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Mortgage Securities Flashcards

1
Q

Identify the three types of mortgage-backed securities

A

Mortgage pass-through securities,
Collateralized mortgage obligations (CMOs) and
Stripped mortgage backed securities (SMBS)

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2
Q

Explain the benefits of securitizing mortgage loans

A

(1) Interest rate risk management- reduce the average life of its asset (to less than 30 years) (2) Credit risk management - reduce dependency on the credit worthiness of its business customers who also have personal loans. Transfer credit risk (3) Liquidity management - provides liquidity to lenders who in turn make more loans to homebuyers (4) Capital management - cash injection from the pool sale to retire debt and improve capital ratios

Interest
Credit
Liquidity
Capital

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3
Q

Explain why mortgage pass-through structures are created

A

Obtain funds to make more loans and to mitigate risk

do not tie up funds in long term assets. bank wants to make more loans

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4
Q

List the major issuers of pass-through securities and explain the differences in their guarantees

A

(1) fully modified pass-throughs - interest and principal are guaranteed (2) timely payment of interest (specified time guaranteed) and ultimate payment of principal (NOT specified time).

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5
Q

Explain how Collateralized Mortgage Obligations (CMOs) differ from Mortgage Pass-Through securities

A

(1) CMO - P&I distributed to different tranches (investment classes). Sequential payment structure (2) Mortgage pass through - pro rata distribution. Receive P&I as they occur in proportion to the ownership claims

CMO- sequential payments to tranches
MPT - true pass thru - pro rata payments

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6
Q

Explain the importance of understanding a CMO’s structure and the priority of the classes in evaluating the value and average lives of the different classes in the structure

A

(1) value can depend on supply in the market (2) prepayment speed can change the life: depend on coupon rate loan quality

Value- supply
Life - Prepayment

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7
Q

Explain, in general terms, the prepayment risks associated with mortgage investments and the various factors that affect these risks.

A

prepayment speeds of the mortgage collateral can depend on such factors as coupon rates, loan quality ( e.g. debt to income, percent borrowed) and geographical diversification.

Declining interest rates - accelerate cash flows - Rising PO (principal only) strip price

Rising interst rates - Slow, extend the life, longer maturity - Declining PO strip price

Think of a downhill slope - fast water flowing down . . cash flowing in fast

Uphill slop - slow climbing up the mountain

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8
Q

List two common measures used to describe MBS prepayment speeds

A

Rising interest rates slow prepayment rates, which extends the average life of the collateral, thus increasing the total amount of interest payments and the length of time those payments are received by the investor. Falling interest rates accelerate prepayments, causing the collateral principal to decline faster, which shortens the average life - thus reducing the interest cash flow and the time over which it is received.

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9
Q

Define measures that are utilized to describe the maturity characteristics of mortgage securities

A

Rising interest rates - slower maturity

Declining interest rates - faster maturity

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10
Q

Identify the two key market risks associated with MBS and explain the influence that prepayments have on these sources of risk.

A

Rising interest rates - Falling price of strip / funding cost cheaper- cash flow is slower

Declining interest rates - Rising price of strip /funding cost expensive - cash flow is faster

non- conforming securities
Credit risk - not guaranteed
Market risk - no transparency

S - sensitivity
L - liquidity

Market Risk is the risk that changes in market prices or rates adversely impact the condition of a financial institution.

Liquidity Risk is the risk that an institution is unable to meet its obligations.

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11
Q

Explain how the value of principal-only and interest-only strips are affected by interest rate changes.

A

interest only vs principal only

Rising interest rates - slow
IO - more cash / longer time
PO - same cash / longer time

Declining interest rates - fast
IO - less cash/ shorter time
PO - same cash/shorter time

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12
Q

Explain why interest-only and principal-only strips can be inappropriate investments for a commercial bank.

A

The sensitivity of POs and IOs to changing interest rates can make them useful in offsetting different types of interest-rate risk. However, due to the volatility and complexity of strips, banking organizations should establish strong monitoring and control systems before investing in these products to avoid the potential for substantial losses.

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13
Q

Explain why understanding credit risk is an important component to the analysis of non-conforming securities.

A

Credit-based aspects of the underlying collateral—such as propensity to default and cash-flow sustainability, along with market-related risk measures—will enter into one’s overall assessment of a security’s value.

Non- conforming - not guaranteed

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14
Q

Explain why the portfolio approach to managing mortgage-backed securities is considered a best practice.

A

The cash-flow uncertainty associated with MBS investments can cause asset liability matching difficulty. The performance of MBS investments should be considered at the security level, portfolio level and on overall balance-sheet management. The degree of analysis required should correspond to the level and complexity of MBS holdings.

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15
Q

Identify regulation and supervision policies governing mortgage-backed securities.

A

SR-98-12 - FFIEC Policy Statement on Investment Securities and End-User Derivatives Activities

SR-95-17 - Evaluating the Risk Management and Internal Controls of Securities and Derivative Contracts Used in Nontrading Activities

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16
Q

Identify the preferred methods for amortizing and accreting premiums and discounts for MBS.

A

When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. In other words, the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding.

The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond’s book value. This means that when a bond’s book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium.

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17
Q

GSE

A

Government-Sponsored Enterprises

Government-sponsored entities were established to promote liquidity in the mortgage market, diversify credit risk and attract capital for the construction and sale of housing. Primary among these agencies are “the big three,” which mainly purchase or guarantee conforming mortgages:

The Federal Home Loan Mortgage Corporation (Freddie Mac), NOT explicitly guaranteed,
The Federal National Mortgage Association (Fannie Mae) NOT explicitly guaranteed, and
The Government National Mortgage Association (Ginnie Mae) - fully guaranteed

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18
Q

Explain how Collateralized Mortgage Obligations (CMOs) differ from Mortgage Pass-Through securities.

A

To meet a broader array of investor needs, financial engineers created another type of MBS called Collateralized Mortgage Obligations (CMOs). In the truest sense, CMOs should be more accurately portrayed as mortgage derivative securities. A mortgage derivative security derives its value from a pledge of collateral comprised of mortgage pools such as pass-throughs, classes from previous CMO deals or mortgage loans. When mortgage loans are used as collateral for CMOs, they are usually referred to as whole loan collateral.

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19
Q

Describe how CMOs are created and the benefits that they provide to investors and issuers.

A

Holders of pass-through securities receive principal and interest on a pro rata basis depending on their ownership interest. CMOs are structured so that the cash flow from the underlying collateral is allocated to different investment classes, usually referred to as tranches.

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20
Q

Primary underwriting criteria that determine conforming status

A

Maximum payment-to-income (PTI) - Represents principal, interest, taxes and insurance required for the loan in relation to the borrower’s income.

Maximum loan-to-value (LTV) - Represents the amount of the loan in relation to the market value or purchase price of the property.

Maximum loan size - Maximum loan amount, set by each of the GSEs for the loans they guarantee, which typically increases each year to keep pace with inflation.

PTI
Max LTV
Max loan size

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21
Q

MBS Mortgage backed security

A

a security where the cash flow depends on the cash flows of an underlying pool of residential mortgages

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22
Q

Is FHA (federal housing administration) conventional or non- conventional.

other examples: veterans admin (VA), rural development admin (RDA)

A

FHA is non-conventional or Government - guaranteed loan. It is backed by the full faith and guarantee of the US government.

conventional loans do NOT carry any form of government guarantee

23
Q

difference between conforming vs non-conforming

A

conforming - meets GSE underwriting standards

non-conforming - do not meet GSE underwriting standards. Non conforming loans incur a rate and origination fee premium

24
Q

What is the CMO legal structure

A

Ownership in a CMO class represents beneficial ownership interest in trust’s assets. the Trust is not taxed - only the investors and residual holders

25
Q

What is the difference between a CMO and a bond

A

CMO - receiver principal over time

Bond - repay in a lump sum at maturity

26
Q

describe the relationship between the primary and secondary market

A

The primary market provides the actual loan to a borrower, whereas the secondary market channels liquidity into the primary market by purchasing loans from originators.

primary - original loan (originator)
secondary - liquidity (second owner)

27
Q

PSA

A

Public Securities Association Standard Prepayment model

Prepayment assumptions are based on data that show during the first few years, a borrower is less likely to move to a different home, is less likely to refinance and is less likely to be able to afford additional payments.

The model assumes a gradual rise of prepayments, which peaks after 30 months.

28
Q

What is a support or companion class

A

companion tranches absorb excess cash flow so the security has more predictable cash flows and average lives

divert principal payments to PAC when prepayment speeds are low, lengthening the companion’s average life

receive excess principal prepayments when speeds are high, thus shortening the companion’s average life

prepayment and extention risk is absorbed by the companion tranches. Think of it as a pillow that aborbs the risk. The companion is in love, so will take on the risk

29
Q

difference between PAC and TAC

A

prepay risk - PAC and TAC
extention risk - only PAC, does not protect TAC
higher yield - TAC has higher risk, since higher risk. TAC not protected against extention risk

30
Q

difference between prepayment and extension risk

A

The risk of a security’s expected maturity lengthening in duration due to the deceleration of prepayments. Extension risk is mainly the result of rising interest rates, and is generally associated with mortgage-related securities. The opposite of extension risk is prepayment risk, which generally occurs in a declining interest rate environment, and is associated with people paying off their loans too quickly.

31
Q

what is negative convexity?

A

When the shape of a bond’s yield curve is concave. A bond’s convexity is the rate of change of its duration, and is measured as the second derivative of price with respect to yield.

Most mortgage bonds are negatively convex.

One property of a non-callable bond is that as interest rates fall, its price will increase. However, with a callable bond, as interest rates fall, the incentive for the issuer to call the bond at par increases; therefore, its price will not rise as quickly as the price of a non-callable bond.

The price of a callable bond might actually drop as the likelihood that the bond will be called increases. This is why the shape of a callable bond’s curve of price with respect to yield is concave or “negatively convex.”

32
Q

What are the more common types of CMOS and thier benefits and risks to investors

A

sequential pay - allow the investor to choose a tranche in the sequence that best meets the investors’ needs, given a certain estimated prepayment speed

PAC - planned amortization class = Tranches are designed to provide more predictable cash flows and average lives than pass-throughs or sequential. Protects a band of prepayment speeds

TAC - targetted amortization class = targets one prepayment speed instead of a band of prepayment speeds. one speed
only protect prepayment risk. not extention risk

33
Q

Is a mortgage pass through security represent direct ownership interest in tha pool of mortgage loans?

A

Yes pass throughs are direct ownership. The proportionate payment of principal and interst is a rough equivalent to owning the mortgages directly, less any servicing fees.

34
Q

What is a companion tranche?

A

A class of tranche found in planned amortization class (PAC) and targeted amortization class (TAC) collateralized mortgage obligations (CMOs) that absorbs variable prepayment rates. The companion trache is so named because it is designed to provide support to the main PAC tranche, which has priority in receiving principal and interest payments so as to give its investors steadier and more predictable cash flows. If the actual rate of prepayments differs from the assumptions made at the time the CMO was issued, the difference is absorbed by the companion tranche.

35
Q

Is the yield on a companion tranche higher or lower than a PAC tranche?

A

Prepayment rates on CMOs are significantly affected by interest rates. If interest rates fall, prepayments increase because homeowners refinance existing mortgages at lower rates, shortening tranche life; this is known as contraction risk. Likewise, if interest rates rise, prepayments decrease and the tranche life increases, leading to extension risk.

The companion tranche protects the PAC tranche from contraction and extension risk by absorbing excess principal payments when prepayments increase, and deferring receipt of principal payments when prepayments decrease. This means that the term of a companion tranche itself can vary widely, contracting when interest rates are low and prepayments increase, and extending when interest rates are high and prepayments decrease. Due to this high degree of variability in its cash flows and term, the yield on a companion tranche is higher than on a PAC tranche.

36
Q

Explain the importance of understanding a CMO’s structure and priority of the classes in evaluating the value and average lives of the different classes in the structure.

A

The bank should investigate where its CMO bond purchases stand in the CMO structure, including which classes stand in from of their purchases and which classes would provide support. Looking at the price, duration and average life volatility should provide bank management with some insight into the relative protection that its purchase holds.

Type II and Type III PACS and subordinated PACs have lower priorities than regular or Super PACs and, therefore are more likely to have busted bands and thus lose their prepayment and extension risks protection.

37
Q

Name 2 types of CMO classes

A

sequential pay

planned amortization class

38
Q

Name 5 types of PAC - planned amortization classes

A 
Targeted amortization class (TAC)
Prepaymetn opportunity (Reverse TAC)
Companion class (Support)
Accural Class (Z)
Z PACs
39
Q

Define synthetic coupon

A

security whose interest rate is altered from the underlying collateral

A synthetic coupon MBS (SMBS) is one which combines some percentage of the principal payments and some other percentage of the interest payments from an MBS to create a new security.

interest % x coupon rate% / % of principal

40
Q

principal only strip PO

A

receive only principal cash flow
investor guaranteed to receive par value of principal
no risk of losing amount. only a timing risk

rates opposite to yield or value

rates rise - value falls
longer maturity, investor has to wait for return

rates fall - value rise
shorter maturity, investor gets money faster

41
Q

interest only strip IO

A

receive only interest payments
as notional principal amortizes and prepays over time, the interest cash flow declines
uncertainty with amount and timing of cash flows, so more risky than PO principal only strip.

direct relationship
rates rise - value yield rise
longer life, more interest payments to the investor
principal pays off slower

rates fall - value yield fall
shorter life,
principal decrease faster, less interest payments to the investor

42
Q

IO - direct relationship

A

Rates increase
prepayment decline
payoff slower
value increase, more cash/ longer time

Rates decrease
prepayment increase
payoff faster
value decrease, less cash / shorter time

43
Q

PO opposite relationship

A

Rates increase
prepayment decline
payoff slower
value decrease, same cash/ longer time

Rates decrease
prepayment increase
payoff faster
value increase, same cash / shorter time

44
Q

explain why interest only and principal only strips can be inappropriate investments for a commercial bank

A

IO and PO strips are exposed to high price volatility. IO strips are one of the few debt instruments that can produce actual negative returns caused by interest rate risk (rather than credit risk). If prepayments is too fast when rates decline, the investor may not recoup the entire investment.

Without proper financial sophistication and analysis, using IO or PO strips for hedging might not work out as intended. This could leave the bank exposed to losses that it thought it was hedged against or even multiply the risks to the bank.

45
Q

Can the principal and interest stream of payments be separated?

A

A mortgage backed security (MBS) is an unusual instrument in thatin any given period, some interest and some principal will be paid to the owner of the security. In essence the owner of a MBS receives two streams of cash flows, one from interest payments and one from principal payments. There is no reason why the two streams of payments cannot be sold separately, and, in fact, this is done frequently.

There are three general classes of these types of securities, the PO, IO and Synthetic Coupon MBS.

46
Q

Describe the main characteristics of jumbo and Alt-A loans.

A

Jumbo - loan size exceeds the agency criterion. strong credit profiles, affuent, financially sophisticated borrowers; large loan sizes $729K vs. 180K agency loans; heavy california concentration; higher credit profiles and LTV ratios below 80%; low default rates

Alt A loans - issues involving limited income documentation, no-owner occupied property or high LTVs. Avg loan size is 250K vs. 180K agency loan.

invstor properties; underwritten using limited or alternative documentation (ie self employed or no history of regular income)

baseline prepay speeds aer high, concept called ongoing “curing” - meaning as borrowers financial situations improve, tehy refinance at lower rates. Despite a higher propensity to cure and higher proportion, sensitivity to interest rate movements tend to be lower than jumbo borrowers because of teh extra documentation-oriented hurdles. They generally do not want to refinance.

47
Q

Describe the structure of commercial MBS, including their unique prepayment features

A

fundamentally based on the property’s income production/ cash flow generation. CMBS tend to exhibit greater cash flow then residential mortgage collateral. CMBS contain explicit prepayment lock-out and penalty provisions that preclude and/or disuade refinancings.

Much less influenced by forces like seasonality, death or divorce, which can affect prepayments in the residential mortgage market.

CMBS are considered non-recourse - that is, if the borrower defaults, the lender cannot seize any other assets of the borrower.

48
Q

Explain why understanding credit risk is an important component to the analysis of non-conforming securities

A

non-conforming securities add credit risk as another risk dimension when compared with agency securities.

the cash flow profile of the underlying collateral in a non-conforming deal stands on its own merits; there is no GSE guaranteeing the timely payment of principal and interest to the investor. As such, the credit profiles (but not the market risk) of non-agency issues are explicitly rated by the major rating agencies. Non-conforming cash flow structures include internal and external forms of credit enhancement that act to mitigate default risk at various levels.

49
Q

Identify the two key market risks associated with MBS, and explain the influence that prepayments have on these sources of risk.

A

uncertain timing and level of cash flow.
MBS is a fixed income investment, but the uncertainty is due to the homeowner’s right to prepay their mortage loan at anytime without penalty

Mortgage prepayments have an inverse relationship with prevailing interest rates

50
Q

Identify non-market risks such as liquidity and credit risk and their influence on the overall risk of these investments.

A

if buying and selling opportunities for a security are limited, a security is exposed to liquidity risk. If you can’t trade the security, then you are not liquid.

Also mortage securities with high levels of prepayment risk or unusual cash flow profiles (bad tranches) couls also be difficult for a bank to sell.

While the agency guarantee protects the investor’s principal, a default behaves the same as a prepayment when the property is sold and the investor is made whole on the loan.

51
Q

Explain in general terms, the prepayment risk associated with mortgage investments and the various factors that affect prepayment

A

x

52
Q

AD

A

Accretion directed securities usually providee a high degree of cash flow stability relative to pass-throughs

extension risk is eliminatedby using the Z tranche interest to insure that principal is payd by teh AD class even if collateral prepayment speeds approach 0 PSA (Public Security Assoc), so that the WAL does not increase

53
Q

support bonds

A

tend to have more average life fluctuation because they absorb prepayment risk shed by classes with higher priority.

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