New Developments in Mortgage-Backed Securities

Foreword Suzanne Denbo Jaffe Program Moderator The market for mortgage-backed securities has undergone one of the most ...

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Foreword Suzanne Denbo Jaffe Program Moderator

The market for mortgage-backed securities has undergone one of the most dramatic changes of any market in modern investment times. Five years ago it represented about $25 billion of investment value. Today it exceeds $250 billion of mostly residential mortgages and could reach $1.5 trillion over the next decade. Further, the securitizing of commercial and other already outstanding mortage debt could cause this market to exceed several trillion dollars. Four favorable characteristics cause the mortgage-backed securities market to be attractive for investors. The first is its enormous size and resulting liquidity. The second is its high quality. The Government National Mortgage Association certificates are full-faith-and-credit obligations of the U.S. Government. The Federal National Mortgage Association and Federal Home Loan Mortgage Association are government-sponsored agencies. The third favorable characteristic of this market is the flexibility to customize or tailor products to meet the needs of the investor. Fast-pay and slow-pay pools can be designed as well as pools of securities focused on certain geographic criteria. Finally, the market is innovative. New products will continue to be developed that meet the needs of the marketplace. New issuers, new

buyers, and new instruments will appear with increasing frequency. Responding to the need of the investment profession to understand this important developing market, the Institute sponsored a one-day seminar, "New Developments in MortgageBacked Securities" on May 23, 1984 in Washington, D. C. This publication is the product of that program. Appreciation is extended to the seminar speakers: James J. Connolly, Salomon Brothers Inc.; Stanley Diller, Goldman, Sachs & Co.; William H. Gross, CFA, Pacific Investment Management Co.; J. Donald Klink, Federal National Mortgage Association; Roland M. Machold, State of New Jersey; Helen F. Peters, Merrill Lynch, Securities Trading Division; Richard T. Pratt, Merrill Lynch Mortgage Capital Inc.; Richard L. Sega, The Travelers Insurance Companies; Richard B. Worley, Miller, Anderson & Sherrerd; Paul A. Yates, GNMA, Ray B. Zemon, Lincoln Income Group. A special thanks also goes to Frank J. Fabozzi, CFA, who edited the publication. Thanks is also extended to Institute staff, Darwin M. Bayston, CFA and Cathryn E. Kittell for their valuable contribution to the program and this publication.

vii

Overview of the Seminar Frank J. Fabozzi, CFA Editor The market for mortgage-backed securities has undergone one of the most dramatic changes of any market in modern investment times. In 1984, the residential mortgage debt outstanding that was "securitized" exceeded $250 billion. Furthermore, more than $1.1 trillion of residential mortgage debt had the potential to be "securitized." When other real estate mortgage debt such as commercial mortgages and multifamily mortgages are considered, the amount of potential real estate mortgage debt that had the potential to be converted to various forms of securities in 1984 exceeded $1.8 trillion. To place the size of the market in perspective, consider that in 1984 corporate bond debt was about $560 billion, Treasury and agency debt was about $980 billion, and tax-exempt issued debt was about $485 billion. Consequently, the amount of real estate mortgage debt outstanding, both securitized and nonsecuritized, was greater than the other three debt markets combined. Innovation and growth in the mortgagebacked securities market have been dramatic. New issuers, new buyers, and new instruments are appearing with increasing frequency. Mortgage pools are being created to fit the specific needs of a broadening range of investment institutions. Traditional buyers, like insurance companies and pension funds, have become more active and are now the creators of new management strategies as well as large pool investors. Despite the dramatic growth of this market, there are players reluctant to invest in this market. The problem is that mortgage-backed securities have investment characteristics that differ from bonds that are usually held in fixed income portfolios structured to satisfy a known liability stream. What may be worse, is that there are investors that own these securities but do not really understand their risk/return characteristics. As was pointed out by one of the presenters, Richard Worley, "Most investors probably know more about their government and corporate holdings than they really understand about their mortgage holdings." The objectives of the seminar were to make

participants aware of: (1) the investment characteristics of mortgage-backed securities with emphasis on the practical attributes that make these securities attractive for a wide range of institutional and individual buyers; (2) recent product and market developments and the future directions in both product and market terms; and (3) the various portfolio strategies and their application to the investment needs and objectives of a broad range of investors. A brief summary of each presentation follows.

GROWTH AND DEVELOPMENT OF THE MORTGAGE-BACKED SECURITIES MARKET Richard Pratt led off with an overview of the secondary market for mortgage-backed securities and the factors that are affecting the secondary market. Of particular interest are the historical yield spreads between mortgage rate levels and 10-year Treasury notes. The average spread of mortgage rate levels over 10-year Treasury notes for the period 1971 to 1979 was 100 basis points. In recent times, however, that spread has narrowed substantially and in May 1984, the time of the seminar, the spread was negative. One of the reasons Dick proffers for this observed change in spreads is the policies of thrift institutions, the major financial institutions which are making mortgage loans at the present time in a deregulated interest rate environment. After reviewing the size of the mortgage and mortgage-backed securities markets and the holders of mortgage-backed securities, he discussed the adjustable rate mortgage (ARM) and its implications, a topic that many of the presenters found imperative to comment on. One particular concern that lenders of adjustable rate mortgages with "teaser" rates (that is, rates below the prevailing rate for the first year) is the increased credit risk. As for market performance of ARMs, Figures 14 through 16 of Dick's presentation provide an interesting comparison of the performance of ARMs relative to the two other

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primary types of mortgage instruments-negative amortization mortgages and Ginnie Mae 13s-under various interest rate scenarios. This presenter concluded with his view of the current mortgage market. He believes that the "mortgage market is a real mess right now." The reasons are tied, in his opinion, to the policies of thrift institutions.

CHARACTERISTICS OF MORTGAGEBACKED SECURITIES What are the investment characteristics of mortgage portfolios? How do these characteristics differ from traditional fixed income securities? What are the opportunities in the mortgage market and how can they be exploited? These questions were addressed by the next two presenters. Helen Peters addressed the first two questions, and Richard Worley focused on the second. It is well recognized that the conventional yield-to-maturity is only an appropriate measure of a bond's potential return if: (1) the bond is held to maturity; and (2) coupon payments can be reinvested at the yield-to-maturity. The realized compound yield, developed by Sidney Homer and Martin Leibowitz in their now classic book Inside the Yield Book," is a better measure of a bond's potential yield because it explicitly assumes a reinvestment rate for the coupon payments. For fixed rate mortgage-backed securities, there are additional complications that make it difficult to assess the value of these securities. In particular, there is uncertainty as to the cash flow associated with mortgage-backed securities because of the prepayment opportunity available to borrowers (homeowners). The lack of adequate data to project prepayments has been a serious drawback to market participants attempting to evaluate these securities. Because of the uncertainty as to how long it will be before all mortgages in the pool will repay the entire principal, it has been customary to calculate yields assuming that all the mortgages will prepay by the end of 12 years. This is known as the "12-year life" assumption. Helen Peters pointed out the problems with using this rule of thumb by examining the underlying assumptions in using a 12-year life. To forecast the cash flow from prepayments, it has been common in • Published by Prentice-Hall, Inc. (New Jersey) and New York Institute of Finance (New York) 1981.

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the industry to measure prepayments based on FHA prepayment experience. Helen explained why FHA experience-regardless of whether one uses the new FHA experience or old FHA experience-is a poor tool to employ for forecasting prepayments. Although there are market participants that have only recently recognized the shortcomings of using FHA experience for this purpose, it is still a popular means for quoting yields. Given the drawbacks of the FHA experience for purposes of forecasting, she next explained how she forecasts prepayments. There are two approaches-explicitly modeling the reaction function of homeowners, and modeling based on option theory. The approach that she recommended is modeling the reaction function of homeowners based on economic and regional factors. According to Helen, this is what "some of the most successful investors have done." Following Helen Peters in our batting order was Richard Worley. Richard began by critically evaluating the reasons often proffered for investing in mortgage-backed securities-a large liquid market with excellent credit quality that yields more than weaker as well as comparable fixed income securities. The credit quality argument holds only in the case of isolated defaults by homeowners; however, in the case of an economic event that might cause massive defaults, default risk is greater than commonly perceived. Some strategies for reducing default risk when managing a mortgage portfolio are suggested by Richard. As for the yield advantage argument for holding mortgage-backed securities, he pointed out that a major part of the premium over comparable or weaker regular fixed income securities observed in the marketplace is compensation for accepting call risk (that is, the risk that the homeowner will repay the principal prior to maturity). Not only do investors not know what the yield is when they purchase mortgage-backed securities, for the reasons that were cited by Helen Peters, but investors don't know the duration of the securities. Duration, which is the weighted average maturity when the cash flows are in terms of present value, is a measure of risk commonly used in fixed income portfolio strategies. Two things are known about yield and duration, according to Richard: (1) yield will be less than you think; and (2) duration will be shorter when you want it to be longer and vice versa. After explaining why, he then goes on to discuss why he believes the discount sector is almost always

cheap and his experience with the discount sector. There are some unique operational aspects of managing a portfolio of mortgage-backed securities. Richard reviewed these concerns and suggested ways that can increase prepayment experience.

RECENT NEW PRODUCTS AND MARKETS There were two presenters in this session: Stanley Diller and Roland Machold. Stan furnished the framework for evaluating passthrough securities so that recent products such as collateralized mortgage obligations (CMOs) can be evaluated. As he stated: 'The key to a good framework is not that it provide all the answers, but that it rank the questions according to their importance." The key point that he made was that the uncertainty associated with the cash flow from owning passthroughs should not be a reason for not employing them in P'?rtfolio strategies to satisfy known liabilities such as dedication strategies. The same managers that are unwilling to use passthroughs because of the uncertainty of the associated cash flow, however, have no compunction about using callable bonds which have low coupons that make call unlikely. It is not logical, according to Stan, to treat the uncertainty over one type of call different from the other. In light of the framework set forth, he evaluated CMOs. Hedging of passthroughs was then addressed by Stan. Roland Machold, Director of the Division of Investments for the state of New Jersey, expressed why he is wary of " 'innovative' mortgage programs which may fragment mortgage markets, are contractually uncertain, have less market liquidity, and have lower quality and less government sponsorship." He believes that the trend in mortgage-backed securities has been in this direction. An unstable and volatile interest rate environment has been the result of this trend. Roland then set forth his views on several new mortgage products. Of particular interest was his view on privately insured mortgage pools. The whole idea of insurance of mortgages, according to this presenter, "is insuring against the uninsurable, the one time economic collapse." As for adjustable rate mortgages and shared appreciation mortgage packages, he doubted whether he would purchase them. He also expressed little enthusiasm for the multiplicity of CMO formats

that are presently being issued. The final point made by Roland is particularly noteworthy. He expressed a concern that was shared by several of the presenters about the political risks associated with the ownership of mortgage-backed securities when he stated: "when you buy a mortgage you are in a very, very small select company. There probably are only 500 to 1,000 major mortgage buyers in this country. And that represents a very small constituency. On the other hand, there are 250 million people in this country who would like to have a low cost mortgage. So when it comes to any sort of regulation or law, or any judicial interpretation of any legal aspect of a mortgage security, particularly new and untested securities such as CMOs and ARMs, buyers are at a great political disadvantage."

THE FUTURE-WHERE DO WE GO FROM HERE? Kierkegaard, the Danish philosopher and theologian, said "Life can only be understood backwards, but it must be lived forwards." To understand where the mortgage securities market is going, some historical perspective of the development of the market is needed. Jay Connolly provides that perspective in his presentation by demonstrating the growth of the market over the past 14 years and the reasons for that growth. Jay explained the hurdles that had to be overcome in order to obtain investor acceptance of mortgage-backed securities. Any new mortgage programs such as those involving commercial and industrial mortgages will more than likely go through the same development process. Against this background, he identified the areas of immediate impact on the market. One of the most significant areas impacting the market is the growth of adjustable rate mortgages. The major problem with ARMs is that there is no secondary market because of the lack of standardization of these instruments. Jay believes that a secondary market is forthcoming; however, it will require a great deal of work by Ginnie Mae, Fannie Mae, and Freddie Mac. Another concern with ARMs is that thrifts have substituted credit risk for interest rate risk. As interest rates rise and monthly payments are adjusted upward, state and local governments may feel political pressure to somehow intervene on the side of homeowners. (Recall Roland Machold's parting words.) Any such action may impact yields.

3

Jay explained why he is optimistic about the future growth of the mortgage sector. The factors that he identified are: (1) the trend by thrifts of embracing a mortgage banking mode of operation, coupled with the activities of the secondary market agencies (Fannie Mae, Ginnie Mae, and Freddie Mac); (2) recently proposed legislation favorable to the market's development; (3) favorable developments in accounting principles; (4) continued expansion and innovation eminating from the secondary market agencies and the private sector; (5) the introduction of new bond type mortgages such as the CMO; and (6) the demographics of the market.

PORTFOLIO STRATEGIES Armed with an understanding of the investment characteristics of mortgage-backed securities and recent innovations that have been introduced to satisfy the needs of particular segments of the market, the next two presenters described various portfolio strategies. The two strategies discussed by the first presenter, William Gross, involved: (1) selecting the coupon sector to invest in; and (2) capitalizing on the investment opportunities in mortgage futures. Bill recommended and set forth his reasons for investing in discount passthroughs in a bull market because of the greater price volatility of discounted securities and high coupon passthroughs in a bear market. He felt that there is no advantage to holding a current coupon passthrough. In his presentation, Bill also highlighted the problem of duration moving in an adverse direction as interest rates change due to prepayments. That is, duration rises as interest rates go up, and duration declines as interest rates go down. This characteristic is commonly referred to as "negative convexity." In his discussion of investment opportunities with mortgage futures (Collateralized Depository Receipts), Bill explained why he thought it was a "super" investment. He characterized the CDR as a "near-perfect investment," 'an investment for all seasons," and"a once-in-a-lifetime situation." Richard Sega explained the role of mortgagebacked securities in the portfolio of a life insurance company and how that portfolio is managed. He first described the key product which created the liability, the Guaranteed Investment Contract

4

(GIC), that investment assets must be capable of satisfying. His organization, The Travelers Insurance Company, selected Ginnie Maes to fund the liabilities created by the GICs because they had no credit risk, good liquidity, standardization, and yield advantage. They operated in the discount sector of the market because they felt prepayments were relatively more stable, and, if they should accelerate, there would be a yield advantage. Richard also described: (1) Travelers pricing process of GICs and how it is tied to the supporting mortgage-backed product; and (2) its Ginnie Mae swapping program. He then explained the motivation for Travelers structuring of a CMO, part of which it retained for its portfolio. He concluded the presentation with a discussion of hedging. He felt that the most insurance companies will do with respect to hedging is sell or buy futures to hedge commitments or anticipated takedowns in their portfolios. Because of apparent regulatory constraints, it is less likely that insurance companies will employ futures to hedge existing assets.

VIEWS FROM WASHINGTON In the final session, Donald Klink, senior vice president for Mortgage-Backed Securities of FNMA, and Paul Yates, director of financial management of GNMA, expressed their views on various topics. Don began with a historical overview of the secondary mortgage market. He then described the players in the mortgage securities business and the present environment. With respect to the present environment, Don discussed FNMA's experience with ARMs. He concluded with a discussion of where sources of mortgage capital will come from in the future. Of particular interest is the potenti.{l to attract foreign investors. In addition to pension funds, the retail market offers potential for raising mortgage capital. Paul began his presentation with an overview of the Government National Mortgage Association and the Ginnie Mae mortgage-backed securities program, highlighting the Ginnie Mae II program and the recently approved ARMs program. He also described the Ginnie Mae II futures contract that was introduced on the Chicago Board of Trade in March 1984.

Growth and Development of the Mortgage-Backed Securities Market Richard T. PraU There are a number of factors that are affecting the secondary markets: its size, some of its directions, and the influence of the major financial institutions in the mortgage market.

OVERVIEW OF THE

SECONDARY MARKET The secondary market is generated from mortgages, and mortgages are generated first from housing starts. (See Figure 1.) The dynamics of the market tend to be dominated by the stock of mortgages; that is, the stock is very large in relation to the flow of mortgages. The flow of mortgages come from the refinancing of properties (the sale of existing homes) and from new housing starts. Perhaps in the past we have focused more heavily on new housing starts than would be warranted in terms of developments in the secondary market. One reason that housing starts are important is that in times of changing interest rates new housing starts generate mortgages at current market rates, which are more easily tradable in the market. In the last few years innovations have made older, deeper discount mortgages more tradable and more securitizable. The main innovator was the Federal Home Loan Mortgage Corporation (Freddie Mac) which began the "swap" program. Under this program, institutions holding portfolios of old, low-yielding mortgages could swap those for securities with the Federal Home Loan Mortgage Corporation bearing essentially the same interest rate. For example, if a savings and loan institution had an eight percent mortgage, it could turn it in to the Federal Home Loan Mortgage Corporation and get back an eight percent security. Under accounting conventions, that was not ruled to be a sale of assets that would trigger a loss on the financial institution's books. The difficulties that have occurred in financial institutions, most notably thrifts, and the very large numbers of mergers, have created tremendous pools of mortgages which have been ac-

quired subject to purchase accounting. This has the effect of liquifying these mortgage portfolios. That is, if Institution A buys or takes over a troubled Institution B, and does it under purchase accounting, the assets and liabilities of the acquired institution are marked-to-market before being brought into the acquiring institution. This means that if an institution had 8 percent mortgages at a value of 64, for example, it had no way of selling them because they were being carried on the books at par (virtually at 100). If the institution sold them at 64, it tended to impact net worth by 3 or 4 percent of liabilities. If the whole portfolio was sold, it could eliminate as much as seven times the selling institution's net worth. That was a quicker trip to oblivion than leaving those mortgages on the books. If, however, the mortgages were acquired in a purchase accounting merger, they were immediately marked at 64. As interest rates dropped in 198283, there became strong incentives to sen the mortgages acquired in this manner. Does that fully explain Figure 1 on housing starts? The effect on the secondary market is one that has been changing. The nature of housing starts has been changing as financial institutions have changed. Going back to 1966 or 1967, for example, there was a fully regulated marketplace. Regulation Q was fully in effect for financial institutions. The method of rationing housing starts made the creation of new mortgage credit essentially available. When interest rates and Treasury rates rose, they rose higher than the rates financial institutions were allowed to pay. As a result, financial institutions could not acquire deposits. For this series of events the new word disintermediation was invented. Disintermediation was a common word a few years ago, while you hardly ever hear it now. Disintermediation was a very important automatic stabilizer for the economy when interest rates rose. In one month housing starts declined from 1,600,000 units to 800,000 units. There was a tap that could turn off almost instantly. With the deregulation of interest rates and

5

FIGURE 1

Housing starts (seasonally adjusted. annual rates)

2,500

I

II I

2,000 1----+~~~;:;._---_A_d¥4_1I__1~--~;:;:;._-_4i~~~--_H_r_---

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1972

1973

1974

1975

1976

19n

1978 1979

1980

1981

1982

1983

1984

1985

Total----Single-Family -- - - - - - Multi-Family - - - - Source:

u.s. Department of Commerce. Housing and Urban Development.

the removal of Regulation Q, the effect on housing starts from a change in interest rates is much less. People get priced out of the market rather than getting rationed out. This makes housing starts a less effective, contracyclical part of the economy, and has changed the nature of both the housing starts and the mortgage credit that is generated. Figure 2 shows the sensitivity of housing starts and, therefore, the creation of new mortgage products, to the level of interest rates. It is

probably one of the better correlations within our economic system. In mortgage-backed securities we have had a history of tremendous safety. Mortgage-backed securities and mortgages have been characterized in the post-World War II period as probably the highest credit instrument issued by private issuers that exists in this country. The reason for the very low loss rates has been that the asset which secures the mortgages, generally has been increasing in value, as can be seen in Figure 3,

FIGURE 2

New home sales and mortgage rates 1,000

18

I , I: .

I

800

16

~

14

10 400 8

1972

1973 1974 1975

1976 1977 1978 1979 1980 1981

1982 1983 1984

1985

Note: Home sales are at seasonally adjusted annual rates. Source: U.S. Department of Commerce and Federal Home Loan Bank Board.

which shows the momentum of home prices from 1972 to the present. Therefore, the incentive not to default on the loan becomes higher and higher as time passes. Although this has been true for the period from 1972 through early 1984, some changes have occurred in later years. In 1981-82, and even the first half of 1984, there was an effect in terms of the rate of inflation on housing starts. Figure 3 indicates that for existing homes, yearly price changes have been running at almost a flat level. We are going to see more difficulty in terms of these assets. We are probably going to see credit issues injected into this, and this is something which simply has not happened in the past.

HISTORICAL YIELD SPREADS Figure 4 shows the yield spread of mortgage rate levels and 10-year Treasury notes. Fund managers may find the results presented in this exhibit puzzling and possibly disturbing. In basis points, the average spread from 1971 through 1979 appears to be something over 100 basis points, with some spikes and some troughs. Then it became much more erratic starting about 1980. At that time, primary mortgage lenders began to get into more financial difficulty as money markets in general became much more volatile with extremely high rates near the end of the Carter administration, and changes in the Fed's actions.

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FIGURE 3

The momentum of home prices (percent change from same month of prior year)

30

I

New Homes

20

10

01-----f.!~~~-----------___4i~1_-4il~_:fJ_-------

-10

~

•

--=:::::::::::;';==

20

---.:i:=-_ _'===ZL.

...J

Existing Homes 15

10

5

OL-_-L_---:;:;===_ _ 1972 Source:

1973

1974

1975

_

~_....l_

1976

___I_ _...L__~:=._l..__..=::::::::I.:::==__L_ _

1977

1978

1980

1981

1982

__'__

1983

___'_

1984

___J

1985

u.s. Department of Commerce and National Association of Realtors.

Then a very high spread occurred in 1982, coinciding with the end of the peak of these interest rate circumstances. Managers who may have locked into long-term portfolios at that time of a 300 basis point spread over Treasuries, especially if they were in discount instruments, obviously obtained the benefits of very high interest rates and a very high spread over Treasuries. The very low spread and the negative spread at the present time are very difficult to understand. Essentially, this is a result of the policies

8

1979

of the major financial institutions which are making mortgage loans. At the present time thrift institutions are still making, or have resumed making, somewhat over half of the mortgage loans being made in this country. They are making them under deregulated interest rates. Consequently, you have an industry that is very fragile in an economic sense, needing economic activity in the very worst way, at least in their own minds. The common wisdom in the thrift industry today is: "Grow out of our problems." With old, low-

FIGURE 4

Yield differential (spread of mortgage rate levels over 10 year T -note)

400

300

/I)

'E

·0

a.. 100 /I)

.~

CD

Or-----------------------tt---fltHif-+....L------+---

-100

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

Source: Federal Reserve Board and FHLBB.

yielding mortgages in their portfolio, thrift institutions require tremendous growth in order to dilute the effect of these mortgages and return to health. This has made for very aggressive solicitation of mortgage loans, the majority of which have been adjustable rate mortgages (ARMs) with very low first year "teaser" rates. This has had a tremendous impact in causing such narrow spreads. Another factor that has had some modest influence is new developments in the secondary market. Probably the major development is the collateralized mortgage obligation (CMO)where mortgages are used as collateral to create bonds which have various characteristics of cash

flows: short, intermediate, and long-term issues. However, this development certainly does not explain the tremendous narrowing of the observed spread. Our analysis shows that taking current Government National Mortgage Association (Ginnie Mae) issues and turning them into a CMO will cost you two or three points for each issue. So, you lose a little bit on each one. It would take a tremendous amount of volume to make any money in that, obviously. Moreover, although the CMO may account for some narrowing of these spreads, it certainly does not account for mortgage obligations moving to a lower yield than Treasury obligations. I believe that this ratio will remain extremely

9

volatile. Money managers will want to watch this carefully. As the financial difficulties of the thrifts develop over the next year or two, they will find it necessary to withdraw from the mortgage market to some extent, and, as a result, it is very likely that these spreads will tend to increase. Money managers using Treasury futures to hedge portfolios of mortgages will therefore be exposed to immense basis risk in such an environment.

SIZE AND COMPONENTS OF THE MORTGAGE MARKET The size of the market, as measured by the mortgage debt outstanding, and the percent change in the mortgage debt outstanding from the previ-

ous periods is shown in Figure 5. Approximately $1.8 trillion of mortgage debt is currently outstanding, and over $1 trillion of residential mortgage debt is outstanding. Figure 6 gives an indication of some of the activity in the secondary market: volume of lender sales, and lender sales as a percent of new originations in terms of billions of dollars for conventional and FHA/VA [Federal Housing Administration/Veterans Administration] mortgage loans. Nearly all FHA/VA loans which are originated are sold. Very few are made by a portfolio lender and heIdi almost all of them find their way into the secondary market. Right now about 60 percent of residential mortgage loans that are being made are ARMs or variable rate mortgages.

FIGURE 5

Mortgage debt outstanding and percent change from previous year 2000 1800 1600 1400 Ul

~ 1200

iii 1000

~

600 600 ...

-----

_- ... - -

--- ---

------

--'"

... ...

~

400E~ _ _--------~ 200

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12

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15 Q)

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10

E Q)

...

(,)

Q)

a..

5

0

Annual from 1970 Legend (1970 -

Total1983)

(1970 -

Home - - - 1983)

Source: Merrill Lynch capital markets--mortgage-backed securities research.

lO

FIGURE 6

Volume of lenders' sales and lenders' sales as a percent of new originations 100 I

I

I

I

80

, I

Ul

c:

I

60

~

I

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6')

40 ~

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c: 0 ~ 100 c: '61 .;: 80 0 ~ 60 CD

-z 0

40

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~

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ll.

20 0

10

11

Annual from 1970

legend

Conventional - - (1970 - 1983)

FHAIVA---(1970 -

1983)

Source: Merrin Lynch capital markets-mortgage-backed securities research.

That would tend to downplay the FHA/VA situation at this time. However, with FHA/VA most likely coming out with a variable rate mortgage of some type, we may see a resurgence in that sector. The FHA/VA has been important in the secondary market in the development of builder bonds. Major builders in the United States have floated their own bond issues and held the mortgages within their own portfolios or in subsidiaries in order to count the sale of the houses which they produce under the installment method for tax purposes. That adds about one to two percent to the profit of their building activities. So they have a very strong incentive to securitize those.

Looking at the bottom half of Figure 6, it can be seen that for FH4/VA, in fact, more than 100 percent of new originations are currently being sold. That is like the fellow who worked 25 hours a day-they made him work during his lunch hour. Here we are seeing previously originated and unsold products moving into the market. Table 1 simply shows debt outstanding. Total mortgages rose from $470.1 billion in 1970 to $1,819.9 billion at the end of 1983. The evolution of mortgage-backed securities from $2.7 billion of Ginnie Maes in 1971 to $50.5 billion in 1982 is shown in Table 2. If there is $1.8 trillion of mortgages and $1.2 trillion of resi-

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TABLE 1. Mortgage data ($ billions)

Debt outstanding

Year

Total mortgages

1-4 family home mortgages

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983

470.1 520.6 596.2 676.9 741.1 800.8 886.2 1012.9 1162.9 1328.2 1463.0 1576.9 1651.3 1819.9

294.6 322.6 365.1 410.8 447.9 490.0 553.8 647.8 759.9 881.5 978.2 1058.9 1109.7 1221.1

Lenders' sales

Multifamily mortgages

Conventional

FHA/VA

Conv.

FHA/VA

60.1 70.0 83.7 93.1 100.0 100.6 104.5 111.5 120.7 128.4 137.1 136.4 136.5 145.6

29.8 49.6 71.8 77.3 64.0 71.3 105.7 150.2 167.6 158.9 115.3 88.2 83.2 169.3

14.5 20.7 19.5 15.8 15.8 17.2 19.4 27.6 33.8 43.4 30.9 22.0 22.9 50.0

2.0 3.4 6.3 1.2 8.2 10.2 13.9 23.5 29.2 33.5 28.0 21.6 42.3 98.1

12.1 15.3 17.0 14.5 12.7 13.6 16.9 25.4 30.8 38.4 29.2 21.7 19.4 56.1

Originations

Source: HUD "Survey of Mortgage Lending Activity."

dential mortgages, why have they not made a bigger impact in the capital markets earlier? They have always been there and yet nobody has really paid very much attention to them, unless you were a mortgage originator, mortgage servicer, or some specialized entity associated with mortgages. Now we are seeing this tremendous excitement concerning mortgage-backed securities, as mortgages move into the mainstream of American capital markets. This has occurred for a couple of reasons. To a large extent it is tied back to the institutions that have been so totally identified with mortgage lending in this country. Mortgage lending has

TABLE 2.

been almost a reflection of the savings and loan industry in terms of its main currents over the years. What has happened in the last few years, of course, has been that technology and deregulation have caught up with the savings and loan industry. Those institutions 10 years ago bought their money under the controlled cost of Regulation Q or its sister regulation, the Federal Home Loan Bank Board. They were limited to making single-family, fixed-rate, long-term mortgages, also under a rather controlled scenario. As the regulation of those funds disappeared, as those institutions had to move to market rates, and as mortgages were no longer made under a sheltered

New Issues of Mortgage securities ($ billions)

Year

GNMA

FHLMC*

1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983

2.7 2.7 3.0 4.6 7.4 13.7 17.4 15.4 24.9 20.6 14.3 16.0 50.5

0.1 0.5 0.3 0.0 0.5 1.4 4.7 6.4 4.5 2.5 3.5 24.2 19.7

FNMA

Conventional MBSs

CMOs

0.7 14.0 13.3

0.2 1.2 1.3 0.5 0.4 0.4 1.2

4.6""

• PCs and GMCs. •• $1.7 billion of FHLMC CMOs. $2.9 billion backed by GNMAs. Source: Lloyd Bush/Bond Buyer

12

sector of finance in this country, they suddenly came to market rates and started to behave like other financial instruments. Suddenly there was the liquification of this $1 trillion or $2 trillion of financial assets. That is why Wall Street became so interested in setting up operations to deal in the mortgage area. Certainly no other area has the amount of financial resources-the raw material-with which to work. It is sort of like the California gold rush. Market size comparisons of new debt issues are shown in Figure 7. The line which goes up at such a very steep rate is the mortgage-backed

New issues of securities-market size comparison ($ billions)

Year

Mortgage securities

Corporate securities

State and local government

1977 1978 1979 1980 1981 1982 1983

22.3 23.0 30.8 23.7 18.9 54.5 89.3

43.4 37.7 39.1 45.8 50.6 53.4 47.3

46.8 48.6 43.7 48.4 47.7 78.9 55.2

Source: Federal Reserve Statistical Bulletin, various issues.

FIGURE 7

Market size comparison of new debt issues 100

80

"

, ,,, ,,

60

../. __ -------~~~~

40

,,,/\,,, , ,, ,, ,

.... .. ...

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.

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20

1977

1978

1979 Annual from 1977

Legend

Mort

Corp ••••••••••• State I Local --------Source: Merrill Lynch capital markets.

13

security area, and in 1983 there were $89 billion of new issues which came forth. State and local governments issued $55.2 billion, and corporations $47.3 billion. Mortgage-backed securities were almost as large as state and local governments and corporates combined, in terms of the issuances brought to market during that time.

HOLDERS OF MORTGAGEBACKED SECURITIES Figure 8 shows who holds mortgage-backed securities. Savings and loans hold 34.2 percent; mutual savings banks, 8 percent; commercial banks, 5.8

percent; state and local governments, 4 percent; and nontraditional investors, 47.9 percent. What is referred to as a "nontraditional investor" is only nontraditional in the sense that they have not traditionally been identified as the large holders of mortgage-backed securities: life insurance companies, private pension funds, public pension funds, trusts, the U.S. government with the Federal Housing Administration pools, mortgage companies, and others. (See Figure 9.) We are seeing a tremendous penetration of nontraditional investors by the secondary mortgage instruments and in the secondary market. As these instruments become more sophisticated and can

FIGURE 8

Estimated holdings of mortgage-backed securities end of 1982

Nontraditional ~ Investors· \ (47.9%)

Savings and Loans ; (34.2%)

/ ..._ - Mutual Savings Banks (8.0%)

State and Local Government Agencies - - - - (4.0%) • For breakdown of nontraditional investors see other pie chart. Sources: HUD data compiled by FNMA.

14

(5.8%)

fIGURE 9

Estimated holdings of mortgage-backed securities end of 1982 (nontraditional investors) Mortgage Companies - and Other (6.9%)

....,

Life lnsurance Companies

j

(10.3%)

~

U.S. Government (FmHA Pools) (10.6%)

Private Pension Funds (8.3%)

t

OnIY)~

Trusts (Pools

(3.5 0Al) • Percentages add up to 47.9 percent as nontraditional investors represented this percent of total 1982 mortgage-backed security holdings.

Source: HUD data compiled by FNMA.

be tailored more and more to resemble almost anything. there will be a complete portability between investors.

ADJUSTABLE RATE MORTGAGES Before giving my perception of the current market, I will briefly discuss the adjustable rate mortgage and some of its implications. In the recent period, with thrift institutions again being the major mortgage lenders and coming out of 1981-82 tremendously weakened, having suffered immensely from interest rate risk-

that is, borrowing short and lending long-they were desperate for something that would give them some protection from interest rate risk while hopefully giving them a reasonable return on assets. The answer, in their minds, was the adjustable rate mortgage, or the variable rate mortgage. It is interesting that until 1981 thrift institutions were virtually prohibited from making variable rate mortgages. It was viewed as public poliey in this country that interest rates on mortgages should be fixed for 30 years. And it was extremely controversial when I was at the Federal Home

15

Loan Bank Board as to whether variable rate mortgages should be allowed. Let's take a look at three examples of the things that we are seeing in the market. Figure 10 shows an analytical system which we have developed for looking at various types of mortgage instruments. At the bottom of Figure 10 there are the following column headings: Negative Am [negative amortization], teaser, and Ginnie Mae 13. These are three of the primary types of mortgage instruments we are seeing today. A negative amortization is, of course, an instrument where the cash flow may be lower than the interest rate on the mortgage. That is, the mortgage is set up to be a 131h percent mortgage, but it only has a cash yield initially of 91h percent, to allow more people to qualify to purchase the home, or to entice them to do so. It obviously substitutes some real estate risk and some credit risk for the interest rate risk on the side of the lender. The teaser is another variable rate mortgage, but it has an initial interest rate

that is much lower than one would expect. And finally, there is the Ginnie Mae 13. Let's look at how these deals are structured. For the negative amortization, the net couponthe cash coupon, originally-is 91h percent. The lender gets three-eighths of one percent for servicing the loan. The net margin is 200 basis points, and that means that the rate at which interest accrues on this is 200 basis points over the one-year Treasury leveL It is a 30-year mortgage, 360 months. There is no adjustment cap; it can adjust, however, as the market adjusts. There is no net-life cap; that is, over the total period it can adjust however the market adjusts. However, there is a payment cap; the payment cannot go up in anyone-year period more than 71h percent. The first adjustment occurs in 12 months, and it will be adjusted annually, initiated at a price of 98, and made with 2 points. The teaser has an initial rate of 10l/z percent. It has three-eighths percent servicing. It has 225 basis points over the one-year Treasury. It

FIGURE 10. Adjustable rate mortgage price-yield system Economic environment: assumption falling rates Year 1 2 3

4 5 6 7 8 9 10 11 12

Rising rates

Stable rates

Index at end of year

Reinvestment rate during year

Index at end of year

Reinvestment rate during year

Index at end of year

Reinvestment rate during year

10.79 10.29 9.79 9.29 9.29 9.29 9.29 9.29 9.29 9.29 9.29 9.29

11.79 11.29 10.79 10.29 10.29 10.29 10.29 10.29 10.29 10.29 10.29 10.29

10.79 10.79 10.79 10.79 10.79 10.79 10.79 10.79 10.79 10.79 10.79 10.79

11.79 11.79 11.79 11.79 11.79 11.79 11.79 11.79 11.79 11.79 11.79 11.79

10.79 11.79 12.79 13.79 14.79 14.79 14.79 14.79 14.79 14.79 14.79 14.79

11.79 12.79 13.79 14.79 15.79 15.79 15.79 15.79 15.79 15.79 15.79 15.79

Deal: Net coupon Service fee Net margin Rem. term Adj. cap Net life cap Payment cap First adj. Next adjustments Pricet

Negative AM

Teaser

GNMA 13

9.500%' 0.375% 200 BP 360 M. 0.000% 0.000% 7.500% 12 M. 12 M. 98.000

10.125% 0.375% 225 BP 360 M. 2.000% 15.625% 0.000% 12M. 12M. 98.250

13.000% 0.500%

N/A 360 M.

N/A N/A N/A N/A N/A 98.500

, Initial payment based on 9.5 percent rate, but the loan accrues from origination at 200 B.P. over the 1 yr index. t Prices are based on market levels at time of analysis. Source: Merrill Lynch capital markets.

16

is a 3D-year mortgage. It cannot adjust in interest rate more than 2 percent per year. As for the net life, at no time can it go higher than 15.625 percent. It adjusts in a year, and it adjusts annually. These are two actual deals that we have seen. They are typi9a1 of some of the adjustable rate mortgages that are in the market at this time. Ginnie Mae 13 is a 13 percent net coupon with a service fee of 0.5 percent, 360 months to maturity, and 1Y2 percent points on it. Figures 11, 12, and 13 show how the ARMs perform versus the Ginnie Mae 13s in the interest rate scenarios assumed in Figure 10. The three scenarios are falling rates, rising rates, and stable rates; and the Treasury rate index under stable

rates is assumed to stay at 10.79 percent. The reinvestment rate is assumed to be 11.79 percent. If interest rates rise, we let them rise 1 percent per year for four years, rising from 10.79 percent to 14.79 percent and then stabilizing. The reinvestment rate is 1 percent higher. Under falling rates, we drop them 0.5 percent per year for four years and then stabilize them. Figure 11 shows the stable rate environment results in terms of the realized yield to prepayment. Reading across the bottom of this exhibit to, say, six years, that would be the yield that the investor would receive if he held this instrument for six years and then it prepaid and he was totally paid off. It can be seen that under this scenario the Ginnie Mae outperforms either

FIGURE 11

ARMs versus GNMA 13 in a stable interest rate environment 14.5

14.0

E Ql ~

13.5

Ql

~

1: Ql E >. co

...5r 13.0 0..

----

,g

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..................

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12.5

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cr: 12.0

........

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........................

11.5 L - _ - L ._ _L-_.....L.._---I_ _...I-_---l_ _ 7 5 6 2 3 4 o

...L__---l.._~...L_ _

8

9

_ L_ _..l...__

10

.

_ L_ _.L__.....J

12

13

14

Prepayment Year Legend

NegAm- Capped •••••••• GNMA13 - - - -

Source: Merrill Lynch capital markets.

17

FIGURE 12

ARMs versus GNMA 13 in a falling interest rate environment 15

~

E

14

\

~

Q)

\

~

'E Q) E >0III

a. Q) ~

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.

11 '--_---'-_ _L.-_--'-_----''---_-'-_---I_ _....L..-_----L_ _- ' - - _ - - L_ _..L...-_--L_ _.1...-_..-J 14 12 13 9 10 11 o 2 3 4 5 6 7 8

Prepayment Year Legend

NegAm-- Capped •••••••• GNMA13 - - - -

Source: Merrill Lynch capital markets.

of the variable rate instruments over the entire life, out to a 13-year prepayment. So, as might be expected, an investor does not gain much from a variable rate instrument if interest rates remain stable. If interest rates fall, the Ginnie Mae outperforms the negative amortization and the capped rate over the life of the instruments again, as might be expected. This is shown in Figure 12. The Ginnie Mae may be biased upward slightly in the sense that if interest rates were falling, one might expect a prepayment to occur earlier rather than later, so it may not have the same expected life as the variable rate mortgages. In a rising rate environment, the variable rate

18

mortgages outperform the fixed rate as can be seen in Figure 13. However, comparing the capped ARM versus the Ginnie Mae it can be seen that it is not until about the fifth year before the capped ARM does outperform the Ginnie Mae. This result is surprising. Here is a variable rate instrument in an increasing interest rate scenario-interest rates rising 1 percent a year-and the Ginnie Mae 13 outperforms it in terms of yield clear out to the 5th year. Even out to the 13th year, it can be seen that the capped ARM, at best, only outperforms the fixed rate by about 50 basis points. In addition, a lender would be incurring a fairly substantial amount of credit risk. With

FIGURE 13

ARMs versus GNMA 13 in a rising interest rate environment 16

... .....

15

... ..... .. .. ... ... .. ... ......... .. ......... .,.. ............... -'

I"

......

14

."

.................

13

. ... I.··.

12

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.....

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1..--_--L._ _L....-_--'-_---li...-_....L-_---I._ _...1.-_......J.._ _..L.-_--L._ _.1..-_--L._ _" - - _ - - - '

o

2

3

4

5

6

7

8

9

10

11

12

13

14

Prepayment Year legend

NegAm--- Capped •••••••• GNMA13 - - - -

Source: Merrill Lynch capital markets.

ARMs the homeowner will be making higher payments over a period of time, and with the Ginnie Mae, the investor has the full faith and credit of the U.S. government. The negative amortization performs rather well-if it is paid off, of course. And that assumes that the value of the property keeps pace with the negative amortization that might occur.

CURRENT VIEW OF THE MORTGAGE MARKET The mortgage market is a real mess right now. I have taken Gresham's Law and turned it into Pratt's Law: bad lending drives good lending out.

There is, in my opinion, a tremendous amount of risk in the primary mortgage markets at this time. Again, I hate to keep going back to the thrift industry, but these institutions make half of all mortgage loans. In the lowest interest rate period in the last 3 years, only 50 percent of them got to a break-even basis. In the first six months of 1983, when Treasury-bills hit seven percent, half of them got back to zero net operating income. What exists is a tremendously distressed industry with $800 billion of assets and nothing to lose. Right now, they see the need to grow and the need to make loans as extremely important. Most of them have no real capital invested.

19

On a mark-to-market basis, a great portion of them have negative real net worth, and so it makes a lot of sense to be extremely aggressive in their lending practices, whether the lending makes much sense or not. If interest rates turn down, it will have turned out to have been a

20

good ploy. But what we have is an industry without risk capital injecting immense amounts of money into this market, and I think that it is, again, a Gresham's Law that bad lending drives good lending out. Consequently, I think the instruments tend to be mispriced.

Pratt Question and Answer Session QUESTION: I noticed that Merrill Lynch has formed a joint venture with Great Western Financial to create a CMO. Do you see this type of joint venture proliferating, and could you elaborate on the marketplace? PRATT: I think you will see a substantial amount of interaction between Wall Street firms and some of the traditional mortgage lenders and more powerful primary mortgage operators in this country. Some of these institutions originate as much as a half a billion dollars a month or more. If you look at any creator of financing in this country, nobody matches the mortgage market. The size of this market is just fantastic. QUESTION: Would you please discuss the credit risk of ARMs? Do S&Ls extend credit to the limit on ARMs, or do they build in some room for future rate increases? PRATT: There is a tremendous variation in how ARMs are underwritten-everything from making the person qualified based on a reasonable expectation of where that interest rate may go, to being willing to take the income of the applicant, and the spouse, and the dog, and everyone in the family-not only in this life, but in the life to come. So you get tremendous variations. There is a good deal of credit risk associated with that, where the underwriting is not very well done. We have seen teaser rates as low as 5 percent. Now, if the lender qualifies someone to be able to repay their loan based on an interest rate of 5 percent, when you know in 12 months the rate jumps to 13.85 percent, the lender is probably asking for some difficulty. The experience of the mortgage insurance companies with variable rate mortgages has been very much less positive. In some of these extremely aggressive mortgages, a mortgage is just a set of options granted to the borrower-the lender just adds one more option, and that is the option of speculating in real estate and walking away. If the lender is granting a good negative amortization with a very low beginning interest rate, the potential borrower reasons: "What the heck? I'll buy this thing, and if I don't like what's happening in a year, I've had a good deal, I've had some tax breaks, and I'll walk away."

And that has happened previously in our history. I remember after World War II in an area that I was familiar with, that housing payments were $70 a month, and rental was $90. So, instead of looking for a place to rent, people would buy the house, and if they had to move in two months, they moved. They moved at 10:30 at night, and they took the toilet with them. We may see some more of that. QUESTION: This is a good question for somebody in the capital markets. What is the probability of mortgage-backed securities crowding out the corporate and public sector? PRATI: They're not going to crowd out government, so let's start with that. Money goes where people are willing to pay the return for it and where the demand exists for it. Looking at the refunding of old mortgages, if, for instance, a big insurance company is selling out a portfolio of low-yielding mortgages through a discount CMO, I do not see that as a net user of funds. The company is, of course, liquifying part of its portfolio, but that money is going to be redeployed. I do not see any reason that this should have substantial crowding-out effects. It would seem to me that where crowdingout would occur is if the net demand for new money was very high in these sources by people believing that there was going to be a tremendous inflation in housing prices. And I do not see that in the immediate future. When I was a university professor in the 1970s, my students woulet do anything they could to get into a house, not because of the dream of the vine-covered cottage, but because they could get 10 percent appreciation on a down payment of 5 percent. QUESTION: Two S&Ls, Coast Capital and Philadelphia Savings, recently sold adjustable rate preferreds secured by a pool of Fannie Mae and Ginnie Mae mortgages. This seems to be an odd security. Can we expect to see more of this, and is it a healthy trend? PRATT: Yes and maybe. To elaborate, what happens in this type of an issuance is that a thrift institution almost always has loss carry-forwards.

21

That is one of the blessings associated with having lived a hard life. What is being done here is that a subsidiary is created, the mortgages are then contributed to the subsidiary, and then the subsidiary issues preferred stock. What this creates is a secured preferred stock, because the subsidiary only his one asset-the mortgages which the institution have given it-and it only has one liability-the preferred stock. The savings institution has a tax-loss carry-forward, so it does not matter that the payment of dividends is not

22

tax deductible, because it does not pay taxes in any case. The corporate purchaser of that preferred stock gets the corporate tax exclusion, and it allows a financial institution, which may be very weak and which would have to borrow on an unsecured basis at, let's say, 15 to 17 percent if it could borrow on an unsecured basis--to borrow at 10l/z percent. So it's a very attractive opportunity for that financial institution, and it mobilizes tax-loss carry-forwards that would otherwise not exist.

Characteristics of Mortgage-Backed Securities (I) Helen F. Peters I will discuss the characteristics of mortgage portfolios and their pitfalls. There clearly are pitfalls, and I will give you some background on them. Richard Worley will explain the opportunities in the market and how to take advantage of them. There are several problems in the mortgage market. There is lack of data available to anyone who is pricing the securities; there is uncertainty with respect to the prepayment aspect or the call feature; and there is the need for rules of thumb to try and provide liquidity in this market. These three aspects combine to make it very difficult to get a handle on prices and yields.

PRICE/YIELD CONVENTIONS The value of any security is typically measured by its price/yield relationship. The traditional way to calculate the yield on a fixed rate mortgage security is the "12-year life" assumption. It assumes that the mortgages in the security are all brand new, will prepay at the end of twelve years, and that they all have the same coupon rate and remaining term to maturity. The 12-year life assumption simplifies the price/yield relationships so that yields can be calculated easily on any fixed rate mortgage. The advantage is that easy rules of thumb can provide liquidity to the market. The cost is that true value can be missed. The first part of the assumption is that the security is priced as if it were new. Most investors who have worked with bonds are amazed to learn that two 8 percent, 30-year fixed payment securities, one issued in 1970 and one in 1978 are priced exactly the same. Although savvy investors will try to figure out true price differentials, our standard price/yield reporting conventions do not take age of the instrument into account. This makes it very difficult for the novice to operate in this market. The more sophisticated investor relies on cash flow analysis in order to price a new versus an old security. The assumption that all mortgages have the same coupon and remaining term to maturity causes problems when there are heterogeneous

mortgages in the security. Originators prefer broad coupon and maturity ranges in securities so that they have a greater chance of packaging their mortgages into more liquid securities. To get around the need for a single coupon and maturity number, the WAC (weighted average coupon) and the WAM (weighted average maturity) are calculated. The use of these average numbers can cause problems. The most serious is that these numbers are calculated at origination and investors typically do not get updates of the WACs and WAMs over time. If the composition of the portfolio changes over time (typically due to prepayments and foreclosures), the WAC and WAM can become unrepresentative of the portfolio composition over time. Another problem is that yields based on averages seldom provide the true picture. Except in rare instances, the yield calculated using averages will not equal the true cash flow yield of a heterogeneous group of mortgages in a security. The third feature, and the one getting the most attention today, is the prepayment assumption. To accurately calculate a price/yield relationship, investors must estimate how long the security will be in existence. Mortgages will typically not last to maturity since many owners either sell their homes or refinance their mortgages in the interim. The 12-year life assumption is a guess that homeowners will prepay on average at the end of 12 years. There are serious problems in the use of this measure. Another tool investors use to measure prepayment is the Federal Housing Administration's (FHA) experience. FHA experience is a historical measure of mortgage prepayments over time. The original series contained data back to 1957. The more recent series includes data that begins in 1970. FHA experience was developed for an entirely different purpose than pricing a security. Though it is a historical measure, investors attempt to use it to forecast rates of prepayment of mortgage portfolios over their remaining life. The problem, however, is that while it may be

23

an appropriate historical measure, it is a very misleading forecasting tool. The problem with FHA experience is that the data are averaged over various interest rate periods. It tries to measure how a mortgage portfolio will prepay in its first year, second year, third year, and so forth. For the first year of prepayment, we have data from 1983 back. For the second year's rate of prepayment, we have data ending in 1982, since we do not have a second year of experience for 1983. For the third year of FHA experience, data are missing from 1983 and 1982. This pattern continues on back with the result that prepayment rates for policy years 1, 2, and 3 contain experience from recent years, whereas policy years 28, 29, and 30 are very historical numbers. Historical data would not be a problem if interest rates were stable. But we have witnessed both a steady upward drift in rates and a very voJatile recent period. Even though there are a fair number of people beginning to recognize that there is a problem in these statistics, FHA experience is still used and many people quote yields using it. Right now there is a debate as to whether one should use the new FHA or old FHA experience. This debate misses the point. The new data are no more accurate than the old data, and in some cases they can be even more misleading because of the composition of the mortgage portfolio being compared to the new FHA experience. One can spend a lot of time actually breaking FHA experience down and finding why there are problems in the new series and in the old series. One can even get into serious debates on how you calculate 200 percent FHA, 300 percent FHA, and other things. I have seen major deals where the statistics for 200 percent and 300 percent FHA had to be regenerated because they were not calculated according to standard conventions. All of this was a lot of sound and fury, because it did not signify much. Telling an investor how much he or she will earn if a portfolio prepays at 200 percent FHA or 300 percent FHA is about as relevant as telling one how much a portfolio will earn under a full moon. If you need a tool to price mortgage portfolios and calculate prepayments, then you should use a standard rate of prepayment, some hard-core number; that is, a number that does not change every year as does FHA experience. A prepayment rate such as two percent a year, three per-

24

cent a year, or five percent a year are standard numbers, and much easier to understand. Rates of prepayments are more accurate tools, but here again there are a few pitfalls because there have been various sets of numbers that have been published. The reason for those various sets of numbers is that there are questions as to the accuracy of the data as they come from the agencies. Specifically with Ginnie Mae portfolios (where it is easy to check for errors in data because the old pools are much more consistent than those of other agencies), problems have been found and erroneous data should be discarded. Also, there have been some statistical errors made in the method of calculating basic summary statistics. Many of these problems have been solved, but in this security, other problems may still exist and the investor should always question the accuracy and appropriateness of information.

FORECASTING PREPAYMENTS Even though one may have historical data, the major problem for any investor is how to forecast prepayment rates. That is what you really want to know. Remember that the homeowners have options on the underlying mortgages to prepay at any time the remaining face amount. There are two approaches to looking at this. Do you take historical data and explicitly model it to analyze what prepayments are going to do, and estimate a reaction function; or do you rely on option theory and explicitly price the value of the option? Both of these approaches are very fruitful, but there are problems in both. Anyone operating in this market should look very carefully at both methods, but try to use his own insights. If you model from historical data, obviously you will have problems in extrapolating the future because there are new events and new things happening. Keep in mind that no econometric model has ever been a perfect forecaster of anything. With the option theory approach, you also have problems trying to explicitly model an option. The problem with this approach is that a homeowner does not have available the same kinds of opportunities that an IBM or another issuer has when they exercise the call option on their securities. You end up trying to incorporate into an option evaluation model a lot of estimates of imperfections in the markets available to the

homeowner. This can be very cumbersome to incorporate into the model. The approach that I continue to use in estimating prepayments at this point is forecasting the data. It is an easier tool to use to help one understand the reaction function that homeowners have. I look at the variables that a homeowner needs to analyze in order to decide whether he is going to exercise the option or not. Obviously an important one is interest rates, but there are other factors that one can look at in estimating these models. There are other economic factors, as wen as some regional factors. I would suggest that others try to analyze the individual components, because that is what some of the most successful investors have done; questioning how the market is changing and how the consumer is going to react.

Are we getting to a more perfect market? We certainly are in many cases, but there are also many more opportunities today for investors to analyze. I think that it is fair to say that we still have a very exciting market for mortgage securities even though there are a lot of new players. One should remember in approaching this market that typicany securities markets attach large risk premiums to that which they do not understand. This market can be very attractive if you spend the time to try to figure it out, but you have to be very careful not to rely on old rules of thumb. Remember that rules of thumb will change over time, because if you do not, you run the risk of being hurt in the mortgage market. Clearly, in a market like this "he who uses the rules of thumb gets his hand chopped o £f ."

25

Peters/Worley Question and Answer Session QUESTION: Mr. Worley you mentioned the due-on-sale mortgage paper several times. Could you elaborate on that a little bit. WORLEY: Some Fannie Mae and Freddie Mac passthroughs and PCs have mortgages behind them that have due-on-sale clauses. That means when a homeowner moves, the mortgage must be paid off. FHA and VA mortgages, which stand behind Ginnie Maes and some Freddie Macs, are assumable. And I think more people than before have learned how to get mortgages assumed. It stands to reason that every time somebody with an assumable mortgage moves, sometimes the mortgages will be prepaid and sometimes they will be assumed, but in the case of due-on-saIe mortgages, it is all enforced and people have to prepay the mortgages. Since prepayment is in the security holder's interest, with other things equal you ought to favor the due-on-sale paper. Now the prices have adjusted, so I am not sure you should prefer the due-on-sale paper at the current spread; it seems like a pretty close call. QUESTION: Is there an experience on spreads between due-on-sale and nondue-on-sale paper? WORLEY: The Freddie Mac paper that had some due-on-sale mortgages in it, going back seven or eight years, prepaid a lot faster than Ginnie Maes until about 1979 or so, when the due-onsale was suspended for a lot of the mortgages that were in this Freddie Mac paper, and their prepayment rates came tumbling down. In this housing recovery, the due-on-sale discount mortgage papers prepaid at about twice the rate that discount Ginnie Maes have prepaid. And at the beginning of the housing recovery, the discount Ginnie Maes for the same coupon had a higher dollar price than the discount Fannie Maes and Freddie Macs. That has been reversed. So I think the yields of an eight percent Ginnie Mae and eight percent Freddie Mac are about the same if you calculated the yield on a Fannie Mae eight at a six percent prepayment rate and a Ginnie Mae eight at about a three percent pre-

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payment rate. They are not exact, but they are close today, so that has adjusted some. QUESTION: How can you be assured the servicing institution will enforce good due-on-sale clauses just by a phone call? WORLEY: I do not think you can be sure. I do know that they are supposed to do it, and I think they can get in trouble if they are caught not doing it. Also, most people, if they have agreed to do something, do it. I am not sure that our calls have increased their enforcement of that at all. By making those calls and asking a number of other questions before we buy mortgage paper, we have been able to create a large portfolio of discounts that have prepaid faster than the universes from which they were created. And so we go ahead and do it, but there is no real guarantee. QUESTION: What is the reliable source of actuarial prepayment statistics? PETERS: Anyone who is on the buy side is in a very good position, because you get to call the research of the best and the brightest, and pick and choose from it. This is a very competitive market and there are a lot of firms that are getting into this area, so I would make sure that you see information from various Wall Street firms. Certainly, if one firm has made an error, the others will catch it. Also, there are different views and the investor should be aware of all of them. But I think that there is a limit to what anyone in a Wall Street firm, or those of you who analyze your own data, can do. Much of the needed information is not collected from originators or the agencies. It would be nice if we did not have to deal only with information based on when the portfolio was originated. We would like to see what is remaining in that portfolio. When you get wide bands on mortgages in securities, how have securities prepaid over time? Have the high coupons prepaid, and are you then left with a pool that has a very different distribution? Are you using the right numbers? I think that those

of you who buy mortgage securities should exert a lot more pressure to get clear information on these portfolios. QUESTION: When is a discount a discount; 70, 80, 90 percent? WORLEY: I used to be an economist, and I still like to try to figure out where things are going; not that I am always right. I think that this is a good kind of security for somebody who has an outlook on the economy and interest rates to invest in, because you might buy that coupon or security at that dollar price, where you think that it's low enough so that it will stay a discount. Helen Peters' model has one of the factors determining prepayment being the distance between the coupon on the mortgage and the current coupon in the marketplace. So you might want to do other things. On the discount that maximizes your chance of being prepaid on that basis, we have not been quite so exacting: we just sort of buy 7 to 8Vzs. They are all about the same. QUESTION: Why is the assumption of constant prepayment rates, such as five percent per year, any more realistic than FHA experience or any better as a convention for quoting yields? PETERS: The ability to use a hard core number is better than using something you do not really understand. If you look at what FHA experience translates into rates of prepayment, you will find it is a very bad forecasting tool. There is a lot one may say about this, but very simply, if we extrapolated interest rates, mortgages would prepay on a curve over time that rose for a while and depending on whether you are analyzing FHA or conventional mortgages flattened around 7 to 10 years and then was steady to maturity. Interest rate environments can change a nice smooth curve to one that varies dramatically over time and responds to different interest rate environments. Obviously you do not prepay your 8 percent mortgages in a 17 percent mortgage rate environment. If you are looking at what forecast of rates of prepayment are coming out of FHA experience, you think you are fine-tuning this, but first you are generating a curve that goes way up at the end. Is that really what you want? And if you

got this curve, are you then going to say you want 200 percent of it, even with this curve up? At least deal with something hard-core. Also, FHA experience changes every year because the new data come out, so you have a new standard. Consequently, 100 percent of FHA experience is not the same as 100 percent from last year's numbers or the previous year's. I would much prefer dealing with a number that may be wrong; five percent may be a bad forecast, but at least I know what I am using. I do not know what I am using with FHA experience. I do not think people who say they bought a portfolio at 50 percent of FHA really know what that means because that number is not concrete. WORLEY: I would like to add to that. There may be two reasons for making a prepayment assumption. One is to try to figure out the value of these securities as a group relative to something else you could buy, like treasuries or corporates. But another is to try to figure out value between one of these mortgages and another. And in terms of figuring out whether mortgages are a good buy relative to treasuries or governments, it probably does not make too much difference whether you use some judgment based on FHA experience or a constant prepayment. It happens that for many securities, 100 percent FHA and about a 5Vz percent prepayment rate assumption give you pretty near the same yield. The reason I prefer using a constant prepayment rate is that comparing one mortgage to another on the basis of an FHA experience can give very misleading results. You can sell one mortgage to yield 100 percent of FHA experience and buy another on that same basis and think you have picked up yield because you were assuming the same prepayment for the two. If these mortgages have different ages, though, you are really not assuming the same prepayment for the two. You are only cutting into an FHA prepayment experience curve at different points. And it may well be that you ought to. It may well be that there is a difference in the propensity of mortgages from a 13-year-old pool to prepay versus mortgages from a 5-year-old pool, because more people move when mortgages are 13 years old than when they are 5. But, it may only be that the data you have for mortgages that are 13 years old covered more

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years when prepayments were slower than the data that you have about mortgages when they were 5 years old, or that the mix of coupons versus the current was different. It purports to be a demographic phenomenon, but there is a lot that goes ii/to it that may be spurious. I do not think you can effectively pick out any difference between the prepayment propensity of a sevenor ten-year-old mortgage. Therefore, why use a standard that does presume a difference? PETERS: The other thing to remember is that we live in an environment of changing interest rates. If you try to use FHA experience to forecast prepayments, your biggest problem is trying to link your forecast of interest rates to your forecast of prepayments. One should try and keep those together, because they make a big difference in how the security is going to do compared with the other kinds of fixed investments that you have available. You can obviously use a model that explicitly ties it: If rates go up, the model forecasts that prepayments will go down by a certain amount; if rates go down, it forecasts prepayments will increase. But you can also do what many investors do, which is intuitive: If rates go up, I think it is going to prepay at three percent, five percentgive yourself a number and try to pull them together. FHA experience makes it very difficult to do that. And, as Richard Worley indicated, the more you move out on this curve, the more you end up at different points. So, you are extrapolating numbers that really do not relate. Pull them together and you will know what you are dealing with. Whether you make good assumptions or bad ones, they are concrete assumptions that you can test against yourself when you go up for your performance review. QUESTION: What is a collateralized mortgage obligation (CMO)? WORLEY: There are a lot of different CMOs. Because investors did not like the uncertainty concerning prepayment rates with mortgages, dealers saw a market for securities that could reduce that uncertainty. Dealers bought a lot of mortgages and separated them into tranches. They gave owners of the first part all the paidout principal repayments of the whole group of mortgages.

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For example, suppose a dealer constructed a billion-dollar pool and broke it into three pieces. Suppose the first tranche was $300 million. The holders of that tranche get all of the paydowns that occur for the whole $1 billion until that is finished. Then holders of the second tranche get all the paydowns until that is finished, and people in the third until that is finished. It seemingly creates a very short security for the first and a very long security for the third. I do not know very much about the middle part. The third will be a very long security if interest rates go up. However, there is no guarantee that that is going to be the case. I do not know whether a CMO based on 17s would have been a very good bond for the investor who bought it back in 1981. There are about a hundred other things that would have gone up more. So, with respect to the long tranche, I don't know that that really offers you a measurable amount of call protection. It is apparent that if you run it out, even on the assumption of a 200 percent FHA experience, it is going to be a long instrument. But what if FHA experience is 3,000 percent? That could happen. The short ones I think had a 40 or 50 basis points pick up to an equal-duration treasury. Since the transactions costs in these things are pretty large, they could eat your 40 or 50 basis points if you do not own it for a while. Second, if the actual prepayments slow down somewhat, it will only lengthen your duration maybe half a year. If they speed up, it will only shorten it by about half a year. But that affects your returns versus the equal-duration treasury. So this is a way of turning a sow's ear into a silk purse, and a lot of people bought them. I do not know if that has had to do so much with the narrowing of spreads between mortgages and treasuries or whether it just occurred at a time that was sort of a feeding frenzy for yield. And everything that yielded more than treasuries were bid up in price, and mortgages just went along. If it is part of the reason that current coupon mortgages were bid up, I think that we should recognize there is some peril in the outlook if things do not turn out the way these people think they wilL QUESTION: Mr. Worley, you talk about backoffice problems of mortgages. Do you implicitly add in a nuisance factor? By that I mean a premium that a mortgage must yield above to pay for the people who call up and figure out prepay-

ments and what areas some of your pools are in, and so forth. WORLEY: Not really. Ours is a lucrative business, and we try to do the best we can for our clients. And if we think that you can make more money for them by owning them, we do so, even if it costs you a little more. Because, I think, the amount it costs you is inconsequential relative to what you can make for your clients. Managing separate accounts is probably not the most efficient way to manage a mortgage portfolio. We are going to try to change that by going to a commingled trust for pension accounts and a mutual fund for endowment and foundation accounts. One of the reasons for that is that if we decide to cut back 10 percent on our holdings of mortgages, when we analyze all of our holdings for all of our different accounts as one portfolio, in terms of analyzing whether mortgages are prepaying at rates we think they should and the different characteristics, it strikes me that a better way to cut back 10 percent is to take the 10 percent of the total that looks the least attractive and sell it. But that is not 10 percent of every account. It might be 30 percent of one account and zero percent of another. So it is hard to go from managing an overall pool of mortgages to managing individual accounts. Among accounts, the prepayments do not occur at exactly the same rate, and so we get differences in return among clients that have nothing to do with different strategy or different objectives. It is just randomness. We would like to get rid of that and make the operation more efficient. It takes some investment in people, and getting them up to speed, but the cost of doing it is low relative to the opportunity. Consequently it is a good deaL QUESTION: Ms. Peters, if you are forecasting prepayments over the life, you are, by definition, forecasting interest rate cycles. If you cannot forecast interest rate cycles effectively, what sense does it make to forecast prepayment rates? PETERS: The way we operate is that we do not forecast interest rates; we let our clients do that. We do not get paid enough to forecast interest rates. Thus, the models that are available will look at forecasts of prepayment rates over different interest rate scenarios. We let our clients who have to forecast interest rates look at how the

portfolio will do. One can also forecast interest rates from the term structure of interest rates and then move from there. I think it is important for someone to know the relationship of prepayments to interest rates. But as I indicated, it is not the job of those of us who look at various securities and how they operate in these markets to actually forecast interest rates. We just explain the relationship there. QUESTION: How do you properly adjust the original weighted average maturity as discount pools become seasoned? WORLEY: One of the first things I learned when I started buying mortgages is the differences between the 12-year and the Green Book. The Green Book is where the Street sold them, and the 12-year is where they bid them. And it is the same with weighted average maturities. When you get a group of mortgages that all mature on the same month, and you know the weighted average or the average maturity of those mortgages, as time passes you know that that maturity has shrunk. If you get disparate mortgages, however, you do not know which ones are prepaid, so there is some uncertainty as to how much the maturity of a mortgage pool has shrunk. If you had widely disparate maturities in a pool, all the short ones could have prepaid, or been the ones that prepaid, and the actual weighted average maturity might have lengthened on you. That is not really something that happens very often. But as a result of all this, Wall Street likes to bid mortgages on their original weighted average maturity. That means whenever you buy other discount securities, part of that return is the marching toward par of the discount as you get closer to maturity. In the case of buying a discount mortgage, a year later Wall Street is going to bid it to the same maturity that existed a year before. And you sort of get robbed of that little bit, and it is not inconsequential. We calculate the remaining average maturity, and we try to do that for all the different mortgages that we own or consider. And we try to trade bonds using Wall Street's bids and offers, where we can usually pick up yield to the remaining average maturityunderstanding that that is not a perfect estimate; but I think it is better than ignoring it. Although

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you can pick up securities, you cannot buy as easily on the original weighted average maturity as you can sell. PETERS: To sum what Mr. Worley stated: You don't have that information later on, in terms of remaining average maturity, and thus, you are guessing, trying to get as much information, look-

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ing at the composition of the pool, and how it might have changed over time. It would be nice if one could be provided with that information; I think it would help the mortgage market a great deal. But it is not yet forthcoming from anyone who operates in the mortgage market at this point in time-the originators and packagers.

Characteristics of Mortgage-Backed Securities (II) Richard B. Wodey The case for mortgage securities that is popular among investors today is fairly simple. As it is a large liquid market of securities with excellent credit quality that yields more than other types of securities of comparable credit quality, or even of weaker credit quality, they should be included in your portfolio. One of the things that I will address is whether this case really holds up.

EVALUATION OF THE REASONS FOR HOLDING MORTGAGEBACKED SECURITIES Let's take a look at the three attractive features often cited for holding mortgage securities: large liquid market, excellent credit quality, and yield advantage.

Large Liquid Market

Yield Advantage

With respect 40 the size and liquidity of the market, one of the dangers is that never have so many securities existed about which their owners have known so little. The market is roughly the size of the corporate bond market today. Most investors probably know more about their government and corporate holdings than they really understand about their mortgage holdings.

To say that mortgages over time yield more than they ought to relative to other securities, is probably too much of a generalization. One of the curious things about these mortgages is that you really cannot calculate the yield, it's impossible. I do not mean that people just do not know how to do it: it cannot be done. Consequently, you can only sort of grope toward it. The realized yield is almost certainly going to be less than any estimated yield which is used as the basis of an investment decision. First, current coupon mortgages are probably about the worst instruments you .can think of for an investor. But even the worst instrument can be a good val1ol.e if the price is right. And I think that is the reason for looking at the mortgage market: sometimes the price is right. It is an instrument where at any time the homeowner can call the security holder out at par. And if one of the purposes of fixed income securities is to be a deflation hedge in an overall portfolio scheme, that is not a very good instrument to serve that purpose. You have to be very conscious of the option that the homeowner has. In a sense, buying a

Credit Quality On the question of credit quality, the credit quality is very good. It is particularly good in times of only a few isolated defaults by homeowners. I'm not sure it is very good in the case of deflation. Some would say that the fixed income portion of a fund should be a deflation hedge. It is doubtful that half of America would be thrown out of their homes if an economic event occurred in which half of America was in default on their mortgage payments. If a few people are out, I think these securities are good credits. There are some ways to manage a mortgage portfolio to try to reduce default risk. The portfolio can be diversified geographically. The portfo-

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lio manager can buy older mortgages instead of newer mortgages. I do not believe that it is a very big risk to begin with. There is probably some risk in the packaging mechanisms. The question, particularly with respect to Fannie Mae, is who really owns the mortgages in the event of a financial difficulty at Fannie Mae. They are trusteed at Fannie Mae. Although they are pledged to investors, Fannie Mae is not covered by the bankruptcy laws. The chances are that if you acquired discount securities you will come out all right or whole, because on a mark-to-market basis Fannie Mae is worth more than the market value you would have at risk. But there are some questions concerning the packaging of the securities that must be investigated.

mortgage is like buying a security and selling a call option at the same time. And there might even be more advantageous markets to do that in; that is, there might be a higher value on a call option in other markets at some time. To think that the yield premium that an investor expects over a regular fixed rate security is all yield, because of credit or the inefficiency of the market, is foolrsh. A very big part of the yield premium is a compensation for accepting call risk. The central part of managing mortgage securities is really managing that option, or that contingency of prepayments.

PREPAYMENT UNCERTAINTY AND THE SELECTION OF THE COUPON SECTOR You can make a lot of money if you know what you are doing in the mortgage market; and you can lose a lot of money if you know what you are doing in the mortgage market! And that is because sometimes these prepayments do not actually occur in the same manner that you expected. No one knows what the yield is, or what the duration is, nor is it possible to figure it out. However, we do know a few things. The first is that when you want duration to be shorter, it will be longer and conversely. The second is that yield will be lower than you think. Let me explain what I mean when I state that the yield will be lower than you think. One source of a bondholder's return is interest on interest over time. Suppose, for example, you acquire a 20-year Treasury today at a 13l1z percent yield, and over the next 20 years interest rates average 13l1z percent, and they end at 13l1z percent; however, suppose that yields varied substantially during that period. If you reinvested the coupons at the prevailing yield, you would have at the end of 20 years a 13Y2 percent yielding portfolio around par. You would have some discounts-low coupons that are at a discount, and some high coupons that are at a premium-but if you just kept reinvesting the coupons, you would earn about 13l1z percent. If you bought a mortgage security, however, that yielded 14 percent and started the same type of program or owning the mortgage security and investing the proceeds back into mortgages when you received the monthly payments, you would almost certainly realize a yield that is less than 14 percent, even though you started with a 14

percent promised yield. This is true, even if over the 20-year period, yields averaged 14 percent. The reason is that if yields were cyclical and varied, say, between 10 percent and 18 percent, but averaged 14 percent, when the yields went to 10 percent, all your 14s would prepay, and you would get a lot of lOs. When yields went up to 14 percent, not many of your lOs would prepay, and when they went to 18 percent, your lOs would not prepay, and not many of your 14s would prepay. When they came back down, not immediately, but quite soon, all of your ISs would prepay. And so at the end of the period you would end up with a portfolio that had a much lower coupon than the average of the coupons 'over the time in which you were in this program. I do not know exactly how much lower, but the yield will be lower. Exposing yourself to that risk for an additional 50 to 70 basis points in the current coupon mortgage market is, in my opinion, a foolish policy. If you are not bullish, you should not own them to begin with. And if you are constructive, there are much higher yi~lding areas of the mortgage market. So I think the current coupon market, to make a generalization, is almost always overvalued, either in an absolute sense or at least relative to the discount area of the mortgage market. I think that the discount area is almost always cheap. As for the premium area of the mortgage market, Bill Gross will discuss that later. Let me explain why I think the discount area is almost always cheap. Although I stated that you don't know what the yield is because the yield depends on prepayments, you can make some estimates of it. However, you must recognize that any assumptions you make about prepayments are going to be wrong. If you believe that discounts are likely to prepay at a four percent rate on average, and you are right about that, the yield you realize is going to be wrong because an average is only an average. Sometimes they will prepay at an annual rate of six percent or eight percent, and other times at two percent or three percent. Unfortunately, they are going to prepay at a six percent or eight percent annual rate when yields are low; but prepay at a two percent or three percent rate when yields are high, and you would like them to prepay at a faster rate. Consequently, over time you might average a four percent prepayment, but you are going to have more money to put to work when yields are lower than the average yield and less to put

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to work when yields are higher than the average yield. And so the realized yield, even if prepayment rates on a discount average four percent, is going to be somewhat less than the estimated yield. I think prepayments will average a bit higher than four percent, probably in the area of six percent for due-on-sale paper, but I think the realized yield will be slightly less than the yield that you calculate at six percent. How much less depends on the timing of the prepayment slowdown or acceleration, and its amplitude. Investors like fixed income securities because there are some fixed parts to them. Mortgages do not have as many fixed parts. With respect to the discount area, one of the advantages of that sector is that many fixed income investors would rather have a certain 13Yz percent than an uncertain quantity that is 13Yz percent or larger. I think that under very conservative assumptions, that is, assuming low prepayments for discounts, they will yield more than Treasuries, though not as much today as in the past. When we put our portfolios up to about 95 percent in discount mortgages in August of 1981, you could buy Ginnie Mae 9Yzs at a yield advantage to Treasuries of about 100 basis points if there was not a single prepayment over the rest of the life of the mortgage. We did not know how many prepayments were going to occur, but some were going to occur, and on a discount any prepayment helps as long as the security remains at a discount. So the worst we were going to get was 100 basis points more than Treasuries if there were zero prepayments, close to what we could get on some of the discount corporate bonds at the time. Anything above that was gravy. We did not know the duration. Because the yield levels were a great deal higher at that time, maybe the duration was six if there were zero prepayments, and five or four if there were faster prepayments. In a bull market, a duration of 5 or 4 did not hurt as long as the bull market did not go to the point where the 9Yzs became premiums. The reason is that with discounts, whenever you get prepaid, it is to your advantage since you buy the same security at a discount. Consequently, you always want it to happen. But all we heard about was that people were not sure about what the prepayments were going to be, and that they wanted to have some certainty in their models. If you really have a need for certainty and for decimals, avoid investing in the mortgage market because it is not going

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to be there. All you are going to do is spend your career approximating or trying to limit the amount of uncertainty about what it is you own. You can, I think, reduce your uncertainty to where you can be sure that you own something that is better than something else; but it is not even possible to know by how much it is better. Moreover, people want to know the duration of the mortgage securities that they own. Although we will give them a number, we do not know what it is. We know that it is going to look longer if we want it to be shorter and conversely. These securities are very volatile. If you think you own an intermediate term security, it will act like a long bond if rates go up. So don't take too much comfort that your portfolio is positioned defensively if you own a lot of these securities. But, on balance, the discounts yield more than the high coupons under conservative prepayment assumptions. This contrasts with other markets where discounts yield less because they have some call protection. For deep discounts within any relevant price range, the takeout is at the investor's advantage rather than the homeowner's. Homeowners do take investors out of mortgages even when it does not make any sense for them to do so, in terms of the mortgage. That is because people move for a lot of different reasons other than mortgages.

UNIQUE OPERATIONAL ASPECTS OF MANAGING A PORTFOLIO OF MORTGAGE-BACKED SECURITIES If you are going to get into managing mortgagebacked securities, you or somebody else in your operation is going to have to spend some time doing things that you have not done before. It is helpful to talk with thrifts, particularly the thrifts who are servicing the securities you own, because it is not really to their advantage to enforce due-on-sale clauses. Although it is in the contract that they should, they lose the servicing if they do. So it might help to contact them and tell them you own the securities, that you are aware of the due--on-sale clause, and you would like them to enforce it. Let them know you are monitoring their progress. I believe you can raise your prepayment experience by doing so. You aTe going to have to tussle with the banks, because they are not yet really very good

at chasing down payments that are due to you after you have sold these securities. That is their job; but sometimes you have to tell them there was a payment still due when you sold a bond. And this takes a lot of time in the back office. We have two or three people who are devoted to just such things as that.

CONCLUSIONS I think that the case for investing in mortgages is that you might make a lot of money doing it if you sort of trudge your way through a lot of uncertainty, and if you make fewer mistakes in doing that than correct decisions. But it is not an area of investments that you can go into and put on automatic pilot. At today's yield spreads there is only one area of the mortgage market that is a better value if you have to make a 10-year automatic pilot decision, and that is the discount area. As for the current coupons, if you have to make an investment decision and walk away from it for 10years, I would think Treasuries would be a much better investment to make than mortgages. What I am afraid of in the next year or two in the mortgage market is that prepayment rates will rise for discounts-and you would think that that would be the case. Usually the best time to buy discounts is when the prepayment rates are at their least, and the time to sell them is when the prepayment rates are at their fastest. The reason is that the market seems to become very pessimistic when the prepayment rates are very slow, and there is no limit, it seems, to how much they shorten their average life expectations when the prepayment rates speed up. Consequently, we are really cruising along now at faster prepayment rates, at least on due-on-sale discount mortgage paper, than most people had expected. It will probably increase some more. But with interest rates headed upward, and I think probably sometime between now and the end of this economic expansion they'll move up more, and move up enough to cause housing to turn down, and mortgage turnover to turn downthese securities are going to get cheap again. There are many people that have been

brought into investing in mortgages who do not understand the security very much. I put most people who bought CMOs on new issues into that category. I may be a little harsh in doing that, but to think that you have really gotten around the call option problem by repackaging a group of mortgages and putting them into parcels is not understanding it. Although you segregated it, you still have the basic problem. It is as harmful to an investor in a one to three year portion (the short part of the CMO) to have a lengthening of half a year or so in the duration, relative to the alternative of investing in a comparable duration treasury, as it is harmful to the investor in the long part of the CMO to find that interest rates are rising substantially and there are very few prepayments; that is, it really is a long instrument. If interest rates came down substantially, the investor does not have much call protection. Maybe there is more than if he owned a whole mortgage, but I think what has been gained on the decline in interest rates has been more than lost on the slowness of prepayments if interest rates rise. I think we will find when we get to this peak of interest rates that many people who own these CMOs are going to think, "these damn mortgages, they did it to me again." As a result, they are just going to swear off mortgages again because they always lose money in them. There will be the disgruntled investor syndrome, sort of hitting at the peak of interest rates, that will cause the mortgages to get cheap again, but probably not as cheap as last time. Due-on-sale has been resolved, it is the law of the land. The discount Ginnie Maes that are prepaying at a slow rate, their price adjustment relative to the due-on-sale paper has reflected that slow rate, so there is not too much optimism in the discount Ginnie Maes. Some of you remember how much the people who invested in mortgages made in the last cycle, and therefore you will be wading in a little sooner, and with more donars, when mortgages begin to get cheap. So I do not think the downside volatility risk is as great in the future as it was in the last cycle. But I think they will get cheap again, and people will not like them again.

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Peters/Worley Question and Answer Session QUESTION: Mr. Worley you mentioned the due-on-sale mortgage paper several times. Could you elaborate on that a little bit. WORLEY: Some Fannie Mae and Freddie Mac passthroughs and PCs have mortgages behind them that have due-on-sale clauses. That means when a homeowner moves, the mortgage must be paid off. FHA and VA mortgages, which stand behind Ginnie Maes and some Freddie Macs, are assumable. And I think more people than before have learned how to get mortgages assumed. It stands to reason that every time somebody with an assumable mortgage moves, sometimes the mortgages will be prepaid and sometimes they will be assumed, but in the case of due-on-saIe mortgages, it is all enforced and people have to prepay the mortgages. Since prepayment is in the security holder's interest, with other things equal you ought to favor the due-on-sale paper. Now the prices have adjusted, so I am not sure you should prefer the due-on-sale paper at the current spread; it seems like a pretty close call. QUESTION: Is there an experience on spreads between due-on-sale and nondue-on-sale paper? WORLEY: The Freddie Mac paper that had some due-on-sale mortgages in it, going back seven or eight years, prepaid a lot faster than Ginnie Maes until about 1979 or so, when the due-onsale was suspended for a lot of the mortgages that were in this Freddie Mac paper, and their prepayment rates came tumbling down. In this housing recovery, the due-on-sale discount mortgage papers prepaid at about twice the rate that discount Ginnie Maes have prepaid. And at the beginning of the housing recovery, the discount Ginnie Maes for the same coupon had a higher dollar price than the discount Fannie Maes and Freddie Macs. That has been reversed. So I think the yields of an eight percent Ginnie Mae and eight percent Freddie Mac are about the same if you calculated the yield on a Fannie Mae eight at a six percent prepayment rate and a Ginnie Mae eight at about a three percent pre-

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payment rate. They are not exact, but they are close today, so that has adjusted some. QUESTION: How can you be assured the servicing institution will enforce good due-on-sale clauses just by a phone call? WORLEY: I do not think you can be sure. I do know that they are supposed to do it, and I think they can get in trouble if they are caught not doing it. Also, most people, if they have agreed to do something, do it. I am not sure that our calls have increased their enforcement of that at all. By making those calls and asking a number of other questions before we buy mortgage paper, we have been able to create a large portfolio of discounts that have prepaid faster than the universes from which they were created. And so we go ahead and do it, but there is no real guarantee. QUESTION: What is the reliable source of actuarial prepayment statistics? PETERS: Anyone who is on the buy side is in a very good position, because you get to call the research of the best and the brightest, and pick and choose from it. This is a very competitive market and there are a lot of firms that are getting into this area, so I would make sure that you see information from various Wall Street firms. Certainly, if one firm has made an error, the others will catch it. Also, there are different views and the investor should be aware of all of them. But I think that there is a limit to what anyone in a Wall Street firm, or those of you who analyze your own data, can do. Much of the needed information is not collected from originators or the agencies. It would be nice if we did not have to deal only with information based on when the portfolio was originated. We would like to see what is remaining in that portfolio. When you get wide bands on mortgages in securities, how have securities prepaid over time? Have the high coupons prepaid, and are you then left with a pool that has a very different distribution? Are you using the right numbers? I think that those

of you who buy mortgage securities should exert a lot more pressure to get clear information on these portfolios. QUESTION: When is a discount a discount; 70, 80, 90 percent? WORLEY: I used to be an economist, and I still like to try to figure out where things are going; not that I am always right. I think that this is a good kind of security for somebody who has an outlook on the economy and interest rates to invest in, because you might buy that coupon or security at that dollar price, where you think that it's low enough so that it will stay a discount. Helen Peters' model has one of the factors determining prepayment being the distance between the coupon on the mortgage and the current coupon in the marketplace. So you might want to do other things. On the discount that maximizes your chance of being prepaid on that basis, we have not been quite so exacting: we just sort of buy 7 to 8Vzs. They are all about the same. QUESTION: Why is the assumption of constant prepayment rates, such as five percent per year, any more realistic than FHA experience or any better as a convention for quoting yields? PETERS: The ability to use a hard core number is better than using something you do not really understand. If you look at what FHA experience translates into rates of prepayment, you will find it is a very bad forecasting tool. There is a lot one may say about this, but very simply, if we extrapolated interest rates, mortgages would prepay on a curve over time that rose for a while and depending on whether you are analyzing FHA or conventional mortgages flattened around 7 to 10 years and then was steady to maturity. Interest rate environments can change a nice smooth curve to one that varies dramatically over time and responds to different interest rate environments. Obviously you do not prepay your 8 percent mortgages in a 17 percent mortgage rate environment. If you are looking at what forecast of rates of prepayment are coming out of FHA experience, you think you are fine-tuning this, but first you are generating a curve that goes way up at the end. Is that really what you want? And if you

got this curve, are you then going to say you want 200 percent of it, even with this curve up? At least deal with something hard-core. Also, FHA experience changes every year because the new data come out, so you have a new standard. Consequently, 100 percent of FHA experience is not the same as 100 percent from last year's numbers or the previous year's. I would much prefer dealing with a number that may be wrong; five percent may be a bad forecast, but at least I know what I am using. I do not know what I am using with FHA experience. I do not think people who say they bought a portfolio at 50 percent of FHA really know what that means because that number is not concrete. WORLEY: I would like to add to that. There may be two reasons for making a prepayment assumption. One is to try to figure out the value of these securities as a group relative to something else you could buy, like treasuries or corporates. But another is to try to figure out value between one of these mortgages and another. And in terms of figuring out whether mortgages are a good buy relative to treasuries or governments, it probably does not make too much difference whether you use some judgment based on FHA experience or a constant prepayment. It happens that for many securities, 100 percent FHA and about a 5Vz percent prepayment rate assumption give you pretty near the same yield. The reason I prefer using a constant prepayment rate is that comparing one mortgage to another on the basis of an FHA experience can give very misleading results. You can sell one mortgage to yield 100 percent of FHA experience and buy another on that same basis and think you have picked up yield because you were assuming the same prepayment for the two. If these mortgages have different ages, though, you are really not assuming the same prepayment for the two. You are only cutting into an FHA prepayment experience curve at different points. And it may well be that you ought to. It may well be that there is a difference in the propensity of mortgages from a 13-year-old pool to prepay versus mortgages from a 5-year-old pool, because more people move when mortgages are 13 years old than when they are 5. But, it may only be that the data you have for mortgages that are 13 years old covered more

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years when prepayments were slower than the data that you have about mortgages when they were 5 years old, or that the mix of coupons versus the current was different. It purports to be a demographic phenomenon, but there is a lot that goes ii/to it that may be spurious. I do not think you can effectively pick out any difference between the prepayment propensity of a sevenor ten-year-old mortgage. Therefore, why use a standard that does presume a difference? PETERS: The other thing to remember is that we live in an environment of changing interest rates. If you try to use FHA experience to forecast prepayments, your biggest problem is trying to link your forecast of interest rates to your forecast of prepayments. One should try and keep those together, because they make a big difference in how the security is going to do compared with the other kinds of fixed investments that you have available. You can obviously use a model that explicitly ties it: If rates go up, the model forecasts that prepayments will go down by a certain amount; if rates go down, it forecasts prepayments will increase. But you can also do what many investors do, which is intuitive: If rates go up, I think it is going to prepay at three percent, five percentgive yourself a number and try to pull them together. FHA experience makes it very difficult to do that. And, as Richard Worley indicated, the more you move out on this curve, the more you end up at different points. So, you are extrapolating numbers that really do not relate. Pull them together and you will know what you are dealing with. Whether you make good assumptions or bad ones, they are concrete assumptions that you can test against yourself when you go up for your performance review. QUESTION: What is a collateralized mortgage obligation (CMO)? WORLEY: There are a lot of different CMOs. Because investors did not like the uncertainty concerning prepayment rates with mortgages, dealers saw a market for securities that could reduce that uncertainty. Dealers bought a lot of mortgages and separated them into tranches. They gave owners of the first part all the paidout principal repayments of the whole group of mortgages.

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For example, suppose a dealer constructed a billion-dollar pool and broke it into three pieces. Suppose the first tranche was $300 million. The holders of that tranche get all of the paydowns that occur for the whole $1 billion until that is finished. Then holders of the second tranche get all the paydowns until that is finished, and people in the third until that is finished. It seemingly creates a very short security for the first and a very long security for the third. I do not know very much about the middle part. The third will be a very long security if interest rates go up. However, there is no guarantee that that is going to be the case. I do not know whether a CMO based on 17s would have been a very good bond for the investor who bought it back in 1981. There are about a hundred other things that would have gone up more. So, with respect to the long tranche, I don't know that that really offers you a measurable amount of call protection. It is apparent that if you run it out, even on the assumption of a 200 percent FHA experience, it is going to be a long instrument. But what if FHA experience is 3,000 percent? That could happen. The short ones I think had a 40 or 50 basis points pick up to an equal-duration treasury. Since the transactions costs in these things are pretty large, they could eat your 40 or 50 basis points if you do not own it for a while. Second, if the actual prepayments slow down somewhat, it will only lengthen your duration maybe half a year. If they speed up, it will only shorten it by about half a year. But that affects your returns versus the equal-duration treasury. So this is a way of turning a sow's ear into a silk purse, and a lot of people bought them. I do not know if that has had to do so much with the narrowing of spreads between mortgages and treasuries or whether it just occurred at a time that was sort of a feeding frenzy for yield. And everything that yielded more than treasuries were bid up in price, and mortgages just went along. If it is part of the reason that current coupon mortgages were bid up, I think that we should recognize there is some peril in the outlook if things do not turn out the way these people think they wilL QUESTION: Mr. Worley, you talk about backoffice problems of mortgages. Do you implicitly add in a nuisance factor? By that I mean a premium that a mortgage must yield above to pay for the people who call up and figure out prepay-

ments and what areas some of your pools are in, and so forth. WORLEY: Not really. Ours is a lucrative business, and we try to do the best we can for our clients. And if we think that you can make more money for them by owning them, we do so, even if it costs you a little more. Because, I think, the amount it costs you is inconsequential relative to what you can make for your clients. Managing separate accounts is probably not the most efficient way to manage a mortgage portfolio. We are going to try to change that by going to a commingled trust for pension accounts and a mutual fund for endowment and foundation accounts. One of the reasons for that is that if we decide to cut back 10 percent on our holdings of mortgages, when we analyze all of our holdings for all of our different accounts as one portfolio, in terms of analyzing whether mortgages are prepaying at rates we think they should and the different characteristics, it strikes me that a better way to cut back 10 percent is to take the 10 percent of the total that looks the least attractive and sell it. But that is not 10 percent of every account. It might be 30 percent of one account and zero percent of another. So it is hard to go from managing an overall pool of mortgages to managing individual accounts. Among accounts, the prepayments do not occur at exactly the same rate, and so we get differences in return among clients that have nothing to do with different strategy or different objectives. It is just randomness. We would like to get rid of that and make the operation more efficient. It takes some investment in people, and getting them up to speed, but the cost of doing it is low relative to the opportunity. Consequently it is a good deaL QUESTION: Ms. Peters, if you are forecasting prepayments over the life, you are, by definition, forecasting interest rate cycles. If you cannot forecast interest rate cycles effectively, what sense does it make to forecast prepayment rates? PETERS: The way we operate is that we do not forecast interest rates; we let our clients do that. We do not get paid enough to forecast interest rates. Thus, the models that are available will look at forecasts of prepayment rates over different interest rate scenarios. We let our clients who have to forecast interest rates look at how the

portfolio will do. One can also forecast interest rates from the term structure of interest rates and then move from there. I think it is important for someone to know the relationship of prepayments to interest rates. But as I indicated, it is not the job of those of us who look at various securities and how they operate in these markets to actually forecast interest rates. We just explain the relationship there. QUESTION: How do you properly adjust the original weighted average maturity as discount pools become seasoned? WORLEY: One of the first things I learned when I started buying mortgages is the differences between the 12-year and the Green Book. The Green Book is where the Street sold them, and the 12-year is where they bid them. And it is the same with weighted average maturities. When you get a group of mortgages that all mature on the same month, and you know the weighted average or the average maturity of those mortgages, as time passes you know that that maturity has shrunk. If you get disparate mortgages, however, you do not know which ones are prepaid, so there is some uncertainty as to how much the maturity of a mortgage pool has shrunk. If you had widely disparate maturities in a pool, all the short ones could have prepaid, or been the ones that prepaid, and the actual weighted average maturity might have lengthened on you. That is not really something that happens very often. But as a result of all this, Wall Street likes to bid mortgages on their original weighted average maturity. That means whenever you buy other discount securities, part of that return is the marching toward par of the discount as you get closer to maturity. In the case of buying a discount mortgage, a year later Wall Street is going to bid it to the same maturity that existed a year before. And you sort of get robbed of that little bit, and it is not inconsequential. We calculate the remaining average maturity, and we try to do that for all the different mortgages that we own or consider. And we try to trade bonds using Wall Street's bids and offers, where we can usually pick up yield to the remaining average maturityunderstanding that that is not a perfect estimate; but I think it is better than ignoring it. Although

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you can pick up securities, you cannot buy as easily on the original weighted average maturity as you can sell. PETERS: To sum what Mr. Worley stated: You don't have that information later on, in terms of remaining average maturity, and thus, you are guessing, trying to get as much information, look-

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ing at the composition of the pool, and how it might have changed over time. It would be nice if one could be provided with that information; I think it would help the mortgage market a great deal. But it is not yet forthcoming from anyone who operates in the mortgage market at this point in time-the originators and packagers.

Recent New Products and Markets (I) Stanley Diller

FRAMEWORK FOR EVALUATING PASSTHROUGH SECURITIES Most of us talk about the mortgage-related securities market as if it were always there, pressing some refined point as though it were second nature. Not long ago the mortgage market depended on intermediaries who both originated and warehoused the loans. They carried them at borrowing costs that were kept down by law and convention and basically lived off the spread. That was the business. And, as those things work, the overhead in running this operation rose to meet the spread. But, when the spread disappeared, with the breakdown of Regulation Q, the overhead did not fall to meet it. So there was a problem. One solution is for these intermediaries to distribute, rather than warehouse the mortgages while retaining the servicing; that is, collection and use of escrow money and advance payments. You see the same type of thing with nonmortgage loans as well: that is, finance companies and banks packaging and selling their loans and receivables to the public, while retaining the servicing. And, of course, there's a fee associated with that. The mortgage banker is a paradigm for this type of operation. You can visit a good-sized mortgage bank and meet the whole company in a small conference room from the president on down. Working lean, they can process a lot of paper, which comes in and goes right back out. They carry the mortgages until there's enough to sell, in one form or another, to pension funds and other long-term holders, often hedging the market exposure during the accumulation. Separating the service from the warehousing this way keeps production costs down, avoids financing problems, and assures a market determination of mortgage rates. This separation is helped a lot by loan securitization which permits title transfer to occur under securities law rather than the much more cumbersome real estate law and convention. Securitizing loans makes them more liquid (or interchangeable) by making them members of a class instead of separate entities. Futures achieve the

same thing by isolating a generic interest rate with none of the peculiarities of individual bonds, and making that the thing (or better, the idea) that is traded. The more general the trading idea the broader the inquiry, and hence the greater the liquidity.

Paydown and Cash Flow Uncertainties But all this happens only when people can relate the idea to their regular business. Securities people think about yield, term, duration, performance under different scenarios, and so on. That is the currently accepted framework for comparing bonds. But all these measures depend on paydown, about which very little is known. The next best thing to knowing what paydown will be is pretending you know or making assumptions that you are willing to act on as if you knew them to be true. And you calculate yields and the rest on this assumed knowledge. The measures calculated with this assumed knowledge can only mirror the assumptions, which makes the precision with which they are often calculated seem ludicrous. Of course, fantasy plays a larger role in fixed income analysis than most people want to acknowledge-what with parallel yield curve shifts and the reinvestment assumption underlying calculated yields. Mortgage prepayment merely adds another source of uncertainty. The latter is more important for its effect on current and prospective prices than on the cash flows it generates. Mortgages underperform a rally, not so much because they pay down more when yields (and therefore reinvestment rates) are lower, but rather because their prices fail to rise as much as other bonds with the same apparent duration. In other words, the prepayment problem lies, not so much in having to reinvest the greater prepayment at lower rates, but rather in the slower price rise caused by the market anticipating this problem. Admittedly, if you hold 17 percent coupons, then receiving the money at 12 percent rates is also a problem. The same point holds for callable bonds: Even with 10

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years' call protection they'll fall behind in a rally, not because they prepayed, but because the expectation of a call (i.e. prepayment) held the price down. Historically, people analyzed mortgages as if they were mandatory sinking fund bonds. Depending on the problem they either compared known cash flows or, if they needed it, they computed yield to average life (YAt). As they came to understand that YAL was not the same as internal rate of return (IRR), they learned to bridge the difference in perceived values between people using either measure. Given the price, IRR is greater for discounts and less for premium passthroughs. Conversely, for a given yield interpreted as IRR, the price is higher than for the same yield interpreted as YAL. Since yield, usually expressed as spread over Treasuries, is the cornmon denominator of value, some traders would buy from those people who interpreted yield as YAL and sell to those who interpreted it as IRK In other words, the objective fact, price, is driven by the subjective idea of value. But all that assumes people know what the cash flows will be that drive the yield. That means they know what prepayment will be, a patent absurdity, that causes them to dissemble more knowledge than they have when they are forced into the computerized bond work. What's the GNMA's duration? Duration-when you don't even know its yield! Still, you need a number even a soft one, which you can get with some assumptions. It's a lot better that way than avoiding GNMAs altogether, as some people do, on grounds that you can't compute some measures that the computerized portfolio program requires. This uncertainty about true value means that one should be more concerned about whether mortgages in some form are good value than with the finely tuned tests used, say, in the options market. Not the eights versus the nines or the fast versus the slow payers, but whether as a group they make sense versus Treasuries or corporates. That's true, albeit to a lesser degree, of most parts of bond analysis: The measurements are more precise than the ideas being measured. The resulting precision is pedantic. Yet, for all its problems, forcing passthroughs through a rigorous framework identifies the important questions and concentrates the mind, making it less amenable to sham arguments and frivolous demonstrations. The key to a good framework is not that it

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provide all the answers, but that it rank the questions according to their importance. For example, many people are reluctant, indeed refuse, to use passthroughs in dedicated portfolios on grounds that their cash flows are uncertain. Uncertain cash flows, according to these people, cannot take care of known liabilities. But these same people have no problem with callable bonds as long as their coupons are low enough to make call improbable. Why treat the uncertainty over one type of call differently from the other? It's a matter of convention, of mind-set, by which unarticulated presumption overwhelms logic. What's wrong with uncertainty when it carries a much greater chance of success than of failure? I remember trying to persuade people to buy Ginny Mae 8s for a dedicated portfolio when yields were 13 or 14 percent. And they'd demur on grounds they didn't know what the cash flow will be. "Well, if you're lucky," I'd say, "It will be faster than I'm assuming, for then you'll get back money at 100 for which you will have paid 70. As long as you can replace the returned principal for less than 100, which means that yields stay above the coupon, you will have more rather than less cash than assumed." In other words, uncertainty over how much more I can make is not a big problem.

Fast Pools Let me move to another example of mind over matter: the fast pool idea. People still exist who will pay up as much as four points for a pool that has paid down at an above average rate in the hope that it will continue. It's hard to justify this behavior. An associate of mine, Tim Beaulac, and I wrote a paper recently on the stability of the paydowns of specific pools. In it we ranked the speeds of individual pools with the same coupon and age in' consecutive periods, whether months, quarters, and so on. We wanted to know whether the rankings were close from one period to the next; whether a pool that was fast in one period was fast in the next. If there was consistency, a scatter plot of the rankings in successive periods would approach a straight line connecting pools with low rankings in either period with those with high rankings. But that's not what we found. Instead we got buckshot, a shapeless glob of random points. There was no relationship between the pool speeds in consecutive periods. There is, therefore, no reason to pay up for

the speed of individual pools, at least not of discounts, which were the only ones we considered. But anyone who has a fast pool that someone else is willing to pay up for should have his head examined if he doesn't sell it. As institutional customers have become increasingly aware of these facts, the merchandise has been finding its way to small inv~stors. Some regional dealers are packaging pools obtained in the institutional market and retailing them on the basis of yields embodying the random high speed. Often the newspapers carry advertisements promising these factitious yields. The other side of not paying up for speed is being willing to sell a fast pool to someone who is. Yet there are far more takers on the first point than the second. Of course, in many cases people are willing to sell the fast pools and are merely waiting for the right price, which often comes from a regional firm.

HEDGING PASSTHROUGHS Last fall Goldman Sachs gave a widely attended presentation on passthroughs during which it unveiled our option model of passthrough performance under different interest rate conditions. This model is described in a recent paper with the awesome title, "The Parametric Analysis of Fixed Income Securities." Several speakers referred to the underperformance of current passthroughs due to their durations going the wrong way-rising when rates rise and the inverse. Mortgage bankers know all about this problem. Many of them sell bond futures against their current production, on an equal-duration basis. During the '82 rally the futures rose a lot more than their mortgages, and they ate the difference. A mortgage is really two securities: One is like an ordinary call-free bond, and the other an option that the mortgage holder is short. When yields fall, the price of either component rises, but since the option is short, its rise must be subtracted from the bond rise. That makes the net rise a lot smaller. In trendy jargon, the mortgage has negative convexity. To neutralize this effect one must go for a long option or another security with a lot of convexity. For example, long zeros make good substitutes for long options for they have roughly the same price movement as yields change. In fact, this option-like quality of very long zeros is the heart of the coupon-stripping business.

Bond "Stripping" Treasury stripping has become one of the most active and profitable parts of the Treasury market. It appears that the natural demand for strips, or indeed for any zero coupon bond, is primarily on the very long end-at least 18 years-and to a much lesser degree the very short end, but rarely in between. 1 think the reason is that that is the only source of large, option-like convexity other than options themselves. And, as the abovenoted paper describes in detail, people want this convexity for many possible purposes, including the one described above. They pay for it by driving their yields through the Treasury curve. So the dealer buys the long bond on the curve, sells the long end through and the short end off the curve (but still well below the long yield, given the positive yield curve) and the rest, the cats and dogs, wherever he can. The latter may be likened to tar in the production of gasoline, the demand for which determines how much oil is distilled and therefore how much of the tar by-product confronts a price-insensitive demand. The more gasoline produced, the lower the price of tar. The intermediate strips are priced in the same way. The demand for the long end triggers the supply of intermediates, which people, for want of a better reason, buy on a yield basis. Since these yields fluctuate with supply, they create interesting arbitrage opportunities. But my main point is that the long end is popular because it provides a big duration and a big convexity. There are two other important motivations for stripping, and they have analogues in the CMO market as well. The first is the yield curve. With a positive yield curve, the yield (or internal rate of return) is not an accurate measure of value. The proper discount rate for calculating the present value of a bond is lower for the earlier coupons. The reason is that the rate used for discounting the money received at some future time should be the rate available on other bonds that payoff at the same time. Therefore the earlier coupons on a long bond are competitive with the principal on a shorter (and lower yielding) bond. The stripper can buy the long bond at a higher yield and sell its earlier coupons ·at lower yields, typically quoted as spreads over the curve. The second motivation for stripping is to exploit yield differences on bonds with the same maturity. You may remember when a high cou-

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pon Treasury yielded up to 100 basis points more than a low coupon bond with the same maturity. But the market did not attach less value to future dollars from a high than from a low coupon bond. When you buy cash as distinct from coupons, the dollars all look alike. Therefore, the dealers would buy the cheaper, high coupon bonds and sell the fungible cash in the strip market. As you might have expected, the spreads between high and low coupons virtually disappeared. The spreads disappearance was not entirely as a result of stripping, however. In principle, with a positive yield curve, a high coupon bond should yield less than a low coupon bond. The reason is that it pays out earlier, and early cash is discounted at a lower rate than is later cash. As a result the present value of the high coupon bond is higher, assuming each of its coupons is discounted at the yield curve rate with the same term, and therefore the recalculated yield is lower. The high coupons' spreads of a few years ago always seemed absurd, and the ad hoc justifications offered at the time equally so. Stripping, almost entirely on the long end, provided the mechanism for eliminating the absurdity. Until it came into use many people inveighed against the spreads, but didn't put enough money on their opinions to eliminate them. But the coupon spreads on the shorter bonds, which were not involved in stripping, also disappeared (on average, some remained and some reversed, but all became relatively small). it appears that once the spreads on the long end were brought into line, with the help of stripping, the absurdity of those on the short end, without that help, became untenable, and the spreads collapsed. This episode reveals the market strength of the alliance between arbitrage and theory, as distinct from theory alone, rather like the historical analogy between religion and military power, whereby people often saw the truth more clearly when it clung to the edge of a sword.

ambience of this new market; the way the deals are structured and explained, and the reasons people give for buying them. As for the security itself, it's a question only of finding a right price. If they have negative convexity or lack liquidity, the price must be low enough to reflect it. The CMO is merely one more device for shifting the ownership of the existing mortgage stock, as well as finding unconventional buyers for the new product. Depository institutions that are dependent on short-term financing cannot carry longterm fixed rate mortgages without bearing potentially fatal risks. Book cost accounting can conceal the losses caused by a rise in interest rates until the cash flow, as distinct from income, is negative, but not beyond that. Neutralizing this risk through hedging merely translates potential into certain death because the yields on new mortgages are not high enough to pay for the hedge (for example a short position in bond futures). Since the spread between the mortgage and CD rates is not much higher than that between the long bond and repo rates, going long the spread in mortgages and short the spread in bond futures comes close to a wash, leaving little to cover overhead and the ravages of negative convexity in the event of a rally. The latter arises from the failure of the mortgage prices to rise as much as the futures do because of potential prepayment. Why don't the mortgages throw off enough juice to defray the cost of hedging? Two reasons come to mind: First, aside from their interest income, mortgages provide their originators with other advantages, such as facilitating the sale of new homes, for those originators that are tied to builders and the so-called servicing. Second, since the overhead of the thrift industry developed at a time when the spread was very high, the interest spread needed to cover it is high. Low overhead originators, particularly the ones tied to builders, are keeping the spreads very tight for the others.

The CMO Market

CMOs versus Coupon Stripping

In turning to CMOs I will recall my earlier remarks about stripping Treasuries, passthrough paydowns, and the problems of fitting a new security into an existing analytical framework. Several earlier speakers have expressed reservations about CMOs. Though apparently directed at the CMO itself, these complaints really concern the

Selling mortgages outright or as passthroughs requires that there be a lot of long term buyers. Breaking down the mortgage cash flows into shorter-term tranches, opens the market to people who want shorter-term assets. Selling these tranches down a steep yield curve has the same economic advantage as coupon stripping. The

problem is that the uncertainty about prepayment, both the actual principal returns and those anticipated in the sluggish price performance in a rally, makes the CMO tranches a lot less clearcut than a stripped coupon. The asserted spreads, reference points, durations, and so on are less precise. But the language of the deal, carried over from the more definite cases, has not been adapted to the uncertainties of CMO measurements. As a result, the nominal accuracy, as for example in four-place price-yield tables, is incongruous and evokes contempt for the whole deal. For example, the uncertainty over prepayment makes the asserted average life conjectural. And since the tranches are sold as spreads off the same maturity on the Treasury curve, the spreads being lower at the short end and rising with maturity, a high speed assumption, and therefore shorter average life, would lower both the spread and the reference point on the curve, particularly at the short end where the curve is steepest and the spreads on competing short-term instruments tightest. By making aggressive speed assumptions while forcing as much of the deal as possible into this problematic sector, the early deals attracted the rate sensitive buyers, but later deals discovered that this group was finite. The problem was aggravated by another feature that CMOs had in common with stripped coupons. I described earlier the advantage of stripping high coupon bonds when their relative yields were high. Selling cash from different securities, instead of the securities themselves, effectively equates them. A similar thing occurs with CMOs. GPMs have been trading about a point cheaper than ordinary GNMAs, largely due to their slower paydowns. The early CMO issuers would substitute them for ordinary GNMAs but price the resulting CMO on the same speed assumptions. (They made up the difference in cash flow between the GPMs and GNMAs with a reserve fund, usually a credit line, that was activated in the unlikely event that the internally generated cash proved insufficient.) By now a more observant market requires that the paydown assumption reflect the proportion of the collateral given to GPMs. In a similar vein, there is disagreement over whether the paydown assumptions, which at the beginning were quite arbitrary, but now are tied to history, should reflect generic or specific-pool

history. My earlier comments on paydown suggest that I support generic. Still another difference with coupon stripping is the tranche, which often pays no interest until the shorter tranches are paid off. I noted earlier that the driving force in the strip market is the greater value the market assigns to the corpus and later coupons because of their greater convexity. Sometimes it pays well through the curve for these pieces, making it possible for the stripper to sell the shorter pieces at a higher yield than otherwise and still make a profit. But the last CMO tranche, the so-called Z-piece, is not entirely analogous to the Treasury corpus. At first blush, it looks like a high yielding corpus with the long duration that ostensibly would allow a big performance in a rally. With the earlier tranches paying down first, the argument went, there is plenty of cushion for the Z-piece. But call exposure lies not only in the prepayment itself but even more in the threat of prepayment, which is anticipated in the price movement. In a rally, the Z-piece could look more like an A-piece. As a result, far from being the driving force behind the CMO pricing, as the corpus is in a Treasury strip, the Z-piece has become a drag. Instead of being a source of option-like convexity, as the Treasury corpus is, the Z-piece is lugging a reputation for negative convexity. In each new deal, it appears to get cheaper and cheaper. Why then have it? Because the coupon income on the collateral that otherwise would be paid out as CMO income, is used instead to prepay CMO principal and thereby lower the CMOs average life and yield. But there's a point at which it costs more than it's worth.

Beguiling Details and Serious Consequences In any case, notwithstanding the cleverness with which the cash flow from the collateral is optimized to get the largest deal for the collateral at the lowest yield, the fact remains that there's relatively little arbitrage left in CMOs. Most of the deals have been done by builders or their mortgage banking subsidiaries, using their current production as collateral. Their main motivation has been their ability to defer taxes on the profits from their new home sales. The idea is that the CMO is considered to be a financing rather than a sale, thereby leaving the mortgage in the build-

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er's hands. The homeowners' mortgage payments are treated as installment payments on the home. In other words, builders have a special reason for doing CMOs. Their interest in arbitrage is limited to buying additional passthroughs to add to their own production so that the deal will be large enough to attract institutional buyers. Usually they're willing to break even on the purchased collateral and look to the gains on their own production. Clearly this heightened supply of CMOs, due to favorable tax treatment, has helped eliminate the arbitrage. What I'm saying is that there aren't any great yield windfalls being made with CMOs. Neither are the buyers taking big hits. Why then the poor image CMOs have, particularly among the more sophisticated money managers? I think the answer lies in the marketing hype when they came out. The collateral was inadequately described and the paydown assumptions overly aggressive. Price-yield tables were disseminated that purported to show the value of each tranche at different yield and prepayment levels without connecting the two, in effect ignoring the negative convexity. And then there were the details. One got buried in a lot of arbitrary facts that dealt more with the sufficiency of the collateral than with the economic risks such as the paydown assumptions and call exposure. It attracted people with a preference for detail over analysis. I've met people who are walking encyclopedias on many deals,

40

who know how a particular reserve fund will work after the third tranche, making nickels and dimes from their expertise at the expense of dollars on the larger questions. I'm reminded of the following lines from MacBeth: "Sometime to win us to our harm/The instruments of darkness tell us truths/Tempt us with honest trifles/To deceive us in deepest consequence." But as this market has seasoned more and more, people have learned to look for the substance and to avoid getting distracted by the details. They have forced the issuers to supply more realistic assumptions. More importantly, I think the idea of collateralizing new debt with existing debt will be around a long time. It increases the availability of credit to financial institutions. Through tranching, it bridges the maturity differences between what ultimate borrowers and ultimate lenders want. Through overcollateralization and insurance, it bridges the disparities in credit needs. And above all, it provides a vehicle for translating relatively illiquid negotiated debt into less illiquid market debt. One of the less appealing aspects of CMOs is that they, in common with Treasury strips, have taken liquid securities and made them illiquid. But that would not be the case with whole loans, multiple-family and commercial loans, and non-mortgage debt. These areas, [ believe have the best growth potential.

Recent

ew Products and

arkets (II)

Roland M. Machold Some years ago I was asked if r would be interested in appearing on the Rukeyser show, "Wall Street Week." r said, well, I'm not sure that you would really want me there. I watch your program from time to time and, to tell you the truth, probably 95 percent of your audience should be invested in money market funds, with maybe a couple of stocks thrown in, and all that talk of "reverse butterfly spreads" and gold futures and stuff like that is very entertaining, but probably a little beside the point. On this occasion, my own view is similar. I'm pretty much a meatand-potatoes investor, and I am very wary of "innovative" mortgage programs which may fragment mortgage markets, are contractually uncertain/ have less market liquidity, and have lower quality and less government sponsorship. That was the frame of mind that I had when I was asked if I would a~ld~ess this group, namely, that I'm not a follower of gimmicks and new products. I think that each of them bears a price and, in my own experience, have posed some very real problems.

NEW JERSEY AND THE MORTGAGE MARKET In New Jersey we invest seven pension funds with about $10 billion, plus another couple of billion dollars of short-term monies. We/ve been investing state pension funds since 1919 in bonds, stocks, and other securities. During most of that period of time we never bought any mortgages whatsoever. In fact, we were very limited in what we could buy. Furthermore, mortgage pools and mortgage markets did not truly exist in the current forms that we recognize. Prior to 1950/ when our division was formed (as a result of some scandals), some of the local municipal police funds, managed by local police officers, had given themselves second mortgages and mortgages on second homes. A number of those funds went bankrupt subsequently, not necessarily related just to mortgage investments, and as a result the police funds and other funds were consolidated under professional management at the state leveL In 1950/ state law closely

limited eligible investments for state funds, and there was no mortgage product in the market that we could have purchased under the law. In the early 1950s we were permitted to buy FHA and VA mortgages, which were a result of programs that were developed after World War II, as well as Capeheart Government guaranteed mortgages, some of which we still own. During the 1960s we got into the FHA multifamily field, and in 1971/ we bought the first Ginnie Mae pool, which had an 8 percent coupon. It/s still on our books and is now about 70 percent paid down. In the mid-1970s we bought some Freddie Macs, and in 1978 we bought conventional mortgage pools, specifically some of the early publicly offered ones with strong credit features. More recently we have participated in the alphabet soup of GPM, GEM, and CMO mortgages. Last year we bought the first Ginnie Mae II pool, and we/ve been looking at the ARMs, SAMs, and reverse annuity SAMs, which have been offered to us. Meanwhile, state investment laws were modified over time to permit a wider range of investments, and by 1977 our only investment standard was the "prudent man" law.

TRENDS IN THE MORTGAGE MARKET Throughout this period of time, up until the time of the first Ginnie Mae, there was a very positive progression in the development of mortgage securities and markets. Higher and more easily measurable quality was introduced by the government guarantees; the pooling mechanisms provided greater liquidity; and there was a commitment to homogeneity' of product. However, Ginnie Mae securities and mortgage investments in general are not perfect securities for investors, due to the changing mix of interest and principal receipts, the uncertainty of prepayments, and the multiplicity and variety of individual pools. As a result, investors cannot easily account for such securities and cannot accurately project their returns and cash flows. Furthermore, markets for fixed income securities and long term interest rates were relatively stable up until 1965/ which

41

tended to minimize the effects of these shortcomings. Since that time, I feel that there has been a reversal of this progression, at first slow, and then more rapid. Since the late 1970s, the trend in mortgage securities has been toward less liquidity and more complexity, greater risk, and lower quality. The effect of these trends has been exacerbated by a far more unstable and volatile interest rate environment. Both these trends and this environment are a reflection of less political will. The only power that can truly bring new force and energy into the mortgage market is the Federal Government, through its agencies or otherwise, and there appears to be a retraction from that commitment. I'm not an expert on what the loss experience was on FHA/VA mortgages, but there were times when the default rates were very high, and this became a very real political issue. Furthermore, the political pressures are very great, both nationally and at the state level, to provide some form of mortgage subsidies, in terms of either risk or rate. Finally, the leadership of the government agencies has been transitory. For that matter, the management of the U.S. government is transitory. So, this in tum affects the continuity and sense of purpose of the government in this area. Consequently, a reluctance by the government to be involved in the mortgage finance business is understandable. However, the alternative is "privatization," which is a handy slogan, but which is unproven in the scope it is addressing and in the present interest rate environment. Privatization is by no means complete, but it appears that FNMA is a great deal more private than public, and that FHLMC may be privatized. In another sense, privatization is a proven concept in that it is a return to the mortgage market which prevailed before the wars, which is hardly encouraging to investors. It seems ironic to me that at a time when the markets for mortgages are so difficult and the demand for mortgages is so great, that the government is withdrawing its leadership and support.

EXAMPLES OF NEW MORTGAGE PRODUCTS Privatization and higher and more volatile interest rates, both the result of a failure of will by the U.S. government, have resulted in the devel-

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opment of many new mortgage products. There has been a tremendous struggle to reach new market niches and new investors and, from the other end, to create affordability for home purchasers. As a result, I have two fears: first, that long-term fixed income investments, such as mortgages, are becoming obsolete due to the economic environment; and second, that the many new securitization programs provide weaker, more uncertain investments. In discussing the new products, I'm not going to try to describe them all as so much has been written about SAMs, GPMs, and TIMs. Instead, I will discuss three specific examples of new mortgage securities. The first is a GEM mortgage. Several years ago the state of Minnesota worked out a specialized program so that the public pension funds would provide a standby arrangement, and then after 10 years take out the remaining mortgages, which had been financed initially through a municipal bond issue of a state agency. The interesting thing about this program is that it is an example of an extremely specialized niche in the market. It required a sharply negative yield curve and complete closeout of the long-term municipal market in order to get the proposed format. Market circumstances changed, and a GEM program which we had approved for New Jersey was never implemented. Yet, there was tremendous competition to develop this product on the part of Wall Street, to the point where the name "GEM" was even registered as a trademark by one of the Wall Street firms. I understand the fum even went to the trouble of buying the right to use the name from a savings and loan association, completely unrelated, that just happened to call themselves the GEM Savings and Loan. And yet the concept was only valid for a short period of time, and the resulting security would have had highly uncertain credit, liquidity, and evaluation features. I'll come back to the mental framework of the banking and brokerage industry, which I consider to be very short-term and not necessarily constructive in the development of the mortgage industry. The second aspect of new mortgage programs is privately insured mortgage pools. We have looked at them very closely and have a very conservative point of view about them. Perhaps that is because of my father's experience. He started at his first job marking mortgages to market in

a small firm in 1928. The president of the firm told him, "don't mind those insured mortgages, they're triple A. Just put them in at par no matter what the price is." Two years later they were all in default. Now, the times have changed, but the credibility of private mortgage insurance is still a concern. The whole idea of the insurance of mortgages is insuring against the uninsurable, the onetime economic collapse. There is no predictable instance, as there would be with, for example, automobile insurance or life insurance, when the payments by the insurance company will have to be made. In effect, these companies can collect very nice premiums, expand their businesses, and assume additional risks for some period of time, until that one incident happens. And when the incident happens, they will be severely hurt. That incident may never happen, but during the period of time in which it is not happening, there will be a very strong natural inclination to continue to diversify their product and build their volume, and in a sense, expose themselves further until that one incident occurs. Let me now discuss a third program, which really doesn't affect any of you directly, except as taxpayers. This is the state pension fund supported mortgage pool. Every state has been approached by the political interests within that state to provide mortgage money when mortgage money was tight. I've found that it is universally popular: the bankers like it, the brokers like it, the homeowners like it, and the politicians like it. Nevertheless, these programs are seriously defective. Such a program was proposed to us, called Jerseyshares. We were asked to be the only investor in a mortgage pool which had no liquidity, lower quality than Government agency pools, and nonconforming mortgages. The program's terms permitted mortgages on 6 family buildings with one commercial enterprise; a 95 percent loan to value ratio; an open-ended forward delivery; and then, slipped in the middle, in a very extensive volume, was the fact that they expected to get a 200-basis-point concession below the rate for Ginnie Mae securities. The plan proposed to raise $1 billion,' but under these terms the rate concession represented a current loss of $110 million. That is to say, for $110 million less cost I could have gone out and bought the same income flow from Ginnie Maes.

From the standpoint of the taxpayer rather than the investor, we must ask some questions about the program: who gets that 200 basis points concession? Well, the bankers can get it if they're just selling from their existing portfolio. After all, they can have some mortgages in their portfolio, which they can just sell and take the profit over the market rate. There are insurance fees involved; there are banking fees for investment bankers; and there are servicing fees. Ultimately, some of the concession gets back down to the builders, but they may not pass it along to the homeowners. Even if some of the concession is passed on to homeowners, these may be very wealthy persons and hardly deserving of public subsidy. So you can conceivably develop a program with a tremendous concession, which benefits only a small group of highly paid and wealthy people that represent powerful political interests in every state. The subsidy that is implicit in this kind of program is never stated. Nobody knows about it. But who pays it? Of course, the taxpayers or the beneficiaries. The lower income results in a higher unfunded pension fund liability that is funded over time through the normal budgeting process and could result in either higher taxes or in fewer services provided by the state. Of course, if the legislature decides not to increase the funding, then the beneficiaries are going to be hurt as well, in terms of fewer benefits or less coverage. I suppose that what most annoys me about this kind of program is that it is not approved by the legislature. This becomes, in effect, an appropriation, but there is no competition in the legislature from the usual services that states have to provide in the form of transportation, education, and social services, and the people who benefit from it are, generally speaking, that small band of professionals that I mentioned before and wealthy homeowners. These in-state mortgage programs have been put into effect in 24 states. The Federal Reserve Bank of Boston recently published an article which showed that all 24 plans offered hidden subsidies. There were two exceptions. The states that were cited as having looked at the program and evaluated it properly in terms of the mortgage market were New Jersey and South Dakota. You might ask: why not give a subsidy? After all, state pension funds are public institutions; these are public funds; everybody needs mort-

43

gages; and it makes everybody happy. The answer is very simple: The funds ultimately belong to the beneficiaries. All fiduciaries operate under the prudent man law, and the fiduciaries' job is to take care of the beneficiaries of the funds.

MORTGAGE INNOVATION A lot of the innovation has to do with developing very complex mathematical models which identify specific cash flows, for example CMOs. As every other speaker has mentioned, these cash flows cannot be accurately identified. But there is a larger issue here, which is that it may not make a difference. Even if they were accurately identified, the investment decision is far overshadowed in the marketplace by the very question of whether we should invest in that sort of cash flow, the very long-term cash flows, or even intermediate term cash flows, at a time when these extremely high and volatile interest rates have changed the bond market, perhaps for all time. I know in our own portfolio, and I think I can speak for many other bond investors, we have shortened the average life of our bond portfolio from 22 years to less than 11 years now, and are continuing to do that as we find other means of investment, either in the very shortterm area or in equities or in real estate. Dealing specifically with some of the new products, I noted that we had bought the first Ginnie Mae and the first Ginnie Mae n. We also bought a portion in the first CMO, but we have little enthusiasm for the multiplicity of CMO formats that are presently being presented to the market. Finally, I doubt very much that we will buy the first adjustable rate mortgage (ARM) packages, and I doubt that we will ever buy a shared appreciation mortgage (SAM). AU of these products have added complexity and uncertainty to the basic mortgage security. The products are not homogeneous; the cash flows are uncertain; in the absence of a strong Government guarantee, the product is likely to have lower quality; the contractual integrity of the new securities has not been tested in the courts; and the new securities appeal only to specialized markets, or markets that may be viable only at certain times in the economic cycle. Unfortunately, the entire innovation effort is an attempt to make a mortgage into something which is not a mortgage, and in fact into other securities which will appeal to the marketplace.

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However, this is a very difficult transformation, and it appears that any transformation will be incomplete. Some securities may be created which are attractive (short- and intermediateterm CMOs), but at the expense of creating less attractive securities (long-term CMOs). The new securities bear a high cost relative to their credit, and furthermore, will have difficulty competing with other securities already occupying the same market niches. For example, ARMs provide an interest rate adjustment within certain limits, but this security will have to compete with floating rate instruments, with more open limits, which are prevalent in international markets. In fact, ARMs will have to compete with all short-term securities which provide the additional liquidity to divert funds into other investment areas. Similarly, the CMO long-term zero coupon "Z" bond cannot effectively compete with similar fixed maturity securities for the market for annuities and dedicated bond portfolios. There is an entire investment infrastructure which is affected by these new products, but we do not know what the effects will be. You might remember in The Right Stuff that wonderful phrase the flyers used when they had a new plane, that they would "fly along the edge of the envelope and beyond." Maybe that's too large a phrase to use in this instance, but it's really true. We do not know what the effect of massive amounts of adjustable rate mortgages will be, for instance, on the government agencies or the mortgage insurers, or, for that matter, on the thrifts and others who will be owning them at some point. There are risks and uncertainties associated with these securities, and those risks have not surfaced or been given the test of time.

OBJECTIVES AND SUGGESTIONS People have asked me from time to time, what do I really want. Well, of course, I'm only a small part of the bond market, but what 1 would hope for is nothing more than to meet the objectives set for me by my board, which are: the preservation of capital; realization of the required actuarial rate of return; and the maximum performance that we can obtain within our fiduciary standards. This is the typical language that pension funds have to deal with as their objectives. However, if you compare these new securities against these objectives, you will note serious shortcomings. Preservation of capital is diluted

by lower quality and less certain cash flows. Realization of the actuarial rate of return may be less quantifiable, as with the case of ARMs. Performance may not be measurable, due to both uncertain cash flows and the limited markets for the new securities. The ideal would be a politically independent government agency that is well managed, issues securities that are fully backed by the U.S. government, and has the ability to design its own securities. Such an agency could intermediate its own mortgage portfolio. It could balance all of its mortgage cash flows with simply designed market instruments with fixed maturities, or if necessary, other securities, in every case to reach all markets and minimize its financing costs. In projecting its cash requirements, the agency could estimate credit and prepayment risks and, if necessary, hedge against them or insure against them in the private sector. In effect, the agency could be like General Motors Acceptance Corporation. While automobile receivables are of shorter duration, the company finances its receivables through a mixture of debt securities ranging from the very short term to the very long term. Each security has the standard maturity and payment terms which are common in the marketplace. The securities are placed with many types of buyers, and all are fully competitive in the marketplace. I believe that if a federal agency could finance a mortgage portfolio with standard market securities, interest savings of between 50 and 100 basis points could be realized by the agency over time. This agency will probably never exist. It is doubtful that Congress would grant the necessary independence. Also, there could be no risk that inexperienced political appointees could influence the agency's decisions. Finally, and most importantly, the agency would have to operate with very tight fiduciary standards which would define appropriate credit standards and a balance between the cash flows of aggregate assets and liabilities in order to eliminate the risks of changing markets. As it is highly unlikely that this concept will ever be implemented, the banking community and the federal agencies are clumsily trying to duplicate it. Let me briefly reflect on both the bankers and the agencies. The investment bankers regard the buyers as very dense people who have to be educated regarding the beauties of their innovations. From my point of view, as a buyer, I have a very long memory (virtually every

mortgage I have purchased is on my books at a loss) and a very long investment outlook. By contrast, the investment bankers I have met have only been in the mortgage business for a few years, and their investment outlook is only as far as the next transaction. There seems to be a tremendous competition to discover an even more complex mortgage security for some fleeting market opportunity, rather than to create simplicity for all markets. As for the federal agencies, they seem to be addressing the concerns of the savings banks and the housing industries. The mortgage buyers are seldom consulted.

FINAL CONCERN: THE INTEGRITY OF GOVERNMENT I have one final concern, which a lot of people do not think about because in analyzing mortgages or cash flows one tends to limit the evaluation of the price and cash flows and the likelihood of prepayments. However, I have an additional concern about the contractual integrity and the political integrity of mortgage securities. This concern shows up in a number of instances. Several years ago in California they passed a law against the enforcement of due-on-sale clauses. Also, several years ago, when the first quasi-adjustable rate mortgages came to their time of adjustment, lenders found out that politically it was unfeasible for them to raise the rate. In other words, the buyer of that particular bond had a benefit, which he thought he had purchased, and it was not an enforceable benefit. We have had an unsettling experience with one of our Ginnie Mae pools. This pool was a Ginnie Mae builder-loan pool, which we were not aware of when we purchased the pool. When this particular pool came out, Ginnie Mae did not choose to tell us that there were builders' loans in the pool, and that they would be all paid down in two years and nine months. As a result of that, when we sold it, we sold it for about $60,000 less than we could have sold a normal Ginnie Mae with the same coupon and backed by 30 year mortgages. So, in effect, Ginnie Mae did something that no private business could possibly do legally: they sold a pig in a poke and never disclosed what they were selling. I do not want to exaggerate my concerns with the government's integrity towards pension funds, but there are presently several bills in Congress which would permit outright the purchase,

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by all investors across the country, of certain types of mortgage packages. In effect, it is a nationallegality law. Of course, this is introduced with the idea of opening up markets that might not have been open before. But this is particularly addressed, I believe, to state pension funds, because if there is, in fact, a national legality law which permits the purchase of any mortgage, we have no protection against poorly conceived mortgage programs. In effect, they could be writing in a loophole to the general prudency law expressed in ERISA and in various state laws. And if, in effect, a federal law comes along which overrules our own prudency laws, or even our own sense of prudency as investors, we will really be naked before the very interests who want us to provide that $110 million concession which I previously cited. The final story I would like to relate is that in the 35 year history of the division we have had one default, a very subtle default, but it was caused by the federal government. It came about because during the second New York blackout, Mayor Beame dosed all the banks. The New York Federal Reserve dosed, and as a result, all the maturities that were coming due that day could not be delivered through the wire system. We had $80 million of maturities that day, and all

46

the commercial paper issuers gave us the extra day's interest; all of the CD issuers gave us the extra day's interest; but the federal government said, "It's not our fault; that's your problem, we didn't dose the bank, Mayor Beame dosed it. So therefore, we're going to keep that interest." Well, they changed their mind two days later, because they figured that was really a little bit arrogant. They gave us the interest, but they did not give us the interest on the interest. Now, that may seem to be a very small point, but actually, it illustrates the fact that the federal government is the proverbial 800-pound gorilla. They can change the rules whichever way they want to. This brings me to my final point: when you buy a mortgage you are in a very, very small select company. There probably are only 500 to 1,000 major mortgage buyers in this country. And that represents a very small constituency. On the other hand, there are 250 million people in this country who would like to have a low-cost mortgage. So when it comes to any sort of regulation or law, or any judicial interpretation of any legal aspect of a mortgage security, particularly new and untested securities such as CMOs and ARMs, buyers are at a great political disadvantage.

The Future-Where Do from ere?

eGo

James J. Connolly I would like to put the mortgage securities market in perspective in order to give you a sense of its size in relation to the capital markets. First I will discuss the total capital market and then break out the mortgage securities sector.

MORTGAGE AND CAPITAL MARKET OVERVIEW The capital market can basically be divided into five sectors: equities, mortgages, corporates, governments, and tax-exempts. It is interesting to see where the mortgage market ranks. The size of the mortgage market is about $2 trillion, broken down into residential and nonresidential debt, compared with corporate bonds of $574 billion, Treasury and agency debt of over $1 trillion, equities of $2 trillion, and tax-exempt debt of $484 billion. So looking at the capital market as a whole, mortgages and equities are the largest individual components. The mortgage market is broken down into one-to-four family, multifamily, commercial, and farm mortgages, with about $1.3 trillion in the one-to-four family sector making it the major component of the mortgage market. This is followed by commercial mortgages at $398 billion, multifamily at $165 billion, and farm mortgages at $115 billion. Focusing on the the one-to-four family sector, one must distinguish between fixed rate and adjustable rate mortgages (ARMs). ARMs have finally been accepted by the consumer. It has taken some time to develop, but they are increasing their share rapidly. Of the $1.3 trillion of one-to-four family mortgage debt outstanding as of the end of this year, about $216 billion of that is in ARMs. This is quite a dramatic increase for a relatively new mortgage design. ARMs started out growing very slowly in the late 70's. However, we estimate that in 1984 there will be $124 billion of ARMs originated which will constitute 62 percent of new mortgage originations. To look at this from a different perspective, ARMs will account for 16 percent of

the total one-to-four family housing market at the end of this year. The ramifications of this rapid development of ARMs will be discussed later. The one-to-four family mortgage debt outstanding can be broken down into the securitized and nonsecuritized sectors. We estimate that $300 billion has been securitized, with the largest component, about $1.1 trillion, still nonsecuritized. Consequently, there is still plenty of mortgage debt out there that can be put into a security form at one time or another. The largest component of the mortgage securities sector is in Ginnie Mae securities, with total issued of just over $200 billion. This is followed by Freddie Mac PCs at $69 billion, Fannie Mae mortgage-backed securities at $33 billion, and conventional passthroughs at $10 billion.

REASONS FOR THE GROWTH OF THE MORTGAGE SECURITIES MARKET There is no question that over the past 14 years the mortgage securities market has been an absolute phenomenon. This success was achieved by bringing the mortgage market to the capital market, rather than the other way around. We had to try to design structures that were acceptable to the bond-type investor, but at the same time did not radically alter the mortgage as an instrument. In addition, the mortgage securities market received critical support from the thrift industry during the early stages of its development period. It has taken many years to achieve the basics that every investor seeks: safety, liquidity, yield, performance and call protection. If you look at the breakdown of mortgage securities, there is a way to rationalize how they grew and developed. The Ginnie Mae security led the way with its guarantee overlaying pools of FHA/VA mortgages. The full faith and credit guarantee provided the credit safety while introducing the monthly cash flow of a pass-through structure. The next development was the intro-

47

duction of agency paper backed by conventional mortgages. This, by definition, caused the investor to look a little bit deeper into the underlying pool of mortgages and also learn a little bit more about the nature and the mathematics of the mortgage itself. The Federal Home Loan Mortgage Corporation (FHLMC) PCs began this process with publicly traded issues in 1977 followed by the Federal National Mortgage Association (FNMA) MBS. The first conventional pass-through security was introduced in 1978. This development removed all government, agency, and quasi-agency guarantees and substitutes private mortgage insurance. Once again, investors were looking deeper into the underlying collateral to better understand the nature and credit of the security. As you would expect, it would have been difficult to start out with a conventional passthrough security before a Ginnie Mae security was created. Investors simply would not have been able to digest such a radical step immediately. Insofar as liquidity is concerned, many money managers in the early 1970s would not purchase any of the mortgage securities because the markets were dominated by the thrift industry. They were concerned about liquidity. The market was liquid when the thrifts were in, and it was illiquid when they were out. Investors had to sort out interest rate trends as wen as the ebb and flow of the thrift industry, in order to try to try to determine security value at any given time. Those influences are no longer there. The liquidity in this market today is phenomenal as evidenced by some of the huge individual trades of recent years and heavy day-to-day trading activity. Billion dollar trades have been completed by individual dealers without the use of large syndicates. The cash, current coupon forward, future and options market in Ginnie Maes provides optimal flexibility and liquidity. As regards yield, there has been a gradual narrowing of spreads in the mortgage securities sector versus Treasuries, particularly over the last year or so. This is due to some special situations, such as CMO's and ARM's, which I will discuss later. On balance investments in mortgages and mortgages securities have provided handsome returns over the years. Back in the mid-1970s, we were trying to interest investors such as yourselves to purchase mortgage securities. Many would come back and say, "mortgage securities are defensive in a bear

48

market, but lack performance in a bull market." Salomon Brothers went back and researched what the performance had been since 1972 and 10 and behold, we found that the performance was in fact very attractive. If, for example, you were to look all the way back to 1972 and compare Salomon Brothers' mortgage passthrough index with a high-grade corporate bond index, or the long-term government index, the performance numbers are very persuasive as regards mortgage securities. Looking back over 10 or 12 years is probably not the best way of looking at things. However, looking back over the past eight years, for example, the mortgage index total rate of return is 93 percent, versus high-grade corporates at 67.7 percent and long Treasuries at 58.9 percent. Over the last five years, the mortgage index total rate of return is 59.5 percent versus 10-year Treasuries at 52.2 percent and high-grade corporate bonds at 39.5 percent. Over the last three years, the mortgage index is 58.5 percent while high-grade corporate bonds is 49 percent, 10 year Treasuries at 48 percent-plus, and long Treasuries at 45.5 percent. Looking at a more difficult period, the first quarter of 1984, the conventional mortgage index total rate of return index is at 2.39 percent; followed by Fannie Mae at 0.74 percent; Freddie Mac at 0.63 percent; the total mortgage index at 0.38 percent; and the Ginnie Mae index at 0.23 percent. However, for the same period, 10-year Treasuries are 0.102 percent; high-grade corporate bonds, 1.36 percent; and 30-year long Treasuries, 1.69 percent. So, from a performance perspective, we finally have overcome the bull/bear market objection and established quite an impressive and consistent record. The most recent hurdle that has been addressed was that of call protection. Mortgages by design have unpredictable cash flows and thus lack call protection. The development of the collateralized mortgage obligation (CMO) design, while it is not perfect, is a major step in the right direction of creating some kind of call protection for this type of security. CMOs will be discussed in further detail later on in my presentation. In summary, we now have a mortgage securities market that has a high degree of safety, an enormous amount of liquidity, and yield incentives. The performance numbers are there, and we are now beginning to refine the concept of call protection and introduce it into the mortgage securities market. An enormous amount has been

accomplished over the last 14 years or so. Of course, there is a great deal more to be done.

AREAS OF IMMEDIATE IMPACT ON MARKET The one significant area of immediate impact is the introduction of the ARMs. Although they started out in very awkward fashion, they have come on very strong, over the past year, and particularly over the last six months. However, they are causing a lot of confusion in market today. For example, the fixed-rate sector of the mortgage securities market, particularly current coupons, is now being impacted by a shortage of product. The majority of new mortgage originations is ARMs. The individual consumer is being attracted to "tickler rates," and yearly llifetime caps making ARMs very attractive compared to fixedrate mortgages. As a result, the flow of new current coupon mortgage security paper into the market has declined, and this has caused the yield spreads to narrow between fixed rate mortgage securities and Treasury securities. In addition, ARMs introduced a whole series of variables about prepayments. Normally, as we go into a 14 percent interest rate level, mortgage originations begin to dry up. This has not happened in this cycle. ARMs are going to continue to keep the mortgage market alive, and, as a result, prepayments will continue to impact various sectors of the mortgage market. To the degree that we continue to have a positive yield curve, and thrift institutions can fund these assets in their mortgage portfolios, ARMs are going to be a significant factor in the market, having a positive impact on the housing recovery and housing affordability. It seems to me that with the introduction of ARMs some thrifts institutions may have substituted credit risk for interest rate risk. By introducing very low tickler rates to stimulate the acceptance of the ARM, some borrowers are going to face payment shock. This can be moderated somewhat by putting on annual caps, and caps over the mortgage life, but one should expect congressional oversight and more disclosure in this area in response to consumer problems. The big challenge facing ARMs is the limited secondary market. There are trades going on among thrift institutions, but ARMs have lacked standardization. There are many different types of ARMs with different initial rates, indices and

caps that vary from institution to institution and region to region. A secondary market cannot be designed when there are so many different types of ARMs. Investors don't have the time to learn each ARM nor can they measure their value. A secondary market will develop but it is going to take a lot of work. Fannie Mae, Freddie Mac, Ginnie Mae, and the private mortgage insurance companies are working hard to set standards and uniform underwriting procedures.

FUTURE OF THE MORTGAGE SECURITIES MARKET There is good reason to remain optimistic about the future of the mortgage securities sector, and the pace at which mortgages are going to be converted into securities. There are a number of reasons for this. One of the major factors is the thrift industry itself, the challenges it is facing, and the trend towards a mortgage banking mode of operation where they originate and sell into the secondary mortgage market. A significant component of their activity has been in the whole loan area, starting in 1981, with the introduction of what is caned "regulatory accounting principles" (RAP), and purchase accounting. This is bringing out substantial whole loan trades from thrift institutions: $500 million, a billion dollars, and the like. While the accounting profession and the Federal Home Loan Bank Board are expected to tighten up a little bit on accounting treatments, thrifts will continue to be active participants in reliquifying mortgage portfolios and trying to generate near-term earnings. The continued expansion and innovation coming out of the secondary market agenciesGinnie Mae, Fannie Mae, Freddie Mac-and also the private sector will be a positive factor. There is excellent chemistry now in this whole sector of the market, and the agencies are willing to look at new things that historically took longer to develop. They are reacting more to the changes in the marketplace. This is a very positive and healthy development. Another factor is the introduction of bond type mortgages-CMOs, for example-that provide better caU protection, and that make the mortgage a more suitable investment for fixedincome investors or nontraditional investors. finally, there is just the whole demographics of the market. While the type of borrower may be a little bit different in the 1980s, or the type of

49

structure may be different from the Cape Cod house with the white picket fence, the demand is going to be there. There is an ongoing driving force in the mortgage sector. Focusing specifically on future developments, the ARMs security in some form or another will be perfected. A large component of the market will not continue to grow without some kind of a security being designed. Considerable resources have already been expended by both the public and private sector to seek an ARM mortgage that is suitable to the consumer and an ARM security that is acceptable to the investor. Still, more work is needed before ARMs achieve the same stature as fixed-rate mortgages in the secondary market. The lack of uniformity of ARMs because of rate caps and teaser rates, as well as the fears of potential payment shock, have made it more difficult to reconcile ARMs with the investment and performance requirements of the portfolio manager. Salomon Brothers is addressing this problem through a computerized model based on option theory to price ARMs. I am confident that a uniform structure will evolve that satisfies all parties. We believe ARMs will complement rather than replace fixed-rate mortgages and that the origination volume of each will vary with changes in interest rate levels and consumer demand. Looking at the secondary market, there are various bills that are working their way through Congress. The Trust For Investment in Mortgages (TIMs) as a concept is surely very powerful; however, I am not sure whether TIMs proposal is going to make it through this session. It could be a catalyst for fundamental changes in mortgage security designs for both fixed-rate loans and ARMs. Most of the refinements in this technology, however, and the further development of the CMO, in the absence of TIMs, will come from the private sector. The commercial, multi-family, and industrial mortgage sectors will follow the security development of the single-family sector. Maybe a Ginnie Mae commercial mortgage will not be developed, but the characteristics and the design features that have been established in the secondary market will be incorporated into this sector. Going one step further, it is logical to expect that consumer receivables could also evolve into a securities market following the mortgage pass-through security design. During the past 14 years, the profile of investors in mortgage securities has diversified. Tradi-

50

tional mortgage investors dominated the market through 1975, but pension funds, investment advisors, insurance companies and trust departments have gradually become more significant participants. In addition the European and Japanese markets have begun to be penetrated. We expect a big component of future market expansion will be coming from foreign investors. Another major development to watch is competition that the traditional mortgage originators-the thrifts industry, mortgage bankers, and commercial banks-are going to experience from a new breed of mortgage originators: Sears, Merrill Lynch, Realtors, and other entities are looking at the mortgage market in a completely different light. This secondary market changed its view of the mortgage market. They can get involved; they can originate; and they can sell. It complements many of the other businesses that they are in. So, new players will emerge in the mortgage sector. In addition, the traditional loan origination process itself will change. Anyone who has been through the process of getting a mortgage knows that it is not a lot of fun. But with the increase in technology, this entire process of originating the mortgage will be made much easier and much quicker, without compromising all the credit investigation and underwriting that would normally go into making a mortgage. Of course, from a consumer's point of view, it does not seem to matter who makes the mortgage as long as the rate is competitive and the service is professionaL Finally, mortgage financing could develop as a benefit in a fringe benefits package among corporations. While it will be a market-rate mortgage, it will be offered to employees much in the same way that health and dental protection plans are used today.

CONCLUSION Let me conclude by stating that Salomon Brothers has made a major commitment to this area for the past seven years. We continue to feel that mortgage securities are an acceptable debt alternative to the bond portfolio manager. We also feel that the traditional mortgage investors, such as thrift institutions, should view their mortgage portfolios more than just a static asset; they can be managed like a bond portfolio. Based upon these concepts, we started the

first vertically integrated mortgage securities department. We now have over 300 people in our mortgage securities department, trading 26 different mortgage and mortgage-related products with $200 billion in trading volume per year. There are some people who saw the opportunities in this market and acted on it a number of years ago, particularly people in the investment advisory area such as yourselves. Others stayed on the sidelines and analyzed it. I think that those who participated early have been rewarded for

their initiative. Those who stayed on the sidelines, if there are still any, have got to look at this market. The reason is simple. A portfolio manager that concentrates on just the corporate sector and the government sector will not see the big mortgage trades, and as such will not be as effective. I personally do not think that this is in your best interest. So for those of you who are not involved, I urge you to include the whole mortgage spectrum in your portfolio strategy.

51

Connolly

uestion and Answer Session

QUESTION: What role, if any, do you think the S&ls and the thrifts will have in the mortgage market in the future? Will it be more short-term oriented? CONNOLLY: The thrift industry will continue to be the significant component of the mortgage market. They have done a superb job of housing America. I believe they will continue to look for ways to reduce their mismatch between liabilities and assets. But that does not mean, for example, that all mortgage in future will be ARMs or short balloon mortgages. They will continue to make 30-year fixed-rate mortgages as long as they can sen them. They don't necessarily want the asset, but they want the origination fee and the servicing. They will continue to refine the adjustable rate mortgage and use it as the primary mortgage product rather than offering shorter term mortgages. However, there are many other parties that are looking to get into the market. So, don't worry about a shortfall in fixed rate mortgage, because there will always be somebody else coming in there to fill the gap.

52

QUESTION: With the growth of the CMOs, there has been some talk about making more information about the pools available, particularly after they are issued. CMOs do not seem to trade very well because nobody knows what is going on in the underlying pools, particularly when there are lenders between Fannie Mae, or Ginnie Mae, or some GPMs, or some conventional. Has there been any discussion about how to make more information known to investors and to other houses who are not involved in official underwriting? CONNOLLY: I would say that if this is viewed to be an impediment to its growth, I assure you, the information will be generated. It is just a question of priorities. There has been some preliminary work done at Salomon Brothers, but I do not know of any definitive work that has been completed; obviously it is something that the Street will have to respond to if it is needed to expand the security.

Portfolio Strategies Using MortgageBacked Securities (I) William H. Gross, CFA I will discuss two topics: first, the factors that should be considered in selecting the sector of passthroughs that should be held and which should be avoided; second, the investment opportunities in mortgage futures. The prepayment problem caused an initial avoidance of passthroughs by the marketplace. In the mid-seventies, the question of monthly cash flow and the lack of liquidity in the early stages caused investor reluctance. But now, for the most part, the liquidity problem is gone. Ginnie Maes, Fannie Maes, and Freddie Macs are as liquid, if not more liquid, than Treasuries. There have been many times when we have gone to the market for bids and offerings on size in all of those markets and received tighter spreads on passthroughs than Treasuries, for instance. So liquidity is no longer a decent argument for staying out of the marketplace. Nor really is the monthly cash flow aspect. Compounding really adds to the benefits associated with holding mortgage-backed securities rather than detracting from them. There can be no reason to avoid the mortgage market other than the problem of "callability"-the fact that forecasting prepayments has always been a difficult proposition, and it probably always will be. I am not going to discuss the advantages and disadvantages of forecasting prepayments. It is very difficult to forecast these levels. To some extent it is correlated with interest rate movements and housing starts, which themselves may be correlated. To a certain extent, if you are forecasting rates, you can have a position on passthroughs in terms of prepayment levels, but it is a very difficult proposition.

SELECTING MORTGAGE-BACKED SECURITY SECTORS I am an advocate of owning a discount passthrough in a bull market because of the greater price volatility of discounted securities. An investor can own high-coupon passthroughs in a bear market. We have done that over the past 20

months. Holding high coupon passthroughs has been very attractive and could continue to be under certain environments. Current-coupon passthroughs, however, are poor investments in terms of their total price performance. Owning a current-coupon passthrough, specifically a passthrough selling between a price of 96 or 97 and 102 or 103, really is to no advantage to the owner. It can only work to his detriment.

The Problem of Negative Convexity The real reason that passthroughs are difficult to understand is due to the prepayments. That brings out the problem of convexity. Convexity is a very difficult term to understand. It refers to the fact that as interest rates go up, the duration of a bond goes down; and as interest rates go down, the duration goes up. Those who have immunized a portfolio or who have run GICs really know that if interest rates change in either direction, you can win on either side of the spectrum. You win if rates go up; you win if they go down. That is simply because of duration and the fact that it moves in a convex pattern: duration comes down as interest rates go up; and duration goes up as interest rates come down. That is the convex curve relating duration to yield. In the mortgage market, however, there is a perverse situation called negative convexity. That is a term obviously opposite from convexity, in which the duration of a bond stands a chance of moving the opposite way that you want it to. Typically, if interest rates come down an investor would want the duration of his bond to go up, because that means it is getting longer, more volatile, and, as a result, can participate in the marketplace as interest rates decline. In fact, the greater the duration, the better, as rates go down. Obviously, on the passthrough side, as interest rates are coming down, prepayments are picking up. There is a chance that, instead of the duration going up, it could actually go down.

53

That could certainly happen with high-coupon passthroughs. We have seen average lives of 1, 2, and 3 years on 16 percent and 17 percent coupons. That really is negative convexity at its worst, shortening the duration as opposed to lengthening it. Negative convexity, therefore, is the real problem in terms of passthroughs. It can work against you on both sides, with interest rates going up, or interest rates going down.

Coupon Spreads That brings up the interesting phenomenon of coupon spreads. Table 1 shows negative convexity in a common sense way. These are typical coupon prices for various Fannie Maes as of last May. You can see the current coupon at par, at 14 percent. The 15 percent is at 103 and so on up the board and then down the board, below par. Without really having to look at a yield table to see what might happen under certain interest rate forecasts, or even to delve into a more complex option theory, intuitively it can be seen that the odds are stacked against the current coupons. Let's look at a 14 percent coupon and see what might happen with basis changes of 100 and up or 100 and down. If interest rates went up 100 basis points, logically one would expect the 14 percent coupon to take the place of the 13 percent in terms of price. The 13 percent was at par a little while back, and now it has been replaced by the 14 percent. One would think, moving down the scale, that the 14 percent takes the place of the 13 percent in terms of a price loss. And that is a price of 95. Therefore, the investor is going to lose approximately 5 points if interest rates go up 100 basis points. Look at what happens when interest rates go down 100 basis points. If suddenly the 14 percent takes the place of the 15 percent in terms of a coupon-in other words, 100 basis points

TABLE 1. FNMA Price spreads Coupon 16 15

12

104 103 100 95 90

11 10

85 81

14 13

54

Price

premium to the current coupon-the price will rise to 103. This is a situation that any bondholder wants to avoid. He can lose 5 points, or he can make 3, and it even gets worse if the same situation is analyzed for the 16 percents, or all the way down to the 12 percents. For the 14 percent, with a 200 basis point change, the investor can make 4 and can lose 10. That is the wrong type of ratio. Managing money is putting probabilities in the right order. An investor would want the outcomes for gain or loss to be reversed. The only way that it could be profitable to give away this option to a holder would be for the 14 percent, or the current coupon, to sen at a yield that adequately compensates the holder for taking the call risk, or for taking the price risk for that fluctuation. These days, and in almost any day relative to the past 10 years, the current coupons have sold almost on an exact level with the discount. Investors are not being compensated in terms of yield for the price performance that may emanate from changes in interest rates. It is just not there. Avoid the current coupons. Take the lower coupons or maybe even the higher coupons. There is a time and place for the high-coupon passthrough. About 20 months ago we bought a large piece of 16 percent coupons from Fannie Mae. It was not a question of whether or not these were going to be prepaid rapidly, because we thought they were, but a function of price. Anything can be of value at a certain price. When we bought these at a price of 106, the common sense logic to all of this-and 20 months ago tables that showed the monthly mortality factors were not available--we thought that if a Fannie Mae 16 percent prepaid entirely within two years and had an average life of one year, that obviously we would lose an average of 6 points to par (from 106 down to 1). That would be compensated by the current yield of about 15.1 percent, producing a yield of approximately 9.1 percent. At the same time, one-year Treasury bills were yielding 8.4 percent, so it became a situation of a worst-case proposition. To our way of thinking, it could not get any worse; they could not prepay any faster than that. So, our stop-out rate was 9.1 percent. Our maximum rate was much higher than that, and, in fact, the high-coupon passthroughs could improve, performance-wise, even if interest rates went up. This is actually what happened. During an environment in which interest rates went up, the

prepayments slowed down gradually and then dramatically. That, to a certain extent, sent the price up. All of a sudden they were not being valued as a short piece of paper. They were being valued as a much longer piece of paperi therefore, the duration was extended above par. That actually produced a price boost. These coupons were trading in the 107 to 108 range a few months ago after the general market had declined 10 to 11 points. So I would suggest that high coupons can be bought. They have to be bought at the right price, and they have to be bought with the obvious understanding that the holder is going to lose a lot of them at par and probably at a very fast rate. There is another factor which we call the "idiot factor." This term stems from my experience in the life insurance business, where we compared policy loan rates and the frequency of policy loans relative to interest rates. We observed that after a while the policy loans basically tapered off, no matter where interest rates were. This was due to the fact that simply everyone that was smart enough-or that had enough energy to take out a policy loan and reinvest it at a higher ratehad already done so and that there was a certain group of people that simply either do not care or do not know that it can be profitable to take out a policy loan and invest it at a higher rate. The same thing exists here in terms of high coupons. There must be an "idiot factor" there somewhere, where there is a core element of homeowners that does not know, does not care, and does not bother to prepay their high-coupon mortgage loans. The closer and closer you get to that core element, obviously, the slower prepayment factors become, and the better the price performance. So an investor looking for a defensive, short-term investment that can be a Treasury-bill-plus type of situation in a bear market should take that factor into account. I am also negative on CMOs, and for the same reasons. The same negative convexity exists in all of the tranches that exist in the passthroughs in general prove to be the failing of this particular vehicle.

TABLE 2.

concerned abouti it is the price performance in the short run, as interest rates change. Table 2 shows the typical performance of a Freddie Mac CMO, with a six-year average life, in a situation of a 100 basis point change either way. Comparing it to a five-year, a ten-year, and a thirty-year Treasury, it can be seen that the CMO is a loser in most instances, except if interest rates do not change. And as we know, that has rarely been the case.

MORTGAGE FUTURES The Ginnie Mae future is called a collateralized depository receipt (CDR). It was first traded in 1975. It was the logical hedging vehicle, and it came into origination even before the Treasury bond futures contract, which now tends to be the most popular. We went out to our clients about 18 months ago because we thought we had found a super investment-and in fact, we did. We described it to them at a number of seminars in the following fashion. A near-perfect investment. My conception of a perfect investment would be something that could go up in price, that could not go down in price, and that paid a high current yield while waiting for something to happen. The Ginnie Mae CDR comes very close to that. An investment for all seasons. The Ginnie Mae CDR is a vehicle that can do well in a bull market, and it can do well in a bear market. That sounds very hard to do but I'll explain it shortly. A once-in-a-lifetime situation. That's a whale of a statement, but I do think this investment opportunity that we got into 18 months ago, and that existed in the marketplace, was a once-ina-lifetime situation. I will not see this opportunity in my investment lifetime again. It is truly uniquei it has provided a return for very little risk in the marketplace, and that is almost an impossible combination to come by.

Total I-year returns for CMOs and treasures FHLMC B-2 6.8 yrs

-100 Basis

No change +100 Basis

It is not the yield that the investor should be

16.8 13.35 8.80

5

yr treas. 16.75 13.25 10.40

10

yr treas. 19.50 13.55 8.40

30

yr treas. 21.6 13.60 6.70

55

What is the GNMA (Ginnie Mae) CDR? A Ginnie Mae CDR is: •

•

•

•

Negotiable, perpetual fixed-income instrument collateralized by GNMA passthroughs, and convertible into GNMAs at holders' option. Collateralized by eight percent GNMAs or their principal equivalent (additional collateral must be deposited when paydown occurs) and a reserve of Treasury bills. Income paid monthly, based on a 7~ percent coupon: at today's prices, the current yield is 11.0 percent. Because of the collateral (government guaranteed GNMAs), we consider CDRs at least AA quality.

Why is this such a fantastic investment? Keep in mind that the Ginnie Mae CDR is a particular instrument. It is not a security, technically, but it's an instrument that can be purchased only in the futures market. The three key words describing this instrument are: perpetual, collateralized, and convertible. The perpetual nature of the instrument comes about from the fact that the originator of the CDR is obligated to pay forever a 7% percent coupon on an annual basis. The holder receives payment monthly. (It is actually $635 per month, and that is equivalent to 7% percent.) That may not seem like such a big deal, but since the price of the Ginnie Mae CDR is around 66, that equates to a current yield of about 11Yz percent today. So it is a decent current yield. It was more attractive when we started, but it is still decent today. It is a perpetual obligation that the originator must pay as long as it is held. It is longer than a 3D-year Treasury bond. It is a perpetual investment that can be looked at as a perpetual preferred. This is one side of this instrument. In a sense the CDR has a split personality. It can be long and it can be short. The perpetual characteristic is the long side. Where does the short side come from? The short side comes from the collateral. This thing is backed by, basically, any Ginnie Mae coupon. But to make it profitable for the originators, the only coupons that they can back this up with are the high coupons: the 15 percents, the 16 percents, and the 17 percents. You immediately can sense the situation. The investor has a perpetual

56

instrument as long as he holds it. On the other hand, he has a short-term instrument because 16 percent and 17 percent Ginnie Maes have been in short supply. They have been two- to threeyear pieces of paper. So the investor has a long bond and a short bond in one instrument, and no matter which way the market goes, the investor is a winner--or a relative winner. That was the situation that was set up 18 months ago in terms of the Ginnie Mae CDR, and to a certain extent still exists today. How Should the GNMA CDR Perform? We showed Figure 1 to our clients about 18 months ago, trying to forecast the performance of the Ginnie Mae CDR. Over the past 18 months interest rates have gone up and prices down, so the lower left quadrant is applicable. A number of lines can be seen there. The dotted line in the upper right hand quadrant, at the very top, is the long Treasury bond. The CDR is the solid line, and the short Treasury-the three- to fiveyear Treasury-is the dotted line that moves basically in the lower sides of the quadrants. We felt that in a bull market the CDR, because of its perpetual nature, would perform similar to a long Treasury bond. Going back in terms of prior experience-there have been certain instances when it has-and even in daily action, the CDR performs quite similar to long Treasury bonds many times. But it is fair to say that the period of time that has really been tested has been the short period of time with rising yields and declining prices. During that time the CDR has actually done better than a three- to fiveyear Treasury. For the most part, the CDR has paralleled, if not improved upon, the performance of the high-coupon Ginnie Maes that back it up as collateral-the 16 percent and 17 percent Ginnie Maes. And over the last 18 months, the CDR has probably gone down 2 percent in value, whereas the long Treasury bond has probably gone down upwards of 15 percent to 16 percent. While the CDR has lost money, it has lost very little, and it has maintained its value relative to almost any short-term instrument in the marketplace, much better than the three- to five- year Treasuries, and better than even the high-coupon 16s and 17s. Today, in terms of its valuation, we think that much of the value has been recognized, but there may come a time in the future for the CDR again.

FIGURE 1

How should the GNMA CDR perform?

PRICES

1

long Bond \ (30yr)

/ ,/

'/ ,/

/

,/

/

/ / //

/

Short Bond (3-5 yr)

l

/

....-Rising

/.

/

_-----

--

------=:::::;:;;;;:;;"r"-=-;;;;...----;;~;:=:YIElDS

/

--- --

Falling~

/ /

/

/ / / / / ./

/ /

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The logical question that probably exists is: Why are "we guys so smart," and nobody else figured this out? Wall Street is populated by brilliant people, and we do not claim to be at the top of the rocket-scientist category, by any means. But there was an opportunity here that no one really could have taken advantage of. For the most part, ERISA [Employee Retirement Income Security Act] constraints on using futures were cleared by the Department of Labor in late 1982. Most pension funds, therefore, could not invest in futures for their clients. Nor could insurance companies, for the most part, invest in futures; nor could banks. So most of the players on the investment side were out of the picture in terms of the ability to even buy this vehicle. Then it can be asked "Well, why didn't a Salomon Brothers, or a Lehman, or a Goldman Sachs buy the CDR and take advantage of this?" The simple answer, I think, is that neither a Gold-

man, Sachs, nor a Salomon is in the marketplace to commit billions of dollars worth of their capital on a long-term basis. They are there for the eighths and they are there for the quarters on a revolving basis. They did not want to invest in this either, even though some of them probably knew about it. So the truth of the matter is that because of rigidities in the marketplace, no one was there to take advantage of it. It was not a question of being smart; it was simply a question of being first. There is still time. We are still investing in the CDR. But investors should think seriously about it, because it can be a vehicle now and in the future that can be utilized as a mortgage substitute, but with very defensive qualities and very aggressive potential at the same time. It is a very dynamic instrument in terms of a hedged situation.

57

Portfolio Strategies Using MortgageBacked Securities (II) Richard l. Sega I will discuss our insurance product, how we came to acquire such a large inventory of mortgagebacked securities, and how we manage them today. I will also explain the motivations for our rather large CMO offering, a piece of which we retain for our own portfolio. The perspective is from the liability side as opposed to the asset portfolio manager's side.

THE PRODUCT: GICs The Guaranteed Investment Contract (GIC) is a product that is a staple cash flow generator for many insurers. These contracts are intermediateterm liabilities of three to seven years for the most part. The sale of these contracts is an intensely competitive business. We deal in large sums, commonly in the tens of millions of dollars in a lump sum. The reason GICs are so popular is that our marketplace is primarily that of pension funds, especially defined-contribution funds, and thrift plans of the type where employees contribute by means of payroll deduction to several different funds at their option, one of which is a fixedincome fund. For that reason, any investment candidate has to have several characteristics. The guarantee has to be able to be given well in advance, publicized to the employees, and held through the period of time during which the contributions will be made. It is important that there be an absolute guarantee of principal. The integrity of the employee money cannot be compromised. There are generally no participations in these contracts. These people are willing to take a fixed, flat guarantee that is not tied to the underlying investment performance, if that guaranteed rate is sufficiently high. So, we the insurer offer to guarantee a compound rate of return with no interest paid out. The contracts offered by insurers vary, but generally they do not payout interest. Essentially what is offered is a zero-coupon bond for a term of, say, five years, and a guaranteed compound rate of return.

58

In assembling a portfolio for this kind of liability, the very first risk encountered is acquisition risk. It can come in either of two ways. The insurer can sell the product first based on where current yields are in the marketplace and then try to invest for it; or, the insurer can warehouse securities with what are believed to be good yields and then try to sell products against it. Either way the insurer can be hurt if the market moves in the wrong direction in the interim. During the period that we acquired most of our portfolio, we tried to eliminate that risk to the extent possible. We tried to perform both sides of the transaction almost simultaneously. To do that, we frequently updated our so-called reference rate-the rate that we use to tie the contract guarantee level down for the clientsometimes hourly when markets were very volatile. As soon as a client accepted our offer, we purchased the securities. We then got a written deposit agreement from the clients, so that they could not back out of the contract later, effectively removing an implied option from the bidding process.

ROLE OF MORTGAGEBACKED SECURITIES The way our marketing operation is structured, we need to have a security that is always there in order to do this effectively. We need very high liquidity, while at the same time we need high yields to compete. Some of our competitors took a credit risk by buying lower quality paper to get that yield; we did not do that. We chose Ginnie Maes to support this business for several years. Some of the reasons that we picked Ginnie Maes were that we could get good liquidity, standardization, and yields equal to or better than comparable quality issues. We could effectively get mortgage yields, without looking through to the whole loans, but getting a piece of paper that was guaranteed by an agency with full government backing. We do virtually all of our work in discount pools. They have rela-

tively more stable prepayments and if they accelerate there is a yield advantage. There are, however/ some problems with Ginnie Maes, particularly from the liability side. The unstable durations, due to the varying prepayments, result in frequent rebalancing for matched book portfolios aI1d immunized portfolios. Close monitoring is necessary. The monthly flows give rise to processing expense, which is not trivial. There are accounting concerns, which are certainly not trivial in an insurance company. There is an additional reinvestment risk. Finally, the yield spreads may be inadequate to compensate the owner of the Ginnie Mae for the call option that is held by the mortgage borrower. Although insurance companies and actuaries tend not to look at the GIC business this way, it can be viewed as a spread-lending business. The insurer is issuing 5-year zero bonds of triple A quality, at around 14 percent, when comparable maturity CATs and TIGRs yield about 11.9 percent. That is not an easy way to make money. Consequently, an insurer must be very careful in selecting portfolio management techniques.

PRIONG PROCESS OF GICs AND MORTGAGE-BACKED SECURITIES Let me briefly review how the pricing process of GICs is tied to the supporting mortgagebacked product. The "pricing process" is the method of setting the guarantee that we are willing to offer to a customer. We use a stochastic model that starts with a probability distribution of interest rates that is generated by our corporate economists. This method of pricing GICs depends on the existence of an interest rate forecast that management is willing to live with and make business decisions on. That is not always easy to get, particularly after examining track records of corporate economists. We also developed an algorithm to project prepayment rates for pools based on various rate levels. This information is then put into a Monte Carlo model that simulates the performance of the asset pool over the expected term of the contract. This gives rise to means and standard deviations of total earnings for that pool. Based on those statistics a risk charge can be generated, depending on a particular risk-reward criteria. There are several ways to do this. Many insurers use a certain maximum probability of ruin. Others use a certain ratio of odds of gains to losses.

Regardless of how an insurer sets its risk-reward criteria, if it can be set down algebraically, the insurer can then calculate a risk charge that reduces the guarantee. Then, theoretically at least, the insurer can arrive at the proper risk-reward relationship and fixed guarantee. Next, let us look at how these contracts actually work and how we start picking the assumptions that are incorporated into this model. Certainly/ if Ginnie Maes are in its portfolio, and an insurer is writing five-year GICs for instance, the insurer is mismatched. In fact, an insurer would want to be mismatched somewhat, considering that all the money is reinvested and interest is not paid out as it is earned. There is a reinvestment component here. The reinvestment component causes losses to the contract if rates fall, so, in essence, the insurer shorts the market, at least with respect to that component. Mismatching of longer assets against liabilities makes the insurer long the market. Together, to some extent, these risks offset. Of course, they are not perfectly correlated. Whipsawing can occur, and you can either win or lose on both legs of that risk. But, in general, those are low-probability events, and they are reflected in the aggregate statistics by means of the Monte Carlo process. In the early days of aggressively pursuing this business, which we still are doing, our rate forecast and our prepayment algorithms indicated that the risk of duration swings was manageable using Ginnie Maes; and we could still produce competitive guarantees even after reasonable provision for adverse deviations from our assumptions was accounted for. We got by the 1981 period pretty much without changing methodology. But as we came to the end of 1981 into 1982/ it became clear that interest rate swings and the resulting prepayment variations were far more volatile than our assumptions anticipated. We were starting to endanger our profitability in the risk charges, so we decided to take several actions to lessen our exposure to the highly variable Ginnie Mae durations. The first thing we did was obvious. We reduced the amount of new business written that was backed by Ginnie Maes and shifted over to other areas of the market, primarily mortgages and private placements. That, of course, reintroduced some of the problems that the Ginnie Maes were originally intended to take care of, but these were some of the risks that we had to absorb.

59

We also embarked on a Ginnie Mae swapping program, and this has been the basis of our management in this portfolio since that time.

GINNIE MAE SWAPPING PROGRAM Our swap methodologies take several steps. First, we have classified all holdings with respect to three attributes. We feel that these three attributes are enough to explain adequately most variations in prepayments most of the time. Prepayment rates have been tied in the literature to just about everything: housing starts, demographic statistics, anything you can think of. But we have been able to explain pretty much all the variability in prepayments that we need to, at least on a cost-effective basis, by looking at age, coupon, and type-type being GPMs, standard singlefamily, or builder buy-down. All of our swap candidates are classified that way. We superimpose our interest rate forecasts on the portfolio. With the resulting predicted prepayment experience that comes out for our model, we can calculate the cash flows that we expect to have. By means of regression analysis, we have determined a rule that tells us what the liquidation yield of a Ginnie Mae should be. That refers to the fact that from discounts through current coupon, Ginnie Maes trade relatively flat in yield, but they start to trade at very high yields as you get above current coupon. Our rule tells us where we expect that pool to trade given our various random walks through interest rates in the future. We selected a holding period that matches our liability horizon in the existing portfolio. That is about four years. Using all of those pieces of information, we can then calculate the expected total amount for a given par amount of Ginnie Mae. For $100,000 of face value, liquidating in 4 years, we can measure the total wealth. Similar calculations are then done for other buy candidates: private placements, commercial loans, and other Ginnie Maes. On the day we look at the swap, we price-effect those accumulations, compare them, and the favorable swaps are undertaken. Using this program we have swapped several hundred million dollars of our Ginnie Maes. The swap model tends to point to the discount pool, which is not surprising, since current coupons tend to be priced relatively rich on a risk-adjusted basis. All swaps, however, depend heavily on an

60

interest rate outlook. There is no uniformly good swap rule that we have come up with. Another factor that has to be considered in any swap decision is a kind of utility theory. That refers to the fact that swaps not only add or subtract value in terms of current values to a portfolio; they also alter the risk/reward relationship of that portfolio. The relative utility to the line area, as the line area happens to be the owner of our portfolio that we manage for, has to be considered. Anybody who owns a portfolio has some idea of how much risk he is willing to take on for how much benefit. . For example, consider a portfolio of GICs that had an expected profit of, say, $10 million and a standard deviation of 5. If the CEO looked at profitability or the risk-reward concept, and just said, "What's my 95 percent confidence interval?" it would be a mean of 10 with a range of o to 20. That may be acceptable. A swap may raise that mean to 25 and raise the standard deviation to 15. While that might seem like a reasonable thing to do in some respects, if you again look at a 95 percent confidence interval, it now has a range of approximately 55 on the profit side to -5 on the down side. But a 2Y2 % probability of a loss greater than $5 million may be totally unpalatable to the stockholders, and you would not accept that kind of swap. Consequently, the marginal utility of any additional reward has to be looked at in terms of how much additional risk you are going to take in the portfolio.

SYNTHETIC-BOND APPROACH FOR CMOs In early 1984 we did a very large issue of CMOs. We had a substantial portfolio of available collateral, so we thought it would be to our advantage to consider such a transaction. Rather than going into the marketplace to buy CMOs, we tried to structure a CMO with a set of classes, one of which was very well suited to the cash needs of our portfolio. We had considerable long-term assets, with cash flows going out to 30 years. Most of our liabilities were in the five-year range. We tried to bring in some of that cash without giving up too much in yield. Profit was not the major motive for this particular transaction, rather portfolio restructuring was the major thrust. Most CMO issues are done

either for tax or accounting benefits and some purely for the arbitrage profit. Certainly the arbitrage profit in our case made it possible for us to slide down the yield curve without giving up anything in yield. But the structuring of the synthetic bond was our primary goal. We created a series of CMO bonds, the second of which was a zero cash flow bond because we did not need cash in the first couple of years out. We needed cash through about the seventh year and structured it that way. This piece was retained in our own portfolio, and we sold the rest of the issue using the arbitrage profit in that portfolio to keep the yield on our piece high, thereby lowering its effective price. CMOs are not Ginnie Maes any more, but they are not traditional bonds either. In looking at the duration of our CMO versus some others that we could have purchased, while the mean duration had moved down to the level in the five-year range that we wanted, the variability in duration was no less, and by some measures it was even greater, than the variability of duration in the underlying Ginnie Mae. So it is not clear that just because one tranche of a CMO issue is purchased, an investor is shedding prepayment risk to some other class. A great deal of analysis under different scenarios and horizons must be performed to make sure that is true, particularly in the case of a liability-driven portfolio like ours. Our marketplace dictates our investment horizon, and that cannot be changed with a change in outlook in interest rates simply to improve the results of a swap.

using futures or options until very recently. In mid 1983, the state of New York passed a revision to their law that allowed some hedging to be done in insurance company portfolios. We really could not do anything until final regulations came out from the State Insurance Department. They have been issued and are fairly restrictive. Most of the hedging that I imagine insurance companies will do, will be to sell or buy futures to hedge commitments or anticipated takedowns in their portfolios. They probably will not be hedging existing assets, because that is one of the things that seems to be prohibited by the regulations. The GNMA CDR contract is not a good hedge for current coupon or discount Ginnie Maes. It tends to track the high coupons and is fairly useless for a portfolio hedge. The Ginnie Mae II contract, while theoretically useful for that purpose, trades only a few hundred contracts per week, so we would not get involved in that one yet either. But I think an increase in insurance company hedging activity will be seen. Insurance companies are limited by a restriction that says that they can only hedge a face amount of up to two percent of admitted assets. That is a fairly limiting restriction, but I think that will be relaxed through time as some experience is gained in this area. If we do get to the point where regulations are relaxed, maybe then the Ginnie Mae II contract will be trading with enough volume to be attractive.

USE OF FUTURES HEDGING Because of regulatory constraints, insurance companies had not been allowed to do any hedging

61

Portfolio Strategies Using MortgageBacked Securities (III) Ray B. Zemon Our portfolio strategy has emphasized discount mortgage-backed securities. We haven't used current coupon issues because we do not feel they provide adequate incremental yield for the implicit call option. We also haven't used mortgages trading at a premium, although we would seriously consider doing so if we expected a stable to slightly higher interest rate environment. Mortgage-backed passthroughs are very complicated securities. As a rule, when you have a simple security, you can have a sophisticated method of analysis; when you have a complex security, you need a simple method of analysisand a lot of judgment. Following this guideline, we have tried to identify a few key factors which should explain the performance of discount mortgage-backed securities relative to other types of bonds. Having specified these key factors, what should be done with them? First we are going to try to identify the consensus expectation for each factor and see if we agree with that expectation. If most market participants perceive that the environment for mortgage-backed securities is likely to be favorable, and they don't change their collective mind, mortgages will generate a market return. If it is anticipated that investors are going to change their minds, for one reason or another, that should create an opportunity to earn a superior return or avoid an inferior return. The principle difference between discount mortgages and other types of securities is prepayment. Homeowners will repay principal prior to the stated terms of the mortgage. This will happen in spite of the fact that the mortgage is trading in the market at a level substantially below its principal value. It should be evident that prepayments are good for the mortgage holder. He can replace the cash flow of the prepaid mortgage with a portion of the principal prepaid; the remainder is gravy.

gaged property changes. This suggests that fluctuations in housing turnover should have a significant impact on prepayments of discount mortgages. Using the housing starts series as a proxy for housing turnover, it is easy to see that this was the case during the 1981 through 1984 period. Figure 1 plots housing starts against percentage prepayment rates. Notice that during 1981 and 1982, both housing starts and prepayments weakened considerably from previous levels. As housing activity picked up in 1983 and 1984, prepayments followed. However, not all changes in home ownership result in a prepayment. Some mortgages have a "due on sale" clause. If the homeowner sells his house, he must repay the mortgage. Since decisions to sell houses are made for many reasons, mortgages are prepaid in spite of the economic value of the homeowner's below market rate mortgage. Other classes of mortgages, notably those which back GNMAs, are assumable by a subsequent homewowner. In spite of this, discount GNMAs also prepay, though at a slower rate than due-on-sale mortgages. One reason assumable discount mortgages are prepaid is connected with the age of the mortgage. Older assumable mortgages seem to prepay faster than newer assumable mortgages. It is not well understood why this is the case. Our suggestion is that the older mortgage is a smaller percentage of the market value of the house than is the newer mortgage. Perhaps it is not worth the trouble to assume the smaller, older mortgage, but is worth the trouble to assume the larger, newer mortgage. Like many explanations of prepayments, it sounds good but is far from proven. Rather than spend a lot of time trying to develop a sophisticated model of aggregate prepayment behavior, we try to look at the data which is freely available to all mortgage investors in an effort to answer two quest.ions:

UNDERSTANDING PREPAYMENTS The only significant reason discount mortgages are prepaid is that the ownership of the mort-

62

1

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FIGURE 1

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Is today's consensus expectation for prepayment likely to be revised upward or downward in the forseeable future?

To do this we look at the historical prepayment reports (provided by virtually every mortgage dealer), ask our friends and competitors for their opinion as to a reasonable prepayment assumption, and ask mortgage analysts what assumptions they are putting into their valuation models. It may not be a scientific approach, but it gets the job done. Most importantly, it does not inspire overconfidence. The answer to the two questions posed above suggests the environment in which mortgage se-

curities will be valued. The four possible combinations are shown in Table l. The most favorable environment for our discount mortgage securities is when the actual prepayments are greater than expected, and the trend of prepayment is increasing. An example of such a period is the fall of 1981 through the summer of 1982. Over this period, GNMA 8s generated a total return of alm:ost 31 percent, which was 7 percent greater than the return of a comparable duration Treasury issue. The least favorable environment is one in which actual prepayments are less than expected and the trend is declining. Not surprisingly, such a period preceded the period of superior perfor-

TABLE 1. The mortgage cycle (prepayment expectations)

Actual> expected Increasing

Actual < expected

Favorable

Prepayment trend Decreasing

Unfavorable

63

mance just cited. From 1979 through 1981, GNMA 8s underperformed comparable duration Treasuries by almost 6 percent. Even the most casual observer should recall the nature of the economic, interest rate, and housing cycle which characterized these two distinct periods.

TABLE 2.

(GNMA 9 percent-25 years to maturity-price $75)

Constant prepayment rate 0% 2 4 6

PREPAYMENTS AND BOND VALUATION How are prepayments integrated into the bond valuation model? The most popular method is what I will call a "fixed prepayment" yield and duration modeL (I choose to ignore the "yield to average life" approach which is completely without merit.) For example, to calculate the yield of a GNMA 9 percent with 25 years until final maturity, if there are no prepayments, the cash flow is easily determined. Equating this cash flow with the price of the GNMA 9 percent, the internal rate of return or yield can be calculated. This yield is comparable to the yield to maturity of any other type of bond (given common compounding intervals). Prepayments are introduced by assuming a particular pattern of prepayments and recalculating the cash flows of the mortgage given this assumed future prepayment pattern. Once the assumed cash flows are in hand, the calculation of a yield and duration is straightforward. The "fixed prepayment" pattern assumption which is easiest to understand is a constant percentage prepayment rate. For example, a reasonable prepayment assumption for GNMA 9 percent might be two percent per year. This says that, in addition to scheduled principal payments, two percent of the outstanding principal will be prepaid each year. This assumption does not affect the final maturity of the security, but rather increases the percent of principal returned in the near future relative to an assumption of no prepayments. For a discount mortgage, the higher the constant prepayment assumption, the larger the percentage of principal returned in the near future, and, therefore, the higher the yield and shorter the duration of the security. See Table 2. At this point, for whatever prepayment assumption is deemed reasonable, we have a yield to maturity and a duration. It is popular to suggest that this is all that is needed to compare mortgages to traditional fixed income securities. This is not the case. A "reasonable" assumption for

Yield and duration as a function of prepayment

'I-

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Durah"on

13.11% 13.71 14.33

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14.99

4.6

5.2

Semi-annual compounding.

prepayments will vary over time. Worse yet, prepayment assumptions vary with fluctuations in interest rates. As rates rise, prepayments tend to slow, and conversely. The shortcoming of the "fixed prepayment" model should now be apparent. Both the yield and duration calculations depend on the assumed cash flow pattern which in turn depends on the prepayment assumption. As rates change, prepayment expectations change, cash flow patterns change, and durations change. Rising rates suggests slower prepayments which implies a longer duration; just as falling rates imply shorter durations. In general, the price performance of discount mortgages will be significantly worse than predicted by the "fixed prepayment" modeL This will be demonstrated below. A more reasonable valuation approach could follow the lines of a horizon or total return analysis. The total return from any security is given by the cash flow received and the change in price which occurs during the return period. The cash flow for a mortgage security is the sum of interest received, scheduled principal payments, and prepayments. A price change will result from: • • •

a change in the general level of interest rates, a change in prepayment expectations, and a residual which is generally called a change in yield spread.

Holding yield spread constant, a total return analysis would try to relate an interest rate forecast to the prepayment assumption. For example, consider a rate forecast which calls for rates to be up 200 basis points, unchanged, and down 200 basis points with equal probability. Also, suppose current prepayments on a GNMA 9 percent are running at two percent per year and are expected to remain at that level if rates are un-

TABLE 3.

Total return analysis-{lfie year period (GNMA 9 percent25 years to maturity-price $75.00---2 percent prepayment assumption)

Cash flow retum: Income Scheduled principal Prepayment Amortization of discount Total

12.7% 0.3

0.7 0.5 14.2%

Interest rate change Change in principal value: At 2 % prepay rate Prepay rate adjustment Total

+200 b.p. (10.2)%

-200 b.p. 12.2%

~

2.1

(14.5)%

14.3%

Average' 0.7% (0.7) 0.0%

• +200, -200, and unchanged rates with equal probability.

changed. Finally, suppose that a 200 basis point increase in rates will cause prepayments to stop and that a 200 basis point decline will cause prepayments to rise to 4 percent. (See Table 3.) The cash flow return portion of Table 3 gives the total return assuming no change in the general level of interest rates and the 2 percent prepayment assumption. Notice that the $25 gain on principal payments contributes 1 percent to the 14.2 percent return, with 70 percent of this due to assumed prepayments. The change in principal value portion of Table 3 shows the impact of interest rate changes and total return. This principal change has been broken into two components to highlight the interrelationship of prepayment and interest rate changes. The first line shows principal changes if rates change and the two percent prepay assumption does not change. This is analogous to the principal change which would occur with a coupon bond. The second line adjusts this principal change for a decline in prepayments when rates rise and an increase in prepayments when rates fall. This adjustment is asymmetric and unfavorable. The reason for this is as prepayments accelerate, the duration of the mortgage declines, and the benefit of the decline in interest rates is muted. Conversely, as rates rise, the duration exposure increases. Given the assumed weightings on the interest rate scenarios, this effect lowers the total return by 70 basis points. The advantage of integrating an interest forecast with a prepayment outlook when evaluating discount passthroughs should be obvious. Equally obvious should be the fact that discount

passthroughs always "look cheap" on a yield and duration basis; "looks" can be deceiving.

SUMMARY The principal difference between discount mortgages and other types of securities is prepayment. The factors which determine the rate of prepayments have been highlighted; a framework for thinking about the impact of prepayments on mortgage returns has been suggested; and a method of making total return comparisons with other types of issues has been demonstrated. Given all this work, it is tempting to conclude that discount mortgages are just as good as any other discount bond. However, I do not think this is the case. The analysis of mortgage securities requires an additional layer of assumption that is not required to value other bonds; we must forecast the time pattern of principal payments. It has been acknowledged that a "reasonable expectation" for prepayments will vary over time for known but unpredictable reasons. This is a manageable risk. But a "reasonable expectation" may also vary for unknown reasons. By definition, this type of risk cannot be managed. I cannot overemphasize how little we know about why historic prepayment patterns look the way they do. Further, we know even less about how past history is likely to perform as a predictor of future prepayment experience. An investor in mortgage securities must make sure that the potential returns from discount mortgage securities ade-

65

quately compensate for the significant incremental risks which are being taken. One final note. There is a class of discount mortgage-backed securities for which prepayment is not a factor; these are project loans. Typically issued to finance low or moderate income rental housing, hospitals, nursing homes, and so forth, the probability of prepayment on these mortgages is very low. As a result, the cash flows are quite predictable, and the yields calculated

66

assuming no prepayments can be compared meaningfully to the yields on other types of securities. In spite of this, and the guarantees of GNMA, FHA, or HEW, these issues trade at yields greater than AA rated corporates. Perhaps this is a case of throwing out the baby with the bathwater, but more likely, it is an opportunity for those fixed income investors willing to take a look.

Views from Washington (I) J.

Donald Klink

Learning a new language is certainly something those in the mortgage business have had to do over the last two or three years, because it is a brand-new ball game. The secondary mortgage market has been around for a number of years, but never to the degree and level of sophistication that we know today. I will begin with a historical overview. This provides a frame of reference as to where the market has been, how it got to where it is today, and the dramatic changes that have taken place in the last couple of years.

HISTORICAL OVERVIEW One would have to say that the secondary mortgage market goes back to sometime in the thirties, when FHA came into being. Fannie Mae came into being in 1938 primarily to be a buyer, to provide a secondary market for the newly created FHA mortgage. And indeed, that has been Fannie Mae's primary role throughout its history. Today, Fannie Mae is the largest holder of mortgages in the world, with a portfolio of about $80 billion. The Fifties Through the fifties there was a secondary market consisting mostly of correspondent relationships. Insurance companies were basically the secondary market. The mortgage banking industry was springing up and developing, particularly in the capital short- and high-growth areas like California and Texas, creating mortgages and selling them to life insurance companies who were very active at that time in buying pools of whole mortgages. It worked well, but it was very inefficient, because each mortgage consisted of a voluminous package and it was necessary to go through all the forms and documents and underwriting and so on. When we look at it now, it seems archaic. Relatively little of that activity goes on today, but nonetheless that is really what got it started. The Sixties In the sixties, the savings and loan associations (S&Ls) became much more active players in the secondary market, largely through selling partici-

pation interests in pools of their mortgages to other S&Ls. This was somewhat more efficient than selling the whole loans, and a very effective way of moving mortgage capital around the country from capital surplus areas to capital deficit areas. Billions and billions of dollars changed hands that way. An investor just bought a participation interest of a pool of mortgages and did not have to deal with all the individual ones. The Seventies In the seventies came the granddaddy of them all, Ginnie Mae. We must give Ginnie Mae the appropriate credit for creating what is now the modem secondary market with the advent of the mortgage-backed security. That is certainly what it is all about today. Probably 90 percent or more of all the FHA/VA mortgages that are originated today are sold through a Ginnie Mae security. There have been periods recently when as many as 50 percent of all the conventional loans originated (the conventional 30-year fixed-rate loans) were sold through that mechanism. That is a dramatic change. For conventional loans, that probably would have been something like 20 percent as recently as 3 years ago. Therefore, we've gone from 20 percent to 50 percent of the mortgages sold in the secondary market in the form of securities-a major change by any measure. The Eighties The eighties have been tumultuous times in the financial markets, but there have also been a lot of opportunities and excitement. Deregulation of the financial institutions has probably been the major stimulant. The S&L's, as a group, typically provided about 70 percent of all the mortgage capital that was needed year-to-year, but they are moving away from that now that they have broader lending powers. Now that they have to pay market rates to all the depositors at their savings windows, the mortgage borrower is no longer subsidized. When you and 1 have to get a mortgage to buy a house, we have to compete with General Motors and everyone else who raises funds in the capital markets. Certainly, putting mortgages in a securities form is by far

67

the most efficient and best understood way of getting that mortgage capital from Wall Street to the borrower.

PLAYERS IN THE MORTGAGE SECURITIES BUSINESS The major players in the mortgage securities business are: the Federal National Mortgage Association (Fannie Mae); the Government National Mortgage Association (Ginnie Mae); and the Federal Home Loan Mortgage Corporation (Freddie Mac), which also started in this business about the same time as Ginnie Mae. We would like to think that even though Fannie Mae is the new kid on the block, not having gotten into the mortgage securities business until October 1981, that we have made a pretty big impact. In the 3 years that we have been in that business we have issued $32 billion of mortgage-backed securities. We think that is a pretty fast start-up rate, and we are quite pleased to have been able to participate in this most recent evolution. You hear about the other players from time to time. They are: RFC, based in Minnesota, which is a mortgage banking company, but also issues its own mortgage-backed securities; FCA, (Financial Corporation of America), which has recently created a mortgage securities subsidiary; Sears Mortgage Company; and "Maggie Mae," which is a subsidiary of MGIC. There are others. There are a lot of players in this game. Up to this point, I think it is fair to say that the market has been pretty well dominated by Fannie Mae, Freddie Mac, and Ginnie Mae; but that is changing. Both Fannie Mae and Freddie Mac are limited as to the loan amounts that they can deal in by law. Currently it's $114,000. So mortgages that are originated above that amount cannot go into a Fannie Mae or a Freddie Mac mortgage-backed security, or, for that matter, be sold to either one for its portfolio. So, that is where some of these others come into play.

THE PRESENT ENVIRONMENT Where are we now? As I mentioned, something like 90 percent of the FHA/VAs go into the Ginnie Mae securities, and 50 percent of the conventionals go into the other securities. We are dealing with a level of sophistication that is unheard of. With the advent of mortgage-

68

backed securities, we have to deal now with things like payment delays, and the effect that has on yield. Let me give an example of that, and what a big effect it can have. When Fannie Mae designed its mortgage-backed security, it had the benefit of both Ginnie Mae's and Freddie Mac's experience. We decided that we would try to update our security as much as we could. We used Ginnie Mae as the basic model, but changed a few features, one of them being the payment delay: that is, that time span from the point that the borrower's payment is due, u~til the mortgage-backed security investors receIve funds. That time span or payment delay varies among the different mortgage-backed securities. In the Ginnie Mae security it is 45 days, in the Fannie Mae mortgage-backed security it is 55 days, and in the Freddie Mac it is 75 days. As a result of these differences in payment delay, the market price for the Fannie Mae is one-halfpoint higher than the Freddie Mac, purely because of that 20-day difference in the timing of the receipt of the payment by the investor. There are other kinds of sophistication that market participants have had to learn, really only in the last few years. Investors have had to learn new terms such as "WAC s" and "WAMs. " WAM is the "weighted average maturity" of the mortgages in a pool, and WAC is the "weighted average coupon" of the same mortgages. It has been suggested that it would be very useful in the trading of these securities if investors had an updated WAM on each pool. That is something that we are working on at Fannie Mae, and once our computer technology is in place to make that happen, which is a few months away, we intend to publish the weighted average maturity of each of our pools every single month. Now it is only available at the time the security is originated. Until recently the mortgage-backed securities market has dealt almost exclusively in the 30year fixed-rate mortgage. However, investors should be aware of the fact that there are mortgage securities out there that do contain other kinds of mortgages, such as Graduated Payment Mortgages (GPMs). About $14 billion or so of the Ginnie Mae securities are backed by GPMs. There are outstanding mortgage securities-at least some Fannie Maes-that have IS-year fully amortized mortgages. There are Ginnie Maes backed by mobile home loans that have a shorter initial maturity. Also, there are mortgage-backed

securities which are backed by Growing Equity Mortgages (GEMs). With GEMs, the borrower's monthly payment increases each month with the additional amount going to principal, which has the effect, of course, of shortening the amortization.

Adjustable Rate Mortgages Recently, Fannie Mae has had the opportunity to experiment with the latest and greatest mortgage, the adjustable rate mortgage (ARM). In the mid-70s, the California state-chartered savings and loans were permitted by their regulatory agency to issue what was then called the variable rate mortgage, now commonly called the California VRM. Many billions of dollars of those mortgages were originated. Some of those thrifts who issued them and held them in their portfolio, have recently, in the last year and a half or so, been exchanging them for mortgage securities and either putting those securities on the market or using the securities as collateral for various types of borrowing. Fannie Mae has issued about $3 billion of that type of mortgage-backed security. By doing so it has given Fannie Mae some experience in how to deal with creating mortgage-backed securities that are backed by mortgages that have changing interest rates. And indeed it does present some interesting challenges. Creating a security for those kinds of mortgages has some pretty unique problems and the staff at Fannie Mae is spending a lot of its time right now dealing with those, not the least of which is the federal income tax treatment. That is, how much of the money that the investor receives should be divided between interest and principal for income tax purposes. With mortgages that have negative amortization-where unpaid interest is added to the principal balance, and then it reduces, and so on-it gets extremely complicated. In any event, we feel that we are right at the leading edge in the development of the adjustable rate mortgage-backed security. Quite frankly, we have not introduced it before now, because we love those kinds of mortgages for our own portfolio. That has been another means of helping Fannie Mae in matching its balance sheet a little bit better by acquiring those more interest-sensitive assets. ARMs now account for about 12 percent of our portfolio and have been

very instrumental in producing a profit for Fannie Mae last year for the first time in three years. There are, however, a lot of concerns about ARMs. One can hardly pick up the paper anymore without reading about some of them. These concerns are primarily aimed at the underwriting issues offering the so-called "teaser rate." For example, a one-year ARM today would probably bear-without any kind of teaser-an interest rate of 12l1z percent or more. But by reducing the first-year rate to as low as 7% percent, and we've heard of even worse cases than that, the lender is really putting the borrower in a pretty vulnerable position when the borrower has to go from that "teaser" interest rate to whatever the market might be at the first adjustment. There are various ways of dealing with that such as limiting the amount of changes from year to year, and so on. It is some of those concerns, however, and the fact that there has not been a lot of standardization of this product, which is the primary reason investors have not yet seen a mortgage-backed security for ARMs. But it is around the corner and Ginnie Mae has announced that it is developing one.

FUTURE SOURCE OF CAPITAL The basic question confronting those of us who are in the business of trying to provide mortgage capital to borrowers is: In the future, where is mortgage capital going to come from? I mentioned earlier that thrifts used to provide 70 percent of it. Fannie Mae certainly has always provided a big share of it, and, in fact, in 1982 provided 22 percent of all the mortgage capital by purchasing 22 percent of all the mortgages originated in the country. But a more typical figure for Fannie Mae would be in the 7 percent to 10 percent range. That is all changing dramatically. We are seeing mortgages first transformed into a mortgagebacked security form, and now we're beginning to see the next stages. CMOs are certainly a good use of these mortgage-backed securities. In that case, the mortgage-backed securities end up being the collateral for CMOs, which are debt offerings, or at least that seems the direction that they are going. There are some controversies surrounding CMOs, however. Builder bonds. Builders have found a clever way to make the tax laws work for them by taking back the mortgages on the houses they sell.

69

They keep the mortgages in their own name, package them into a security, and then use the security to back a bond known as a builder bond. That allows them to get installment sales treatment on those houses because, in effect, they are providing the buyer with financing. They are merely using the mortgages as a means of raising the capital that they need to hold those mortgages. It is an interesting technique, and it has been very actively sold. Pension funds. Of course all of us are looking at the various places where investors might find interest in mortgages. Pension funds are clearly one of those places. The level of investment in mortgaged-backed securities on the part of pension funds today is relatively small; it is greater in the public funds than in the private funds, but there has been growing interest. The State of California Employees' Retirement Fund is the largest single holder of Fannie Mae securities, as I believe, they are of Ginnie Maes. So we hope to see continued interest there. Foreign markets. There is both interesting and exciting potential in foreign markets. The activity in foreign markets that has gone on to date has almost entirely been in Ginnie Maes; however, there have been a few other sales or borrowings backed by mortgage securities in the foreign markets. Ginnie Maes are being listed in a couple of the foreign exchanges. That permits investment on the part of several types of institutions abroad. Retail market. This may be one of the most exciting potential markets of all. After all, everyone wants to get high yields. As I mentioned

70

earlier, certainly the thrifts are all competing with each other at the savings window for those funds. The advent of IRA/s has brought about a renewed interest--or, more appropriately, a brandnew interest in the mortgage vehicle for investment. There has been a lot of activity in selling mortgages in unit trusts. Between $10 billion and $20 billion dollars of mortgage-backed securities have been sold at the retail level in s~all pieces, some in as small as $1/000 denominations, through the unit trusts. Most of those unit trusts have been backed by Ginnie Maes; however, there are a few out there now with Fannie Maes and Freddie Macs. Fannie Mae announced recently that it is going to be participating in a test with several lenders around the country in the marketing of Fannie Mae mortgage-backed securities in denominations as small as $1/000. This suggestion was made to Fannie Mae by several lenders over the past several months. We began to take a look at it and decided it was worth a try. There are many questions to be answered, probably more by those marketing the securities than by Fannie Mae. Probably there will be about five financial institutions participating in the test. We are not sure at this point how long the test period will go on, but no doubt for several months. If the test is successful, if indeed there is a market, if it is cost-effective, and if people really do express an interest in making this type of investment, Fannie Mae securities will then be made available across the board in $1/000 denominations. All we can do at this point is to just sit back and watch and see.

Yates/Klink Question and Answer Session QUESTION: Other than due-on-sale provisions, why does prepayment experience vary so widely between similar coupon Ginnie Maes, Fannie Maes, and Freddie Macs? KLINK: There are still many of those questions unanswered. Certainly, the due-on-sale provision would be the primary one, that is, where the loan is due when the borrower sells his property. It probably also has to do with geographic characteristics: loans tend to prepay faster in some parts of the country than others-particularly where there are more people moving around, or people moving in and out. Alaska is a good example. I think they have one of the fastest prepayment experiences of any state in the country. Of course, it also has to do largely with the relative interest rates on the loans in the pool versus what interest rates are currently. When rates came down in 1983, we saw prepayment experiences of some of our 16 percent and 17 percent pools go to 2,000 percent FHA, which is 200 times what you would ordinarily have expected for an FHA pool. So, there is a combination of factors. Occasionally, we will see one of our pools either going much slower or much faster than others. We do try to see if there is anything unique about that pool, or if there is something perhaps in the reporting that is erroneous. We have not really found anything aside from the factors I have mentioned. Of course, there are a lot of people on Wall Street who are frequently referred to as "speed freaks" or "rocket scientists." They make their whole career out of trying to find out why one pool pays faster than the other-more houses on the sunny side of the street or whatever. I've not heard any theories other than the ones that I've mentioned. I might point out that in the Fannie Mae securities, if more than 25 percent of the loans in the pool are in anyone state, we do publish that fact and indicate what state it is. But otherwise investors can assume that they are more broadly distributed. YATES: One of the concerns that we have always had at Ginnie Mae about fractionizing the mar-

76

ketplace is the geographical distribution of any of the pools, and for that reason we have never published them. As a matter of fact, we don't even track them. One of the documents that we receive does contain the geographical composition of the pool, and through the Freedom of Information Act we have had some people ask to access that. But then when they realize the actual work that is involved in digging that out of our microfilm records, they generally give it up. QUESTION: What is the outlook for builder bonds, and what is the outlook for the installment method of accounting? KLINK: There are many questions today as to whether the installment-sales rule will be permitted to continue. My understanding is that there have been several forces at work that would suggest that when Congress looks at that issue, they should look at all uses of installment sales (Le., General Motors via GMAC and others) and not just look at its use in the builder bonds related to housing. So, beyond that, I don't think I have any prediction. As for purchase accounting, I'd have to refer to someone from the accounting profession. It is controversial. It does apply almost uniquely to the thrifts, at least in the context of mortgages. It has been used very widely to date. There are still many thrifts which have been involved in mergers and have not yet taken advantage of it, but there are large pools of mortgages that could be put on the market and, through that vehicle, defer or amortize their losses over a long period by charges against goodwill. Not being an accountant, I don't know that I can add much more to that. QUESTION: Mr. Yates, why has the Ginnie Mae II program gotten off to such a slow start? YATES: Well, as certainly the majority of you know, there is a price differential between Ginnie Mae I and Ginnie Mae II. It is like many other things in life: If you ask 10 dealers tomorrow

what it is, you'll get 10 different answers. I don't know why the marketplace perceives it that way. You have to put a certain value on the additional 5 days of payment, and Ginnie Mae I payment is by the 15th and Ginnie Mae II is by the 20th. Certainly, the marketplace puts a certain value on that. We think that the other features, such as a central paying agent-and that's of extreme importance to many institutions-and the multipleissuer concept make the Ginnie Mae II ultimately a better product. But until the marketplace perceives it that way, it's just my personal opinion that the slower start is going to stay in first gear. What brings it about? I don't know. We have the opportunity for Ginnie Mae I holders to convert free of any type of charges, or nominal charges, to Ginnie Mae II. Certainly a large-scale conversion would produce the liquidity I think the Ginnie Mae II needs. Unfortunately, there are several high-powered legal opinions that say the entire Ginnie Mae I pool must convert. That is a hurdle in my judgment that hasn't been surmounted yet. QUESTION: Mr. Klink, you mentioned that some major brokers may be participants in your retail offerings of small mortgage participations. If they don't participate, how would an investor buy them, and how would you expect rates on these to compare with larger issues? KLINK: Well, as I mentioned, many of the Wall Street houses that have large retail operations have, for some time, been very active. I'm told

of one that claims to have at least $8 billion outstanding in unit trusts. So these $1,000 denominations have been available through those retail outlets. At least in the early part of the test period we are entering, there probably will not be any Wall Street firms involved. However, once we have passed the test stage, and it is available across the board, anyone who owns one of our securities can come to us and have it earmarked, so to speak, to be distributed in $1,000 denominations. Therefore, any broker on the Street would be able to offer it. But the way it is going to be marketed initially will be through lenders, primarily thrift institutions, who were the ones who came to us initially and expressed an interest. They want it as an additional product to offer to their traditional savings customers. QUESTION: How effectively does Fannie Mae police the enforcement of due-on-sale clauses? KLINK: If we don't do anything else at Fannie Mae, we do certainly police that. We have made quite an issue of that from the very first days of our mortgage-backed securities. We absolutely require that the servieers of our pools enforce due-on-sale wherever and whenever it is legally enforceable. There is still a little carryover of the Wellencamp decision in a few places, and some federal legislation. But that has a phaseout period, and we monitor this very carefully. We have teams of people around the country constantly reviewing the lender's servicing performance, and that's probably the first thing they look at when they go in.

77

Views from Washington (II) Paul A. Yates THE GOVERNMENT NATIONAL MORTGAGE ASSOCIATION The Government National Mortgage Association or "Ginnie Mae" is a wholly owned corporation of the United States government, located within the Department of Housing and Urban Development (HUD). It was created by Congress in 1968. The president is a presidential appointee who reports to the Secretary of HUD. Its role as a federal corporation is to support the government's housing objectives by establishing secondary market facilities for residential mortgages, primarily using private capital, to the extent possible. Through the mortgage-backed securities program, we hope to increase the overall supply of mortgage credit available for housing by providing a vehicle that will channel funds from the securities markets into the mortgage market. Everybody knows that, but what may not be known is that Ginnie Mae has a total staff of 54 people. That's it! And about 32 of those are involved in mortgage-backed securities. The rest work in other support functions and in our president's office. From the fees and revenues produced by the fees, Ginnie Mae is totally self-supporting and does not cost the taxpayers one nickel. We issued our first pool on February 19, 1970. In our 14 years of existence we have generated a $650 million surplus. Now that is hard money. It is not funny bookkeeping by the government or by anybody else. A fee is charged for everything done. Losses from fraud and other types of exposures have been less than $15 million in the history of the program. It was not really designed to be that "profitable," however, the popularity of the program has produced this tremendous excess of revenues over our costs. We now believe, as many people at the Office of Management and Budget do, that this surplus is a minimal reserve for the government's contingent liability. There has been a great deal of talk in the newspapers and other parts of the media about Ginnie Mae disappearing someday. I have been there through several administrations, and it is my own personal belief, and I know that I'm talk-

ing for other people at Ginnie Mae when I say this, that we do not think Ginnie Mae is going to disappear as long as there is a FHA and a V A. Our job is to be a catalyst, a surety, a guarantorhowever you want to think of us-for the government mortgage loan market. The FNMA and FHLMC and a lot of other places do a wonderful job in those mortgage markets that are nongovernment. That is appropriate. But where the government mortgage loan market is concerned, GNMA will continue to be a dominant force for some time. The 1985 federal budget, as a matter of fact, has the Ginnie Mae commitment authority at a level of $64 billion, equivalent to our 1983 capacity. That gives Ginnie Mae ample opportunity to provide the same vehicle that we have had for 14 years. There is little credit risk to the holders of Ginnie Mae mortgage-backed securities. The Ginnie Mae guarantee carries the full faith and credit of the United States. These securities have enjoyed an active and well-established secondary market for some time, with over $16'0 billion outstanding at the end of 1983, and over $190 billion actually traded or re-registered during the year. Ginnie Maes are probably the most widely held and traded mortgage-backed securities il} the world. We are anticipating that for fiscal 1984 Ginnie Mae will issue about $35 billion. The commitment authority for this year is running at an annualized rate of around $42 to $43 billion. The spread between the commitment issuances and the actual issuances of securities has narrowed considerably over the last several years. Although this is due to many factors, the increase in fees last year on the commitment authority had a great deal to do with it.

OVERVIEW OF THE GINNIE MAE MORTGAGE-BACKED SECURITIES PROGRAM Ginnie Mae securities are traded within the United States in the over-the-counter market, as most government guaranteed securities are. There has been more and more activity on the Luxem-

71

bourg Stock Exchange and the stock exchange of Singapore, in which certain Ginnie Mae issues have been listed over the last several years, due primarily to institutional interests in those areas of the world. Figure 1 illustrates the mortgage-backed securities program and how it works. When a family buys a home, they contact a lender or an issuer, as we refer to them. A contract is made. The issuer comes to us to receive the commitment authority, issues a pool-which we do through the Chemical Bank in New York, our primary transfer agent and central paying agent--and delivery is made, usually through a securities dealer, most frequently in the forward-delivery market.

our volume is way down in terms of last year. But yet, we are projecting that we will issue, as I indicated earlier, somewhere in the range of $35 billion, and that of course will be the second record in our history. Last week Ginnie Mae passed $206 billion in total issuances. The outstanding balances, which of course represent what is available for trading, are approximately $174 billion. Figure 2 shows the impressive growth in cumulative issues from our birth through 1983. It is interesting to look at Ginnie Mae securities issued in relation to the FHA and VA singlefamily loans that have been finally endorsed. In 1982 and again in 1983, we actually represented 100 percent of the FHA/VA market-more than 100 percent if you want to look at it as they count them. In 1983 FHA/VA issued $36 billion. We issued $50 billion. It's the way the numbers are put together. Figure 3 tracks where they are. With the usage of nominee names, of course, we feel that those Ginnie Maes owned by major institutional-

Historical Growth of the Program Prior to 1983, our biggest year in terms of issuances of securities was 1979, in which we issued $25 billion. Last year was a record for us, as it was for many, many other people. We are a little downhearted at Ginnie Mae today because FIGURE 1

How the "GNMA II mortgage-backed securities program" works MORTGAGES MADE AND SECURITIES ISSUED

FAMILY BUYS HOME

IIlt'tl

FHAlVAJ FmHA

Monthly mortgage payments

Insures mortgages

Makes mortgage loan to buy home

LENDER SECURITIES ISSUER Custom Pools

,..-------t: Holds documents

GNMA

Multiple Issuer

I

Reporting

72

Guarantees timely payments on securities

Pass-through ACH transfers of monthly of monthly,..;;--------.., payment I- payments

CENTRAL PAYING AND TRANSFER AGENT

INVESTOR

1.--------..1 Ownership transfers

Pools Marketing

CUSTODIAN OF MORTGAGE DOCUMENTS

INVESTORS PURCHASE GUARANTEED SECURITIES

CUSTODIAN ACCOUNTS FOR P&I, T&I

SECURITIES DEALER

Markets and trades securities

I

FIGURE 2

GNMA securities issued (cumulative issues 1970-1983)

$ Millions 180,000

160,000

140,000

120,000

100,000

80,000

60,000

40,000

20,000

1970

1971

1972

197319741975

19761977

1978

1979

19801981

1982

1983"

"Through July 31,1983

type investors in the country are represented a lot more than can be seen there in the specific pieces.

The Ginnie Mae II Program Ginnie Mae introduced a new program in July of last year, called Ginnie Mae II. It was a necessity to take advantage of many technological advances that have come about since we first opened for business in 1970. The primary features are a central paying agent and transfer agent, which is represented by the Chemical Bank in New York. The program otherwise works pretty much basically the same. We created a jumbo pool, or a multiple-issuer concept, which gives the distinct advantage of larger, geographically dispersed type pools. That type of approach should produce improved prepayment consistency. But I do not think any of us are at a point where

we have developed a good feeling about that yet. However, some organizations are concerned about the high prepayment history of some of the multiple-issuer pools. It is a little bit too early to tell. Through April 1984, we approved approximately 475 issuer organizations for this new program and issued roughly $4.2 billion in Ginnie Mae lIs. The present volume is about 20 percent in Ginnie Mae lIs. We hope that that will increase. We would like to find an easy way to make Ginnie Mae II the thrust of the future. In time I believe that the marketplace will recognize that it is, in the long run, a better product and, therefore, price it accordingly.

The Ginnie Mae II Futures Contract In addition, a new Ginnie Mae II futures contract was introduced on the Chicago Board of Trade

73

FIGURE 3

Percentage distribution of holdings of GNMA securities of type by holder (through November 30, 1983)

Pension and Retirement Funds 15.9%

I

\~ . .- - - - Nominees

15.8%

~

Other 5.3% ----------t~,

State and Local Government Funds 2.8% Insurance Companines 2.9%

~

1

Private Individuals 2.0%

in March of 1984. It has a much more clearly defined relationship than the old Ginnie Mae I CORso With these two contracts now, the CBT should respond to the needs of the mortgage market in a variety of cash market-type situations. There are several attractive features of a Ginnie Mae II contract. It specifies a direct delivery of Ginnie Maes at a rate much closer to current production. The price cap on the coupons that can be delivered is a distinct advantage. We think that it would discourage the delivery of high coupons that may possibly trade at large premiums. A delivery window that has been established, defining the coupons that are deliverable in satisfaction of the contracts, is a very distinct advantage. The upshot of all this should be a much more stable and liquid Ginnie Mae market, particularly Ginnie Mae II. A primary benefit for the organizations that participate in the program-S&Ls and commercial banks-is that they can produce a

74

~

1.-._--

Mortgage Bankers and Securities Dealers 11.2%

Commercial Banks 4.1%

Corporations 3.6%

fixed-rate mortgage and hold it in their portfolios without exposure, or certainly with lessened exposure, to interest rate risk. For the mortgage bankers, it certainly reduces the risk of their holding their own portfolio until they can be packaged or sold in the secondary market. The Recently Approved ARMs Program Ginnie Mae will have an adjustable rate mortgage (ARMs) program. The final regulations for FHA should be published about May 30th. The program should be up and ready about August 1, 1984, which means that we might be issuing our first securities about November 1, 1984. Of course, there should be some market activity several months prior to that. It is exciting to be in the forefront of the first standardized national securities program for ARMs. It is a very important tool to the home buyer and to mortgage lend-

ers. It should add a great deal of liquidity to the mortgage markets and hence to the lending institutions. The rate will be based on the Treasury's oneyear constant maturity weekly index and will be adjusted annually on four dates. There will be a one percent floor and ceiling on annual changes, with a maximum change of five points over the life of the loan. Maturities will generally be 30 years, with lesser maturities available, depending upon the demand that we see. There is no way of telling, of course, but rates are expected to start about 1Y2 percent below the current fixed rate. The marketplace will tell us how the one percent cap will be received and priced. But, on balance, it looks like a pretty good program. It is certainly one that will not place the home buyer

in jeopardy, and that is a deep concern that Ginnie Mae has. Many investors are looking for instruments that will protect them against the volatility of rates that has occurred in the past. Some of the distinct advantages for investors are a reduced interest rate risk and the mortgagebacked security of a Ginnie Mae, which in effect becomes a short term security. And, hopefully, we will have a very simple nationwide program with an attractive interest rate linked to a nationally recognized index, with greatly improved liquidity without a price-rate risk, and, of course, with the government guarantee. The home buyer is protected by a one percent ceiling on rate increases and a five percent ceiling over the life of the loan.

75

Yates/Klink Question and Answer Session QUESTION: Other than due-on-sale provisions, why does prepayment experience vary so widely between similar coupon Ginnie Maes, Fannie Maes, and Freddie Macs? KLINK: There are still many of those questions unanswered. Certainly, the due-on-sale provision would be the primary one, that is, where the loan is due when the borrower sells his property. It probably also has to do with geographic characteristics: loans tend to prepay faster in some parts of the country than others-particularly where there are more people moving around, or people moving in and out. Alaska is a good example. I think they have one of the fastest prepayment experiences of any state in the country. Of course, it also has to do largely with the relative interest rates on the loans in the pool versus what interest rates are currently. When rates came down in 1983, we saw prepayment experiences of some of our 16 percent and 17 percent pools go to 2,000 percent FHA, which is 200 times what you would ordinarily have expected for an FHA pool. So, there is a combination of factors. Occasionally, we will see one of our pools either going much slower or much faster than others. We do try to see if there is anything unique about that pool, or if there is something perhaps in the reporting that is erroneous. We have not really found anything aside from the factors I have mentioned. Of course, there are a lot of people on Wall Street who are frequently referred to as "speed freaks" or "rocket scientists." They make their whole career out of trying to find out why one pool pays faster than the other-more houses on the sunny side of the street or whatever. I've not heard any theories other than the ones that I've mentioned. I might point out that in the Fannie Mae securities, if more than 25 percent of the loans in the pool are in anyone state, we do publish that fact and indicate what state it is. But otherwise investors can assume that they are more broadly distributed. YATES: One of the concerns that we have always had at Ginnie Mae about fractionizing the mar-

76

ketplace is the geographical distribution of any of the pools, and for that reason we have never published them. As a matter of fact, we don't even track them. One of the documents that we receive does contain the geographical composition of the pool, and through the Freedom of Information Act we have had some people ask to access that. But then when they realize the actual work that is involved in digging that out of our microfilm records, they generally give it up. QUESTION: What is the outlook for builder bonds, and what is the outlook for the installment method of accounting? KLINK: There are many questions today as to whether the installment-sales rule will be permitted to continue. My understanding is that there have been several forces at work that would suggest that when Congress looks at that issue, they should look at all uses of installment sales (Le., General Motors via GMAC and others) and not just look at its use in the builder bonds related to housing. So, beyond that, I don't think I have any prediction. As for purchase accounting, I'd have to refer to someone from the accounting profession. It is controversial. It does apply almost uniquely to the thrifts, at least in the context of mortgages. It has been used very widely to date. There are still many thrifts which have been involved in mergers and have not yet taken advantage of it, but there are large pools of mortgages that could be put on the market and, through that vehicle, defer or amortize their losses over a long period by charges against goodwill. Not being an accountant, I don't know that I can add much more to that. QUESTION: Mr. Yates, why has the Ginnie Mae II program gotten off to such a slow start? YATES: Well, as certainly the majority of you know, there is a price differential between Ginnie Mae I and Ginnie Mae II. It is like many other things in life: If you ask 10 dealers tomorrow

what it is, you'll get 10 different answers. I don't know why the marketplace perceives it that way. You have to put a certain value on the additional 5 days of payment, and Ginnie Mae I payment is by the 15th and Ginnie Mae II is by the 20th. Certainly, the marketplace puts a certain value on that. We think that the other features, such as a central paying agent-and that's of extreme importance to many institutions-and the multipleissuer concept make the Ginnie Mae II ultimately a better product. But until the marketplace perceives it that way, it's just my personal opinion that the slower start is going to stay in first gear. What brings it about? I don't know. We have the opportunity for Ginnie Mae I holders to convert free of any type of charges, or nominal charges, to Ginnie Mae II. Certainly a large-scale conversion would produce the liquidity I think the Ginnie Mae II needs. Unfortunately, there are several high-powered legal opinions that say the entire Ginnie Mae I pool must convert. That is a hurdle in my judgment that hasn't been surmounted yet. QUESTION: Mr. Klink, you mentioned that some major brokers may be participants in your retail offerings of small mortgage participations. If they don't participate, how would an investor buy them, and how would you expect rates on these to compare with larger issues? KLINK: Well, as I mentioned, many of the Wall Street houses that have large retail operations have, for some time, been very active. I'm told

of one that claims to have at least $8 billion outstanding in unit trusts. So these $1,000 denominations have been available through those retail outlets. At least in the early part of the test period we are entering, there probably will not be any Wall Street firms involved. However, once we have passed the test stage, and it is available across the board, anyone who owns one of our securities can come to us and have it earmarked, so to speak, to be distributed in $1,000 denominations. Therefore, any broker on the Street would be able to offer it. But the way it is going to be marketed initially will be through lenders, primarily thrift institutions, who were the ones who came to us initially and expressed an interest. They want it as an additional product to offer to their traditional savings customers. QUESTION: How effectively does Fannie Mae police the enforcement of due-on-sale clauses? KLINK: If we don't do anything else at Fannie Mae, we do certainly police that. We have made quite an issue of that from the very first days of our mortgage-backed securities. We absolutely require that the servieers of our pools enforce due-on-sale wherever and whenever it is legally enforceable. There is still a little carryover of the Wellencamp decision in a few places, and some federal legislation. But that has a phaseout period, and we monitor this very carefully. We have teams of people around the country constantly reviewing the lender's servicing performance, and that's probably the first thing they look at when they go in.

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Glossary of Terms* Accretion: The process or effect of accumulating accrued coupon payments as additional principal. Average Life: The weighted average time to principal repayment. It is useful as an approximation of a single maturity where the mean or average maturity is used to describe the life of the instrument. (See "Duration" and "Half-Life.") Bond Value: The amount of bonds of a given structure that will be supported by a mortgage's scheduled cash flow, but the amount is limited to the unpaid mortgage balance. Breakeven Prepayment Rate: The prepayment rate which produces a required cash flow yield on a passthrough security. It can also refer to a cash flow yield that satisfies the required spread over treasuries of specified average life or duration. Cash Flow Bond: See Paythrough Bond. Cash Flow Yield: A monthly internal rate of return of an investment in a projected stream of monthly principal and interest payments. The yield will vary with the prepayment assumption that determines the cash flow pattern. Collateralized Mortgage Obligation: A type of mortgage-backed corporate bond (also known as CMOs, Fast-Pay/Slow-Pay Bonds, and Serialized Mortgage-Backed Securities), characterized by a multiclass (or multitranche) prioritization structure. Such issues are partitioned into several classes and are not redeemed until all bonds of an earlier priority have been redeemed. This creates a series of bonds of distinct expected maturities. Conditional Prepayment Rate (CPR): A measure of prepayments which assumes that each month a constant proportion of then outstanding mortgages will prepay. Corporate Bond Equivalent Yield: An upward adjustment to reflect monthly payment of interest rather than semiannual payment of interest which is the convention in the corporate and government bond markets.

• Prepared by Kenneth H. Sullivan, First Vice President and Manager of Mortgage Research and Product Development, Drexel Burnham Lambert Inc., for The Handbook of Mortgage-Backed Securities, edited by Frank J. Fabozzi (Probus Publishing, forthcoming 1985).

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Coupon Rate: The annual interest paid on a fixedincome instrument. Delay: This refers to the "stated" delay time elapsed to the first payment of principal and interest (GNMAs-45 days, FHLMC PCs--75 days, FNMA MBSs-54 days, conventional passthroughs--54 days). The "actual" delay, or penalty, is 30 days less than the "stated" delay. Due-on-Sale Clause: A clause in a loan agreement that requires the payment of the remaining loan balance upon a sale or other transfer of title of the underlying collateral, such as real estate. Duration: A measure of the sensitivity of an instrument's price to changes in yields. It is calculated by taking a weighted average of the time periods to receipt of the present value of the cash flows from an investment. (See "Average Life" and "Half Life.') Duration Variability: A measure of the extent to which the duration of a cash flow may vary from its expected value due to fluctuation in yields and/or prepayment rates. Factor: The outstanding principal balance in decimal form. The proportion of the original principal balance still outstanding. Fast-Pay Bonds: Bonds of a high priority class with respect to redemption priority over other bonds in an issue. As a result, they will be redeemed at a faster rate than others in the same issue. Federal Home Loan Mortgage Corporation: Also known as "FHLMC" and "Freddie Mac." FHLMC is a private corporation authorized by Congress, that sells participation certificates and collateralized mortgage obligations backed by pools of conventional mortgage loans. Federal Housing Administration: The FHA is a division of the Department of Housing and Urban Development, whose business includes insuring residential mortgage loans under a nationwide system. Federal National Mortgage Association: Also known as "FNMA" and "Fannie Mae." FNMA was created by Congress to support the secondary mortgage market. A private corporation, it buys and sells residential mortgages insured by FHA or guaranteed by VA. FNMA also issues mort-

gage-backed securities backed by conventional mortgages. FHA Experience: A statistical series, revised periodically, which represents the proportion of mortgages that "survive" a given number of years from their origination. FHLMC Participation Certificates: Securities backed by a pool of mortgages owned by FHLMC. Certificates ownership interests in the specific pool of mortgages.

Fully-Modified Passthrough: A passthrough for which the timely payment of principal and interest is guaranteed by the issuer. A GNMA is an example of a fully-modified passthrough. Government National Mortgage Corporation: Also known as "GNMA" and "Ginnie Mae." A wholly-owned U.S. government corporation. As part of the Department of Housing and Urban Development, GNMA issues and guarantees mortgage-backed securities which are backed by the full faith and credit of the United States government. Graduated Payment Mortgages (GPM): Mortgages which differ from conventional mortgages because not all payments are equaL There is a graduation period where payments start at a relatively low level and rise for some number of years. Grantor Trusts: Trusts whereby the grantor (certificate holder) retains control over the income or assets, or both, to such an extent that such grantor will be treated as the owner of the property (mortgage assets) and its income for tax purposes. The result is to make the income from a grantor trust taxable to the grantor, but not to the trust which receives it. Half-Life: The period until half of the original principal amount of the pool is repaid. (See "Duration" and"Average Life.") Midgets: GNMA passthrough security with an intermediate term (15 years). It is similar in structure to the original 30-year GNMA security. Mortgage-Backed Bond: A bond whose payments are secured by a set of mortgages. Mortgage Yield: An industry convention. An internal rate of return calculation based on a 12year life assumption (for most securities). Optional Redemption: An optional call provision reserved by the issuer which becomes exercisable after a certain number of years from issue date. This provision allows the "cleanup" of small

amounts of remaining principal with thin marketability. Overcollateralization: The extent to which the bond value of the assets or the cash flow produced by the assets (collateral) exceed the liability or the cash flow required to meet liability obligations. It is usually expressed as a percentage of par amount of the liability. (See Bond Value.) Pass-Back: A feature of a collateralized bond that provides that some fraction (possibly all) of the "excess" cash flow from collateral is passed to the issuer. (See Pass Forward, Bond Value, Overcollateralization.) Pass-Forward: A feature of a collateralized bond that provides that some portion (possibly all) of the "excess" cash flow from collateral is used to redeem outstanding bond principal. Excess cash flow is the proceeds from collateral beyond that required to maintain the over-collateralization ratio. Passthrough Security: A security which derives its cash flow from underlying mortgages where the issuer passes through to the investor the principal and interest payments made on the mortgages on a monthly basis. Pay-Through Bond (Cash Flow Bond): A debt obligation secured by a mortgage pooL They are fully amortizing instruments whose principal and interest payments closely track the cash flow of the collateral, in that scheduled amortization of the bonds is met by scheduled collateral cash flows, and mortgage prepayments accelerate redemption of bonds. Principal Balance: The actual balance of an obligation exclusive of accrued or unpaid interest. Prioritization: The ranking or ordering of security classes for sequence in which they are to be redeemed, such as in a multiclass bond issue. Seasoning: The aging of a mortgage. The amount of time that has elapsed since origination. Service Fee: The fee collected by the issuer of passthroughs or the originator of whole loans. Sinking Fund: The obligation to retire liabilities according to a schedule, which results in a substantial, partial redemption of the issue before final maturity. Slow-Pay Bonds: Bonds in a low priority class compared with bonds in other classes with respect to the order of redemption, which results in slow redemption when compared to the other classes.

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T.I.M.S.: (Prospective) "Trusts for Investment in Mortgages" are entities structured as nontaxpaying entities limited to active investing in residential mortgages and mortgage-backed securities and issuing multiple classes of ownership interests. They are prohibited from active business such as mortgage origination or servicing. Twelve- Year LIfe: The assumption that the cash flow associated with a mortgage will consist of level payments until the 12th year, when the remaining principal balance is paid in fun. Yield To Average Life: The yield to maturity of a bond with a maturity that is the same as the

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average life of a corresponding passthrough. Yield To Half Life: Yield to the point at which half of the original principal has been paid. Yield To Maturity: An internal rate of return calculation on a security held to maturity. Zero Coupon CMOs: CMO bonds that are either true zero coupon instruments or accrual bonds. An accrual bond (or compound interest bond) is a coupon bond that during some part of its life accumulates accrued interest as increased pri~cipal rather than as cash paid. This accumulation is called accretion.