Prepaying Securities

Overview

A prepaying security is one in which the principle is repaid prior to the maturity of the
security and the repayment of principle is not from the holder or issuer.

We are going to introduce an additional party, the borrower, this is someone who has
received a loan and has the goal of making payments to reduce the amount of the loan
to zero. So, our three parties in a prepaying security are: borrower, issuer and investor.

The most important thing to remember with these securities are that the investor has
claim on cash flows, which basically means the investor is receiving the payments of
the borrower, but this is generally done through an additional party.

The subject of prepaying securities is an extensive one in modern finance; this

training is designed to provide a broad overview. It is encouraged that you take time
to investigate further as questions and/or issues come up.

Basics of Prepaying Securities

While traditional/vanilla bonds such as Corporate and Municipal Bonds can act like a
prepaying security, these are known as sinking funds when the amount or percent of
principle repayment is known since issuance. Prepaying securities are different as
payment amounts and other items are unknown from payment to payment. But the
vast majority of prepaying securities start as large pools of loans, and these pools can
be sold as large pools or broken into smaller pools and sold or even sold as slices of
an overall pool, which is known as a tranche.

How does this work?

The borrower (entity who took on the loan) and the lender also known as a loan
originator (entity loaning the money) initially make a contract it is to have the loan
originator give money to the borrower and in return the borrower agrees to make
payments to the loan originator.

If the relationship stays as described above, it is a what we think of as a “normal”

borrower – lender relationship. But in a prepaying security the loan originator has sold
the rights to receive the payments from the borrower to another party, who we
eventually view as the investor.
But why would a lender sell the rights to receive payments when they could keep it
for themselves? That is a good question, and it has many potential answers, but one of
them is risk management.

When someone buys a home and uses a loan to do so they enter into a contract with
the lender and a payment schedule is created with promise of payment. The moment
the loan contract is committed to, that amount is known as the original units. If the
person sticks to the loan contract exactly (which is generally considered the minimum
monthly payment amount) then the lender knows exactly what their gain will be on
the investment/loan. But the borrower may miss a payment, make accelerated
payments or even default on the loan. If the borrower pays principle off faster than
expected, the lender loses out on potential interest they thought they might receive,
but these accelerated payments are good for the borrower. On the other hand, if a
borrower defaults on a loan, the lender may potentially never collect that principle or
interest.

That means every loan carries risk to the lender, but if the lender could at some point
sells that loan to someone else, say an investor, they would receive payment for the
remaining principle outstanding and transfer the rights to any future payments to the
buyer/investor. This selling of cashflows is really the selling of an asset, which would
be receivables (the cash flow) to another party, the investor. This eliminates the risks
that the lender had regarding that cash flow when they held the rights to the

payments and transfers it to the investor. So, taking the relationship between a
borrower and lender and transfer the lender relationship to the investor you just put
together a prepaying security.

It is important to note that some loans/debt has extra fees built into the contract to
control the prepayment risk, generally called a prepayment penalty, this is done to
prevent the principle from being paid down too quickly, significantly disrupting cash
flows. This extra fee is especially important to classify when we are talking about
Insurance clients. It is generally assigned to a transaction as a PPAP, or pre-payment
penalty, not to the insurance company but was charged to the borrower, which in turn
flowed out to investor, which in this case is an insurance company.

When the borrower makes a payment to the loan originator and that payment gets
pooled with any other loans and then sent to the investor. This intermediary is called
the issuer because they are the entity building and selling the investment. This can
sometimes be through another intermediary known as a SPV or special purpose
vehicle that was create just for the purpose of selling the investment.
The investor receives a payment (generally monthly with a prepaying security) based
on how much money they have purchased of the investment. Which is based an
interest rate and is paid out in some sort of regular interval.

Let us back up just a bit, what exactly are these payments the investor is receiving?
When a borrower makes a payment in a single amount, this is known as a P & I
payment. Because the amount of the single payment accounts for 2 separate buckets,
one being principle and the other interest hence the P&I payment.

When the borrower makes their P&I payment, the principle side of the payment goes
towards reducing or paying down the principle of the loan. At Clearwater we call this
principle reduction payment a PPD or principle paydown, sometimes shortened to just
paydown. The result of this principle

payment is that the borrower reduces what they owe on the loan making the remaining
principle amount to be repaid smaller, this new reduced balance is known as current
units.

The interest side of the P&I payment is just that, interest, or what is accounted for as
being the gain on the investment. Since prepaying securities are bonds interest would
actually be the coupon payment, and because it is just a coupon payment it is
calculated the same as a vanilla bond.

An additional component of a prepaying security is what is known as a factor. A

factor is similar to current units, but instead of a value it is a percent. So, a factor is
the percent of principle outstanding. Factors are expressed as decimals and usually
start at 1.00, or 100%, of principle to repaid until we get to 0, meaning all principle
has been repaid and everywhere in between.

For example, if today I take out a $500,000 home loan, that will always be my
original units. But let us say after 10 years of payments I have $250,000 left to be
repaid that would be my current units and my factor would be .5, or 50% if left to be
repaid.

Factors also allow for the trading of prepaying securities as well as borrowing. It
allows a business to obtain immediate capital based on future income attributed to a
particular amount due on an account receivable which is determined by the cash flow
schedule at the time of purchase. It allows trading to occur when other interested
parties want to purchase the funds due at a discounted price in exchange for providing
cash up front.
As we mentioned earlier factors change as principle is paid down. When we receive
the last payment that fulfills all principle we call that the final paydown, you could
think of this as the “maturity” payment as well. But since it is not actually a maturity
payment Clearwater creates a sell transaction with the number of units and a price of
0, to clear the units from

our system. This transaction is created using the settle date of the final paydown.

Types of Prepaying Securities

Examples of prepaying securities are mortgage-backed securities (including Fannie

Mae, Freddie Mack, and Ginne Mae securities), collateralized mortgage obligations
(CMO’s), and asset-backed securities (ABS). In addition to mortgages, they may be
comprised of car loans, credit card receivables, or other types of loans.

Pass-Throughs – The most basic type of prepaying security whereby monthly interest
and principal payments are passed-through to investors based on their proportional
ownership of the asset pool.

Examples – MBS (Mortgage Back Security), ABS, GNMA (Ginnie Mae) and RMBS

Note – These prepaying securities offer the same risk/return characteristics to all
investors.

Collateralized – Pools of loans that tranche cash flows to create multiple types of
securities.

Examples – CMO, CBO, CDO, and CMBS

Note – These securities tranche cash flows to offer numerous risk/return options for
investors.

Strips – Pools of loans that offer interest and principal payments as separate securities.

Examples – Interest Only (IO), Principle Only (PO), Other IO, and Synthetics

Note – These securities can be stripped from either Pass-Throughs or Collateralized

prepayers.

Prepaying Security Vocabulary

Original Units – The number of units outstanding prior to principle being repaid. This
number is usually a large, round number like 4 million. Original Units are only
affected by trades – buying or selling.

Current Units – The number of outstanding units Original Units multiplied by the
factor. This is the balance of the remaining principle.

Factor – The proportion of a loan/principle outstanding, relative to the original

amount of the loan. Equal to current units divided by original units. On Clearwater’s
system, current units & PPD predictions are functions of the factors we receive from
3rd party sources.

Note – Factors must be greater than 0 but can also exceed 1. For pools of loans, the
maximum factor is bounded by the maximum amount of interest that can be
capitalized.

Principal Paydown – Payments from a borrower of a loan that reduce the outstanding
principle.

Note – Paydown predictions are dictated by factor changes provided by third party.

Principal Shortfall – Occurs when a portion or the entire principle payment has not
been made.

Interest Shortfall – Occurs when a portion or the entire interest has not been paid after
the loan payments have been paid.

Note – This often results from borrowers prepaying part of their loan(s) in a prior
month.

Capitalized Interest – Unpaid interest added to the outstanding principle of the loan to
be paid later. It is the cost of borrowing to acquire or construct a long-term asset.
CAPI’s can cause factors greater than 1, because we might end up with more than
100% of the original units needing to be paid off when interest is added to principle.

Note – In our reconciliation tool, CAPI (Capitalization of Interest) will populate as an

unlinked, non-cash-affecting transaction in Entered Transactions.

Payment Delay – The number of days between when principle/income payments are
accounted for (effective date) and when cash is physically received.
Legal Final Maturity – The contracted date by which all principle of a security must
be paid off.

Note – This is not specific to prepaying securities, all bonds have a legal final
maturity.

Effective Maturity – The expected date the final paydown of principle is likely to
occur.

Note – This date is not static and depends on the borrowers behavior of missed
payments or accelerated payments.

Prepaying Securities Formulas

Current Units = (Original Units) (Factor)

Paydown = (Original Units) (Old Factor- New Factor), where New < Old Factor

Paydown = Old Current Units – New Current Units

Capitalized Interest (CAPI) = (Original Units) (Old Factor- New Factor), where New
> Old Factor

Trade Principle = (Original Units) (Factor) (price/100)

Trade Proceeds = Trade Principle + Dollar Accrued

Dollar Accrued = (day accrual(dollar))(days since last coupon)

Day Accrual Decimal = (coupon rate/days per year)

Day Accrual Dollar = (day accrual decimal)(original units) (factor)/100

Decimal Accrued = (day accrual)(decimal)(days since last coupon)

You will notice that these many of these equations are the same as with bonds, and
that is because prepaying securities are bonds and so the calculations will be the same.
We are just adding the factor and paydown calculations.