Investing in Mortgage-Backed Securities

Transcription

1 Investing in Mortgage-Backed Securities Scott Wood Portfolio Strategist September 20, 2018 Securities offered through ProEquities, Inc., a registered Broker-Dealer and Member of FINRA and SIPC. Protective Securities is a division of ProEquities, Inc. Securities and insurance products offered are not financial institution deposits, have no financial institution guarantee, not FDIC/NCUA insured, and may involve loss of principal 1

2 Agenda Overview of Mortgage backed Securities Analyzing MBS and making purchase decisions using Bloomberg What we like in the current environment What is a Mortgage backed security? Mortgage Backed Securities (MBS) Also referred to as RMBS Residential Mortgage Backed Securities Single family homes or 2 4 family homes Also referred to as a pass through A pro rata portion of the principal and interest payments are passed through to the investor A MBS represents a claim on a cash flow stream from underlying mortgage loans that have been securitized (less servicing fees) 2

3 What is securitization? Banks originate mortgage loans and sell a bulk of them to a trust The trust assembles all these loans and others into collections, or pools The pools receive a guarantee/credit enhancement during this process Securities are issued which are backed by the mortgages; investors receive monthly cashflows (P&I) from the underlying mortgages 3

4 Who issues MBS? Government National Mortgage Association (GNMA) Also know as Ginnie Mae Backed by the full faith and credit of the U.S. government Promotes homeownership to low to middle income families Guaranteed the first mortgage pass thru security in 1968 FHA/VA loans Smaller loan size 0% risk weighted Who issues MBS? Federal National Mortgage Association (FNMA) Also know as Fannie Mae Government sponsored enterprise (GSE) Also known as an agency MBS Conventional mortgage loans Medium income borrowers, medium size loans 20% risk weighted Timely payment of principal and interest is guaranteed by FNMA not by the U.S. government Has to buy loans out of pool that are 90+ days delinquent Historical default rate = 0% 4

5 Who issues MBS? Federal Home loan Mortgage Corporation (FHLMC) Also know as Freddie Mac Government sponsored enterprise (GSE) Also known as an agency MBS Conventional mortgage loans Medium income borrowers, medium size loans 20% risk weighted Timely payment of principal and interest is guaranteed by FHLMC not by the U.S. government Has to buy loans out of pool that are 90+ days delinquent Historical default rate = 0% Advantages of a MBS? Attractive yielding asset Fits well within most investment portfolios Excellent credit quality Built in cashflow ladder Good liquidity and can be used as collateral for borrowing 5

6 Options with MBS MBS pools come in maturities similar to mortgage loan offerings of: 10yr 15yr 20yr 30yr Like mortgages, they also come in a variety of coupons Choosing the right MBS There are numerous individual options inside each category of a MBS pool For example, if looking for a 10yr MBS pool, each pool could have different: Coupons Seasoning Geographic distribution Collateral make up (LTV, FICO, etc.) This allows the investor to select a better performing pool or one that fits their A/L parameters better 6

7 Risks of an MBS? An MBS can pay and pre pay differently than expected/modeled Prepayment is the ability of the homeowner to prepay (pay extra) principal at any time without penalty Investor needs to evaluate the yield and maturity under a range of prepayments Two Prepayment Risks Contraction risk borrower prepays early Hurts investors yields when MBS are purchased at a premium. Causes reinvestment risk. Extension Risk borrower slows prepayments Cash flows slow and extend out Hurts investor yield when MBS were purchased at a discount 7

8 Prepayment Option Homeowners can prepay mortgage without penalty Exercised most frequently when market interest rates are lower refinancing into a lower rate Can make extra principal payments and shorten final maturity Pay off early in full for any reason Sell home for a variety of reasons moving, divorce, death, etc Refinance into a new loan with better terms rate, maturity, etc Default Prepayment Measures Conditional Prepayment Rate (CPR) Annualized ratio of monthly principal prepayments to previous months principal balance. 6% CPR = 100% PSA CPR measures prepayments, it does not include regular principal payments Public Security Association Benchmark (PSA) 100% PSA: 0.2% prepayment rate of outstanding balance Rises 0.2% per month until 30 th month Constant prepayment rate of 6% thereafter 8

9 Measuring Prepayment Rates CPR 10% CPR means an additional 10% of cashflow payments over and above the normal paydown A 0 CPR means there was no prepayments of principal that month The higher the CPR, the faster the MBS is paying down A bond paying at a 25 CPR is paying faster than a bond paying at a 12 CPR Measuring Prepayment Rates PSA PSA takes into account the tendency for loans to prepay faster as they age Remember, newer loans tend to not refinance much and less incentive for turnover PSA acknowledges that prepayments will change during the life of the mortgage The higher the PSA, the faster the bond is prepaying principal A bond paying at 150 PSA is paying faster than a bond paying at a 78 PSA 9

10 Predicting Prepayments Depends on the pool of mortgages and by analyzing the pool statistics, an investor can make some estimate of future cashflows There are a number of items (coupon, seasoning, etc.) to consider when analyzing an MBS that will determine the estimate of prepayments and the performance of the bond Predicting Prepayments Servicers 10

11 Analyzing MBS Using Bloomberg Screens Factors That Affect MBS Pricing Average Life Coupon Seasoning Maturity Prepayment Speeds Loan Count & Size Geographic Distribution Collateral 11

12 Choosing the right MBS Choosing the right coupon is also a consideration Depends on the strategy of the investor and their projection for rates going forward In general, the higher the coupon, the shorter the WAL Depending on the current interest rate environment, it also may mean a much higher price Choosing the right MBS Some investors like seasoned MBS pools, meaning the bond has been on the market for a while and the mortgages have been prepaying Investors see more cashflow stability as the longer the pools seasoned, the less likely for higher prepayments as the economic incentive of the homeowner to re fi is lower 12

13 MBS Strategies Larger pool sizes 1,000+ Loans Vary WAL, Coupons Look at performance under different prepay scenarios Be aware of tails Look at seasoned pools Analyzing an MBS pool Best and easy place to analyze an MBS pool is on Bloomberg Computer that your broker has access to and can provide analytical screens on bonds Main screen needed for preliminary analysis is the YT screen, or Yield Table, from Bloomberg Provides a wealth of information 13

14 The Yield Table (YT) Yield Table (YT) Ticker 14

15 Yield Table (YT) CUSIP Yield Table (YT) Coupon Final Maturity 15

16 Yield Table (YT) Total Loans in the pool Yield Table (YT) Geographic & origination dates 16

17 Yield Table (YT) Wtg avg orig loan size Max loan size Yield Table (YT) WAC (WAM) WALA 17

18 Yield Table (YT) Settlement Date Price Average Life Spread to Treasury Yield Table (YT) Average historical prepayment speeds Historical prepayment speeds 18

19 Yield Table (YT) Base case speed & yield Yield Table (YT) 19

20 Analyzing an MBS pool WAL Since the MBS pool pays down each month, investors evaluate MBS on an average life basis Because of the nature of MBS, the stated (final) maturity of the MBS will most likely not be its true life Average life is calculated as the weighted average time to principal payment, with the individual loan balances creating the weights Once calculated, WAL tells us how many years it will take to receive half of the outstanding principal Analyzing an MBS pool WAL Different prepayments speeds create different WALs The slower the loans in the pool pre pay the longer it will take for the bond to pay down, therefore the longer the WAL (the bond extends) Conversely, the faster the loans prepay the faster the bond will pay off, the shorter the WAL (the bond shortens) 20

21 Yield Table (YT) Base case speed & yield Yield Table (YT) 21

22 Yield Table (YT) Analyzing an MBS pool WAL Investors can enter in extreme prepayment speeds to see the outer limits of the WAL A 0 PSA/CPR assumes no prepayments Will give you the longest WAL A very high speed give the investor an idea of how short the bond could be The speeds also impact the yield 22

23 Yield Table (YT) Discount Bond Impact of premium price Why the negative yield? Proper accounting methods require the investor to write down premium each month If prepayments come in faster than projected, the investor will have to write down the premium quicker than projected, therefore impacting their income for the month, and the yield 23

24 Yield Table (YT) Premium Bond Focus on Cashflows MBS are also know as pass throughs, meaning they have a built in ladder of cash flows The investor needs to analyze the collateral specs of the pool to make an estimate of the cash flows Investors look at the CFG function on Bloomberg to get an estimate of expected cashflows under different prepayment speeds 24

25 Cashflow Graph (CFG) Basecase Analyzing cashflows Investors will want to focus on a variety of prepay speeds to determine the degree of shortening or extension of cashflows Both of these scenarios could be a risk 25

26 Contraction risk Problem for the investor: Cashflows are back to the investor sooner, earlier than modeled at time of purchase, usually in a falling rate environment If the investor paid a premium to purchase the bond, the premium will need to be recognized quicker, potentially creating a negative yield on the investment Higher cashflows back to the investor may need to be re invested in a lower rate environment Cashflow Graph (CFG) Rates down 300bps Fast Prepays Tail 26

27 Extension risk Problem for the investor: Lower cashflows back to the investor means less cashflow to re invest at higher rates or to fund loan demand or withdrawal activity, normally in a rising rate environment If investor bought at a premium, the premium can be written down at a slower pace, therefore enhancing yield Cashflow Graph (CFG) Rates up 300bps Slower Prepays 27

28 Cashflow Table Monthly Cashflow Table Monthly 28

29 Analyzing an MBS The investor should analyze the following Bloomberg screens when purchasing an MBS: DES: YT: CFG: CLC: TRA: FMED: Description of the bond Yield Table/Analysis Cashflow analysis Collateral analysis (3 6 pages) Total return analysis Risk test Description (DES) 29

30 Collateral Description (CLC) Collateral Description Origination Year 30

31 Collateral Description GEO Collateral Description Quartiles 31

32 Collateral Description Orig Loan Size Collateral Description Debt to Income 32

33 High Risk Test (FMED) Test on Bloomberg that is not required, but a good tool to review Need to enter price, and also select the Scan option at the bottom Shows WAL and price sensitivity +/ 300 bps Test #3 is helpful to see price sensitivity Good barometer for policy limits High Risk Test (FMED) Test Not Required 33

34 Analyzing an MBS The investor should develop a commentary section discussing the thought process/strategy behind buying the bond and why it fits into the portfolio If possible run the bond through an ALM model to see changes in NII and NEV under a variety of scenarios If buying a group of bonds, should have these modeled in an ALM model prior to purchase Choosing the right MBS For most CUs, the most appropriate pools are 10 & 15yr MBS Investor should determine the structure that would fit best on the balance sheet, not the highest yielding MBS Compare bonds and parameters Look at coupon, WAL, yield, cashflow projections and price sensitivity 34

35 Choosing the right MBS Some strategies include: Investor buys high coupon MBS if rates are moving higher Means higher dollar price (premium bond) Higher rates could mean slower prepayments, and therefore better yield and better protection for writing down premium (slower prepays) Choosing the right MBS Some strategies include: Investor buys low coupon MBS with shorter final (10yr/15yr MBS) if rates are low and may remain flat or moving higher Means lower dollar price (less premium risk) Prepayment will be slow, so higher rates or slightly lower rate won t impact prepayments as much Limits extension and contraction risk 35

36 Choosing the right MBS Some strategies include: Investor buys seasoned MBS pools (longer loan age), low coupon MBS with shorter final (10yr/15yr MBS) if rates are low and may remain flat or moving higher Means higher dollar price (premium risk) Choosing the right MBS 10yr MBS are a great fit as they have shorter maturities and WALs & has limited extension risk given the short final maturity 10yr mortgages are typically held by homeowners as a financial planning tool as they typically have decent equity in their home Prepayments are typically low, especially in lower coupon MBS 36

37 MBS Spreads Yield Table (YT) 10Yr New 37

38 Choosing the right MBS 15yr MBS are also a nice fit for most portfolios, but do have a longer final maturity and WAL, which may not fit in some CU investment policies Look for seasoned pools Allows investors to move out slightly longer on the yield curve to pick up additional yield Compliments holding in the 10yr MBS Usually more supply and better prepayment history Yield Table (YT) 15Yr 2.5% Seasoned 38

39 Yield Table (YT) 15Yr 2.5% Moderately Seasoned Yield Table (YT) 15Yr 3% New 39

40 Choosing the right MBS 20yr & 30yr MBS offer better yields, but also longer WALs and much more extension risk Better supply here as well, but a much longer asset If a CU doesn t like to add 20yr or 30yr mortgages to their balance sheet, they probably shouldn t add these MBS pools to their investment portfolio Yield Table (YT) 30Yr Seasoned 40

41 Investing in MBS Considerations Policy allowable Investment accounting of premium/discount price and of amortization Comfortable with structures Safekeeping Market values Policy language for MBS If the choice is to add MBS to the portfolio, certain items need to be detailed in the Investment & ALM policy Investor need to determine what will be allowable, and develop the proper limits Also needs to detailed analysis that will be completed 41

42 Policy language for MBS The Credit Union may invest in a variety of agency MBS structures issued by GNMA, FNMA, and/or FHLMC Establish limits: MBS purchase limit of $X per investment Aggregate limit for entire MBS portfolio Will be a certain percentage of the investment portfolio or capital Establish maximum term, stated in weighted average life at time of purchase, in the base case and in an up 300 basis point assumption Recommended Bloomberg Screens The investor purchase file should include the following Bloomberg screens for an MBS: DES: Description of the bond YT: Yield Table/Analysis CFG/CFT:Cashflow analysis CLC: Collateral analysis (3 6 pages) TRA: Total return analysis FMED: Risk test 42

43 MBS Callables 10 Year 3.46Yr WAL 3.08% 15 Year 3.74Yr WAL 3.12% 4.40Yr WAL 3.22% 4.79Yr WAL 3.25% 30 Year 5.13Yr WAL 3.45% 2 NC3Mo 2.85% 2.5 NC3Mo 3.0% 2.75 NC3Mo 3.0% 3 NC1Yr 3.0% 3.5 NC1.5Yr 3.02% 4 NC1Yr 3.17% 5 NC6Mo 3.32% Pricing provided by Bloomberg as of 9/18/18 Investments For a Rising Rate Environment Short callables and step ups Short CD s Floaters Vizo Financial Share accounts (PSA, PSA30, PSA90) Low Premium SBA Pools Amortizing Products MBS Low Premium SBA Pools DUS 43

44 Due Diligence There is more to investing than yield alone Model various rate scenarios Know what you re investing in Review term sheet, prices and Bloomberg screens carefully Make sure you fully understand the risks If you can t explain it to your ALCO, examiner or how it should be modeled for ALM purposes, don t buy it! Scott Wood Portfolio Strategist swood@vfccu.org Thank you!! 44