THE HANDBOOK OF MORTGAGE BACKED SECURITIES sixth edition

THE HANDBOOK OF MORTGAGE-BACKED SECURITIES THE HANDBOOK OF MORTGAGE-BACKED SECURITIES Sixth Edition FRANK J FABOZZI, Ph.D., CFA, CPA Editor McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2006, 2001, 1995 by Frank J Fabozzi All rights reserved Printed in the United States of America Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher DOC/DOC ISBN 0-07-146074-8 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, futures/securities trading, or other professional service If legal advice or other expert assistance is required, the services of a competent professional person should be sought —From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers McGraw-Hill books are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs For more information, please write to the Director of Special Sales, Professional Publishing, McGraw-Hill, Two Penn Plaza, New York, NY 10121-2298 Or contact your local bookstore This book is printed on recycled, acid-free paper containing a minimum of 50% recycled, de-inked fiber Library of Congress Cataloging-in-Publication Data The handbook of mortgage-backed securities / [edited] by Frank J Fabozzi.––6th ed p cm Includes bibliographical references and index ISBN 0-07-146074-8 (hardcover : alk paper) Mortgage-backed securities—United States Portfolio management—United States I Fabozzi, Frank J HG4655.H36 2005 332.63′23––dc22 2005017828 C O N T E N T S Preface xxi Contributors xxv SECTION ONE MORTGAGE-BACKED SECURITIES (MBS) PRODUCTS AND THE MORTGAGE MARKET Chapter An Overview of Mortgages and the Mortgage Market Anand K Bhattacharya, Frank J Fabozzi, and William S Berliner Product Definition and Terms Mortgage-Loan Mechanics The Mortgage Industry 15 The Loan Underwriting Process 17 Generation of Mortgage Lending Rates 20 Risks Associated with Mortgages and MBS 27 The Evolving Roles of the GSEs 32 Chapter MBS Investors 35 Steven Abrahams The Sources of Competitive Advantage in Investing in MBS Fannie Mae and Freddie Mac 39 Insurers 41 Total-Return Portfolios 42 Change in the Competitive Landscape 44 The Portfolio Meets the Market 44 v 35 vi Contents Chapter Mortgage Pass-Through Securities 45 Linda Lowell and Michael Corsi Federally Sponsored Mortgage Pass-Through Programs 46 Pass-Through Cash Flows 52 Impact of Cash-Flow Variability on Yield and Average Life 58 Determinants of Prepayment Speeds 62 Gauging a Pool’s Prepayment Risk 68 Anatomy of the Pass-Through Market 74 Chapter Trading, Settlement, and Clearing Procedures for Agency MBS 81 Jeffrey D Biby, Srinivas Modukuri, and Brian Hargrave TBA Trading: Turning Pool-Specific Securities into Generic Securities 81 Settlement Procedures for Agency Pass-Throughs 82 BMA Good Delivery Guidelines 83 Variance 85 Trading and Settlement Procedures for Other MBS Products 86 Clearing Procedures for MBS 86 Summary 87 Appendix: What Happens When an Investor Buys a Mortgage-Backed Security? 88 What if the Dealer Fails to Deliver 90 Chapter Defining Nonagency MBS 93 Thomas Zimmerman The Nonagency Market 93 Defining Characteristics 94 Credit 98 Distribution of Characteristics 101 Evolution of Loan and Borrower Characteristics 104 Credit and Prepayment Performance 106 Agency Expansion into Nonagency Zones 111 Summary 111 Contents vii Chapter Credit Enhancements for Nonagency MBS Products 113 Frank J Fabozzi External Credit Enhancements 113 Internal Credit Enhancements 116 Use of Interest-Rate Derivative Instruments 122 Chapter Understanding the Prospectus and Prospectus Supplement 127 David M Lukach, Yogesh Gupta, Thomas Knox, and John Gibson Securities Act Registration Statements: The Disclosure Framework 128 Disclosures for Form S-3 Registered MBS Offerings 129 Typical Sections of a Prospectus and Prospectus Supplement 132 Conclusion 156 Chapter Waterfall Cash-Flow Mechanics in European RMBS 157 Alexander Batchvarov, William Davies, and Altynay Davletova General Forms of Waterfalls 157 Variations in European RMBS Waterfalls by Country 159 Combined or Split RMBS Waterfalls: Compare and Contrast Summary 168 165 SECTION TWO ALTERNATIVE MORTGAGE PRODUCTS Chapter Exploring the MBS/ABS Continuum: The Growth and Tiering of the Alt-A Hybrid Sector 171 Satish Mansukhani Exploring the MBS/ABS Continuum: Defining the Risk Space The MBS/ABS Continuum in the Hybrid Sector 173 172 Prepayment and Credit Performance Follow Relative Placement along the Continuum 175 Deal Structures also Mirror Relative Placement along the Continuum 179 Sufficient Credit Enhancement to Withstand Multiples of Default Frequency Experienced on Weaker Subprime Mortgages 180 The Value of Available Funds CAPS 183 viii Contents Chapter 10 Alt-A Mortgages and MBS 187 Anand K Bhattacharya, William S Berliner, and Jonathan Lieber Background 187 Loan-Level Characteristics 190 Factors Underlying Prepayment Behavior 192 Empirical Prepayment Performance 200 Recent Developments 204 Chapter 11 Fixed-Rate Alt-A MBS 207 Satish Mansukhani, Arjune Budhram, and Mu’taz Qubbaj Fixed-Rate Alt-A Collateral 208 Alt-A Prepayments 222 Historical Drivers of Prepayments and Defaults 228 Credit Performance and Enhancement 234 Practical Portfolio Manager Opportunities and Considerations 252 Chapter 12 Hybrid Adjustable-Rate Mortgages (ARMs) 259 Anand K Bhattacharya, Steve Banerjee, Ricardo Horowicz, and Wei Wang Popularity and Issuance of Hybrid ARMs 260 Characteristics of Hybrid ARM Loans 261 Hybrid ARM Refinance Incentive 266 Comparing Hybrid ARM S-Curves 272 Comparing Hybrid ARM Seasoning Curves 275 Loan-Level Drivers of Hybrid ARMs 277 Interest-Only (IO) Hybrid ARMs 282 Jumbo Hybrid ARM Credit Performance 284 Conclusions 285 Chapter 13 Hybrids: Product, Performance, Investor Base, and Frameworks to Assess Relative Value 287 Satish Mansukhani, Adama Kah, and Mu’taz Qubbaj Hybrid Origination and Issuance Securitization of Hybrids 290 The Hybrid Borrower 291 288 Contents ix Prepayment Profiles of Hybrids 295 Trading Conventions in the Hybrid Market 311 Investors in the Hybrid Secondary Markets 314 A Conceptual Framework for Relative-Value Assessments of Hybrids Cap Valuations on Hybrids 319 Index Levels: Implied Forwards and Historical Peaks 319 Relative Value of Hybrids 320 Identifying Characteristics/Features of Hybrids 327 316 Chapter 14 Interest-Only ARMs 333 David Liu Overview of IO ARMs 335 Credit Implications 347 Prepayment Experience 353 Conclusion 361 Chapter 15 Residential Asset-Backed Securities 363 John McElravey Market Development 364 Characteristics of Subprime Borrowers Prepayment Speeds 369 Relative-Value Consequences 372 Key Aspects of Credit Analysis 374 Structural Considerations 378 Conclusion 387 366 Chapter 16 Customized Mortgage-Backed Securities 389 Anand K Bhattacharya and Paul Jacob Historical Perspective 389 Major Categories of Customized MBS 391 Determinants of Market Payups 397 Evaluation of Customized Pools: Current-Yield Approach 400 Evaluation of Customized Pools: Option-Adjusted Spread Analysis Measuring the Duration of a Customized Pool 407 Challenges and Issues in Customized MBS Valuation 410 401 x Contents Chapter 17 The Prepayment and Credit Characteristics of Reperforming FHA/VA Loans 413 Anand K Bhattacharya, William S Berliner, and Jonathan Lieber The Process of Delinquency Curing 414 Prepayments 416 Credit Fundamentals: Overview 426 Chapter 18 Prepayment-Penalty Mortgage-Backed Securities 441 Anand K Bhattacharya, William S Berliner, and Jonathan Lieber Legal Framework for Imposition of Prepayment Penalties 442 Prepayment-Penalty Loan Structures 443 The Dynamics of the Prepayment Penalty 448 Borrower and Lender Dynamics 449 Prepayment Behavior of Prepayment-Penalty Loans 452 The Impact of Prepayment Penalties on Security Performance and Duration Conclusions 462 SECTION THREE MORTGAGE DERIVATIVES: CMOs AND STRIPPED MBS Chapter 19 Stripped Mortgage-Backed Securities 465 Cyrus Mohebbi, Gary Li, and Todd White Overview of the SMBS Market 466 Investment Characteristics 470 Summary 480 Chapter 20 PAC Bond Features and Performance 481 Linda Lowell and Michael Corsi Collars 482 Effective Collars 484 PAC Collar Drift 485 How Likely Is Breaking the PAC Bands? 486 Pay Order and Average Life Stability 488 Average-Life Profile versus Option-Pricing Models 490 458 Index GO pools, 415–416 Government National Mortgage Association (GNMA) average loan size, 591–592 buyout effects, 593–594 credit guarantees, GNMA II program, 48, 592 GNMA I program, 48, 592 loan assumability, 591 LTV ratio, 592–593 market share, 590 multifamily pools See GNMA multifamily pools pass-through market, 47 pass-through programs, 48–49 platinum pool option, 49 prepayment life cycle, 594–595 project loan pass-throughs, 1158 project loans See GNMA project loans vs Fannie Mae prepayments, 593–595 vs Freddie Mac prepayments, 593–595 Government-sponsored enterprises (GSEs) defined, evolving roles of, 32–34 growth rates, 33 as investors, 39–41 liquidity advantage, 74 oversight of, 40–41 pass-through pool, 22 proposals for regulation, 33 GSEs See Government-sponsored enterprises (GSEs) Guaranty fee, 7, 21 Gupta, Yogesh, 127 Hargrave, Brian, 81 Hayre, Lakhbir, 832 Hedge funds investment opportunities for, 257 as investors in hybrids, 315–316 Hedge ratios, 1060 Hedging effectiveness, 1082 of interest-only (IO) strips, 1054–1056 IO inventory carrying cost, 1045–1048 measuring effectiveness of, 1060 mortgage servicing rights, 1048–1050 of mortgage servicing rights (MSRs), 1054–1056 1225 pass-through, 1025 with TBAs, 1062–1064 tracking errors, 1060–1062 Hedging methodology, 1080–1082 durations, 1097–1099 prepayment speeds, 1100 standard deviation of total return, 1083–1085, 1088, 1090–1092, 1094 “swap-only” hedge, 1093 “swap plus mortgage” hedge, 1089, 1093 HELOC See Home equity line of credit (HELOC) Hewlett, Duane C., 1187 Home equity line of credit (HELOC), 93, 94, 95 characteristics, 96–97 Home equity loans (HELs) top ten issuers, 367 vs agency CMO yields, 372–373 Home price appreciation annual, 728–729 regional, 730–731 risk multiplier, 729 Home price appreciation index (HPI), 562 and equity effect, 563 Home sales See also Housing turnover actual vs projected, 541 and mortgage variety, 542 turnover-related prepayment, 541 U.S annual rate, 540 Homeshark, 684 Horowicz, Ricardo, 259 Horowitz, David S., 759 Ho, T.S.Y., 831 Housing turnover adverse selection, 682 and capital gains tax repeal, 559 as component of prepayment, 542, 543 and geography, 543 home price appreciation, 562–566 and interest rates, 558, 559 and loan age, 559–560 lock-in effect, 560–562 and mortgage variety, 543 points-paid effect, 565 prepayments, 560, 677–680, 706 rates, 557–558, 706 rate/term refinancing, 566–567 seasonal variations, 565–566, 589–591 submodel, 705, 706 1226 Howard, C Douglas, 803 Hybrid ARMs, agency vs fixed-rate, 292 benchmark indices, 328 borrowers See Hybrid borrowers cap structure, 328–329, 331 cap valuations, 319 characteristics, 261–266, 327 conforming, 265 convertible vs nonconvertible, 330 defined, 259, 287 FICO scores, 294 fixed-rate component, 694 floor, 694 growth, 289 index, 328, 331 index levels, 319–320 index rate, 694 initial cap, 694 interest-only (IO), 6, 266, 282–284 investors in secondary markets, 314–316 jumbo See Jumbo hybrid ARMs loan-level drivers, 277–282 loan-to-value (LTV) ratios, 292, 294 loan types, 693 lookback period, 329, 330 margin, 328, 694 market, 260–261, 693, 695–697 months to reset (MTR), 330 nonagency market, 697–698 OAS analytics, 717–718 OAS models, 316 occupancy status, 294–295 origination, 288–289 pool characteristics, 291 postreset payment analysis, 282–283 prepayment behavior, 277–282 prepayment characteristics, 716, 718 prepayment histories, 698–699 prepayment penalties, 734–735 prepayment profiles, 295–296 primary rate spread, 289 product vs fixed-rate incentive, 268–270 refinance incentive, 266–272 refinancing See Hybrid refinancing submodel relative value assessment, 320, 323–324 relative-value assessment, 316–319 S-curves for, 272–275 seasoning curves for, 275–277 Index securitization, 290 trading conventions, 311 types of loans, 328 vs agency debt, 321–322 vs 15-year MBS, 325–327 yield-curve slope impact, 695–696 Hybrid borrowers attributes, 699–700 first-time, 708 motivation for purchase, 291, 316–319 qualifier, 706 rate refinancer, 705 self-selection by, 715 traditional, 705, 709 Hybrid refinancing submodel aging ramp, 712 burnout, 713–714 dual-rate, 709 first-rate reset, 714–715, 716 fixed-rate refinancing, 709 historic lows, 711 hybrid-to-hybrid incentives, 709 incentives, 707–709 loan-size impact, 712 prepayment by product type, 714 stickiness of rates, 710–711 Hyperamortization, 1140 Income ratios, 19 Index, Indexed money managers as investors in hybrids, 315–316 Insurance See also Mortgage insurance against fraud, 115 against special-hazard losses, 116 Insurers investment opportunities for, 256 as investors, 41–42 leverage at, 41 regulation of, 42 Interest coverage (IC) test, 1214 Interest-only (IO) ARMs affordability, 356 alt-A sector, 339–341 borrower motivation to purchase, 338 borrower payment shock, 358–360 borrower profile, 353–354 characteristics, 335–337 cumulative default rates, 347–350 early history, 338 key points, 361 Index layered risk, 343, 346 market growth, 333, 353 market share, 334 prepayment experience, 353 product types, 336–337 refinancing-response curves, 354–356 reset effects, 358–360 short-term benefits, 356 Interest-only (IO) hybrids prepayment profiles, 308, 310 vs non-IO ARMs, 351, 352 Interest-only (IO) inventory hedge analysis, 1016 hedging carrying cost, 1011–1014 Interest-only (IO) loans, 11, 465, 469 monthly returns, 1077 portfolio valuation, 1075–1080 unhedged, 1077–1080 vs fully amortizing loan, 12–13 Interest-only (IO) strips, 1012 duration, 1053 hedge correlations, 1057–1059 hedge instruments, 1056–1057 hedging, 1054–1056 use of swaptions, 1064–1065 Interest-rate cap, 124 Interest-rate corridor, 125 Interest-rate derivatives, 122–126 Interest-rate hedging, 1215–1216 Interest-rate paths present value, 763–764 selection, 765–766 simulation, 761–763 Interest-rate process, 551 Interest-rate risk, 82 Interest-rate swaps, 123–124 Internal tail, 1125 Inverse floaters characteristics, 526–530 coupon cap, 525 coupon features, 526 effective duration, 527, 529–530 floating-rate portfolio hedge, 530–531 interest-rate play, 530 investment characteristics, 526–530 multiplier, 525 structure, 523–526 Treasury-Eurodollar spread, 528 yield-curve shifts, 526 yield enhancement, 530 1227 Investors competition among, 37 total-return, 42–43 Jacob, David P., 857, 1133 Jacob, Paul, 389 Jumbo hybrid ARMs, 263–265, 283 credit performance, 284–285 cumulative default rates, 348 pools, 290–291, 295 prepayment environment, 300–302, 303–305 prepayment rate, 283 spreads to swaps, 313 vs agency hybrids, 327 vs fixed rate, 293 Jumbo interest-only (IO) hybrids prepayment profiles, 309–310 Jumbo loans See also Jumbo hybrid ARMs; Prime jumbo loans BB tranches, 437–439 borrower profile, 702 characteristics by loan size, 659–661 credit quality, 376–377 defaults, 683, 684 FICO-score distribution, 667 prepayment-penalty issuance, 447 refinancing profiles, 658, 666 vs conforming mortgages, 685–686 Jump Z bonds, 505–506, 861 cumulative vs noncumulative, 505–506 jump rules, 505 sticky vs nonsticky, 506 Kah, Adama, 287 Kalotay, Andrew, 799, 803 Kaplan-Meier hazard method, 720–721 Key-rate durations (KDRs), 1081 approach, 831 defined, 1010 of Ginnie Mae 30-year pass-through, 1010–1011 profiles, 1011 Knox, Thomas, 127 Laggards, 804 spreads, 813–814, 815–817 Lancaster, Brian, 783 Lancaster-Cable default study default timing curve, 1194 key findings, 1189–1190 loss severity by property type, 1191 1228 Layered PAC bonds, 518–521 average-life volatility, 519–520 structure, 518–520 Layered risk, 217 effect of rate premium increase, 217–221 of IO ARMs, 343, 346 Leapers, 804, 805 effect on value, 814–815 spreads, 813–814 Leffler, Peter, 1209 Lehman Brothers MBS index duration, 896–898 index prices vs PSA prices, 872–875, 883–885 index returns vs PSA prices, 904–907, 907–912 index returns vs PSA returns, 875, 880–883 nonzero returns difference, 912–917 nonzero values, 915 paydown factor date, 894–895 paydown return, 902–904 pool factor date, 879, 888 price calculation, 885–887 price dynamics, 904 pricing and valuation, 901–904 PSA switch date, 878–879, 887–888 return calculations, 917–920 return dynamics, 876–877, 905–907 returns universe, 891–894 same-day settlement assumption, 869–872 total returns, 901, 921–928 zero total return, 901 Lemons market, 1132 Lenders depository institutions, 16 direct, 15 nondepository institutions, 16 originators, 16 and prepayment-penalty loans, 449–452 servicers, 16–17 Letter of credit (LOC), 114 Levin, Alexander, 623, 624, 783 LIBOR See London Interbank Offered Rate (LIBOR) Lieber, Jonathan, 187, 413, 441 Lifetime cap, 329 Li, Gary, 465 Liu, David, 333 Index Loan age as credit risk factor, 1193 Loan-level information, 548 Loan-level prepayment models attributes, 615–616 documentation, 605, 611 FICO scores, 605, 609–611 geography effect, 612–614 lien status, 606, 614 loan balance, 605, 606–607 loan-to-value (LTV) ratio, 605, 607–608 minimizing loan dispersion, 604–605 occupancy status, 606, 611–612 predictive strength, 617–619 private mortgage insurance, 606 process, 614–617 real estate appreciation, 608–609 survival analysis, 614, 619–621 vs pool level, 603 Loan origination as credit risk factor, 1193 Loan purpose, 630 multipliers for, 638 Loans See also FHA loans; Jumbo loans; Mortgages; Prime jumbo loans; Reperforming loans; Subprime loans; VA loans classification, 744 defaulted, 744 See also Defaults delinquent, 744 roll-rate analysis, 744, 746 Loan servicer, 630 Loan size, 575–577 as credit risk factor, 1193 decline of, 577 vs conforming loan limits, 577 vs loss severity, 971 Loan terms, 4–5 Loan-to-value (LTV) ratio, 100 as credit risk factor, 1192 defined, 18 distribution by sector, 102–103 on hybrid ARMs, 292 as key in prepayments, 676–677 repayment risk multipliers, 729–730 Location as credit risk factor, 1191 Lock-in effect, 560–562 Lock-out, 1202 period, 1138 Index London Interbank Offered Rate (LIBOR), 5, 124 forward rates, 321 Longitude PDCA technology, 1043–1044 Lookback function, 657 Lookback period, 329 Loss severity average, 972 cumulative losses, 975–977 by loan characteristics, 970–973 by loan rate, 975 model, 972–974 and occupancy, 977 vs loan size, 971, 974 Low-credit pools, 986–987 Low-credit seasoning, 988 Lowell, Linda, 45, 495, 507 Low-loan-balance (LLB) prepayment sector, 555 LTV ratio See Loan-to-value (LTV) ratio Lukach, David M., 127 Luo, Michael M., 1009 Lu, Tim, 857, 1157 Macaulay duration, 826 Macaulay, Frederick, 826 Malozemov, Leonid, 603 Malysa, John, 1209 Mann, Jordan I., 869 Mann, Steven V., 931 Mansukhani, Satish, 171, 207, 287 Manzi, James M., 1133 Margin, 5, 287 Master servicer, 1129 MBS See Mortgage-backed securities (MBS) MBS dollar roll See Dollar roll financing MBS risk-adjusted carry See Risk-adjusted carry McElravey, John, 363 Merrick, Susan S., 1209 Miller, Beverly, 1163 Modeling See Prepayment modeling Modified duration, 826 formula, 829 Modukuri, Srinivas, 81 Mohebbi, Cyrus, 465 “Moneyness” adjustment, 843–846 Months to reset (MTR), 330 1229 Mortgage-backed securities (MBS) See also Collateralized mortgage obligations (CMOs); Commercial MBS (CMBS); Nonagency MBS; Residential MBS (RMBS); Stripped MBS (SMBS) average life, 760 customized See Customized MBS duration See Duration identifying value of, 855 indexing See Lehman Brothers MBS index nonagency See Nonagency MBS pool-specific trading, 623 registration requirements, 129–131 stripped See Stripped mortgage-backed securities (SMBS) valuation See Valuation Mortgage balance conforming vs nonconforming, Mortgage banking industry, 15–17 depository institutions, 16 Mortgage broker, 15 Mortgage call option risk characteristics, 1032–1036 Mortgage credit See Credit Mortgage duration See Duration Mortgage insurance active companies, 382 cancellation, 608–609 characteristics, 383 deep MI, 382–384 Mortgage market alternative-B sector, competition in, 44 outstanding debt, segments, 35 subprime sector, Mortgage options convexity, 1037–1039 defined, 1023 duration, 1037–1039 hedging with, 1024–1025 markets, 1023–1024 pricing, 1029–1032 and relative-value trades, 1025–1029 risk characteristics, 1032–1037 users, 1024–1029 Mortgage originators, 1024–1025 Mortgage payment factor formula, 9–10 1230 Mortgage pipelines guidelines, 85 Mortgage products menu, 707 Mortgage put option risk characteristics, 1036–1037 Mortgage rates attractiveness, 1066 current-coupon, 1065 prediction, 600–602 primary vs secondary spreads, 1065 secondary, 1065 and synthetic par rate, 571 turnover effect on, 808 vs 10-year swap rate, 601–602 vs 10-year treasury rate, 601 Mortgage REITs, 315 Mortgage returns unpredictability, 824 Mortgages See also Adjustable-rate mortgages (ARMs); Alt-A mortgages; Fixed-rate mortgages; Hybrid ARMs; Loans adjustable-rate, defined, fixed-rate, fully-amortizing, interest-rate exposures, 831 lien status, risk exposures, 831 second-lien, underwriting process, 17–20 uninsured pools, 300 Mortgage servicing rights (MSRs), 1069 back testing, 1074–1075 convexity, 1070 defined, 1053 hedge correlations, 1057–1059 hedge instruments, 1056–1057 hedging, 1054–1056, 1067 industry growth, 1054 servicing analysis, 1087–1089 servicing models, 1067 use of swaptions, 1064–1065 valuation, 1070 volatility, 1053 Mortgage term shortening of, 65–66 Municipal Bond Insurance Corporation, 114 Muth, Christopher, 719 Index NAIC See National Association of Insurance Commissioners (NAIC) NAR See National Association of Realtors (NAR) NAS class See Nonaccelerating senior (NAS) class National Association of Insurance Commissioners (NAIC), 42 National Association of Realtors (NAR) and seasonal adjustments, 680 National Housing Act of 1934, 8, 1157 Negative amortization, 14–15, 330 Negative convexity, 29, 60–61, 62, 768 Net interest margin (NIM) securities, 121 No income/no asset (NINA) loans, 20 Nonaccelerating senior (NAS) class, 251 Nonagency alt-A investor pools, 994–995 discount speeds, 995 Nonagency hybrid model housing-turnover submodel, 705 jumbo borrower profile, 702 nonagency data, 701–703 of prepayments, 703–705 refinancing submodel, 704 See Hybrid refinancing submodel Nonagency market collateral profiles, 650 subsectors, 649–650 Nonagency MBS characteristics, 94, 96–97 credit rating required for, 98–99 FICO score distribution, 101, 102 lien status, 97 loan and borrower characteristics, 104–106 loan limits, 97–98 loan size distribution, 102–103 loss coverage, 110 losses, 108–109 LTV ratio distribution, 102, 103 major sectors, 94, 95 market, 93–94 prepayment models See Nonagency valuation models prepayment sensitivity, 108–109 securitized as agency pass-throughs, 111 Nonagency valuation models baseline refinancing profile, 653–654 Bears, Stearns database, 647–648 and burnout, 655 changing face of, 645–646 Index disclosure deficit, 650 evaluation of, 687–688 impact of agencies, 648–649 innovative features, 646–647 lookback function, 657 mortgage rate spread, 685 representative deals, 689–692 underwriting guidelines, 648 yield curve, 674–675 Nonconforming alt-A mortgages, 217, 220–222, 223 characteristics, 223 default rates, 234, 237 prepayments, 222, 225, 227 turnover speed, 226 Noncumulative Z bonds, 505–506 Nonperforming loans defined, 413 “Nonratings-dependent” swap, 125 Nonsticky Z bonds, 506 Notional amount, 123 Notional principal, 123 Nursing homes FHA financing of, 1185 OAS curve durations (OCDs), 837–839 advantages and disadvantages, 839 OAS valuation models, 61, 316, 760–762 average life, 769 effective duration, 768 hedgeability, 1074, 1080–1082 hedged return calculation, 1081–1082 methodology, 1069–1074, 1095 options-adjusted convexity, 768–769 options-adjusted duration, 767 sample PAC/support structure, 772–779 sample plain-vanilla structure, 769–772 sample reverse-pay structure, 779–780 Obazee, Philip O., 1187 Occupancy type, 630 multipliers for, 639 Office of Federal Housing Enterprise Oversight (OFHEO), 40, 728, 729 Office of the Controller of the Currency (OCC), 443 Office of Thrift Supervision (OTS), 443 Option-adjusted convexity (OACs), 835 Option-adjusted durations (OADs), 834–837 Option-adjusted spread (OAS) See also OAS valuation models 1231 analysis, 401–407 of hybrid ARMs, 405–406, 717–718 interpretation of, 766 method, 551 as pricing method for SMBS, 478–479 Option-adjusted values (OAVs), 835 Optional termination, 147 Option cost, 834 Originators, 16 Overcollateralization, 120–121 Overcollateralization (OC) test, 1214 PAC companion bonds, 511 average lives, 516 prepayment speeds, 515 PACs See Planned amortization classes (PACs) Parity Act (1982), 443 Pass-through securities See Agency pass-through securities Paydown estimation, 916 Payment shock on IO ARMs, 358–360 Payup, 623 matrix, 642 practical, 641, 643 theoretical, 640 PDL See Principal deficiency ledger (PDL) Percent-of-price (POP) duration, 832–834 Permitted assets, 123 Phelps, Bruce D., 869, 901 Physical delivery, 86–87 “Piggyback” loan, “Plain vanilla” swap, 124 Planned amortization classes (PACs) attraction of, 481 average life, 860–861 average life profile, 490–491 average life stability, 488–489 busted, 486 cash flows, 865 collar drift, 485–486 with companion bonds, 513 defined, 481 duration, 865 extension protection, 487–488 interest-only (IO) certificates, 1201, 1205 pay order, 489 prepayment lockout, 488 prepayment speeds, 515 as reduced-risk CMO structures, 507 1232 Planned amortization classes (PACs) (Cont.): with reverse TAC, 516 schedule, 482–484 structure See Structuring collars Treasury yield curve, 864 wide vs tight window, 491 Points add-ons, 26 sample calculation, 25 vs rates matrix, 195, 197 Pool insurance, 115–116 Pool payups, 979–980 for attributes, 981 Pool trading, 979 Positive convexity, 768 PPMs See Prepayment-penalty mortgages (PPMs) Practical payup, 641, 643 Preferred-share caps, 1215 Premium-coupon pass-through securities, 467 Prendergast, Joseph R., 1023 Prepayment burnout, 396, 805 lockout period, 1138 penalty class, 740, 742 risk multipliers, 729–730, 740, 741 Prepayment behavior alt-A vs jumbo loans, 226, 228 borrower incentives, 198–200 and credit quality, 666–668 delinquency status impact, 423–424, 426 geography effect, 612–614 involuntary, 425 and loan size, 421 and losses, 440 propensity to prepay, 621–622 rate refinancing, 569–584 refinancing model, 542–546 regional differences, 70 of reperforming loans, 416–421 speeds, 422–423 technology effects on, 537–539 turnover-related, 541 types of events, 420–421 voluntary, 424 vs default, 535 2001 vs 1998 ratio, 578 Prepayment curves fixed vs adjustable-rate loans, 370 Index Prepayment derivatives, 1041–1042 auction-available products, 1042–1044 hedging applications, 1045–1051 history, 1042 payoffs against referenced index, 1045 product types, 1044–1045 Prepayment environment of agency hybrids, 297–299, 303–307 of hybrid ARMs, 295–296 of jumbo hybrids, 300–302, 303–305, 310 Prepayment-linked notes, 1105 increasing popularity, 1107–1108 redemption schedule, 1105–1106 relative value, 1108–1110 tax advantages, 1116 vs agency debentures, 1109 vs balloons, 1109, 1113 vs callable debentures, 1107, 1109, 1115 vs hybrid ARMs, 1109, 1114 vs short CMOs, 1109, 1111–1112 Prepayment lockout, 1122 Prepayment modeling active-passive decomposition for, 624–630 adjustable-rate analysis, 731–735 baseline functions, 736–737 categorical variable, 722 continuous variable, 723 cumulative losses, 754 documentation, 743, 751 and enhanced agency data, 630–636 and enhanced pool agency data, 630 fixed-rate analysis, 735–739 framework for, 719–722 interest-rate sensitivity, 732–733, 735–736 loan amount, 739 loan purpose, 742, 751 loss severity by product, 752 occupancy, 743, 751 penalties effect, 733–734, 737–739 portfolio stratification, 724–725, 728 property type, 743–744, 751 regional loss severity, 753 regional stratification, 726–728 strategy, 723–724 Prepayment models See also Agency prepayment model accuracy of, 549, 550 Applied Financial Technology model, 541 attribute-sensitive, 598–600 construction, 540 Index generic, 536–537 loan-level See Loan-level prepayment models purpose, 539 reliability of, 548–549 uses of, 540 Prepayment option valuation of, 549, 551 Prepayment penalties, 1123 classifications, 446 dynamics, 448–449 federal law restrictions, 443 impact on behavior, 458–462 impact on performance and duration, 458–462 “soft” vs “hard,” 444, 458 state law restrictions, 442 Prepayment-penalty mortgages (PPMs) defined, 441 impact on behavior, 452–458 post-expiration behavior, 458 prepayment behavior, 452–458 structures, 443–448 Prepayment protection, 980, 982 ranking of characteristics, 989 Prepayment rates Fannie May vs subprime lenders, 371–372 Prepayment risk, 27–30, 784 See also Prepayment models mean-reverting risk factors, 788 quantifying price of, 785 single-jump-diffusion pattern, 789 single-jump risk pattern, 788 valuation for, 796 WAC as indicator of, 68 Prepayment risk- and option-adjusted spread (prOAS) calibration to TBAs, 791–792 case study, 794–797 defined, 784 prepayment errors, 784 prepayment surprises, 784 price of risk constant (PORC) model, 783 risk assessment, 794 risk dynamics, 792–793 as risk-free OAS, 785 risk-neutral prepayment model, 785 risk-neutral prepay multiples, 790 turnover risk, 789–790 1233 Prepayments, 15 of alt-A mortgages, 190–191 annual rate, 54 curtailments, 682–683 determinants, 107 effect of loan size, 71 effect on yield, 59 and enhanced data, 634 FICO score as determinant, 99 in full, 63 impact on loan attributes, 655–656 involuntary, 682–683, 747 See Defaults loan characteristics, 71–72 models, 73–74 new vs seasoned pools, 627 of pass-through securities, 54–55 PSA standard, 56 reasons for, 28, 652–653 stability, 107–108 vs credit, 108 Prepayment score, 551–552 historical performance, 552 Prepayment seasoning ramp, 397 Prepayment sensitivity of AA-rated classes, 243 of A-rated classes, 244 of BBB-rated classes, 245 Prepayment speed, 982–985 of agency hybrids, 306 by documentation style, 202–203 extension protection, 990–993, 993–994 by FICO score, 202–203 by occupancy type, 200–201 by property type, 201, 202–203 roll down, 306 and weighted-average coupon, 854 and weighted-average loan age, 854 and weighted-average maturity, 854 Price of risk constant (PORC) model, 783 drawbacks, 786 Prime jumbo loans, 8, 95 characteristics, 96–97, 223 collateral characteristics, 172 deal structure, 179–180 default rates, 234–236 size distribution, 102–103 Principal components analysis, 1013 Principal deficiency ledger (PDL), 159 Principal-loss test, 122 1234 Principal-only (PO) products as hedge instruments, 1056 increasing importance of, 1068 loans, 465, 469 vs IOs, 1059 PrOAS See Prepayment risk- and optionadjusted spread (prOAS) Property type, 630 as credit risk factor, 1190–1191 multipliers for, 640 Proportional hazards, 621 model, 722 Prospectus contents, 128 asset pool information, 135–137 cover page, 132–133 credit enhancement, 148–149 credit support, 143 delinquency experience, 137–138 description of certificates, 139–143 distributions, 141–142 fees and expenses, 143–146 interest rate information, 133–135 prepayment provision, 149–153 redemption provisions, 146 risk factors, 153, 155–156 PSA See Public Securities Association PSA curve, 559 Public Securities Association (PSA), 557 model, 27–28 prepayment standard, 56 Qubbaj, Mu’taz, 207, 287 RAM Re, 115 Rate attractiveness, 1066 Rate incentive, 569–572 and interest-rate process, 571 Rate/points matrix, 195 Rate premium, 668–670 Rates vs points matrix, 195, 197 Rate/term refinancing, 18, 64, 566–567 “Ratings-dependent” swap, 125 Real estate mortgage investment conduit (REMIC), 414–415 structural forms, 429 Recombo premium, 468 Referent cell coding method, 722 Refinancing of ARM loans, 546–547 Index burnout effect See Burnout cash-out, 64–65, 608 of conventional loans, 564 “credit-driven,” 548 efficiency, 683–685, 809 and efficiency gains, 578 hybrid alternatives, 584–585 median loan age, 560 over the Internet, 684–685 pool-regeneration effect, 586 rate/term, 18, 64, 566–567 reasons for, 63 simulated interest-rate path, 763–764 technology effects on, 537–539 threshold-media effect, 572, 583–584 Refinancing behavior by financial engineers, 804 impact of loan size on, 659–661 by laggards, 804, 813–815, 815–817 by leapers, 804, 813–814, 813–815 Refinancing option market cost, 810–812 Relative-value trades, 1025–1029 calls/calls trade, 1026–1028 examples, 1029 REMIC See Real estate mortgage investment conduit (REMIC) Remittance date, 329–330 Reperforming loans BB tranches, 436–439 credit score, 419 defaults, 432, 434 defined, 413, 414 FHA/VA vs generic loans, 416 historical performance, 430–431 prepayment behavior, 416–421 role of HUD, 431 structural considerations, 430 voluntary vs involuntary episodes, 420 Required servicing, 17, 21 Reserve funds forms of, 121 Residential ABS available funds cap (AFC), 384–387 bond insurance structures, 378–379 credit analysis, 374–377 credit profiles, 366–368 cumulative net-loss trigger, 381–382 deep mortgage insurance, 382–383 delinquency trigger, 381 Index expected defaults, 380 FICO scores, 368 home equity loan (HEL) sector, 365 indexed to LIBOR rate, 384 market growth, 363–364 origin, 365 risk-based capital regulations, 364 senior/subordinate structures, 378, 379 “shifting interest” structures, 379 shift toward first-lien loans, 365 step-down date, 380 step-up coupon, 387 top-ten issuers, 367 Residential MBS (RMBS), 1135–1136 Dutch, 159–160, 161–162, 164, 167 Italian, 159–160, 162, 164, 167–168 Spanish, 159–160, 162, 164, 167–168 U.K prime, 159–161, 167 U.K subprime, 159–161, 164, 166–167 waterfall structures See Cash-flow waterfalls Resolution Trust Corporation (RTC), 1133 Return on equity (ROE) formula, 36 Reverse engineering, 138 Reverse TAC bonds, 514 average lives, 516 prepayment speeds, 516 volatility, 517 Reverse turbos, 1215 Richard, Scott F., 759 Rickey, Branch, 44 Rilander, Adam, 943 Risk prepayment See Prepayment risk Risk-adjusted carry calculations, 943 defined, 943 exposure to vega, 946–947 hedging convexity, 945–946 hedging duration, 944–945 hedging volatility, 946–947 interpretation, 948 uncovering the risks, 944 Risk-based pricing, 20 characteristics, 24, 26 Risk factors convexity, 857 disclosed in prospectus, 153, 155–156 duration, 857 1235 Risk multipliers, 729–730, 740, 741 Risk-neutral prepayment model, 787 Risk-reduction strategies, 508 Risk-to-payup method, 407–408 RMBS See Residential MBS (RMBS) Roberts, Blaine, 833 ROE See Return on equity (ROE) Roll-rate analysis, 744, 746 Same-day settlement, 915 Sanders, Anthony, 835 Schultz, Glenn, 719 S-curve, 570, 579 Searle, Will, 783 Seasoning ramp, 396 Secondary mortgage rate, 1065 Second-lien mortgages, Securities Act of 1933, 127 Sekhar, Aryasomayajula, 603 Sella, Roberto M., 1009 Senior interest, 119 Senior percentage, 119 Senior/subordinate structures, 117–120 credit enhancement, 247 deal triggers, 246–247 default curves, 250 overcollateralization, 249 with shifting interest mechanism, 119–120 Servicer effects, 586–590 Servicers, 16–17 attributes, 588–589 prepayment relationship, 587 special, 1131, 1154 types of, 1129, 1131 Servicing, 17 Shifting interest, 118 Simulation, 761 Single monthly mortality (SMM), 27, 646 “Situation curing,” 669 SMBS See Stripped MBS (SMBS) Smith, William, 1053 SMM See Single monthly mortality (SMM) Snyderman default study, 1187–1189 default timing curve, 1194 key findings, 1188–1189 Snyderman, Mark, 1187 Spatial diversification, 1125–1126 Special servicers, 1131 aggressive litigation by, 1131 role in CMBS deals, 1154 1236 Spreads for computing daily prices, 1102 at origination, 197 Srinivasan, V.S., 555, 645, 693 Standard & Poor credit classifications, 366, 368 Stated-income loans, 20 Static spread, 834 Step-down date, 380 Sticky Z bonds, 506 Story, Jennifer, 1209 Stripped Giant Mortgage Participation Certificate Program, 468 Stripped MBS (SMBS) buyers, 469–470 collateralized with discount coupons, 479 collateralized with premium coupons, 480 convexity, 477 defined, 465 effective duration, 476 Ginnie Mae collateral for, 468–469 investment characteristics, 470–480 market growth, 466 prepayment effect on value, 472–473 prepayment S-curve, 473–474, 478 prepayment variation, 471–472 price performance, 473 pricing with OAS, 478–479 private insurance for, 469 projected price behavior, 475 types of, 466–467 Structural lockout bonds vs loans, 1147 Structuring collars defined, 482 drift, 485 effectiveness, 484 prepayment speed, 483 top vs bottom collar, 484 Subordinate interest, 118 Subprime ARMs characteristics, 344–345 cumulative default rates, 348 product types, 344–345 Subprime loans, 94, 95 borrower characteristics, 366, 368 collateral characteristics, 172, 174 credit enhancement, 180–181 credit performance, 176–178 deal structure, 179–180 Index prepayment-penalty issuance, 448 prepayment profile, 369–372 prepayments by age, 175–176 Subprime mortgage pools loan types, 377 Subservicer, 1129 Super senior bonds, 1144 Support bonds, 507 Support IO, 1201–1202, 1205 Surety bond, 114–115 Survival analysis hazard function, 619, 620, 621 probability-density function, 620 propensity to prepay, 621–622 Survival function, 619, 620 Synthetic CMOs, 1105 Synthetic-coupon pass-through securities, 466, 467 Szakallas, Dan, 623, 783 TAC See Targeted amortization class (TAC) Targeted amortization class (TAC) companion See Companion TAC bonds defined, 507 reverse, 514–517 Target par amount, 1211 TBA See To-be-announced (TBA) Teaser rates, 329 Teaser surfing, 542 Theoretical payup, 640 Three-bond hedge assumptions, 1021 computation, 1014–1017 mortgage pass-through example, 1017–1020 prepayment-sensitive IO example, 1021 Three-factor hedging, 1013–1014 Threshold-media effect, 572, 583–584, 711 Thrifts as MBS investors, 37–39 Tier-1 alt-A mortgages collateral characteristics, 172 credit performance, 176–178 deal structure, 179–180 prepayments by age, 175–176 Tier-2 alt-A mortgages collateral characteristics, 172 credit performance, 176–178 deal structure, 179–180 prepayments by age, 175–176 Index Tilman, Leo M., 825 To-be-announced (TBA) contract, 1023–1024 and customized MBS, 399, 409 duration, 408, 409 hedging with, 1062–1064 markets, 411 roll, 399–401 To-be-announced (TBA) coupons, 75–76 dollar roll financing, 76–77 To-be-announced (TBA) trading, 81–82 Total-rate-of-return managers investment opportunities for, 255–256 Total-return portfolios accounting restraints on, 43 as MBS investors, 42–43 Toy, William, 762 Trade-up buying, 608 Tranches reperforming BB, 436–439 Transunion, 18 Trick Z bonds, 504–505 Triggers, 121–122 delinquency test, 122 principal-loss test, 122 Trust IOs, 466, 467 Trust POs, 466, 467 Turnover, 29 effect on mortgage rates, 808 interest rate effect on, 66 and seasonality, 66 Turnover model, 802–803 Turnover profiles alt-A vs jumbo loans, 226 Underwriting process, 17–20 reduced documentation, 19–20 Underwriting standards, 579–582 Greenpoint vs non-Greenpoint CPR, 582 rate-premium effect, 582 VADM bonds, 503 VA loans credit guarantees, credit score, 419 delinquent, 413–414 guaranty program, 427–429 loan limits, 46 loss probability, 429 loss severity, 434–436 1237 maximum size, prepayment behavior, 417–418 securitization, 414 Valuation baseline prepayments vs refinancings, 821 dynamic valuation model, 761–762 econometric models, 800 implied prepayment distribution, 818–821 nominal spread, 760 OAS analysis See OAS valuation model open-theoretic models, 799–800, 801 option-based prepayment model, 801 option-less bullet mortgage rates, 806, 807 prOAS valuation, 783–784 refinancing behavior model, 803 refinancing option, 808–812 simulation technique, 761–765 static spread, 761 term structure of rates, 806 turnover model, 802 valuation, 759–769 valuation framework, 817–818 yield, 760 Veterans Affairs (VA) loans See VA loans WAC See Weighted-average coupon (WAC) WALA See Weighted-average loan age (WALA) WAM See Weighted-average maturity (WAM) Wang, Wei, 259 Weighted-average coupon (WAC), 21, 53, 630, 854, 1213 as indicator of prepayment risk, 68 interest-only (IO) certificates, 1200–1201 Weighted-average debt service coverage ratio (WADSCR), 1145 Weighted-average life (WAL), 1213 Weighted-average loan age (WALA), 53, 462, 630, 854 Weighted-average loan-to-value ratio (WALTV), 1145 Weighted-average maturity (WAM), 21, 53, 630, 854 Weighted-average original FICO score, 630, 631 multipliers for, 638 Weighted-average original loan balance (WAOLB), 631 multipliers for, 637 1238 Weighted-average original LTV (WAOLTV) ratio, 630, 631 multipliers for, 638 Weighted-average rating factor (WARF), 1213 Weighted-average spread (WAS), 1213 Westhoff, Dale, 555, 645, 693 White, Todd, 465 Williams, George O., 803 Wolff, Lan-Ling, 835 Yang, Deane, 799 Yerneni, Sree Sudha, 1069 Yield curve, 674–675 Yield-curve risk, 1010 Yield-curve slope, 695–697 Yield maintenance, 1122 Yields for computing daily prices, 1102 Yield sensitivity, 154 Index Z accrual, 499 Z bonds, 861 accrual mechanism, 499–500 accrual structure, 495–499 average-life calculation, 499 cumulative, 505–506 defined, 495 duration, 504 jump, 505–506 in PAC companion structures, 503 performance, 504 prepayment effect, 497–498 prepayment risk, 504 principal balance, 496–499 trick, 504–505 Zero-convexity bond (ZCB), 1030 Zero-volatility spread, 834 Zimmerman, Thomas, 93, 951 ABOUT THE EDITOR Frank J Fabozzi is the Frederick Frank Adjunct Professor of Finance in the School of Management at Yale University and a Fellow of the International Center for Finance From 1986–1992, he was a Visiting Professor of Finance in the Sloan School at MIT Frank is on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University He is the editor of The Journal of Portfolio Management, an associate editor of The Journal of Fixed Income, and a consulting editor of The Journal of Structured Finance He earned a doctorate in economics from the City University of New York in 1972 In 2002, Frank was inducted into the Fixed Income Analysts Society’s Hall of Fame He earned the designation of Chartered Financial Analyst and Certified Public Accountant He has authored and edited dozens of widely acclaimed books on fixed income securities and investments, including The Handbook of Fixed Income Securities, Fixed Income Mathematics, and numerous others ... buy-and-hold strategy As the editor of The Handbook of Mortgage- Backed Securities, I am effectively the portfolio manager of the assets of this book the chapters The sixth edition must justify to... C E T he sixth edition of The Handbook of Mortgage- Backed Securities is designed to provide not only the fundamentals of these securities and the investment characteristics that make them attractive... Mortgage Strategy Group UBS THE HANDBOOK OF MORTGAGE- BACKED SECURITIES SECTION ONE MORTGAGE- BACKED SECURITIES (MBS) PRODUCTS AND THE MORTGAGE MARKET CHAPTER ONE AN OVERVIEW OF MORTGAGES AND THE