The Mechanics of Investing in Mortgage-Backed and Asset-Backed Securities 105 Robert Young and Lakhbir Hayre. Mortgage-backed securities (MBS) and asset-backed securities (ABS)1 represent the largest sector in the bond market.
WHAT ARE MORTGAGE- AND ASSET-BACKED SECURITIES?
The purpose of this book is to provide a comprehensive, sophisticated and clear treatment of the MBS and ABS markets. Scheduled performance reflects the amortizing nature of most consumer loans; in other words, the principal borrowed is repaid gradually over the term of the loan, rather than in one lump sum at the maturity of the loan.
DEVELOPMENT OF THE MARKET
Ginnie Mae (formerly known as the Government National Mortgage Association, or GNMA) is still part of the US. The agency MBS market refers to mortgage-backed securities guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac, and totaling more than $2.5 trillion (as of the end of 2000), it represents the majority of the MBS/ABS market.
ORGANIZATION OF THIS BOOK
By convention, securities backed by two types of mortgage loans—home equity loans and manufactured housing loans—are classified as ABSs. The last part of the book contains a glossary of common terms (the MBS and ABS markets, like every specialized field, has its share of jargon).
USING THIS BOOK
GROWTH OF THE SECONDARY MORTGAGE MARKET
Note that MBS are a larger percentage of the index than Exhibit 1.1 suggests, since almost half of all Treasury securities are bonds with maturities of less than one year, and are therefore excluded from index.1. Exhibit 1.4 also shows cumulative returns for various Salomon Smith Barney fixed income indices; MBS have outperformed Treasuries and corporate bonds by significant margins.
AGENCY PASS-THROUGH SECURITIES
Ginnie Mae, Freddie Mac and Fannie Mae are responsible for almost all the issuances and outstanding principal amount of mortgage refinances. Freddie Mac issued a small volume of pass-throughs in the 1970s, while Fannie Mae began its MBS program in late 1981.
TERMINOLOGY
Pass-throughs issued under an alternative program called Ginnie Mae II5 and those issued by Fannie Mae and Freddie Mac allow for variations in interest rates on the underlying loans. For a recent update on the Ginnie Mae II program, see Bond Market Roundup: Strategy, Salomon Smith Barney, December 12, 1998.
TYPE OF AGENCY PASS-THROUGH COLLATERAL
Smaller amounts of pass-throughs are backed by 20- and 10-year loans, which were primarily issued as refinancing vehicles during the various refinancing waves of recent years. Adjustable Rate Mortgages (ARMs) ARMs became popular during the high interest rate period of the early 1980s.
TYPES OF PASS-THROUGH TRADING
The Good Delivery Guidelines specify the allowable variance in the actual face amount of the groups from the agreed face amount,8 the maximum number of groups per $1 million of face value, and so on. 8 Because the initial pool amount can be any arbitrary amount (e.g. in the example in Figure 1.6), it will generally be difficult to obtain pools whose outstanding amounts exactly equal the agreed amount of trade.
MULTIFAMILY PASS-THROUGH PROGRAMS
BASICS OF MORTGAGE SECURITY ANALYSIS
Exhibit 1.10 shows Ginnie Mae 6.5% cash flows if prepayments are made at a constant rate of 100% PSA. Exhibit 1.11 also illustrates the characteristic S-curve that characterizes prepayment rates as a function of the economic incentive to refinance (ie, the amount the coupon is in the money).
OPTION-ADJUSTED ANALYSIS OF MORTGAGE SECURITIES
For a given interest rate path and a given spread s, the expected value of MBS is given by equation 1.2. It is a measure of the cost to the investor of volatility in interest rates and thus in prepayments.
STRUCTURED MORTGAGE-BACKED SECURITIES
Also important is the structure of the CMO, for example the number of support classes still in the deal. IO STRIPs receive all interest payments from the underlying collateral and nothing from the principal.
THE NON-AGENCY MARKET
Appendix 1.23 provides a rough schematic representation of some of the main sectors in the non-compliant market.34 Some larger issuers in the various sectors are also shown. A heavy California (and to a lesser extent, Northeast) concentration, with most deals having 30% to 50% of loans from California. Salomon Smith Barney recently published a comprehensive discussion of the all-A market,36 so we will keep the discussion brief here.
MBS MARKETS OUTSIDE THE UNITED STATES
Instead of the pro rata system used in the USA, advance payments in Denmark are distributed by a lottery system, where each bond (nominally DKK 1,000) is one lot. But as the jump in volume in recent years suggests, many of the barriers to securitization have been easing, and volume is expected to increase in the coming years. However, according to the study, the term retail sales includes "not loans to self-employed persons," an exclusion that would eliminate a significant portion of loans in the United States.
BACKGROUND
Despite its recent beginnings, the ABS market is now an important sector in its own right. We then focus on two major sectors of the ABS market: cars and credit cards. The much smaller outstanding size of the ABS market is a clear function of the shorter history than that of the other markets.
WHY DO CORPORATIONS ISSUE ABSS?
Rating changes, both upgrades and downgrades due to collateral performance (but less volatility than the unsecured corporate market) The size of the ABS market relative to other fixed income markets can be seen in Exhibit 2.1. Securitization diversifies sources of capital, reduces the size of the balance sheet and frees up capital associated with the securitized assets. In the 15-year history of the ABS market, until 1998, the only downgrades that occurred were caused by third-party credit enhancement deterioration.
WHAT IS THE MARKET SIZE AND COMPOSITION?
As a result, the issuer in the corporate bond market would need to split such issues and tap separately into the commercial paper, medium term notes and corporate underwritten markets to achieve the same flexibility and access the most diverse investor base possible. . The increased globalization of the ABS market adds even more diversity to the range of potential investors in a typical ABS transaction. We see the diversity of the investor base in Figure 2.5, which shows Salomon Smith Barney's placement of fixed and variable rate credit card securitizations in 1999.
THE LEGAL STRUCTURE
A PRIMER ON THE AUTO LOAN MARKET
Cash Reserve Account – The seller generally deposits cash in advance into a cash reserve fund. Turbo Payments – The fund can accelerate the repayment of senior classes by using the excess spread to higher tranches. Alternatively, the excess spread can also be used to "turbo" higher classes instead of creating a cash reserve account.
A PRIMER ON CREDIT CARD ASSET-BACKED SECURITIES
The monthly principal as a percentage of the outstanding amount paid from the credit card issuer's account base is called the principal payment rate. The payment rate is generally calculated monthly to correspond with the billing cycle for credit card usage. In today's environment, the important factor for off-balance sheet treatment is (1) the legal isolation of the receivables and (2) evidence that the seller-servicer no longer “controls” the receivables. Different ownership interests are indicated by the transferor's interest and the investor's interest. The transferor's interest (also known as the sellers' interest) is the smallest amount required by the rating agencies to absorb the decrease (referred to as the sellers' required interest) but is usually a much larger amount.
APPENDIX
COMMON CREDIT CARD TERMS, TRIGGERS, AND TERMINOLOGY
SETTLEMENT PROCEDURES
Variance refers to the difference between the face amount of the pools delivered and the agreed face amount. Smith Barney an amount equal to the current face amount times the agreed price of 98-03, plus accrued interest from the beginning of the month. In our example, Freddie Mac releases an updated pool factor at the end of the last business day of August.
MORTGAGE SECURITIES LENDING
A decrease in the market value of the securities may result in a margin call, while an increase will result in a payment to the borrower of funds. The repo principal (the money provided to the borrower) is simply the market value of the collateral obtained by the lender, less the haircut. The interest cost of the loan (repo rate) is obtained by applying the repo rate to the repo principal.
CLEARANCE AND SETTLEMENT IN THE BACK OFFICE
As far as Freddie Mac and the Federal Reserve are concerned, Bank V is the holder of the security and should receive payments of principal and interest on it. Customer U is the beneficial owner (ie, the true owner) of the pool through its Clearing Bank V. Fedwire, operated by the Federal Reserve Banks, settles Freddie Mac and Fannie Mae pools and CMOs.
The Salomon Smith Barney Prepayment Model
HOUSING TURNOVER
The faster seasoning (as well as higher overall turn rate) of the Colorado 6.5s is clearly seen in Figure 4.8.13. The lock-in effect refers to the borrower's disincentive to move because the existing loan rate is lower than prevailing market rates. So, the more locked-in a borrower is (the greater the difference between the borrower's below-market and prevailing mortgage rates), the lower the borrower's turnover rate.
REFINANCING BEHAVIOR
A term that approximates the average coupon ratio in the mortgage universe to current mortgage rates. The most dramatic change has been the upward shift in the lower end of the S-curve between 1987 and 1993. The housing inflation index for collateral,32 which provides an indication of the amount of equity in a home;.
DEFAULTS
Two ratios are usually calculated – the borrower's monthly mortgage payments divided by gross monthly income and the total monthly debt payments divided by gross monthly income. It turns out that the answer is yes—mortgage default rates show a characteristic dependence on the age of the mortgage. The 100% SDA curve is a reasonable model for the typical default rates experienced by 30-year conventional funds under "normal" circumstances.
CURTAILMENTS AND PAYOFFS
Defaults remain constant at that level for the remaining life of the security. They average around 0.5% CPR early in a broker pool's life, which is consistent with the prepayment rates implied by WAM reductions, but can rise sharply to as much as 15% to 20% CPR at the end of the mortgage. term. CPR for the first two-thirds of the life of a conventional 30-year mortgage pool, then quickly increases to an average of as much as 15% to 20% CPR during the last third of the pool's life.
APPLYING THE MODELING FRAMEWORK
Credit-driven refinances typically make up the largest component of the HEL rate and depend on the borrower's credit – the poorer the credit, the higher the rate. 48 In many countries outside the United States, hybrid mortgages are either the norm (e.g., the Netherlands), or in countries where variable-rate loans are the norm (e.g., England), a "fixed-rate" loan fixed" usually means a hybrid. (eg, the coupon is . "fixed" for a certain period). The effect of the penalty is accurately captured by the model, which tracks actual speeds quite well.
PREPAYMENT MODELS: A USER’S GUIDE
53The long-term projection is a weighted average of the vector of month-by-month projections. One can define partial prepayment durations for any of the important variables discussed in the previous few sections. Note that the total prepayment duration is approximately, but not exactly, the sum of the sub-durations of the turnover and refinancing components.
APPENDIX 4A
For seasoned premiums, the partial duration for the turnover and refinancing component is more or less of equal importance. At the same time, the partial duration associated with large discounts for the turnover component is quite high, suggesting that there is significant prepayment risk associated with that sector. The risk is highlighted by the general difference in forecasts about the strength of the housing market and the flavor rates of discounts among Wall Street firms.60.
THE SALOMON SMITH BARNEY HOUSING TURNOVER MODEL
