Trading and Capital-Markets Activities Manual
Profiles: Residential Mortgage-Backed Securities
A mortgage loan is a loan which is secured by the collateral of a specified real estate property. The real estate pledged with a mortgage can be divided into two categories: residential and non-residential. Residential properties include houses, condominiums, cooperatives, and apartments. Residential real estate can be further subdivided into single-family (one- to four-family) and multifamily (apartment buildings in which more than four families reside). Non-residential property includes commercial and farm properties. Common types of mortgages which have been securitized include traditional fixed-rate level-payment mortgages, graduated-payment mortgages, adjustable-rate mortgages (ARMs), and balloon mortgages.
Mortgage-backed securities (MBS) are products that use pools of mortgages as collateral for the issuance of securities. Although these securities have been collateralized using many types of mortgages, most are collateralized by one- to four-family residential properties. MBS can be broadly classified into four basic categories:
1. mortgage-backed bonds
Mortgage-backed bonds are corporate bonds which are general obligations of the issuer. These bonds are credit enhanced through the pledging of specific mortgages as collateral. Mortgage-backed bonds involve no sale or conveyance of ownership of the mortgages acting as collateral.
A mortgage-backed pass-through security provides its owner with a pro rata share in underlying mortgages. The mortgages are typically placed in a trust, and certificates of ownership are sold to investors. Issuers of pass-through instruments primarily act as a conduit for the investors by collecting and proportionally distributing monthly cash flows generated by homeowners making payments on their home mortgage loans. The pass-through certificate represents a sale of assets to the investor, thus removing the assets from the balance sheet of the issuer.
Collateralized Mortgage Obligations and Real Estate Mortgage Investment Conduits
Collateralized mortgage obligations (CMOs) and real estate mortgage investment conduit (REMICs) securities represent ownership interests in specified cash flows arising from underlying pools of mortgages or mortgage securities. CMOs and REMICs involve the creation, by the issuer, of a single-purpose entity designed to hold mortgage collateral and funnel payments of principal and interest from borrowers to investors. Unlike pass-through securities, however, which entail a pro rata share of ownership of all underlying mortgage cash flows, CMOs and REMICs convey ownership only of cash flows assigned to specific classes based on established principal distribution rules.
Stripped Mortgage-Backed Securities
Stripped mortgage-backed securities (SMBS) entail the ownership of either the principal or interest cash flows arising from specified mortgages or mortgage pass-through securities. Rights to the principal are labeled POs (principal only), and rights to the interest cash flows are labeled IOs (interest only).
CHARACTERISTICS AND FEATURES
Products Offered under Agency Programs
The Government National Mortgage Association (GNMA or Ginnie Mae), Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), and the Federal National Mortgage Association (FNMA or Fannie Mae) are the three main government-related institutions which securitize like groups of mortgages for sale to investors. Major mortgage-purchasing programs sponsored by these three agencies are listed below.
While the majority of outstanding mortgage loans are structured as 30-year fixed-rate loans, in recent years the size of the 15-year, fixed-rate sector has grown. Declining interest rates and a steep yield curve have led many borrowers to refinance or prepay existing 30-year, higher-coupon loans and replace them with a shorter maturity. This experience also has demonstrated the prepayment risk inherent in all mortgages.
Public Securities Association Prepayment Rates
Mortgagors have the option to prepay the principal balance of their mortgages at any time. The value of the prepayment option to investors and mortgagors depends on the level of interest rates and the volatility of mortgage prepayments. Prepayment rates depend on many variables, and their response to these variables can be unpredictable. The single biggest influence on prepayment rates is the level of long-term mortgage rates; mortgage prepayments generally increase as long-term rates decrease. While future long-term rates are not known, higher volatility in long-term interest rates means lower rates are more likely, making the prepayment option more valuable to the mortgagor. This higher value of the prepayment option is reflected in lower mortgage security prices, as mortgage investors require higher yields to compensate for increased prepayment risk.
The importance of principal prepayment to the valuation of mortgage securities has resulted in several standardized forms of communicating the rate of prepayments of a mortgage security. One standard form is that developed by the Public Securities Association (PSA). The PSA standard is more accurately viewed as a benchmark or reference for communicating prepayment patterns. It may be helpful to think of the PSA measurement as a kind of speedometer, used only as a unit for measuring the speed of prepayments.
For a pool of mortgage loans, the PSA standard assumes that the mortgage prepayment rate increases at a linear rate over the first 30 months following origination, then levels off at a constant rate for the remaining life of the pool. Under the PSA convention, prepayments are assumed to occur at a 0.2 percent annual rate in the first month, 0.4 percent annual rate in the second month, escalating to a 6.0 percent annual rate by month 30. The PSA's annualized prepayment rate then remains at 6.0 percent over the remaining life of the mortgage pool (see chart 1). Using this convention, mortgage prepayment rates are often communicated in multiples of the PSA standard of 100 percent. For example, 200 percent PSA equals two times the PSA standard, whereas 50 percent PSA equals one-half of the PSA standard.
Mortgage Pass-Through Securities
Mortgage pass-through securities are created when mortgages are pooled together and sold as undivided interests to investors. Usually, the mortgages in the pool have the same loan type and similar maturities and loan interest rates. The originator (for instance, a bank) may continue to service the mortgage and will ''pass through'' the principal and interest, less a servicing fee, to an agency or private issuer of mortgage-backed securities. Mortgages are then packaged by the agency or private issuer and sold to investors. The principal and interest, less guaranty and other fees are then ''passed through'' to the investor, who receives a pro rata share of the resulting cash flows.
Every agency pass-through pool is unique, distinguished by features such as size, prepayment characteristics, and geographic concentration or dispersion. Most agency pass-through securities, however, trade on a generic or to-be-announced (TBA) basis. In a TBA trade, the seller and buyer agree to the type of security, coupon, face value, price, and settlement date at the time of the trade, but do not specify the actual pools to be traded. Two days before settlement, the seller identifies the specific pools to be delivered to satisfy the commitment. Trading in agency pass-throughs may take place on any business day, but TBA securities usually settle on one specific date each month. The Public Securities Association releases a monthly schedule that divides all agency pass-throughs into six groups, each settling on a different day. Agency pass-throughs generally clear through electronic book-entry systems.
Collateralized Mortgage Obligations
Since 1983, mortgage pass-through securities and mortgages have been securitized as collateralized mortgage obligations (CMOs).
While pass-through securities share prepayment risk on a pro rata basis among all bondholders, CMOs redistribute prepayment risk among different classes or tranches. The CMO securitization process recasts prepayment risk into classes or tranches. These tranches have risk profiles ranging from extremely low to significantly high risk. Some tranches can be relatively immune to prepayment risk, while others bear a disproportionate share of the risk associated with the underlying collateral.
CMO issuance has grown dramatically throughout the 1980s and currently dominates the market for FNMA and FHLMC pass-throughs or agency collateral. Given the dramatic growth of the CMO market and its complex risks, this subsection discusses the structures and risks associated with CMOs.
In 1984, the Treasury ruled that multiple-class pass-throughs required active management; this resulted in the pass-through entities' being considered corporations for tax purposes rather than trusts. Consequently, the issuer was no longer considered a grantor trust, and the income was taxed twice: once at the issuer level and again at the investor level. This ruling ultimately had complex and unintended ramifications for the CMO market.
The issue was ultimately addressed in the Tax Reform Act of 1986 through the creation of real estate mortgage investment conduits (REMICs). These instruments are essentially tax-free vehicles for issuing multiple-class mortgage-backed securities. REMIC is a tax designation; a REMIC may be originated as a trust, partnership, or other entity.
1. Today almost all CMOs are structured as real estate mortgage investment conduits (REMICs) to qualify for desirable tax treatment.
The Tax Reform Act of 1986 allowed for a five-year transition during which mortgage-backed securities could be issued pursuant to existing Treasury regulations. However, as of January 1, 1992, REMICs became the sole means of issuing multiple-class mortgage-backed securities exempt from double taxation. As a practical matter, the vast majority of CMOs carry the REMIC designation. Indeed, many market participants use the terms ''CMO'' and ''REMIC'' interchangeably.
CMOs do not trade on a TBA basis. New issue CMOs settle on the date provided in the prospectus and trade on a corporate basis (three business days after the trade) in the secondary market. Common CMO structures include sequential pay, PACs, TACs, and floaters and inverse floaters as described below.
Sequential pay structure. The initial form of CMO structure was designed to provide more precisely targeted maturities than the pass-through securities. Now considered a relatively simple design for CMOs, the sequential pay structure dominated CMO issuance from 1983 (when the first CMO was created) until the late 1980s. In the typical sequential pay deal of the 1980s (see chart 2), mortgage cash flows were
Chart 2-Four-Tranche Sequential Pay CMO
divided into four tranches, labeled A, B, C, and Z. Tranche A might receive the first 25 percent of principal payments and have an average maturity, or average life, of one to three years.2 Tranche B, with an average life of between three and seven years, would receive the next 25 percent of principal. Tranche C, receiving the following 25 percent of principal, would have an average life of 5 to 10 years. The Z tranche, receiving the final 25 percent, would be an ''accrual'' bond with an average life of 15 to 20 years.3
The sequential pay structure was the first step in creating a mortgage yield curve, allowing mortgage investors to target short, intermediate, or long maturities. Nevertheless, sequential pay structure maturities remained highly sensitive to prepayment risks, as prepayments of the underlying collateral change the cash flows for each tranche, affecting the longer-dated tranches most, especially the Z tranche. If interest rates declined and prepayment speeds doubled (from 100 percent PSA to 200 percent PSA as shown on chart 2), the average life of the A tranche would change from 35 months to 25 months, but the average life of the Z bond would shift from 280 months to 180 months. Hence, the change in the value of the Z bond would be similarly greater than the price change of the A tranche.
Planned amortization class (PAC) structure. The PAC structure, which now dominates CMO issuance, creates tranches, called planned amortization classes, with cash flows that are protected from prepayment changes within certain limits. However, creating this ''safer'' set of tranches necessarily means that there must be other tranches, called ''support'' bonds, that are by definition more volatile than the underlying pass-throughs. While the PAC tranches are relatively easy to sell, finding investors for higher-yielding, less predictable support bonds has been crucial for the success of the expanding CMO market.
Chart 3 illustrates how PACs are created. In the example, the estimated prepayment rate for the mortgages is 145 percent of the PSA standard, and the desired PAC is structured to
2. Average life, or weighted average life (WAL), is defined
as the weighted average number of years that each principal dollar of
the mortgage security remains outstanding.
be protected if prepayments slow to 80 percent PSA or rise to 250 percent PSA. The PACs therefore have some protection against both ''extension risk'' (slower than expected prepayments) and ''call risk'' (faster than expected prepayments). In order to create this 80 to 250 percent ''PAC range,'' principal payments are calculated for 80 percent PSA and 250 percent PSA.
The area underneath both curves indicates that amount of estimated principal that can be used to create the desired PAC tranche or tranches. That is, as long as the prepayment rates are greater than 80 percent PSA or less than 250 percent PSA, the four PACs will receive their scheduled cash flows (represented by the shaded areas).
This PAC analysis assumes a constant prepayment rate of between 80 and 250 percent of the PSA standard over the life of the underlying mortgages. Since PSA speeds can change every month, this assumption of a constant PSA speed for months 1 to 360 is never realized. If prepayment speeds are volatile, even within the PAC range, the PAC range itself may narrow over time. This phenomenon, termed ''effective PAC band,'' affects longer-dated PACs more than short-maturity PACs. Thus, PAC prepayment
Chart 3-Principal Payments
A PAC bond classified as PAC 1 in a CMO structure has the highest cash-flow priority and the best protection from both extension and prepayment risk. In the past, deals have also included super PACs, another high-protection, lower-risk-type tranche distinguished by extremely wide bands. The mechanisms that protect a PAC tranche within a deal may diminish, and its status may shift more toward the support end of the spectrum. The extent of a support-type role that a PAC might play depends in part on its original cash-flow priority status and the principal balances of the other support tranches embedded within the deal. Indeed, as prepayments accelerated in 1993, support tranches were asked to bear the brunt, and many disappeared. A PAC III, for example, became a pure support tranche, foregoing any PAC-like characteristics in that case.
A variation on the PAC theme has emerged in the scheduled tranche (SCH). Like a PAC, an SCH has a predetermined cash-flow collar, but it is too narrow even to be called a PAC III. An SCH tranche is also prioritized within a deal using the above format, but understand that its initial priority status is usually below even that of a PAC III. These narrower band PAC-type bonds were designed to perform well in low-volatility environments and were popular in late 1992 and early 1993. At that time, many investors failed to realize what would happen to the tranche when prepayments violated the band.
In chart 3, the four grey shaded areas represent the PAC structure, which has been divided into four tranches to provide investors with an instrument more akin to the bullet maturity of Treasury and corporate bonds.4 The two support tranches are structured to absorb the full amount of prepayment risk to the extent the prepayment rate for the PAC tranches is within the specified range of 80 to 250 percent PSA. The second panel of chart 3 shows principal cash flows at the original estimated speed of 145 percent PSA, which are divided between the PAC and support bonds throughout the life of the underlying mortgages.
4. Treasury and corporate bonds usually return principal to investors at stated maturity; the PAC structure narrows the time interval over which principal is returned to the investors.
Chart 4 shows how both PACs and the support tranches react to different prepayment speeds. The average lives of the support bonds in this example could fluctuate from 112 to 25 years depending on prepayment speeds. Simply put, support-bond returns are diminished whether prepayment rates increase or decrease (a lose-lose proposition). To compensate holders of support bonds for this characteristic (sometimes referred to as "enegative convexity"), support bonds carry substantially higher yields
Chart 4--Principal Payments
Targeted amortization tranche structure. A targeted amortization tranche (TAC) typically offers protection from prepayment risk but not extension risk. Similar to the cash-flow schedule of a PAC that is built around a collar, a TAC's schedule is built around a single pricing speed, and the average life of the tranche is ''targeted'' to that speed. Any excess principal paid typically has little effect on the TAC; its targeted speed acts as a line of defense. Investors in TACs, however, pay the price for this defense with their lack of protection when rates increase, subjecting the tranche to potential extension risk.
Floaters and inverse floaters. CMOs and REMICs can include several floating-rate classes. Floating-rate tranches have coupon rates that float with movements in an underlying index. The most widely used indexes for floating-rate tranches are the London Interbank Offered Rate (LIBOR) and the Eleventh District Cost of Funds Index (COFI). While LIBOR correlates closely with interest-rate movements in the domestic federal funds market, COFI has a built-in lag feature and is slower to respond to changes in interest rates. Thus, the holders of COFI-indexed floaters generally experience a delay in the effects of changing interest-rate movements.
5. Price/yield curves for most fixed-income securities have a slightly convex shape, hence the securities are said to possess convexity. An important and desirable attribute of the convex shape of the price/yield curve for Treasury securities is that prices rise at a faster rate than they decline. Mortgage price/yield curves tend to be concave, especially in the range of premium prices, and are said to possess negative convexity. Securities with negative convexity rise in price at a slower rate than they fall in price.
Since most floating-rate tranches are backed by fixed-rate mortgages or pass-through securities, floating-rate tranches must be issued in combination with some kind of ''support.'' The designed support mechanism on floaters is an interest-rate cap, generally coupled with a support bond or inverse floater. If interest rates rise, where does the extra money come from to pay higher rates on the floating CMO tranches? The solution is in the form of an inverse floating-rate tranche. The coupon rate on the inverse tranche moves opposite of the accompanying floater tranche, thus allowing the floater to pay high interest rates. The floater and the inverse tranches ''share'' interest payments from a pool of fixed-rate mortgage securities. If rates rise, the coupon on the floater moves up; the floater takes more of the shared interest, leaving less for the inverse, whose coupon rate must fall. If rates fall, the rate on the floater falls, and more money is available to pay the inverse floater investor and the corresponding rate on the inverse rises.
Effectively, the interest-payment characteristics of the underlying home mortgages have not changed; another tranche is created where risk is shifted. This shifting of risk from the floater doubles up the interest-rate risk in the inverse floater, with enhanced yield and price ramifications as rates fluctuate. If rates fall, the inverse floater receives the benefit of a higher-rate-bearing security in a low-rate environment. Conversely, if rates rise, that same investor pays the price of holding a lower-rate security in a high-rate environment. As with other tranche types, prepayments determine the floating cash flows and the weighted average life of the instrument (WAL).
With respect to floaters, the two most important risks are the risk that the coupon rate will adjust to its maximum level (cap risk) and the risk that the index will not correlate tightly with the underlying mortgage product. Additionally, floaters that have ''capped out'' and that have WALs that extend as prepayments slow may experience considerable price depreciation.
Stripped Mortgage-Backed Securities: Interest-Only and Principal-Only
Interest-only (IO) and principal-only (PO) securities are another modification of the mortgage pass-through product. This market is referred to as the stripped mortgage-backed securities (SMBS) market. Both IOs and POs are more sensitive to prepayment rates than the underlying pass-throughs.6 Despite the increased exposure to prepayment risk, these instruments have proved popular with several groups of investors. For example, mortgage servicers may purchase POs to offset the loss of servicing income from rising prepayments. IOs are often used as a hedging vehicle by fixed-income portfolio managers because the value of IOs rises when prepayments slow-usually in rising interest-rate environments when most fixed-income security prices decline.
Two techniques have been used to create IOs and POs. The first, which dominates outstandings in IOs and POs, strips pass-throughs into their interest and principal components, which are then sold as separate securities. As of October 1993, approximately $65 billion of the supply of outstanding pass-throughs had been stripped into IOs and POs.7 The second technique, which has become increasingly popular over the past few years, simply slices off an interest or principal portion of any CMO tranche to be sold independently. In practice, IO slices, called ''IOettes,'' 8 far outnumber PO slices.
Since IOs and IOettes produce cash flows in proportion to the mortgage principal outstanding, IO investors are hurt by fast prepayments and aided by slower prepayments. The value of POs rises when prepayments quicken and falls when prepayments slow because of the increases in principal cash flows coupled with the deep discount price of the PO.
IOs and IOettes are relatively high-yielding tranches that are generally subject to considerable prepayment volatility. For example, falling interest rates and rising prepayment speeds in late 1991 caused some IOs (such as those backed by FNMA 10 percent collateral) to fall up to 40 percent in value between July and December. IOs also declined sharply on several occasions in 1992 and 1993 as mortgage rates moved to 20- and 25-year lows, resulting in very high levels of prepayment. CMO dealers use IOettes to reduce coupons on numerous tranches, allowing these tranches to be sold at a discount (as preferred by investors). In effect, much of the call risk is transferred from these tranches to the IOette. The fact that IO prices generally move inversely to most fixed-income securities makes them theoretically attractive hedging vehicles in a portfolio context. Nevertheless, IOs represent one of the riskiest fixed-income assets available and may be used in a highly leveraged way to speculate about either future interest rates or prepayment rates. Given that their value rises (falls) when interest rates increase (decrease), many financial institutions, including banks, thrifts, and insurance companies, have purchased IOs and IOettes as hedges for their fixed-income portfolios, but such hedges might prove problematic as they expose the hedger to considerable basis risk.
6. This counterintuitive result arises because
IO and PO prices are negatively correlated.
Both pass-through securities and CMOs are purchased by a broad array of institutional customers, including banks, thrifts, insurance companies, pension funds, mortgage ''boutiques,'' 9 and retail investors. CMO underwriters customize the majority of CMO tranches for specific end-users, and customization is especially common for low-risk tranches. Since this customization results from investors' desire to either hedge an existing exposure or to assume a specific risk, many end-users perceive less need for hedging. For the most part, end-users generally adopt a buy-and-hold strategy, perhaps in part because the customization makes resale more difficult.
Uses by Banks Within the mortgage securities market, banks are predominately investors or end-users rather than underwriters or market makers. Furthermore, banks tend to invest in short to intermediate maturities. Indeed, banks aggressively purchase short-dated CMO tranches, such as planned amortization classes, floating-rate tranches, and adjustable-rate mortgage securities.
To the extent that banks do operate as market makers, the risks are more diverse and challenging. The key areas of focus for market makers are risk-management practices associated with trading, hedging, and funding their inventories. The operations and analytic support staff required for a bank's underwriting operation are much greater than those needed for its more traditional role of investor.
Regulatory restrictions limit banks' ownership of high-risk tranches. These tranches are so complex that the most common approaches and techniques for hedging interest-rate risks could be ineffective. High-risk tranches are so elaborately structured and highly volatile that it is unlikely that a reliable hedge offset exists. Hedging these instruments is largely subjective, and assessing hedge effectiveness becomes extremely difficult. Examiners must carefully assess whether owning such high-risk tranches reduces a bank's overall interest-rate risk.
9. Mortgage boutiques are highly specialized investment firms which typically invest in residuals and other high-risk tranches.
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