Structured Products – MBS

Note: Text from the workshop presentation – “Structured Products – MBS”

Structured Financial Products

• Bond products created through the SECURITIZATION
• Referred to the collection of
  • Mortgage Backed Securities
  • Asset Backed Securities
• Characteristics
  • Assets are used a as collateral
  • Assets have current and/or future cash flows
  • Assets are Pooled
  • Possible prepayment
• It is also referred as Mortgage Sector of Bond Market

Mortgage

• Loan secured by the collateral of some specified real estate property which obliges the borrower to make a predetermined series of payments
• Mortgage collateral
  • Residential properties
  • Commercial properties etc
• Mortgage Rate
  • Interest rate of the loan
  • Also referred as Contract Rate
• Mortgage Designs
  • Structure of payments, rates and duration

Mortgage Structures

• Fixed Rate & Level Payments
  • Fixed interest rate
  • Fixed monthly payments
• Adjustable Rate
  • Varying interest rate
• Balloon
• Growing Equity
• Reverse Mortgages etc

Fixed Rate, Level Pmnt

• Popular Design
• Interest and Principal amounts are included in monthly payments
• Monthly payments are calculated using the formula:

Mortgage Risks

• Interest Rate Risk
  • Mortgages are usually are of long-term
• Credit Risk / Default Risk
  • Borrower’s ability to pay back
• Prepayment Risk
  • Mortgages can be paid back earlier than scheduled
  • Mortgages are usually refinanced during low interest rates
  • Force lender to lend the money for lower rates

Problems of Mortgages

• Illiquid – difficult sell the mortgage loans
• Funds held for almost unknown period of time
• Higher exposure to Credit Risk and Interest Rate Risk
• Statistically higher exposure to Prepayment Risk
• SECURITZATION IS THE SOLUTION

Mortgage Grades

• Confirming Mortgage /Prime
  • Mortgage that is satisfy all the underwriting standards of Federal Agency (like Fannie Mae etc)
• Non-confirming Mortgage / Subprime
  • Mortgage that does not satisfy the underwriting standards of Federal Agency

LTV – Loan To Value

• Loan-to-Value ratio
• Ratio of the loan amount to the market value of the property
• Market values is appraisal value
• The lower the LTV the greater the protection
• The higher the LTV the greater the risk of default
• Borrower classes – ‘A’ to ‘D’
• A class – prime
• B – D -> subprime borrowers

Securitization Process

Picture

Securitization

• Process of creating a new financial instruments by packaging cash flows from pool of loans/receivables
• Securities are secured by underlying loans/receivables
• American Securitization Forum (ASF)

Securitization Process

• Originator – company that creates loans (mortgages vendor etc)
  • Initial mortgage lender
• Borrowers – loan borrowers
  • Cash flows
• SPV (Special Purpose Vehicle) / SPE (Special Purpose Entity)
  • New Independent legal entity
• Investors
  • security holders

Purpose of Securitization

• Convert illiquid Mortgages into tradable instruments (capital markets)
• Replenish the funds of original investors (for further investments)
• Remove assets from balance sheet
• Efficient Lower finance cost comparing to other forms
• Alternative to typical Debt and Equity Financing
• Credit enhancement
• Serve the demands of different type of investors

US MBS Market

• MBS are secured by
  • Residential Mortgages (RMBS)
  • Commercial Mortgages (CMBS)
• Agency MBS
  • Issued by Federal Agencies
• Non-agency MBS
  • Issued by private entities
• US outstanding MBS Market value – 6+ trillion

MBS Types

• MPS (Mortgage Passthrough Securities) OR Passthrough MBS OR Simply MBS
  • Securities issued by creating shares from pool of one or more mortgages
  • Mortgage in the pool called as SECURITIZED
• CMO (Collateralized Mortgage Obligation)
  • Class of Bond created from the cash flows of MPS
  • Derivative of MPS
• Stripped MBS
  • Interest and Principal of mortgage cash flows are separated to create SMBS
  • Two types
    • Interest Only (IO SMBS) Bond
    • Principal Only (PO SMBS) Bond

MPS – Risk

• Prepayment Risk
  • Mortgage prepayment (full or partial) will cause the uncertainty of cash flows
  • Contraction Risk
    • In case of lower market rate, prepayment may cause reduced life of loan
  • Extension Risk
    • In case of higher market rate, payments may slow down
    • Investors lose the opportunity of higher interest

CMO

• Class of MBS that are referred as TRANCHES (Slices)
• Each Tranch is a different bond class
  • Different maturity
  • Different coupon
• Usually cash flows from MPS are directed towards Tranches. Hence CMS are referred as derivatives.

Purpose of CMO

• Mitigate Prepayment Risk of MPS
• Create bonds of different classes to serve different needs
• Create bonds such as interest only and principal only

CMO Structures/Types

• Sequential Pay Tranches
• Accrual Tranches
• Floating-Rate Tranches
• Structured Interest Only Tranches
• Planned Amortization Class Tranches

CMO Structures/Types (2)

• Sequential-pay Tranch
  • First tranch receives all principal prepayments until it is value is zero, then next tranch until its value is zero and so on
  • Tranches are Retired sequentially
• Accrual Tranch
  • Tranch that doesn’t take interest certain times and it uses that to payoff other earlier tranches
  • It is also referred as Z-Bond
• Floating Rate Tranch
  • Tranch that has Floating Rate Coupon
  • Floating Rate is tied to some index (usually LIBOR)
• Structured Interest Only Tranch
  • Receives interest only
• Planned Amortization Class Tranch
  • Cash flow patterns is scheduled in case of prepayment is in within certain band
  • Amortization is pre-determined with prepayment limits

Sample CMO

• Freddie Mac Series 1706
  • Collateral is 7% MPS
  • Total 17 tranches in structure
  • 10 PAC tranches
  • 3 scheduled tranches
  • Floating Rate
  • Reverse Floating Rate