Group 3 (Aque, Arizabal, Dural, Gonzales, Virata) ACFINA3 Mortgage Bonds at Ticonderoga Submitted on: March 13, 2014

Introduction Talbot and Morgan Stanway, who had careers in large investment banks, founded Ticonderoga Management. This company focused on selling traditional fixed income instruments (corporate and government bonds) but they also branched out and traded Mortgage-backed securities (MBSes). MBSes are a different kind of security as they were created from pooled mortgage loans. They are commonly issued by one of the three US agencies (Ginnie Mae, Fannie Mae, Freddie Mac) They are called pass-throughs and they could be pooled again to create collateral for a more complex type of security, a collateralized mortgage obligation. Because of this, different classes of securities with different maturities, risk coupons and risk profiles were created. Ticonderoga was trying to be innovative and creative with regards to their investments and so they started a new investment style, going for relative payment risk for MBSes. The goal of the company was to identify and exploit non-systemic arbitrage opportunities that appear in the market. Securities Basically, any type of asset with a revenue stream could be transformed into either marketable securities or asset backed securities (ABS). The possible collaterals for an ABS are the following: mortgage loans, credit card receivables, car-loan payments, leasing payments, project-finance loans, student loans, home-equity loan cash flows. The lending companies prefer this as it would get their original loans off the books which would seem as if they had free money to lend to borrowers Mortgaged Back Securities It is a type of asset backed security that is secured by a mortgage. These are usually sold to government agencies like Ginnie Mae that securitizes or packages the loans together and sell

them to investors. It is also one of the largest markets because of derivative products (collateralized mortgage obligations) and unlike treasury bonds (pay semi-annually), MBS pay principal and interest monthly. Three Issuers: Ginnie Mae, Fannie Mae, Freddie Mac The Government National Mortgage Association (GNMA), or Ginnie Mae, was established in the United States in 1968 to promote home ownership. As a wholly owned government corporation within the Department and Development (HUD), Maes mission is of Housing Urban Ginnie to

expand affordable housing in the United States by

channeling global capital into the nations housing finance markets Creation and cycle of mortgaged backed securities

The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, was founded in 1938 during the Great Depression as part of the New Deal. The corporation's purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS), allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market by reducing the reliance on locally-based savings and loan associations (aka "thrifts")

Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac was created in 1970 to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac

buys mortgages on the secondary market, pools them, and sells them as a mortgage-backed security to investors on the open market. Complexity of Prepayments The value of pass through securities depended much on its cash flows since mortgage payments also included prepayments or unscheduled payments on top of scheduled interest and principal repayments. In other words, the borrower pays more money required in order to pay back the loan in advance. This prepayment risk could result to either contraction or extension risk. Contraction risk occurs when mortgage rates decrease and as a result prepayments increase. This, in turn leads to investors receiving their principal back sooner than expected and would have to reinvest in current, lower interest rates. Extension risk, on the other hand is the opposite of contraction risk. When higher mortgage rates occur, prepayments would be minimal and so the principal of investors would be tied up for a longer period of time and they would be unable to reinvest at current, higher interest rates. Computation for Prepayments Two methods used are the Conditional Prepayment Rate (CPR) and the Public Securities Association (PSA). CPR= (Month/30) * 6% Creation of Collateralized Mortgage Obligations (CMO)

Collateralized mortgage obligations are an example of complex financial instruments. It repackages and directs payments of principal and interest from a collateral pool of different types and maturities. In comparison with mortgage backed securities, CMOs provided better cash flow certainty while still giving the same credit quality and yield advantage. However CMOs were less liquid in secondary markets because of the uniqueness of each security. Tranching in CMOs usually done to meet investor needs where each tranche offers varying degrees of risk to the investor and also to reduce prepayment risk. The following are examples of tranches in CMO. IO/PO bonds Interest only (IO) and principal only (PO) CMO bonds are obtained by stripping the interest cash flows from theprincipal cash flows of mortgage collateral. The interest cash flows form one bond, which is the IO. The principal cash flows form a second bond, which is the PO. Sequential pay bonds A sequential pay bond is a collateralised mortgage obligation (CMO) in which some tranches do not start receiving principal payments until the prior tranches are paid off. Thus, each class of bond is retired sequentially. Floaters and inverse floaters It is a bond or other type of debt whose coupon rate has an inverse relationship to a benchmark rate. An inverse floater adjusts its coupon payment as the interest rate changes. When the interest rate goes up the coupon payment rate will go down because the interest rate is deducted from the coupon payment. A higher interest rate means more is deducted, thus less is paid to the holder. Planned amortization classes These tranches use a mechanism similar to a sinking fund to establish a fixed principal payment schedule that directs cash flow irregularities caused by faster- or slower-than expected prepayments away from the PAC tranche and toward another tranche. Trading Mortgage Backs at Ticonderoga

Ticonderogas mortgage backed security activities targeted CMOs and MBSes. Its main goal is to identify and exploit nonsystematic arbitrage opportunities that appear in MBS market. Ticonderoga also has a policy in which if a trade started losing money and reached a stop-loss limit they implemented, then they would immediately stop the trade; accept the losses and move on to the next trade. Ticonderoga sometimes also hedes the interest rate risk involved with taking on investments like CMOs. The prepayment risk that comes with CMOs can be accepted as long as they figure out which tranche they should invest in.

Conclusion The financial crisis happened because banks were not as careful and they did not really take into consideration the credit-worthiness of the borrower. This is because they were not affected even if the loan was not paid back.

Because mortgage-backed securities allowed financial institutions other than banks to enter the mortgage business, a lot of different lenders started taking advantage of the opportunity and entered the industry. This resulted into competition for the banks which is the reason why it was easy for people to obtain loans.

MBSs were not regulated. There were no governing bodies in charge of regulating these securities. After the crisis, the government started to look over the ways in which they can finally make the industry more stable.