L4 Mortgage-Backed Securities revised

L4 Mortgage-Backed Securities revised - Mortgage-Backed...

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Unformatted text preview: Mortgage-Backed Securities Real Estate Finance K. S. Maurice Tse The University of Hong Kong ktse@econ.hku.hk Content Why Mortgage-backed Securities Mortgage-backed bonds (MBBs) Mortgage pass through securities (MPTs) Mortgage pay-through bonds (MPTBs) Collateralized Mortgage obligations (CMOs) Issues about Collateralized Debt Obligations (CDOs) and the subprime crisis. Interesting website: www.hkmc.com.hk Concept about Securitization Example: HSBC March 06, 2006 Market price of 1 Share = HK$134, 1 lot =400 shares, Min investment = HK$53,600 Expected dividend stream = $5.66 per share What are you buying with that $53,600?? Source of Gains = Dividend Stream + Price Appreciation Dividend Stream and Price Appreciation Dividend Stream is more safe, but price appreciation is very risky. What if I only like the dividend stream which is safer? What if I only like the price appreciation which is more risky but has higher expected returns? Securitization !!! How does securitization work Source of Gains = Dividend Stream + Price Appreciation Pays dividend only, no price appreciation (e.g. $40 per share) Security S + Security R No dividend, only price changes (e.g. $100 per share) > Retirees and old people who need steady income stream to live on HSBC ?? Younger investors who want higher returns Security S HSBC $134 per sh Security R If Security S + Security R > HSBC Successful Securitization WHY ???? How does it work – Example 2 Suppose I will receive a 5- year fixed income stream (a bond) with $100/year. 100 0 1 100 2 100 3 100 4 100 5 Due to market segmentation, there is specific demand for each type of securities, say, short term and long term. 100 100 0 1 100 2 3 Long-term V(L) 100 4 100 5 0 1 2 Short-term V(S) Successful Innovation V(S) + V(L) > V M ortgage - Backed Securities Governance Structure of MBS Role of trustee is to monitor the mortgage pool to ensure the mortgages satisfy the conditions necessary for maintaining the QUALITY of the issued bonds. B or r ow er s I n v est or s: I ndi vid ual I nst i t ut i onal $ Cash Mortgage $ Price P ool i n g M or t gages: C om m er ci al B an k s M or t gage Compani es Ot her s Commer cial M or t gages Resident i al M or t gages M or t gage-Rel at ed Secur it i es $ price Income Stream I ssu e B on d s MBBs Mortgage T r u st Mortgage Backed Securities in Hong Kong Back-to-back guaranteed MBS Programme Structure of the "Sw ap and Hold" transaction Mortgage Backed Securities in Hong Kong Back-to-back guaranteed MBS Programme P ass - through of coupon The objective of the programme is to provide an efficient way of developing a secondary market for the mortgages held by the bank through a standardized structure, which carries the guarantee of the HKMC. As the HKMC is wholly-owned by the Exchange Fund, the implied backing of the government will enhance investor's confidence in MBS. Origins of Mortgage-Related Risks Securitization allow s banks to transfer credit risk to capital m arkets and focus on generating fees rather than interest incom e The role of insurance companies, like A.I.G., in providing credit enhancement or protection made asset values on bank balance sheets dependent, in part, on insurance company solvency. For this reason, regulators viewed the potential bankruptcy of A.I.G., which had a very large CDS portfolio, as posing a systemic risk. 9 “The best laid schem es of m ice and m en often go aw ry !” K ey M istakes O f M ice and M en* *John Steinbeck's 1936 novel - Of Mice and Men 10 I. Mortgage-Backed Bonds (MBBs) When issuing MBBs, the issuer establishes a pool of mortgages and issue bonds to investors. Issuer retains ownership of the mortgages, but they are pledged as security and are usually placed in trust with a third-party trustee Responsibility of the trustee is to make certain on behalf of the security owners that the provisions of the bond issue are complied with. A Mortgage-backed bond promises to bond investors a fixed stream coupon payment (interest payment) and repayment of face value at maturity. Cash Flows to MBBs Constant Cash Flows Stream to MBB Investors Prepayments Coupon Payments Periodic Mortgage Payments Amortized principal payments and interests Mortgage Pools MBBs MBB Investors Face Value Question Suppose Mortgage Bank wants to issue $1 billion mortgage-backed bonds (MBBs). How much mortgages are needed for issuing the $1 billion MBBs?? Size of Mortgage Pool > $1 billion of MBBs Features of Mortgage-Backed Bonds Overcollateralization In order to protect the MBB investors, the issuers place mortgages in the pool with outstanding loan balances in excess of the dollar amount of securities being issued. The mortgage collaterals pledged in excess of the par value of securities issued range between 125% to 240%. Why Overcollateralization? Some borrowers may default. Some borrowers may prepay early. Some borrowers may delay making payments. Features of MBS contd. Mark-to-Market Trustee regularly marks to market all mortgages in the pool. The market value of mortgages in the pool are maintained at the agreed upon level (say 125% to 240%). Whenever the market value of the pool falls below the agreed upon level, the issuer must replenish the pool with more mortgages of the same quality. Otherwise, the trustee will liquidate the pool. Market to market Mortgage Pool $20 million (Trustee) Mortg to MBBs ratio = 2x MBBs $10 million Cash flows are known. When interest rate increases, the market value of mortgages decline Size of mortgage pool < $20m How do we determine the value of MBBs? Need the market yield or required rate of return on MBBs Investment Rating will affect the market yield Trustee will require the mortgage bank to inject more mortgages of the same type and quality into the pool to bring the mortgage-MBBs ratio to 2x Features of MBS contd. Investment Rating MBBs are underwritten by investment banking companies (e.g. the prominent ones include First Boston Company, Solomon Brothers, and Goldman Sachs) and sold through underwriting syndicate. Independent bond rating agency such as Standard and Poor’s and Moody’s Corporation rate these MBBs based on: Quality (reflecting types of mortgages: residential, commercial, second mortgages and their loan-to-value ratios) Extent of geographic diversification Interest rates on mortgages in the pool Likelihood of prepayment before maturity Extent of over-collateralization Appraised value and debt coverage ratio in the case of commercial mortgages Features of MBS contd. P ricing M ortgage - Back ed Bonds An MBB promises investors the stream of cash flows to be received in the future. The cash flow stream consists of coupon payments (interest payments) and the repayment of the principal (face value) when the bond matures. Let B be the face value, r be the coupon rate which determines the coupon payments C (= r * B), and n be the number of periods to maturity. Then the cash flows to an MBB investor is as follows: Cont ract ual Cash Fl ow s Pri ce (P0) r t=0 • • • • 1 C r C r 2 C ..... C ...... r 3 ... n – 1 C+B n C = Coupon Payment B = Face value Po = Price bond today. n = Time to maturity Features of MBS contd. P ricing M ortgage - Backed Bonds The price of an MBB is just the present value of all future coupon payments and the principal at maturity. If the investors require a rate of return r, the price of the MBB is n 1 − (1 + r ) − n C B B + ⇒ P = C P=∑ + t n (1 + r ) (1 + r ) r (1 + r ) n t =1 What determines the coupon payment C ? Quality of the mortgage security in the trust Overcollateralization Creditworthiness of the issuer. What determines the market required rate of return r ? Riskiness of the Mortgage-Backed Bond (Credit Rating) Yields on other securities comparable to the MBB in the market. Features of MBS contd. Marking the Mortgage Portfolio to Market The quality of the mortgage pool has a direct impact on the market value of the MBB. In order to ensure that the market value of the pool is equal to the agreed upon level of collateralization, the trustee must regularly monitor and determine the market value of the pool. Features of MBS contd. P roblem s in Valuation of the P ool Many different interest rates on mortgages placed in the trust. Mortgages amortize principals. Borrowers may prepay early. Borrowers may default. The number of outstanding mortgages in the pool may decrease. The pricing technique involves : Determine the number and outstanding balance of each type of mortgage in the trust Determine the market yield on each type of mortgage based on the expected maturity n e instead of the contracted maturity n. Because of the promised stream of fixed coupon payments and principal repayment, MBBs issuers are responsible for the risk management of the underlying mortgage pool. Key Concept: How could MBS improve the profit margin of a bank? Consider a bank which is specialized in mortgage lending. Amount of deposits ($) loanable to mortgage borrowers = L Mortgage interest rate = 10% After the bank makes a mortgage loan, the bank will securitize the mortgage loan by issuing MBS: Interest Rate on MBS = 8% Overcollateralization required for MBS = 25% Because of the over-collateralization requirement (25%), the bank can only issue $80 MBS for every $100 mortgage loan made. How will securitization affect the profit margin of the bank? Key Concept: How could MBS improve the profit margin of a bank? Contd. Cash Flows Analysis Inflows from Mortgage Loans + (10%) L + (10%)(0.8L) + (10%)(0.8 L) + (10%)(0.8 L) : : 3 2 Time 1 2 3 4 : : Outflows to Mortgage-Backed Securities -8%(0.8L) -8%(0.8 L) -8%(0.8 L) -8%(0.8 L) : : 4 3 2 Profit Margin = Total Inflows – Total Outflows = ?? Key Concept: How could MBS improve the profit margin of a bank? Contd. Total inflows = = = = = = = = 0.1L + 0.1(0.8L) + 0.1(0.8 L) + 0.1(0.8 L) + … 2 3 4 0.1L (1 + 0.8 + 0.8 + 0.8 + 0.8 …. ) 0.1L [1/(1-0.8)] 0.5L 0.08(0.8L) + 0.08(0.8 L) + 0.08(0.8 L) + 0.08(0.8 L) + … 2 3 4 0.08(0.8L) (1 + 0.8 + 0.8 + 0.8 + 0.8 …. ) 0.08(0.8L) [1/(1-0.8)] 0.32L 2 3 4 2 3 Total Outflows Profit Margin with MBS = 0.5L – 0.32L = 0.18L Profit Margin without MBS = 0.1L only !!! II. Mortgage Pass-Through Securities The value of a mortgage-backed security highly depends on the characteristics of the underlying mortgage pools. Issuer: Mortgage Companies, Mortgage Corporation (HK), Banks, or Government-Related Agencies Date of first issue Guarantor against default on mortgages: Private Mortgage Insurance, Government or who else ?? Types of Mortgages in pool: FRM, GPM, GEM, ARM, Seconds, Construction Loan Mortgages, Government financed housing project loans (e.g. United States) etc. Interest rate on mortgages in underlying pools allowed to vary or not?? Second mortgages allowed in the pools or not?? Nature of payment guarantee: Timely payment of P & I and prepayments Guarantor: Government? Government-Related Agencies? Private Insurance Agencies?? Servicing fee (basis points): Dependent on range of interest rates in pooled mortgages, ranging from 25 – 44 basis points. Guarantee fee (basis points): e.g. 6 basis points for pass-throughs in the United States Cash Flows to MPTs Constant Cash Flows Stream to MPTs Investors Periodic Mortgage Payments Prepayments Coupon Payments Amortized principal payments and interests Mortgage Pools MPTs MPT Investors Face Value Prepayments Mortgage Pass-Through Payment Example: Assume a $1,000,000 of 10% fixed interest rate mortgages have been pooled as security for an issue of 100 pass-through securities. For simplicity, it is assumed that the mortgages have 5 years term to maturity. Pass-through will carry a coupon rate (pass through rate) of 9.5%. The servicing fee is the difference between the pooled mortgage rates and the coupon rate and is 0.5%. The dollar amount servicing fee is the rate of service fee multiplied by the outstanding balance. Example Contd 1 − (1 + 10%) −5 ⇒ PMT = 263797 100000 = PMT 0.1 Analysis Cash Flows from Mortgage Pass-Through Security 0% PSA Principal & Interest $263,797 $263,797 $263,797 $263,797 $263,797 Total PMT’s to Investor 258797 259616 260517 261508 262598 Payment to Individual Investor 2588 2596 2605 2615 2626 Year 0 1 2 3 4 5 Pool Balance 1000000 $836,203 $656,025 $457,830 $239,816 $0 PrePayment 0 0 0 0 0 Total Payments 263797 263797 263797 263797 263797 Service Fees 5000 4181 3280 2289 1199 Value of Cash Flow = 2588 2596 2605 2615 2626 + + + + ( 1 + r) 1 ( 1 + r) 2 ( 1 + r) 3 ( 1 + r) 4 ( 1 + r) 5 The amount of cash that the issuer receives at the time of securitization depends on the prevailing market interest rate, r, at the time the MPTs are being marketed. V alue of Cash Fl ow = 2588 2596 2605 2615 2626 + + + + (1 + r )1 (1 + r )2 (1 + r )3 (1 + r )4 (1 + r )5 Example Contd Graphical Presentation Value of Cash Flows $13,000 $12,000 $11,000 $10,000 $9,000 $8,000 11% 13% 15% Market Interest Rate 17% 1% 3% 5% 7% 9% Prepayment Assumptions for Mortgage Pass-Through Securities There are four commonly used methods used by issuers to incorporate prepayment assumptions in pricing securities: Average Maturity Constant Rates of Prepayment Reference Rates Federal Housing Administration Prepayment Experience PSA (Public Securities Association) Model Prepayment Assumptions for Mortgage Pass-Through Securities Average Maturity Assumes that the pool of mortgages will be paid off at the end of certain number of years called the average maturity (usually 12 years for a 30-year mortgage). The price of an MPT is then determined based on the average maturity instead of the contract maturity. An average prepayment rate is assumed for all mortgages in the pool. Simple to use. However, the 12-year rule lacks accuracy and fails to reflect the interest rate factor and the household characteristics that will affect prepayment behavior. Prepayment Assumptions for Mortgage Pass-Through Securities Constant Rates of Prepayment Assumes that a fixed proportion of the mortgages in the pool will be paid off every year. Again, it is simple to use. It fails to reflect the fact that prepayment due to default is more frequent in the early years of a mortgage. It tends to understate the prepayment rate in the early years and overstate in the later years. It fails to reflect the interest rate factor and the household characteristics that will affect prepayment behavior. Hong Kong Experience July 2002, Source: Hong Kong Mortgage Corporation Hong Kong Experience August 2004, Source: Hong Kong Mortgage Corporation Prepayment Assumptions for Mortgage Pass-Through Securities Reference Rates: FHA (Federal Housing Administration) Prepayment Experience The assumptions of prepayment are based data collected by the FHA on actual prepayment experience over several decades. The data base developed on mortgage terminations and prepayments is extensive enough to provide useful guidelines on prepayment assumptions. For faster or slower prepayment on pools of mortgages, the prepayment rates can be adjusted to be greater than 100% FHA or less than 100% FHA rate. Major problem of FHA is that the experience in the past may not be the same in the future. Prepayment Assumptions for Mortgage Pass-Through Securities Reference Rates: The PSA (Public Securities Association) Model Simplified version of the FHA data base. Although it suffers from the same problem as the FHA, it has become an industry standard for prepayment assumptions used in the pricing of most mortgagebacked securities. The current 100% PSA starts with 0.2% each month for the first year, increases at 0.2% each month until the 30th month, and then levels off at 0.5% each month. Example: MPTs with Prepayment Assume a $1,000,000 of 10% fixed interest rate mortgages have been pooled as security for an issue of 100 pass-through securities. Assume the mortgages have 5 years term to maturity. The pass-through will carry a coupon rate (pass through rate) of 9.5%. Servicing fee is the difference between the pooled mortgage rates and the coupon rate and is 0.5%. Dollar amount servicing fee is the rate of service fee multiplied by the outstanding balance. 100% PSA = 2%, 4%, 6%, 6%, 6% Example Contd. Results 1 − (1 + 10%) −5 ⇒ PMT = 263797 YR1 : 100000 = PMT 0.1 1 − (1 + 10%) −4 ⇒ PMT = 257488 YR2 : 816203 = PMT 0.1 Principal & Interest Total PMT’s to Investor Payment to Individual Investor 2788 2861 2778 2447 1969 Cash Flows from Mortgage Pass-Through Security 100% PSA: 2%, 4%, 6%, 6%, 6% Year 0 1 2 3 4 5 Pool Balance 1000000 $816,203 $607,687 $387,634 $179,788 $0 PrePayment 20000 32648 36461 23258 0 Total Payments 283797 290136 280821 246609 197767 Service Fees 5000 4081 3038 1938 899 $263,797 $257,488 $244,360 $223,351 $197,767 278797 286055 277783 244671 196868 Yr 1 Principal Distribution = 263,797 – 10%(1000000) + 20000 = 183,797 Yr 1 Pool Balance = 1000000 – 183,797 = 816,203 Yr 2 Principal Distribution = 257,488 – 10%(816,203) + 32648 = 208,515.7 Yr 2 Pool Balance = 816,203 – 208,515.7 = 607,687 E ffect of P repaym ent on the m arket p rice of an M P T 100% PSA, Normal Prepayment 0% PSA, No Prepayment (9.5%, $10,000) What’s the difference between the pricing of MBBs and MPTs ?? Effect of Prepayment on MPTs Value of MPT What can we say about the effect of prepayment on MPTs?? Prepayment ↑, Value of MPT approaches to Par Value Value of MPT is more sensitive to ∆R when R < R* Value of MPT is LESS sensitive to ∆R when R > R* PAR How to Price MPTs ?? 200% PSA 100% PSA 0% PSA MPT selling at premium, > PAR MPT selling at discount, < PAR Net Pass-Thru Rate, R* Market Yield %, R The Pricing of MPTs when R < R* Value of MPT When R < R*, borrowers who borrow at R* will refinance at the lower market interest rate R and hence prepayment increases from 0% PSA to 100%PSA or higher. ↑ Prepayment Value of MPT ↓ PAR 200% PSA 100% PSA 0% PSA Net Pass-Thru Rate, R* Market Yield %, R The Pricing of MPTs when R > R* Value of MPT When R > R*, borrowers who borrow at R* will NOT refinance at the higher market interest rate R and hence prepayment = 0% PSA. PAR 200% PSA 100% PSA 0% PSA Net Pass-Thru Rate, R* Market Yield %, R The Pricing of MPTs when R > R* The pricing function for MPTs has a kink !! When R < R*, we price MPTs along the lower function corresponding to PSA > 0%, say 200% PSA When R > R*, we price MPTs along the function corresponding to 0% PSA Value of MPT 200% PSA PAR 0% PSA Net Pass-Thru Rate, R* Market Yield %, R Pricing of MPTs versus MBBs Value of MPT 200% PSA PAR Note that the pricing function for MBBs is very close to that of 0% PSA. Why ?? For MPTs and MBBs with the same terms, the value of MPTs is generally less than that of MBBs when market interest rates fall. When market interest rate increases, value of MPTs is closer to MBBs. 0% PSA Net Pass-Thru Rate, R* Market Yield %, R Some Remarks about the Mortgage Backed Securities in Hong Kong before 96 1. 2. In August 1994, Cheung Kong and Citibank started to issue securitized mortgages for investment in Hong Kong. The major investors are institutional investors. Individual investors are relatively few at this point in time. Two characteristics of the local market that distinguish these mortgage-backed securities from those in the U.S. are: The mortgages in Hong Kong are mostly adjustable rate mortgages and therefore the risk of prepayment is less severe than that in the U.S. where a good percentage of the mortgages are fixed-rate. Default risk is still a major factor that will affect the value of the local MBS’s. The payment of cash flows from the mortgage-backed securities to the investors are not guaranteed or insured by the Hong Kong government. The issuers such as the developers may provide some guarantee on the payments. However when the local real estate market is declining in profitability, the guarantee made by the developers may become dubious as they themselves also experience shortage of cash. III. Mortgage Pay-Through Bonds (MPTBs) MPTBs can be viewed as a hybrid between MBBs and MPTs. The pools underlying the MPTBs are mainly residential mortgages. Like the MBBs, MPTBs are debt obligations of the issuer and the investors do not have any ownership interest in the underlying pool of mortgages. Like the MPTs, the cash flows from the pool will be passed through to the investors in the form of coupon payments and principals that ensue from normal amortization and prepayment of loans in the pool. Features of MPTBs Over-collateralization in the form of more mortgages and Government Securities Factors Underlying I nvestm ent Ratings on M P TBs: Riskiness of Mortgages in the Pool. Types of mortgages: residential, commercial, second mortgages and their loan-to-value ratios, Extent of geographic diversification Extent of overcollateralization Nature of Government-Related Securities constituting the excess collateral Interest rates on mortgages in the pool Likelihood of prepayment before maturity Appraised value and debt coverage ratio in the case of commercial mortgages Letters of credit and third-party guarantee or insurance are used by MPTB issuers to enhance their creditworthiness in order to improve their credit ratings. In the case of losses and severe defaults on the pool, the issuers are held liable for the promised cash flows to the security holders. Features of MBPTs Contd Mark-to-Market Since the amortization and prepayments are directly passed through to the security holders, the market value of the collateral is not as important as with the mortgage-backed bonds. There is generally no need to mark the collateral to the market or to provide for replenishment of collateral as long as the amount of overcollateralization is adequate. Furthermore, the pass-through of the principal imposes a less stringent requirement for overcollateralization as for MBBs. Features of MBPTs Contd Valuation With respect to MPTBs, contrary to MBBs, the issuer does not bear prepayment risk (borne by investors). The risks ensuing from prepayment patterns and reinvestment rates (market interest rates) that are so important for the valuation of MPTs are equally important for MPTBs. This uncertainty in cash flows from prepayments has induced the creation of another type of security which provides more protection against prepayment risk than MPTs and MPTBs, but less than that of an MBB. Collateralized mortgage obligation (CMO) I V. Collateralized M ortgage O bligations (CM Os) What is it? Consider a mortgage that provides a stream of payments as depicted below. P P P P P P P P | _____| _____| _____| _____| _____| _____| _____| _____| T he owner of this mor tgage can issue two classes of securities against the mor tgage wi th the following payment patterns: Class I : x x x | _____| _____| _____| _____| _____| _____| _____| _____| y y y y y | _____| _____| _____| _____| _____| _____| _____| _____| Class I I : P P P P P P P P |_____|_____|_____|_____|_____|_____|_____|_____| Class I: Class II: x x x |_____|_____|_____|_____|_____|_____|_____|_____| y y y y y |_____|_____|_____|_____|_____|_____|_____|_____| CMOs The payments x and y from the two classes of new securities are made from the mortgage payments P. In general x and y are less than P. If all that the CMOs did was to rearrange the cash flow stream, there would be no added value created by the CMO business. For the CMOs to be profitable to the issuer, two conditions must exist. Many investors rely on tools such as yield spread and average-life analysis. These tools are insufficient to analyze mortgage-backed securities and CMO bonds. Different investors have different cash flow needs and therefore are willing to pay a price for a package of cash flows that meets their specific needs. Investors more often than not misanalyze and hence misprice bonds. K now ledge is P ow er! Types of CMOs Example Four different classes of bonds with different maturities and coupon rates Over-collateral = $4 million Coupon rates offered for Class A-C = 9.5% < 10% Coupon rate offered for Class Z = 10.5% > 10% A spread created between “the rate of return from the pool” and the “weighted average rate of interest” promised to security holders-source of profit to the issuer as return on the equity used as collateral Fees may also be charged on credit enhancements, managing, and administering the mortgage pool. Example Contd: Types of CMOs Asset s: M or t gages: $104,000,000 30-year s, f i x ed r at e 10% Stated M aturi ty Cl ass A Bonds Cl ass B Bonds Cl ass C Bonds Cl ass Z Bonds E qui ty T otal Debt and Net Worth 5-9 9-14 12-17 28-30 Coupon Rate 9.00% 9.25% 9.75% 10.5% A mount I ssued $30,000,000 $30,000,000 $25,000,000 $15,000,000 $4,000,000 $104,000,000 M aj or I n v estor s: C l ass A: C om m er ci al B an k s, M on ey M ar k et F u n d s, Cor p or at i on s C l ass B an d C: I n su r an ce Com p an i es, Pen si on F u n d s, T r u st s, I n t er n at i on al I n v estor s C l ass Z: I n su r an ce Com p an i es, Pen si on F u n d s, T r u st s, I n t er n at i on al I n v estor s an d Agr essiv e L on g -t er m B on d s M u t u al F u n d s Example Contd. Cash Flows Tranches A, B, C, Z Mortgage Pool $104 million CMOs Bank CMOs Investors $100 m Residual Cash Flows to the Issuer’s Equity ($4 m) Example Contd. Cost vs Returns ??? Tranche A $30 m @ 9% Earn 10%, fixed for 30 yrs Mortgage Pool $104 m Tranche B $30m @ 9.25% Tranche C $25m @ 9.75% Tranche Z $15m @ 10.5% Weighted Average Coupon Rates = 30/100 * 9% + 30/100 * 9.25% + 25/100 * 9.75% + 15/100 * 10.5% = 9.4875% Structure of CMOs Tranches A, B, C, Z A B C Z Principal Interest Interest only Interest only A matures Principal Interest B matures Principal Interest C matures Principal Interest 0, interests withheld will be paid as principals to A, B, & C Mechanics Coupon rate of interest is not paid to all tranches at the same time. Interest is paid currently on Tranches A, B, and C, but not on tranche Z until principal on all other tranches is repaid. Interest on tranche Z will be accrued into an investment balance. All accrued interest to tranche Z will be allocated first to the security holders in tranche A in order to keep the maturity of tranche A short enough. All current amortization of principal and prepayments from the entire mortgage pool will also be allocated first to tranche A. Until the A tranche is repaid, the B and C tranches only receive interest payments. When A is paid up in principal, then all principal allocations will be made to B and so on. 0 1 2 3 4 5 6 Annual Cash Flow s into 7 C M O M ortgage Pool 8 ( $110,322) 9 10 (Prepaym ent = 0% PSA) 11 12 −30 13 1 − (1 + 10%) ⇒ PMT = 110322 14 1040000 = PMT 0.1 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Cash Flows Analysis Year Pr incipal M or tgage and I nter est i nto Pool Pool at 10% 0% PSA T otal A mor t izat ion E xcluding Pr epayment s I nter est A mount Owed to Secur ity H older s 1,040,000 1,033,678 1,026,723 1,019,073 1,010,658 1,001,401 991,219 980,018 967,698 954,145 939,237 922,838 904,800 884,957 863,130 839,121 812,711 783,659 751,703 716,551 677,884 635,349 588,562 537,096 480,483 418,209 349,707 274,356 191,469 100,293 0 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $110,322 $6,322 $6,955 $7,650 $8,415 $9,257 $10,182 $11,201 $12,321 $13,553 $14,908 $16,399 $18,039 $19,842 $21,827 $24,009 $26,410 $29,051 $31,956 $35,152 $38,667 $42,534 $46,787 $51,466 $56,613 $62,274 $68,502 $75,352 $82,887 $91,176 $100,293 104,000 103,368 102,672 101,907 101,066 100,140 99,122 98,002 96,770 95,414 93,924 92,284 90,480 88,496 86,313 83,912 81,271 78,366 75,170 71,655 67,788 63,535 58,856 53,710 48,048 41,821 34,971 27,436 19,147 10,029 1,000,000 993,678 986,723 979,073 970,658 961,401 951,219 940,018 927,698 914,145 899,237 882,838 864,800 844,957 823,130 799,121 772,711 743,659 711,703 676,551 637,884 595,349 548,562 497,096 440,483 378,209 309,707 234,356 151,469 60,293 - Cash Flow Analysis: Amount Owed at End of Period 150,000 165,750 183,154 202,385 223,635 247,117 273,064 301,736 333,418 368,427 407,112 449,859 497,094 549,289 606,964 670,696 741,119 743,659 711,703 676,551 637,884 595,349 548,562 497,096 440,483 378,209 309,707 234,356 151,469 60,293 - Tranche Z (Coupon Rate = 10.5%; Amount = $0.15 mill.) Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Accrued Interest $15,750 $17,404 $19,231 $21,250 $23,482 $25,947 $28,672 $31,682 $35,009 $38,685 $42,747 $47,235 $52,195 $57,675 $63,731 $70,423 $2,541 ($31,956) ($35,152) ($38,667) ($42,534) ($46,787) ($51,466) ($56,613) ($62,274) ($68,502) ($75,352) ($82,887) ($91,176) (60,293) Accumulate d Accrued Interest $15,750 $33,154 $52,385 $73,635 $97,117 $123,064 $151,736 $183,418 $218,427 $257,112 $299,859 $347,094 $399,289 $456,964 $520,696 $591,119 $593,659 $561,703 $526,551 $487,884 $445,349 $398,562 $347,096 $290,483 $228,209 $159,707 $84,356 $1,469 ($89,707) ($150,000) Principal Allocation $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 ($2,541) $31,956 $35,152 $38,667 $42,534 $46,787 $51,466 $56,613 $62,274 $68,502 $75,352 $82,887 $91,176 60,293 Interest Payments 77817 78084 74729 71038 66978 62512 57599 52195 46251 39712 32519 24607 15904 6331 Total Payments 75277 110041 109881 109705 109512 109299 109065 108808 108525 108213 107871 107494 107080 66624 Cash Flow Analysis: Amount Owed at End of Period 150,000 165,750 183,154 202,385 223,635 247,117 273,064 301,736 333,418 368,427 407,112 449,859 497,094 549,289 606,964 670,696 741,119 743,659 711,703 - Tranche Z (Coupon Rate = 10.5%; Amount = $0.15 mill.) Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 30 Accrued Interest $15,750 $17,404 $19,231 $21,250 $23,482 $25,947 $28,672 $31,682 $35,009 $38,685 $42,747 $47,235 $52,195 $57,675 $63,731 $70,423 $2,541 ($31,956) (60,293) Accumulate d Accrued Interest $15,750 $33,154 $52,385 $73,635 $97,117 $123,064 $151,736 $183,418 $218,427 $257,112 $299,859 $347,094 $399,289 $456,964 $520,696 $591,119 $593,659 $561,703 ($150,000) Principal Allocation $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 ($2,541) $31,956 60,293 Interest Payments 77817 78084 6331 Total Payments 75277 110041 66624 Yr Yr Yr Yr Yr Yr 1: accrued interest = 150,000*10.5% = 15,750 1: Am ount Ow ed = 150,000 + 15,750 = 165,750 9: M aturity of Tranche A 14: M aturity of Tranche B 17: M aturity of Tranche C 18 – 30: Tranche Z investors receive their paym ents Cash Flow Analysis: Tranche A(Coupon Rate = 9%; Amount = $0.3 mill) Amount Owed at Coupon Interest Year End of Period at 9% Total Payment 0 300,000 1 277,928 $22,072 27,000 49,072 2 253,569 $24,358 25,013 49,372 3 226,688 $26,881 22,821 49,702 4 197,022 $29,666 20,402 50,067 5 164,284 $32,738 17,732 50,470 6 128,154 $36,130 14,786 50,915 7 88,282 $39,872 11,534 51,406 8 44,279 $44,003 7,945 51,948 9 44,279 3,985 48,264 1: P rincipal Allocation from P ool = $6,322 1: I nterest Accrued from Z = 15,750 1: P rincipal Allocation = 6,322 + 15,750 = 22,072 8: P rincipal Allocation from P ool = $12,321 8: I nterest Accrued from Z = 31,682 8: P rincipal Allocation = 12,321+ 31,682 = 44,003 9: P rincipal Allocation from P ool = $13,553 9: I nterest Accrued from Z = 35,009 9: Left over P rincipal Allocation to Tranche B= 13,553 + 35,009 – 44,279 = $4,283 Principal Allocation from Pool and Z Class Yr Yr Yr Yr Yr Yr Yr Yr Yr Cash Flow Analysis: Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Tranche B (Coupon Rate = 9.25%; Amount = $0.3 mill) Amount Owed at End of Period 300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000 295,718 242,125 182,979 117,706 45,668 Principal Allocation from Pool and Z Class $0 $0 $0 $0 $0 $0 $0 $0 $4,282 $53,593 $59,145 $65,274 $72,037 45,668 Coupon Interest at 9.25%% 27,750 27,750 27,750 27,750 27,750 27,750 27,750 27,750 27,750 27,354 22,397 16,926 10,888 4,224 Total Payment 27,750 27,750 27,750 27,750 27,750 27,750 27,750 27,750 32,032 80,947 81,542 82,199 82,925 49,893 Yr Yr Yr Yr Yr Yr Yr Yr 1 - Y8: All cash flow allocations go to Tranche A first. 9: Left over principal allocation from Tranche A = $4,282 10: P rincipal Allocation from P ool = $14,908 10: I nterest Accrued from Z = 38,685 10: P rincipal Allocation = 14,908+ 38,685 = 53,593 14: P rincipal Allocation from P ool = $21,827 14: I nterest Accrued from Z = 57,675 14: Left over P rincipal Allocation to Tranche C= 21,827+57,675 – 45,668 = $33,834 Cash Flow Analysis: Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Tranche C (Coupon Rate = 9.75%; Amount = $0.25 mill) Amount Owed at End of Period 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 216,166 128,426 31,592 Principal Allocation from Pool and Z Class $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 33,834 87,741 96,833 31,592 Coupon Interest at 9.75% 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 21,076 12,521 3,080 Total Payment 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 24,375 58,209 108,817 109,355 34,672 Yr 1 - Y8: All cash flow allocations go to Tranche A and Tranche B first. Yr 14: Left over principal allocation from Tranche B = $33,834 Yr 17: Principal Allocation from Pool = $29,051 Yr 17: I nterest Accrued from Z = 2,541 so that principal allocation equal to a m ount ow ed Cash Flow Analysis: Amount Owed at End of Period 150,000 741,119 743,659 711,703 676,551 637,884 595,349 548,562 497,096 440,483 378,209 309,707 234,356 151,469 60,293 - Tranche Z (Coupon Rate = 10.5%; Amount = $0.15 mill.) Year 0 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Accrued Interest Accumulate d Accrued Interest Principal Allocation Interest Payments Total Payments $70,423 $2,541 ($31,956) ($35,152) ($38,667) ($42,534) ($46,787) ($51,466) ($56,613) ($62,274) ($68,502) ($75,352) ($82,887) ($91,176) (60,293) $591,119 $593,659 $561,703 $526,551 $487,884 $445,349 $398,562 $347,096 $290,483 $228,209 $159,707 $84,356 $1,469 ($89,707) ($150,000) $0 ($2,541) $31,956 $35,152 $38,667 $42,534 $46,787 $51,466 $56,613 $62,274 $68,502 $75,352 $82,887 $91,176 60,293 77817 78084 74729 71038 66978 62512 57599 52195 46251 39712 32519 24607 15904 6331 75277 110041 109881 109705 109512 109299 109065 108808 108525 108213 107871 107494 107080 66624 Yr Yr Yr Yr Yr Yr 1 - Yr 16: All cash flow allocations go to Tranches A, B and C first. 17: Total P aym ents = 77817 – 2541 = 75277 17: Am ount ow ed = 741,119 + 2,541 = $743,659 18: I nterest P aym ent = $743,659 * 10.5% = $78,084 18: P rincipal Allocation from P ool = $31,956 18: Total paym ent = 78,084 + 31,956 = $ 110,041 Cash Flow Analysis: R esidual C ash Flow s t o I ssuer E x am ple: Yr 5: P aym ent to A = $ 50,470 P aym ent to B = $ 27,750 P aym ent to C = $ 24,375 P aym ent to Z = $0 R esidual CF = 1 10322 – 50470 27750 - 24375 - 0 = $ 7,727 Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Total Cash Flows into Pool 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 110322 Total Payments to Tranches A, B, C, and Z 101,197 101,497 101,827 102,192 102,595 103,040 103,531 104,073 104,672 105,322 105,917 106,574 107,300 108,101 108,817 109,355 109,949 110,041 109,881 109,705 109,512 109,299 109,065 108,808 108,525 108,213 107,871 107,494 107,080 66,624 Residual Cash Flows to Equity Class -400,000 9,125 8,826 8,495 8,130 7,727 7,282 6,791 6,249 5,651 5,001 4,405 3,748 3,022 2,221 1,506 968 373 282 441 617 811 1,023 1,257 1,515 1,798 2,109 2,451 2,828 3,243 43,699 End Mortgage-Backed Securities ...
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This note was uploaded on 09/06/2010 for the course FINA FINA0805 taught by Professor Tse during the Spring '09 term at HKU.

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