Mortgage-Backed and Asset-Backed Securities: High Credit Quality and Cash Flow Stability
Jim Womack, CFAManaging Director & Principal
March 2011
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Mortgage-Backed & Asset-Backed SecuritiesIntroduction: High Credit Quality and Cash Flow Stability
• For Some, A Mortgage-Backed (MBS) or Asset-Backed Security (ABS) Carries a Negative Connotation.
• For Many More, These Sectors Provided Ultra High Credit Quality and
Cash Flow Stability Even In the Height of Market Turmoil in 2008 & 2009.
• Today, Investors Are Seeking High Quality Alternatives To Low Yielding Treasury and Agency Debentures.
• The Market For Many Types of MBS and ABS Is Deep, Transparent, Liquid and Offers Relatively High Yields.
• Investment Officers Can Meaningfully Raise The Yield On Their Portfolios By Selectively Including These Assets In Their Arsenal of Eligible Investments…Without Sacrificing Credit Quality or Cash Flow Stability.
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Asset-Backeds: How The Typical Auto Structure WorksTwo Types of Credit Support: Overcollateralization & Subordination
Pool of Auto Loans
Lesser Amount ofBonds Backed by Loans
Still Lesser AmountOf Senior (AAA Rated)
Bonds Backed by LoansLesser Amount of
Bonds Backed by Loans
Overcollateralization
Subordination
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Asset-Backeds: How The Typical Auto Structure WorksSubordination Protects The Senior Note Holders 5 Ways
D BB 40,135,000 3th Loss Protection 2.0%
Class Rating Size Percent
A1A2-AA2-BA3A4
AAAAAA AAAAAAAAA
410,000,000200,000,000650,000,000392,000,000249,260,000 93.0%
B A 60,200,000 5th Loss Protection 3.0%
C BBB 40,135,000 4th Loss Protection 2.0%
Reserve Account 2nd Loss Protection 0.8%
Reserve Account 1st Loss Protection 1.0%
8.8%Total Subordination For Senior Note Holders
5.7%Overcollateralization at Origination
14.5%Total Credit Support to Senior Bondholders
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1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
9/93 9/94 9/95 9/96 9/97 9/98 9/99 9/00 9/01 9/02 9/03 9/04 9/05 9/06 9/07 9/08 9/09 9/10
Fitch Prime Auto ABS Cumulative Net Loss Index1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%Source: Fitch Ratings
Asset Backeds: How The Typical Auto Structure WorksHistorically, Even The Lowest Rated Bonds Have Been Well Protected
Reserve Account 0.8%
Reserve Account 1.0%
D BB 40,135,000 2.0%
C BBB 40,135,000 2.0%
B A 60,200,000 3.0%
Class Rating Size PercentA1
A2-AA2-BA3A4
AAAAAA AAAAAAAAA
410,000,000200,000,000650,000,000392,000,000249,260,000 93.0%
8.8%Total Subordination For Senior Notes
5.7%Overcollateralization at Origination
14.5%Total Credit Support to Senior Notes
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Asset-Backeds: Selected Bonds Through The CrisisIn Good Economic Times and Bad, Credit Support Increases Over Time
0
5
10
15
20
25
30
35
40
45
50
CapitalAuto
03-2 A4
Wachovia Auto
04A A4
CarmaxAuto
03-2 A4
OnyxAuto
04-C A3
Unemployment Rate
0
5
10
15
20
25
30
35
40
45
50
USAAAuto
06-4 A3
Wachovia Auto
05-B A4
Household Auto
06-3 A3
HondaAuto
07-1 A3
HouseholdAuto
07-1 A3
WachoviaAuto
07-1 A3A
Harley Davidson07-2 A4
ChaseAuto
03-B A3
WachoviaAuto
05-B A4
WFSAuto
02-4 A4
AmericreditAuto
05-AX A3
WFSAuto
02-2 A4
Auto ABS as of December 2005
Auto ABS as of December 2009
Cre
dit
Su
pp
ort
(%
)C
red
it S
up
po
rt (
%) Original Credit Support
Credit Support at 12-2009
Original Credit Support
Credit Support at 12-2005
Unemployment Rate
Source: Servicer Reports
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Class Rating Size Percent
A1A2
A3-AA3-BA4
AAAAAA AAAAAAAAA
349,000,000334,000,000294,500,000294,500,000478,000,000
Asset-Backeds: What About Insured Bonds?Example: FGIC Takes Less Protection And a Fee to Guarantee Notes
7.3%Overcollateralization at Origination
9.2%Total Credit Support to FGIC Insurance Co.
Reserve Account Loss Protection For Insurance Provider 1.5%
9.2% PLUS AnInsurance Policy
by AAA Rated FGICTotal Credit Support to Senior Bondholders
100%
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Asset-Backeds: Even Wrapped Issues Performed WellMany Insured Bonds Were Initially Downgraded, Then Upgraded
CREDIT RATINGS CHANGES
Reference Issue: COAFT 2006-C A4,
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Merrill Lynch AAA Rated Auto ABS & Similar Maturity A Rated Corporates
Source: Merrill Lynch and Bloomberg Data as of December 31, 2010
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Asset-Backeds: More Yield Than Lower Rated CorporatesComparing Yield of AAA Auto ABS vs. A Rated Corporate Bonds
AAA Rated Auto ABS Average Yield: A Rated Corproate Average Yield:
Since InceptionSince Inception
(ex 2008 & 2009)
4.69% 4.75%
4.41% 4.61%ABS +0.28% ABS +0.14%
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“Moody’s has placed fifteen tranches from eight loan securitizations sponsored by Ford Motor Company in 2006 and 2007 on review for possible upgrade. The build up of credit enhancement more than offsets modest increases in lifetime cumulative losses observed in the underlying collateral pools.”
Asset-Backeds: Auto-Loan ABS Was In The Press Too! Because It Performed Like It Was Supposed To
“Rebound in used vehicle prices benefits auto ABS transactions.” - Fitch Ratings, 10-15-09
“Due to available credit enhancement and structural protections, ratings for prime
senior tranches of ABS auto loan transactions have remained stable year-to-date.” - Fitch Ratings, 10-26-09
- Moody’s Investor Service, 8-21-09
“Most Senior GMAC prime auto ABS ratings able to withstand “depression” unemployment scenario.”
“Auto-loan Backing is Popular; Investors Like These Tried and Tested Securities”
- Headline, Wall Street Journal, 9-16-2009
- Moody’s Investor Service, 5-12-09
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Mortgage-Backed SecuritiesTraditional GSE Guaranteed Mortgage-Backed Securities
Key Features and Characteristics of MBS:
• Bonds Receive Principal and Interest Monthly, Because Borrowers Make Monthly Mortgage Payments
• Borrowers Can Repay Their Loans Without Penalty and at Any Time
• The Speed at Which They Prepay Their Loan is Measured by PSA & CPR
100 PSA or 100% of the PSA model rate, calls for prepayments to start slowly and build to a 6% constant prepayment rate (CPR) after 24 months.
However: If mortgage rates declined, the prepayment rate could jump to 200+PSA and reach a 12%+ constant prepayment rate after 24 months (because
homeowners are refinancing).
• People Prepay Their Mortgages For a Variety of Reasons
They Refinance, Get Transferred, Death, Divorce, Buy Bigger/Smaller Home, Etc.
PSA = Prepayment Speed Assumption, CPR = Constant Prepayment Rate
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Positive Convexity
Yield
Price
+1%-1%
+1.1%
-0.9%
Mortgage-Backed SecuritiesNon-Callable Bonds Have Positive Convexity
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Negative Convexity
Yield
Price
+1%-1%
+0.8%
-1.2%
Mortgage-Backed SecuritiesBecause The Home Owner Can Prepay At Any Time, Mortgage-Backed Securities, Like Other Callable Bonds, Have Negative Convexity
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Homeowner
Bank
Government Sponsored Entity (Ginnie Mae, Fannie Mae,
Freddie Mac)
Investors
Trustees
Guaranteed Timely Principal & Interest
Investors receive pro-rata share of interest, principal, and principal prepayments.
Investors have uncertainty about when they get principal back.
Mortgage-Backed SecuritiesTraditional Mortgage Pass-Through & Cash Flow Profile
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Key Features and Characteristics of 30-Year Loans & MBS:
Mortgage-Backed SecuritiesTraditional 30-Year Mortgage Lending
• 30-Year Loans Spread Payments Out to Reduce Monthly Payment
• Nearly All of The Payment In The Early Years Is Interest
• The Interest Rate Level Impacts The Monthly Payment For the Borrower on a 30-Year Loan More Than on a 15-Year or 10-Year Loan (A Key Reason Why People Don’t Refinance Their Cars)
So 30-Year Borrowers Are Typically Very Rate Sensitive
• Borrowers Can Repay Their Loans Without Penalty and at Any Time
• Agency MBS are Backed by The Homeowner, by The Agency,and by The Implied Guarantee Of The Government.
• Bondholders Receive An Attractive Yield Above Treasuries, Agency Issued Debentures and Other Types of Securities Because
Borrowers Can Repay Their Loans Without Penalty and at Any Time
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Source: Merrill Lynch and Bloomberg Data as of December 31, 2010
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30 Year MBS Pass-through Average Yield: A Rated Corproate Average Yield:
Since InceptionSince Inception
(ex 2008 & 2009)
6.40% 6.23%
5.66% 5.52%MBS +0.74% MBS +0.71%
30-Year Mortgage-Passthroughs & Similar Maturity A Rated Corporates
Mortgage-Backeds: More Yield Than Corporates…But Why? Comparing Yield of MBS vs. A Rated Corporate Bonds
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8 YearBond
5 YearBond
2 YearBond
NO REFINANCELESS Trading UpLESS RenovationLESS DownsizingGet Transferred
Death, Divorce, Etc.
Trading UpMajor Renovation
DownsizingGet Transferred
Death, Divorce, Etc.
REFINANCEMORE Trading UpMORE RenovationMORE Downsizing
Get TransferredDeath, Divorce, Etc.
Mortgage RatesNear Current Rates
Mortgage RatesHIGHER
Mortgage Rates LOWER
12% CPRPer Year
6% CPRPer Year
25% CPRPer Year
OR OR
Mortgage-Backed SecuritiesTraditional 30-Year Mortgage Pass-Through & Cash Flow Profile
Mortgage Rates UNCHANGED
3 Year Extension 3 Year Contraction
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Key Features and Characteristics of 10-Year Loans & MBS:
Mortgage-Backed SecuritiesTraditional 10-Year Mortgage Lending
• 10-Year Loans Are Made To People Who Want To Pay Debt Back Fast
• Most of the Payment Is Principal, So The Interest Rate Has Less of an Impact on The Monthly Payment
So 10-Year Borrowers Are NOT Typically Rate Sensitive
• Borrowers Can Repay Their Loans Without Penalty and at Any Time
• 10-Year Pass-throughs Receive An Attractive Yield Above Treasuries, Agency Issued Debentures and Other Types of Securities,But Less Than a 30-Year Passthrough
• The Shorter The Loan, The Less Variability The Cash Flows At a Given Prepayment Speed
• They Have The Same Credit Backing as Bonds Backed by 30-Year Loans
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10-Year Mortgage-Passthroughs & Similar Maturity A Rated Corporates
Source: RW Baird Research and Bloomberg Data as of January 31, 2011
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Mortgage-Backeds: Outsized Yield Premiums For MBS NowComparing Yield of MBS vs. A Rated Corporate Bonds
AAA Rated Auto ABS Average Yield: A Rated Corproate Average Yield:
Since InceptionSince Inception
(ex 2008 & 2009)
3.92% 4.05%
3.73% 4.91%MBS +0.19% MBS +0.14%
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NO REFINANCELESS Trading UpLESS RenovationLESS DownsizingGet Transferred
Death, Divorce, Etc.
Trading UpMajor Renovation
DownsizingGet Transferred
Death, Divorce, Etc.
REFINANCEMORE Trading UpMORE RenovationMORE Downsizing
Get TransferredDeath, Divorce, Etc.
Mortgage RatesNear Current Rates
Mortgage RatesMUCH HIGHER
Mortgage RatesMUCH LOWER
OR OR
Mortgage-Backed SecuritiesTraditional 10-Year Mortgage Pass-Through & Cash Flow Profile
Mortgage Rates UNCHANGED
4.0 YearBond
3.4 YearBond
2.9 YearBond
0.6 Year Extension 0.5 Year Contraction
7% CPRPer Year
25% CPRPer Year
12% CPRPer Year
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Government Sponsored Entity (Ginnie Mae, Fannie Mae,
Freddie Mac)
Class 3Class 2
$$
$
Class 1
$$
$ $$
$
Classes Increase Cash Flow Certainty
Investor certainty is increased.
Investors in short-term, intermediate-term and long-term securities can now participate in the mortgage-backed securities market.
Homeowner
Bank Trustees
Guaranteed Timely Principal & Interest
Mortgage-Backed SecuritiesCollateralized Mortgage Obligations (CMOs) & Cash Flow Profile
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Sequntial Class CMO:
Mortgage-Backed SecuritiesThe Two Main Types of Collateralized Mortgage Obligations (CMOs)
Pre-Planned Ammortization Class (PAC) CMO:
• Cash Flow Stability Improved vs. Pass-Through Since Tranches Get Paid Back In Sequential Order.
• Collateral Subject to Big Prepayment Swings Can Still Cause Some Cash Flow Variability (e.g., A Sequential Backed By New 30 Year Loans).
• A Sequential Backed By More Stable Collateral Can Greatly Improve Cash Flow Stability (e.g., A Sequential Backed By Seasoned 15 Year Loans).
• Can Be The Most Stable Form of Mortgage-Backed Security.
• Cash Flow Structured to Follow Pre-Planned Schedule Subject to Prepayment Speeds Remaining Within Stated Parameters (e.g., Cash
Flows Unchanged Assuming PSA Between 100 and 350).
• The Key is to Analyze “Stressed” Prepayment Assumptions to Ensure The Bond Will Act Like You Expect
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Mortgage-Backed SecuritiesAnalyzing The PAC CMO Structure
• The PAC Can Have Stability Because Other Support Bonds Make It So.
PACCMO
$$
$
Support Class 1
$$
$ $$
$
SupportClass 2
• If Prepayments Are Greater Than Expected, The Support Classes Will Take The Additional Prepayments So The PAC Doesn’t Have To.
• If Prepayments Are Less Than Expected, The Support Classes Will Forego Principal So The PAC Gets The Desired Amount.
• Investors Typically Run “Stress Tests” To Ensure The Support Classes Are Adequate To Provide The Required Stability For The PAC Class.
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Mortgage-Backed SecuritiesThe Well Structured PAC CMO Structure
Consistent Payment History Well Within Wide PAC Bands
1 Year Bond at +83 bps Over Treasuries
• A Well Structured PAC CMO Often Provides Greater Yield and Cash Flow Stability Than Traditional Agency Callable Debentures
• Yields On Well Structured PAC CMOs Are Comparable to A-Rated Corporates.
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Mortgage-Backed & Asset-Backed SecuritiesSummary: High Yield and High Quality Are Not Mutually Exclusive
• Investors Are Looking For High Quality Alternatives To Low Yielding Government Debentures
• The Mortgage-Backed and Asset-Backed Sectors Can Offer Attractive Investments That Can Add Significant Yield and Total Return Over
Time.
• Premiums Comparable to or Higher Than Many ‘A’ Rated Corporate Bonds.
• Bonds Backed By Traditional Fixed Rate Mortgages and Auto Loans, As An Example, Have A Proven Track Record of Maintaining The Highest Credit Quality Even In The Deepest Economic Downturns.
• Credit Quality Is Primarily Achieved By Loan Diversification, Over-Collateralization, Subordination and/or Agency Guarantees.
• Cash Flow Stability Is Achieved Primarily By Collateral Type and Security Structure
• When High Credit Quality and Cash Flow Stability Are Properly Combined, Event Risk Can Be All But Eliminated
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Thank You!