Guide To Mortgage- New York Backed Securities
See the Disclosure Appendix for the AnalystCertification and Other Disclosures.U N I T E DF I X E DS T A T E SNOVEMBER 3, 2004I N C O M ER E S E A R C HMortgage SecuritiesUNITED STATESLakhbir S. Hayre(212) 816-8327lakhbir.s.hayre@citigroup.comNew YorkRobert Young(212) 816-8332robert.a.young@citigroup.comNew YorkThis report can be accessedelectronically via: FI DirectYield BookE-MailPlease contact your salespersonto receive fixed-income researchelectronically.Guide to MortgageBacked Securities
See the Disclosure Appendix for the AnalystCertification and Other Disclosures.U N I T E DF I X E DS T A T E SNOVEMBER 3, 2004I N C O M ER E S E A R C HMortgage SecuritiesUNITED STATESLakhbir S. Hayre(212) 816-8327lakhbir.s.hayre@citigroup.comNew YorkRobert Young(212) 816-8332robert.a.young@citigroup.comNew YorkThis report can be accessedelectronically via: FI DirectYield BookE-MailPlease contact yoursalesperson to receive fixedincome research electronically.Guide to MortgageBacked Securities
November 3, 2004Guide to Mortgage-Backed SecuritiesContentsI. IntroductionWhy Mortgage Securities?.Outline of Paper .678II. Agency Pass-Through SecuritiesTerminology .Types of Agency Pass-Through Collateral .Types of Pass-Through Trading.An Agency Pass-Through Trade .Multifamily Pass-Through Programs.91013151720III. Basics of Mortgage Security AnalysisMeasuring Prepayments.The Effect of Prepayments on MBS Cash Flows .A Brief Primer on Prepayment Analysis and Modeling .Yield, Average Life, and Nominal Spreads .2222232428IV. Option-Adjusted Analysis of Mortgage SecuritiesThe Z-Spread .Option-Adjusted Spread .Interest Rate Volatility and Calculation of OAS .Option Costs and Interpretation of OAS.Effective Duration.Convexity .30303132333536V. Mortgage Securities Lending39Repurchase Transactions . 39Dollar Rolls. 424VI. Structured Mortgage SecuritiesDevelopment of the CMO Market.A CMO Trade .CMO Bond Types .Stripped Mortgage-Backed Securities .4545474952VII. The Nonagency MarketCash Flow Structure of Nonagency Mortgage Securities .Types of Nonconforming Residential Mortgages.Commercial Mortgage-Backed Securities .55555659Appendix A. Resources for MBS and ABS Investors61Appendix B. Glossary of Common Terms64Appendix C. Standard Agency Definitions of CMO Bond Types70Appendix D. Settlement Dates71Appendix E. Mortgage Mathematics73Appendix F. Clearance and Settlement in the Back Office77Appendix G. Risk-Based Capital Standards80Citigroup Global Markets
Guide to Mortgage-Backed SecuritiesNovember 3, 2004AcknowledgmentsThis is the third edition of the Guide to Mortgage-Backed Securities, originally published in1995. For this updated version, sections on MBS trade mechanics, mortgage securities lending,and a number of useful appendices have been added. We thank Ana DiStefano for her careful andpatient preparation of this paper and Peg Pisani for her fine editing of all three editions. We alsothank Darrell Wheeler, Ivan Gjaja, and Gaurav Bansal for their helpful comments. Last, butcertainly not least, we thank Ben Hebert for his extensive help in updating this paper.Citigroup Global Markets5
November 3, 2004Guide to Mortgage-Backed SecuritiesI. IntroductionThe mortgage-backed securities (MBSs) market has experienced phenomenal growthover the past 25 years. The total outstanding volume of MBSs has increased fromabout 100 billion in 1980 to more than 4.2 trillion, and as Figure 1 shows, MBSsform a major component of the US bond market.Figure 1. Size of Various Sectors of the US Debt Market in 2004a (Dollars in Trillions)Single-Family (1–4) Mortgage DebtMortgage-Backed SecuritiesAsset-Backed SecuritiesUS TreasuriesCorporate BondsAgency Debt 7.64.21.83.84.62.7a As of the end of second quarter 2004.Sources: Inside MBS & ABS, Bond Market Association.What accounts for the explosive growth of the MBS market? Increased securitizationof mortgages and ready acceptance of MBSs by fixed-income investors are both keyreasons. Mortgage originators became much more disposed to sell loans into thesecondary market after the high-interest-rate environment of the late 1970s and early1980s, when the disadvantages of holding fixed-rate long-term loans in theirportfolios became apparent. The growing market share of originations by mortgagebankers, who have little interest in holding onto mortgage loans, also has contributedto the increasing securitization of mortgages. In addition, many institutions haveincreasingly come to view securitization as a means of turning illiquid assets intoliquid securities and, hence, a tool for efficient balance sheet management.The federal government has played an equally important role. Three agencies,Ginnie Mae (the Government National Mortgage Association), Fannie Mae (theFederal National Mortgage Association), and Freddie Mac (the Federal Home LoanMortgage Corporation) are major players in the secondary mortgage market in1issuing and guaranteeing MBSs. These federal housing finance agencies werecreated to facilitate the flow of mortgage capital and, hence, to ensure that lendershave adequate funds to make new mortgage loans. The three agencies are generallycredited with significantly reducing the cost of mortgage borrowing for Americanhomebuyers, as well making mortgages more widely available.On the demand side, MBSs have come to represent a significant portion of fixedincome holdings for many types of investors over the past decade. Figure 2 shows abreakdown of holdings of MBSs by investor type.1Although all three entities are commonly referred to as agencies, only Ginnie Mae is now a true agency. Fannie Mae, which thegovernment established in 1938, and Freddie Mac, which Congress created in 1970, are now private entities, although both havestrong ties to the government. The market convention is to refer to all three as agencies (although government-sponsored enterprises(GSEs) is becoming a more common term for Fannie Mae, Freddie Mac, and other such entities), and we follow this convention.6Citigroup Global Markets
November 3, 2004Guide to Mortgage-Backed SecuritiesFigure 2. Mortgage-Backed Securities — Holdings by Investor Type, as of Year-End 2003 (Dollars in Billions) 1,40029.3% 1,200 1,000 80018.4% 60010.1% 4008.8%7.0%4.9% 2006.7%5.3%3.2%0.7%2.4%0.8%1.8%0.7% 0BanksLifePension Savings and Foreign PrivateInsurance FundsLoans Investors InvestorsCompaniesMutualFundsFederal FHL Banks FN/FH MBS Dealers REITsCreditPortfolioUnionsOth. (incl. FinanceHedge CompaniesFunds)Note: Numbers shown at the top of the bars are holdings as a percentage of total outstanding MBSs.Source: Inside MBS & ABS.Why Mortgage Securities?As Figure 2 indicates, MBSs are now core investments for most institutionalinvestors, for a number of reasons: Higher returns. MBSs typically yield 100bp or more over Treasuries and offerhigher yields than comparable-quality corporate bonds. Although some of thishigher yield compensates for their complexity and embedded prepaymentoptions, MBSs still have outperformed comparable Treasuries and corporatebonds over time. Credit quality. Ginnie Mae MBSs are backed by the full faith and credit of theUS government and, hence, like Treasuries, are considered to carry no creditrisk. Fannie Mae and Freddie Mac MBSs do not have US governmentguarantees, but because of Fannie Mae’s and Freddie Mac’s close ties to thegovernment, their MBSs are perceived to have minimal credit risk. MBSs fromother (private) issuers typically carry triple-A or double-A ratings from one ormore of the credit rating agencies. Choice of investment profiles. The MBS sector provides a wider range ofinvestment characteristics than most other parts of the fixed-income market.For example, MBSs are available with negative, short, or very long durations.Prepayment sensitivities can range from low to very high. Coupons can befixed (from 0% to more than 1,000%) or floating (directly or inversely with arange of indices). Liquidity. The amount of outstanding MBSs, trading volume (second only to USTreasuries), and involvement of major dealers provide an active, liquid marketfor the majority of MBSs. Development of analytic tools. Since the mid-1980s, many major dealers (andsome buy-side firms) have devoted considerable resources to developing analyticmodels for evaluating MBSs. These efforts have led to a better understanding ofmortgage cash flows and greater comfort with the characteristics of mortgagesecurities.Citigroup Global Markets7
November 3, 2004Guide to Mortgage-Backed SecuritiesOutline of PaperMBSs are more complex and challenging than traditional noncallable bonds, or evenstandard callable corporates. Much of this complexity arises from mortgagors’ optionto prepay their loans at any time. Thus, the cash flows from an MBS depend on therate at which the underlying loans are prepaid. Prepayment rates, in turn, depend onvarious factors, such as mortgage rates, economic conditions, and mortgagecharacteristics. Thus, determining the risk/reward profile of a particular MBS is moredifficult and involves more analysis and effort than for traditional bonds.The purpose of this paper is twofold: first, to provide an introduction to MBSs andmethods of MBS analysis for fixed-income investors new to MBSs, and second, to actas a reference for those already familiar with MBSs. The paper is organized as follows: Section II reviews key features of agency mortgage pass-through securities, themost basic and most prevalent type of MBSs, and discusses the mechanics ofMBS cash flows. Section III discusses the basics of MBS analysis, such as prepayment estimationand modeling, and nominal spreads. Section IV describes option-adjusted spread methodology, which has become thestandard way of evaluating MBSs. Section V explains repurchase transactions and dollar rolls, a common MBSinvestment strategy. Section VI gives an overview of structured MBSs, such as collateralizedmortgage obligations (CMOs) and interest-only MBSs. Section VII provides an introduction to the various types of nonagency MBSs.This paper also includes seven appendices, which contain additional information onthe topics discussed in the previous sections: Appendix A contains a list of resources for MBS investors. Appendix B provides a glossary of common terminology. Appendix C lists standard definitions for CMOs. Appendix D extends the discussion of settlements dates. Appendix E offers an introduction to MBS mathematics. Appendix F discusses the back-office clearance and settlement processes. Appendix G introduces risk-based capital standards and their applications toMBSs.8Citigroup Global Markets
November 3, 2004Guide to Mortgage-Backed SecuritiesII. Agency Pass-Through SecuritiesThe basic mortgage-backed security structure is the pass-through. As the nameimplies, a pass-through passes through the monthly principal and interest payments(less a servicing fee) from a pool of mortgage loans to holders of the security. Thus,investors in the pass-through are, in effect, buying shares of the cash flows from theunderlying loans. Structured MBSs, such as collateralized mortgage obligations(CMOs) and interest-only and principal-only STRIPs (IOs and POs), carve upmortgage cash flows in a variety of ways to create securities with given prepaymentand maturity profiles. We discuss pass-throughs in this section, and we describestructured mortgage securities (agency and nonagency) later in this paper.Development of the Pass-Through MarketThe pass-through is the most common structure for mortgage-backed securities. Apass-through issuer acquires mortgages either by originating them or by purchasingthem in the whole-loan market. Many mortgages with similar characteristics arecollected into a pool, and undivided ownership interests in the pool are sold as passthrough certificates. The undivided interest entitles the owner of the security to a prorata share of all interest payments and all scheduled or prepaid principal payments.The growth of the pass-through market stems in large part from the active role of theUS housing finance agencies in the primary and secondary mortgage markets. GinnieMae, Freddie Mac, and Fannie Mae account for nearly all of the issuance andoutstanding principal amount of mortgage pass-throughs.The programs of the three major federal housing agencies reflect the historicaldevelopment of US housing policy. Fannie Mae was created in 1938 as a whollyowned government corporation. Its charter mandated that it purchase FederalHousing Administration (FHA)-insured (and, since 1948, Veterans2Administration (VA)-guaranteed) mortgages for its portfolio. Congress intended toensure that mortgage lenders would continue to be able to make residential mortgageloans, even in periods of disintermediation (when withdrawals by depositors arehigh) or when delinquencies and defaults are high. Fannie Mae's purchase activitiesencouraged the standardization of repayment contracts and credit underwritingprocedures for mortgages.In 1968, the government restructured its role in the housing finance market. FannieMae was privatized, although it retained its mandate to buy FHA/VA loans for itsown portfolio. Ginnie Mae was spun off as a separate agency that would undertakesome of Fannie Mae's previous activities. In particular, Ginnie Mae assumed thefinancing of home loans not ordinarily underwritten in the established mortgagemarket, such as loans to low-income families.2The FHA and the VA are US government entities that provide mortgage insurance intended to serve low- and moderate-income homebuyersand military veterans, respectively.Citigroup Global Markets9
November 3, 2004Guide to Mortgage-Backed SecuritiesGinnie Mae’s most important activity has been its mortgage pass-through program,which was instituted in 1970. Under this program, Ginnie Mae guarantees thepayments of principal and interest on pools of FHA-insured or VA-guaranteedmortgage loans.The enhanced availability of credit to homeowners who qualify for FHA and VAloans led to calls for similar treatment for non-government-insured (or conventional)mortgages. In 1970, Congress established Freddie Mac to develop an activesecondary market for conventional loans, and in 1972, Fannie Mae began to purchaseconventional mortgages. Thus, by 1972, lenders could sell their newly originatedconventional mortgages to either Fannie Mae or Freddie Mac.Freddie Mac issued a small volume of pass-throughs in the 1970s, while Fannie Maebegan its MBS program in late 1981. As Figure 3 indicates, issuance volume from allthree agencies increased as rates rallied in the mid-1980s, and it hit new peaks in therefinancing waves of 1993, 1998, and (most dramatically) in 2003.Figure 3. Agency Pass-Through Securities Issuance, 1984–2003 (Dollars in Billions)2,200Freddie Mac2,000Fannie Mae1,800Ginnie 90199219941996199820002002Source: Bond Market Association.TerminologyIn Figure 4 we provide a description of a fairly typical mortgage pass-through, orpool. The lower half of Figure 4 gives key current pool characteristics. Thisinformation is updated each month by the agencies (traditionally called “pool factortapes”) for their pools (for nonagency MBSs, issuers provide updated data for their3deals each month).310The WA credit score and LTV ratio are the weighted-average original credit scores and LTV ratios for the loans remaining in the pool.Citigroup Global Markets
November 3, 2004Guide to Mortgage-Backed SecuritiesFigure 4. Fannie Mae Pool 486183Issue DateCollateralNet CouponCurrent BalanceFactorWACWAMWALA3/01/9930-Year Fixed-Rate Loans6.0% 3,174,0290.126959616.583%23-00 Yrs.5-07 Yrs.DelayOriginal Balance55 Days 25,000,304Current Loan SizeWA Credit ScoreWA LTV RatioPct. Investor LoansPct. Refinance Loans 93,354715812%49%WA Weighted-average. WAC Weighted-average coupon. WALA Weighted-average loan age. WAM Weighted-average maturity.Note: Current balances, factor, WAM, and WALA as of September 1, 2004.Sources: Fannie Mae, The Yield Book , and Citigroup.Figure 4 shows some of the terminology and information used to analyze MBSs: Net coupon and WAC. The net coupon of 6% is the rate at which interest is4paid to investors, while the weighted-average coupon (WAC) is 6.583% on thepool of mortgages backing the pass-through. The difference between the WACand the net coupon is called the servicing spread. Pass-throughs issued by FannieMae and Freddie Mac (as well as Ginnie Mae II5 program securities) allow forvariations in the note rates on the underlying loans (as is the case for the pool inFigure 4). In this case, the WAC could change over time (as loans are prepaid),and, hence, the latest updated WAC is shown. For Ginnie Mae pools that havebeen issued under the so-called Ginnie Mae I program, the underlying mortgageloans all have the same note rate with a servicing spread of 50bp. WAM and WALA. The weighted-average maturity (WAM) is the average(weighted by loan balance) of the remaining terms on the underlying loans, whilethe WALA is the weighted-average loan age. The sum of the WAM and WALAin Figure 4 is (23-00 5-07), or 28-07. If the underlying loans had original termsof 30 years, why is this figure not 30 years exactly? There are two reasons:(1) some of the loans m
Guide to Mortgage-Backed Securities November 3, 2004 Citigroup Global Markets 5 Acknowledgments This is the third edition of the Guide to Mortgage -Backed Securities, originally published in 1995. For this updated version, sect
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