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The Smokin' Cracktuary
05-02-2008, 07:44 AM
So on one of the note cards I have (Carmody) it says that non-agnecy CMO's have more credit risk and prepayment risk than agency pass-throughs.

Did it say that in the text? I refuse to go back and re-read, but I don't really see how it could have.

They clearly have more credit risk, yes. But not only do non-agency CMOs have less prepayment risk than agency pass-throughs, they have less prepayment risk than agency CMOs. They may prepay faster, but they are far less negatively convex, so they have far less prepayment "risk". In other words, they prepay faster, but have more stability in that prepayment speed, reducing prepayment risk.

Now, I am almost positive that it talked about that in the text. It mentioned it as a function of the underlying collateral. Now they may have jumbo prepayments, but I don't think that does enough to make them have more prepayment risk.


Regardless, I know from experience where I work, we are very large investors in non-agency CMOs for just that reason. They have far less negative convexity than agency CMOs.

So is the card wrong, or am I thinking about this all wrong?

Hayden
05-02-2008, 09:43 AM
You're the one who actually works with this stuff so please don't skewer me if I seem naive. I think what they're getting at is that prepayment models are established for Agency CMOs with regards to changes in interest rates. Convexity is only talking about changes in prepayment speeds with regards to interest rates. Non-Agency CMO prepayment speeds do not depend as much on interest rates and thus don't have as much negative convexity, but they have the added complexity that they depend on the credit rating of the borrowers. Credit curing can cause (avoid alliteration always) sub-prime borrowers to refinance more rapidly. However, it might be impossible to know exactly where everyone is in the credit curing process (whereas interest rates are readily available) and even if you did know, the connection between credit curing and refinancing may not be as well established as the connection between interest rates and refinancing.

The Smokin' Cracktuary
05-02-2008, 11:02 AM
You're the one who actually works with this stuff so please don't skewer me if I seem naive. I think what they're getting at is that prepayment models are established for Agency CMOs with regards to changes in interest rates. Convexity is only talking about changes in prepayment speeds with regards to interest rates. Non-Agency CMO prepayment speeds do not depend as much on interest rates and thus don't have as much negative convexity, but they have the added complexity that they depend on the credit rating of the borrowers. Credit curing can cause (avoid alliteration always) sub-prime borrowers to refinance more rapidly. However, it might be impossible to know exactly where everyone is in the credit curing process (whereas interest rates are readily available) and even if you did know, the connection between credit curing and refinancing may not be as well established as the connection between interest rates and refinancing.


This is all very true, but...

There are a couple things to consider.

Prepayments due to credit curings are, for the most part, random events. Maybe correlated to macroecnomic conditions, but there really aren't any external forces that cause them to speed up or slow down. And on a large enough pool of assets, you expect the experience to be relatively predictible. Law of large numbers.

It is highly unlikely that you will have large chunks prepaying because of credit curing at one time. At least not on an inconsistent basis. If a great deal of prepayments due to credit curing happen often, that means it will be stable and predictible, and by definition less risk. So the only way to cause a great deal of instablility, is to have large groups prepaying sparatically.

You could also make the arguement that if there are a large chunks of people iproving their credit in short periods of time, it suggests a strong economy, which suggest higher interest rates. But that isn't really in the scope of the discussion, and not infalable truth either.

In any case, that is a big part of the reason that non-agency CMO's prepay faster. But while faster, still more stable. More stable = less risk, at least in most circles.

The largest cause of variations in prepayment speeds is undoubtedly interest rate changes, regardless of agency or non-agency. Non-agency CMOs are simply less sensitive to interest rate changes, which are the primary drivers of prepayment RISK. Less prepayment volatility, means less prepayment risk (again, in most circles).

But the final and probably least bullsh*t point I will make:

What is prepayment risk?

Well it's interest rates going down, causing faster repayment of principal, force investor to reinvest at a lower rate. This is the heart of prepayment/call risk. The fact that the investor must reinvest at a lower rate.

If prepayments happen when rates are high, that is good for the investor because he can get back money that is earning a low rate, and reinvest at a higher rate. This is not risk. This is good.

People who prepay because of credit curing can and will do it whether interest rates are high or low. So unexpectedly fast prepayments would benefit the investor in higher rate environments.

The very fact that prepayments for non-agency CMOs are not as correlated with interest rates, and you could make the case that some may even be negatively correlated with interest rates (by that I mean some mortgages in the pool, hence reducing the interest rate sensitivity for the entire pool), means there is, by definition, less prepayment risk.

The primary component of prepayment "RISK" is the reinvestment risk.

The Smokin' Cracktuary
05-02-2008, 11:19 AM
This is all very true, but...

There are a couple things to consider.

Prepayments due to credit curings are, for the most part, random events. Maybe correlated to macroecnomic conditions, but there really aren't any external forces that cause them to speed up or slow down. And on a large enough pool of assets, you expect the experience to be relatively predictible. Law of large numbers.

It is highly unlikely that you will have large chunks prepaying because of credit curing at one time. At least not on an inconsistent basis. If a great deal of prepayments due to credit curing happen often, that means it will be stable and predictible, and by definition less risk. So the only way to cause a great deal of instablility, is to have large groups prepaying sparatically.

You could also make the arguement that if there are a large chunks of people iproving their credit in short periods of time, it suggests a strong economy, which suggest higher interest rates. But that isn't really in the scope of the discussion, and not infalable truth either.

In any case, that is a big part of the reason that non-agency CMO's prepay faster. But while faster, still more stable. More stable = less risk, at least in most circles.

The largest cause of variations in prepayment speeds is undoubtedly interest rate changes, regardless of agency or non-agency. Non-agency CMOs are simply less sensitive to interest rate changes, which are the primary drivers of prepayment RISK. Less prepayment volatility, means less prepayment risk (again, in most circles).

But the final and probably least bullsh*t point I will make:

What is prepayment risk?

Well it's interest rates going down, causing faster repayment of principal, force investor to reinvest at a lower rate. This is the heart of prepayment/call risk. The fact that the investor must reinvest at a lower rate.

If prepayments happen when rates are high, that is good for the investor because he can get back money that is earning a low rate, and reinvest at a higher rate. This is not risk. This is good.

People who prepay because of credit curing can and will do it whether interest rates are high or low. So unexpectedly fast prepayments would benefit the investor in higher rate environments.

The very fact that prepayments for non-agency CMOs are not as correlated with interest rates, and you could make the case that some may even be negatively correlated with interest rates (by that I mean some mortgages in the pool, hence reducing the interest rate sensitivity for the entire pool), means there is, by definition, less prepayment risk.

The primary component of prepayment "RISK" is the reinvestment risk.

Disclaimer: I would like to point out that I am not stating any of this as fact. It is all merely the view of my brain, nothing more

TiderInsider
05-02-2008, 01:39 PM
I agree with Hayden...I think its an issue of predictability.

Hayden
05-02-2008, 02:11 PM
This is all very true, but...

There are a couple things to consider.

Prepayments due to credit curings are, for the most part, random events. Maybe correlated to macroecnomic conditions, but there really aren't any external forces that cause them to speed up or slow down. And on a large enough pool of assets, you expect the experience to be relatively predictible. Law of large numbers.

It is highly unlikely that you will have large chunks prepaying because of credit curing at one time. At least not on an inconsistent basis. If a great deal of prepayments due to credit curing happen often, that means it will be stable and predictible, and by definition less risk. So the only way to cause a great deal of instablility, is to have large groups prepaying sparatically.

You could also make the arguement that if there are a large chunks of people iproving their credit in short periods of time, it suggests a strong economy, which suggest higher interest rates. But that isn't really in the scope of the discussion, and not infalable truth either.

In any case, that is a big part of the reason that non-agency CMO's prepay faster. But while faster, still more stable. More stable = less risk, at least in most circles.

The largest cause of variations in prepayment speeds is undoubtedly interest rate changes, regardless of agency or non-agency. Non-agency CMOs are simply less sensitive to interest rate changes, which are the primary drivers of prepayment RISK. Less prepayment volatility, means less prepayment risk (again, in most circles).

But the final and probably least bullsh*t point I will make:

What is prepayment risk?

Well it's interest rates going down, causing faster repayment of principal, force investor to reinvest at a lower rate. This is the heart of prepayment/call risk. The fact that the investor must reinvest at a lower rate.

If prepayments happen when rates are high, that is good for the investor because he can get back money that is earning a low rate, and reinvest at a higher rate. This is not risk. This is good.

People who prepay because of credit curing can and will do it whether interest rates are high or low. So unexpectedly fast prepayments would benefit the investor in higher rate environments.

The very fact that prepayments for non-agency CMOs are not as correlated with interest rates, and you could make the case that some may even be negatively correlated with interest rates (by that I mean some mortgages in the pool, hence reducing the interest rate sensitivity for the entire pool), means there is, by definition, less prepayment risk.

The primary component of prepayment "RISK" is the reinvestment risk.

If you wrote all of this on the exam question I would venture to guess you would get a high score on said question.

Hayden
05-02-2008, 02:17 PM
I agree with Hayden...I think its an issue of predictability.Yes this is basically what I was getting at. I would also consider approaching a question like this by breaking down the risks of each type of collateral for NACMOs. What I said above could be true for sub-prime, alt-a, or reperforming loans, but almost the exact opposite could be said about jumbo loans. I believe it was said somewhere in the text that jumbo loans are assumed to given to individuals who are more financially astute. Therefore they might prepay at a faster rate than ACMOs when the oppurtunity presents itself.

campbell
05-02-2008, 03:21 PM
If you wrote all of this on the exam question I would venture to guess you would get a high score on said question.

Having seen grading occur, I would concur. We are given a grading outline based on the official course of reading, but we can (and do) change the grading outline if we find other legitimate answers to the question.

The Smokin' Cracktuary
05-02-2008, 04:46 PM
I agree with Hayden...I think its an issue of predictability.

Again, if you aren't forced to reinvest at a lower rate, there is no risk.

Agency CMO's predictably prepay faster when rates go down. Their predictability does not take away any of the risk. Investors still have to prepay at a lower rate.

Risk does not come from unpredictibility, not in this case. And if you say your prepayments happen faster than you predicted, thats model risk, not prepayment risk.

For NACMOs, you may not be able to predict by how much faster prepayments will get when rates go down, but generally it will not be as much as Agency CMOs. Since you know, generally speaking, that they won't react to interest rate drops as much, there is less prepayment risk.

Once again, the primary factor in prepayment risk, is reinvestment risk. In fact, it is the only factor.

If people prepayed faster when reinvestment rates were high, there would be no risk. No reinvestment risk means no prepayment risk.

Less reinvestment risk means less prepayment risk. Less call sensitivity to falling interest rates by definition means less reinvestment risk.

Hence, NACMO's have less prepayment risk, no matter how you slice it.