13 13 C h a p t e r Mortgage-Backed SecuritiesMortgage-Backed Securities second edition Fundamentals of Investments Valuation & Management Charles J.Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 2 Mortgage-Backed Securities Our goal in this chapter is to examine the investment characteristics of mortgage pools. Goal © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 3 A Brief History of Mortgage-Backed Securities Traditionally, local banks wrote most home mortgages and then held the mortgages in their portfolios of interest-earning assets. Then, when market interest rates climbed to near 20% in the early 1980s, bank customers flocked to withdraw funds from their savings deposits to invest in money market funds. Today, an originator usually sells the mortgage to a mortgage repackager, who accumulates them into mortgage pools. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 4 A Brief History of Mortgage-Backed Securities Financed by mortgage-backed bonds (also called mortgage pass-throughs), each mortgage pool is set up as a trust fund. A servicing agent collects the mortgage payments and then passes the cash flows through to the bondholders. The transformation from mortgages to mortgage-backed securities (MBSs) is called mortgage securitization. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 5 Work the Web For more information on mortgage- backed securities, visit: http://www.investinginbonds.com © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 6 Fixed-Rate Mortgages The size of the monthly payment is determined by the requirement that the present value of all monthly payments, based on the financing rate specified in the mortgage contract, be equal to the original loan amount. Fixed-rate mortgage Loan that specifies constant monthly payments at a fixed interest rate over the life of the mortgage. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 7 Fixed-Rate Mortgages where r = annual mortgage financing rate T = mortgage term in years () 12 12 1 1 1 12 amountloan paymentMonthly × + − × = T r r Fixed-Rate Mortgages 13 - 8 McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 9 Fixed-Rate Mortgage Amortization Each monthly mortgage payment has two separate components: c payment of interest on outstanding mortgage principal d pay-down, or amortization, of mortgage principal The relative amounts of each component change throughout the life of the mortgage. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 10 Fixed-Rate Mortgage Amortization Suppose a 30-year $100,000 mortgage loan is financed at a fixed interest rate of 8%. Monthly payment = () 76.733$ 1208.111 1208.000,100$ 1230 = +− × × In the first month, Interest payment = $100,000 × .08/12 = $666.67 Principal payment = $733.76 – $666.67 = $67.09 New principal = $100,000 – $67.09 = $99,932.91 In the second month, Interest payment = $99,932.91 × .08/12 = $666.22 Principal payment = $733.76 – $666.22 = $67.54 New principal = $99,932.91 – $67.54 = $99,865.37 [...].. .13 - 11 Fixed-Rate Mortgage Amortization Mortgage amortization can be described by an amortization schedule, which states the scheduled principal payment, interest payment, and remaining principal owed in any month McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 12 Fixed-Rate Mortgage Amortization 13 - 13 Fixed-Rate Mortgage Amortization McGraw Hill / Irwin 13. .. rules The three best-known types of CMOs are: interest-only (IOs) and principal-only (POs) strips, sequential CMOs, and protected amortization class securities (PACs) McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 31 Interest-Only and Principal-Only Strips Interest-only strips (IOs) pay only the interest cash flows to investors, while principal-only strips (POs)... Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 32 Interest-Only and Principal-Only Strips McGraw Hill / Irwin 13 - 33 Sequential CMOs Sequential CMOs carve a mortgage pool into a number of tranches (slices) For example, A, B, C, and Z-tranches Each tranche is entitled to a share of mortgage pool principal and interest on that share of principal However, cash flows are... through immediately, except for the Z-tranche Interest on Z-tranche principal is paid as cash to the topmost tranche in exchange for a transfer of an equal amount of principal, until all the principal in the topmost tranche has been fully paid off McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 35 Sequential CMOs McGraw Hill / Irwin 13 - 36 Protected Amortization Class... fees): Payment of interest on outstanding mortgage principal Scheduled amortization of mortgage principal Mortgage principal prepayments McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 27 Cash Flow Analysis GNMA Fully Modified Mortgage Pools McGraw Hill / Irwin 13 - 28 Macaulay Durations for GNMA Mortgage-Backed Bonds The interest rate risk for a bond is often measured... steadily in each month until it reaches an annual rate of 6% (for 100 PSA) in month 30 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 22 PSA Mortgage Prepayment Model McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 23 PSA Mortgage Prepayment Model By convention, the probability of prepayment in a given month is stated as a single... Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 25 Work the Web Visit the Public Securities Association at: http://www.psa.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 26 Cash Flow Analysis GNMA Fully Modified Mortgage Pools Each month, GNMA mortgage-backed bond investors receive pro rata shares of cash flows derived from fully... by Macaulay duration, which assumes a fixed schedule of cash flow payments However, the schedule of cash flow payments for mortgage-backed bonds is not fixed With falling interest rates, prepayments speed up, and vice versa McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 29 Macaulay Durations for GNMA Mortgage-Backed Bonds Historical experience indicates that interest... SMM = 1 – (1 – CPR)1/12 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 13 - 24 PSA Mortgage Prepayment Model The average life of a mortgage in a pool is the average time for a single mortgage in the pool to be paid off, either by prepayment or by making scheduled payments until maturity For a pool of 30-year mortgages, Prepayment Schedule Average Mortgage Life (years)... McGraw-Hill Companies, Inc All rights reserved 13 - 18 GNMA Clones Like GNMA, both FHLMC and FNMA operate with qualified underwriters who accumulate mortgages into pools financed by an issue of bonds However, since FHLMC and FNMA are only GSEs, their fully modified pass-throughs do not carry the same default protection as GNMA fully modified pass-throughs McGraw Hill / Irwin © 2002 by The McGraw-Hill . month. Fixed-Rate Mortgage Amortization 13 - 12 Fixed-Rate Mortgage Amortization 13 - 13 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 14 Fixed-Rate. D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 2 Mortgage-Backed Securities Our goal in this chapter is to examine. McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 13 - 4 A Brief History of Mortgage-Backed Securities Financed by mortgage-backed bonds (also called mortgage pass-throughs),