securitized products: an overview of mortgage- and asset-backed · pdf filesecuritized...

Securitized Products: An Overview of Mortgage- and Asset-Backed Securities

Jim Womack, CFAManaging Director & Principal

March 12, 2015Monte Carlo Resort & Casino

Las Vegas, Nevada

Mortgage-Backed & Asset-Backed Securities:What Are They and How Are They Different From Other Bonds?

• Bonds backed by many ( th d ) f b

Generally Speaking:

(or thousands) of borrowers.

• Credit worthiness is often independent of the issuer.

• Significant credit support at issuance that builds over time

St dit fil t• Strong credit profile not reliant on asset valuations.

Unique Advantages of MBS / ABS:

• Efficiently Achieve Greater Creditand Economic Diversity

• Gain Credit Stability Through Even the Worst of Market Conditions

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• Reduce or Eliminate the Event Risk Inherent in Single Credit Issues

• Attractive Yields vs. Other Types of Lower Rated Bonds

High Credit Quality and Cash Flow StabilityAn “Apples to Apples” Comparison of Historical Excess Returns

SECTOR INDEX DURATION

ANNUALEXCESS RETURN

Merrill Lynch AAA Credit Card ABS 2.3 Years 0.89%* **

Merrill Lynch AAA Auto ABS 1.3 Years 0.84%

Merrill Lynch 1-3 Year Agency CMO PAC 1.9 Years 0.84%*

*

**

**

Merrill Lynch 1-3 Year Corporate (AAA-A) 1.9 Years 0.75%

Merrill Lynch 1-5 Year Corporate (AAA-A) 2.8 Years 0.67%

*

*

**

**Merrill Lynch 1 5 Year Corporate (AAA A) 2.8 Years 0.67%

Merrill Lynch 1-3 Year Callable Agencies 1.4 Years 0.14%* ***

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* Data as of December 31, 2014** Annualized duration adjusted excess return vs. Treasuries since December 1996 (earliest available excess return data on ABS)*** Annualized duration adjusted excess return vs. Treasuries since December 1998 (earliest available excess return data on Callable Agencies)

Source: Merrill Lynch & Bloomberg

Mortgage-Backed & Asset-Backed Securities:High Credit Quality, Low Event Risk and Stable Return Profile

15.0%

‘AAA’ Securitized, ‘A’ Rated Corporate& Agency Cumulative Excess Returns

10.0%

0.0%

5.0%

-5.0%

0.0%

-10.0%1997 1999 2001 2003 2005 2007 2009 2011 2013

1-3 Year AAA-Rated Securitized Index

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1 3 Year AAA Rated Securitized Index1-3 Year A-Rated Industrials Index

Source: Barclays Capital, BofA Merrill LynchInception of BofA Merrill Lynch Excess Return data is 12/31/1996

1-3 Year Agency Index

Asset-Backed Securities: The Basics Non-Housing Related Receivables in Bankruptcy Remote Structures

AAA AAA AAA AAA RatedRated

ABS TrustABS Trust

A RatedA Rated

AA RatedAA Rated

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BBB RatedBBB Rated

Asset-Backeds: Remembering The Great Financial CrisisNot The Headlines You Remember!

“Most Senior GMAC prime auto ABS ratings able to withstand ‘depression’ unemployment scenario.”

Moody’s Investor Service 5 12 09

“Moody’s has placed fifteen tranches from eight loan securitizations sponsored by Ford Motor Company in 2006 and 2007 on review for

- Moody s Investor Service, 5-12-09

sponsored by Ford Motor Company in 2006 and 2007 on review forpossible upgrade. The build up of credit enhancement more than offsets modest increases in lifetime cumulative losses observed in the underlying collateral pools.” - Moody’s Investor Service 8-21-09y g p Moody s Investor Service, 8 21 09

“Auto-loan Backing is Popular; Investors Like These Tried and Tested Securities” - Headline Wall Street Journal 9-16-2009

“Due to available credit enhancement and structural protections, ratings for prime senior tranches of ABS auto loan transactions have

Tested Securities - Headline, Wall Street Journal, 9-16-2009

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ratings for prime senior tranches of ABS auto loan transactions have remained stable year-to-date.” - Fitch Ratings, 10-26-09

Asset-Backeds: How The Typical Auto Structure WorksTwo Types of Credit Support: Overcollateralization & Subordination

Overcollateralization

L A t f

Pool of Auto Loans

Lesser Amount ofBonds Backed by Loans

Subordination

Still Lesser AmountOf Senior (AAA Rated)

Bonds Backed by LoansLesser Amount of

Subordination

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Lesser Amount ofBonds Backed by Loans

Asset-Backeds: How The Typical Auto Structure WorksSubordination Protects The Senior Note Holders 5 Ways

Class Rating Size PercentA1

A2-AAAAAAA

210,000,000400,000,000A2 A

A2-BA3A4

AAA AAAAAAAAA

400,000,000450,000,000592,000,000249,260,000 93.0%

B AA 60,200,000 5th Loss Protection 3.0%

C A 40,135,000 4th Loss Protection 2.0%

D BBB 40,135,000 3th Loss Protection 2.0%

Reserve Account 2nd Loss Protection 0.8%

R A t 1 t L P t ti 1 0%Reserve Account 1st Loss Protection 1.0%

8.8%Total Subordination For Senior Note Holders5.7%Overcollateralization at Origination

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g

14.5%Total Credit Support to Senior Bondholders

Asset Backeds: How The Typical Auto Structure WorksHistorically, Even The Lowest Rated Bonds Have Been Well Protected

1.5%Fitch Prime Auto ABS Cumulative Net Loss Index

1.5%

Monthly Rolling 12-Months

1.2%

0.9%

1.2%

0.9%

0.6%

0.2%

0.6%

0.3%Class Rating Size Percent

Source: Fitch Ratings

0.0%9/93 9/94 9/95 9/96 9/97 9/98 2001 2003 2005 2007 2009 2011 2013

0.0%Source: Fitch Ratings

B AA 60,200,000 3.0%

A1A2-AA2-BA3A4

AAAAAA AAAAAAAAA 93.0%

210,000,000400,000,000450,000,000592,000,000249,260,000

Reserve Account 0.8%

Reserve Account 1.0%

D BBB 40,135,000 2.0%

C A 40,135,000 2.0%

, , %

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%

8.8%Total Subordination For Senior Notes5.7%Overcollateralization at Origination

14.5%Total Credit Support to Senior Notes

Asset-Backeds: How The Typical Auto Structure WorksNatural Deleveraging: The Credit Enhancement Grows As Bonds Pay Down

AAACredit Support 14.5% 15.9% 24.7% 65.2%Credit Support 14.5% 15.9% 24.7% 65.2%

A1 A2 A

Total Credit Support to A1

AAA0.3 YearWAL

A2-AA2-BAAA1.1 Year WAL

A3AAA2.2 Year WAL

A4AAA3.8 Year WAL

B T h AA R t d 4 4 Y WAL

Support to Senior

BondholdersAt Origination

B Tranche, AA Rated, 4.4 Year WAL

C Tranche, A Rated, 4.7 Year WAL

D Tranche, BBB Rated, 4.9 Year WAL14.5%

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Reserve Accounts

Still a Need For A Structured Approach to InvestingBeyond the Rating: Ensuring High Credit Quality and Cash Flow Stability

Factors to Analyze at Purchase (e.g., New Issue):

Overcollateralization Overcollateralization

Subordination

Underlying Loan Characteristics Underlying Loan Characteristics~ Fico Scores (Credit Profile of Borrowers)~ Loan Terms (Length, LTV, etc.)~ Distribution of Loan Terms~ Geographic Distribution

Collateral Characteristics~ New Autos vs Used Autos New Autos vs. Used Autos~ Cars vs. SUVs

Sponsor/Servicer (e.g., Ford, GE, etc.)E i ( biliti t t d d f l iti ti )

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~ Experience (capabilities, strategy and procedures for loss mitigation)~ Financial Condition

Still a Need For A Structured Approach to InvestingBeyond the Rating: Ensuring High Credit Quality and Cash Flow Stability

Factors for Ongoing Analysis:

Deal Specific Credit Metrics~ Delinquencies (30, 60, 90+ Days)~ Cumulative Net Losses~ Changes in Credit Enhancement

Economic Fundamentals~ Collateral Values (i.e., Used Auto Prices) Collateral Values (i.e., Used Auto Prices)~ Economic Environment (unemployment, housing, gas prices, etc.)~ Fleet Age

Financial Market Conditions Financial Market Conditions~ ABS Spreads (particularly on lower rated tranches)~ Equity Performance (stock prices of issuer/servicers )~ Corporate Debt Performance (spreads on corporate debt or CDS)

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p ( p p )

Mortgage-Backed SecuritiesThe Mortgage Market Is One of the Deepest and Most Liquid Markets

Marketable Debt Outstanding12 Average Daily Trading Volume

600$11 9

8

10

400

500$11.9

$8 7

$505

6

8

$ Tr

illion

s

300

400

$ Bi

llions

$8.7$7.5

2

4

100

200$2.1 $179

$200 0

$20 $5

- 13 -Source: The Securities Industry and Financial Markets Association Data as of December 31, 2014

Mortgage-Backeds: More Yield Than Corporates…But Why? Comparing Yield of MBS vs. A Rated Corporate Bonds

30-Year MBS Pass-Through & Like Maturity A Rated Corporate Yields10.0

6.0

8.0

rcen

t

4.0

Yiel

d in

Per

0.0

2.0

30 Year MBS Pass-through Average Yield:A R t d C t B d A Yi ld

5.69%5 01%

MBS Yield Advantage:

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

0 68%

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A Rated Corporate Bond Average Yield: 5.01% Advantage: 0.68%

Source: Merrill Lynch, Bloomberg Data as of December 31, 2014

Mortgage-Backed SecuritiesThe Traditional Mortgage Pass-Through

Homeowner Bank Trustees

Guaranteed Timely Principal & Interest

Government Sponsored Entity (Ginnie Mae, Fannie Mae, Freddie Mac)


I t i t h f i t tInvestors receive pro-rata share of interest, principal, and principal prepayments.

Investors have uncertainty about when they get principal back

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Investorsget principal back.

Mortgage-Backed SecuritiesTraditional GSE Guaranteed Mortgage-Backed Securities

Key Characteristics of MBS:

Bonds Receive Principal and Interest Monthly Because Borrowers Bonds Receive Principal and Interest Monthly, Because Borrowers Make Monthly Mortgage Payments

Borrowers Can Repay Their Loans Without Penalty and at Any Time

They Refinance, Get Transferred, Death, Divorce, Buy Bigger/Smaller Home, Etc. People Prepay Their Mortgages For a Variety of Reasons

PSA = Prepayment Speed Assumption, CPR = Constant Prepayment Rate

The Speed of Loan Prepayment is Measured by PSA & CPR

100 PSA or 100% of the PSA model rate, calls for prepayments to start slowly and build to a 6% constant prepayment rate (CPR) after 24 months.

However: If mortgage rates declined, the prepayment rate could jump because

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However: If mortgage rates declined, the prepayment rate could jump because homeowners are refinancing (i.e., +200 PSA or 24CPR).

Mortgage-Backed SecuritiesBecause The Home Owner Can Prepay At Any Time, Mortgage-Backed

Price

Securities, Like Other Callable Bonds, Have Negative Convexity

Price

Negative Convexity+0.8%

-1.2%

Yield

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Yield+1%-1%

Mortgage-Backed SecuritiesTraditional 30-Year Mortgage Lending

30-Year Loans Spread Payments Out to Reduce Monthly Payment

Key Characteristics of 30-Year Loans & MBS:

Nearly All of The Payment In The Early Years Is Interest

p y y y

The Interest Rate Level Impacts The Monthly Payment For the Borrower

So 30 Year Borrowers Are Typically Very Rate Sensitive

e te est ate e e pacts e o t y ay e t o t e o o eon a 30-Year Loan More Than on a 15-Year or 10-Year Loan(A Key Reason Why People Don’t Refinance Their Cars)


So 30-Year Borrowers Are Typically Very Rate Sensitive

Bondholders Recei e An Attracti e Yield Abo e Treas ries Agenc Iss ed Bondholders Receive An Attractive Yield Above Treasuries, Agency Issued Debentures and Other Types of Securities Because Borrowers Can Repay Their Loans Without Penalty and at Any Time

S

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Agency MBS are Backed by The Homeowner, by The Agency, and byThe Implied Guarantee Of The Government

Mortgage-Backed SecuritiesTraditional 30-Year Mortgage Pass-Through & Cash Flow Profile

Mortgage Rates UNCHANGED

Mortgage RatesHIGHER

Mortgage Rates LOWER

NO REFINANCELESS Trading UpLESS RenovationESS D i i

Trading UpMajor Renovation

Downsizing

REFINANCEMORE Trading UpMORE Renovation

LESS DownsizingGet Transferred

Death, Divorce, Etc.

DownsizingGet Transferred

Death, Divorce, Etc.MORE Downsizing

Get TransferredDeath, Divorce, Etc.

12% CPRPer Year

6% CPRPer Year

25% CPRPer Year

8 YearBond

5 YearBond

2 YearBond

- 19 -3 Year Extension 3 Year Contraction

Mortgage-Backed SecuritiesTraditional 15-Year and 10-Year Mortgage Lending

Key Characteristics of 15-Year & 10-Year Loans & MBS: 15-Year & 10-Year Loans Are For People Who Want To Pay Debt Back Fastp y

More of the Payment Is Principal, So The Interest Rate Has Less of an Impact on The Monthly Payment

So 15-Year & 10-Year Borrowers Are Typically LESS Rate Sensitive

The Shorter The Loan, The Less Variability The Cash Flows Are At a Given Prepayment Speed


They Have The Same Credit Backing as Bonds Backed by 30-Year Loans

15-Year and 10-Year Pass-throughs Receive An Attractive Yield Above Treasuries, Agency Issued Debentures and Other Types of Securities,

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, g y yp ,But Less Than a 30-Year Pass-through

Mortgage-Backed SecuritiesTraditional 10-Year Mortgage Pass-Through & Cash Flow Profile

Mortgage Rates UNCHANGED

Mortgage RatesHIGHER

Mortgage Rates LOWERREFINANCE

MORE Trading UpMORE RenovationMORE D i i

Trading UpMajor Renovation

Downsizing

NO REFINANCELESS Trading UpLESS RenovationLESS Downsizing MORE Downsizing

Get TransferredDeath, Divorce, Etc.

gGet Transferred

Death, Divorce, Etc.LESS DownsizingGet Transferred

Death, Divorce, Etc.

12% CPRPer Year

7% CPRPer Year

25% CPRPer Year

4.0 YearBond

3.4 YearBond

2.9 YearBond

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0.6 Year Extension 0.5 Year Contraction

Mortgage-Backed SecuritiesCollateralized Mortgage Obligations (CMOs) & Cash Flow Profile

Homeowner Bank Trustees


Government Sponsored Entity (Ginnie Mae, Fannie Mae, Freddie Mac) Classes Increase Cash Flow Certainty

Investor certainty is increased

Class 3Class 2

$$

$

Class 1$

$$ $

$$

Investor certainty is increased.

Investors in short-term, intermediate-term and long-term securities can now participate in the mortgage backed

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participate in the mortgage-backed securities market.

Mortgage-Backed SecuritiesThe Two Main Types of Collateralized Mortgage Obligations (CMOs)

Seqential Class CMO: Cash Flow Stability Improved vs. Pass-Through Since Tranches

Get Paid Back In Sequential Order

Big Prepayment Swings Can Still Cause Some Cash Flow Variability(e.g., A Sequential Backed By New 30 Year Loans).(e.g., A Sequential Backed By New 30 Year Loans).

A Sequential Backed By Stable Collateral Can Greatly Improve Cash Flow Stability (e.g., Sequential Backed By Seasoned 15 Year Loans).

Pre-Planned Ammortization Class (PAC) CMO: Can Be The Most Stable Form of Mortgage-Backed Security.

Cash Flow Structured to Follow Pre-Planned Schedule Subject to Prepayment Speeds Remaining Within Stated Parameters

Th K i t A l “St d” P t A ti t

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The Key is to Analyze “Stressed” Prepayment Assumptions to Ensure The Bond Will Act Like You Expect

Mortgage-Backed SecuritiesAnalyzing The PAC CMO Structure

The PAC Can Have Stability Because Other Support Bonds Make It So.

If Prepayments Are Greater Than Expected, The Support Classes Will Take The Additional Prepayments So The PAC Doesn’t Have To.

If Prepayments Are Less Than Expected, The Support Classes Will Forego Principal So The PAC Gets The Desired Amount.

$ $ $

Forego Principal So The PAC Gets The Desired Amount.

PACCMO

$$

$

Support Class 1

$$

$ $$

$

SupportClass 2

Investors Typically Run “Stress Tests” To Ensure The Support Classes

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yp y ppAre Adequate To Provide The Required Stability For The PAC Class.

Mortgage-Backed SecuritiesThe Well Structured PAC CMO Structure

Consistent Payment History Well Within Wide PAC Bands

2 Year Bond at +50 bps Over Treasuries

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• Often Greater Yield and Cash Flow Stability Than Callable Agencies• Yields Comparable or Higher than A-Rated Corporate Bonds.

Source: Bloomberg

Mortgage-Backed SecuritiesThe Key Factors That Drive Cash Flow Stability

Collateral Characteristics:

L T Sh t E l M St bilitLoan Term: Shorter Equals More StabilityLoan Balance: Lower Equals More StabilitySeasoning (Loan Age): Longer Equals More Stability

S i S

Seasoning (Loan Age): Longer Equals More StabilityMortgage Rate: Out-of-money Equals More Stability

Security Structure:Structure Often Enhances Collateral Characteristics, But There Is No Substitute For Careful Analysis.

Pre-Planned Amortization (PAC) CMO More StabilitySequential Amortization (SEQ) CMO Some Stability

y

Generally Speaking:

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Sequential Amortization (SEQ) CMO Some StabilityMortgage Pass-through Least Stability

Mortgage-Backed Securities: Why So Much On Cash Flow Stability: Minimizing Extension (And Call) Risk

“Taper Tantrum”

Sample (Actual)MBS & CMO

Portfolio

TypicalMortgageCollateral

Duration: 2.1 Years

Yield-to-Maturity: 1.3%

3.2 Years

1.3%SHORTER

LOANS

Wtd. AverageOriginal Loan Term: 16 Years 30 Years

Wtd. Average $ Price: $104.2 $107.3

MORESEASONED

Avg. Origination Date: 2004

Current Avg Balance: $79K

2012

$300KCurrent Avg. Balance: $79K $300KLOWER LOAN

BALANCEAvg. Time to Maturity: 9 Years 30 Years

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Impact of 50 Basis PointRate Decline on Payment: $19 / mo $85 / mo

MORE STRUCTURE

Source: Merrill Lynch, Bloomberg, Atlanta Capital Data as of September 2012


“Taper Tantrum”

0 4%

0.6%

0.8%

2 0

3.0Sample (Actual) MBS & CMO Portfolio Duration Variability

UNCHANGED

0.0%

0.2%

0.4%

1.0

2.0

Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13

0.4%

0.6%

0.8%

2.0

3.0Merrill Lynch Callable Agency Index Duration Variability

1.4 Years to 2.4 Years

0.0%

0.2%

0.4%

1.0

2.0

Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13

0.4%

0.6%

0.8%

2.0

3.0Merrill Lynch 0-3 Year CMO PAC Index Duration Variability

1.1 Years to 2.7 Years

- 28 -

0.0%

0.2%

1.0Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13

Source: Merrill Lynch, Bloomberg, Atlanta Capital


“Taper Tantrum”

Negative Convexity (e.g., The 1-Year, Non-Call, 5-Year Callable Bond)

1 Year 5 Year

y y g ( )

Purchase Call Maturity D t

1 Year 5 Year

Date Date Date

April 30 Yield(Yield to Call)

Duration(Duration to Call)

May-AugustReturn

1-Year T-Note Index Return:1-Year, NC 5-Year Callable Bond:

(Yield to Call) (Duration to Call) Return0.14% 1.0 yr 0.07%

1.0 yr0.97% (2.96%)

Reaching for Yield Adding yield almost always means adding some form of risk (credit risk,

- 29 -

duration, negative convexity, etc.). It’s important to understand the riskswith each investment and how they impact the overall portfolio.

Source: Merrill Lynch, Bloomberg


“Taper Tantrum”

Sample (Actual)

Why So Much On Cash Flow Stability: Minimizing Extension (And Call) Risk

Merrill Lynch 1-5Callable Index

Effective

MBS & CMOPortfolio

Merrill LynchMortgage Index

Effective Duration (Beg)

M k Yi ld

1.3 Years 2.2 Years2.4 Years

Market YieldTo Worst (Beg) 0.68% 1.04%2.60%

May 2013Price Return (0.32%) (0.36%)(1.70%)

- 30 -Source: Merrill Lynch; Atlanta Capital; BondEdge

Mortgage-Backed & Asset-Backed SecuritiesSummary: High Yield and High Quality Are Not Mutually Exclusive

The Mortgage-Backed and Asset-Backed Sectors Can Offer Attractive Investments That Can Add Significant Yield and T t l R t O TiTotal Return Over Time

Premiums Are Comparable to or Higher Than Many ‘A’ Rated Corporate Bonds and the Return Profile Is More StableCorporate Bonds and the Return Profile Is More Stable

Traditional Mortgage Bonds and Many ABS Structures Have A Proven Track Record of Maintaining The Highest Credit QualityProven Track Record of Maintaining The Highest Credit Quality In Even The Deepest Economic Downturns

Cash Flow Stability Is Achieved Primarily By Collateral Type and Cash Flow Stability Is Achieved Primarily By Collateral Type and Security Structure

When High Credit Quality and Cash Flow Stability Are Properly

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When High Credit Quality and Cash Flow Stability Are Properly Combined, Event Risk Can Be All But Eliminated

Thank You!Thank You!

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