ALTERNATIVE INVESTMENTS

AIDE MEMOIRE
Section 1 Real Estate
Definition of Alternative Investments:

Not very easily defined explicity thus more easily defined by what it is not.
Alternative investments are those investments which are non-traditional, i.e. not Bonds,
Equities or Cash.

Characteristics of Alternative Investments:

They are typically (though not exclusively) unlisted.

o But commodities and some real estate, as well as complex derivatives are indeed
listed
o Real estate tends to be listed through Property Groups or through mutual Real
Estate
Historically rather unregulated though all, as with all things, the lack of regulation is
temporary and over time, regulatory control tightens. Nonetheless, theyre still much
unregulated relative to traditional asset classes.
Generally illiquid (save for Commodities and Currencies, some of the most liquid markets in
the world)
Risk/Return characteristics differ wildly from those of stocks and bonds Implications for
valuation.

Investment Universe

Investment Universe

Traditional Alternative Investments

Modern Alternative Investments

Traditional Investments

Private Equity ("Angel Investing")

Hedge Funds

Commodities

Managed Futures

Real Estate - Landlords, Property

Developers

Distressed Securities (Junk Bonds) (+) Risk

Equities
Cash
Bonds

Other Specialised Investments

Collectables
o Very Inefficient Markets
o Requires the specialised knowledge of pundits or experts
o Very Illiquid
o Types: Art, Coins, Stamps, Cars & Wine
Currencies (more of a traditional market, at least in terms of efficiency)
Carbon Credits much more of a market than collectables but not as developed as that of
currencies, also falls under the purview of the greater Market for Externalities

Other common Features of Alternative Investments

Relative Illiquidity
o These stocks tend to be assosiciated with a return premium as compensation for
the poor liquidity a liquidity premium as it were (NB: Hedge Funds)
o Investors thus tend to have a long investment time horizon to combat this poor
liquidity
o Patience is key
Diversification Potential
o Because of the inefficiencies and peculiarities of these markets, there is quite a bit
of diversification potential
o However, this is hindered by the poor liquidity
Due Diligence
o High Due Diligence Costs
o Again, a function of the idiosyncrasies of the markets in which they operate.
o Implies:
Complex Investment structures and strategies
Pundit knowledge dependent evaluation may draw heavily on assetclass, business-specific and other expertise
Reporting of results and performance thus often lacks transparency
o Repeatability is difficult, Higher potential for fraud
Benchmarking
o Complex procedures necessary to determine valid benchmarks
o This results in difficult performance appraisal
o I.e. It is difficult to say: Portfolio Manager A has done well and thus difficult to
answer the question Should I invest with him/her?
Informational efficiency
o As previously stated, Alternative investments are informationally much less
efficient than listed markets
o Theory would then have it that it is possible to beat the market
o There is scope for adding value through skill and superior information.
Fees
o Investment management fees are typically higher than that of traditional asset
management.
o This is only really applicable for managed investments:

Private Equity
Hedge Funds etc.

The role of Alternative Investments (AI) in a portfolio

AI can be broadly classified by the primary role they play in a portfolio

1. Risk Factor Exposure
Investments that provide exposure to risk factors not easily accessible
through traditional (stock/bond) investments
In this way they are exposed to higher potential returns (theoretically)
E.g. Real Estate + Long Only commodities (long futures + long underlying +
rollover)
2. Specialised Investment Strategy exposure
Investments that provide exposure to specialised investment strategies run
by an outside manager
I.e. Youre exposed to the managers skill and potential informational
superiority
E.g. Hedge Funds + Managed Futures
3. Combination
Any investments that combine features of the above 2 groups
E.g. Private Equity /Distressed Securities

Who invests in Alternative Investments?

High-net-worth individuals (among the pioneer investors in hedge funds for example)
o Angel Investors
o Venture Capitalists
o Private Equity (unlisted equity) firms
Institutional Investors
o Generally have a huge capital base behind them e.g. Banks, Insurers
o However, banks and insurers tend to face strict regulatory control
o Even other investors might have self-imposed limitations in their investment policy
statements

Broad Reasons for Investing in Alternative Investments

Risk Diversification
Return enhancement (almost counteracts the above aim, if traditional theory is worth
anything that is)
Broadening the investment opportunity set
o Speaks to market efficiency and saturation
o Perhaps investors are looking for a Niche or very specific market?
o Again, tied up with above 2 points.

General Trends and Regulations in the SA market

Internationally and particularly in the US we find that high-net-worth individuals, trusts and
companies in the US have the bulk of their investments in Alternative Investments
This isnt currently the trend in SA, at least for the time being
Revised Regulation 28
o Applies to SA pension funds
o AI
Requires that Alternative Investments form up to 15% of a pension funds
holdings
Hedge Funds (HF) and Private equity (PE) in particular are capped at 10% of
entire holdings (or at 66% of total alternative investment holdings)
(probably to limit risk)
Moreover specific/individual HF & PE investments are capped at 2.5%
(perhaps with the aim of diversification)
o Property
25% Limit for physical property (of the whole or of the AI portion?)
25% Max for listed, but 15% max for unlisted
o Commodities
Up to 10% invested in commodities
10% Max for investment in Gold but 5% in any other commodity Implies
gold is seen as a safer bet

PROPERTY AS AN INVESTMENT CLASS

Introduction

For most people, Real Estate/ Property is the biggest investment they will ever make.
Historically it has been seen as the archetypal investment ownership is of course
modelled on property

Property Types

Residential
1. Single Family homes (detached/ semi-detached houses)
2. Multi-family homes (flats, apartments etc.)
Non-residential (generally where the bulk of investment falls, particularly in listed property)
1. Office
2. Retail
3. Industrial
4. Hotel/Motel
However, there is a necessary distinction between ownership and
management/ the operation of hotels
Namely, one company might own the hotel and another might manage it
(some companies specialise in the ownership and others in the
management)
5. Recreational e.g. Gold Course, Stadiums, Theatres, Resorts
6. Institutional/ Special purpose e.g. Hospitals

Sources of returns
1. Capital Appreciation (the change in the market value of the property over time)
2. Ongoing income - rent (analogous to coupons in the case of bonds and dividends in the
case of equity)
The next question is: How do these streams of income (i.e. coupons vs rent) differ?

Normal Vacancy and Market equilibrium

The normal Vacancy or equilibrium vacancy is as a result of property market structural

features i.e. at any given time, much like the distinction between full employment and
natural unemployment; we find that there is some minimum level of vacancy.
There are many reasons for this namely:
o Churn or rental transition
o Rental appreciation
Equilibrium changes are most often driven by the demand side : for whatever reasons,
demand for property increases rent increases Vacancy rates decrease long lag
more property is built/ repurposed property supply increases rent comes down again
Vacancy rates are thus a key indicator of demand
They can however be driven by the supply side.

Supply Factors

Vacancy rates (what percentage of property available to rent is not currently being rented)
Interest Rates and financing ability (because of the large capital outlay required)
Age, suitability and availability of existing stock of real estate (i.e. as time goes on more
and more properties deteriorate and depreciate requiring repurposing and/or
reconstruction as well as perhaps additional construction.
o E.g. is the area electrified and is there running water?
o Is it an ageing Victorian property?
Construction costs (labour and legislation plays a large role, as well as commodities)
Land costs and availability (largely a function of the social order, population size and the
legality of ownership)
o E.g. Cape Town and its Geographic restrictions
o

Demand Factors
1. The Key Demand factor is location
o Location is not fixed i.e. the factors which influence the attractiveness of a location
are always influx (the average wealth of the neighbourhood, the average age of
buildings, transport proximity, the quality of roads, noise, retail available etc.)
o E.g. The Johannesburg CBD , gentrification, urban regeneration
o Nonetheless you cant pack up a building (well generally at least), and any existing
building is liable to changes in the quality of its location
2. Demand Factors for Houses and apartments
o The number of households (family size and family development etc.)
o The distribution of ages in the population
o Household incomes
o Housing prices (a little circular this)
o Interest rates (those purchasing houses might need financing)
o Affordability very broad, perhaps referring to purchasing power or inflation?
3. Demand Factors for offices and commercial properties
o The presence and employment numbers of high office use industries (generally the
services industry or firms of professionals and administration)
4. Demand factors for Warehousing
o The presence and size of warehouse using industries
o Such as:
Wholesaling
Distribution
Assembling
Manufacturing
5. Demand Factors for Retail Space
o Very similar to the demand factors for houses and apartments
o Household incomes
o Demographics (ages, gender, population size, density)
o Trends
General Notes/ Trends

Residential house prices are NOT the best barometer for the capital appreciation of
institutional investment
This is because most institutional investors focus on non-residential properties
Average SA Nominal House prices have been rising steadily
Real House prices have fluctuated greatly; nominal house prices have not always kept up
with inflation
More and more black South Africans are owning property, particularly in the luxury and high
value sectors, though growth is slowing

Real Estate Cycle

Generally, Real Estate price growth is cyclical

The period of this cycle is rather long

Phases of the property cycle
1. Expansion
2. Hyper supply
3. Slump
4. Recovery
Why?
1. This is a function of the normal economic growth pattern
2. The mechanism is the interest rate
3. It is a rather complex dynamic, as it is influenced by general inflation

Factors Affecting the South African Property Cycle

1. Inflation
2. Interest rates
3. The availability of finance
This has most recently been impacted by NCA of 2007
When there is a reduction in the access to credit we see a depression in demand
4. General infrastructure
Eskom
There is very limited available capacity
5. Political Uncertainty
6. Foreign Influences
Other indicators

Recent trends declining emigration and foreign home buyers (some of this is driven by
African foreign home buyers, though the numbers fluctuate)
Household debt to disposable income household debt as a percentage of disposable
income

Generally, the higher this value, the weaker the housing market (households are less
able to access credit for housing if already highly leveraged)
Generally speaking (+) Expensive to build than to buy, except during the financial crisis
Generally we see that the number of building plans completed is an indicator of the number
passed (though the number passed < the number completed), also there is a little bit of lag
(admin))

Rental Income

Normally the main source of income derived from property

One measure of potential revenue is the GPRP or the Gross Potential Rental Revenue
Its the theoretical rent if there was 100% occupancy

= 2 2

Rentable area vs. Usable area

Rentable area the total area available
Useable area what individual tenants rent

>1

Why this distinction? Prices are usually quoted per unit of useable area and thus
need to be scaled up
Percentage Rental
In the retail sector: rent is a combination of a base rent and percentage rent
The percentage rent is generally a % of the retail businesss turnover
This percentage rent is also known as overage - and is based on retail sales over a
pre-specified point known as the breakpoint
Implications
i. Landlord has an incentive to have the most successful lessees, should a
business fail to meet their breakpoint may be managed out
ii. Lessee has an incentive to present to the landlord the lowest possible
revenue
In this framework, any proper prediction of rental requires the prediction of:
i. Vacancies
ii. The turnover of the retail lessees

() =
= +

The Financial Components of a lease

Definition of a lease: a legal contract between the lessor (the renter) and the lessee (the
person who rents). Typically a 2-5 year term for offices and warehouses (though much
shorter for residential properties).
Base Rent
o The initial rent in R/m2

Escalation Rent
o Generally the annual rate at which rent will increase over the term of the lease.
o

This value depends on the type of property (e.g. the grade of the offices) as well as
the location

= +

Percentage Rent
o Only applicable in the case of retail properties
o As defined above

Rental Reversion

Positive Rental reversion

o When the expected inflation implicit in the escalation rate is much lower than actual
inflation.
o i.e. Actual > Expected
o Upon expiry the new rental contract will have a much higher rent (in line with
current and historical actual inflation)
o Lessee benefits during the term
o Lessor benefits on renewal
Negative Rental reversion
o Actual < Expected
o Lessor benefits during the term
o Lessee benefits on renewal

Effective Rent

An approximation used to compare different leases and leasing alternatives

Used to transform the increasing annuity to a level annuity i.e.
1. Calculate the PV of all future lease cash-flows at the relevant discount rate
2. Calculate the payment of an equivalent level annuity

Operating Expenses (Generally for commercial rentals)

1. Reimbursable expenses
These expenses are usually recovered from the tenants pro-rata to area occupied
no net cash-flow effect
Examples
i. Common Area Maintenance e.g. hallways, common toilets, security
ii. Property taxes
2. Non-reimbursable expenses not recovered from the tenants
a) Insurance on the property
b) Management (internal or outsourced)
c) Utilities (though sometimes this entirely managed by the tenant)
3. Tenant Improvements

Those improvements made such as fixtures, flooring and dry-walling made to make
the rental space suitable for the tenant
Often the landlord bears some or all of this cost (depends on the supply of office
space and the competition for new tenants)
4. Capital Expenditure (Capex)
Some things the owner must bear the cost of, particularly if they wish to improve
the building/ rental features
E.g. Elevators, parking lots
Direct Property Valuation

The appraisal process:

Physical and Legal Identification - boundaries might get blurred over time, there
could also be contestation between the owner and the municipality

Identification of property rights to be valued -There's always the issue of

userfracts

Specification of the purpose of the appraisal - Whether its for sale or for the
dissolution of an estate

Specification of the effective date of value estimate

Gathering and analysis of market data >> Application of techniques for

valuation

Methods of valuation
o Absolute Valuation (CFs and discounting)
o Relative valuation (using multiples)

1. Cost Approach (quite subjective)

= +

Land = valued using the sales of comparable land

The cost of the structure = based on current building costs (Very accuracy?)
Depreciation = generally to account for the age of the building (what rate to use?)
2. Comparables

() =

The unit of comparison here is the Gross Income (GI) of a similar recently sold
property

() =

() =

The Sales comparison approach

Unit of comparison: /2 of the recent sales of similar properties
This is then adjusted upwards/downwards based on factors such as
Location

 Vacancy Rate
Age of building
3. Cap Rate (best known method)
()

( ) =

Yet again, the comparison is based on the sales of similar properties

This is a measure of unleveraged returns i.e. doesnt account for financing costs/
tax

() =

() = + + +
+ ( )
=

4. DCF

Requires:
1)Predicted Cashflows (estimation)
2)Discount rate/s (which to use?)
3)Reversion value/ terminal Value (which growth rate to use?)

=
( + + )
( + )
=

1
(1+)

+ (1+)22 + + (1+) +

(+)
1
(1+)

Method Comparison

DCF
a. Implies a long-term perspective
b. Links the value to income generation
c. Robust to bubble valuations
Cap Rate
a. Appropriate for short-term valuations
b. Appropriate for less cyclical markets

Property Financing

The 5 Cs of Credit
a. Character
b. Cash flow
c. Capital
d. Collateral
e. Conditions
Elements of property financing
1. Ratios
2. Amortising Loans
3. Risks to lender

4. Refinancing
Loan-to-Value Ratio (LTV)

a. Generally the balance outstanding decreases over time

b. Generally the market value of the property increases over time
c. Generally, we should see the LTV decrease as time goes on i.e. lim0 =
0
d. Also, generally the higher the LTV Higher Risk
As a result, we tend to see less credit-worthy individuals with lower initial LTVs (i.e.
requiring a larger deposit, or only financing a smaller portion of the purchase price)
LTV is of importance, particularly w.r.t. refinancing

Coverage Ratios

Interest Coverage Ratio Debt-to-interest coverage ratio in company analysis

..

Debt Service Ratio includes both the interest and the principal repayments
1. =

..
..

Property Expense Ratio (PER) measures the impact/ magnitude of operating expenses
1. Useful for comparison of different properties
2. =

...

Amortising Loans

Generally mortgages consist of fixed payments over the term of the loan
The interest portion declines over time as the outstanding balance of the loan diminishes
Variables
1. Capital Amount capitalised costs (admin) less deposit
2. Interest rate fixed/ fluctuates with prime
Higher interest rate higher annual repayment
NB: generally quoted as nominal annual rates
3. Term of the loan
Residential 20 years
Non-residential 10 years
Loans with long terms only eat into the capital portion after many
repayments larger total amount of interest paid

Renting vs. Owning

The rental vs. ownership decision isnt as simple as a monthly cash-flow decision
Ownership
1. Entails additional costs such as maintenance, utilities, management & insurance
2. Has taxation implications

3. Youve the potential for capital appreciation

4. Your long term financing liability is matched/ secured by a very illiquid asset
(namely the property)
Factors reducing equity in a property the risks of ownership
1. The over-mortgaging of a property
2. Poor maintenance
3. Damage (thats why insurance is so important)
4. Negative market conditions (House price decreases by loan outstanding remains
constant)

Risks to the mortgage Provider

Default Risk a function of the credit-worthiness of the borrower, mitigated by certain

covenants which aim to restrict the actions of the borrower (particularly companies)
1. Positive (to-do) Loan covenants
1. Minimum dividend payment levels
2. Insurance Cover: lender requires borrower to insure the property to protect
the lenders interest (property is used as collateral)
3. Sweep Provision: Lender has the first right to the cash flows generated by
the property - to prevent the borrower collecting all the rent and then filing
for bankruptcy in the case of the loss of a major tenant
2. Negative (no-to-do) Loan covenants
1. Employees not to be fired in the firm
2. Prepayment penalties
Interest Rate Risk unfavourable movements in the interest rate might induce refinancing
and impact the above and below
Prepayment risk (generally a tie-off between the default risk and the prepayment risk)
1. Higher prevailing interest rates: borrower obtains a loan from you or if he has a loan
defaults on his payments
2. Lower prevailing interest rates: borrower refinances the loan prepayment
3. Preventative methods:
1. Prepayment penalty (negative covenant)
2. Lockout clauses

Refinancing

Borrowers Perspective
1. An improved credit profile (bolstered my project success) and/or changes in interest
rates might allow for refinancing at a more favourable interest rate.
2. Benefits
1. Lower interest rates lower finance costs
2. The ability to withdraw funds from the project (might be able to get a loan
larger than the current outstanding balance positive cash injection for
other purposes)
3. Costs
1. The appraisal, legal and accounting fees that a new loan application entails

2. Loan origination fees

3. Prepayment penalties (not always the case)
When to Refinance
1. Interest Rates have declined
2. The borrowers creditworthiness has increased significantly
3. The Lender is better off (i.e. it is better for the lender to allow the borrower to
refinance with them at a lower rate to avoid losing the business to a competitor
with an even lower interest rate)
4. The owner can withdraw capital tax free? (Generally a function of the owners
credit-worthiness)
When evaluating the option to refinance: compare the initial cost of refinancing with the
benefits (the decrease in monthly/annual payments) and calculate the IRR
Alternatively: compare the initial cost, with the benefits per month and the savings on
paying out the loan in the case of early market sale.

How to invest in property?

1. Direct Investing
a. Benefits
Customizable leverage
Better selection
More control
Less C/F delay
b. Costs
High cost + High initial capital outlay
Poor diversification
Liquidity constraints
2. Property Syndication (quite direct)
Generally quite costly
Even poorer liquidity constraints
Often difficult to achieve scale
Potential for conflict
3. Listed Property (indirect)
Good liquidity + diversification
Built-in leverage
Less choice + require dividends for cash flows
Layers of costs economies of scale?
4. Collective Investment Schemes, mutual funds and unit trusts (indirect)
Mostly as above, though to a lesser extent \
The benefits of indirect investing

Very little experience is required

Very liquid
Economies of scale

Very accessible low start-up costs

Listed Property investments

These are listed companies that own and invest in properties and whose shares trade freely
on the exchanges
US, EU, Aus + SA Real Estate Investment Trusts (REITs)
Has generally outperformed the ALSI
Historically in SA there were only: property unit trusts (PUTs) and Property Loan Stocks
(PLSs), with 6 of the former and 20 of the latter on the JSE. Also some PLSs were unlisted.
PUTs
A unit trust (i.e. a collective/ pooled investment fund)
One share is linked to a number of debentures (unsecured loan stock, although this
isnt really the case) known as linked units.
Net income is paid as interest to the debenture holders
PUTs dont pay tax, but the investors interest income is taxable at a
marginal rate
Gearing is limited to 30% (quite low)
Governed by the Registrar of Unit Trusts
All income must be paid out
PLSs
A loan stock company
Pretty much the same as a PUT but w/o the governing body.
Also no limitations on gearing.
Also retained income is taxed.

REITs possible as from May 2013

Company REITs = PLSs

Trust REITs = PUTs
Requirements
Must own (+) R300 million in property
Gearing < 60%
75% + Earnings from rentals/ other indirect property ownership
75% + Earnings must be paid out to investors
Taxation
All s/h distributions are tax deductible (marginal rates, 0 for pensioners)
No CGT on property sale P/L to stimulate liquidity
No securities transfer tax (STT) on REIT shares
Interest tax exemption no longer available to shareholders?

Analogy between Property and Bonds

Both have a relatively constant stream of income

Limited uncertainty
Argument is that the gap between Bond yields and Property yields should be quite stable

Property Earnings yield > Bond Yield (risk-return characteristics require this)

Valuing Listed Property

1. DCF Method
Assumption: NOI will grow at a constant rate
Capitalisation rate = discount rate less growth rate = r g =
=

= , ,
= = ( + +
)

(++)

2. Net Asset Value Method

Active Property Portfolio Management

This entails the ongoing improvement of and trading in properties in order to optimise and
increase in returns
Sometimes: the improvement and reinvestment in existing properties may yield higher
returns than buying new properties.
This sort of management is the cornerstone of property investment and is distinct from
tenant management

Tenant management the ongoing management and support of tenants

Places a role in all forms of rental real-estate, but mostly in the retail sector
Owner tries to optimise the tenant mix Attract profitable tenants and eliminate struggling
tenants
A rather holistic process must consider the synergies and mutual interactions between
tenants (a little spirit sciencey eiy?)
The question of Anchor Tenants
o Large, often national tenants, who attract shoppers to the centre but often demand
specific lease terms and exclusivity.

Risks vs. Returns of Listed Property

Returns
o Capital Gains share prices should increase over time as the value of properties held
by the PLS, PUT or REIT increase over time Lowe volatility relative to equity
o Dividends/Distribution should (theoretically at least) grow in line with the
increased rent (tied to escalation rates)
Risks
o Very vulnerable to changes in the vacancy rate
o Also impacted by bad property management decisions:
Overpaying for a large property (portfolio management)
Losing key tenants (tenant management)
Redevelopment/ Reinvestment in a property that doesnt work (portfolio
management)

Reporting for Listed Properties

Distribution per linked unit Dividends per share

Net asset value per linked unit NAV/ share
Net Tangible value per linked units = Assets Intangible assets liabilities per unit
GLA = Gross Lettable Area

Section 2- Mortgage-Backed Securities

Definition of Mortgage: A mortgage is a loan secured by a real estate property.

The borrower is obliged to make a series of payments according to some pre-specified rules.
The lender has the right to foreclose on the loan if the borrower defaults i.e. the lender can
seize the specified property/ other assets for the loan amount

Participants in the Mortgage Market

Mortgage originator
o Not necessarily the bank
o Often just an outsourced firm which helps you obtain the desired loan (in this case
they are an intermediary Home Loan Brokers)
o It can, however, also be the bank.
o Ultimately the loan originator is the bank
Credit bureau
o Suppliers the would-be borrower with a credit score
Mortgage servicer
1. Collects the monthly payments from the borrowers
2. Maintains the records
3. Manages the PMI (private mortgage insurance)
4. Administers escrow balances (collected money used to pay rates and taxes uprfront)
5. Deals with foreclosure if necessary
Mortgage insurer
o Typically the lender requires that the borrower has private mortgage insurance if
LTV > 0.8
o This is to protect the lender in the case of default
o Cost borne by the borrower

Calculation Notes

Level Payment = Fixed rate mortgages

o

1
)
1+

Interest rates are quoted as nominal annual rates divide by 12 to get the effective
monthly rate
o Assumes: fixed interest for lender, no prepayment, no default (dependent on
property prices?)
o For MBS assume that they all have the same mortgage rate and maturity
Interest only mortgage
o Pays interest over the life of the loan
o Pays the principal right at the end
Adjustable rate mortgage
o Interest rate is variable and linked to some reference rate
o

1(

o
o
o

Interest rate = reference rate + spread

The rate is adjusted at periodic reset dates floating peg
They have safety nets
Periodic cap = limits the amount the rate may jump at reset dates
Lifetime cap = limits the amount the rate may jump over its lifetime
Balloon Mortgages
o Generally involves a variable (low) interest rate and then sum lump-sum
o This lump sum is either paid in cash or is refinanced

The risks of investing in mortgages

1. Default risk
2. Interest rate risk NB generally we assume the entire pool has the same interest rate
Interest rate increases/decreases are both risks
It has implications for refinancing or a decrease in value of the loans
3. Prepayment risk
All about timing and expectations prepayment affects our cash-flow (in both
directions)
4. Liquidity risk
What happens if we cant get the mortgage/ MBS off our hands?
MBS often trade at a higher value than that of the underlying loans
Definition of MBS: Mortgage backed securities are tradable bonds or debt instruments which are
backed (secured) by residential mortgage loans.

A whole group of mortgages is purchased and formalised using an SPV (to ring-fence legally)
Shares are then sold in that SPV, these shares are bonds whose cash-flows are backed by the
cash-flows from the mortgage repayments

Residential Mortgage-backed security types

1. Mortgage Pass-through Securities (pass-through MBSs)
A security created when 1 + holders of mortgages form a pool of mortgages
They then sell participation certificates in the pool (the securitisation of the
mortgage)
2. Collateralised Mortgage Obligations (CMOs)
Created from (1) derivative mortgage-backed security
3. Stripped mortgage-based securities
Created from (1) derivative mortgage-backed security
Commercial Mortgage-backed securities (CMBSs)
1. Mortgage Loans are pooled together/ bundled into an SPV (Special Purpose Vehicle)
SPVs only asset is the loans.
2. SPV sells fixed income securities which have a claim to the loan repayment cash flows
Generally sold to institutional investors

Parties to CMBSs
I.

II.
III.

IV.

Pool Originator ( Loan originator)

Generally an investment bank
Assembles the pool of loans (then transfers them into the SPV)
Markets them to investors (road show+ prospectus)
All of this is for a fee ($$$)
Issuer
Usually the SPV (the legal entity/ pseudo-company which holds the loans)
Master Servicer
Generally, the maintenance of the CMBS pool is outsourced.
The master servicer is this outsourced manager
Collects debt, distributes the cash-flows to the investor, maintains records
Also responsible for meeting regulatory requirements
Special Servicer
Only deals with the special circumstances of loans in default and/or foreclosure.
Paid on a commission basis once work is done

Advantage to the loan originator of securitization

No need to actually service the loans (all taken care of by the master servicer)
Immediate cash-flow
o When the loans are sold to SPV through the pool originator immediate and full
cash-flow.
Overcomes capital limitations
o By selling the loans off they reduce their outstanding loans (an asset to them)
given their existing capital base/ reserve
o Can therefore lend more/ originate new loans
o They earn origination fees each time they start the loan cycle again
o $$$
Interest rate spread
o CMBSs often sold at a lower average interest rate higher nominal value/ price
than the original loans.
o They thus gain from this interest rate spread

Other reasons for MBS creation (primarily residential)

Diverse investor requirements can be satisfied (speaks more to CMOs)

Creates liquidity in mortgage markets now loans can be moved
Results in the diversification of risks to the investor now able to invest in 50% of all the
loans instead of 5/10 of the actual loans
It created a new investment class in the saturated debt market

Definition of a pass-through: A pass-through security is a type of MBS where the payments of

interest and principal from the underlying pool of mortgages is passed through to the individuals
who own shares in the pool (generally unencumbered and pro-rata)

Pass-through agencies
o
o

Government agencies can guarantee the timely payment of the principal and/or interest
repayments
As much as they might guarantee the payments of the MBS, they themselves might default.

Types of pass-throughs

Fully modified pass-through

o Timely payment of both the interest and the principal is guaranteed
o This ensure that you get the right amount at the right time
o Relatively low-risk
Modified pass-through
o Only the timely payment of interest is guaranteed by the agency
o The scheduled principal is of course passed through as it is collected
o There is however a guarantee that all principal will be repaid by some specified
date

Pass-through agencies
1. Government National Mortgage Association (Ginnie Mae)
Backed by the full faith and credit of the US Gov
Default risk free
Security = MBS
All Fully-modified pass-throughs
2. Federal National Mortgage Association (Fannie Mae)
Guaranteed by Fannie Mae and not the US gov
Security = MBS
All Fully-modified pass-throughs
3. Federal Home Loan Mortgage Corporation (Freddie Mac)
Guaranteed by Freddie Mac and not the US gov
Security = participation certificates
Offers modified and fully-modified pass-throughs
4. Private Label Pass-through agencies

Some private banks create pass-throughs in much the same way as the government
agencies
No implicit/explicit guarantees from the US gov
(+) Risk

Cash-flow characteristics

The exact CF = f(underlying mortgages) = principal repayments + interest

CF to security holders = Morgage Payments received (Servicing + Other Fees)

o Other fees include fees by the guarantor or whoever guarantees the issue
For pass-through securities, the overall coupon rate is known as the pass-through rate
Assumptions
o Pass-through MBSs exhibit negative convexity (embedded call option)
o Valued as if there is no reinvestment risk i.e. valued as if cash-flows could be
reinvested at the coupon rate

Weighted Average Coupon (WAC) Rate (NOMINAL ANNUAL forms the interest part in the PV equ.)

The pool consists of mortgages with

o Various coupon rates
o Various maturities
o Various levels of creditworthiness
There is some overall risk of pre-payment, captured by the prepayment rate (generally
calculated monthly)
An investor in MBS needs to be able to project this rate to project future CFs and to account
for the pre-payment risk

= , =
= 1 1 + 2 2 + +
= , =
= 1 1 + 2 2 + +

Prepayment Risk

Prepayment Risk = risk associated with the uncertainty of cash-flows inherent in prepayment
patterns.
Types
1. Contraction Risk everything is paid faster than expected
Mortgage Rates Decline relative to coupon rate
MBS has a fixed coupon rate MBS price (+) [Investor ]
Also, because mortgage holders can now refinance at a lower rate More
prepayment than expected MBS price (-) [Investor ]
Prepaid CF to MBS has to be reinvested at the lower mortgage rates
[Investor ]
2. Extension Risk everything is paid slower than expected

Mortgage Rates Increase relative to coupon rate

MBS has a fixed coupon rate MBS price (-) = [ investor]
Also, because mortgage holders now under pressure, no scope for
refinancing Less prepayment than expected MBS price (+)
= [ investor]
There is less prepayment to be reinvested at the desirable higher rates (than
expected) = [ Investor]

Prepayment and Asset/Liability management

Pension Funds
o Long term liabilities which will need to be met at some later stage
o Because of the long duration of these investments they want to ensure they get
the necessary cash-flows at the right time, particularly they dont want to get too
much cash too soon (reinvestment risk)
o Liable to contraction risk
Thrift & Commercial banks
o Short term liabilities which need to be met negative consequences when
payments come slower than expected in the MBS
o Liable to extension risk

Prepayment Rates

Conditional Prepayment Rate (CPR)

o We assume that some fraction of the outstanding principal is prepaid each month
o Conditional on the remaining principal balance in the pool
o An annual prepayment rate needs to be converted to monthly rate for
calculations, called the SMM
Single Monthly Mortality rate (SMM)
o

(1 )12 = 1 = 1 (1 )12

Monthly repayments and prepayments (NB. Monthly annuity repayment must be calculated
each month again)
o
o
o
o
o
o

=
=
=
=
= ( )
= +

Public Security Agency (PSA) prepayment benchmarks

The PSA has provided a benchmark for the calculation of prepayment rates (often scaled
up/down) As such the normal benchmark is known as 100% PSA
This specifies the CPR as the mortgage reaches maturity
100% PSA
o 0.2% CPR for the first month

o
o

Increasing by 0.2% for the next 29 months

6% CPR from 30th month onwards

Factors affecting prepayment behaviour

A. Prevailing mortgage rate
1. The spread between the contract rate (the WAC) and the prevailing mortgage rate
2. The path of interest rates (whether increasing or decreasing)
B. Seasonal Factors
o People tend to move in spring instead of winter they might prepay and refinance
then etc.
C. Type of Loan
o Balloon mortgages, for example, have very specific prepayment behaviours
D. General Economic Activity
o One might argue that employment (+) prepayment (+)
How to mitigate prepayment risk?

Cash-flows from mortgage payments are directed towards different tranches/ bond classes
Results in Collateralised Mortgage Obligations (CMOs)
This doesnt eliminate the prepayment risk, but redistributes it amongst the tranches
allowing investors to choose based on their risk profile

Definition of Collateralised debt obligations (CDOs): Bond classes which are created by structuring
asset-backed securities into multiple tranches so as to redistribute risk
Definition of CMOs: MBS pass-throughs which have structured into multiple tranches to redistribute
prepayment and default risk
CMOs vs CDOs

CDOs are more general they can hold any income producing debt
o E.g. credit cards, vehicle loans, student loans
CMO is a specific type of CDO

CMOs and Tranches

The security cash-flows are bundled into different tranches

Different tranche different risk profile
Senior tranche (AAA)
First claim on all cash-flows
Lowest default risk lower yield
Highest prepayment risk
Each tranche is assessed and rated via a rating agency based on their default risk

Types of CMOs
1. Sequential Pay tranches
Each tranche is retired sequentially
There are various rules which specify the distribution of CFs
For example:
i. All principal (+ repayment) payments go to tranche 1 until its balance is 0
ii. Then all to tranche 2
iii. Then to tranche 3
iv.
Observations
i. Tranche 1 has the highest contraction risk and the lowest default risk and
expansion risk
ii. The monthly coupon interest is calculated on the months opening
principal balance
2. Accrual tranches
a. Interest is paid to each tranche monthly based on outstanding balance
b. One tranche, the Z-bond/ Accrual tranche receives no interest, no principal, but
simply accrues
c. Otherwise it functions much like a sequential pay tranche
d. Z-bond is repaid right at the end Max default risk, Min prepayment risk
3. Floating Rate tranches
Generally, CMOs are based on fixed rate mortgages
These fixed cash-flows are then divided into (e.g. tranche B to Tranches B1 + B2) two
tranches via. The coupon rate
i. The floating-rate tranche generally follows some reference rate e.g. LIBOR

1.00 ,
1.00

1 1.00

Floor of the floater = premium added

Cap of the floater = floater valued at LIBOR associated with the floor
of the inverse
ii. The inverse-floating rate tranche follows the inverse of the ref. rate
Floor of the inverse = 0%, has a LIBOR associated with it
iii. Rule Interest out = interest In
4. Structured interest-only (IO) strips (Stripped MBS)
This tranche receives all the interest

CMO coupon rate < WAC excess interest is paid to the interest only tranche
Principal is repaid at the end No prepayment risk (at least directly)
i. If r is (+) , less prepayment earn the interest for longer
ii. For a variable rate mortgage (+) r (+) CFs (+) discount rate
indeterminate effect
High default risk
5. Principal-only strips (PO) (Stripped MBS)
This bond class receives all the principal
Principal is received whenever it is paid (it is contingent on prepayment rates etc.)
i. When default occurs if it is Government backed, you still get principal
just no prepayment
Ideally payment received as soon as possible (higher IRR) we would prefer
higher prepayment would prefer the prevailing mortgage rates to (-)
Analysing a CMO tranche

Higher LTV ratio Higher risk higher yield lower price

Higher debt-service-coverage-ratio lower risk lower yield higher price

Tranching and Credit Enhancement

Credit enhancement occurs when the MBS/CMOs credit quality is raised above that of the
underlying mortgage pool.
o Because of this, secondary market investors need not have specialised knowledge of
mortgage risks
o This is outsourced to credit rating agencies
Types of Credit Enhancement
o External
Corporate guarantee
A letter of credit
Pool insurance (Ginnie Mae par example)
Bond insurance
o Internal
Subordination
Overcollateralization = + tranches than the principle
Credit Rating
o 3 Major rating industries: Fitch, Moodys, S&P
o They analyse each tranche to determine the credit rating
o This is done using statistical models (built on historical loan data)
o Each tranche and its creditworthiness are considered individually
Subordination
Underlying mortgage quality
Priority of CF
o Senior tranches higher credit rating

Subordination and Credit Rating

Definition of subordination: The subordination of a tranche is the amount of the total pools
principal that disappears before the tranche loses principal size of the principal cushion
below it
Adjusted default probability

Desired Rating
Adjustment
AAA
100%
AA
80%
A
60%
BBB
40%
Loss severity (a rate, not an amount)
o Measure of the loan balance vs. property value (like the LTV) in the case of default

o
o
o
o
o

= =
=
= .
=
=

Required subordination
o
o
o
o

=
() =
= ()
=

= ( )

Section 3- Credit Risk

Definition of Credit Risk: This is the risk of default, the risk of counterparty not paying back
Who cares about credit risk?

Suppliers (who supply on credit)

Creditors
Investors (i.e. you care about whether you get your bond coupon payments)
YTM is an indicator of this risk

Expected value of discounted CFs under Q

= [ ( ) ]

=
=
= (% )
=

. . 1.5 =

= = = ( )

(1+ )

2
2

(1+ )

3
2

(1+ )

=
= = Bond formula (remember principal)
= =1 + (1 )
o Price and PVDs and PVDN can all be immediately calculated
o From this we can calculate the risk neutral probability

Default Rates

The conditional default rates of good credit rated companies increase over time. Why?
o If youre at 0 it can only get worse?
o Youre only rated at the beginning forecasting is only valid for the immediate
future
The conditional default rates of bad credit rated companies decrease over time. Why?
o Informational asymmetries at the beginning all people in the CCC are regarded
as the same sort of borrower, but some are in fact good and others are bad.
o As time goes on only the good remain default prob. Decreases

Credit Default Swaps (CDS)

This can be seen as an insurance product which insures against the risk of default of a bond
(known as the reference obligation) issued by a particular company (the reference entity).
A kind of credit derivative

Credit Events

The firm goes bankrupt

The firm fails to pay a coupon

The firm restructures the terms of the debt

Structure of a CDS

The protection seller increases their exposure to credit risk (the event in the underlying)
Payoff Methods
o Delivery the protection buyer swaps the defaulted bond with the protection seller
for its par value
o Cash Settlement the protection buyer keeps the defaulted bond
Gets a cash settlement of (1 ) from the protection seller
Assumption: the buyer pays his periodic payment even at the moment of
the credit event (default) but not after
Payment
o CDS spread = periodic payment = 80 bps (basis points) x Par Value
NB: annualized amount (nominal)
o 100 bps = 1 percent
o Dealer buy-at-the-bid, Dealer sells-at-the-ask
o Bid/ask e.g. 50/70

USE of CDSs

Shift credit risk e.g. buy protection

Diversify credit risk e.g. Buy protection on one loan (the one that you have) and sell on
another (not necessarily one you have a loan on)

Setting the spread

[ ] = [ ]

= (1 )
=
Under the equation we drop
1(

=1
o

1
)

1+
2

1(

1
)
1+
2

= =1

1
(1+
)
2

, & , =