Introduction To Mbs Market

Published Date: 02 Nov 2017

Lu, James Group: Andrew Hauser, James Lu, Kate Panttser, & Daniel Richey 5/6/2013

Table of Contents

Introduction to MBS Market

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

Mortgage-backed securities exhibit a variety of structures. The most basic types are pass-through (PT) participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. More complicated MBSs, known as collaterized mortgage obligations (CMO) or mortgage derivatives, may be designed to protect investors from or expose investors to various types of risk. A collateralized mortgage obligation or "Pay-through bond" are debt obligations of a legal entity that is collateralized by the assets it owns. Pay-through bonds are typically divided into classes that have different maturities and different priorities for the receipt of principal and in some case of interest. They often contain a sequential pay security structure with at least two classes of mortgage-backed securities issued, with one class receiving scheduled principal payments and prepayments before any other class. For tax purposes, it is important for pay-through securities to be classified as debt for income tax purposes. A stripped mortgage-backed security (SMBS) where each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:

An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.

A net interest margin security (NIMS) is securitized residual interest of a mortgage-backed security

A principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.

Securitization

The process of securitization is complicated, and is highly dependent on the jurisdiction within which the process is conducted. The basics are:

Mortgage loans (mortgage notes) are purchased from banks and other lenders, and possibly assigned to a special purpose vehicle (SPV)

The purchaser or assignee assembles these loans into collections, or "pools"

The purchaser or assignee securitizes the pools by issuing mortgage-backed securities

While a residential mortgage-backed security (RMBS) is secured by single-family or two to four family real estate, a commercial mortgage-backed security (CMBS) is secured by commercial and multifamily properties, such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites. A CMBS is usually structured as a different type of security than an RMBS. These securitization trusts include government-sponsored enterprises and private entities which may offer credit enhancement features to mitigate the risk of prepayment and default associated with these mortgages. Since residential mortgages in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment), the monthly cash flow of an MBS is not known in advance, and therefore presents risk to MBS investors. This is a very important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall. Absent protection, such prepayments would return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive.

In the United States, the most common securitization trusts are Fannie Mae and Freddie Mac, U.S. government-sponsored enterprises. Ginnie Mae, a U.S. government-sponsored enterprise backed by the full faith and credit of the U.S. government, guarantees its investors receive timely payments, but buys limited numbers of mortgage notes. Some private institutions also securitize mortgages, known as "private-label" mortgage securities. Issuances of private-label mortgage-backed securities increased dramatically from 2001 to 2007, and then ended abruptly in 2008 when real estate markets began to falter. An example of a private-label issuer is the real estate mortgage investment conduit (REMIC), an entity usually used for CMOs.

There are a variety of underlying mortgage classifications in the pool:

Prime mortgages are conforming mortgages with prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.

Alt-A mortgages are an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)[24]

Subprime mortgages have weaker credit scores, no verification of income or assets, etc.

Jumbo mortgages are mortgageswith the size of the loan bigger than the "conforming loan amount" as set by Fannie Mae.

Although, these types are not limited to MBS only. Bonds backed by mortgages, but are not MBS can also have these subtypes.

TBAs

TBAs are a special 'type' of Mortgage Backed Security that is a kind of virtual security. TBAs are traded by MBS traders with notional amounts. There are settlement days when the traders have to make good on their trades. At that time, they choose fractions from various pools to make up their TBA. In a TBA transaction, the parties agree on a price for delivering a given volume of Agency Pass-Through Mortgage-Backed Securities at a specified future date. The distinguishing feature of a TBA transaction is that the actual identity of the securities to be delivered at settlement is not specified on the date of execution ("Trade Date"). Instead, the parties to the trade agree on only five general parameters of the securities to be delivered: issuer, mortgage type, maturity, coupon, and month of settlement.

Covered bonds

In Europe there exists a type of asset-backed bond called a covered bond, commonly known by the German term Pfandbriefe. Covered bonds were first created in 19th century Germany when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated since the creation of a law governing the securities in Germany in 1900. The key difference between covered bonds and mortgage-backed or asset-backed securities is that banks that make loans and package them into covered bonds keep those loans on their books. This means that when a company with mortgage assets on its books issue the covered bond its balance sheet grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities payments.

Current Size, breadth And Depth Of the Market

The collapse of the MBS market is well-documented and there are a number of sources that can provide a more detailed account of how it occurred. We discuss role of MBS in the recent financial crisis in more details in section …For investors, what matters is whether they can return to the market for safe, bond-like returns or find other ways to garner substantial profits from the still-recent market collapse. It is important to understand that there are very safe parts of the MBS market. The Fed and government housing agencies remain huge investors in MBSs, especially those from the particularly toxic years between 2005 and 2008. But since then, financial institutions have implemented more stringent underwriting standards. This means that recent MBS issues have returned to being safer investments for the vast majority of investors. Private buyers are only now just starting to return as investors in MBSs. The Fed has largely stopped its role as the primary buyer, though it continues to hold the securities it already purchased, letting them decline naturally over time. Given the massive MBS holdings it has, the Fed would be hard pressed to find enough private buyers as the market stands right now. The primary buyers of MBS in the past were fixed income money managers and institutions, including pension funds, banks, and insurance companies. They are trickling back into the market because other alternatives for fixed income investments yield very low rates these days. MBS yields are still pretty low given the volume support the Fed has provided. However, they have appeal when compared to other types of bonds, such as U.S. Treasuries.

The securitization of many mortgages into MBSs will continue to be an important part of the market, but it has gone through historically uneven times. Overall, the Fed has to be credited with saving the market. For starters, it provided liquidity when there wasn't any. Its actions also kept mortgage rates relatively low and likely saved even more foreclosures from hitting the market. The market will slowly return to normal as private buyers step back up to the plate.

Freddie Mac began issuing in 1971; Fannie Mae began issuing in 1981. As of the fourth quarter 2011 there is about $ 5,656,737 million in total U.S. Agency MBS outstanding. In 2011 Fannie Mae, Freddie and Ginnie Mae issued $610,495, $301,174 and $327,000 million respectively [1] . Charts 1-3 of the Appendix A show dynamics of the US Agency MBS securities since 1981 through 2011. The charts suggests that historically Fannie Mae remains the largest issue of regular PTs compared to Freddie Mac and Ginnie Mae. The pick of agency MBS issuance refers to 2003, when Fannie Mae issued $1,199,549 million in PTs and $255,428 million in CMO [2] which suggests a 65 percent increase compared to 2002. As of April 2013, mortgage rates remain low, moderately extending the solid improvements and bringing rates very close to 2013 lows. .

Mortgages not guaranteed by the government, known as "non-agency", are far more volatile and thus more appealing to return-hungry investors. Their price is closely correlated to that of the houses which underpin their value. Repayments are also higher when house prices are buoyant: if the house is worth less than the mortgage, the owner may simply walk away. Picking up those mortgages at rock-bottom prices has delivered returns of 30% or more for savvy hedge funds in 2012.

Main players

Andrew to provide…

Purpose of this instrument

Kate’s second draft… everyone needs to go over the material and perhaps make enhancements.

There are many reasons for mortgage originators to finance their activities by issuing MBS. First of all, MBS help to transform relatively illiquid, individual financial assets into liquid and tradable capital market instruments. The high liquidity of most mortgage-backed securities means that an investor wishing to take a position need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread. Second, they allow mortgage originators to replenish their funds, which can then be used for additional origination activities. Also MBS are used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction). MBS are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives. These securities allow issuers :

to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing;

to remove assets from their balance sheet, which can help to improve various financial ratios, utilise capital more efficiently and achieve compliance with risk-based capital standards.

Reasons (other than investment or speculation) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing).

Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risks, and that competitive securitization markets with multiple securitizes may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis. In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer are said to make the securitizing firm's leverage less transparent, thereby facilitating risky capital structures and allowing credit risk under-pricing. Off balance sheet securitizations are believed to have played a large role in the high leverage ratio of U.S. financial institutions before the financial crisis.

Current conditions of the secondary market

Andrew to provide…

Risks in the instrument

VERY IMPORTANT!!! Daniel to provide and everyone needs to contribute for further enhancement…

Pricing Models – An introduction

James to "summarize" the information obtained from the Tuckman book…

Static Cash Flow Models

It is the earliest approach to pricing mortgage-backed securities. These models assume that prepayment rates can be predicted as a function of the age of the mortgages in a pool. Typical assumptions, based on empirical regularities, are that the prepayment rate increases gradually with mortgage age and then levels off at some constant prepayment rate. In a slightly more sophisticated approach, past behavior as a function of age is used directly to predict future behavior.

Two Severe problems:

The model is not a pricing model at all, instead a pricing analysis

It provides misleading price-yield and duration yield curves. Since these models assume that cash flows are fixed, the predicted interest rate behavior or mortgages will be qualitatively like the interest rate behavior of bonds with fixed cash flows.

Implied Models

Recognizing the difficulties encountered by static cash flow models, implied models have a more modest objective. They do not seek to price mortgage-backed securities but simply to estimate their interest rate sensitivity. Making the assumption that the sensitivity of a mortgage changes slowly over time, they use recent data on price sensitivity to estimate interest rate sensitivity numerically.

Several drawbacks:

They are not pricing models once again

The sensitivity of MBS to interest rates may change rapidly over time, as the qualitative behavior of mortgages is similar to that of callable bonds. The duration of callable bonds can change rapidly relative to that of noncallable bonds.

Prepayment Models

Composed of two separate models

Turnover model

Refinancing model

They use historical data and expert knowledge to model prepayments as a function of several variables. More precisely a prepayment model predicts the amount of prepayments to be experienced by a pool of mortgages as a function of the chosen input variables.

Prepayment models usually define an incentive function, which quantifies how desirable refinancing is to homeowners. This function can also be used to quantify the lock-ion effect, that it how averse a homeowner is to selling a home and giving up a below-market mortgage.

Lagged or past interest rates may be used to model the media effect. For example, bot the change in rates over the past month and the level of rates relative to recent lows are proxies for the focus of homeowners on interest rates and on the benefits of refinancing.

Noninterest rate variables that enter into turnover and refinancing models may include any variable deemed useful in predicting prepayments. Examples:

Mortgage age

Points paid

Amount outstanding

Season of the year

Geography

Disadvantages of prepayment function models:

It is a statistical model as opposed to models of homeowner behavior. The risk of such an approach is that historical data, on which most prepayment function models are based, may lose their relevance as economic conditions change.

Implementing Prepayment Models

Scheduled mortgage payments plus any prepayments as predicted by the prepayment function would give the cash flow from a pool of mortgages on any particular date and state. And given a way to generate cash flows, pricing along the tree would proceed in the usual way, by computing expected discounted values.

The tree technology assumes that the value of a security at any node depends only on interest rates or factors at that node. This assumption excludes the possibility that the value of a security depends on past interest rates, in particular, on how interest rates arrived at the current node.

A popular solution to pricing path-dependent securities is Monte Carlo Simulation.

Step 1

It uses a term structure model to generate rate paths. As in the case or interest rate trees, the term structure model may match the current term structure of interest rate trees in whole or in part. Since prepayment models are usually used to value mortgages relative to government bonds or swaps, practitioners thend to take the entire term structure as given.

Valuation – Pass Through Cash Flow Model with Monte Carlo Simulation

James to create a step by step illustration and a discussion on the overall methodology…

Pricing Methodology

Role of MBS in the recent crisis

Andrew to provide…

Appendix A

James to provide the full pricing model from the Excel Print Out…

Any other Tables or Information needs to be in here…

Chart 1. U.S. Agency MBS Issuance [3] 

Chart 2. U.S. Agency CMO Issuance

Chart 3. U.S. Agency MBS Outstanding: Single Family

Chart 4. Agency MBS Outstanding: Multi Family

Chart 5. Fannie Mae MBS Issuance

Chart 6. Fannie Mae CMO Strips Issuance

Chart 7. US Non-Agency Commercial Real Estate Securities Outstanding By Rating

Chart 8. US Non-Agency Residential Real Estate Securities Outstanding: Home Equity