Asset Securitization - Comptroller's Handbook - Borrower is Party to Securitization PG 8
L - Securitization
Transcript of 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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II.Incentives and Mechanics of Pass-
Through Security Creation
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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II.Incentives and Mechanics of Pass-
Through Security Creation
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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II.Incentives and Mechanics of Pass-
Through Security Creation
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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III.Effects of Prepayments
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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III.Effects of Prepayments
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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III.Effects of Prepayments: PSA
Model
Monthlyprepaymentrate (%)
30
360 Months
125% PSA
100% PSA
75% PSA
7 %
6%
4/2%
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III.Effects of Prepayments: PSA
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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III.Effects of Prepayments: PSA
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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III.Effects of Prepayments:
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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III.Effects of Prepayments:
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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III.Effects of Prepayments:
Option Model Approach
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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IV. Collateralized Mortgage Obligation
(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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IV. Collateralized Mortgage Obligation
(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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IV. Collateralized Mortgage Obligation
(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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IV. Collateralized Mortgage Obligation
(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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IV. Collateralized Mortgage Obligation
(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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V.Mortgage-Backed Bonds
(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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V.Mortgage-Backed Bonds
(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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V.Mortgage-Backed Bonds
(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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VI.Innovations in Securitization
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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VI.Innovations in Securitization
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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VI.Innovations in Securitization
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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VI.Innovations in Securitization
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
___________________________________________________________