Mortgage Backed Securities

Mortgage-Backed Securities

Chris Lamoureux, PhD

Head of FinanceEstes/Neill Professor of Finance

University of Arizona

04/08/23 Mortgage Backed Securities 2

Background

A dominant aspect of the US economy is widespread home ownership (owner-occupied housing). In the 2000 Census, 66.2% of American households owned their own home. This compares to a homeownership rate of less than 50% in 1890, and 43.6% in 1940.


International Rates of Home Ownership

US: 66.2%UK: 67.9%Japan: 60.3%France: 54.3%Germany: 40.5%Republic of Korea: 53.3%


MortgagesUS Public policy has attempted to increase

home-ownership. Prior to the 1970’s most mortgages were owned by the financial system (Banks and S&Ls).

Because these loans are very standardized, they were the first type of securitized loans.

A mortgage is a collateralized, amortizing loan.It has a prepayment option.


MBS’sThe most basic MBS is an Agency Passthrough

security.Passthrough Features:

– Type of Guarantee• Fully modified passthrough – timely payment of both

interest and principal.• Modified passthrough – timely payment of interest,

principal passed through when collected (guaranteed to be no later than a pre-specified date).

– Number of LendersSingle or multiple lender (impacts extent of diversification).


MBS Features (Cont’d.)– Mortgage Design of loans.

Esp. FRM vs. ARM– Mortgage Characteristics

• Government-insured vs. Conventional• Maximum Loan size• Amount of Seasoning permitted• Assumability• Maturity• Servicing Spread.

– Payment Procedure (Delays / Method).


Agency PassthroughsThree Types:

1. GNMA– Fully modified– Only FHA, VA, and RHS (Rural Housing Service)

loans allowed– GNMA I – only single lender pools.– GNMA II – both single- and multiple-lender pools.– Servicing Spread:

– GNMA I: 50 basis points.– GNMA II: 150 basis points.


3 Types (Cont’d.)2. Federal Home Loan Mortgage Corp (Freddie

Mac) (Participation Certificate)1. Cash Program.2. Guarantor / Swap Program.– Wide variety of pools.– Spread: 50 – 250 basis points.

3. Federal National Mortgage Association (Fannie Mae)

– All are fully modified.– Otherwise, very similar to Freddie Mac.


CMOs

In June, 1983, FHLMC offered the first CMO. The CMO is a more sophisticated way of distributing the cash flows from a pool of mortgages than the straightforward passthrough.


CMOs (Cont’d.)The first CMOs focused on providing a variety of terms-to-

maturity (durations) to investors. They are known as sequential pay structures (aka: plain

vanilla; clean).The mortgages are pooled and the future cash flows are

allocated according to specific classes or tranches.Example: $1 million pool of FNMA 7.5%s consistent with 185% PSA:Tranche A:Receives all principal flow from Months 1 through 64, when

principal balance is 0 + Stated Coupon.


CMOs (Cont’d.)Tranche B:Receives stated coupon + all principal flow from Months 65

through 107, when principal balance is 0.Tranche C:Receives stated coupon + all principal flow from Months 108

through 134, when principal balance is 0.Tranche Z:Receives no cash flows until first 3 tranches are retired

(although face amount accrues at stated coupon) then all remaining principal flows.

(Cash flows shown in Sundaresan, Figure 9-9, p. 327.)


CMOs (Cont’d.)In 1986, following large drops in mortgage rates,

and increased pre-payments, issuers developed and issued prepayment protected bonds called planned amortization classes. (PACs)

PACs have a principal payment schedule--like a sinking fund that can be maintained over a range of prepayment rates.

The relative certainty of these PAC tranches is obtained by setting up a companion tranche that absorbs the uncertainty.


Trading MBS 1.MBS do not trade in the same manner as treasuries

or even corporate debt. Most trades are conducted on a TBA basis, where the basic structure of a security, but not the specific security is agreed to trade. This is meant to make for fungibility in the MBS market. So a trade specifies the WAC, WAM, prepayment history, and then most trades will actually comprise securities from several pools.


Trading MBS 2.Most trading in MBS occurs according to a

schedule established by the Public Securities Association. I take the following time-line example from Tierney & Moore’s Chapter 5 from The Handbook of Mortgage-Backed Securities, (Fabozzi, ed.) 1995.

On June 18, the portfolio manager calls a dealer and agrees to buy a 30-Yr FannieMae pass-through with $1 million face value, coupon 8.5%. Agreed upon price: 102 47/64 w/ no other characteristics specified.


Trading MBS 3.On July 9 the manager receives a fax that states

that 2 pools will be delivered in 2 days:1. A new pool issued on July 1 with 1.00 factor.2. A pool issued on June 1 –just beginning to pay

principal with a factor .99.

The dealer will deliver 98% of the requested face value. The settlement date is July 13, where the manager pays the agreed upon premium plus accrued interest from July 1 through July 12.


Trading MBS 4.On the settlement date, the portfolio manager receives

notice that Fedwire has credited its securities account and debited its cash account.

On the last day of the month (July 31) Fedwire surveys all accounts and records our portfolio manager as the owner of record if its purchased MBS.

On the 4th business day of the month (Aug. 6) Fannie Mae releases pool factors. Fannie Mae pass-throughs pay coupons on the 25th of the month to holders of the last record date. The interest and principal payment will be credited to the manager’s account via Fedwire.


Trading MBS 5.

The “factor” in this case is the remaining principal multiplier for the previous month. This is multiplied by the original principal x the passthrough rate x 1/12 to come up with this month’s interest cash flow.

Mortgage Backed Securities

Economy & Finance

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