borrowers wish to refinance their existing mortgages at a new and lower rate.

Other factors that influence prepayments include seasonality, age of mortgage pool, personal, housing prices, and refinancing burnout.

FIXED RATE, LEVEL-PAYMENT MORTGAGES #

A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial. A level-payment, fixed-rate conventional mortgage has a fixed term, a fixed interest rate, and a fixed monthly payment. Even though the term, rate, and payment are fixed, the cash flows are not known with certainty because the borrower has the right to repay all or any part of the mortgage balance at any time.

Allocation Between Principal and Interest

Fully amortizing fixed-rate mortgage:

• The mortgage payment consists primarily of interest in the early years.
• Interest is calculated on a declining principal balance so the interest payable will gradually decrease over time. As a result, more of the fixed mortgage payment will be applied toward reducing the principal amount.
• The crossover point is the point in the mortgage where principal and interest allocation amounts are the same. After that point, relatively more amounts will be allocated to principal.
• Mortgages with shorter amortization periods result in less interest paid and more of the payment applied toward reducing the principal balance sooner. In other words, equity buildup occurs at a quicker rate when the amortization period is shorter.

SECURITIZATION #

To reduce the risk from holding a potentially undiversified portfolio of mortgage loans, a number of financial institutions (originators) will work together to pool residential mortgage loans with similar characteristics into a more diversified portfolio. They will then sell the loans to a separate entity, called a special purpose vehicle (SPV), in exchange for cash. An issuer will purchase those mortgage assets in the SPV and then use the SPV to issue mortgage-backed securities (MBSs) to investors; the securities are backed by the mortgage loans as collateral.

PASS THROUGH SECURITIES

Fixed-rate pass-through securities trade in one of the following ways:

• The specified pools market.
• The To Be Announced (TBA) market.

MEASURING PREPAYMENTS SPEED

The value of an MBS is a function of:

• Weighted average maturity (WAM).
• Weighted average coupon (WAC).
• Speed of prepayments.

Regarding prepayment speeds, the single monthly mortality (SMM) rate is derived from the conditional prepayment rate and is used to estimate monthly prepayments for a mortgage pool:

SMM = 1 – (1 – CPR)^1/12

DOLLAR ROLL TRANSACTION #

A dollar roll transaction occurs when an MBS market maker buys positions for one settlement month and, at the same time, sells those same positions for another month.

HOW TO VALUE A DOLLAR ROLL

The process involves assessing the income and the expenses related over the holding period. Income is determined by coupon payments, reinvested interest, and principal payments. Expenses are determined by financing costs [i.e., repurchase (repo) market].

Factors that impact dollar roll valuations:

• The security’s coupon, age, and WAC.
• Holding period (period between the two settlement dates).
• Assumed prepayment speed.
• Funding cost in the repo market.

FACTOR CAUSING A DOLLAR ROLL TO TRADE SPECIAL

implied cost of funds, then the dollar roll is trading special. It could be caused by:

• A decrease in the back month price (due to an increased number of sale/settlement transactions on the back month date by originators).
• An increase in the front month price (due to an increased demand in the front month for deal collateral).
• Shortages of certain securities in the market that require the dealer to suddenly purchase the security for delivery in the front month, thereby increasing the front month price.

PREPAYMENT MODELLING #

Borrowers may prepay a mortgage due to the sale of the property or a desire to refinance at lower prevailing rates. In addition, prepayments may occur when the borrower has defaulted on the mortgage or when the borrower has cash available to make partial prepayments (curtailment).

It’s four components are:

1. Refinancing: Refinancing a mortgage involves using the proceeds of a new mortgage to pay off the principal from an existing mortgage.
2. Turnover: It is typically the case that the mortgage is due once the property is sold. This is referred to as due on sale. Because most borrowers sell their homes without regard for the path of mortgage rates, MBS investors will be subjected to a degree of housing turnover that does not correlate with the behavior of rates. One factor that slows the degree of housing turnover is known as the lock-in effect. This essentially means that borrowers may wish to avoid the costs of a new mortgage, which likely consists of a higher mortgage rate.
3. Defaults: When a borrower defaults, mortgage guarantors pay the interest and principal outstanding. These payments act as a source of prepayment. Modeling prepayments from default requires an analysis of loan-to-value (LTV) ratios and FICO scores, as well as an overall analysis of the housing market.
4. Curtailments: Partial payments by the borrower are referred to as curtailments. These partial payments tend to occur when a mortgage is older or has a relatively low balance. Thus, prepayment modelling due to curtailment typically takes into account the age of the mortgage.

DYNAMIC VALUATION #

The Monte Carlo methodology is a simulation approach for valuing MBSs. The binomial model is not appropriate for valuing MBSs because MBSs have embedded prepayment options and the historical evolution of interest rates over time impacts prepayments.

A mortgage security is valued using the Monte Carlo methodology by simulating the interest rate path and refinancing path, projecting cash flows for each interest rate path, calculating the present value of cash flows for each interest rate path, and calculating the theoretical value of the mortgage security.

SECURITIZATION #

The option-adjusted spread (OAS) is the spread that, when added to all the spot rates of all the interest rate paths, will make the average present value of the paths equal to the actual observed market price plus accrued interest. The zero-volatility spread (^-spread) is the spread that an investor realizes over the entire Treasury spot rate curve, assuming the mortgage security is held to maturity. The option cost is the implied cost of the embedded prepayment option and is calculated as the difference between the z-spread and OAS.

Four major limitations of OASs are related to:

1. modeling risk associated with Monte Carlo simulations,
2. required adjustments to interest rate paths,
3. model assumption of a constant OAS over time, and
4. dependency on the underlying prepayment model.