Foundations of the Fixed Income Market:Securitization of Assets

Chris CreedNovember 2003

Fixed Income - Introduction• This business can be thought of as having 2 major components:

- Interest Rate Products- Credit-Sensitive Products

• Which breaks down into two questions:

- “What is the probability that I will get my investment back?- “How much should I get compensated for loaning my money out for that time-frame?”

Fixed Income Basics - Rates

• Basically: Time Value of Money

• What two questions should you be asking?(how do I calculate D and CF)

i

ii CFDPV

Fixed Income Basics - Rates

• What are the discount factors and how do I calculate them?

• How do I figure out the relative value between two different types of bonds?

• What is the benchmark for me to compare other bonds to? Why do I need a benchmark?

Yield of a Bond

• Price = • If you know the price and you solve for y, you

will get the “interest rate” required to solve the above equation.

• How will this enable us to compare two different bonds?

nn

y

CF

y

CF

y

CF

)1(...

)1()1( 22

11

“Minimum Yield” – Treasuries• “Foundation of Fixed Income” – provides a risk-free benchmark

• Why?

– Credit-Free yields of different maturities

– Liquid Hedging instrument

Yie ld Curve

0

1

2

3

4

5

6

0 5 10 15 20 25 30 35

Benchmark Treasury Note

Yie

ld

Series1

2 – 2.044323 – 2.492255 – 3.4638410 – 4.4624630 – 5.27545

Comparing Bonds vs. US Treasuries

• If a 5-year bullet bond issued by CitiGroup traded at a yield of 3.9825% what could we say about that? Is that cheap? What do we need to know first?

• What is the risk-free rate of a 5year bond? (5yr UST = 3.470).

• So – now what can we say?

“Spread Products”• Many Fixed Income Products are quoted as

a spread in yield above the treasury curve.• e.g. A Corporate bond with a spread of

220bps with a maturity of 11/15/08 would have a yield of what?– 5-year yield = 3.4700– 3.4700+2.20 = 5.6700%

• What is the problem w/ the UST Curve?

Interest Rate (Vanilla) Swaps

Bank Customer

• Bank Pays the Customer a fixed rate (4.895%)

• Bank receives from the Customer a floating rate (3mo Libor)

• Why is this exactly the same as the bank selling a bond to the customer?

• What if I found the rate at which the bank is indifferent to paying fixed or receiving fixed?

•What if I found that rate for multiple maturities?

Interest Rate Swaps

• (Refer to Professor Palacios’ Lecture Note number 13 for an in-depth discussion).

USD Swap Curve

0

1

2

3

4

5

6

0 10 20 30 40 50 60

M aturity

Yie

ld Series1

2 2.39682

3 3.03225

4 3.51554

5 3.89634

6 4.18596

7 4.41579

8 4.60301

9 4.76154

10 4.89496

11 5.01036

12 5.10996

13 5.19846

14 5.27406

15 5.33821

20 5.53146

25 5.5843

30 5.59545

35 5.60195

40 5.60045

45 5.59045

50 5.58045 Source: GS Nov 10th 3pm Closes

Interest Rate Swaps (cont.)

• Swaps are also very liquid – and an effective form of hedging spread product. Why?

• Many Spread Products can be quoted in spread above the USD Swap curve in addition to the US Treasury Curve.

• In fact, our CitiGroup 5 year bond example really was quoted as Swaps + 8bps

• Should Corporate Debt ever trade tighter than Swaps+0? Tighter than Treasuries+0?

Introduction to Asset Securitization

• “What is a Mortgage”

• Mortgages as a Fixed Income investment

• What else can you securitize?

Tradable Fixed Income Supply

U.S. Dollar Denominated Debt Market

Mortgages43%

ABS2% Sov/Supers

2%

Corporates13%

US Agency15%

US Treasuries25%

(2002 Information)

What is a Mortgage?

• Simply: Mortgages are the loan that homeowners borrow from banks to purchase their homes

• The homeowner pays a monthly amount that consists of both Principal and Interest.

• The borrower pledges the underlying land as collateral for the loan

• If the borrower fails to make re-payment, the mortgage gives the lender the right of foreclosure on the loan and therefore can seize the property

• This can be viewed as an investment by the banks in the mortgage market – they are purchasing an asset that pays a monthly amount of Principal and Interest (P&I)

• The banks often sell these assets to other investors to raise capital

Home Owner Lending Institution

MortgageFunds =

What are Mortgage Backed “Pass-Through” Securities?

• A number of similar mortgages (underlying collateral, design, rates and maturities) are combined into a single group

• Mortgage documents associated with this group are delivered to a custodian and are assigned an identification (pool) number

• A Mortgage Backed Security (MBS) is issued with a face amount equal to the cumulative outstanding principal balance of the mortgages (original balance)

• The mortgages that have been pooled together serve as the collateral for the security

• Most MBS are guaranteed and/or issued by a U.S. Government Agency (FNMA, Freddie Mac or GNMA)

+ + = SecuritizedMortgage Pool

or Pass-throughs

SecuritizedMortgage Pool

or Pass-throughs

Agency Conforming MBS Origination Process

(next page)

Pooled by Mortgage Banks

Individual Mortgages Average Balance $125,000

Gross WAC: 8.50%

Judged for Sale by Balance (2000 cap of $275,000),

Documentation and Pay Histories

Mortgage Banking (Sells - Buys) Trading Desk

CMO Desk

E.G.: $500 FNMA issue

PO 6.5 yr

S Inverse Floater $10mm 6.5 yr

PA $250mm

5 yr

PB $50mm 10 yr

STRUCTURING CMOs REMICs

END PURCHASERS

Non-Conforming Conforminggg

Banks & Mortgage Servicers

TRADING

8.50% -.44 %

-.06 % 8.00%

(servicing fee) (guarantee fee)

8.50% -.25 %

-.25 % 8.00%

FNMA/FHLMC

FNMA or FHLMC 30 Yr.

GNMA BOUGHT BY AGENCIES

FHA/VA

P2 $100mm

4 yr

F Floater $40mm 6.5 yr

Z $50mm 20 yr

Agencies ~ 20%

Insurance Companies &

Regional Desks ~ 20% ~ 40-50%

Residential loans originated within the conforming Agency guidelines are guaranteed by an Agency, sold to the Street then either traded in pass-through form or used to structure a CMO…

Non-Conforming MBS Origination Process

(previouspage)

Pooled by M ortgage Banks

Ind iv idua l M ortgages

A verage B a lance $125 ,000

G ross W A C : 8 .50%

Judged fo r S a le by B a lance(2000 cap o f $275 ,000),

D ocum en ta tion and P ay H is to riesNon-Conforming

Either W hole Loans

G eograph ica l loca tions , z ip code , p roperty type ,pay h is to ry, o rig ina l and cu rren t LTV ,occupancy, pu rpose , insu rance

Ability to Pay W illingness to Pay Value of Asset

- Incom e verification- Asset verification- F inancial ratios (F ICO s)

- Tape data- Current 12 m onth pay

history- 30,60,90, 120+ day

delinquencies- Age

- B P O- A ppra isa l- G eography- Z ip C ode

D e t e r m i n e d B y:

LoanC harac te ris ticsR eview ed :

Or Senior/Subordinate96%

Aaa

4%

SubordinatedT ranche

Tranche by C redit

A A 15% 13.1 yrA 15% 13.5 yrB B B 12% 13.8 yrB B 19% 14.2 yrB 12% 15 yrU R 27% 16 yr

Tranche by T im e

$50 m m 6 yr$30 m m 12 yr

Conforming

Credit Underw riters G SM C Custodian

Loans that do not conform to Agency standards are sold in “whole loan” form or structured into a senior/subordinate private label CMO…

Who Buys Mortgages?

Mortgage Security Holdings by Investor Type in 2002…

Amounts in $US billions

Banks and Agencies drive investment flows in the mortgage market, holding nearly 60% of all MBS

19

Overview of the U.S. Mortgage Securities Market

• Largest Sector of the U.S. Debt Market:– Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion as

compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate bonds.

– Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure to the U.S. Government securities. The U.S. investment grade corporate debt market is less than 1.5 trillion in size.

• MBS can enhance portfolio performance significantly– Major mortgages indices have outperformed comparable duration U.S. Treasuries by an

average of more than 140 bp over the past 10 years.

– The U.S. mortgage market consists of a wide array of securities to suit most investor needs. A full range of credit qualities, durations, risk profiles and yields exist in this market.

• High Credit Quality– Most of the MBS market is issued by U.S. Government agencies which have an implied AAA

rating: GNMA issues carry full faith and credit of the U.S. Government, Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government.

– Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower rated securities (down to single-B) are also available.

Why Invest in Mortgages?

• Yield and no credit concerns

• Yield …

• Yield …

• Yield …

• Yield …

What’s the catch?

• You are purchasing a product with an imbedded call option– Duration is very hard to determine.– Variability in Average Life can be substantial

• You are purchasing an amortizing product– Reinvestment of Principal monthly can reduce

yield.

"Duration" Deserves Special Focus in Mortgages...

• Modified duration, Macaulay duration, cashflow duration: all measure a mortgage's price sensitivity to rate movements, assuming the cashflows are held constant.– Usually not a good assumption in mortgage product owing to prepayments– Durations often quoted as a percentage of modified duration

• Option-adjusted duration (OAD), model duration: measure price sensitivity for small rate movements, assuming constant OAS– Doesn't account for how securities actually trade– Reliant on prepayment model

• Empirical duration, EOAD: regression of performance vs rates– can be price or OAS vs rates– adjusted for volatility, slope of the curve

23

Prepayment Risk• Prepayment Option

– Any payments by borrower made in excess of scheduled principal payments are called prepayments

– The option is defined by the borrower's right to prepay all or part of the mortgage at any given time

– The uncertainty for the mortgage holder which results is termed prepayment risk

• Prepayment Motivation– Prepayment may occur for one of several reasons

• sale of property

• default

• refinancing

– Motivations beyond rational economic considerations play an important roll in assessing prepayment risk

• Risk for Mortgage Holder– Interest rate risk (re-investment risk): Should mortgage be fixed-rate, market

risk arises as a result of prepayment if rates fall and coupons are above market

– Liquidity risk: Should mortgage portfolio be securitized for debt issuance, prepayment implies the need to raise new financing

Duration and Convexity

• Duration (simply):

• Convexity is the change in Duration as yields change

yield

price

2 3 4 5 6 7 80

5

10

15

20

25

30

35

40

Yield (%)

gain from

convexity

(negative)

2 3 4 5 6 7 85

10

15

20

25

30

35

40

45

Yield (%)

gain from

convexity

Price PricePositive Convexity Negative Convexity

Options and Convexity

• If you are long a call option – are you long gamma or short gamma?

• Why is being long an MBS similar to being short a call option? Who are you short this option to?

• Can you hedge this with options?

Non-Mortgage Asset-Securitization

• Commercial Mortgage Products (multi-family houses, office buildings, shopping malls, golf courses…)

• Traditional ABS: Credit Card Receivables, Home Equity Credit, Student Loans, Automobile Leases/Loans,…

• Television Syndication Rights, Power Utility Rentals, Revenue from Oil Drillings; Revenue from Bars….

• If it pays a fairly predictable payment over time, and if you can tell a story, if you can solve the credit problem… you can securitize it!