FRBSF Weekly Letter
96-01; January 5, 1996
The securitization of mortgages has fundamentally changed home mortgage
financing. In the past, the vast majority of home mortgages were originated
and funded by depository institutions. Today about half of total home
mortgage debt outstanding is held by a wide variety of financial institutions
and investors in the form of mortgage-backed securities. The proliferation
of these instruments is generally seen as improving access to mortgage
financing by separating origination from funding, which integrates home
mortgage financing into the overall capital market. To facilitate capital
flows into this $1.6 trillion market, financial engineers also have focused
on unbundling the risks in these securities through collateralized mortgage
obligations. Although these have been the fastest growing component of
the mortgage-backed securities market for years, their issuance has dropped
off substantially since 1993.
This Weekly Letter describes several major innovations in the market
for mortgage-backed securities, including the risk characteristics of
these instruments. In addition, it looks at some explanations for the
recent decline in collateralized mortgage obligations. While this decline
is related in part to the fall-off in mortgage origination, it also may
be a response to the losses incurred by investors on some of the more
exotic variations of this instrument.
One of the simplest types of mortgage-backed securities is the "pass-through,"
which is created by pooling traditional fixed-rate, level payment mortgages.
The payments made on the underlying mortgages are "passed through"
unaltered to the security holders on a pro rata basis. This means that
the cash flows of the pass-through match the cash flows of the underlying
mortgages almost exactly (after administrative expenses), including any
prepayments (early paying down of principal). Pass-throughs, then, allow
the securitization of the mortgages, but not necessarily the unbundling
of risks.
Most pass-throughs do not expose their holders to credit risk because
they are guaranteed by federal agencies; they do, however, expose their
holders to prepayment risk that is, uncertainty over the prepayment of
the underlying mortgages. The presence of prepayment risk greatly complicates
the valuation of mortgage-backed securities. On the one hand, decreases
in market
interest rates would increase prepayment of existing mortgages as a result
of refinancing, which forces the investor to reinvest the cash flows at
the lower prevailing market interest rates. On the other hand, increases
in interest rates would slow down prepayment. This reduces the cash flows
available to the investor for reinvestment at the higher prevailing interest
rates and simultaneously extends the maturity of the security.
To appeal to investors with different preferences for risk and return,
a number of variations of collateralized mortgage obligations have been
developed to redistribute the prepayment risk in pass-throughs. For example,
a pass-through can be structured into a planned amortization class (PAC)
and a non-planned amortization class. In order to achieve the planned
amortization schedule in the PAC tranche, any excess or shortfalls in
prepayment are first absorbed by the non-PAC tranche before affecting
the PAC. As a result, while the PAC tranche has relatively low prepayment
risk, the non-PAC tranche is loaded with it. However, it is possible that
an unexpectedly high volume of prepayment could swamp the non-PAC tranche,
in which case the PAC becomes busted and its amortization schedule cannot
be met.
Another variation of the collateralized mortgage obligation strips the
interest payments of the underlying mortgages to an interest-only class
and the principal payments to a principal-only class. Both classes are
very sensitive to prepayment of the underlying mortgages. In the interest-only
class, prepayment wipes out future cash flows (interest payments), whereas
in a principal-only class, a slowdown in prepayment redistributes a portion
of current cash flows into the future, extending the instrument's maturity.
These instruments are attractive to investors because their cash flow
patterns are not readily available from other debt instruments. For example,
the value of interest-only instruments moves together with interest rates;
that is, generally speaking, when interest rates rise, the value of an
interest-only instrument rises due to decreases in prepayment that result
in higher future interest payments from the underlying mortgages. The
comovement between interest rates and an interest-only instrument's value
is just the opposite of the relationship between interest rates and a
conventional, fixed-rate bond; therefore, an interest-only instrument
can provide a useful hedge against interest rate risk for bond portfolio
managers.
In contrast, the value of a principal-only instrument responds to changes
in interest rates much the way a conventional bond does, except the magnitude
is greater. An increase in interest rates depresses the principal-only
instrument's value because its cash flows will be realized later due to
a slowdown in prepayment. This effect is compounded by a higher discount
factor (as a result of higher interest rates) and the maturity extension
of the instrument. This means the value of a principal-only instrument
drops by relatively more than that of a comparable maturity conventional
bond for a given interest rate rise. Similarly, as interest rates drop,
a principal-only instrument appreciates relatively more in value than
a conventional bond, since its cash flows are both realized sooner (due
to prepayment) and discounted at lower rate (due to falling rates and
a shortening of maturity). Hence, although a principal-only instrument
moves with interest rates much the way a conventional bond does, it clearly
has higher interest-rate risk.
Another variation of the collateralized mortgage obligation is the "floater,
" which refers to floating rates. For a floater, the coupon rate
is reset periodically (usually quarterly) according to an interest rate
index (usually LIBOR) subject to some coupon caps. Due to the floating-rate
structure, floaters have low price volatility and behave like money market
instruments. Prepayment risk is less of an issue for floaters, since their
coupon rates move in line with market interest rates and, hence, the reinvestment
rate. Despite their floating-rate structure, floaters are collateralized
by fixed-rate pass-throughs.
Using a fixed-rate payment stream to support floating-rate cash flows
can expose the floaters to potential cash-flow shortfalls. This could
occur if the required payments on the floater exceeded the cash flows
from the underlying mortgages and the issuer of the collateralized mortgage
obligation could not make up the difference. In order to guard against
that, some floaters are supplemented by a letter of credit from a top-rated
financial institution that guarantees their floating-rate cash flows.
However, to avoid the rather expensive credit guarantee, most floaters
are issued in conjunction with an inverse floater, with a simultaneous
pay down schedule.
For an inverse floater, the coupon rate moves in the opposite direction
of the companion floater's interest rate index to offset the movement
in the floater's coupon rate, so that the weighted-average coupon rate
matches the fixed-rate coupon rate of the supporting pass-through. While
a floater's price by design is always close to its par value, the value
of an inverse floater is very sensitive to interest rate movements and
prepayments. If interest rates rise, the value of an inverse floater would
be greatly depressed by four factors: a lower coupon rate and maturity
extension, compounded by a high discount factor as a result of higher
interest rates and longer maturity. Falling interest rates, on the other
hand, would greatly lift an inverse floater's value when higher coupon
rates, shrinking maturity, and a lower discount rate are all working in
its favor.
Further magnifying an inverse floater's price volatility is coupon leveraging.
It is quite common to have each dollar of an inverse floater accompany
multiple dollars of a floater. This requires an inverse floater's coupon
rate to move by a larger step to balance the movement in the floater's
coupon rate. For example, suppose $10 million of inverse floaters are
issued in conjunction with $40 million of floaters. In order for the weighted-average
coupon on the floaters and the inverse floaters to remain fixed, the coupon
rate of the inverse floaters must move in the opposite direction and four
times as much as the coupon rate move of the floaters. Hence, even a small
change in interest rates is translated into a big change in the inverse
floaters' coupon rate, resulting in a sizable gain (or loss) in value
when interest rates fall (or rise). Thus, although inverse floaters have
minimal credit risk, their exposure to interest-rate risk can be huge,
far greater than that of a conventional debt instrument.
In sum, mortgage-backed securities derive their cash flows from the
payments of the underlying mortgage pool. Depending on how the underlying
mortgage payments are distributed among various classes of security holders,
different securities can have very different risk-return profiles. Although
federal credit guarantees tend to make default risk of little concern
for these securities, some mortgage-backed securities can be very vulnerable
to interest rate movements.
Figure 1 illustrates the
pattern of growth for mortgage-backed securities and collateralized mortgage
obligations since 1985. During 1992-1993, issuance of mortgage-backed
securities got a big boost as low interest rates triggered a refinancing
boom. In 1993, when the 30-year fixed-rate mortgage rate dropped below
7 percent, mortgage originations reached $1.01 billion, and the securitization
rate rose to 66 percent, of which 32 percent were collateralized mortgage
obligations.
In 1994, however, the picture changed dramatically as interest rates
headed upward. With mortgage rates gradually climbing back to over 9 percent
by the end of that year, refinancing dropped sharply. While the securitization
rate in 1994 dropped slightly to 56 percent of originations, the percentage
of mortgages that were turned into collateralized mortgage obligations
plummeted to only 16 percent.
One reason for the disproportionate decline in collateralized mortgage
obligation issuance in 1994 may be to the sizable losses in some of the
these securities, most notably principal-only instruments and inverse
floaters, due to the reversal of interest rates. The well-publicized collapse
of several hedge funds that specialized in collateralized mortgage obligations,
the problems in a number of trust funds, including the Orange County debacle,
as well as the charge against some financial firms that they improperly
sold these products to individual investors, were severe blows to this
market. These losses heightened the awareness of the interest rate risk
underlying some types of collateralized mortgage obligation securities,
despite their low credit risk.
As investors have become more sensitive to the potential losses in these
securities, they have demanded greater compensation for bearing the risks
in these securities, which has depressed their prices further. The change
in demand for these securities thus brought the issuance of collateralized
mortgage obligations almost to a halt. It remains to be seen whether the
demand for these instruments will return, and if so, for which types.
Simon H. Kwan
Economist
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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