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Chapter 8 Managing interest rate risk using loan sales and securitisation

Chapter outline
Loan sales
Types of loan sales contracts
Using a loan sale to manage interest rate risk
Why FIs sell loans
Factors encouraging loan sales growth in the future
Securitisation
Converting on-balance-sheet assets to a securitised asset
The pass-through security
Prepayment risk on pass-through securities
Prepayment models
The collateralised mortgage obligation (CMO)
The mortgage-backed bond (MBB) or covered bond
Can all assets be securitised?

Appendix 8A: Option related prepayment models (online at book website)

Appendix 8B: Mortgage pass-through strips (online at book website)

Learning objectives
8.1 Discover why FIs sell loans.
8.2 Learn about the types of loan sales contracts.
8.3 Understand how FIs use loan sales and securitisation to manage interest rate risk.
8.4 Learn which assets can be securitised and the types of assets most securitised by
Australian FIs.
8.5 Discover how an FI can change the risk characteristics of their balance sheets using
securitisation.
8.6 Be able to identify the different forms of securitisation available to FIs.
8.7 Understand prepayment risk and how this can be modelled.

Overview of chapter
This chapter introduces students to both loan sales and securitisation. The key focus is on the
types of loan sales and securitisation assets, and the techniques used to create them. The two
key loan sale contracts, participations and assignments, are discussed and compared, followed
by an example of how loan sales can be used to manage interest rate risk. The reasons why
FIs sell loans and the future potential for loan sale growth are also introduced.
Securitisation and the ways in which FIs can convert their on-balance-sheet assets to
securitised assets introduce the discussion of securitisation. Three types of securitised assets
are presented—pass-through securities, collateralised mortgage obligations and mortgage-
backed bonds (i.e. covered bonds). Prepayment risk is introduced as a key component of the
discussion of pass-through securities. More difficult material covering the mechanics of
securitisation strips and prepayment models is available for more rigorous courses in the two
appendices to the chapter (‘Option related prepayment models’ and ‘Mortgage pass-through
strips’). Newer types of securitisation are also discussed along with a discussion of the
complex CDO development and its role in the sub-prime crisis in the US in 2007.
Loan sales and securitisation are introduced in this chapter, and as the key risk area
covered in this chapter is interest rate risk, the chapter discusses how these instruments can be
used to manage IRR. As for derivative instruments in Chapter 7, in later chapters the benefit
of derivatives, loan sales and securitisation to other types of risk mitigation (in particular
credit—Chapters 10 and 11—and liquidity risks—Chapters 14 and 15) are discussed. As the
poor assessment of risk in securitisation programs was an underlying cause of the global
financial crisis (GFC), the GFC is mentioned often throughout the chapter, and there are a
number of Industry and Global Perspectives which also focus on the crisis and the role of
securitisation in particular.
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(c) McGraw-Hill Education (Australia) 2015
Chapter 8 Teaching Suggestions
Similar to Chapter 7, this chapter is dense as it contains the introduction to two important
concepts: loan sales and securitisation. Consequently, the chapter spends some time
describing the concepts and their markets in Australia. As the risk topic of discussion at this
stage of the book is interest rate risk (IRR), in each case the chapter discusses how loan sales
and securitisation can be used by FI managers to mitigate IRR. However, risks discussed later
in the book will refer students to loan sales and securitisation discussed in Chapter 8, and then
show how these products and techniques may be used to manage both credit risk and liquidity
risk.

Unlike the derivative instruments discussed in Chapter 7, loan sales and syndication, and
securitisation are less likely to have been covered by any other course in a finance program.
As such, the descriptive content of the chapter should be covered.

Before discussing the teaching suggestions, I propose that while all risks and risk
techniques are important, this chapter covers more challenging material (in particular the
securitisation material) which may best be left to more advanced courses.

If you choose to omit the material on securitisation, then you may choose to cover the
relatively simple but important concepts of loan sales and loan syndication. In this case, I
would suggest that you cover these topics with your lecture on credit risk—and also refer
students to the fact that such products can be used to manage both interest rate risk and
liquidity risk. The chapter is easily divided—and loan sales are discussed first and in
completion before securitisation is introduced.

If you decide to introduce securitisation, but not the technical aspects of securitisation, then
there is sufficient descriptive material on pass-through securities, covered bonds and CMOs to
produce an interesting lecture. I would strongly encourage at least this short coverage of
securitisation for a number of reasons, including:
1. Securitisation is an important part of any bank’s strategy—for liquidity, credit and IR
risk reasons.
2. The problem in assessing the risk of securitisation was an underlying cause of the
global financial crisis. I suspect if the traders and investors knew more about them, the
impact of such a critical event may have been lessened. So if we take our roles as
educators seriously, then we need to alert students to key risks of such products.
Hence, including at least a discussion of securitisation in the course will help such
understanding.
3. Securitisation is a key fund-raising mechanism for Australian DIs (especially the
smaller DIs) and the Australian government took measures following the GFC to
ensure that the market for Australian securitised assets did not fail completely.
4. Covered bonds are now available to be issued by Australian banks and are used for
liquidity and other regulatory purposes. Hence, they may become a more important
part of the bank risk management regime.

Another possibility in constructing your curriculum is that rather than link securitisation to
a particular risk, you could cover securitisation as a stand-alone topic (assuming that loan
sales are included in your discussion of credit risk, as mentioned above).

Loan sales:
This topic is very straightforward and relatively simple for students. It is also a good topic to
show students how banks can manipulate their products to assist in the management of
various risks. Students usually get this readily.

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(c) McGraw-Hill Education (Australia) 2015
 As the students by now should have a good idea of the size of the bank balance sheets, and
an understanding of the regulations (as well as prudential management decisions) which
restrict the proportion of lending to one particular entity, a nice way to commence the issue of
loan sales and loan syndication is to ask students how banks are able to lend to large
multinational companies (such as BHP-Billiton) which require very large loans. Lending to
such organisations could break all of the rules—both internal lending limits as well as
regulatory limits of lending.

The second part of this question is—how does a bank retain its good relationship with a
large multinational customer without breaking its internal and regulatory risk limits?

The ensuing discussion should lead to the options of selling part of the loan, all of the loan,
or sharing the loan—that is, loan sales and/or syndication.

You may also want to discuss why there is a small secondary loan market in Australia,
compared with other parts of the world, and why loan syndications are more usually the
option for Australian banks.

Having explored the different options and discussed loan sales more generally, you can
then turn to the use of management of interest rate risk, and more specifically how a loan sale
can change the duration of a bank’s asset portfolio—changing the elasticity of the asset
portfolio to interest rate movements.

Of course, in later lectures, you can refer back to Chapter 8 to discuss how loan sales can
assist in the management of both credit risk and liquidity risk.

Securitisation:
Securitisation to loan sales is like futures contracts are to forward contracts. Loan sales and
syndications are unique and related to one loan. Securitisation, on the other hand, packages a
number of loans together into a relatively generic security related product which can be easily
marketed.

The Australian securitisation market has been very large, and while issuance almost ground
to a halt during the GFC, it remains an important part of the DI’s armoury of products.

How you choose to cover this topic depends on how much time you devote to it. You could
leave much of the descriptive material to student reading, and then in lectures ask the
question:
• What is the difference between a pass-through security, a covered bond and a
collateralised mortgage obligation (CMO)?

The discussion could draw out the key features of each type of security, how they differ
and what they are likely to be used for. You may also at this stage extend the discussion to
assets other than mortgages and refer students to the examples in the book—if they don’t
already raise them in the discussion.

The process of securitisation—and the fact that the securitisation vehicle is removed from
the DI—is important in student understanding of how securitisation gets assets off the balance
sheet. Further, concepts such as prepayment and fully amortised are important to draw out in
the discussion. You may set an exercise for students so that they revise the cash flows
associated with fully amortised mortgages and what happens if there is a large prepayment to
assist in their understanding of these concepts.

From this point, you can go into a great deal more detail about prepayment risk and its
impact on the management of the securitisation program, liquidity issues, etc., but that
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(c) McGraw-Hill Education (Australia) 2015
depends on the extent to which the topic is covered in your lecture. If your course is advanced
and you need to examine securitisation in some detail, then please also refer to Appendices
8A and 8B—which cover some complex issues relating to the measurement of prepayment
risk and mortgage pass-through strips.

Like loan sales, securitisation enables DIs to change the duration of their asset portfolio,
and thereby the interest sensitivity of these portfolios. In addition, securitisation can assist in
the mitigation of credit risk and liquidity risk—and so their introduction here is useful to draw
on in the discussion of these other risks.

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(c) McGraw-Hill Education (Australia) 2015
Answers to end-of-chapter questions

Questions and problems

1 What is the difference between loans sold with recourse and loans sold without recourse
from the perspective of both sellers and buyers? LO 8.1

Loans sold without recourse means that the credit risk is transferred entirely to the buyer. In
the event the loan is defaulted, the buyer of the loan has no recourse to the seller for any
claims. Thus, the originator of the loan can take it off the balance sheet after selling the loan.
In the case of a sale with recourse, credit risk is still present for the originator because the
buyer could transfer ownership of the loan back to the originator. Thus, from the perspective
of the buyer, loans with recourse bear the least amount of credit risk.

2 What is the difference between loan participations and loan assignments? LO 8.1

In a loan participation, the buyer does not obtain total control over the loan. In an assignment,
all rights are transferred upon sale, thereby giving the buyer a direct claim on the borrower.
Monitoring incentives are higher under loan assignments as opposed to loan participations
because the buyer is the sole holder of the loan. Thus, there is no free-rider problem.
Monitoring costs are lower because the loan assignment buyer must only monitor the
borrower’s activities, while the loan participation buyer must monitor both the borrower and
the originating FI.
Risk exposure is greater under loan participations than under loan assignments because
participations have a ‘double risk’ exposure. The buyer of the loan participation is exposed to
the credit risk of the originating FI as well as the credit risk of the borrower.

3 A bank has made a three-year $10 million loan that pays annual interest of 8 per cent. The
principal is due at the end of the third year. LO 8.1, 8.2

(a) The bank is willing to sell this loan with recourse at an interest rate of 8.5 per cent. What
price should it receive for this loan?

If the bank sells with recourse, it should expect:

($0.80m) × PVA n=3, k=8.5 + ($10m) × PV n=3, k=8.5 = $9.8723 million

(b) The bank has the option to sell this loan without recourse at a discount rate of 8.75 per
cent. What price should it receive for this loan?

If the bank sells without recourse, it should expect:

($0.80m) × PVA n=3, k=8.75 + ($10m) × PV n=3, k=8.75 = $9.8093 million

(c) If the bank expects an 0.5 per cent probability of default on this loan, is it better to sell
this loan with or without recourse? It expects to receive no interest payments or principal
if the loan is defaulted.

If sold with recourse and the expected probability of default is taken into account, it should
expect to receive (0.995) × $9.8723 = $9.8229, which is still higher than selling it without
recourse. So, it should sell it with recourse.

(d) Explain how the sale of the loan with recourse will change the duration characteristics of
the balance sheet.

If the average duration of the bank’s asset prior to the sale is greater than three years, then the
sale of the loan will increase the duration. However, if the average duration of the bank’s
assets is less than three years, then the sale of the loan will lower the average duration of the
Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 5 of 15
(c) McGraw-Hill Education (Australia) 2015
assets remaining on the balance sheet. The only other situation would be if the average
duration of the bank’s assets prior to sale was equal to three years, in which case the sale of
the loan would have no impact on the average duration of the on-balance-sheet assets.

4 Why are yields higher on loan sales than on commercial paper issues with similar
maturity and issue size? LO 8.1, 8.3

Commercial paper issuers generally are blue chip corporations that have the best credit
ratings. Banks may sell the loans of less creditworthy borrowers, thereby raising required
yields. Indeed, since commercial paper issuers tend to be well-known companies,
information, monitoring and credit assessment costs are lower for commercial paper issues
than for loan sales. Moreover, since there is an active secondary market in commercial paper,
but not for loan sales, the commercial paper buyer takes on less liquidity risk than does the
buyer of a loan sale.

5 In addition to managing credit risk, what are some other reasons for the sale of loans by
FIs? LO 8.3

The reasons for an increase in loan sales, apart from hedging credit risk, include:

(a) Removing loans from the balance sheet by sale without recourse reduces the amount
of deposits necessary to fund the FI, which in turn decreases the amount of regulatory
reserve requirements that must be kept by the FI.

(b) Originating and selling loans is an important source of fee income for the FIs.

(c) One method to improve the capital to assets ratio for an FI is to reduce assets. This
approach often is less expensive than increasing the amount of capital.

(d) The sale of FI loans to improve the liquidity of the FIs has expanded the loan sale
market which has made the FI loans even more liquid, thus reducing FI liquidity even
further. Thus, by creating a market, the process of selling the loans has improved the
liquidity of the asset for which the market was initially developed.

(e) Finally, loan sales have been considered a substitute for securities underwriting.

6 An FI is planning the purchase of a $5 million loan to raise the existing average duration
of its assets from 3.5 years to 5 years. It currently has total assets worth $20 million, $5
million in cash (0 duration) and $15 million in loans. All the loans are fairly priced.
LO 8.2

(a) Assuming it uses the cash to purchase the loan, should it purchase the loan if its duration
is seven years?

The duration of the existing loan is:

0 + $15m/$20m(X) = 3.5 years  Existing loan duration = 4.667 years

If it purchases $5 million of loans with an average duration of 7 years, its portfolio duration
will increase to $5m/$20m(7) + $15m/$20m(4.667) = 5.25 years. In this case, the average
duration will be above 5 years (of its liabilities). The FI may be better off seeking another
loan with a slightly lower duration.

(b) What asset duration loans should it purchase in order to raise its average duration to five
years?

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 6 of 15
(c) McGraw-Hill Education (Australia) 2015
The FI should seek to purchase a loan of the following duration:
$5m/$20m(X) + $15m/$20m(4.667 years) = 5 years  X = duration = 6 years.

7 In addition to assisting in the management of interest rate risk, what are four factors that
are expected to encourage loan sales in the future? Discuss the impact of each factor.
LO 8.3

The reasons for an increase in loan sales, apart from hedging credit risk, include:
• New capital requirements for credit risk, which suggests a further need for FIs to reduce
their risky portfolios and replace them with lower risk assets. This suggests increased loan
sales activity.
• The trend towards market value accounting makes it easier to trade different categories of
loans.
• Loan sales as trading instruments, which makes it attractive for commercial banks and
investment banks to specialise in specific loan categories and to market them effectively,
since they require only brokerage functions as opposed to performing asset
transformations.
• Loan sales allow an FI to remove credit risk from their balance sheet as long as the loans
are sold without recourse.
• The ability to allocate loan credit ratings should cause more investors to enter the market.
• The growth of distressed loans in international markets should provide opportunities for
domestic investors to enter this market at substantially reduced prices.

8 Outline the costs and benefits of securitising car loans. LO 8.4

The costs of securitising car loans are:

• Features of car loans are not standardised and are therefore difficult to pool into
securities.
• Since each car loan is typically small in face value, many loans must be pooled to
construct securities of any substantial face value.
• Since each security pool will be composed of many small loans, monitoring costs for
ultimate securities holders would be very large.
• Servicing costs will be significant given the frequency of cash flows and the number of
underlying creditors.

The benefits of securitising car loans are:

• Since each security pool will be composed of many small loans, securitisation provides
risk diversification benefits.
• As a result of risk-adjusted capital requirements, it is more costly for banks to finance car
loans. Securitising car loans would increase the availability of financing to this sector of
the economy.

9 Consider a mortgage pool with principal of $20 million. The maturity is 30 years with a
monthly mortgage payment of 10 per cent per annum. (Assume no prepayments.) LO 8.6

(a) What is the monthly mortgage payment (100 per cent amortising) on the pool of mortgages?
10%
The monthly mortgage payment, R, is (the monthly interest rate is = 0.833%):
12
1

$20m = R
(1.00833)360
0.00833
R = $175 514.31

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 7 of 15
(c) McGraw-Hill Education (Australia) 2015
(b) If the mortgage-backed security insurance fee is 60 basis points and the servicing fee is 40
basis points, what is the yield on the pass-through security?

The annual yield is 10% – 0.44% – 0 .06% = 9.5%. The monthly yield is
9.5%
= 0.79167%.
12

(c) What is the monthly payment on the pass-through security in part (b)?

The monthly payment, R, is:

1
1−
(10079167
. ) 360
$20m = R
0.0079167
R = $168 170.84

(d) Calculate the first monthly servicing fee paid to the originating banks.

The first monthly servicing fee, R, is (the monthly fee rate is

0.40%
= 0.033% ):
12
R = (0.000333 )($20 m ) = $6666

10 Calculate the value of (a) the mortgage pool and (b) the pass-through security in question 9 if
interest rates increased 100 basis points. (Assume no prepayments.) LO 8.6

(a) The mortgage pool’s value, V, is (the monthly discount rate is

11%
= 0.9167%) :
12
 1 
1 − (1.009167)360 
V = $175 514.31  = $18 430 116
 0.009167 
 
 
10.5%
(b) The pass-through security’s value, V, is (the monthly discount rate is = 0.875%):
12
 1 
1 − (1.00875)360 
V = $168 170.84  = $18 384 565
 0.00875 
 
 

11 A bank originates a pool of 500 30-year mortgages, each averaging $150 000, with an annual
mortgage coupon rate of 8 per cent. If the mortgage-backed security insurance fee is 60 basis
points and the bank’s servicing fee is 19 basis points: LO 8.6

(a) What is the present value of the mortgage pool?

$500 × $150 000 = $75 million.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 8 of 15
(c) McGraw-Hill Education (Australia) 2015
(b) What is the monthly mortgage payment?

There are 360 monthly mortgage payments (30 years × 12 months). Monthly mortgage
payments are:
 1 
 1 − 360 
  1 + 0.08  
  12  
$75m = R  
0.08
 
 12 
 
 
R = $550 323.43

(c) For the first two payments, what portion is interest and what is principal repayment?

For the first monthly payment, the monthly interest is:

8%/12 × $75 million = $500 000.

Therefore, for the first monthly mortgage payment, $500 000 is repayment of interest
and $50 323.43 is repayment of principal.

For the second monthly payment, the principal outstanding is:

$75m – $50 323.43 = $74 949 676.57.

The monthly interest payment is: $499 664.51.

The principal payment in the second month is:

$550 323.43 – $499 664.51 = $50 658.92.

(d) What are the expected monthly cash flows to securitised bondholders?

The annual securitised bond rate is 8% – (6 + 19) basis points = 7.75%. Bondholders receive
monthly payments of:
 1 
1 − 360 
  1 + 0.0775 
  12  
$75m = R  
0.0775
 
 12 
 
 

R = $537 309.18

(e) What is the present value of the pass-through security bonds? (Assume that the risk-adjusted
market annual rate of return is 8 per cent compounded monthly.)

The discount yield is 8 per cent annually, compounded monthly. The present value of the
pass-through bonds is:

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 9 of 15
(c) McGraw-Hill Education (Australia) 2015
  1 
1− 360 
  0.08  
 1 +  
PV = 537 309.18  12 
 = $73 226 373.05
 0.08 
 12 
 
 

(f) Would actual cash flows to securitised bondholders deviate from expected cash flows as in
part (d)? Why or why not?

Actual payments will equal expected payments if and only if no prepayments are made. If any
mortgages are prepaid as a result of refinancing or homeowner mobility, the monthly
payments will change. In the month in which prepayments are made monthly payments will
increase (to reflect the principal repayments). In all subsequent months, monthly payments
will decline (to reflect the lower face value of the pass-through bonds).

(g) What is the bank’s expected monthly cash flows?

The bank gets the difference between the monthly mortgage payments and the pass-through
payments: $550 323.43 – $537 309.18 = $13 014.25.

(h) If all of the mortgages in the pool are completely prepaid at the end of the second month,
what is the pool’s weighted average life? (Hint: Use your answer to part (c).)

Time Expected principal Timex principal

payments
1 month $50 323.43 $50 323.43
2 month $74 949 676.57 $149 899 353.10
$75 000 000.00 $149 949 676.50

149 949 676.50

WAL = = 19 993months
75million

After the first two months, principal payments total:

$50 323.43 + $50 658.92 = $100 982.35.

Total principal outstanding after two months is:

$75 million –100 982.35 = $74 899 017.65.

Therefore, the second month’s principal payment is:

$50 658.92 + $74 899 017.65 = $74 949 676.57.

(i) What is the price of the pass-through security if its weighted-average life is equal to your
solution for part (h)? (Assume no change in market interest rates.)

The pass-through security with a weighted-average life of 1.9993 months has only two cash
flows. The first month’s cash flow is $537 309.18. The second month’s cash flow is

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(c) McGraw-Hill Education (Australia) 2015
$537 309.18 plus the extra principal repayment of $74 899 017.65 = $75 436 326.83. The
present value of the pass-through security is:

537 309.18 75 436 326.83

PV = + 2
= $74 974 229.44
0.08  0.08 
1+ 1 + 
12  12 

(j) What is the price of the pass-through security with a weighted-average life equal to your
solution for part (h) if market yields decline by 50 basis points?

Market yields decline 50 basis points to 7.5% per annum compounded monthly. The present
value of the pass-through security is:

537 309.18 75 436 326.83

PV = + 2
= $75 036 111.70
0.075  0. 075 
1+ 1 + 
12  12 

12 If 150 $200 000 mortgages are expected to be prepaid in three years and the remaining 150
$200 000 mortgages in a $60 million 15-year mortgage pool are to be prepaid in four years,
what is the weighted-average life of the mortgage pool? Mortgages are fully amortised with
mortgage coupon rates set at 10 per cent to be paid annually. LO 8.2, 8.6, 8.7

The annual mortgage payment is:

 1 
1 − 
 (1 + 010
. )
15

$60m = R
 010
. 
 
 

R = $7 888 426.61

Annual mortgage payments, with no prepayments, can be decomposed into principal and
interest payments:

Yr Balance Payment Interest Principal Remaining

(R) (fixed) payment payment principal
1 $60 m $7.888 m $6 m $1.888 m $58.112 m
2 58.122 7.888 5.811 2.077 56.034
3 56.034 7.888 5.603 2.285 53.749
4 53.749 7.888 5.375 2.513 51.236

The first year’s interest is $6 million (0.10 × $60 million). Deducting this from the first
year’s mortgage payment yields a principal payment of $1 888 426.61 at the end of the first
year.
Outstanding principal is $58 111 573.39.
The second year’s interest payment is 0.10 × $58 111 573.39 = $5 8111 157.34. Deducting
this from the annual mortgage payment yields a second annual principal payment of
$2 077 269.27 for a principal outstanding of $56 034 304.12.
The third year’s regular interest payment is $5.603 million. Deducting this from the annual
mortgage payment yields a third annual principal payment of $2.285 million for a principal

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 11 of 15
(c) McGraw-Hill Education (Australia) 2015
outstanding of $53 749 307.92. The principal outstanding at the end of the fourth year,
without prepayments, is $51 235 812.10.
However, at the end of the third year, half of the mortgages in the mortgage pool are
completely prepaid. That is, at the end of the third year, an additional principal payment of
50% × $53 749 307.92 = $26 874 653.96 is received for a remaining outstanding principal
balance of $26.875 million. Total third-year principal payment is therefore $29.16 million =
the regular principal payment of $2.285 million plus an extra payment of $26.875 million.
The fourth year annual interest payment is 10% × $26.875 million = $2.687 million,
leaving a regular fourth year principal payment of $7.888 million – $2.687 million =
$5 200 961.21. This end-of-fourth-year principal payment would have left an outstanding
principal balance of $21 673 692.75, which is paid in full at the end of the year. Fourth-year
principal payments total $26.875 million = $5.201 million plus $21.674 million.
Prepayments alter the annual cash flows for years 3 and 4 as follows:

Yr Balance Payment Interest Principal Remaining

(R) (fixed) payment payment principal
3 56.034 7.888 5.603 29.16 26.875
4 26.875 7.888 2.687 26.875 0
$60 m

Calculating the weighted-average life:

Time Expected principal payments Time × princ.

1 1.888 1.888
2 2.077 4.154
3 29.160 87.480
4 26.875 107.500
60 201.022

201.022
WAL = = 3.35years
60

13 What would be the impact on mortgage-backed security pricing if the pass-through security
was not fully amortised? What is the present value of a $10 million pool of 15-year
mortgages with an 8.5 per cent monthly mortgage coupon per annum if market rates are 5
per cent? (The mortgage-backed security guarantee fee is assumed to be 60 basis points and
the bank servicing fee 40 basis points. Assume that the pass-through security is fully
amortised.) LO 8.6. 8.7

There are 180 monthly payments (15 years × 12 months). The pass-through security monthly
coupon rate is 8.5% – 0.5% = 8% p.a. The monthly pass-through payment is:
 1 
 1 − 180 
  1 + 0.08  
  12  
$10m = R  
0.08
 
 12 
 
 
R = $95 565.21

The present value of the pass-through security at a 5% market rate is:

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 12 of 15
(c) McGraw-Hill Education (Australia) 2015
  1 
1 − 180 
 1 + 0.05  
 
PV = 95 565.21 
12 
0.05 
 
 12 
 
 
PV = $12.085 million

14 What factors affect prepayment probability? LO 8.7

Prepayment probabilities are affected by homeowners’ expectations about future interest

rates, mobility rates and financial awareness. In addition, prepayments increase as the costs of
refinancing decrease (this is determined in part by the competitive structure of the financial
services industry). Finally, the structure of existing mortgages relative to maturity, fixed
versus floating rates, or existing mortgage covenants (e.g. against assumption of mortgages)
will all impact on prepayment probabilities.

15 Consider $200 million of 30-year mortgages with a coupon of 10 per cent per annum paid
quarterly. LO 8.6, 8.7

(a) What is the quarterly mortgage payment?

There are 120 quarterly payments over 30 years. The quarterly mortgage payments are:
 1 
1 − 120 
 1 + 0.10  
 
$200m = R  
4 
0.10 
 
 4 
 
 

R = $5 272 358.60

(b) What are the interest repayments over the first year of life of the mortgages? What are the
principal repayments?

Qtr Balance Payment (R) Interest Principal Remaining

(fixed) payment payment principal
1 $200m $5.272m $5m $0.272m $199.728m
2 199.728 5.272 4.993 0.279 199.449
3 199.449 5.272 4.986 0.286 199.163
4 199.163 5.272 4.979 0.293 198.87

(c) Construct a 30-year CMO using this mortgage pool as collateral. There are three tranches
(where A offers the least protection against prepayment and C offers the most). A $50
million Tranche A makes quarterly payments of 9 per cent per annum; a $100 million
Tranche B makes quarterly payments of 10 per cent; and a $50 million Tranche C makes
quarterly payments of 11 per cent.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 13 of 15
(c) McGraw-Hill Education (Australia) 2015
 (i) Assume non-amortisation of principal and no prepayments. What are the total promised
coupon payments to the three classes? What are the principal payments to each of the
three classes for the first year?
(ii) If, over the first year, the trustee receives quarterly prepayments of $10 million on the
mortgage pool, how are the funds distributed?
(iii) How are the cash flows distributed if in the first half of the second year prepayments are
$20 million quarterly?
(iv) How can the CMO issuer earn a positive spread on the CMO?

Tranche A: 9%/4 × $50 million = $1 125 000 quarterly

Tranche B: 10%/4 × $100 million = $2 500 000 quarterly
Tranche C: 11%/4 × $50 million = $1 375 000 quarterly
Total interest payments: $5 million quarterly

Regular Tranche A payments are $1.125 million quarterly. If there are no prepayments the
regular pass-through security quarterly payment of $5.272 million is distributed among the
three tranches. $5 million is the total coupon payment for all three tranches. Therefore, $0.272
million of principal is repaid each quarter even if there are no prepayments. Tranche A
receives all principal payments. Tranche A cash flows are $1.125 million + $0.272 million =
$1.397 million quarterly.

Qtr Balance Payment (R) Interest Principal Remaining

(fixed) payment payment principal
1 $50m $1.397m $1.125m $0.272m $49.728m
2 49.728 1.397 1.119 0.278 49.45
3 49.45 1.397 1.113 0.284 49.166
4 49.166 1.397 1.106 0.291 48.875

Quarterly prepayments on the entire mortgage pool are $10 million. They are credited
entirely to Tranche A until all principal is paid off. The payments are distributed as follows:

Qtr Balance Payment (R) Interest Principal Remaining

(fixed) payment payment principal
1 $50m $11.937m $1.125m $10.812m $39.188m
2 39.188 11.937 0.882 11.055 28.133
3 28.133 11.937 0.633 11.304 16.829
4 16.829 11.937 0.379 11.558 5.271

In the second year, quarterly payments on the entire mortgage pool are $20 million. The
quarterly payment on Tranche A is $1.125 plus $20.272 million for a total quarterly payment
of $21.397 million. The payments are distributed as follows:

Qtr Balance Payment (R) Interest Principal Remaining

(fixed) payment payment principal
5 5.271 21.397 0.119 21.278 0

After the fifth quarter, Tranche A is completely paid off. There is $16.007 million cash
flow remaining ($21.278 less the remaining Tranche A principal of 5.271). That leaves
$16.007 million in prepayments to be applied towards Tranche B.
The way the terms of the CMO are structured, the average coupon rate on the three classes
equals the mortgage coupon rate on the underlying mortgage pool. However, given the more
desirable cash flow characteristics of the individual classes, the FI may be able to issue the
CMO classes at lower coupon rates. The difference between the sum of all coupon payments

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 14 of 15
(c) McGraw-Hill Education (Australia) 2015
promised on all CMO tranches and the mortgage coupon rate on the underlying mortgage
pool is the FI’s servicing fee.

16 How does securitisation impact on the FI’s role as a delegated monitor? LO 8.6

If the FI packages loans and sells them without recourse, then the FI does not perform any
monitoring function over the life of the loan. The FI may simply service the loan on behalf of
the ultimate securities holders.

17 How does the FI use securitisation to manage its risk exposure? (Be sure to consider interest
rate, currency, liquidity and credit risks.) LO 8.5

In the process of intermediation on behalf of its customers, the FI assumes risk exposure. The
FI can reduce that risk exposure by altering its product base, thereby affecting the portfolio
mix obtained in the course of intermediation. However, this is likely to be quite costly in
terms of customer goodwill and loss of business. Securitisation enables FIs to manage risk
exposure by changing their portfolio mix without alienating customers. That is, customers are
still serviced and the FI continues to intermediate. Balance sheet alterations are made
subsequent to and independent of the intermediation activity. Thus, the FI can make portfolio
changes and still fulfil the franchise of the intermediary.
Interest rate risk exposure is reduced by matching the durations of assets and liabilities.
Securitisation enables the FI to accomplish this since the FI can determine which loans to
package and sell off. Credit risk exposure is minimised by selling loans without recourse.
Foreign exchange rate risk exposure is reduced by matching the foreign currencies in which
the assets and liabilities are denominated. Securitisation allows the FI to sell off unmatched
assets. Finally, securitisation reduces liquidity risk since the FI does not have to fund the
asset.

Web questions
18 Go to the website of the Australian Treasury Department and find information about the
government’s ‘Stream Two: Support smaller lenders to compete with the big banks’ and
describe how this scheme also assists the Australian securitisation market. LO 8.4

The answer will depend on the date of the assignment. At the website www.treasury.gov.au,
click on ‘Reports’ and then use the search function to find the required report.

19 Go to the website of the Reserve Bank of Australia and find a speech by Chris
Aylmer, head of domestic markets department, to the Australian Securitisation Forum on 11
November 2013, titled ‘Developments in Secured Issuance and RBA Reporting Initiatives’.
From this, determine the total bond issues by banks, and discuss the difference between
covered bond issues and unsecured issues and the advantages of each for an FI manager.

LO 8.5, 8.6

19

The answer will depend on the date of the assignment. At the website, click on ‘Speeches’
and then on ‘2004’ and find the speech referred to.

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 15 of 15
(c) McGraw-Hill Education (Australia) 2015
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