Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities / Edition 1 available in Hardcover
- Pub. Date:
About the Author
Read an Excerpt
A Concise Guide to Mortgage-Backed Securities (MBSs)
(Please note: Exhibits and any other illustrations cited in the following text refer to the print edition of this work, and are not reproduced here.)
This chapter provides an introduction to mortgage securities and methods of analyzing them. While it lays the groundwork for the more detailed treatment of various topics in the rest of this book, it can also be used as a concise but comprehensive overview of the market for nonspecialists. The chapter is organized as follows:
Section 1.1 describes the growth of the market.
Section 1.2 reviews key features of agency mortgage pass-through securities, the most basic and most prevalent type of MBS.
1.1 GROWTH OF THE SECONDARY MORTGAGE MARKET
The mortgage-backed securities (MBSs) market has experienced phenomenal growth over the past 20 years. The total outstanding volume of MBSs has increased from about $100 billion in 1980 to about $3 trillion, and as Exhibit 1.1 shows, mortgage-backed securities form a major component of the U.S. bond market.
Exhibit 1.2 shows a breakdown of Salomon Smith Barney's U.S. Broad Investment Grade (BIG) Index. Note that MBSs are a bigger proportion of the index than suggested by Exhibit 1.1, as almost half of all Treasury securities are Bills with maturities less than one year, and are hence excluded from the index.
What accounts for the rapid growth of the MBS market? Increased securitization of mortgages and ready acceptance of MBSs by fixed-income investors are both key reasons. Mortgage originators became much more disposed to sell loans into the secondary market after the high-interest-rate environment of the late 1970s and early 1980s, when the disadvantages of holding fixed-rate long-term loans in their portfolios became apparent. The growing market share of mortgage bankers, who have little interest in holding onto mortgage loans, also has contributed to the increasing securitization of mortgages. In addition, many institutions have increasingly come to view securitization as a means of turning illiquid assets into liquid securities, and hence a tool for efficient balance sheet management.
The federal government has played an equally important role. Three agencies, the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Associations (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac) are major players in the secondary mortgage market in issuing and guaranteeing MBSs. These federal housing finance agencies were created to facilitate the flow of mortgage capital and, hence, to ensure that lenders have adequate funds to make new mortgage loans. The three agencies are generally credited with significantly reducing the cost of mortgage borrowing for American home buyers, as well as making mortgages more widely available. On the demand side, MBSs have come to represent a significant portion of fixed-income holdings for many types of investors over the past decade. In Exhibit 1.3 we show a breakdown of holdings of MBSs by investor type.
Why Institutional Investors Buy Mortgage Securities
MBSs have quickly become popular fixed-income investments for many reasons, including:
Higher returns. MBSs typically yield 100bp (basis points) or more over Treasuries and offer higher yields than comparable-quality corporate bonds. Although some of this higher yield compensates for their complexity and embedded prepayment options, MBSs still have outperformed comparable Treasuries and other corporate bonds in most years since the early 1980s, as shown in Exhibit 1.4.
Exhibit 1.4 also shows cumulative returns on various Salomon Smith Barney fixed-income indices; MBSs have outperformed Treasuries and corporate bonds by substantial margins. Even during the 1990s, when conditions were ideal for Treasuries and corporate bonds--falling interest rates and a sustained recovery from the early 1990s recession--and the environment tough for MBSs, with several major refinancing waves, MBSs still did relatively well versus comparable fixed-income instruments.
Credit quality. Ginnie Mae MBSs are backed by the full faith and credit of the U.S. government and, hence, like Treasuries, are considered to carry no credit risk. Fannie Mae and Freddie Mac MBSs do not have U.S. government guarantees, but because of Fannie Mae's and Freddie Mac's close ties to the government, their MBSs are perceived to have minimal credit risk and do not seem to trade at a noticeable credit premium to Ginnie Maes. MBSs from other (private) issuers typically carry AAA or AA ratings from one or more of the credit rating agencies.
Choice of investment profiles. Given the variety of MBSs created, this sector provides a wider range of investment characteristics than most other parts of the fixed-income market. For example, MBSs are available with negative, short, or very long duration. Prepayment sensitivities can range from low to very high. Coupons can be fixed (from 0% to more than 1,000%) or floating (directly or inversely with a range of indices).
Liquidity. The amount of outstanding MBSs, trading volume (second only to U.S. Treasuries), and the involvement of major dealers provide an active, liquid market for most MBSs.
Development of analytic tools. Since the mid-1980s, many major dealers (and some buy-side firms) have devoted considerable resources to developing analytic models for evaluating MBSs. These efforts have led to a better understanding of mortgage cash flows and a higher level of comfort with the characteristics of mortgage securities.
1.2 AGENCY PASS-THROUGH SECURITIES
The basic mortgage-backed security structure is the pass-through. As the name implies, a pass-through passes through the monthly principal and interest payments (less a servicing fee) from a pool of mortgage loans to holders of the security. Thus, investors in the pass-through are, in effect, buying shares of the cash flows from the underlying loans. Structured MBSs, such as collateralized mortgage obligations (CMOs) and interest-only (IO) and principal-only (PO) stripped MBSs (or STRIPs), carve up mortgage cash flows in a variety of ways to create securities with given prepayment and maturity profiles. In this section we discuss pass-throughs; we describe structured mortgage securities (agency and non-agency) later in this chapter.
Development of the Pass-Through Market
The pass-through is the most common structure for mortgage-backed securities. A pass-through issuer acquires mortgages either by originating them or by purchasing them in the whole-loan market. Many mortgages with similar characteristics are collected into a pool, and undivided ownership interests in the pool are sold as pass-through certificates. The undivided interest entitles the owner of the security to a pro rata share of all interest payments and all scheduled or prepaid principal payments.
The growth of the pass-through market stems in large part from the active role of the U.S. housing finance agencies in the primary and secondary mortgage markets. Ginnie Mae, Freddie Mac, and Fannie Mae account for nearly all of the issuance and outstanding principal amount of mortgage pass-throughs.
The programs of the three major federal housing agencies reflect the historical development of U.S. housing policy. Fannie Mae was created in 1938 as a wholly owned government corporation. Its charter mandated that it purchase Federal Housing Administration(FHA)-insured and, (since 1948), Veterans Administration(VA)-guaranteed mortgages for its portfolio. Congress intended to ensure that mortgage lenders would continue to be able to make residential mortgage loans, even in periods of disintermediation (when withdrawals by depositors are high) or when delinquencies and defaults are high. Fannie Mae's purchase activities encouraged the standardization of repayment contracts and credit underwriting procedures for mortgages.
In 1968, the government restructured its role in the housing finance market. Fannie Mae was privatized, although it retained its mandate to buy FHA/VA loans for its own portfolio. Ginnie Mae was spun off as a separate agency that would undertake some of Fannie Mae's previous activities; in particular, Ginnie Mae assumed the financing of home loans not ordinarily underwritten in the established mortgage market, such as loans to low-income families. Ginnie Mae's most important activity has been its mortgage pass-through program, which was instituted in 1970. Under this program, Ginnie Mae guarantees the payments of principal and interest on pools of FHA-insured or VA-guaranteed mortgage loans.
The enhanced availability of credit to home owners who qualify for FHA and VA loans led to calls for similar treatment for nongovernment-insured (or conventional) mortgages. In 1970, Congress established Freddie Mac to develop an active secondary market for conventional loans, and in 1972, Fannie Mae began to purchase conventional mortgages. Thus, by 1972, lenders could sell their newly originated conventional mortgages to either Fannie Mae or Freddie Mac.
Freddie Mac issued a small volume of pass-throughs in the 1970s, while Fannie Mae began its MBS program in late 1981. As Exhibit 1.5 indicates, issuance volume from all three agencies increased tremendously in the 1980s, hit a peak in the refinancing waves of 1993, and recently hit record levels with the heavy volume of refinancing in 1998.
Exhibit 1.6. provides a description of a fairly typical mortgage pass-through, or pool, including key current pool characteristics which are updated each month by the agencies (through electronic tapes called pool factor tapes) for their pools (for non-agency MBSs, issuers provide updated tapes for their deals each month).
Ginnie Mae guarantees timely principal and interest payments on all of their pools. On Fannie Mae and Freddie Mac pools, the respective agencies guarantee principal and interest payments to investors. Private-label MBSs, which the rating agencies typically rate triple-A, are issued with various forms of credit enhancement, based on rating agency requirements.
Exhibit 1.6 also shows some of the terminology and information used to analyze MBSs:
Net coupon and WAC. The net coupon of 9% is the rate at which interest is paid to investors, 4 while the weighted-average coupon (WAC) of 9.5% is the weighted-average coupon on the pool of mortgages backing the pass-through. The difference between the WAC and the net coupon is called the servicing spread. The majority of Ginnie Mae pools are issued under the so-called Ginnie Mae I program, and for such pools, the underlying mortgage loans all have the same note rate (9.50% for the pool in Exhibit 1.6) with a servicing spread of 50bp. Pass-throughs issued under an alternative program called Ginnie Mae II 5 and those issued by Fannie Mae and Freddie Mac allow for variations in the note rates on the underlying loans. In the latter case, the WAC could change over time (as loans are prepaid), and hence, the latest updated WAC would be shown.
WAM and WALA. The weighted-average maturity (WAM) is the average (weighted by loan balance) of the remaining terms on the underlying loans, while the WALA is the weighted-average loan age. Note that the sum of the WAM and WALA in Exhibit 1.6 is (20-05 + 9-04), or 29-09. If the underlying loans had original terms of 30 years, why is this figure not 30 years exactly? There are two reasons: (1) some of the loans may have had original terms of less than 30 years (e.g., 25 years) because pass-throughs backed by 30-year loans in fact may have mortgages with any original term of greater than 15 years (although the majority of loans will typically have 30-year original terms); and (2) some mortgagors are in the habit of sending in extra monthly payments, above and beyond the scheduled monthly payment, to build up equity in their properties at a faster rate. These extra payments, often referred to as curtailments or as partial prepayments (as opposed to a full prepayment of the whole mortgage) shorten the remaining term until the mortgage is paid off because the monthly payment remains unchanged (for fixed-rate loans) while the balance to be amortized decreases. The WAM will reflect the extent of this shortening.
Delays. Cash flows are passed through to investors with a delay to allow servicers time to process mortgage payments. For the Ginnie Mae pool shown in Exhibit 1.6, the stated delay is 45 days, which means that the principal and interest for September, say, is paid on October 15, rather than on October 1. Thus, the actual delay is 14 days. Fannie Maes have a stated delay of 55 days, while FHLMC Golds have a stated delay of 45 days. 6 Of course, these delays are factored into calculations of returns to investors.
Pool factor. The Ginnie Mae pool in Exhibit 1.6 had a factor of 0.10478598 as of June 8, 2000. The factor is the proportion of the original principal balance outstanding as of the stated factor date. The factor declines over time because of scheduled principal payments (amortization) and prepayments. In this case, amortization alone would have reduced the factor by less than 10% since the pool was issued in 1991; thus, this pool clearly has experienced heavy prepayments. As we discuss in the next section, a comparison of the actual factor with the factor under amortization alone is used to estimate prepayment rates on mortgage pools.
TYPE OF AGENCY PASS-THROUGH COLLATERAL
In general, the agencies segregate loans into pools by the following categories:
Type of property (single-family or multifamily);
Payment schedule (level, adjustable, other);
Original maturity; and
Loan coupon rate.
Single-family loans, defined as loans on one- to four-family homes, provide the collateral for the great majority of agency pass-throughs. A brief description of agency multifamily programs is given later in this section. Here we review single-family collateral types.
Government and Conventional Loans
Loans insured by two U.S. government entities, the FHA and the VA, collateralize Ginnie Mae pools. Other loans are referred to as conventional loans. Conventional loans back almost all Fannie Mae and Freddie Mac pools, although both agencies have issued pools backed by FHA/VA loans.
Because of restrictions on loan size and lower downpayment requirements, FHA and VA borrowers tend to be less affluent than conventional borrowers, characteristics likely to lead to slower Ginnie Mae prepayment rates. However, because income levels and housing costs vary from region to region, certain regions have greater concentrations of FHA/VA loans. Hence, prepayment differentials between Ginnie Mae and Fannie Mae/Freddie Mac speeds can partly reflect regional housing market differences.
Conforming and Nonconforming Loans
Conventional loans may be segregated further into conforming and nonconforming loans. Conforming loans are those that are eligible for securitization by Fannie Mae and Freddie Mac, which means that the original loan balance must be less than the specified Fannie Mae/Freddie Mac limit (currently $240,000 and changed each year based on housing inflation) and that the loans must meet Fannie Mae/Freddie Mac underwriting guidelines (in terms of required documentation, borrower debt-to-income ratios, loan-to-value (LTV) ratios, etc.).
Nonconforming loans form the collateral for private-label MBSs. In most cases, these loans are nonconforming because they exceed the Fannie Mae/Freddie Mac loan size limit (jumbo loans). However, the sizes of a significant number of loans in private-label deals are below this limit, but are nonconforming because they do not meet Fannie Mae and Freddie Mac underwriting standards. An overview of non-agency MBSs is given in Part Six.
Payment Schedules and Loan Terms
Within each of these administrative categories, loans are further classified by payment type and term.
Fixed-Rate or Level-Pay Loans These loans remain the basic collateral for pass-throughs. As the name implies, they are fully amortizing loans with fixed coupons and, hence, fixed monthly payments. The most popular loan term is 30 years, although 15-year loans appeal to those who want to build up equity faster in their homes and who can afford higher monthly payments. Smaller amounts of pass-throughs are backed by 20-year and 10-year loans, which were mainly issued as refinancing vehicles during the various refinancing waves of the past several years.
Adjustable-Rate Mortgages (ARMs) ARMs became popular during the high-interest-rate period of the early 1980s. Since then, they have continued to account for a significant fraction of total mortgage originations. During periods of high fixed mortgage rates, as much as 60% of originations have been ARMs, but even when fixed rates are low, ARMs typically constitute at least 15% of originations. An explanation for their popularity is the low initial coupon (or teaser rate), that attracts borrowers (such as first-time home buyers) who want to minimize their starting monthly payments. After the teaser rate period is over, the coupon resets off a specified index, such as the one-year Treasury rate, subject to periodic caps (the maximum amount that the coupon can change at each reset date) and life caps (the upper limit on the ARM coupon). Securitization rates for ARMs are typically less than for fixed-rate loans, because some originators hold them in their portfolios.
A recent development is the hybrid ARM. As the name implies, a hybrid has features of both fixed-rate loans and ARMs: It has a fixed coupon for a specified number of years (typically three, five, seven, or ten), after which the coupon, as with a standard ARM, resets periodically off a specified index.
Balloon Loans Fannie Mae and Freddie Mac securitize these loans. The loans amortize according to a 30-year schedule, with a balloon payment due at the end of five or seven years. Balloon MBSs were first issued in late 1990 and were quite popular in the refinancing waves of 1992 and 1993, but have declined in popularity since then, partly because of the growing popularity of hybrid ARMs.
There are various other payment types, such as graduated payment mortgages (GPMs), which typically have lower initial monthly payments and higher subsequent ones relative to a standard fixed-rate loan. The idea behind these mortgages is to make it easier to purchase a home for first-time buyers. Such types are a fairly minor segment of the market nowadays.
In Exhibit 1.7, we summarize some of the key features of the main agency pass-through programs.
TYPES OF PASS-THROUGH TRADING
Most agency pass-through trading is on a to-be-announced (TBA) basis. In a TBA trade, the buyer and seller decide on general trade parameters, such as agency, coupon, settlement date, par amount, and price, but the buyer typically does not know which pools actually will be delivered until two days before settlement. The seller is obligated to provide pool information by 3 P.M. two days prior to settlement (the 48 Hours Rule). The pools delivered are at the discretion of the seller, but must satisfy Good Delivery guidelines established by the Bond Market Association, a trade group representing bond dealers (formerly known as the Public Securities Association, or PSA). Good Delivery guidelines specify the allowable variance in the current face amount of the pools from the nominal agreed upon amount, the maximum number of pools per $1 million of face value, and so on.
The TBA market facilitates liquidity in pass-through trading because most individual pass-through pools are small. Almost all newly issued pools trade as TBAs. Most price quotes shown for pass-throughs, and valuation analyses such as those in the next section, are for TBA coupons. Such pricing and analysis assume WACs and WAMs based on an estimate of what is most likely to be delivered at the time.
Investors also can specify a particular loan origination year (or vintage, sometimes also referred to as a specific WAM) when buying a block of pass-throughs. For example, whereas a TBA trade might be for $100 million of 30-year Ginnie Mae 7s, a vintage trade might specify $100 million of 1993 30-year Ginnie Mae 7s. The investor would then receive Ginnie 7% pools collateralized by loans originated in 1993. Because the 1993 Ginnie 7s may have favorable prepayment characteristics relative to new production (e.g., more burnout or more seasoning), they would typically sell at a premium to TBAs. This blended market has become much more active in the past few years.
A large and active market also exists in specified pools, in which buyers know exactly which pools they are buying, and, hence, relevant characteristics such as WAC, WAM, age, prepayment history, and so on. With this extra degree of certainty, specified pools typically trade at a premium to comparable TBA coupons.
Story Bonds While most trading in specified pools involves fairly seasoned bonds, a recent development is the trading of new pools with specific prepayment characteristics. Some examples include:
Prepay penalty pools, which are backed by loans that carry a penalty (typically about six months of interest) if the loan is refinanced within the first three or five years.
Low WAC pools, which are pools with WACs lower than the typical TBA average. For example, conventional TBA 7s currently are assumed to have a WAC of 7.60%, so 7% pools with a WAC of, say, 7.40% will trade at a premium to TBA 7s.
Low loan balance pools, which are backed by "smaller than average" loans. Because refinancing costs are more of a hurdle for such loans and because smaller loan balances can imply less affluent borrowers, then other things being equal, such loans may prepay more slowly than average.
Freddie Mac Giant PCs and Fannie Mae MegaPools, introduced in mid-1988, and Ginnie Mae Platinum pools, introduced in late 1994, are mortgage pass-throughs that the agencies create by combining already outstanding pass-throughs. Such pools benefit investors who own small pass-through pools or seasoned pools that have paid down. These investors can swap their holdings for a pro rata share of a new Giant PC, MegaPool, or Platinum pool. Similarly, these programs help lenders design more marketable securities. Lenders can take recently securitized smaller pools that are still held in portfolio and aggregate them into a bigger pool.
From the investor's perspective, large pools provide the following advantages in addition to greater liquidity:
Greater diversification. When the combined pool is backed by pass-throughs from many investors, the geographic distribution of the underlying mortgages is typically greater. This diversification reduces the risk of random prepayment and default variations. Thus, the prepayment rates of combined pools would follow average mortgage sector prepayment rates more closely than would most standard pools.
Lower administration costs. Investors can track the monthly payments and balances for a few large pools more efficiently than they can for a greater number of small pools.
Lower reverse repurchase rates. Investors can achieve lower financing rates when entering into reverse repurchase agreements by pledging bigger pools. Securities dealers and banks often pass on the administrative cost savings of larger pools to the customer.
MULTIFAMILY PASS-THROUGH PROGRAMS
Although small in comparison to the single-family MBS sector, pass-throughs backed by multifamily mortgages comprise a sizable market as shown in Exhibit 1.7. Fannie Mae and Freddie Mac have securitized multifamily loans (defined as mortgages on five or more family homes) for many years, and their programs have gone through various revisions over the years. Investors should note some common features of multifamily MBSs:
- Many multifamily loans have prepayment penalties, giving the investor a degree of call protection. The penalty is often in the form of yield maintenance; thus, the amount of the penalty depends on the decline in interest rates since issuance. The objective is to fully compensate the investor for the prepayment.
Many multifamily loans have balloon payments due, with the balloon date typically occurring between 5 and 15 years.
Project loans is a term that refers to FHA-insured mortgage loans made on a variety of property types such as multifamily housing, nursing homes, and hospitals. The loans are either securitized as Ginnie Mae pass-throughs or sold as FHA PCs. Project loans typically have prepayment penalties. In addition, some project loans are putable; in other words, the investor has the option of selling the bond to the issuer for a specified price at specified times.
Multifamily pass-throughs and project loans are special cases of MBSs backed by commercial real estate loans. Commercial mortgage-backed securities (CMBSs) combine the features of standard MBSs with those of callable corporate bonds and are further discussed in Part Six.
Table of ContentsIntroduction.AN OVERVIEW OF THE MARKET.A Concise Guide to Mortgage-Backed Securities (MBSs).An Introduction to the Asset-Backed Securities (ABSs) Market.The Mechanics of Investing in Mortgage- and Asset-BackedSecurities.PREPAYMENT ANALYSIS AND MODELING.Anatomy of Prepayments: The Salomon Smith Barney (SSB) PrepaymentModel.Random Error in Prepayment Projections.The Mortgage Origination Process.The Impact of the Internet on Prepayments.COLLATERAL SECTORS.Ginnie Mae.Adjustable Rate Mortgages (ARMs).Hybrid ARMs.Jumbo Loans.Alternative-A Loans.OPTION-ADJUSTED SPREADS AND DURATIONS.The SSB Two-Factor Term Structure Model.Mortgage Durations and Price Moves.AGENCY COLLATERALIZED MORTGAGE OBLIGATIONS (CMOs) AND STRIPPEDMBSs.Structuring Mortgage Cash-Flows.COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBSs).A Guide to CMBs.A Guide to Interest Only CMBSs.A Guide to Fannie Mae DUS MBSs.MORTGAGE-RELATED ASSET-BACKED SECURITIES.Home Equity Loan (HEL) Securities.Prepayments on RFC Fixed-Rate Sub-Prime/HELs.Manufactured Housing (MH) Loan Securities.NON-MORTGAGE-RELATED ASSET-BACKED SECURITIES.Class C Notes: Opening the Next Frontier in Credit CardAsset-Backed Securities.A Fresh Look at Credit Card Subordinate Clauses.Recreational Vehicle and Boat Loan ABSs.The ABCs of CDO Equity.Student Loans.NON-U.S. MARKETS.The Mortgages Market in the United Kingdom.The CMBs Market in the United Kingdom.The Mortgage Market in Australia.APPENDICES.
What People are Saying About This
This is an excellent and comprehensive guide that is clearly required reading for anyone interested in these important financial markets. I particularly liked the many explicit examples of prepayment modeling approaches.
Francis A. Longstaff, Professor of Finance, The Anderson School, University of California, Los Angeles
This is an enormously comprehensive study of the MBS and ABS markets by one of the most respected people in the field. Its unmatched wealth of institutional and technical detail make it an invaluable reference to anyone interested in these markets.
Richard Stanton, Associate Professor of Finance, Haas School of Business, University of California, Berkeley
Lakhbir Hayre's work ranks in the top echelon of fixed income research of the past two decades. Both new entrants and seasoned market professionals can benefit from the insights compiled in this volume.
Greg Parseghian, Senior Vice President and Chief Investment Officer, Freddie Mac