| GENERAL
DESCRIPTION
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). Nonresidential 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
2. pass-through securities
3. collateralized mortgage obligations and real estate mortgage
investment conduits
4. stripped mortgage-backed securities
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.
Pass-Through Securities
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.
Abbreviation Description
GNMA
30-YR -30-year single-family programs
15-YR -15-year single-family programs
GPMs-duated-payment programs
PROJ Loans- Project-loan programs
ARMs- Single-family adjustable-rate programs
FNMA
30-YR SF -30-year single-family programs
30-YR MF- 30-year multifamily programs
30-YR FHA/ VA FHA/VA- 30-year single- and multifamily programs
15-YR- 15-year single-family programs
SF ARMs- Single-family adjustable-rate programs
MF ARMs - Multifamily adjustable-rate programs
Balloons - Balloon-payment seven-year programs
Two-step- Five- and seven-year two-step programs
FHLMC 30-YR - 30-year single-family programs
15-YR - 15-year single-family programs
TPMs- Tiered-payment single-family programs
ARMs - Single-family adjustable-rate programs
MF- Multifamily programs
5- & 7-year balloons Balloon-payment, five- to seven-year
programs
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 bench-mark 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 pre-payment rate then remains
at 6.0 percent over the remaining life of the mortgage pool . Using this
convention, mortgage pre-payment 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.
Nonagency pass-throughs are composed of specific pools
and do not trade on a TBA basis. New issues settle on the date provided
in the prospectus. In the secondary market, these securities trade on
an issue-specific basis and generally settle on a corporate basis (three
business days after the trade).
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.
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 , mortgage cash flows were 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. 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.
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 ),
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.
Let us see how PACs are created. In an example, the estimated
prepayment rate for the mortgages is 145 percent of the PSA standard,
and the desired PAC is structured to 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.
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 . 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
protection can break down from extremely high, extremely low, or extremely
volatile prepayment rates.
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.
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.
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,"
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.
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.
USES
Both pass-through securities and CMOs are purchased by a broad array
of institutional customers, including banks, thrifts, insurance companies,
pension funds, mortgage "boutiques, " 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.
DESCRIPTION
OF MARKETPLACE
Primary Market
The original lender is called the mortgage originator. Mortgage originators
include commercial banks, thrifts, and mortgage bankers. Originators generate
income in several ways. First, they typically charge an origination fee,
which is expressed in terms of basis points of the loan amount. The second
source of revenue is the profit that might be generated from selling a
mortgage in the secondary market, and the profit is called secondary-marketing
profit. The mortgage originator may also hold the mortgage in its investment
portfolio.
Secondary Market
The process of creating mortgage securities starts with mortgage originators
which offer consumers many different types of mortgage loans. Mortgages
that meet certain well-defined criteria are sold by mortgage originators
to conduits, which link originators and investors. These conduits will
pool like groups of mortgages and either securitize the mortgages and
sell them to an investor or retain the mortgages as investments in their
own portfolios. Both government-related and private institutions act in
this capacity.Ginnie Mae; Freddie Mac, and Fannie Mae are the three main
government-related conduit institutions; all of them purchase conforming
mortgages which meet the underwriting standards established by the agencies
for being in a pool of mortgages underlying a security that they guarantee.
Ginne Mae is a government agency, and the securities it guarantees carry
the full faith and credit of the U.S. government. Fannie Mae and Freddie
Mac are government-sponsored agencies; securities issued by these institutions
are guaranteed by the agencies themselves and are generally assigned an
AAA credit rating partly due to the implicit government guarantee.
Mortgage-backed securities have also been issued by private entities
such as commercial banks, thrifts, homebuilders, and private conduits.
These issues are often referred to as private label securities. These
securities are not guaranteed by a government agency or GSE. Instead,
their credit is usually enhanced by pool insurance, letters of credit,
guarantees, or over-collateralization. These securities usually receive
a rating of AA or better.
Private issuers of pass-throughs and CMOs provide a secondary market
for conventional loans which do not qualify for Freddie Mac and Fannie
Mae programs. There are several reasons why conventional loans may not
qualify, but the major reason is that the principal balance exceeds the
maximum allowed by the government (these are called "jumbo" loans in
the market).
Servicers of mortgages include banks, thrifts, and mortgage bankers.
If a mortgage is sold to a conduit, it can be sold in total, or servicing
rights may be maintained. The major source of income related to servicing
is derived from the servicing fee. This fee is a fixed percentage of the
outstanding mortgage balance. Consequently, if the mortgage is prepaid,
the servicing fee will no longer accrue to the servicer. Other sources
of revenue include interest on escrow, float earned on the monthly payment,
and late fees. Also, servicers who are lenders often use their portfolios
of borrowers as potential sources to cross-sell other bank products.
PRICING
Mortgage valuations are
highly subjective because of the unpredictable nature of mortgage prepayment
rates. Despite the application of highly sophisticated interest-rate simulation
techniques, results from diverse proprietary prepayment models and assumptions
about future interest-rate volatility still drive valuations. The subjective
nature of mortgage valuations makes marking to market difficult due to
the dynamic nature of prepayment rates, especially as one moves farther
out along the price-risk continuum toward high-risk tranches. Historical
price information for various CMO tranche types is not widely available
and, moreover, might have limited value given the generally different
methodologies used in deriving mortgage valuation.
Decomposition of MBS
A popular approach to analyzing and valuing a callable bond involves
breaking it down into its component parts-a long position in a noncallable
bond and a short position in a call option written to the issuer by the
investor. An MBS investor owns a callable bond, but decomposing it is
not as easy as breaking down more traditional callables. The MBS investor
has written a series of put and call options to each homeowner or mortgagor.
The analytical challenge facing an examiner is to determine the value
and risk profile of these options and their contribution to the overall
risk profile of the portfolio. Compounding the problem is the fact that
mortgagors do not exercise these prepayment options at the same time when
presented with identical situations. Most prepayment options are exercised
at the least opportune time from the standpoint of the MBS investor. In
a falling-rate environment, a homeowner will have a greater propensity
to refinance (or exercise the option) as prevailing mortgage rates fall
below the homeowner's original note (as the option moves deeper into the
money). Under this scenario, the MBS investor receives a cash windfall
(principal payment) which must be reinvested in a lower-rate environment.
Conversely, in a high- or rising-rate environment, when the prevailing
mortgage rate is higher than the mortgagor's original term rate, the homeowner
is less apt to exercise the option to refinance. Of course, the MBS investor
would like nothing more than to receive his or her principal and be able
to reinvest that principal at the prevailing higher rates. Under this
scenario, the MBS investor holds an instrument with
a stated coupon that is below prevailing market rates and relatively unattractive
to potential buyers. Market prices of mortgages reflect an expected rate
of prepayments. If prepayments are faster than the expected rate, the
mortgage security is exposed to call risk. If prepayments are slower than
expected, the mortgage securities are exposed to extension risk (similar
to having written a put option). Thus, in practice, mortgage security
ownership is comparable to owning a portfolio of cash bonds and writing
a combination of put and call options on that portfolio of bonds. Call
risk is manifested in a shortening of the bond's effective maturity or
duration, and extension risk manifests itself in the lengthening of the
bond's effective maturity or duration.
HEDGING
Hedging mortgage-backed securities
ultimately comes down to an assessment of one's expectation of forward
rates (an implied forward curve). A forward-rate expectation can be thought
of as a no arbitrage perspective on the market, serving as a pricing mechanism
for fixed-income securities and derivatives, including MBS. Investors
who wish to hedge their forward-rate expectations can employ strategies
which involve purchasing the underlying security and the use of swaps,
options, futures, caps, or combinations thereof to hedge duration and
convexity risk.
With respect to intra-portfolio
techniques, one can employ IOs and POs as hedge vehicles. Although exercise
of the prepayment option generally takes value away from the IO class
and adds value to the PO class, IOs and POs derived from the same pool
of underlying mortgages do not have a correlation coefficient of negative
one. If that were the case, the value of a pass-through security would
always be hedged with respect to interest rates. However, IOs and POs
do represent extremities in MBS theory and, properly applied, can be used
as effective risk-reduction tools. Because the value of the prepayment
option and the duration of an IO and PO are not constant, hedges must
be continually managed and adjusted.
In general, a decline in
prepayment speeds arises largely from rising mortgage rates, with fixed-rate
mortgage securities losing value. At the same time, IO securities are
rising in yield and price. Thus, within the context of an overall portfolio,
the inclusion of IOs serves to increase yields and reduce losses in a
rising-rate environ-ment. More specifically, IOs can be used to hedge
the interest-rate risk of Treasury strip securities. As rates increase,
an IO's value increases. The duration of zero-coupon strips equals their
maturity, while IOs have a negative duration. Combining IOs with strips
creates a portfolio with a lower duration than a position in strips alone.
POs are a means to synthetically
add discount (and positive convexity) to a portfolio, allowing it to more
fully participate in bull markets. For example, a bank funding MBS with
certificates of deposit (CDs) is exposed to prepayment risk. If rates
fall faster than expected, mortgage holders (in general) will exercise
their prepayment option while depositors will hold their higher-than-market
CDs as long as possible. The bank could purchase POs as a hedge against
its exposure to prepayment and interest-rate risk. As a hedging vehicle,
POs offer preferable alternatives to traditional futures or options; the
performance of a PO is directly tied to actual prepayments, thus the hedge
should experience potentially less basis risk than other cross-market
hedging instruments.
RISKS
Prepayment Risk
All investors in the mortgage sector share a common concern: the mortgage
prepayment option. This option is the homeowner's right to prepay a mortgage
any time, at par. The prepayment option makes mortgage securities different
from other fixed-income securities, as the timing of mortgage principal
repayments is uncertain. The cash-flow uncertainty that derives from prepayment
risk means that the maturity and
duration of a mortgage security are uncertain. For investors, the prepayment
option creates an exposure similar to that of having written a call option.
That is, if mortgage rates move lower, causing mortgage bond prices to
move higher, the mortgagor has the right to call the mortgage away from
the investor at par.
While lower mortgage interest rates are the dominant economic incentive
for prepayment, idiosyncratic, noneconomic factors to prepay a mortgage
further complicate the forecasting of prepayment rates. These factors
are sometimes summarized as the "five D's": death, divorce, destruction,
default, and departure (relocation). Prepayments arising from these causes
may lead to a mortgage's being called away from the investor at par when
it is worth more or less than par (that is, trading at a
premium or discount).
Funding and Reinvestment Risk
The uncertainty of the maturities of underlying mortgages also presents
both funding and reinvestment risks for investors. The uncertainty of
a mortgage security's duration makes it difficult to obtain liabilities
for matched funding of these assets. This asset/liability gap presents
itself whether the mortgage asset's life shortens or lengthens, and it
may vary dramatically.
Reinvestment risk is normally associated with duration shortening or
call risk. Investors receive principal earlier than anticipated, usually
as a result of declines in mortgage interest rates; the funds can then
be reinvested only at the new lower rates. Reinvestment risk is also the
opportunity cost associated with lengthening durations. Mortgage asset
durations typically extend as rates rise. This results in lower investor
returns as they are unable to reinvest at the now higher rates.
Credit Risk
While prepayments expose pass-throughs and CMOs to considerable price
risk, most MBS pass-throughs have little credit risk. Approximately 90
percent of all outstanding pass-through securities have been guaranteed
by Ginnie Mae, Fannie Mae, and Freddie Mac. This credit guarantee gives
"agency" pass-through securities and CMOs a decisive advantage over
nonagency pass-throughs and CMOs, which comprise less than 10 percent
of the market.
In general, nonagency pass-through securities and CMOs use mortgages
that are ineligible for agency guarantees. Issuers can also obtain credit
enhancements, such as senior subordinated structures, insurance, corporate
guarantees, or letters of credit from insurance companies or banks. The
rating of the nonagency issue then partially depends upon the rating of
the insurer and its credit enhancement.
Settlement and Operational Risk
The most noteworthy risk issues associated with the trading of pass-through
securities is the forward settlement and operational risk associated with
the allocation of pass-through trades. Most pass-through trading occurs
on a forward basis of two to three months, often referred to as "TBA"
or "to be announced" trading. During this interval, participants are
exposed to counterparty credit risk.
Operating risk grows out of the pass-through seller's allocation option
that occurs at settlement. Sellers in the TBA market are allowed a 2.0
percent delivery option variance when meeting their forward commitments.
That is, between 98 and 102 percent of the committed par amount may be
delivered. This variance is provided to ease the operational burden of
recombining various pool sizes into round trading lots. This delivery
convention requires significant operational expertise and, if mismanaged,
can be a source of significant risk in
the form of failed settlements and unforeseen carrying costs.
Price Volatility in High-Risk CMOs
When the cash flow from pass-through
securities is allocated among CMO tranches, prepayment risk is concentrated
within a few volatile classes, most notably residuals, inverse floaters,
IOs and POs, Z bonds, and long-term support bonds. These tranches are
subject to sharp price fluctuations in response to changes in short- and
long-term interest rates, interest-rate volatility, prepayment rates,
and other macroeconomic conditions. Some of these tranches-especially
residuals and inverse floaters-are frequently placed with a targeted set
of investors willing to accept the extra risk. These classes are also
among the most illiquid bonds traded in the CMO market.
These high-risk tranches, whether held
by dealers or investors, have the potential to incur sizable losses (and
sometimes gains) within a short period of time. Compounding this price
risk is the difficulty of finding effective hedging strategies for these
instruments. Using different CMOs to hedge each other can present problems.
Although pass-through securities from different pools tend to move in
the same direction based on the same event, the magnitude of these moves
can vary considerably, especially if the underlying mortgage pools have
different average coupons.
Risks in "Safe" Tranches
Investors may also be underestimating
risks in some "safe" tranches, such as long-maturity PACs, PAC 2s, and
3s, and floaters, because these tranches can experience abrupt changes
in their average lives once their prepayment ranges are exceeded. Even
floating-rate tranches face risks, especially when short-term rates rise
significantly and floaters reach their interest-rate caps. At the same
time, long rates may rise and prepayments slow, causing the floaters'
maturities to extend significantly since the floater is usually based
on a support bond. Under such circumstances, floater investors could face
significant losses.
In addition to possible loss of
market value, these safe tranches may lose significant liquidity under
extreme interest-rate movements. These tranches are currently among the
most liquid CMOs. Investors who rely on this liquidity when interest-rate
volatility is low may find it difficult to sell these instruments to raise
cash in times of financial stress. Nevertheless, investors in these tranches
face lower prepayment risk than investors in either mortgage pass-throughs
or the underlying mortgages themselves.
Cap Risk
The caps in many floating-rate CMOs and
ARMs are an embedded option. The value of floating-rate CMOs or ARMs is
equal to the value of an uncapped floating-rate security less the value
of the cap. As the coupon rate of the security approaches the cap rate,
the value of the option increases and the value of the security falls.
The rate of change is non-linear and increases as the coupon approaches
the cap. As the coupon rate equals or exceeds the cap rate, the security
will exhibit characteristics similar to those of a fixed-rate security,
and price volatility will increase. All else being equal, securities with
coupon rates close to their cap rates will tend to exhibit greater price
volatility than securities with coupon rates farther away from their cap
rates. Also, the tighter the "band" of caps and floors on the periodic
caps embedded in ARMs, the greater the price sensitivity of the security
will be. The value of embedded caps also increases with an increase in
volatility. Thus, all else being equal, higher levels of interest-rate
volatility will reduce the value of the floating-rate CMO or ARM.
FFIEC Regulations Concerning Unsuitable
Investments
The Federal Financial Institutions Examination
Council (FFIEC) issued a revised policy statement concerning securities
activities for member banks. These rules became effective February 10,
1992, for member banks and bank holding companies under the Board's jurisdiction.
A bank's CMO investments are deemed unsuitable if-
the present weighted average life (WAL) is greater than 10 years,
the WAL extends more than four years or shortens more than six years
for a parallel interest-rate shift of up and down 300 basis points, or
the price changes by more than 17 percent from the asking price for
a parallel interest-rate shift of up and down 300 basis points.
An affirmation of any of these three parameters means that the bond
in question (1) may be considered high risk and (2) may not be a suitable
investment for banks or bank holding companies. An institution holding
high-risk securities must demonstrate that they reduce overall interest-rate
risk for the bank.
Floating-rate CMOs with coupons tied to indexes other than LIBOR (sometimes
called mismatched floaters) are generally exempt from the average-life
and average-life sensitivity tests. Given the degree of price sensitivity
associated with these securities, however, institutions that purchase
non-LIBOR-indexed floaters must maintain documentation showing that they
understand and are able to monitor the risks of these instruments. The
documentation should include a prepurchase analysis and at least an annual
analysis of the price sensitivity of the security under both parallel
and nonparallel shifts of the yield curve.
LEGAL LIMITATIONS FOR BANK INVESTMENT
Pass-Through Securities Ginnie Mae, Fannie Mae, and Freddie Mac pass-through
securities are type I securities. Banks can deal in,
underwrite, purchase, and sell these securities for their own accounts
without limitation. CMOs and Stripped MBS CMOs and stripped MBS securitized
by small business-related securities and certain residential-and commercial-related
securities rated Aaa and Aa are type IV securities. As such, a bank may
purchase and sell these securities for its own account without limitation.
CMOs and stripped MBS securitized by small business-related securities
rated A or Baa are also type IV securities and are subject to an investment
limitation of 25 percent of a bank's capital and surplus. Banks may deal
in type IV securities which are fully secured by type I transactions without
limitations. CMOs and stripped MBS securitized by certain residential-
and commercial-mortgage-related securities rated A or Baa are type V securities.
For type V securities, the aggregate par value of a bank's purchase and
sales of the securities of any one obligor may not exceed 25 percent of
its capital and surplus.
REFERENCES Bartlett, William W. Mortgage-Backed
Securi-ties. Burr Ridge, Ill.: Irwin Publishing, 1994. Becketti, Sean,
and Charles S. Morris. The Prepayment Experience of FNMA Mortgage-Backed
Securities. New York: New York University Salomon Center, 1990. Cilia,
Joseph. Advanced CMO Analytics for Bank Examiners-Practical Applications
Using Bloomberg. Product Summary. Chicago: Federal Reserve Bank of Chicago,
May 1995. Davidson, Andrew S., and Michael D. Herskovitz. Mortgage-Backed
Securities- Investment Analysis and Advanced Valuation Techniques. Chicago:
Probus Publishing, 1994. Fabozzi, Frank J., ed. The Handbook of Mortgage-Backed
Securities. Chicago: Probus Publish-ing, 1995. Fabozzi, Frank J. Valuation
of Fixed-Income Securities. Summit, N.J.: Frank J. Fabozzi Associates,
1994. Klinkhammer, Gunner, Ph.D. "Monte Carlo Analytics Provides Dynamic
Risk Assess-ment for CMOs." Capital Management Sciences, Inc. October
1995. Kopprasch, Robert W. "Option Adjusted Spread Analysis: Going Down
the Wrong Path?" Financial Analysts Journal. May/June 1994. Zissu, Anne,
and Charles Austin Stone. "The Risks of MBS and Their Derivatives."
Jour-nal of Applied Corporate Finance. Fall 1994 Secondary Market for
CMOs. 4110.1 Residential Mortgage-Backed Securities February 1998 Trading
and Capital-Markets Activities Manual Page 14
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