Chapter 11Chapter 11

Valuation of Valuation of Mortgage Mortgage SecuritiesSecurities

Chapter 11Chapter 11Learning ObjectivesLearning Objectives

Understand the valuation of mortgage Understand the valuation of mortgage securitiessecurities

Understand cash flows from various Understand cash flows from various types of mortgage securitiestypes of mortgage securities

Understand how changes in interest Understand how changes in interest rates affect mortgage securities valuesrates affect mortgage securities values

Understand mortgage securities and Understand mortgage securities and hedging against interest rate riskhedging against interest rate risk

TRADITIONAL DEBT TRADITIONAL DEBT SECURITY VALUATIONSECURITY VALUATION Typically fixed, semi-annual interest Typically fixed, semi-annual interest

payments with face value paid at payments with face value paid at maturitymaturity

Value moves inversely with market Value moves inversely with market interest ratesinterest rates

Yield to maturity at a given point in Yield to maturity at a given point in time is based on current market time is based on current market valuevalue

MORTGAGE-RELATED MORTGAGE-RELATED SECURITIESSECURITIES

Cash flows have three Cash flows have three components: interest, principal components: interest, principal amortization, and prepaymentsamortization, and prepayments

Total principal on mortgage pool is Total principal on mortgage pool is constant but principal payments constant but principal payments may be accelerated or delayed may be accelerated or delayed based on changes in market ratesbased on changes in market rates

MORTGAGE RELATED MORTGAGE RELATED SECURITIESSECURITIES

Market rates rise, mortgage Market rates rise, mortgage prepayment slows down as prepayment slows down as borrowers hold onto low-rate loansborrowers hold onto low-rate loans

Market rates decline, mortgage Market rates decline, mortgage prepayment increases due to prepayment increases due to refinancingrefinancing

PASS-THROUGHSPASS-THROUGHS The rate of mortgage prepayment The rate of mortgage prepayment

is crucial in pass-through valuationis crucial in pass-through valuation Several models of expected Several models of expected

prepayment:prepayment:– FHA Twelve-Year Prepaid LifeFHA Twelve-Year Prepaid Life– Constant Prepayment RateConstant Prepayment Rate– FHA ExperienceFHA Experience

PASS-THROUGHSPASS-THROUGHS Prepayment models (cont.):Prepayment models (cont.):

– Public Securities Association (PSA) ModelPublic Securities Association (PSA) Model Current industry standardCurrent industry standard Combines FHA experience with CPR modelCombines FHA experience with CPR model

– Econometric Prepayment ModelsEconometric Prepayment Models– Refinancing ModelsRefinancing Models

Based on title search activity which precedes Based on title search activity which precedes refinancingrefinancing

PASS-THROUGHSPASS-THROUGHS No rearranging of the cash flows from No rearranging of the cash flows from

the mortgage poolthe mortgage pool Prepayments have a significant impact Prepayments have a significant impact

on the timing of cash flows and thus on the timing of cash flows and thus the value of those cash flowsthe value of those cash flows

If selling at a discount, accelerated If selling at a discount, accelerated (delayed) prepayment increases (delayed) prepayment increases (decreases) the realized yield (decreases) the realized yield

PASS-THROUGHSPASS-THROUGHS For pass-throughs selling at a premium, For pass-throughs selling at a premium,

delayed prepayment increases yield and delayed prepayment increases yield and accelerated prepayment decreases yieldaccelerated prepayment decreases yield

Coupon rates reflect market rates at Coupon rates reflect market rates at time of issuetime of issue

High coupon pass-throughs suffer price High coupon pass-throughs suffer price compression due to prepayment compression due to prepayment expectationsexpectations

PASS-THROUGHSPASS-THROUGHS Changes in market rates have two Changes in market rates have two

impacts on pass-through value: both impacts on pass-through value: both the discount rate and the assumed the discount rate and the assumed prepayment will changeprepayment will change

In senior/subordinated pass-throughs In senior/subordinated pass-throughs the senior security has enhanced the senior security has enhanced rights to cash flows and subordinated rights to cash flows and subordinated security bears all the default risksecurity bears all the default risk

MORTGAGE-BACKED MORTGAGE-BACKED BONDSBONDS

Cash flows are structured as traditional Cash flows are structured as traditional non-callable debt with periodic interest non-callable debt with periodic interest payments and face value at maturitypayments and face value at maturity

Seek to be sufficiently over collateralizedSeek to be sufficiently over collateralized Cash flows not paid to investors are Cash flows not paid to investors are

placed in a sinking fundplaced in a sinking fund Financial rating based on amount of Financial rating based on amount of

overcollateralizationovercollateralization

MORTGAGE-BACKED MORTGAGE-BACKED BONDSBONDS

Overcollateralization is related to Overcollateralization is related to the balance in the sinking fundthe balance in the sinking fund

Variables that affect the balance of Variables that affect the balance of the sinking fund at maturity include the sinking fund at maturity include the mortgage prepayment rate, the the mortgage prepayment rate, the reinvestment rate on the sinking reinvestment rate on the sinking fund, the initial overcollateralization, fund, the initial overcollateralization, and the default rateand the default rate

COLLATERALIZED COLLATERALIZED MORTGAGE OBLIGATIONSMORTGAGE OBLIGATIONS

Cash flows are made up of various Cash flows are made up of various tranches and residual classtranches and residual class

Any mortgage prepayments are Any mortgage prepayments are passed to bondholders thus there is passed to bondholders thus there is no sinking fund no sinking fund

This means that the CMO issuer faces This means that the CMO issuer faces no interest rate or reinvestment riskno interest rate or reinvestment risk

Yield is higher on longer tranchesYield is higher on longer tranches

COLLATERALIZED COLLATERALIZED MORTGAGE OBLIGATIONSMORTGAGE OBLIGATIONS

CMOs are structured differently CMOs are structured differently from pass-throughs thus from pass-throughs thus prepayment behavior affects prepayment behavior affects pricing and yield differentlypricing and yield differently

Price and yield on shorter-term Price and yield on shorter-term tranches will not vary as much tranches will not vary as much with prepayment as compared to with prepayment as compared to pass-throughspass-throughs

STRIPSSTRIPS Cash flows may be rearranged to Cash flows may be rearranged to

produce principal-only and interest-produce principal-only and interest-only stripsonly strips

Principal-only (PO) strips receive all Principal-only (PO) strips receive all principal payments when they are principal payments when they are receivedreceived

Amount of principal equals the initial Amount of principal equals the initial pool balance but the timing is unknownpool balance but the timing is unknown

STRIPSSTRIPS If prepayment accelerates, principal is If prepayment accelerates, principal is

returned fasterreturned faster Interest-only strips receive the Interest-only strips receive the

interest when it is paidinterest when it is paid Total amount of interest is not known Total amount of interest is not known

but is based on principal outstandingbut is based on principal outstanding Accelerated prepayment reduces Accelerated prepayment reduces

principal and reduces interest amountprincipal and reduces interest amount

STRIPSSTRIPS Thus accelerated prepayment may Thus accelerated prepayment may

be advantageous for PO investors be advantageous for PO investors and disadvantageous for IO and disadvantageous for IO investorsinvestors

A change in market interest rates A change in market interest rates changes the discount rate used to changes the discount rate used to value securities and alters value securities and alters prepayment behaviorprepayment behavior

STRIPSSTRIPS PO Strip: Interest rate goes up, PO Strip: Interest rate goes up,

discount rate goes up, prepayment discount rate goes up, prepayment goes down and net effect is value goes down and net effect is value goes downgoes down

IO Strip: Interest rate goes up, IO Strip: Interest rate goes up, discount rate goes up, prepayment discount rate goes up, prepayment goes down and net effect is value goes down and net effect is value goes upgoes up

FLOATERSFLOATERS Floaters are classes of a CMO that have Floaters are classes of a CMO that have

a rate that moves with the marketa rate that moves with the market These are matched with an institution’s These are matched with an institution’s

short-term liabilities that move with short-term liabilities that move with the marketthe market

The interest rate on the floater is The interest rate on the floater is usually pegged to some short-term usually pegged to some short-term rate such as LIBORrate such as LIBOR

FLOATERSFLOATERS Since rate is variable, there is a risk of Since rate is variable, there is a risk of

loss if market rates risk significantlyloss if market rates risk significantly To solve this problem an inverse To solve this problem an inverse

floater is created out of the same floater is created out of the same tranchetranche

Inverse floater is a bond on which the Inverse floater is a bond on which the interest rate moves opposite to the interest rate moves opposite to the market ratemarket rate

SERVICING RIGHTSSERVICING RIGHTS Lenders sell off loans and often retain Lenders sell off loans and often retain

the servicing rightsthe servicing rights Servicing includes collecting monthly Servicing includes collecting monthly

payments, maintaining escrow payments, maintaining escrow accounts, forwarding proper payments accounts, forwarding proper payments to purchasers, sending delinquency and to purchasers, sending delinquency and default notices, initiating foreclosure default notices, initiating foreclosure proceedings and collecting on PMIproceedings and collecting on PMI

SERVICING RIGHTSSERVICING RIGHTS Revenue from servicing includes Revenue from servicing includes

the servicing fee, float on the the servicing fee, float on the escrow accounts, and float escrow accounts, and float between receipt of monthly between receipt of monthly payments and payments to payments and payments to purchaserspurchasers

Costs include administrative costs Costs include administrative costs and overheadand overhead

SERVICING RIGHTSSERVICING RIGHTS Fee is usually between 0.25 and 0.50 Fee is usually between 0.25 and 0.50

percent of the mortgage balancepercent of the mortgage balance Value is affected by interest rate Value is affected by interest rate

changes similar to IO stripschanges similar to IO strips Rates rise, discount rate goes up and Rates rise, discount rate goes up and

prepayment accelerates. Combines to prepayment accelerates. Combines to reduce the value of servicing rightsreduce the value of servicing rights

SERVICING RIGHTSSERVICING RIGHTS Excess servicing rights are fees Excess servicing rights are fees

greater than “normal”greater than “normal” Usually occurs when mortgages Usually occurs when mortgages

are sold with a promised rate less are sold with a promised rate less than the coupon on the mortgagesthan the coupon on the mortgages

The greater the spread, the larger The greater the spread, the larger the excess servicing feesthe excess servicing fees

SERVICING RIGHTSSERVICING RIGHTS Reasons for excess servicing rightsReasons for excess servicing rights

– Mortgage-backed securities generally Mortgage-backed securities generally have coupons in one-half point intervalshave coupons in one-half point intervals

– Premium securities may sell at Premium securities may sell at unattractive prices due to fears of unattractive prices due to fears of prepaymentprepayment

– Mortgage pools may contain loans with Mortgage pools may contain loans with different coupons thus some loans may different coupons thus some loans may have excess servicinghave excess servicing

VALUE CREATION IN VALUE CREATION IN MBSsMBSs

Value is created even though no Value is created even though no additional cash flow is createdadditional cash flow is created

Securitization eliminates liquidity risk Securitization eliminates liquidity risk and makes the market largerand makes the market larger

Securitization rearranges the cash flows Securitization rearranges the cash flows into more and less risky componentsinto more and less risky components

Asymmetric information may distort Asymmetric information may distort values - lenders may have superiorvalues - lenders may have superior