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Trading and Capital-Markets Activities Manual

Instrument Profiles: Description of Marketplace
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

DESCRIPTION OF MARKETPLACE 

Primary Market 

The original lender is called the mortgage originator. Mortgage originators include commercial banks, thrifts, and mortgage bankers. Originators generate income in several ways. First, they typically charge an origination fee, which is expressed in terms of basis points of the loan amount. The second source of revenue is the profit that might be generated from selling a mortgage in the secondary market, and the profit is called secondary-marketing profit. The mortgage originator may also hold the mortgage in its investment portfolio. 

Secondary Market 

The process of creating mortgage securities starts with mortgage originators which offer consumers many different types of mortgage loans. Mortgages that meet certain well-defined criteria are sold by mortgage originators to conduits, which link originators and investors. These conduits will pool like groups of mortgages and either securitize the mortgages and sell them to an investor or retain the mortgages as investments in their own portfolios. Both
government-related and private institutions act in this capacity. 

Ginnie Mae; Freddie Mac, and Fannie Mae are the three main government related conduit institutions; all of them purchase conforming mortgages which meet the underwriting standards established by the agencies for being in a pool of mortgages underlying a security that they guarantee. Ginne Mae is a government agency, and the securities it guarantees carry the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are government-sponsored agencies; securities issued by these institutions are guaranteed by the agencies themselves and are generally assigned an AAA credit rating partly due to the implicit government guarantee. 

Mortgage-backed securities have also been issued by private entities such as commercial banks, thrifts, homebuilders, and private conduits. These issues are often referred to as private label securities. These securities are not guaranteed by a government agency or GSE. Instead, their credit is usually enhanced by pool insurance, letters of credit, guarantees, or over-collateralization. These securities usually receive a rating of AA or better. 

Private issuers of pass-throughs and CMOs provide a secondary market for conventional loans which do not qualify for Freddie Mac and Fannie Mae programs. There are several reasons why conventional loans may not qualify, but the major reason is that the principal balance exceeds the maximum allowed by the government (these are called ''jumbo'' loans in the market). 

Servicers of mortgages include banks, thrifts, and mortgage bankers. If a mortgage is sold to a conduit, it can be sold in total, or servicing rights may be maintained. The major source of income related to servicing is derived from the servicing fee. This fee is a fixed percentage of the outstanding mortgage balance. Consequently, if the mortgage is prepaid, the servicing fee will no longer accrue to the servicer. Other sources of revenue include interest on escrow, float earned on the monthly payment, and late fees. Also, servicers who are lenders often use their portfolios of borrowers as potential sources to cross-sell other bank products. 

PRICING 

Mortgage valuations are highly subjective because of the unpredictable nature of mortgage prepayment rates. Despite the application of highly sophisticated interest-rate simulation techniques, results from diverse proprietary prepayment models and assumptions about future interest-rate volatility still drive valuations. The subjective nature of mortgage valuations makes marking to market difficult due to the dynamic nature of prepayment rates, especially as one moves farther out along the price-risk continuum toward high-risk tranches. Historical price information for various CMO tranche types is not widely available and, moreover, might have limited value given the generally different methodologies used in deriving mortgage valuation. 

Decomposition of MBS 

A popular approach to analyzing and valuing a callable bond involves breaking it down into its component parts-a long position in a non-callable bond and a short position in a call option written to the issuer by the investor. An MBS investor owns a callable bond, but decomposing it is not as easy as breaking down more traditional callables. The MBS investor has written a series of put and call options to each homeowner or mortgagor. The analytical challenge facing an examiner is to determine the value and risk profile of these options and their contribution to the overall risk profile of the portfolio. Compounding the problem is the fact that mortgagors do not exercise these prepayment options at the same time when presented with identical situations. Most prepayment options are exercised at the least opportune time from the standpoint of the MBS investor. In a falling-rate environment, a homeowner will have a greater propensity to refinance (or exercise the option) as prevailing mortgage rates fall below the homeowner's original note (as the option moves deeper into the money). Under this scenario, the MBS investor receives a cash windfall (principal payment) which must be reinvested in a lower-rate environment. Conversely, in a high- or rising-rate environment, when the prevailing mortgage rate is higher than the mortgagor's original term rate, the homeowner is less apt to exercise the option to refinance. Of course, the MBS investor would like nothing more than to receive his or her principal and be able to reinvest that principal at the prevailing higher rates. Under this scenario, the MBS investor holds an instrument with a stated coupon that is below prevailing market rates and relatively unattractive to potential buyers. 

Market prices of mortgages reflect an expected rate of prepayments. If prepayments are faster than the expected rate, the mortgage security is exposed to call risk. If prepayments are slower than expected, the mortgage securities are exposed to extension risk (similar to having written a put option). Thus, in practice, mortgage security ownership is comparable to owning a portfolio of cash bonds and writing a combination of put and call options on that portfolio of bonds. Call risk is manifested in a shortening of the bond's effective maturity or duration, and extension risk manifests itself in the lengthening of the bond's effective maturity or duration. 

Option-Adjusted Spread Analysis 

For a further discussion of option-adjusted spread (OAS) analysis or optionality in general, see section 4330.1, ''Options.'' 

HEDGING 

Hedging mortgage-backed securities ultimately comes down to an assessment of one's expectation of forward rates (an implied forward curve). A forward-rate expectation can be thought of as a no-arbitrage perspective on the market, serving as a pricing mechanism for fixed-income securities and derivatives, including MBS. Investors who wish to hedge their forward-rate expectations can employ strategies which involve purchasing the underlying security and the use of swaps, options, futures, caps, or combinations thereof to hedge duration and convexity risk.10 

With respect to intra-portfolio techniques, one can employ IOs and POs as hedge vehicles. Although exercise of the prepayment option generally takes value away from the IO class and adds value to the PO class, IOs and POs derived from the same pool of underlying mortgages do not have a correlation coefficient of negative one.11 If that were the case, the value of a pass-through security would always be hedged with respect to interest rates. However, IOs and POs do represent extremities in MBS theory and, properly applied, can be used as effective risk-reduction tools. Because the value of the prepayment option and the duration of an IO and PO are not constant, hedges must be continually managed and adjusted.

In general, a decline in prepayment speeds arises largely from rising mortgage rates, with fixed-rate mortgage securities losing value. At the same time, IO securities are rising in yield and price. Thus, within the context of an overall portfolio, the inclusion of IOs serves to increase yields and reduce losses in a rising-rate environment. More specifically, IOs can be used to hedge the interest-rate risk of Treasury strip securities. As rates increase, an IO's value increases. The duration of zero-coupon strips equals their maturity, while IOs have a negative duration.12 Combining IOs with strips creates a portfolio with a lower duration than a position in strips alone.13 

POs are a means to synthetically add discount (and positive convexity) to a portfolio, allowing it to more fully participate in bull markets. For example, a bank funding MBS with certificates of deposit (CDs) is exposed to prepayment risk. If rates fall faster than expected, mortgage holders (in general) will exercise their prepayment option while depositors will hold their higher-than-market CDs as long as possible. The bank could purchase POs as a hedge against its exposure to prepayment and interest-rate risk. As a hedging vehicle, POs offer preferable alternatives to traditional futures or options; the performance of a PO is directly tied to actual prepayments, thus the hedge should experience potentially less basis risk than other crossmarket hedging instruments. 

10. Davidson, Andrew S., and Michael D. Herskovitz. Mortgage Backed Securities-Investment Analysis and Advanced Valuation Techniques. Chicago: Probus Publishing, 1994. 
11. Zissu, Anne, and Charles Austin Stone. ''The Risks of MBS and Their Derivatives.'' Journal of Applied Corporate Finance, Fall 1994. 
12. Ibid., p. 102. 
13. Ibid., p. 104. 

RISKS 

Prepayment Risk All investors in the mortgage sector share a common concern: the mortgage prepayment option. This option is the homeowner's right to prepay a mortgage any time, at par. The prepayment option makes mortgage securities different from other fixed-income securities, as the timing of mortgage principal repayments is uncertain. The cash-flow uncertainty that derives from prepayment risk means that the maturity and duration of a mortgage security are uncertain. For investors, the prepayment option creates an exposure similar to that of having written a call option. That is, if mortgage rates move lower, causing mortgage bond prices to move higher, the mortgagor has the right to call the mortgage away from the investor at par. 

While lower mortgage interest rates are the dominant economic incentive for prepayment, idiosyncratic, non-economic factors to prepay a mortgage further complicate the forecasting of prepayment rates. These factors are sometimes summarized as the ''five D's'': death, divorce, destruction, default, and departure (relocation). Prepayments arising from these causes may lead to a mortgage's being called away from the investor at par when it is worth more or less than par (that is, trading at a premium or discount). 

Funding and Reinvestment Risk The uncertainty of the maturities of underlying mortgages also presents both funding and reinvestment risks for investors. The uncertainty of a mortgage security's duration makes it difficult to obtain liabilities for matched funding of these assets. This asset/liability gap presents itself whether the mortgage asset's life shortens or lengthens, and it may vary dramatically. 

Reinvestment risk is normally associated with duration shortening or call risk. Investors receive principal earlier than anticipated, usually as a result of declines in mortgage interest rates; the funds can then be reinvested only at the new lower rates. Reinvestment risk is also the opportunity cost associated with lengthening durations. Mortgage asset durations typically extend as rates rise. This results in lower investor returns as they are unable to reinvest at the now higher rates. 

Credit Risk 

While prepayments expose pass-throughs and CMOs to considerable price risk, most MBS pass-throughs have little credit risk.14 Approximately 90 percent of all outstanding pass-through securities have been guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac.15 This credit guarantee gives ''agency'' pass-through securities and CMOs a decisive advantage over non-agency pass-throughs and CMOs, which comprise less than 10 percent of the market. 

In general, nonagency pass-through securities and CMOs use mortgages that are ineligible for agency guarantees. Issuers can also obtain credit enhancements, such as senior subordinated structures, insurance, corporate guarantees, or letters of credit from insurance companies or banks. The rating of the non-agency issue then partially depends upon the rating of the insurer and its credit enhancement. 

Settlement and Operational Risk 

The most noteworthy risk issues associated with the trading of pass-through securities is the forward settlement and operational risk associated with the allocation of pass-through trades. Most pass-through trading occurs on a forward basis of two to three months, often referred to as ''TBA'' or ''to be announced'' trading.16 During this interval, participants are exposed to counterparty credit risk. 

Operating risk grows out of the pass-through seller's allocation option that occurs at settlement. Sellers in the TBA market are allowed a 2.0 percent delivery option variance when meeting their forward commitments. That is, between 98 and 102 percent of the committed par amount may be delivered. This variance is provided to ease the operational burden of recombining various pool sizes into round trading lots.17 This delivery convention requires significant operational expertise and, if mismanaged, can be a source of significant risk in the form of failed settlements and unforeseen carrying costs. 

14. Credit risk in a pass-through stems from the possibility that the homeowner will default on the mortgage and that the foreclosure proceeds from the resale of the property will fall short of the balance of the mortgage. 
15. For a full explanation of the minor differences between these agencies, see chapter 5 in Fabozzi, The Handbook of Mortgage-Backed Securities, 1995. 
16. In the forward mortgage pass-through trading, or TBA trading, the seller announces the exact pool mix to be delivered the second business day before settlement day. 
17. ''Good delivery'' guidelines are promulgated by the Public Securities Association in its Uniform Practices publication. 

Price Volatility in High-Risk CMOs 

When the cash flow from pass-through securities is allocated among CMO tranches, prepayment risk is concentrated within a few volatile classes, most notably residuals, inverse floaters, IOs and POs, Z bonds, and long-term support bonds. These tranches are subject to sharp price fluctuations in response to changes in short- and long-term interest rates, interest-rate volatility, prepayment rates, and other macroeconomic conditions. Some of these tranches-especially residuals and inverse floaters-are frequently placed with a targeted set of investors willing to accept the extra risk. These classes are also among the most illiquid bonds traded in the CMO market. 

These high-risk tranches, whether held by dealers or investors, have the potential to incur sizable losses (and sometimes gains) within a short period of time.18 Compounding this price risk is the difficulty of finding effective hedging strategies for these instruments. Using different CMOs to hedge each other can present problems. Although pass-through securities from different pools tend to move in the same direction based on the same event, the magnitude of these moves can vary considerably, especially if the underlying mortgage pools have different average coupons.19 

Risks in ''Safe'' Tranches 

Investors may also be underestimating risks in some ''safe'' tranches, such as long-maturity PACs, PAC 2s, and 3s, and floaters, because these tranches can experience abrupt changes in their average lives once their prepayment ranges are exceeded. Even floating-rate tranches face risks, especially when short-term rates rise significantly and floaters reach their interest-rate caps. At the same time, long rates may rise and prepayments slow, causing the floaters' maturities to extend significantly since the floater is usually based on a support bond. Under such circumstances, floater investors could face significant losses. 

In addition to possible loss of market value, these safe tranches may lose significant liquidity under extreme interest-rate movements. These tranches are currently among the most liquid CMOs. Investors who rely on this liquidity when interest-rate volatility is low may find it difficult to sell these instruments to raise cash in times of financial stress. Nevertheless, investors in these tranches face lower prepayment risk than investors in either mortgage pass-throughs or the underlying mortgages themselves. 

Cap Risk 

The caps in many floating-rate CMOs and ARMs are an embedded option. The value of floating-rate CMOs or ARMs is equal to the value of an uncapped floating-rate security less the value of the cap. As the coupon rate of the security approaches the cap rate, the value of the option increases and the value of the security falls. The rate of change is non-linear and increases as the coupon approaches the cap. As the coupon rate equals or exceeds the cap rate, the security will exhibit characteristics similar to those of a fixed-rate security, and price volatility will increase. All else being equal, securities with coupon rates close to their cap rates will tend to exhibit greater price volatility than securities with coupon rates farther away from their cap rates. Also, the tighter the ''band'' of caps and floors on the periodic caps embedded in ARMs, the greater the price sensitivity of the security will be. The value of embedded caps also increases with an increase in volatility. Thus, all else being equal, higher levels of interest-rate volatility will reduce the value of the floating-rate CMO or ARM. 

18. Examples of single-firm losses include a $300 million to $400 million loss by one firm on POs in the spring of 1987; more recently, several firms have lost between $50 million and $200 million on IO positions in 1992 and 1993. 
19. For a discussion of the idiosyncratic prepayment behavior of pass-throughs, see Sean Becketti and Charles S. Morris, The Prepayment Experience of FNMA Mortgage-Backed Securities. New York University Salomon Center, 1990, pp. 24-41. 

FFIEC Regulations Concerning Unsuitable Investments 

The Federal Financial Institutions Examination Council (FFIEC) issued a revised policy statement concerning securities activities for member banks. These rules became effective February 10, 1992, for member banks and bank holding companies under the Board's jurisdiction. A bank's CMO investments are deemed unsuitable if- 

  the present weighted average life (WAL) is greater than 10 years, 
  the WAL extends more than four years or shortens more than six years for a parallel interest-rate shift of up and down 300 basis points, or 
  the price changes by more than 17 percent from the asking price for a parallel interest-rate shift of up and down 300 basis points. 

An affirmation of any of these three parameters means that the bond in question (1) may be considered high risk and (2) may not be a suitable investment for banks or bank holding companies. An institution holding high-risk securities must demonstrate that they reduce overall interest-rate risk for the bank. 

Floating-rate CMOs with coupons tied to indexes other than LIBOR (sometimes called ''mismatched floaters'') are generally exempt from the average-life and average-life-sensitivity tests. Given the degree of price sensitivity associated with these securities, however, institutions that purchase non-LIBOR-indexed floaters must maintain documentation showing that they understand and are able to monitor the risks of these instruments. The documentation should include a pre-purchase analysis and at least an annual analysis of the price sensitivity of the security under both parallel and nonparallel shifts of the yield curve. See the Commercial Bank Examination Manual for more information on the FFIEC testing parameters detailed above. 

ACCOUNTING TREATMENT 

The accounting treatment for investments in mortgage-backed securities is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING

Pass-through securities are assigned the following weights: 

GNMA                                                    0 

FNMA and FHLMC                                20 percent 
Private label                                          50-100 percent 

Collaterialized mortgage obligations are assigned the following weights: 

Backed by Ginnie Mae, 
Fannie Mae, or 
Freddie Mac securities                       20-100 percent 

Backed by whole loans 
or private label pass-throughs            50-100 percent 

Stripped MBS are assigned a 100 percent risk weighting. 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Pass-Through Securities 

Ginnie Mae, Fannie Mae, and Freddie Mac pass-through securities are type I securities. Banks can deal in, underwrite, purchase, and sell these securities for their own accounts without limitation.

 CMOs and Stripped MBS 

CMOs and stripped MBS securitized by small business-related securities and certain residential and commercial-related securities rated Aaa and Aa are type IV securities. As such, a bank may purchase and sell these securities for its own account without limitation. CMOs and stripped Residential Mortgage-Backed Securities 4110.1 Trading and Capital-Markets Activities Manual April 2001 Page 13 MBS securitized by small business-related securities rated A or Baa are also type IV securities and are subject to an investment limitation of 25 percent of a bank's capital and surplus. Banks may deal in type IV securities which are fully secured by type I transactions without limitations. 

CMOs and stripped MBS securitized by certain residential- and commercial-mortgagerelated securities rated A or Baa are type V securities. For type V securities, the aggregate par value of a bank's purchase and sales of the securities of any one obligor may not exceed 25 percent of its capital and surplus. 

REFERENCES 

 Bartlett, William W. Mortgage-Backed Securities. Burr Ridge, Ill.: Irwin Publishing, 1994. 
 Becketti, Sean, and Charles S. Morris. The Prepayment Experience of FNMA Mortgage-Backed Securities. New York: New York University Salomon Center, 1990. 
 Cilia, Joseph. Advanced CMO Analytics for Bank Examiners-Practical Applications Using Bloomberg. Product Summary. Chicago: Federal Reserve Bank of Chicago, May 1995. 
 Davidson, Andrew S., and Michael D. Herskovitz. Mortgage-Backed Securities- Investment Analysis and Advanced Valuation Techniques. Chicago: Probus Publishing, 1994. 
 Fabozzi, Frank J., ed. The Handbook of Mortgage-Backed Securities. Chicago: Probus Publishing, 1995. 
 Fabozzi, Frank J. Valuation of Fixed-Income Securities. Summit, N.J.: Frank J. Fabozzi Associates, 1994. 
 Klinkhammer, Gunner, Ph.D. ''Monte Carlo Analytics Provides Dynamic Risk Assessment for CMOs.'' Capital Management Sciences, Inc. October 1995.  
 Kopprasch, RobertW. ''Option Adjusted Spread Analysis: Going Down the Wrong Path?'' Financial Analysts Journal. May/June 1994. 
 Zissu, Anne, and Charles Austin Stone. ''The Risks of MBS and Their Derivatives.'' Journal of Applied Corporate Finance. Fall 1994 Secondary Market for CMOs. 

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