Secondary Mortgage Market

Michael Chen
HD Dimension
2006-02-14
Table Of Contents

 Market Overview: Size, Players,

Securitizations
 Why securitization
 Risk Analysis, Prepayment Risk
 Securities: Pay-Through; CMO
 Misc
Market Overview - Size

 Origination: $2.6-$3 trillion @2005.

 mortgage debt outstanding : >8.8trillion
in @2005 (by Piper Jaffray)
Market Overview - Major Players
 Issuers/Sellers: Agencies, Mortgage Banks, etc
 Serviers

 Underwriters: Investment Banks

 Investors (who write the check)
 Other supporting parties: Insurer, etc
Why securitization
 Re-distribution of risk, especially
prepayment risk
 Create liquidity by catering to different
investors: Pension Funds; Insurance
Companies; Corporate Investors: Banks,
Corporations; Mutual Funds; Hedge
Funds
 MBS: simple -> complex yet standard
 CMBS: complex -> standard
Why securitization – cont.
Risks
 Risks with Mortgage Origination – Pipeline/Inventory
Risks
 Price Risk
 Fallout Risk
 Prepayment Risk after origination
 Portfolio risks
 Prepayment risk
 Credit Risk
 Liquidity Risk
 Price Risk
 Etc. e.g., Deficiencies of the Fixed Rate Mortgage
Risks – Prepayment Risk
 The single most important risk in MBS.
Why?
 Where is it from? due to (1) refinance, (2)
turnover – other factors
 What is prepayment risk: borrowers have
the right to prepay their mortgage loans.
Cash flow pattern of any mortgage and
mortgage related security is significantly
influenced by the prepayment behavior of
these borrowers.
 Extension risk: e.g., from 100 PSA to 50
PSA. Borrowers return money at a
slower rate, thus average life become
longer, this is dangerous for investors
with shorter duration of its liabilities Cash Flow of Mortgage Passthrough Securities with different PSA speed

(such as bank)
 Contraction risk: e.g., from 100 PSA to $8,000,000

150 PSA. Borrowers return money at a $7,000,000

faster rate, thus average life become $6,000,000

Cash Flow ($)

shorter, this is dangerous for investors $5,000,000

with longer duration of its liabilities (such $4,000,000
as pension fund or insurance $3,000,000
companies) $2,000,000

$1,000,000
$-
0 50 100 150 200 250 300 350 400
nth Month

CF@100 PSA CF@165 PSA CF@300 PSA

Risks – Prepayment Risk cont.
 How to measure it?
 CPR(Conditional/Constant Prepayment Rate) and SMM(Single Month
Mortality Rate)
 FHA experience

 PSA (Public Securities Association) Standard Prepayment Model

Type of securities
 Mortgage Pay-Through Bonds
 Collateralized Mortgage Obligations (CMO)
Pass-Through
 A mortgage pass-through security represents a “pro-rata” or proportional
ownership of an underlying pool of mortgages. That is, the mortgage cash flows,
both principal and interest are “passed through” to the investor, apart from a fee
for services rendered by an intermediary and a guarantor.
 Example: XYZ Bank has originated numerous 6% FRMs this month. Rather than
retain these mortgages, XYZ with the assistance of GNMA (Government National
Mortgage Association), issues a 5.5% pass-through security which it then sells to
an investment bank.
 Where does the 50 bp go? 44 bp goes to XYZ for servicing the pool; 6 bp goes to
GNMA for its re-insurance role (guarantee fee);
 XYZ’s responsibilities:
 make scheduled payments to the 5.5% security holders including the prepayment of
principal;
 insurance: in the event of default, it is also XYZ’s responsibility to make up any shortfall
in principal (like a prepayment);
 GNMA’s responsibilities:
 re-insurance: only if XYZ cannot meet its obligations does GNMA pay off the principal
and interest in a timely fashion;
Collateralized Mortgage Obligations
(CMOs)
 CMOs are multiple class (Buzz word: Tranche)
mortgage pay through bond;
 CMOs are designed to minimize the prepayment risk
borne by investors in mortgage pass-through bonds;
 Like mortgage-backed bonds and mortgage pay
through bonds:
 CMOs are debt obligations of an issuer secured by mortgage
collateral;
 the issuer retains ownership of the collateral;
 all collateral cash flows pass through to the investors;
 Like mortgage pass through securities and mortgage
pay through bonds: all collateral cash flows pass
through to the investors;
CMO - Sequential-Pay CMO
 A class or tranche is retired sequentially;
 Each class receives periodic coupon
payments in accordance with its amount
of principal outstanding;
 But the disbursement of principal is
made in a special way: no bond class is
entitled to receive principal payments
until the entire principal of the bond
classes before it have been paid off;
CMO - Sequential-Pay CMO –cont.
CMO – more complex securities
 Purpose: re-distribute
prepayment risk, cater to
investors of different
tastes.
 Types
 with accrual tranche (Z
tranche)
 IO, PO
 Floater / Inverse Floater
 Planned Amortization
Classes Tranche (PAC)
 Target Amortization
Classes Tranche (TAC)
Misc

 1. Please send email to

2006Michael.chen@gmail.com with title
“Request for secondary mortgage
teaching slide” today or tomorrow. I will
send it out to you.
 Q&A
 Good luck!