Secondary Mortgage Market

Transcription

1 Secondary Mortgage Market I. Overviews: Primary market: where mortgage are originated (between bank and borrower). Secondary market: where existing mortgages are bought or sold. A. Mortgage Backed Securities (MBSs): Agencies purchase mortgages in the secondary market They will then pledge the mortgage as collateral for the debt they issue. The debt they issue referred to as "mortgage-backed securities" (MBSs). MBSs can be bought and sold and are considered part of the secondary market. B. Why MBSs? 1. Liquidity: it is difficult to sell a mortgage (or mortgages) when a bank needs liquidity (cash). a). Mortgages are not homogeneous i. Interest rate ii. Date of maturity iii. Loan to value ratio iv. Borrower characteristics v. Sell 25 million of loans would be difficult b). Difficult to judge default risk; national investors do not have the ability to judge the soundness of the loan underwritten by a local bank. 2. Mismatch of the supply and demand of capital: a). Regional mismatch (rich vs. poor) - from surplus to deficit area. b). Type of investors i. Investors invest in pension ii. Pension invest in MBS iii. Switch the interest rate risk to pension funds; they are better equipped to handle the interest rate risk. 3. Characteristics of mortgaged backed securities: a). Credit enhancement: It has less default risk than that of the underlying mortgages (because of insurance, rating, agency guarantee) b). Avoid double taxation: Interest revenue is not taxable c). Tailor (rearrange) cash flows so as to appeal to investors d). Therefore, many types of mortgage backed securities 4. Examples of MBSs: a). Mortgage Pass-Through Securities (MPTS) b). Mortgage Backed Bonds (MBB) c). Mortgage Pass-Through Bonds (MPTB) d). Collateralized Mortgage Obligations (CMOs) 5. Valuation of mortgage backed securities a). Traditional debt i. Present value model: value of the mortgage is the summation of the present values of all payments discounted at the required rate of return. ii. Yield to maturity (IRR): where the market value of the mortgage equals the summation of the present values of all future payments discounted at the IRR iii. Sensitivity to change in interest rate (duration)

2 b). Mortgage backed security i. Differ from traditional debt securities; its cash flows consist of: (a) Scheduled amortization of principal (b) Interest on remaining principal (c) Prepayment of portion of the pool ii. We know: (a) The total amount of principal paid will be the same (without default), regardless of changes in interest rates. (b) The time of the payments, however, will be sensitive to the changes in the interest rate. (c) The interest payment will be a function of the principal payment. If principal payment is delayed, investors receive more interest payments. Conversely, if the principal payments are accelerated, the total amount of interest payments will be reduced. (d) Change of market interest rates will affect the timing of prepayments (the call option) and, therefore, affect the value of the MBSs. If market rate greater than the coupon rate, it is likely to see a (faster? or slower?) prepayment schedule. If coupon rate greater than the market rate, it is likely to see a (faster? or slower?) prepayment schedule. iii. Effect of prepayment on the cash flows of MBSs (a) Accelerated prepayments when coupon rate is much higher than the market interest rate. (b) It is possible that the value of the high coupon pass-through will be offset by the high expected prepayment, therefore: (c) Change in market interest rates has two impacts on the value of MBSs. The discount rate will change The assumed prepayments will change (d) Prepayment affects value; therefore, we will have to understand prepayment patterns. 6. Prepayment patterns a). 12-year prepaid life i. All loans be prepaid at end of year 12 (based on the average life of mortgages from FHA data) ii. Not reliable. This method is abandoned b). Constant prepayment rate (CPR) i. Prepayment is 1% per month of the remaining principal ii. (BB - principal)*1% = prepayment c). FHA experience i. Publish a schedule of the FHA loans for each of the 30 years of their maturity ii. For an example, see a table in the textbook iii. History might not repeat itself. Economic condition differs across periods d). Public Securities Association model (PSA) i. 0.2% prepayment rate for the first month ii. prepayment rate increases 0.2% per month until month 30. At that time prepayment rate is 6%

3 iii. Prepayment rate remains constant for the remaining 330 months iv. Adjusting regional difference by using 50%, 100%,, or 200% PSA. e). Econometric prepayment models ($$$) i. Age of the mortgage ii. Season of the year iii. Current projected interest rates relative to the coupon on the mortgages iv. Geographical location of properties v. Borrower characteristics: age, wealth, and income. vi. Explain 85% of historical valuation in prepayment rates vii. Need to predict the movements of other variables (such as expected interest rate), which is equally difficult to do. viii. Market rate and pool rate is the most important factor ix. Expected future rates are also important, although it is difficult to estimate (yield curve is a good indicator)

4 PSA & Multiples of PSA 9 150% PSA Annual Prepayment Rate (%) % PSA 50% PSA 0 30 Age of Mortgage Pool (months) Interest Rate Differential & Prepayment Rates (market rate - pool rate) (12% pool rate) Prepayment Rate %

5 Collateralized Mortgage Obligations (CMOs) A. The security: 1. Re-arrange the uncertain cash flows from a pool of mortgages into those desired by investors. 2. Re-arrange into several bond-like securities (tranches) with different maturities. 3. A typical CMO will have 3-5 tranches. (One will be the residual tranche). 4. Due to the uncertainty in the timing and amount of cash flows, the issuer often owns the residual tranche. B. For example: 1. Issuer sells $100 million in CMOs + $6 million equity as credit enhancement. The CMO ($100 million) is over collateralized ($106 million). 2. CMO has four tranches (A, B, C, Z) and an equity position. 3. Tranche A earns 9.25% interest rate. Receive interest payment Receive principal payments of all mortgages Receive all prepayments Receive deferred interest earned by tranche Z (transferred to tranche A holder) No payment to tranche Z until tranches A, B, C are paid-off 4. Tranche B earns 9.5% interest rate. Receive interest payment Receive no payment on principal, prepayment, and deferred interest from tranche Z until tranche A is paid-off 5. Tranche C earns 10% interest rate Receive interest payment Receive no payment on principal, prepayment, and deferred interest from tranche Z until tranches A and B are paid-off 6. Tranche Z (residual tranche) earns 10.5% interest rate Does not receive cash payment until tranches A, B, and C are paid-off. Loan balance increases by the amount of accrued interest. 7. Equity position Receives whatever left after tranches A, B, C, and Z are paid-off. Structure of the CMO Example Pool balance. $106,000,000: coupon rate %: maturity. 30 years Coupon Maturity Amount CMO Tranches (%) (Years) ($) Tranche A ,000,000 Tranche B ,000,000 Tranche C ,000,000 Tranche Z ,000,000 Equity Amount 6,000,000

6 MORTGAGE POOL: Market Interest Rate = 10.25% Term to Maturity = 30 Years Loan Amount = $106,000,000 Mortgage Constant = % Annual Payments at 100% of PSA Mortgage Pool Ending Debt Principal Interest Prepaid PSA Adjed. % period Balance Service Payment Payment Principal Rate PSA Remain 0 $106,000, $104,015,425 $11,479,564 $614,564 $10,865,000 $1,370, $99,523,055 $11,330,330 $668,749 $10,661,581 $3,823, $93,135,241 $10,911,131 $710,017 $10,201,113 $5,677, $86,860,048 $10,284,177 $737,815 $9,546,362 $5,537, $80,935,662 $9,667,846 $764,691 $8,903,155 $5,159, $75,340,138 $9,088,452 $792,547 $8,295,905 $4,802, $70,052,814 $8,543,781 $821,417 $7,722,364 $4,465, $65,054,231 $8,031,753 $851,339 $7,180,413 $4,147, $60,326,059 $7,550,410 $882,351 $6,668,059 $3,845, $55,851,031 $7,097,914 $914,492 $6,183,421 $3,560, $51,612,876 $6,672,536 $947,805 $5,724,731 $3,290, $47,596,257 $6,272,651 $982,331 $5,290,320 $3,034, $43,786,714 $5,896,731 $1,018,114 $4,878,616 $2,791, $40,170,614 $5,543,340 $1,055,201 $4,488,138 $2,560, $36,735,091 $5,211,127 $1,093,639 $4,117,488 $2,341, $33,468,009 $4,898,824 $1,133,477 $3,765,347 $2,133, $30,357,908 $4,605,238 $1,174,767 $3,430,471 $1,935, $27,393,967 $4,329,246 $1,217,560 $3,111,686 $1,746, $24,565,960 $4,069,794 $1,261,913 $2,807,882 $1,566, $21,864,223 $3,825,891 $1,307,880 $2,518,011 $1,393, $19,279,614 $3,596,606 $1,355,523 $2,241,083 $1,229, $16,803,481 $3,381,061 $1,404,901 $1,976,160 $1,071, $14,427,634 $3,178,434 $1,456,077 $1,722,357 $919, $12,144,309 $2,987,951 $1,509,118 $1,478,833 $774, $9,946,146 $2,808,883 $1,564,091 $1,244,792 $634, $7,826,158 $2,640,546 $1,621,066 $1,019,480 $498, $5,777,708 $2,482,298 $1,680,117 $802,181 $368, $3,794,488 $2,333,534 $1,741,319 $592,215 $241, $1,870,493 $2,193,686 $1,804,751 $388,935 $119, ($0) $2,062,218 $1,870,493 $191,725 ($0) Present Value = $8,399,418 $66,083,742 $31,516,840

7 TRANCHE A: Market Interest Rate = 9.25% Loan Amount = $30,000,000 Tranche A Ending Pool Interest From Z Total Period Balance Principal Payment Tranche Payment 0 $30,000,000 ($30,000,000) 1 $26,440,425 $1,984,575 $2,775,000 $1,575,000 $6,334,575 2 $20,207,680 $4,492,369 $2,445,739 $1,740,375 $8,678,484 3 $11,896,751 $6,387,815 $1,869,210 $1,923,114 $10,180,139 4 $3,496,517 $6,275,193 $1,100,450 $2,125,041 $9,500,683 5 $0 $3,496,517 $323,428 $0 $3,819,945 6 $0 $0 $0 $0 $0 7 $0 $0 $0 $0 $0 8 $0 $0 $0 $0 $0 9 $0 $0 $0 $0 $0 10 $0 $0 $0 $0 $0 11 $0 $0 $0 $0 $0 12 $0 $0 $0 $0 $0 13 $0 $0 $0 $0 $0 14 $0 $0 $0 $0 $0 15 $0 $0 $0 $0 $0 16 $0 $0 $0 $0 $0 17 $0 $0 $0 $0 $0 18 $0 $0 $0 $0 $0 19 $0 $0 $0 $0 $0 20 $0 $0 $0 $0 $0 21 $0 $0 $0 $0 $0 22 $0 $0 $0 $0 $0 23 $0 $0 $0 $0 $0 24 $0 $0 $0 $0 $0 25 $0 $0 $0 $0 $0 26 $0 $0 $0 $0 $0 27 $0 $0 $0 $0 $0 28 $0 $0 $0 $0 $0 29 $0 $0 $0 $0 $0 30 $0 $0 $0 $0 $0 IRR = % NPV = ($0.00)

8 TRANCHE B: Market Interest Rate = 9.50% Loan Amount = $30,000,000 TRANCHE B: Ending Pool Interest From Z Total Period Balance Principal Payment Tranche Payment 0 $30,000,000 ($30,000,000) 1 $30,000,000 $0 $2,850,000 $0 $2,850,000 2 $30,000,000 $0 $2,850,000 $0 $2,850,000 3 $30,000,000 $0 $2,850,000 $0 $2,850,000 4 $30,000,000 $0 $2,850,000 $0 $2,850,000 5 $25,223,961 $2,427,869 $2,850,000 $2,348,171 $7,626,039 6 $17,033,708 $5,595,524 $2,396,276 $2,594,729 $10,586,529 7 $8,879,209 $5,287,324 $1,618,202 $2,867,175 $9,772,702 8 $712,397 $4,998,583 $843,525 $3,168,229 $9,010,337 9 $0 $712,397 $67,678 $0 $780, $0 $0 $0 $0 $0 11 $0 $0 $0 $0 $0 12 $0 $0 $0 $0 $0 13 $0 $0 $0 $0 $0 14 $0 $0 $0 $0 $0 15 $0 $0 $0 $0 $0 16 $0 $0 $0 $0 $0 17 $0 $0 $0 $0 $0 18 $0 $0 $0 $0 $0 19 $0 $0 $0 $0 $0 20 $0 $0 $0 $0 $0 21 $0 $0 $0 $0 $0 22 $0 $0 $0 $0 $0 23 $0 $0 $0 $0 $0 24 $0 $0 $0 $0 $0 25 $0 $0 $0 $0 $0 26 $0 $0 $0 $0 $0 27 $0 $0 $0 $0 $0 28 $0 $0 $0 $0 $0 29 $0 $0 $0 $0 $0 30 $0 $0 $0 $0 $0 IRR = % NPV = $0.00

9 TRANCHE C: Market Interest Rate = 10.00% Loan Amount = $25,000,000 Tranche C Ending Pool Interest From Z Total Period Balance Principal Payment Tranche Payment 0 $25,000,000 ($25,000,000) 1 $25,000,000 $0 $2,500,000 $0 $2,500,000 2 $25,000,000 $0 $2,500,000 $0 $2,500,000 3 $25,000,000 $0 $2,500,000 $0 $2,500,000 4 $25,000,000 $0 $2,500,000 $0 $2,500,000 5 $25,000,000 $0 $2,500,000 $0 $2,500,000 6 $25,000,000 $0 $2,500,000 $0 $2,500,000 7 $25,000,000 $0 $2,500,000 $0 $2,500,000 8 $25,000,000 $0 $2,500,000 $0 $2,500,000 9 $17,483,333 $4,015,775 $2,500,000 $3,500,893 $10,016, $9,139,819 $4,475,028 $1,748,333 $3,868,486 $10,091, $626,986 $4,238,155 $913,982 $4,274,677 $9,426, $0 $626,986 $62,699 $0 $689, $0 $0 $0 $0 $0 14 $0 $0 $0 $0 $0 15 $0 $0 $0 $0 $0 16 $0 $0 $0 $0 $0 17 $0 $0 $0 $0 $0 18 $0 $0 $0 $0 $0 19 $0 $0 $0 $0 $0 20 $0 $0 $0 $0 $0 21 $0 $0 $0 $0 $0 22 $0 $0 $0 $0 $0 23 $0 $0 $0 $0 $0 24 $0 $0 $0 $0 $0 25 $0 $0 $0 $0 $0 26 $0 $0 $0 $0 $0 27 $0 $0 $0 $0 $0 28 $0 $0 $0 $0 $0 29 $0 $0 $0 $0 $0 30 $0 $0 $0 $0 $0 IRR = % NPV = ($0.00)

10 TRANCHE Z: Market Interest Rate = 10.50% Loan Amount = $15,000,000 TRANCHE Z: Ending Accured Pool Interest Total Period Balance Interest Principal Payment Payment 0 $15,000,000 ($15,000,000) 1 $16,575,000 $1,575,000 $0 $0 $0 2 $18,315,375 $1,740,375 $0 $0 $0 3 $20,238,489 $1,923,114 $0 $0 $0 4 $22,363,531 $2,125,041 $0 $0 $0 5 $24,711,701 $2,348,171 $0 $0 $0 6 $27,306,430 $2,594,729 $0 $0 $0 7 $30,173,605 $2,867,175 $0 $0 $0 8 $33,341,834 $3,168,229 $0 $0 $0 9 $36,842,726 $3,500,893 $0 $0 $0 10 $40,711,213 $3,868,486 $0 $0 $0 11 $44,985,890 $4,274,677 $0 $0 $0 12 $41,596,257 $0 $3,389,633 $4,723,518 $8,113, $37,786,714 $0 $3,809,542 $4,367,607 $8,177, $34,170,614 $0 $3,616,101 $3,967,605 $7,583, $30,735,091 $0 $3,435,522 $3,587,914 $7,023, $27,468,009 $0 $3,267,082 $3,227,185 $6,494, $24,357,908 $0 $3,110,101 $2,884,141 $5,994, $21,393,967 $0 $2,963,941 $2,557,580 $5,521, $18,565,960 $0 $2,828,007 $2,246,367 $5,074, $15,864,223 $0 $2,701,737 $1,949,426 $4,651, $13,279,614 $0 $2,584,609 $1,665,743 $4,250, $10,803,481 $0 $2,476,132 $1,394,359 $3,870, $8,427,634 $0 $2,375,847 $1,134,366 $3,510, $6,144,309 $0 $2,283,325 $884,902 $3,168, $3,946,146 $0 $2,198,163 $645,152 $2,843, $1,826,158 $0 $2,119,988 $414,345 $2,534, $0 $0 $1,826,158 $191,747 $2,017, $0 $0 $0 $0 $0 29 $0 $0 $0 $0 $0 30 $0 $0 $0 $0 $0 IRR = % NPV = $0.00

11 RESIDUAL CASH FLOWS TO EQUITY Required Rate of Return = % Equity Amount = $6,000,000 Equity Position Pool Interest Total Period Principal Payment Payment 0 ($6,000,000) ($6,000,000) 1 $0 $1,165,000 $1,165,000 2 $0 $1,125,467 $1,125,467 3 $0 $1,058,788 $1,058,788 4 $0 $970,871 $970,871 5 $0 $881,556 $881,556 6 $0 $804,900 $804,900 7 $0 $736,987 $736,987 8 $0 $668,660 $668,660 9 $0 $599,488 $599, $0 $566,602 $566, $0 $536,072 $536, $0 $504,103 $504, $0 $511,009 $511, $0 $520,533 $520, $0 $529,573 $529, $0 $538,162 $538, $0 $546,330 $546, $0 $554,105 $554, $0 $561,515 $561, $0 $568,585 $568, $0 $575,339 $575, $0 $581,801 $581, $0 $587,991 $587, $0 $593,931 $593, $0 $599,639 $599, $0 $605,135 $605, $222,292 $610,435 $832, $1,983,220 $592,215 $2,575, $1,923,996 $388,935 $2,312, $1,870,493 $191,725 $2,062,218 IRR = % NPV = $0.00

12 C. CMOs: layering 1. CMOs can be backed by a MBS issued by another agency. 2. Buy GNMA pass-through (not individual mortgages) 3. Re-package to different trenches 4. Sell CMOs 5. "Layering" of MBSs. D. CMOs: SWAPS 1. A lender sells mortgages to an agency 2. The agency, in turn, issues MRS back to the lenders 3. The lender will retain the servicing and receive service fee. 4. Liquidity advantage E. CMOs: Interest Only (IO) and principal Only (PO) strips 1. Changes in interest rates have two impacts on each of the strips: change discount rate and change prepayment. 2. PO: when interest rate up: discount rate up, value down; prepayment down, value down. Since it will take longer time for investors to receive payment, the value drops even more. 3. IO interest rate up: discount rate up, value down; prepayment down, value up. The effect on the cash flow might dominate the change in discount rate. 4. As opposed to traditional debt securities, the value of the IO strip move in the "same" direction as market interest rates. 5. IO strip has negative duration. It is a good instrument to hedge inflation (interest rate risk) F. CMOs: Service Rights 1. Collect monthly payments 2. Maintain escrow account for insurance and taxes 3. Forward payment to the purchasers of the loans 4. Send notices of delinquency and default 5. Initiate default process 6. Making claim to mortgage insurers for losses on defaulted mortgages 7. Loan service fee: between 0.25% to 0.5% (usually 0.325%) of mortgage balance 8. Similar to IO strip 9. Change of interest rate affects the value of service right. 10. Prepayments eliminate all future revenue associated with loan 11. Very sensitive to change of interest

13 MORTGAGE POOL: Market Interest Rate = 10.25% Term to Maturity = 30 Years Loan Amount = $106,000,000 Mortgage Constant = % Annual Payments at 100% of PSA Mortgage Pool Ending Debt Principal Interest Prepaid PSA Adjed. % Period Balance Service Payment Payment Principal Rate PSA Remain 0 $106,000, $104,015,425 $11,479,564 $614,564 $10,865,000 $1,370, $99,523,055 $11,330,330 $668,749 $10,661,581 $3,823, $93,135,241 $10,911,131 $710,017 $10,201,113 $5,677, $86,860,048 $10,284,177 $737,815 $9,546,362 $5,537, $80,935,662 $9,667,846 $764,691 $8,903,155 $5,159, $75,340,138 $9,088,452 $792,547 $8,295,905 $4,802, $70,052,814 $8,543,781 $821,417 $7,722,364 $4,465, $65,054,231 $8,031,753 $851,339 $7,180,413 $4,147, $60,326,059 $7,550,410 $882,351 $6,668,059 $3,845, $55,851,031 $7,097,914 $914,492 $6,183,421 $3,560, $51,612,876 $6,672,536 $947,805 $5,724,731 $3,290, $47,596,257 $6,272,651 $982,331 $5,290,320 $3,034, $43,786,714 $5,896,731 $1,018,114 $4,878,616 $2,791, $40,170,614 $5,543,340 $1,055,201 $4,488,138 $2,560, $36,735,091 $5,211,127 $1,093,639 $4,117,488 $2,341, $33,468,009 $4,898,824 $1,133,477 $3,765,347 $2,133, $30,357,908 $4,605,238 $1,174,767 $3,430,471 $1,935, $27,393,967 $4,329,246 $1,217,560 $3,111,686 $1,746, $24,565,960 $4,069,794 $1,261,913 $2,807,882 $1,566, $21,864,223 $3,825,891 $1,307,880 $2,518,011 $1,393, $19,279,614 $3,596,606 $1,355,523 $2,241,083 $1,229, $16,803,481 $3,381,061 $1,404,901 $1,976,160 $1,071, $14,427,634 $3,178,434 $1,456,077 $1,722,357 $919, $12,144,309 $2,987,951 $1,509,118 $1,478,833 $774, $9,946,146 $2,808,883 $1,564,091 $1,244,792 $634, $7,826,158 $2,640,546 $1,621,066 $1,019,480 $498, $5,777,708 $2,482,298 $1,680,117 $802,181 $368, $3,794,488 $2,333,534 $1,741,319 $592,215 $241, $1,870,493 $2,193,686 $1,804,751 $388,935 $119, ($0) $2,062,218 $1,870,493 $191,725 ($0) Present Value = $8,399,418 $66,083,742 $31,516,840

14 MORTGAGE POOL: Market Interest Rate = 10.25% Term to Maturity = 30 Years Loan Amount = $106,000,000 Mortgage Constant = % Annual Payments at 0% of PSA Mortgage Pool Ending Debt Principal Interest Prepaid PSA Adjed. % period Balance Service Payment Payment Principal Rate PSA Remain 0 $106,000, $105,385,436 $11,479,564 $614,564 $10,865,000 $ $104,707,878 $11,479,564 $677,557 $10,802,007 $ $103,960,871 $11,479,564 $747,007 $10,732,558 $ $103,137,296 $11,479,564 $823,575 $10,655,989 $ $102,229,304 $11,479,564 $907,992 $10,571,573 $ $101,228,243 $11,479,564 $1,001,061 $10,478,504 $ $100,124,574 $11,479,564 $1,103,670 $10,375,895 $ $98,907,778 $11,479,564 $1,216,796 $10,262,769 $ $97,566,261 $11,479,564 $1,341,517 $10,138,047 $ $96,087,238 $11,479,564 $1,479,023 $10,000,542 $ $94,456,616 $11,479,564 $1,630,623 $9,848,942 $ $92,658,854 $11,479,564 $1,797,761 $9,681,803 $ $90,676,822 $11,479,564 $1,982,032 $9,497,533 $ $88,491,632 $11,479,564 $2,185,190 $9,294,374 $ $86,082,460 $11,479,564 $2,409,172 $9,070,392 $ $83,426,348 $11,479,564 $2,656,112 $8,823,452 $ $80,497,984 $11,479,564 $2,928,364 $8,551,201 $ $77,269,463 $11,479,564 $3,228,521 $8,251,043 $ $73,710,018 $11,479,564 $3,559,445 $7,920,120 $ $69,785,730 $11,479,564 $3,924,288 $7,555,277 $ $65,459,203 $11,479,564 $4,326,527 $7,153,037 $ $60,689,207 $11,479,564 $4,769,996 $6,709,568 $ $55,430,286 $11,479,564 $5,258,921 $6,220,644 $ $49,632,326 $11,479,564 $5,797,960 $5,681,604 $ $43,240,075 $11,479,564 $6,392,251 $5,087,313 $ $36,192,618 $11,479,564 $7,047,457 $4,432,108 $ $28,422,797 $11,479,564 $7,769,821 $3,709,743 $ $19,856,570 $11,479,564 $8,566,228 $2,913,337 $ $10,412,303 $11,479,564 $9,444,266 $2,035,298 $ ($0) $11,479,564 $10,412,303 $1,067,261 $ Present Value = $106,000,000 $16,722,843 $89,277,157 $0

15 Proportion of Total Present Value 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Proportion of Total Present Value of Cash Flow of principal and Interest Principal Interest % PSA Value of GNMA 12, IO, & PO; Various Market Rates No more prepayment prepayment Percentage of Par Pass-Through IO IPO PI % 6% 7% 8% 9% 10% 11% 12% Market Rate

16 Value of GNMA 8, IO & PO; Various Market Rates Pass-Through IO PO Percentage of Par % 5% 6% 7% 8% 9% 10% 11% Market Rate Yield Comparison of Whole Mortgage Pool and Subordinated Security; Senior Security Sold to yeild 40 Basis Point Difference, GNMA 10 20% Whole Pass-Through 15% Subordinated Security 10% Yield (%) 5% 0% -5% Foreclosure Rate in Years 1 Through 4

17 II. Lessons learned A. In the early 80s: 1. Market interest rate is much higher than the coupon rate of pooled mortgages 2. If you can find the "fast-pays" poll, you will enjoy superior return. (You beat the market) 3. Someone says, "He can do it" 4. This person looks at historical prepayment rate of the mortgage pool 5. However, the pool with fast-pay has tendency to slow the rate of prepayment 6. Result: undesirable outcome B. In Market interest is 10%, while some people have a rate at 15% 2. FHA send out letters to encourage prepayment by reducing refinancing cost 3. In the next couple weeks, the price of GNMA 15 fell by 200 basis points or a lost of about $22 million in value. C. Games by lenders (in 1990 s) 1. "Lower your FHA mortgage with no out-of-pocket cost and no paper work" 2. If market rate is approximately 10% and the coupon rate, say, is 13%. Lender offers to refinance at 12% (no costs) a). Mortgage borrower wins b). Pass-through investor loses c). Lender incurs refinance cost, but wins big when it sells the 12% mortgage to GNMA at high prices. 3. Seven months later, they offer to replace the 12% loan with 11% refinance. Again, someone wins and investors suffer. 4. Be careful when you buy a bond at premium