L - Securitization

8/6/2019 L - 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 andother assets backed by securities.

Many types of loans and assets are being repackaged inthis fashion including royalties on recordings ( DavidBowie, Rod Stewart).

Original use was to enhance the liquidity of theresidential 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, anddeposit 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 FHM

A.

FNMA actually creates MBSs by purchasing andholding packages of mortgages on its balancesheet; it also issues bonds directly to finance thosepurchases.


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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 theTreasury.

It buys mortgage loans from FIs and swaps MBSs forloans.

It also sponsors conventional loan pools as well asFHA/VA mortgage pools and guarantees timely

payment of interest and principal on the securities itissues.


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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) with3

0 years inmaturity and 12 percent interest rate.

Each mortgage receives credit risk protection fromFHA.

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 is8%).

Must issue more than $96 million in liabilities due to a10% reserve requirements (106.67m = $96m/(1-0.1)).

(+ FDIC premia).


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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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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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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 itsregulatory taxes.


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II. FurtherIncentives

Investors ofGNMA securities are protectedagainst 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:

G

NM

Awould bear the cost of making the promisingpayments in full and on time to GNMAbondholders.


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II. FurtherIncentives

Given the default protection, the returns toGNMA 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-costmortgages 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 veryvaluable call option on the mortgage when thisoption is in the money.


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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.


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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

% permonth 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 mortgagepool prepayment exactly match this pattern are said

to assume 100 percent PSA behavior.


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Model

Monthlyprepaymentrate (%)

30

360 Months

125% PSA

100% PSA

75% PSA

7 %

6%

4/2%


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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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Model

On approach to control these factors is by

assuming some fixed deviation of any

specific pool from PSAs assumed averageor benchmark pattern. E.g., one pool may

be assumed to be 75% PSA, and another

125% PSA. The formal has a lowerprepayment rate than historically

experienced; the latter, a faster rate.


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III.Effects of Prepayments:

OtherEmpirical Models

Most empirical models are proprietary

versions of the PSA model in which FIs

make their own estimates of the pattern onmonthly prepayments.

FIs begin by estimating a prepayment

function from observing the experience ofmortgage holders prepaying during any

particular period on mortgage pools.


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OtherEmpirical Models

The conditional prepayment rates in month i forsimilar 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 isestimated, the bank can calculate the expectedcash flows on the mortgage pool underconsideration and estimate its fair yield given thecurrent market price of the pool.


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Option Model Approach

Fair price on pass-through decomposable into two parts P

GNMA = PTBOND - PPREPAYMENT OPTION

Option-adjusted spread between GNMAs and T-bondsreflects value of a call option. Specifically, the abilityof the mortgage holder to prepay is equivalent to thebond investor writing a call option on the bond and themortgagee owning or buying the option. If interest

rates fall, the option becomes more valuable as itmoves into the money and more mortgages are prepaidearly by having the bond called or the prepaymentoption 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 GNMAsand T-bonds plus an additional yield forwriting the valuable call option.


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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 isflat;

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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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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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 promisedpayment (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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End of Year 1: since interest rates can

change up or down by 1% per annum,

mortgages are not prepaid. GNMAbondholders receive the promised payment

R=$401,114 with certainty.


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End of Year2:There are three possible mortgagerates; 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 yr2= $402,114 + $365,561 = $767,675Thus CF2 = .25($767,675) + .75($402,114) =$493,504.15


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End of Year3: since there is a 25%

probability that mortgages are prepaid in yr

2, the investor will receive no cash flows atthe end of yr3. However, there is also a

75% probability that mortgages will not be

prepaid in yr2, the investor will receive thepromised payment R = $402,114.

CF3 = .25($0) + .75($402,114) = $301,586


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Deviation of the Option-Adjusted Spread:

The required yield on a GNMA with

prepayment risk is divided into the requiredyield on T-bond plus a required spread for the

prepayment call option given to the mortgage

holders: E(CF1) E(CF2) E(CF3)

P = ------------ + ------------- + -------------- (1+d1+Os) (1+d2+Os)

2 (1+d3

Os)3


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Deviation of the Option-Adjusted Spread:

Where

P= Price ofGNMA

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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Assume that the T-bond yield curve is flat, so that d1 = d2=d3

= 8%; then

$401,114 $493,504 $301,585 P = ------------ + ------------- + --------------

(1+.08+Os) (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 exceedsthat of the original pass-throughs.

Prepayment effects differ across tranches.

Improves marketability of the bonds.


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(CMO)

The Value Additivity of CMOs:

Suppose an investment bank buys a $150m

issue ofGNMAs and places them in trust ascollateral. 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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(CMO)

Assume that in month 1 the promised

amortized cash flows on the mortgages are

$1m but there is an additional $1.5m cashflows 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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(CMO)

Principal Payments:

The $1.5m cash flows remaining will be paid to Class

A holders to reduce its principal outstanding to$50m-$1.5m=$48.5m.

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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(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 notpay this interest, however, until all other classes

are fully retired. Then Z-class holders received

coupon and principal payments plus accruedinterest payments. Thus, Z-class has

characteristics of both a zero-coupon bond and a

regular bond.


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(CMO)

Class R: CMOs tend to be over-collaterized:

CMO issuers normally uses very conservative

prepayment assumptions. If prepayments are slowerthan 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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V.Mortgage-Backed Bonds

(MBBs)

Differs from pass-throughs and CMOs intwo key dimensions:

1.While pass-throughs and CMOs removemortgages from balance sheets, MBBsnormally remain on the balance sheet.

2. Pass-throughs and CMOs have a direct link

between the cash flow on the underlyingmortgages, with MBBs the relationship is oneof collateralization.


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(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

OtherMortgages $ 8 Insured Deposits $10

__________________________________________________________________


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(MBBs)

Regulatory concerns: the bank gains only

because the FDIC is willing to bear enhanced

credit risk through its insurance guarantees todepositors.


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(MBBs)

Other drawbacks to MBBs:

MBB ties up mortgages on the balance sheet.

The need to overcollaterize to ensure a high-qualitycredit 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 themortgagees. 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 thevalue of the IO strips.

Prepayment Effect: As interest rates fall, mortgagees

prepay their mortgages. The number ofIO payments the

investor receives is likely to shrink, which reduces the

value ofIO bonds.


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IO Strip (continued):

Specifically, one can expect that as interest rates fall

below the mortgage coupon rate, the prepaymenteffect gradually dominates the discount effect, so

that over some range of the price or value ofIO

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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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 holderspay 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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PO Strip (Continued):

As interest rates fall, both the discount and

prepayment effects point to a rise in the valueof 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, especiallyfor yields below the stated mortgage coupon

rate.


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Securitization of other assets

CARDs (Certificates of Amortized Revolving

Debts)

Various receivables, loans, junk bonds, ARMs.

VII C All A B


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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.

I

f off=balance-sheet, the issueron reserve requirements, deposit

insurance premiums, and capital

adequacy requirements

___________________________________________________________

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