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MRMM-7-basics-of-residential-mortgage-backed-securities.html
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<title>Market Risk Measurement and Management | Chapter 7 | Basics of Residential Mortgage Backed Securities</title>
<meta name="description" content="Financial Risk Manager Part 2 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<section>
<h1>Chapter 7</h1>
<h3>Basics of Residential Mortgage Backed Securities</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<section>
<h2>Securitization</h2>
<p><em>Definition: A process through which financial institutions pool similar assets in a portfolio and sell the portfolio to investors</em></p>
<img src="images/MRMM7/securitization-process.png" alt="diagram of the securitization process" />
<aside class="notes">
A securitization process occurs when several institutions get together, create a special purpose vehicle (SPV) containing a pool similar assets, and then sell the portfolio to investors
</aside>
</section>
<section>
<h2>Main Players in the RMBS Market</h2>
<ul>
<li>Ginnie Mae</li>
<li>Fannie Mae</li>
<li>Freddie Mac</li>
<li>Private Labels</li>
</ul>
<aside class="notes">
Agency MBS are those backed by government agencies. Ginnie Mae's main function is to guarantee RMBS backed by loans made through the Federal Housing Administration (FHA) and other federal programs. Fannie Mae provides guarantees on loans securitized through it and also holds a mortage portfolio that it finances by issuing debt. Freddie Mac operates in a similar manner as Fannie Mae. Non-agency or private label RMBS are not subject to the constraints of agency-backed securities (i.e. principal below a given cutoff, loan-to-value ratios less than 80%, etc.).
</aside>
</section>
</section>
<section>
<h2>Mortgages and the Prepayment Option</h2>
<ul>
<li>Coupon payments comprise both interest and principal</li>
<li>Mortgages often refinance in low interest rate environments</li>
<li>Prepayment factors:</li>
<ol>
<li>Seasonality</li>
<li>Age of mortgage pool</li>
<li>Family circumstances</li>
<li>Housing prices</li>
<li>Burnout effect</li>
</ol>
</ul>
<aside class="notes">
The portion of a coupon rate that is attributable to interest declines over time. This is because the outstanding principal on which the interest is based declines over time as it is paid down. The possibility that a mortgage will be refinanced in a low interest rate environment is referred to as prepayment risk since the investor may not be able to redeploy that capital in an equally attractive investment opportunity.
</aside>
</section>
<section>
<h2>Valuing Mortgage Backed Securities</h2>
<ul>
<li>Weighted average maturity (WAM)</li>
<li>Weighted average coupon (WAC)</li>
<li>Prepayment speed</li>
<ul>
<li>Constant maturity mortality</li>
<li>PSA experience</li>
</ul>
</ul>
<aside class="notes">
In practice, prepayment speed is often proxied by some average prepayment rate, such as a constant maturity mortality (which assumes there is constant probability of prepayment over the life of the security) or the PSA experience (an industry bechmark/convention that expresses a current belief about the prepayment speed).
</aside>
</section>
<section>
<h2>Pass-Through Securities</h2>
<p><em>Definition: A simple MBS representing a claim to a fraction of the total cash flow from the pool</em></p>
<ul>
<li>Declining interest rates encourage refinancing activity and increases the conditional prepayment rate, thus:</li>
<ul>
<li>Effective duration is lower than would otherwise be expected</li>
<li>Effective convexity is negative</li>
</ul>
</ul>
<aside class="notes">
Effective duration = (-1/P)(P<sub>UP</sub>-P<sub>DOWN</sub>)/(2×Δbps). Effective convexity = (1/P)(P<sub>UP</sub>+P<sub>DOWN</sub>-2×P)/(Δbps<sup>2</sup>)
</aside>
</section>
<section>
<h2>Collateralized Mortgage Obligations</h2>
<p><em>Definition: Securities with structures that are more complex than pass-through securities</em></p>
<ul>
<li>Offers different levels of exposure to prepayment risk</li>
<li>Common structures:</li>
<ul>
<li>CMO sequential structure</li>
<li>CMO planned amortization class (PAC)</li>
<li>Interest only (IO) and principal only (PO) stripes</li>
</ul>
</ul>
<aside class="notes">
In a sequential structure, the principal is divided into tranches which receive cash flows according to (1) a fixed coupon rate in proportion to the tranche principal and (2) sequentially, all principal payments, up to the point at which the tranche is paid out. In a PAC structure, the various tranches receive prepayments according to a prespecified PSA schedule. Any differences in realized prepayments are absorbed by a Companion tranche, until such time as it is fully paid out. IO strips receive all of the interst payment from the underlying collateral and none from the principal. PO strips receive all of the principal payments, both scheduled and unscheduled, from the underlying collateral and no interest.
</aside>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
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