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20161114172432ln04_2.pptxLN04
Overview of MBS Market
FRL 383 Fall 2016
LN 4: Overview MBS Market
1
1
Material
FBB.2, also
Overlap is partial
F.11 (parts of)
S.(1,2),6
BF.19
Overview
Types of MBS (Mortgage-Backed Securities, aka MRS, or Mortgage-Related Securities)
Trading
Structuring
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Introduction
MBS = mortgage backed security
Generic term for a debt-like security that is backed by mortgages (which are in turn backed by real property)
Primary market: Mortgages originated
Secondary market: Sold into capital markets; MBS, REITs
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Introduction
Creation of MBS is called (mortgage) securitization and involves
Pooling & Structuring
Pooling = collecting “similar” mortgages
Structuring = rearranging cash flows
Characteristics
Security backed by mortgages (sometimes also leases)
Credit enhancement
Alter duration, prepay exposure
Legal structure so as to avoid double taxation
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Introduction
Types of MBS
Mortgage pass-through securities (MPT)
Proportional, direct ownership in underlying pool
Little, if any, structuring
Collateralized mortgage obligations (CMO)
Pool is collateral
Extensive structuring (“tranching”)
Aka REMICs – Real Estate Mortgage Investment Conduits
Strips: IO and PO
Interest-only and principal only cash flows
Mortgage-backed bonds
Mortgage pay-through bonds
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LN 4: Overview MBS Market
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Rationale
Supply-side: Liquidity for originators
Fresh lending possible; A=E+D and E/A>x, E/AR>y
Moderates boom-bust cycles in housing
Historically: Regulation-Q
Demand-side: Asymmetric information issues
Standardization (mortgages not homogeneous)
Credit risk insurable
Scale
Capital markets better suited to deal with interest rate risk when compared to banks
Geographical need-of-funds matching
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Rationale
Additionally, secondary market development is encouraged by:
Life insurance funds traditionally purchased whole loans, but began reducing exposure 70’s and 80’s
Mortgage bankers need to find fresh sources of capital
Pension funds growing and needed long-term investments
Why long-term?
Government begins removing obstacles (state blue-sky laws), and subsidizing its development (chartering FNMA and FHLMC, for example, and expanding the role of GNMA)
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Creation
Generic MBS
Structure (see diagram, over)
Owner sells mortgage receives cash
Short mortgage, long house
Originator (S&L, mortgage banker,..)
Buys mortgage from borrower, pays cash
Sells mortgage to secondary market agency or firm, receives cash
Ends up flat
Secondary market agency/firm
Buys whole loans and sells MBS to capital markets
Ends up flat or long mortgages, short MBS
Investors (capital markets)
Short cash, long MRS
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Generic MBS Creation
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Secondary
market agency
or firm
Borrowers
Homeowners,
investors
Investor
Pension fund,
insurance co,
Mutual fund, etc
Originator
Mort. Banker,
S&L, Thrift, …
Cash
Cash
Buys
Mortgage
Sells
MBS
Flat Mortgage
Flat Cash
(+) Mortgage
(-) MBS
(+) MBS
(-) Cash
(-) (Mortgage)
(+) (Cash) (i.e., asset)
Mortgage
Cash
MBS Creation
Fundamental unit = pool
Mortgages with more or less similar characteristics
Note rate, term, credit quality, balance, etc.
Pools are transformed into MBS either as
Agency deals
Fannie Mae, Freddie Mac and Ginnie Mae
Underwriting standards
Guarantee fee
Private label transactions
All others
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Creation
Structuring (tranching)
Split up CFs (interest and principal)
Create tranches of different
Duration/average life
Credit quality
Reflects market segmentation
Duration: Banks vs. life insurance/pension funds
Risk tolerance: credit & interest rate risk
Structured MBS are broadly called collateralized mortgage obligations (CMO)
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Creation
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Creation: Private Label
Credit enhancement
Internal: Subordination (senior/sub) (see Exh 2.2)
First loss (unrated, residual) tranche
Junior tranches (AA-B), mezzanine
Senior tranches (AAA)
Shifting interest structure:
Prepay goes to senior tranches first (according to shifting interest % schedule)
Increases subordination level
And therefore enhances credit quality
Internal: Overcollateralization (O/C structure)
Loan collateral (sum mortgage principal) > deal total
External: Insurance
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Creation
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Creation: Stratification
Fixed rate: security coupon created by
Deciding on deal coupon
Splitting mortgages into
Premium (net note rate > security coupon) and
Discount (net note rate < security coupon) loans
Discount loan rates are “brought to deal coupon” by stripping off principal
This excess principal is sold as a WAC PO tranche
Premium loan excess interest is paid to a WAC IO tranche
Principal of this tranche is notional
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Trading
Mortgage loan timeline
Hedging requirements for pipeline leads to a thriving forward market
Pre-identified pools
TBA trades
Stipulated trade
More info available than in TBA
Often an undeliverable TBA, or a pool with better characteristics than deliverable minimum
Dollar rolls
Securities trade in (typically up to 3) forward markets
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LN 4: Overview MBS Market
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MBS Trading: Dollar Rolls
Dealers are often short MBS
Creating CMO’s, Depository Institutions receive favorable tax treatment for actual security rather than forward instrument, etc.
Need to borrow these from investors in the dollar roll market
Roll-in: dealers take security from investor (borrow), investor borrows cash
No margin requirement or OC
Roll-out: dealers return substantially similar security, receive cash
Same issuer and program, coupon, maturity, similar mortgage collateral, aggregate principal must be within 0.1% of original delivered,
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Trading: Dollar Rolls
Compare with a repo agreement
Like a spot sale plus a forward contract
Investor sells security in a front month and agrees to repurchase (substantially similar) security in a back month
Dealer only returns a “substantially similar” security
Not same mortgages, principal has been paid down
Keeps CF’s from pool
Therefore repurchase price < sales price (difference is called the forward drop)
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Trading: Dollar Rolls
Why would an investor loan security, rather than hold it?
Dealer is loaning investor cash at an implied rate
Call this the breakeven reinvestment rate
The investor acts as a borrower, the dealer as a lender
Like a secured loan (MBS is security)
If the actual reinvestment rate for the investor is greater, she has a (somewhat risky) arbitrage opportunity
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Trading: Dollar Rolls
Let’s see how this happens using the (Bloomberg) exhibits in FH.38 (p 931, also handout).
FBB.2 has a shorter discussion – less clear, though
Why “somewhat risky?”
Need an estimate of prepayment rate. The higher the realized rate, better for the investor (lower implied breakeven rate)
The dealer need only return substantially similar security – so adverse selection risk (dealer may deliver poorer-performing security, even though within delivery guidelines)
FRL 383 Fall 2016
LN 4: Overview MBS Market
20
MBS Trading: Dollar Rolls
Breakeven rate depends on
Sales price less repurchase price = forward drop
MBS coupon payment
MBS scheduled principal payments
MBS unscheduled principal payments (projected)
Returned MBS attributes
Amount of under- over-delivery permitted
Compare to reinvestment rate available to investor
FRL 383 Fall 2016
LN 4: Overview MBS Market
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MBS Trading: Dollar Roll Analysis
Exh.38-1:
Bloomberg Analysis Screen 1/2 (Discount PT)
Exh.38-2:
Bloomberg Analysis Screen 2/2
Exh.38-3:
Bloomberg Analysis Screen 1/2 (Premium PT)
Exh.38-4:
Bloomberg Roll Matrix (Discount PT)
Exh.38-5:
Bloomberg Roll Matrix (Premium PT)
FRL 383 Fall 2016
LN 4: Overview MBS Market
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Loan Stratification
Sheet1
| Exh 2.3: Loan Stratification and Coupon Creation in a Private Deal | ||||||||||
| Security Coupon | 5.750% | PO % | = (Security coupon - Net Note rate)/Security Coupon | |||||||
| Base Ser | 25 | bps | ||||||||
| Trustee | 0.9 | bps | ||||||||
| WAC PO | WAC IO | |||||||||
| Note rate | Net Note Rate | Balance in Cohort $mm | NNR less Coupon | PO % | PO % × Balance $mm | non-PO Yield | Rate Contr to WAC IO | Contr to WAC IO Notional | WAC IO Coupon | |
| Discount Loans | 5.000% | 4.7410% | 0.5 | -1.009% | 17.55% | 0.0877 | 5.750% | 0.000% | - 0 | |
| 5.125% | 4.8660% | 2.6 | -0.884% | 15.37% | 0.3997 | 5.750% | 0.000% | - 0 | ||
| 5.250% | 4.9910% | 5.0 | -0.759% | 13.20% | 0.6600 | 5.750% | 0.000% | - 0 | ||
| 5.375% | 5.1160% | 8.0 | -0.634% | 11.03% | 0.8821 | 5.750% | 0.000% | - 0 | ||
| 5.500% | 5.2410% | 16.4 | -0.509% | 8.85% | 1.4518 | 5.750% | 0.000% | - 0 | ||
| 5.625% | 5.3660% | 21.0 | -0.384% | 6.68% | 1.4024 | 5.750% | 0.000% | - 0 | ||
| 5.750% | 5.4910% | 31.0 | -0.259% | 4.50% | 1.3963 | 5.750% | 0.000% | - 0 | ||
| 5.875% | 5.6160% | 37.0 | -0.134% | 2.33% | 0.8623 | 5.750% | 0.000% | - 0 | ||
| 6.000% | 5.7410% | 45.0 | -0.009% | 0.16% | 0.0704 | 5.750% | 0.000% | - 0 | ||
| Premium Loans | 6.125% | 5.8660% | 55.0 | 0.116% | 0.00% | - 0 | N/A | 0.116% | 55.0 | 0.06 |
| 6.250% | 5.9910% | 70.0 | 0.241% | 0.00% | - 0 | N/A | 0.241% | 70.0 | 0.17 | |
| 6.375% | 6.1160% | 41.0 | 0.366% | 0.00% | - 0 | N/A | 0.366% | 41.0 | 0.15 | |
| 6.500% | 6.2410% | 42.0 | 0.491% | 0.00% | - 0 | N/A | 0.491% | 42.0 | 0.21 | |
| 6.625% | 6.3660% | 37.0 | 0.616% | 0.00% | - 0 | N/A | 0.616% | 37.0 | 0.23 | |
| 6.750% | 6.4910% | 30.5 | 0.741% | 0.00% | - 0 | N/A | 0.741% | 30.5 | 0.23 | |
| 6.875% | 6.6160% | 22.0 | 0.866% | 0.00% | - 0 | N/A | 0.866% | 22.0 | 0.19 | |
| 7.000% | 6.7410% | 21.0 | 0.991% | 0.00% | - 0 | N/A | 0.991% | 21.0 | 0.21 | |
| 7.125% | 6.8660% | 8.0 | 1.116% | 0.00% | - 0 | N/A | 1.116% | 8.0 | 0.09 | |
| 7.250% | 6.9910% | 4.0 | 1.241% | 0.00% | - 0 | N/A | 1.241% | 4.0 | 0.05 | |
| 7.375% | 7.1160% | 3.0 | 1.366% | 0.00% | - 0 | N/A | 1.366% | 3.0 | 0.04 | |
| Pool Balance = | 500.0 | WAC PO Face = | 7.2128 | WAC IO Notional = | 333.5 | 0.486% | ||||
| WAC PO | 7.2 | |||||||||
| DL nonPO | 159.3 | |||||||||
| PL nonPO | 333.5 | |||||||||
| 500.0 |
Sheet2
Sheet3
Agency Pooling
Timeline
FH Exh 38-1
FH Exh 38-2
FH Exh 38-3
FH Exh 38-4
FH Exh 38-5
