marketplace. We also look at the remaining types under the example of the auto loan market for the reason that they are relatively homogenous and stable. These activities are likely to serve as a template for the con- tinued development of the European market.
interest only, typically with an endowment policy, or straight repay- ment mortgages, also common are capped and fixed rate.
The capital markets, obviously, are not interested in individual debt obligations. However if all of these obligations are pooled together then the characteristics of the collection are often attractive. Such then is the motive behind MBSs. In the US certain MBSs enjoy government sponsorship; in which case the credit rating will be AAA. There are three agencies which are either owned by, or have government association.
These are the Government National Mortgage Association (GNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal National Mortgage Association (FNMA). The overwhelming majority of mortgages will be financed by these agencies. Do not think however that the consumer goes directly to the agency. They lend to intermedi- aries. Table 4.1 illustrates the development of this phenomenon.
MBSs are issued both as ‘pass through’ and ‘pay through’ securities, often referred to as CMOs. The latter formed by pooling ‘pass throughs’, and redistributing the principal and interest according to a pre-set formula.
‘Pass throughs’ represent an undiluted claim on the asset base. Cash received by the vehicle (no distinction is made between interest and principal) is passed directly on to the underlying securities. These all have a single class structure, that is no holder has rights to the cash flow that are senior or subordinated to the other holders (Figure 4.5).
There are a number of varieties of pass through which can be categor- ized as ‘straight pass through’ whereby interest and principal is paid directly to investors as it is received in the pool. ‘Partially modified pass through’, where some payments may be delayed but ultimately covered by the guarantee2and then the ‘modified pass through’ whereby all pay- ments are made regardless of whether there is money in the pool. There is also a type of pass through which categorizes the investors into two groups the ‘callable’ and the ‘call class’. The latter receive nothing but hold the right to call the security at a certain price and date in the future.
Table 4.1 Issuance of MBSs ($ billion).
2003* 2002 2001 2000 1999
FHLMC 198 531 379 159 226
FNMA 410 727 524 213 299
GNMA1 51 111 109 59 108
GNMA2 19 63 67 46 46
Source:Bloomberg LP. *Until April 2003.
2The guarantee must supply the extra funds.
CMOs were created to obviate the problem of pre-payment. In the US almost every borrower can refinance their mortgage without incurring penalties. This causes considerable problems for the investor because the maturity of their security is not known. CMOs address this issue by separating out the interest and principal payments such that some tranches entirely bear the pre-payment risk.
‘Pay through’ securities are the manifestation of the CMO, represent- ing aggregations of pass through securities. They represent differenti- ated interests on the underlying assets. Cash received by the vehicle is distributed according to the class of the security. Thus senior debt has a preferential claim. We now discuss the common tranche types.
Tranche types
Sequential pay
These are organized into a sequence for the repayment of principal.
This principal is received and distributed according to the class letter.
But if the principal is redeemed more quickly than expected the matur- ity of the class will decrease. Conversely if pre-payment grows more slowly, then the average life is expanded. Thus, the pre-payment is vital in determining the maturity of the security and hence its market value.
Planned amortization
The PAC is set up to pay principal at a pre-determined rate when pre- payments occur within a specified range. This provides protection against both early and delayed amortization. This is arranged by sub- ordinating principal payments to other tranches. Because of the greater certainty of maturity investors will accept a lower yield.
Issuer Mortgage A
Mortgage B
Security A
Security B
Security C
Figure 4.5 The CMO arrangement.
Targeted amortization
The TAC gives investors protection against early pre-payment. This is done by ascribing a constant rate of principal payment to the class. If pre-payments occur more rapidly than expected the excess is diverted to the other tranches.
Support class
Designed to alleviate pre-payment on other categories. Investors agree to subordinate their principal repayments to other holders in exchange for a higher return.
Floating-rate tranches
These pay floating rates of interest usually expressed as a spread to a common interest rate.
The call class
Investors in this category receive no interest or principal until the other classes have been paid. They potentially have the longest life of all the tranches. Scheduled interest payments that are missed are added to the principal amount until cash becomes available following the retirement of other classes. This is a benefit because when inter- est payments begin they will be based upon a larger principal.
IO and PO mortgage-backed securities
Subsequent securities can be stripped into their component interest and principal payments. The US expression of stripping refers to the fact they trade independently and in the manner of a zero coupon bond which has appeal to certain types of investors.
Figure 4.4 shows the relative importance of mortgage activity within the US and Figure 4.8 displays the relative importance within the European marketplace.