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
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