vi: debt market instruments 20: asset-backed securities

VI: Debt Market Instruments

20: Asset-Backed Securities

Chapter 20: Asset-Backed Securities © Oltheten & Waspi 2012

Asset Backed Securities

Investment Companies Investment Trusts Open End Companies (Mutual Funds) Closed End Companies

Securitization Mortgage Backed Securities Other Securitization


Investment Companies


Net Asset Value

Net Asset Value = Market Value of Assets Units


Open Ended (Mutual Fund)

We can create a new partnership (unit) only if we have Open Ended Capitalization


Open Ended (Mutual Fund)

We can destroy the partnership (unit) only if we have Open Ended Capitalization.

This can entail selling assets to realize sufficient funds to redeem the unit.


Closed End Fund

Cannot create new partnership units Closed End Capitalization means that the

number of units are fixed)


Investment Companies

Open Ended (Mutual) Funds Create and destroy/redeem units as needed Primary market only

Closed End Funds Units are fixed After initial offering units must be bought and

sold in the secondary market where they trade just like stocks.


Why Investment Companies

Economies of scale Diversification Lower transaction costs

Professional management


Performance

Average annual return 1980-2005

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00%

S&P Index 12.3%

10.0%

7.3%

Mutual Funds

Mutual Fund Investor


Performance

Average annual return 1980-2010

© Oltheten & Waspi 2012

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

S&P Index 8.06%

10.0%

7.3%

Mutual Funds

Mutual Fund Investor

Chapter 20: Asset-Backed Securities

Mortgage Backed Securities



Mortgages

Structured so that payments are Monthly Even over the life of the loan


Mortgages

$1,000,000 principal loan 8½% 30 years

1r1

r1r*PrincipalPaymentMonthly m

m


Mortgages

$1,000,000 principal loan 8½% 30 years

Monthly mortgage payment? How much is principal repayment How much is interest? After the first payment what is the loan

principal?


Mortgages

Month One: Payment = $7,689.13 Interest = $7,083.33 Principal = $605.80

Now owe $999,394.20

1r1

r1r*PrincipalPayment m

m


Calculator Techniques [2nd][Quit] [2nd][FV] [2nd][P/Y] 12 [2nd][BGN] [2nd][Quit]

1000000 [PV] 8.5[I/Y] 30 [2nd][xP/Y][N]

[CPT][PMT]

Clear 12 pmts/yr End of Period pmts Calculator Mode

PV=-$1m Rate = 8.5% N=360 months

$7,689.13


Calculator Techniques

[2nd]Amort [2nd][CLR WORK] [↓] 12

Amortization P1 = 1 P2= P2=1

BAL = - 999,394.20 PRN = 605.80 INT = 7,083.33

P1=1 to P2=1 means that you

get month 1 only


Mortgages


Principal portion of payment

I nterest portion of payment

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

0 60 120 180 240 300 360

Months

Paym

en

t p

er

Mo

nth


Mortgages


$0

$200,000

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

0 60 120 180 240 300 360

Months

Rem

ain

ing

Pri

ncip

al


Primary Market

The bank writes 10, 30 year mortgages of $1,000,000 at 8½%

No more money


Primary Market -> Secondary Market

Mortgages

Secondary Market

Investors

$$$

Bank

$$$

More Mortgages


The Secondary Market

If the Bank can sell the mortgages to investors then it will have capital to extend more loans.



Put the 10 $1m mortgages into a $10,000,000 pool (group)

Guarantee each mortgage by GNMA or FNMA



GNMA Government National Mortgage Association

Wholly owned government corporation within HUD Neither originates or purchases mortgage loans

FNMA Federal National Mortgage Association

GSEs owned by its shareholders (until Sept 7, 2008) In 2008 owned approx ½ of the $12 trillion mortgage

market



Divide the pool into 1000 $10,000 units 8.0% goes to the Investor 0.1% goes to Ginnie Mae 0.4% goes to the Originating Bank (me)

I sell the units to investors through a broker


Pass Through Securities

A pass-through security is a pro-rated ownership of all the mortgages in the pool Each unit represents 1/1000th of each of the

10 mortgages in the pool.


Risk

Credit Risk: There is no credit risk because if the

homeowner defaults GNMA will use its own funds to make payments until the mortgage is foreclosed and the mortgage paid off.

Prepayment or Contraction Risk: This is the risk that the mortgage is paid off

early. Prepayment risk is similar to an open call without penalty.


CMO

Put Through securities: all units in a pool are equal

Collateralized Mortgage Securities: units are unequal. inventive structures Tranches / classes


Securitization

Securitization is the process by which loans are turned into securities for sale to investors.

The creation of this secondary market allows the primary market to function more efficiently


Securitization

Mortgages Car Loans Consumer debt

vi: debt market instruments 20: asset-backed securities

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