It makes moving to another location less difficult. It also gives the chance to refinance. Credit Risk.
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Like any debt instrument, mortgages involve credit risk. Credit risk arises from uncertainty over whether the borrower will perform as required to fulfill interest and principal payments. Mortgage insurance is provided by several federal government programs as well as by private mortgage insurance companies. It insures mortgages of low- and moderate-income families to promote ownership for those people. The FHA insurance covers the whole amount of the loan, but there is a limit to what the size of the loan could be. It can pay the lender the insured amount and let the lender take the title of the house.
The FHA can also reimburse the lender for the entire loan amount and take the title of the house. These are called conventional mortgages. Such insurance can be obtained from a mortgage insurance company MIC. The MIC industry was created in s but collapsed in the s. It gained popularity again in the s. Recently, private insurers have been accused of abuses such as repeated sale of PMI insurance policies to borrowers with enough equity to not require mortgage insurance.
This is taken from the gross yield on the loan so it is netted to the investor. These corporations are able reduce their risk of mortgage default by diversifying their large portfolios across the nation. Therefore the credit risk of mortgage-backed securities issued by Fannie Mae and Freddie Mac reflects the credit rating of those corporations. Pass-through programs.
Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securi…
Ginnie Mae. These programs are backed by the full faith and credit of the US government. Therefore, they have virtually the same risk as US treasury securities except for the prepayment risk. Ginnie Mae I has the lowest servicing spread with 6 basis points for guarantee fee and 44 basis points for servicing fees. The majority of Ginnie Mae pass-throughs are issued under Ginnie Mae I, where the securities are backed by single-family fixed-rate or year mortgages and one-year adjustable rate mortgages.
Freddie Mac offers a pass-through program that offers full and timely payment of interest and principal. Like Freddie Mac notes and bonds, these pass-throughs are not guaranteed by the full faith and credit of the US government. However, some market participants view them as similar in credit worthiness to Ginnie Mae pass-throughs. Freddie Mac charges guarantee fee under 25 basis points and a servicing fee between basis points .
Freddie Mac has implemented a contract feature that adjusts the guarantee fee up or down relative to the current level of security price spreads. Fannie Mae. Fannie Mae offers a pass-through program which, like Fannie Mae notes and bonds, is not backed by the full faith and credit of the US government.
Pass-through securities became a popular instrument by the early s, but they held some major drawbacks to investors. The first and most important was that pass-throughs did not offer complete certainty of cash flow. Depending on the actual prepayment from borrowers, investors might end up with a security with different maturity than expected. Furthermore, pass-throughs did not fully address the different needs of investors for instruments with various maturities. While pension funds and life insurance companies looked for securities with long maturity, banks and thrifts wanted to invest in shorter term instruments.
As an answer to those drawbacks and the demands of different types of investors, Collateralized Mortgage Obligations CMOs were created. CMOs provided less uncertainty as to the average life of the investment, and they offered a full spectrum of maturities that appeal to investors with different perspectives.
First issued by Freddie Mac in , CMOs are in essence multiclass securities backed by a pool of pass-throughs or by mortgage loans. The mortgage cash flows are distributed to investors by the MBS issuer based on a set of predetermined rules. Some investors will receive their principal payments before others according to the schedule. The issuer structures the security in classes, called tranches , which are retired sequentially. With the payments from the underlying mortgages, the CMO issuer first pays the coupon rate of interest to the all investors in each tranche.
An Introduction to Asset-Backed Bonds and Securitisation
After that, all the principal payments are directed first to the bond class with the shortest maturity. When the first bond class is retired, the principal payments are directed to the bond class with the next shortest maturity. This process continues until all the tranches are paid fully and if there is any collateral remaining, the residual may be traded as a separate security. In the figure below class A is the class with the shortest maturity. After class A is retired, principal payments go to class B.
The last class D has the longest maturity. This bond is usually the last tranche in a CMO deal, and it does not receive any interest until its principal payment starts. However, interest is accrued and added to the principal balance. Z-bonds help stabilize the cash flow of earlier classes, because the interest that should have been paid to the Z-bond is used to pay the other tranches. The PAC is structured so that investors receive a predetermined principal cash flow under a range of possible prepayment scenarios using a mechanism similar to a sinking fund.
The investor will receive a fixed amount of principal no matter whether the prepayment rate increases or decreases, as long as it stays within the specified range, which is usually called prepayment band or PAC band. However, the additional stability of the PAC bonds is achieved by creating a less stable support bond also known as companion bond or non-PAC bond. The companion bond absorbs prepayments when prepayments are higher than expected, and it defers principal payments when prepayments are slower than expected.
Because the average life variability is higher for companion bonds, they usually pay a higher yield. TAC bonds provide call protection only if prepayment speed increases from the projected, while reverse TAC bonds give protection only against slowdown of prepayments. Floating-rate bonds. This type of instrument is usually attractive to European and Japanese institutional investors and US commercial banks.
The floater and the inverse floater combined give the return of a fixed-rate instrument. Inverse floaters are attractive instruments for the purpose of hedging against interest rate risk. Stripped MBSs, first issued in , are created by dividing the cash flows from the underlying mortgages or mortgage securities into two or more new securities. Each stripped security receives a percentage of the underlying security principal or interest payments. Stripped securities can be partially stripped, meaning that each investor receives some combination of principal and interest payments, or completely stripped.
Strips can also be structured to be an Interest-Only IO , which receives only interest from the underlying securities, and Principal-Only PO , which gets only the principal payments without any interest. Both IOs an POs show substantial price volatility in an environment of changing mortgage rates. Principal-Only PO securities are traded at a substantial discount to par value. The return from the PO strip depends on the prepayment rate. Higher prepayment rate would mean higher return, since the investor purchased the PO at a discount and gets back the face value faster.
In an environment where mortgage rates decline, we expect to see faster prepayment rate, which will cause the PO price to increase. Conversely, if mortgage rates rise, the price of PO will fall. The Interest-Only IO securities are structured so that investors receive only interest on the amount of outstanding principal. Therefore, the return on IOs is inversely related to the speed of prepayments. SlideShare Explore Search You. Submit Search.
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