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Chapter 23 Asset-backed securities.

WHAT IS IT?

Asset-backed securities (ABS) are debt-type securities that are secured by a pool of similar debt obligations or receivables. The market for these securities arose in the early 1980s with the advent of mortgage-backed securities (MBS). Now virtually all forms of debt obligations and receivables have been securitized in the United States: residential mortgages; home equity loans; manufactured housing loans; timeshare loans; auto, truck, RV, aircraft and boat loans and leases; credit card receivables; equipment loans and leases; small business loans; student loans; trade receivables (of just about any type--e.g., airline tickets, telecommunications receivables, toll road receipts); and lottery winnings. Although the basic concepts--many based upon tax and accounting effects and desired results--are essentially the same, each asset class presents unique structuring considerations, and the players are constantly looking for ways to improve structures to achieve higher ratings (and thus lower costs) and to reduce expenses. Securitizations outside the United States have been more limited, but the market is growing. In Latin America the principal asset class to be securitized has been trade receivables (primarily the "future flow" from trade receivables).

For most non-corporate or non-institutional investors, mortgage-backed securities are the most familiar and accessible class of asset-backed securities. Mortgage-backed securities are simply ownership of an interest in a pool of residential mortgages. A trustee is assigned to hold the titles to all mortgages in the pool and to see that all mortgages and properties are in acceptable form and that payments are properly made.

Three of the best-known sources of these instruments are the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC). GNMA is a wholly-owned U.S. government corporation within the Department of Housing and Urban Development. FNMA is a government-sponsored corporation owned entirely by private stockholders, though it is regulated by the Department of Housing and Urban Development. FHLMC was created by Congress and is owned by the twelve Federal Home Loan Banks. The securities they issue are appropriately nicknamed, "Ginnie Maes," "Fannie Maes," and "Freddie Macs." State and local government agencies, as well as institutions in the private sector, such as the Bank of America, also issue various types of mortgage-backed securities. These privately issued securities are known collectively as "Connie Macs."

Although the markets and types of non-mortgage asset-backed securities are growing rapidly, the principal market for non-institutional investors is still mortgage-backed securities. Consequently, this chapter will focus on mortgage-backed securities.

WHEN IS THE USE OF THIS TOOL INDICATED?

1. When an investor desires a relatively secure type of investment that in most cases is guaranteed by the United States Treasury or a federal agency. Large money center banks that also offer a high degree of security generally offer private issues. Another factor contributing to the safety of these issues is the broad geographical distribution of the underlying mortgages. Many mortgage-backed securities obtain their underlying mortgages from throughout the country and, therefore, are not overly influenced by economic conditions in any one state or region.

2. When the investor desires a relatively high rate of return. The competitive yield on instruments such as GNMAs is generally higher than other long-term government securities.

3. When the investor requires a high level of cash flow. These instruments typically provide monthly payments that consist of both interest and the return of some portion of the loan principal. Payments to investors in the pass-through type of instrument may vary somewhat from month to month because some mortgages within the pool may be paid off before maturity and others may be partially prepaid.

4. When the investor desires a high level of liquidity. There is a very active secondary market for these issues because they are bought and sold through investment bankers, and their price and yield quotations are easily found in the financial sections of most major newspapers.

5. When the investor seeks to diversify his portfolio beyond stocks and corporate bonds. Mortgage-backed securities are essentially an investment in real estate and, therefore, provide an alternative to money market funds and other income-oriented corporate securities.

ADVANTAGES

1. Mortgage-backed bonds are virtually risk-free in terms of return of principal and certainty of income.

2. Because interest rates on residential mortgages are usually higher than short-term money market rates or even long-term corporate bond rates, these issues provide one of the highest rates of return available from debt instruments. GNMAs, for example, offer the highest yield of any actively traded, federally guaranteed security. They have tended to yield 15% to 20% more than the yield on intermediate Treasury bonds. They have also outperformed AAA-rated corporate bonds over the period from 1985 through 2005 by about 5%.

3. Holders of mortgage-backed securities are usually guaranteed a monthly payment of interest and principal, whether or not the issuer has actually collected these sums. (In the case of "straight pass-through" certificates, GNMA guarantees only the proper performance of the mortgage servicing and the payment of only that interest and principal actually collected. In the case of "modified pass-through" certificates, GNMA guarantees the timely payment of principal and interest, whether or not collected by the originating association.)

4. Payments are generally made by the fifteenth day of the calendar month following the month in which collections on mortgages are made. Monthly principal payments to investors may actually increase at times because homeowners may voluntarily pay off their mortgage loans (e.g., when they sell their homes), or accelerate payments of principal (e.g., to reduce the term of their mortgage and the overall amount of interest paid on the loan.)

5. There is a well-developed secondary market for mortgage-backed securities, especially for those issued by federal agencies. In the private sector, the larger the issuer, the more active the market for mortgage-backed securities of that issuer. This means that investors will have little or no difficulty in selling their securities if the need arises.

However, the selling price of an issue is not guaranteed and is subject to change as the level of mortgage interest rates changes. For example, if mortgage rates rise, the price of previously issued securities tends to decline because more attractive rates are available in the marketplace. Likewise, if rates fall, the price of existing issues will tend to increase.

6. Early repayments of mortgage loans may be subject to prepayment penalties. This operates to the advantage of the investor since these amounts are passed through and added to his monthly income.

DISADVANTAGES

1. Like other interest-sensitive assets, the price of mortgage-backed securities will tend to fall when market interest rates rise. This potential for capital depreciation could seriously affect the investor who is forced to sell his investment before it matures.

2. Mortgage-backed securities are subject to two types of inflation risk: (1) the risk that the purchasing power of their income will be eroded over time; and (2) the risk that the purchasing power of capital received at maturity will have diminished. This second risk is minimized to a degree by the very nature of the instrument itself--the investor constantly recovers principal that is available for reinvestment or current consumption.

3. A direct investment in mortgage-backed securities is difficult for many investors because a high minimum investment is required. For instance, a GNMA certificate has a principal value of $25,000 at its inception. (The actual amount an investor pays may be less than $25,000 if the pool of mortgages has been in existence for some time and some of the original principal has been repaid.) However, this disadvantage may be overcome by investing in mutual funds that specialize in mortgage-backed securities. These funds are discussed in more detail below.

4. Mortgage-backed securities carry the risk that the underlying mortgages will be paid off more quickly than anticipated and, thus, the holder will receive the stated interest for a shorter time period than desired.

[FIGURE 23.1 OMITTED]

Mortgages are prepaid for a variety of reasons as homeowners relocate and refinance. The prepayment experiences on mortgage-backed securities vary depending on the underlying mortgages, and there is no way of accurately predicting an individual security's life. However, the general level of interest rates will affect prepayments because refinancing becomes more or less economically advantageous. For example, a new 30-year mortgage would have an average life of 21 years based on the scheduled amortization included in the monthly payments. When a large group of these mortgages are aggregated, however, about 10% of these mortgages on average are pre-paid when interest rates and housing conditions remain constant. If you assume an annual prepayment rate of 10%, a mortgage pool's average life is reduced to about 8 years. This average life could be even shorter, though, if market interest rates decline substantially below the existing mortgage rates, leading more homeowners to refinance. Conversely, when interest rise substantially above the existing mortgage rates, fewer homeowners refinance and mortgage-backed securities will tend to be paid off more slowly than otherwise anticipated.

Figure 23.1 shows the cash flow patterns for three mortgage securities in which the underlying mortgages are prepaid at annual rates of 5%, 15%, and 25%. The mortgage securities with prepayments running at about 15% provide annual cash flows (both interest and principal) of 20% to 25% of one's initial investment in the first few years, with declining rates of cash flow as the years pass. In contrast, the mortgage security that is experiencing 5% in prepayments has a much steadier cash flow. The security experiencing 25% prepayments has even higher cash flows in the initial years. As the figure illustrates, owning a portfolio of mortgage securities is like owning a substantial portion of bonds with a relatively short maturity, a moderate portion of bonds with an intermediate maturity, and a small portion of bonds with a long maturity. This helps explain why mortgage securities generally experience less dramatic interest-rate-related price changes than most 10-year-or-longer maturity bonds.

5. Since the periodic payments from mortgage-backed securities include both interest and a return of principal, mortgage-backed bondholders face greater reinvestment risk than regular bondholders. The periodic payments must be reinvested and if interest rates have fallen, that money will be reinvested at lower rates, thus, lowering future total return. Also, prepayments generally accelerate when it is least desirable from the mortgage-backed security holder's point of view. If market interest rates decline substantially below the existing mortgage rates, more homeowners are likely to refinance, forcing the mortgage-backed security holder to reinvest the payments at lower yields. Conversely, prepayments are generally delayed when it is most desired (i.e., under conditions of higher interest rates).

Investors who purchase mortgage-backed securities at a premium in the secondary market are at especially high risk from early prepayment. Rapid payoffs will reduce their realized yield. This occurs because investors are unlikely to fully amortize (i.e., recover) the premium before the bonds are repaid.

TAX IMPLICATIONS

1. The interest income from mortgage-backed securities is reportable as ordinary income in the year received. Each investor will receive from the issuer a monthly statement indicating what part of the distribution represents (1) scheduled amortization of principal, (2) interest, and (3) unscheduled collection of principal.

2. The portion of each monthly payment that represents the return of principal is a nontaxable repayment of the original investment. However, in some cases, principal payments may represent a discount on the purchase of the mortgages in the past or, if the bond is acquired in the secondary market, a market discount, and to this extent must be included as ordinary income. The investor must therefore report as ordinary income his ratable share of any discount income realized on the purchase of each of the mortgages in the pool under the "original issue discount" and "market discount" rules. These rules are discussed in more detail in Chapter 43, "Taxation of Investment Vehicles."

3. Prepayment penalties, assumption fees, and late payment charges passed through to the investor are ordinary income reportable in the year received.

4. Gains on the sale of these issues are typically capital gains. But, if an investor purchased a new issue at a discount (called "original issue discount"--see Chapter 43), the remaining unrecognized portion of the discount will be taxed as ordinary income. Similarly, any remaining unrecognized market discount will be taxed as ordinary income.

5. Amounts withheld from the investor by the issuer of the certificate to pay servicing, custodian, and guarantee fees are expenses incurred for the production of income and as such are deductible as miscellaneous itemized deductions. However, these miscellaneous items must be combined with certain miscellaneous items from other sources, and the total is deductible only to the extent it exceeds 2% of the investor's adjusted gross income.

ALTERNATIVES

1. Many large mutual fund organizations sponsor funds that specialize in mortgage-backed securities. They invest shareholders' funds in a diversified portfolio of securities issued by GNMA, FNMA, the Federal Home Loan Mortgage Corporation, and private issuers such as the Bank of America. These funds are particularly attractive to small investors who may not be able to invest $25,000 directly in mortgage-backed securities. They also offer automatic monthly reinvestment of interest, principal, or both, for investors who do not need additional income. In some cases mutual funds employ financial futures as well as put and call options to hedge against changes in interest rates that affect the rate of prepayments. This provides investors with some additional protection against the prepayment risk and reinvestment risk inherent in direct ownership of mortgage-backed securities.

2. Real Estate Investment Trusts (REITs) offer some of the same features as mortgage-backed securities even though they are quite different in form. Investors in REITs purchase common shares in the REIT instead of bonds. These funds are then invested by the investment trust in a diversified portfolio of real estate such as apartment buildings, shopping centers, office complexes, and real estate mortgages. In order to qualify as a real estate investment trust under the Internal Revenue Code, 90% of the entity's income must be obtained from rents, dividends, interest, and gains from the sale of securities and real estate properties. REITs are discussed in Chapter 21.

3. Collateralized mortgage obligations and Real Estate Mortgage Investment Conduits (REMICs) are quite similar in many respects to pass-through participation certificates and other mortgage-backed-bonds. These are discussed in Chapter 22.

WHERE AND HOW DO I GET IT?

An investor can call a brokerage firm and purchase mortgage-backed securities in much the same fashion as stocks and bonds. Also, these issues may be purchased through those banks and thrift institutions that offer their customers investment services.

WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?

Investors can expect to pay a modest commission or service charge to the brokerage firm or bank handling the transaction. This fee is typically $15 to $25 for each thousand dollars invested, and the fee may be included in the total cost of the securities purchased rather than shown separately as a commission or service charge.

HOW DO I SELECT THE BEST OF ITS TYPE?

At first glance it may appear that all mortgage-backed securities are similar. Yet there are a number of distinctions an investor should consider in the selection process. These include:

1. The Identity of the Issuer--A United States government guarantee assures the investor of the highest degree of safety of principal. A guarantee by a private mortgage issuer (e.g., the Bank of America) may be safe, and yet an investor should not have quite the same level of confidence that those payments of principal and interest will be made.

2. The Age of the Mortgages in the Pool--The payments received from older mortgages are made up of larger amounts of mortgage principal and smaller amounts of interest. This is because the early payments made on a mortgage are almost all interest and only a small amount is used to reduce the outstanding principal of the loan. Principal amounts in excess of basis will be taxed as capital gains, while interest will be taxed as ordinary income.

3. The Nature of the Underlying Mortgages Included in the Pool--Safety of principal and certainty of income payments depend upon: (a) the quality of the mortgages; (b) the number and size of the mortgages; (c) the distribution of mortgage maturities; and (d) the geographic distribution of mortgages. These factors will affect the amount of monthly cash flow and the breakdown between principal and interest as well as the regularity, predictability, and certainty of payment.

4. The Guarantees on the Security and the Mortgages--There are four types of guarantees that are given by issuers in order to enhance their creditworthiness. These include the following: (a) guarantees on interest payments; (b) guarantees on principal payments; (c) mortgage guarantee insurance; and (d) hazard insurance (covering such risks as earthquakes and floods). Because not all of these guarantees will apply to every issue, the investor should select the issues that provide those guarantees that are most important to him.

5. The Risk-Return Tradeoff--The securities that provide the lowest level of risk and that offer the most prompt payment (i.e., GNMAs) trade at a lower yield than other mortgage-backed securities. Conversely, various private issues trade at much higher yields because of their somewhat higher risk. A compromise is the Freddie Mac issue, which provides a level of security and guarantee of timely payment only slightly lower than a GNMA, but that may trade at a yield ranging from 15 to 40 basis points higher.

The table in Figure 23.2 illustrates the various factors that should be considered by an investor with respect to each of the major types of mortgage-backed securities.

WHERE CAN I FIND OUT MORE ABOUT IT?

1. Listings of mortgage-backed securities issued by GNMA and FNMA are carried daily in the Wall Street Journal (www.wsj.com) and other major newspapers. These listings show the securities available, current prices, and the yield on each issue.

2. The larger brokerage houses and mortgage banking firms publish a variety of booklets on mortgage-backed securities. Two of the best sources of information are First Boston Corporation and Salomon Brothers, both located in New York City. An excellent guide to mortgage-backed securities and other U. S. government issues is the Handbook of Securities of the United States Government and Federal Agencies published by First Boston Corporation.

QUESTIONS AND ANSWERS

Question--What are the two major types of mortgage-backed securities?

Answer--The two general types of mortgage-backed securities are: (1) pass-through certificates, and (2) mortgage-backed bonds. In the pass-through arrangement, investors actually own a share of the pooled mortgages. The stream of income generated by payments of principal and interest on mortgage loans is passed through to the investor. Mortgage-backed bonds are general obligations of issuing institutions and do not constitute a sale of assets as is the case with the pass-through arrangement. This debt is collateralized by a pool of mortgages that is held by a trustee representing the bondholders. Payments of principal and interest on mortgage-backed bonds are made out of the institution's overall asset earnings generated primarily through mortgage loans.

Question--How does a pass-through certificate work?

Answer--There are several variations of pass-through certificates. A straight pass-through pays principal and interest as they are collected from the mortgage pool. If payments on the underlying mortgages are delayed, payments to holders of pass-through investors are similarly delayed. A partially modified pass-through guarantees that monthly principal and interest payments will be made to a certain extent, even if not collected from the mortgage pool. For example, the issuer might guarantee payments up to 5% of the original or current principal amount of the certificate. A modified pass-through guarantees payment of the scheduled monthly principal and interest payments, irrespective of the amounts that are collected from the mortgage pool.

Question--What types of mortgage-backed bonds are there?

Answer--There are essentially four types of mortgage-backed bonds:

1. pay-through bonds;

2. straight mortgage-backed bonds;

3. collateralized mortgage obligations (CMOs); and

4. Real Estate Mortgage Investment Conduit (REMIC) bonds.

Pay-throughs (also called "cash-flow" bonds) are designed so that the required amortization from the pool of mortgages will at all times be at least equal to the payments of both interest, at the coupon rate, and scheduled principal on the bonds. Additional payments of principal are made to bondholders when there are prepayments on the mortgage pool. Therefore, the life of the bonds is determined by the life of the mortgage pool. Although these instruments are treated differently than pass-throughs from the issuer's standpoint (because they are considered the debt of the issuer rather than a sale of claims on the underlying mortgage pool), they are functionally equivalent to pass-throughs from the investor's perspective. (Some pay-throughs are not fully amortizing; some may have balloon payments due at maturity.)

Straight mortgage-backed bonds are similar to conventional corporate bonds, except that a mortgage pool rather than the general assets of a regular corporation secures them. They feature scheduled interest payments on a monthly, quarterly, semi-annual, or annual basis. Principal is typically not scheduled to be repaid until the bonds mature, although interim principal repayments are not uncommon. The issuer is often required to maintain a specified amount of mortgages in the mortgage pool. If a mortgage is prepaid or foreclosed, the issuer usually must substitute similar mortgages into the pool. Many straight mortgage-backed bonds are callable at the discretion of the issuer, similar to most conventional corporate bonds. In many cases these issues have a sinking fund feature that requires the issuer to deposit principal received on the underlying mortgages in an escrow account and to call (i.e., buy back) a specified portion of the outstanding bonds at specified intervals or when the sinking fund reaches certain levels. The bonds are generally called by random lot. In other words, some bondholders, determined at random, are periodically required to redeem their bonds before the maturity date.

Collateralized mortgage obligations (CMOs) and REMIC bonds (i.e., regular interests in REMICs) are more complicated hybrid securities combining features of pass-through certificates and conventional corporate bonds. These bond issues typically have several classes of interests (technically called "tranches") with differing rights to interest and principal from the underlying mortgage pool. They are designed to give investors the benefit of the high yields characteristic of other mortgage-backed securities without the same degree of uncertainty as to when principal will be repaid. Because of their importance as well as their unique and complex features, CMOs and REMICs are discussed in Chapter 22 and will not be discussed further in the remainder of this chapter.

Question--What is the minimum investment in a GNMA or FNMA certificate?

Answer--Initially these certificates have a principal value of $25,000. The amount actually paid may be less depending on whether the certificate is being sold at a lower amount due to amortization of principal (which may have occurred after the establishment of the particular pool). In such cases, the certificates may be purchased for substantially less since the original mortgage pool is actually lower in value. Increments above the $25,000 initial minimum are $5,000 for GNMA issues. There are no similar restrictions above the $25,000 minimum on FNMA issues.

Question--What if one or more of the mortgages in a pool goes into default?

Answer--In most cases, the issuer of the mortgage-backed security, such as GNMA or FNMA, must continue to pay the full amount of principal and interest payments even though a mortgage may be in default. As a matter of fact, the security holder will not be aware of any defaults and is not affected by them.

Question--What is the average maturity of a mortgage-backed security?

Answer--Most of the residential mortgages that make up the pools behind these issues are 30-year mortgages. However, homeowners may pay off their mortgages in advance (which typically occurs when a home is sold), make partial prepayments (which reduce the average life of the pool), or go into default. Taking all of these factors together, the average life of most mortgage-backed securities tends to be about 8% years in length. However, older pools with lower interest rate mortgages are not likely to be paid off as quickly and will have a longer average life. Mortgage pools of VA and FHA mortgages tend to have longer average lives than other mortgage pools. Mortgage-backed bonds are typically issued with maturities ranging from five to 12 years.

Question--Can the yield on these issues be compared to those available on corporate bonds?

Answer--Yes, but there are some important differences. Mortgage-backed securities lack a definite maturity date and their average life can only be estimated. This uncertainty can have a major impact on the actual rate of return earned on such an investment. Also, most corporate bonds pay interest semiannually, while the interest on GNMAs and FNMAs is paid monthly. This means that interest on mortgage-backed securities can be compounded monthly rather than just twice each year. Over the course of six monthly payments, the effective rate of return earned on the mortgage-backed bond will be higher than one paying interest semiannually even though the stated rate on each issue is the same.

Question--How is the yield on a mortgage-backed security determined?

Answer--The yield an investor will actually receive on mortgage-backed securities depends critically on the rate of prepayments on the underlying mortgages. Both the yield quotation and the projected maturity depend on the specific prepayment assumption. Realized prepayment depends on the demographic, financial, and contractual nature of the underlying mortgage assets, as well as on the structure and guarantees of the mortgage-backed security issue itself.

Question--How is the quoted yield on mortgage-backed securities determined?

Answer--The quoted yield on a mortgage-backed security is the "internal rate of return" (IRR) of all cash inflows (i.e., the interest and principal payments) and cash outflows (i.e., the price paid for the security). Simply stated, the IRR can be viewed as follows: If the investor placed the purchase price of the security in an interest-bearing savings account paying interest equal to the IRR, he could withdraw cash from the account exactly matching the projected cash flows from the security with no balance left over. The quoted yield (IRR) depends critically on when prepayments of principal are assumed to occur. Yields have been quoted in different ways by different dealers, making comparisons based on quoted yields extremely difficult, and often irrelevant.

Question--What prepayment assumptions are used to determine quoted yields?

Answer--The "weighted average life" (WAL) is commonly used in the secondary mortgage market as a measure of the effective maturity of a mortgage pool. The WAL will be longer if the assumed prepayments are slower but shorter if the assumed prepayments occur faster. Anumber of conventional specifications of assumed prepayment rates have been used.

The first and simplest specification is to assume the "standard mortgage yield." This specification assumes there are no prepayments whatsoever until year 12 on 30-year mortgages, when all the mortgages in the pool are assumed to prepay entirely. Of course, in reality some prepayments are inevitable before year 12. Therefore, a quoted yield based on these "standard" prepayments assumption seriously understates the potential yield on a security trading at a deep discount, and it overstates the potential yield on one selling at a premium.

A second prepayment specification bases assumed prepayments on FHA experience. The FHA compiles historical data on the actual incidence of prepayments on the mortgage loans it insures. The quoted yield is determined by assuming some ratio of FHA experience. For example, if prepayments are expected to be slower than historical FHA experience, a ratio of 75% of the FHA experience might be used. The benefit of this method is that it uses historically validated assumptions, including in particular the tendency to have higher prepayments in the first few years of the mortgage pool than in later years. The problem with this method is that it incorporates information on a variety of market conditions and mortgages that may not reflect the attributes of the underlying mortgage pool. Figure 23.3 shows the annual FHA prepayment rates based on 1981 experience.

[FIGURE 23.3 OMITTED]

A third prepayment specification is the "constant prepayment rate" (CPR). This specification assumes that the percentage of the principal balance that is prepaid during a given year is a constant, such as 6%. Because of its simplicity, the CPR method has often been used to determine quoted yields. Figure 23.3 shows the annual prepayment rates based on a 4% constant assumed rate.

Finally, many quoted yields are now based on the standard prepayment experience offered by the Public Securities Association (PSA), an industry trade group. The PSA's goal is to bring some standardization to the marketplace. Essentially, the PSA standard is a combination of the PSA experience method and the CPR method. The first 30 months of the PSA standard calls for a steadily rising prepayment rate. After that, the rate is assumed constant at 6%. Figure 23.3 shows the assumed annual prepayments using the PSA standard method. Similar to the FHA method, the prepayments may be expected to be faster or slower than normal. For example, 150% of the PSA standard would project prepayment rates that are, again, half as great as under normal conditions.

Question--How are the yields an investor will actually realize related to the quoted yield and the rate at which prepayments occur?

Answer--The yield an investor actually realizes may vary significantly from the quoted yield if the actual rate of prepayments of principal differs from the assumed rate of prepayments that was used to calculate the quoted yield.

Investors who buy mortgage-backed securities at a premium (i.e., when the coupon rate paid on the security exceeds the current market rate of return for comparable securities) will realize yields that are less than the quoted yields if actual prepayments are faster than assumed when computing the quoted yield. This general principle can be demonstrated with a simple example. A regular bond maturing in two years with a face value of $1,000 and paying an annual coupon of $100 is priced at $1,017.59-a $17.59 premium over the face value. The quoted yield (IRR), assuming the bond is not "called" (i.e., prepaid) before the end of the second year, is therefore 9%. In other words, bonds of similar quality selling at their face values of $1,000 carry coupon rates of 9%. However, if the bond is called for $1,000 after the first year, the actual yield is 8.1%. (The $100 coupon less the $17.59 loss in value on the bond divided by the original investment of $1,017.59 equals 8.1%.) Consequently, the realized yield when principal is prepaid after year one (rather than after year two as assumed when computing the quoted yield) is less than the quoted yield of 9%. Although assumed and actual principal repayment schedules for mortgage-backed securities are more involved than in this simple example, the same general relationship between quoted and realized yields holds.

Conversely, realized yields on mortgage-backed securities purchased for premiums will be higher than quoted yields if actual prepayments are slower than assumed. This relationship can be demonstrated by simply reversing the example described above. An investor who purchases the bond for $1,017.59 and anticipates that it will be called after one year for $1,000 expects a yield (quoted yield) of 8.1%. If the bond is not called as expected after one year, the actual realized yield will be 9%.

Similarly, investors who buy mortgage-backed securities at a discount (i.e., when the promised interest rate is less than current market rates for comparable securities) will realize yields that are greater than the quoted yields if actual prepayments are faster than assumed prepayments. For example, an investor who buys a $1,000 face-value bond with an 8% annual coupon and a 2-year maturity for $982.41 (a $17.59 discount) has an expected yield to maturity (quoted yield) of 9%. If the $1,000 face value of the bond is prepaid at the end of the first year, the realized yield is 9.93%. (The $80 coupon plus the $17.59 appreciation on the bond divided by the $982.41 purchase price equals 9.93%.) Therefore, when actual prepayments of principal are faster than assumed, the realized yield on debt instruments purchased at a discount is greater than the quoted yield based on the assumed prepayments. Conversely, realized yields will be lower than quoted yields if actual prepayments are slower than assumed prepayments.

Investors who buy mortgage-backed securities at par (i.e., when the promised interest rate is equal to current market rates for comparable securities) will realize yields equal to the quoted yield, regardless of when prepayments occur.

In addition, regardless of whether investors purchase their securities at a premium, a discount, or at par, the timing of prepayments will also significantly affect their potential total return, including reinvestment. Specifically, if actual prepayments are faster than assumed, reinvestment return will be lower than expected if interest rates have fallen. If interest rates have risen, reinvestment return will increase. Conversely, if actual prepayments are slower than assumed, reinvestment return will be either higher or lower than expected depending on whether interest rates have risen or fallen, respectively.

The greater the difference between the assumed prepayments and the actual prepayments, the greater the difference will be between the quoted and realized yield. Consequently, to compare potential investments in mortgage-backed securities and to determine a realistic estimate of the potential yield, investors must understand the types of prepayment assumptions that are used to compute quoted yields.

Question--Are there any tax-free issues of mortgage-backed securities?

Answer--Yes, a small number of tax-exempt issues are available through the municipal bond departments of investment banking and brokerage firms. These securities are designed to raise funds for low-income housing construction and subsidized low interest mortgage loans. They are generally issued by state and local housing authorities.

Question--Are there marketable securities backed by other types of loan agreements?

Answer--Yes, in recent years investment bankers have been extremely creative and have come up with new marketable securities backed by every kind of loan agreement imaginable. Securities have been issued that are backed by auto loans, computer leases, and even credit card charge accounts.

Some lesser-known loan-backed securities come close to the record that Ginnie Mae 30-year home mortgage securities have experienced for high yields and safety. Specifically, the Student Loan Marketing Association (Sallie Mae) is a government-chartered corporation that creates a market in federally guaranteed student loans. It buys the loans from lending institutions and finances those purchases by issuing bonds to the public. Unlike mortgage pass-throughs, which are set up so that both interest and principal payments are "passed through" to investors each month, these bonds, called Sallie Maes, are in the form of conventional bonds. They pay interest semiannually, have set maturity dates, and return all principal when they mature. Although the bonds don't carry an explicit government guarantee, they are virtually risk-free because the underlying student loans are federally guaranteed. Sallie Maes, which are issued in minimum denominations of $10,000, yield about 0.25% more than Treasury bonds of comparable maturities.

Few investors realize that the same agency that issues Ginnie Maes also issues pass-through securities backed by mobile-home loans. These high-yielding, government-guaranteed securities have shorter maturities than conventional Ginnie Maes and tend to have less prepayment risk. That's a plus for investors seeking high-yield securities that sell at a premium. The securities are sold in four maturities: 12-years, 15-years, 18-years, and 20-years.

Question--Are Ginnie Maes subject to state taxation?

Answer--Federal statues provide that all Treasury bonds, notes, and other obligations of the federal government are not subject to state income taxation; however, Ginnie Maes are not direct obligations of the federal government. They are issued by private financial institutions, and the timely payment of interest and principal is guaranteed by the Government National Mortgage Association. Even though Ginnie Maes are backed by the full faith and credit of the federal government, the securities are not direct federal government obligations. Therefore, Ginnie Maes are subject to state income and personal property taxes as well as local taxation. The United States Supreme Court made this determination in June 1987.1 This decision also extends to other privately issued securities guaranteed by the federal government.

CHAPTER ENDNOTES

(1.) Rockford Life Insurance Company v. Illinois Department of Revenue, 107 S.Ct. 2312 (1987).
Figure 23.2
TYPES OF MORTGAGE-BACKED SECURITIES

                                        Freddie           Freddie
                    Ginnie Mae          Mac PC            Mac GMC

Payment Stream    Monthly;          Monthly;          Semi-annually;
                  guaranteed 15-    guaranteed 44-    annual
                  day delay.        day delay.        principal
                  Periodic          Periodic          payments.
                  prepayments.      prepayments.

Underlying        FHA/VA            Conventional      Conventional
Asset             mortgages.        mortgages.        mortgages.

Guarantee         Full faith and    Freddie Mac net   Freddie Mac net
                  credit of U.S.    worth; private    worth; private
                  Treasury.         mortgage          mortgage
                                    insurance on      insurance on
                                    mortgages with    mortgages with
                                    LTV over 80.      LTV over 80.

Liquidity/        Active market     Active market     Less active due
Secondary         due to high       due to high       to high volume
Market            volume of         volume of         of issue, lower
                  issue, risk-      issue, low-       issue volume.
                  free status.      risk status.

First Issued      1970              1971              1971

Rating/Risk       Government        Considered        Same as Freddie
Equivalent.       security; no      nearly            Mac PC.
                  rating            equivalent to a
                  required.         government
                                    security; no
                                    rating.

                       FNMA         Mortgage-Backed
                       CMBS              Bond

Payment Stream    Monthly;          Semi-annually;
                  guaranteed 25-    principal at
                  day delay.        maturity or
                  Periodic          sale.
                  prepayments.

Underlying        Conventional      General assets.
Asset             mortgages.

Guarantee         Freddie Mac net   Over-
                  worth; private    collateralized
                  mortgage          by 150-200%
                  insurance on      with mortgage
                  mortgages with    portfolio.
                  LTV over 80.

Liquidity/        Unknown at this   Same as
Secondary         time.             Institution PC.
Market

First Issued      1981              1975

Rating/Risk       Same as Freddie   AAA due to
Equivalent.       Mac PC.           continuous
                                    maintenance of
                                    over-
                                    collateralized
                                    position.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:Tools of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Date:Jan 1, 2006
Words:6288
Previous Article:Chapter 22 Real Estate Mortgage Investment Conduits (REMICs).
Next Article:Chapter 24 Oil and gas.
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