Chapter 11 Valuation of Mortgage Securities. Chapter 11 Learning Objectives Understand the valuation...
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Transcript of Chapter 11 Valuation of Mortgage Securities. Chapter 11 Learning Objectives Understand the valuation...
Chapter 11Chapter 11Valuation of Valuation of
Mortgage SecuritiesMortgage Securities
Chapter 11Chapter 11Learning ObjectivesLearning Objectives
Understand the valuation of Understand the valuation of mortgage securitiesmortgage securities
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 rates affect mortgage securities valuesvalues
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 Typically fixed, semi-annual interest payments with face value interest payments with face value paid at maturitypaid at maturity
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) Public Securities Association (PSA)
ModelModel 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 Based on title search activity which precedes refinancingprecedes refinancing
PASS-THROUGHSPASS-THROUGHS
No rearranging of the cash flows No rearranging of the cash flows from the mortgage poolfrom the mortgage pool
Prepayments have a significant Prepayments have a significant impact on the timing of cash flows impact on the timing of cash flows and thus the value of those cash and thus the value of those cash flowsflows
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 For pass-throughs selling at a premium, delayed prepayment premium, delayed prepayment increases yield and accelerated increases yield and accelerated prepayment decreases yieldprepayment decreases yield
Coupon rates reflect market rates Coupon rates reflect market rates at time of issueat time of issue
High coupon pass-throughs suffer High coupon pass-throughs suffer price compression due to price compression due to prepayment expectationsprepayment expectations
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 Seek to be sufficiently overcollateralizedovercollateralized
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 This means that the CMO issuer faces no interest rate or faces no interest rate or reinvestment riskreinvestment 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 produce principal-only and interest-only stripsinterest-only 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 Amount of principal equals the initial pool balance but the timing initial pool balance but the timing is unknownis 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 Floaters are classes of a CMO that have a rate that moves with the have a rate that moves with the marketmarket
These are matched with an These are matched with an institution’s short-term liabilities institution’s short-term liabilities that move with the marketthat move with the 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 accounts, forwarding proper payments to purchasers, sending payments to purchasers, sending delinquency and default notices, delinquency and default notices, initiating foreclosure proceedings and initiating foreclosure proceedings and collecting on PMIcollecting 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 prepayment accelerates. Combines to reduce the value of servicing rightsto reduce 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 MBSsVALUE CREATION IN MBSs
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 Securitization rearranges the cash flows into more and less risky flows into more and less risky componentscomponents
Asymmetric information may distort Asymmetric information may distort values - lenders may have superiorvalues - lenders may have superior