6.6 MBS Instrument and Market Features Flashcards
The debt-to-income ratio (DTI)
used to measure a borrower’s credit quality
calculated as a monthly mortgage payment as a percentage of a borrower’s gross pre-tax income
Prime loans
have been granted to borrowers with high credit quality. They have good credit history and sufficient income to service their mortgage obligations
Subprime loans
borrowers with low credit quality, or the loan is not the first lien on the property.
Residential mortgage-backed securities (RMBS)
securitized home mortgage loans.
based on pools of home mortgage loans. Investors receive cash flows in the form of interest, scheduled principal payments, and prepayments. RMBS are commonly structured as either mortgage pass-through securities or collateralized mortgage obligations.
A prepayment option
allows a borrower to repay some or all of the outstanding principal
To mitigate this prepayment risk and achieve more certainty over the timing of incoming cash flows
lenders impose penalties on early retirement of mortgage principal.
These penalties are more common in Europe, but relatively rare in the United States.
A mortgage is described as being “underwater”
if the value of the property is less than the amount of outstanding principal (i.e., the LTV ratio is greater than 1).
f a borrower defaults on an underwater mortgage, the lender may not be able to recoup the full amount of the outstanding loan from a foreclosure sale
contraction risk
When prepayments come in earlier than scheduled due to a decrease in interest rates
a type of prepayment risk that is also a significant concern for MBS investors.
Not only do prepayments leave investors with cash to reinvest in a low interest rate environment, they also reduce the duration of an MBS and limit its potential price appreciation.
extension risk
the opposite of contraction risk
If interest rates increase, homeowners will not be motivated to prepay mortgages with relatively low rates.
Investors will have less cash than anticipated to be reinvested in this higher interest rate environment.
Expected cash flows have a lower present value because they will take longer to receive and they are being discounted at a higher rate.
time tranching
the allocation of incoming cash flows to different tranches according to timing rules.
For example, tranches can be prioritized in terms of the order in which they receive principal repayments.
This ensures that certain classes of bonds will absorb prepayments before other classes are affected.
Effectively, time tranching creates bond classes with different expected maturities, allowing investors to choose their preferred level of prepayment risk exposure.
Mortgage Pass-Through Securities
shares that represent a claim to the cash flows from an underlying pool of mortgages, but without rules to allocate cash flows differently among tranches.
In other words, cash flows simply pass through to all investors in the same way
The amount of cash flow received by investors is reduced by the servicing and administrative fees that issuers and third parties charge for activities such as collecting payments, sending payment notices, maintaining records, and providing tax information.
The pass-through rate earned by investors is the net interest rate on the underlying mortgages after accounting for the deduction of administrative fees.
Collateralized Mortgage Obligations
The key difference between collateralized mortgage obligations (CMOs) and mortgage pass-through securities
CMOs redistribute cash flows among multiple tranches.
This does not eliminate or even reduce overall prepayment risk and credit risk, but it does allow investors to choose their desired levels of exposure.
Sequential-Pay CMO Structures
each class (or tranche) is retired sequentially, allowing investors to choose the class that corresponds to their desired maturity.
the sequential-pay tranching structure does not eliminate all uncertainty about the timing of cash flows.
The average life of each tranche will vary depending on the actual prepayment rate.
In a basic sequential-pay CMO structure
each tranche receives the same coupon rate, but all scheduled principal payments and prepayments are directed to one tranche until its full par value is repaid. After that, principal payments are directed to the next tranche. This is done until all tranches are completely paid off.
Z-Tranches (also known as accretion bonds or accrual bonds)
an example of time tranching
CMBS investors receive no payment until the end of an initial accrual period, during which the principal value of the tranche is credited at the stated coupon rate.
Once the accrual period ends, investors start receiving payments that include both principal and accrued interest.
Including a Z-tranche in a CMO benefits other investors by freeing up cash flows to be distributed to other tranches.
Z-tranches have very long average lives, which eliminates contraction risk but also makes them very difficult to value.
Principal-only (PO) tranches
receive only the principal repayments (including prepayments) from the underlying pool of mortgages
Their value is very sensitive to interest rates, increasing when prepayments increase due to falling rates. PO tranches can be used in both pass-through structures and CMOs.
Interest-only (IO) tranches
complement PO tranches by receiving only interest payments from the pool.
Unlike PO tranches, these have no par value.
Cash flows to IO tranches are decreased in low interest rate environments due to the increase in principal prepayments.
Investors use IO tranches as a tool to hedge their exposure to interest rate risk.
Floating-rate tranches
can be created in CMO, even one that is based on a pool of exclusively fixed-rate mortgages.
This is accomplished by creating an inverse floating-rate tranche to offset the floating rate tranche.
When interest rates increase, the floating-rate tranche will pay more and the inverse floating tranche will pay less (and vice versa when interest rates fall).
Payments are linked to a reference rate and are often subject to both a cap and a floor rate.
Like IO tranches, these can be used to hedge interest rate risk exposure.
Residual tranches
receive only the cash flows that remain after obligations to all other tranches have been met. They are attractive to investors with higher levels of risk tolerance, such as hedge funds.
Planned amortization class (PAC) tranches
give investors even more protection against prepayment risk than sequential-pay CMOs. This is accomplished by having a support tranche to absorb all principal payments in excess of what is required to satisfy the schedule of the PAC tranches. If the actual prepayment rate stays within an expected range, each PAC tranche will be repaid on schedule. PAC tranches will only absorb prepayments after the support tranche has been repaid. The greater predictability provided by PACs also reduces extension risk. Of course, the average life of the support tranche is highly volatile, even if the prepayment rate remains within the defined range. Investors willing to tolerate this volatility can benefit from high expected returns.
Commercial Mortgage-Backed Securities (CMBS)
redistribute cash flows from a pool of mortgages on commercial properties (e.g., apartment buildings, offices, warehouses).
Like residential CMOs, CMBS are structured in tranches. A residual tranche, also known as an equity tranche, absorbs the first default losses from the underlying pool of mortgages.
Using a subordinated structure reduces the credit risk of more senior tranches.
Structural call protection at the CMBS level
achieved with sequential payments based on each tranche’s credit rating.
The highest-rated tranches are repaid before those with lower ratings and default losses are absorbed by the lowest-rated tranches.
Loan-level call protection comes from the following mechanisms:
Lockout periods during which prepayments are prohibited
Prepayment penalty points that borrowers must pay the SPE to refinance, such as 1% of the outstanding loan balance
Defeasance provisions that require the borrower to purchase a portfolio of government securities that replicate the future cash flows that the lender would receive in the absence of prepayments
For a CMO that includes Planned Amortization Class (PAC) tranches, if the prepayment rate is within the anticipated range, which of the following tranches most likely protects investors from prepayment risk?
a) PAC tranche
b) Senior tranche
c) Support tranche
c) Support tranche
If the prepayment rate is within the specified range, all prepayment risk is absorbed by the support tranche. This provides greater predictability of the size and timing of cash flows paid to investors in the PAC tranches.
