Asset Backed

8/13/2019 Asset Backed

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Asset-Backed Securities

ABS derive their cash flows from a pool of

underlying assets

MBS = mortgage backed securitiesCARS = certificates for automobile receivables

CARDS = certificates for amortizing revolving

debts

HELS = home equity loan securities


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The underlying assets generate cash flows of

principal and interest which can be repackaged

and sold to investors.

Fixed income

assets

Principal

Interest

Asset-backed

securities


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In ABS, the underlying assets are collectedinto a pool.

Pool assets are standardized.

The asset pool is placed in trust.

Claims on the cash flows generated by theasset pool are structured:

Pass-through structuresMulti-class structures

Securities representing these claims are sold.


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Securitization

By pooling and repackaging cash flows, ABSissuers can convert illiquid fixed income assetsinto marketable bonds.

Requires trust structure to hold underlyingassets, and

Credit enhancement to achieve investment

grade bond ratingExternal: guarantees

Internal: over-collateralization.


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Issuers

Mortgage related agencies

Ginnie Mae (pass-thoughs)

Freddie Mac (PCs)Fannie Mae (MBS)

Private label MBS

Citi, GE, Prudential

Private label ABS

GMAC and other auto companies

Finance companies

Credit card issuers


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Investors

Insurance companies

Pension funds

Mutual funds

Wealthy individuals


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MBS

Backed by mortgage loans.

A mortgage loan is a loan secured by real

estateThe mortgage is a security agreement that gives

the lender the right to seize by foreclosure theproperty securing the loan if the borrower defaults

Mortgage loans are originated by banks andother financial firms.

Once originated, a mortgage loan may be held,sold to an investor for cash, or pooled andsecuritized.


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Mortgage Loan Types

Fixed-rate, level pay (plain vanilla)

Term of loan is fixed (30 years is common in US)

Contract rate of interest is fixed for the life of theloan.

Payments (usually monthly) are constant for the

term of the loan

The payments fully amortize the loan.FHA, conventional, conforming,

nonconforming, jumbo


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Mortgage Loan Types

Graduated payment loans (GPMs)Low initial payments and period of negative

amortization

Graduated equity loans (GEMs)

Fixed coupon with growing payments

Balloons

Adjustable rate mortgages (ARMs)Various index rates

Caps and collars


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Mortgage Loan Payments

The payments on a plain vanilla mortgage are

determined by

X P0i12

1 1 i12

12T

Initial

principal

Contract

rate of

interest

Mortgage

term in

years


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For Example

The monthly payments on a $187,000 loan

written at 10% for 15 years is

X$187,000.10

12

1 1.1012

180

$2,009.51

In Excel, you can use the financial function

PMT(rate, nper, pv,fv,type)


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Mortgage Loan Payments

Each payment consists ofinterest equal to i/12 times the amount of principal

owing at the time the payment is due, and

scheduled principal repayment

Payments are calculated such that the interestdue is paid first and then the remainder of the

payment is used to reduce the principal owed.

A table listing the payments and how they aredivided between interest and principal is calledan amortization schedule.


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Amortization Schedule

For example, here are the first few lines of an

amortization schedule for a 15-year, 10% fixed

rate loan with an initial principal of $187,000Balance Scheduled Balance

Before Principal After

Payment Due date Payment Payment Interest Repayment Payment

1 1/15/93 $187,000.00 $2,009.51 $1,558.33 $451.18 $186,548.822 2/15/93 $186,548.82 $2,009.51 $1,554.57 $454.94 $186,093.88

3 3/15/93 $186,093.88 $2,009.51 $1,550.78 $458.73 $185,635.154 4/15/93 $185,635.15 $2,009.51 $1,546.96 $462.55 $185,172.605 5/15/93 $185,172.60 $2,009.51 $1,543.11 $466.41 $184,706.206 6/15/93 $184,706.20 $2,009.51 $1,539.22 $470.29 $184,235.907 7/15/93 $184,235.90 $2,009.51 $1,535.30 $474.21 $183,761.698 8/15/93 $183,761.69 $2,009.51 $1,531.35 $478.16 $183,283.539 9/15/93 $183,283.53 $2,009.51 $1,527.36 $482.15 $182,801.38


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A better way to visualize the amortization

process is to look at a graph of the payments

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

1 23 45 67 89 111 133 155 177

Principal

Interest


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The principal balance remaining after any

number of payments can be determined by

constructing an amortization schedule or byemploying the formula

Ps P0

1 1 i12

12Ts

1 1 i12

12T


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The logic of this formula is that the principal

balance remaining after s payments is always

the present value of the remaining 12T-spayments discounted at the contract rate of

interest

Ps P0

1 1 i12

12Ts

1 1 i12

12T


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Graphically


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Mortgage Servicing

Servicing

Collection and forwarding of payments

Administration of escrow accountsServicing fees

Typically 50 basis points

Right to service loan is sold by owner of

mortgage loan


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Mortgage Servicing

For example

Scheduled Balance

Servicing Principal After

Payment Payment Fee Interest Repayment Payment

1 $2,009.51 $77.92 $1,480.42 $451.18 $186,548.822 $2,009.51 $77.73 $1,476.84 $454.94 $186,093.883 $2,009.51 $77.54 $1,473.24 $458.73 $185,635.154 $2,009.51 $77.35 $1,469.61 $462.55 $185,172.605 $2,009.51 $77.16 $1,465.95 $466.41 $184,706.206 $2,009.51 $76.96 $1,462.26 $470.29 $184,235.90

171 $2,009.51 $8.00 $152.03 $1,849.48 $17,354.50172 $2,009.51 $7.23 $137.39 $1,864.89 $15,489.61

173 $2,009.51 $6.45 $122.63 $1,880.43 $13,609.18174 $2,009.51 $5.67 $107.74 $1,896.10 $11,713.08175 $2,009.51 $4.88 $92.73 $1,911.90 $9,801.17176 $2,009.51 $4.08 $77.59 $1,927.84 $7,873.34177 $2,009.51 $3.28 $62.33 $1,943.90 $5,929.44178 $2,009.51 $2.47 $46.94 $1,960.10 $3,969.34179 $2,009.51 $1.65 $31.42 $1,976.43 $1,992.90180 $2,009.51 $0.83 $15.78 $1,992.90 ($0.00)

This servicingannuity is worth

about $5,450 at a

9.5% discount

rate


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For Example

Consider a mortgage thats been outstanding

for two years and rates have fallen 2%

Original loan amount: $187,000.00Term (yrs): 15

Contract rate of interest: 10.00%

Monthly payment $2,009.51

Balance after 24 payments $175,067.73

New rate 8.00%Value of balance remaining $194,517.70

Benef it of ref inancing $19,449.97

New montly payment $1,808.58


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Prepayments

To the extent that prepayments cannot be

perfectly predicted, they create uncertainty

about the term of mortgage loans.This uncertainty is a disadvantage from the

standpoint of an investor.

Whats worse: Prepayments are more likely

when rates fall and less likely when they rise,so prepayment risk is positively correlated with

interest rate risk


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Pass-throughs

The simplest type of MBS

Similar mortgages are pooled and

Principal and interest payments are passed throughto investors (pro rata)

Less servicing and insurance (credit enhancement)

fees

Pass-through cash flows are uncertain becauseprepayments of mortgages within the pool are

uncertain.


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Prepayment models

To price a pass-through bond, an estimate of

prepayments is needed.

Prepayments will affect the duration of the bonds(Can you see how?)

There are several models for estimating

prepayments

However, none of these models is designed todescribe borrower response to changes in

interest rates.


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CPR

The constant prepayment rate model assumes a

constant percentage of the outstanding principal

will prepay each month.CPR is an annual rate that can be translated to

a single monthly mortality rate (SMM) as

SMM

1

1

CPR

112

An SMM of z% means that z% of the principal remaining

in the pool after all scheduled payments have been made

will prepay during the month


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CPR

For example, a CPR of 6%

Translates to an SMM of .514%

So if you owned a pass-through with abeginning of the month balance of $181,824.99

and $494.30 of scheduled principal payments,

then prepayments would be predicted at

.00514 $181,824.99 $494.30 $932.58


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PSA

The Public Securities Association standardspecifies that the CPR is .2% during the firstmonth of a pool,

Increases by .2% per month until the 30thmonth

Levels off at 6% for the remainder.

Prepayment speeds are quoted as % of PSASlow: less than 100% PSA

Fast: greater than 100% of PSA


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FHA Experience

HUD publishes data on FHA insured

mortgages that can be used to extrapolate

prepayment speeds.Patterns can be discerned for different types of

pools.

The pattern for a given pool type can then be

used to estimate a prepayment speed for otherpools of that type.


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Example with 165% PSA

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

$3,500.00

$4,000.00

1 21 41 61 81 101 121 141 161


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Effect of Changing PSA

Impact on duration

Excel spreadsheet


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Asset Backed

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