LM04 An Introduction to Asset-Backed Securities

Part 3

5. Mortgage Pass-Through Securities

Residential mortgage-backed securities are bonds created from the securitization of residential mortgage loans. In the U.S., residential mortgage-backed securities are divided into the following three sectors:

1. Those guaranteed by a federal agency (Ginnie Mae) whose securities are backed by the full faith and credit of the U.S. government.
2. Those guaranteed by either of the two government-sponsored enterprises or GSEs (Fannie Mae and Freddie Mac) but not by the U.S. government. They do not carry the full faith and credit of the U.S. government.
3. Those issued by private entities that are not guaranteed by a federal agency or a GSE.

The first two sectors (guaranteed by the government or a quasi-government entity) are called the agency RMBS. The third sector is called non-agency RMBS.

Examples of agency RMBS include:

• Mortgage pass-through securities
• Collateralized mortgage obligations

The two differences between agency RMBS issued by GSEs and non-agency RMBS are as follows:

• Non-agency RMBS use credit enhancements to reduce credit risk, while agency RMBS issued by the GSEs are guaranteed by the GSEs themselves.
• For a loan to be included in a pool of loans backed by an agency RMBS, it must satisfy the underwriting standards of the government agencies.

5.1.     Mortgage Pass-Through Securities

A mortgage pass-through security is created when one or more holders of mortgages form a pool of mortgages and sell shares or participation certificates in the pool. The investors receive a share of cash flows from the underlying pool of mortgage loans.

Cash Flow Characteristics

• Monthly mortgage payments consist of interest, scheduled principal repayment, prepayments.
• Payments are made to security holders each month.
• The servicer collects monthly payments, sends payment notices to borrowers, sends reminders if payments are overdue, maintains records of principal balances, etc.
• The servicing fee is part of the mortgage rate.
• The amount of cash flow from mortgage loans is not equal to that received by the investors. Similarly, there is a delay in passing the cash flow from mortgage loans to the security holders.
• Monthly cash flow of a mortgage pass-through security = monthly cash flow of the underlying pool of mortgages – servicing and other fees. In other words, investors of the mortgage pass-through security receive less than the cash flow coming in from the mortgage loans because a servicing fee is collected by the servicer.

How is the rate and maturity of a mortgage loan calculated?

• Pass-through rate: A mortgage pass-through security’s coupon rate is called the pass-through rate. For example, if the mortgage rate for a pool of mortgages is 8%, the annualized servicing fee is 0.6%, then the investors receive an average return of around 7.4%.
• Weighted average coupon (WAC): Each of the mortgage loans in the securitized pool may not have the same mortgage rate. The WAC is found by weighting the rate of each mortgage loan in the pool by the percentage of the mortgage outstanding relative to the outstanding amount of all mortgages in the pool.
• Weighted average maturity (WAM): Similarly, not all the loans in the pool will have the same maturity. WAM is found by weighting the remaining number of months to maturity for each mortgage loan in the pool by the amount of the outstanding mortgage balance.

Conforming and Non-conforming Loans

A mortgage loan must meet certain criteria to be included in a pool of loans backing an RMBS. Listed below are some of the underwriting standards of an agency they must conform to:

• Maximum loan-to-value ratio: It should be below the maximum LTV to conform.
• Maximum size of the loan
• Loan documentation

If a loan meets the underwriting standards, then it is called a conforming loan.

Non-conforming mortgages that serve as collateral for mortgage pass-through securities do not meet the underwriting standards and are privately issued by thrift institutions, commercial banks, etc.

Example

Assume that a pool includes four mortgages with the following characteristics:

Calculate the weighted average coupon rate and weighted average maturity.

Solution:

The total outstanding amount is $10,000 and hence, the weights are as follows: Mortgage 1 = 10%, 2 = 20%, 3 = 40% and 4 = 30%.

The weighted average coupon is:

The weighted average maturity (WAM) is:

Prepayment risk: The risk associated with uncertainty in future cash flows because of principal repayments is called prepayment risk. It has two components: contraction risk and extension risk.

• Contraction risk is the risk that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of purchase because homeowners refinance at now-available lower interest rates. For instance, assume the interest rate is 8% when the Smiths take the loan. If two years later it falls to 6%, then they will prepay the loan and refinance at the lower rate.
• Extension risk is the risk that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. From an investor’s perspective, the security becomes longer in maturity than it was at the time of purchase.

Instructor’s Note

Contraction risk occurs when interest rates decline.

Extension risk occurs when interest rates rise.

Prepayment Rate Measures

To value a mortgage pass-through security, one must be able to forecast its cash flows. But, the cash flows are uncertain because it is not known ahead of time when homeowners may prepay principal during the mortgage’s life. The only way to predict future cash flows is by making some assumptions about the prepayment speed/rate.

The two measures of prepayment rate are:

• Single month mortality rate: this is a monthly measure.
• Conditional repayment rate: this is an annual measure.

Single month mortality (SMM) measures prepayments in a month. An SMM of x% means that x% of the outstanding mortgage balance at the start of the month minus the scheduled principal repayment, will be repaid that month.

Conditional repayment rate (CPR) is an annualized version of SMM.

A CPR of 6%, for example, means that approximately 6% of the outstanding mortgage balance at the beginning of the year is expected to be prepaid by the end of the year.

100 PSA prepayment benchmark: The 100 Public Securities Association (PSA) prepayment benchmark is expressed as a monthly series of CPRs. The benchmark assumes that prepayment rates are low for newer mortgages and increase as time passes. A PSA assumption greater than 100 PSA means that prepayments are assumed to be faster than the benchmark. In contrast, a PSA assumption lower than 100 PSA means that prepayments are assumed to be slower than the benchmark.

Cash Flows

The cash flows associated with a mortgage pass-through security have the following components:

• Scheduled principal repayment
• Principal pre-payment
• Interest payment

The interest payment is based on the principal outstanding at the start of the period and the interest rate. The principal pre-payment can be estimated based on the SMM (or CPR) number. The higher the SMM, the higher the prepayment.

Instructor’s Note

The curriculum shows the cash flow calculations for a hypothetical mortgage pass-through security. If you have the time you can study the curriculum example. However, from a testability perspective it is more important that you understand the concept which is explained here.

Weighted Average Life

Recall that one of the basic characteristics of a bond is its maturity. But, in the case of a MBS the legal maturity date does not reveal much about the characteristics of the security because of prepayments.

The weighted average life (average life) gives investors an indicator of how long investors can expect to hold the MBS before it is paid off. The table below shows the average life at different prepayment rates. For instance, at a prepayment rate of 125 PSA, the average time for principal repayment is 10.1 years. Notice that the average time drops drastically to 3.2 years as the prepayment rates go up to 600 PSA.

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