Mortgages and MortgageBacked Securities

1
Mortgages and Mortgage-Backed Securities

• Mortgages are loans to individuals or businesses
  to purchase a home, land, or other real property
• Many mortgages are securitized
• securities are packaged and sold as assets
  backing a publicly traded or privately held debt
  instrument
• Four basic categories of mortgages issued
• home, multifamily dwelling, commercial, and farm

2
Mortgage Characteristics

• Lien - a public record attached to the title of
  the property that gives the FI the right to sell
  the property if the mortgage borrower defaults
• Down payment - a portion of the purchase price of
  the property a FI requires the mortgage borrower
  to pay up front
• Private mortgage insurance - insurance contract
  purchased by a mortgage borrower guaranteeing to
  pay the FI the difference between the value of
  the property and the balance remaining on the
  mortgage

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3

• Federally insured mortgages - originated by FIs
  with repayment guaranteed by either the Federal
  Housing Administration (FHA) or the Veterans
  Administration (VA)
• Conventional mortgages - issued by FIs that are
  not federally insured
• Amortized - when the fixed principal and interest
  payments fully pay off the mortgage by its
  maturity date
• Balloon payment mortgages - requires a fixed
  monthly interest payment for a three- to
  five-year period with full payment of the
  mortgage principal required at the end of the
  period

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4

• Fixed-rate mortgage - locks in the borrowers
  interest rate and thus the required monthly
  payment over the life of the mortgage, regardless
  of market rate changes
• Adjustable-rate mortgage - where the interest
  rate is tied to some market interest rate with
  potential for change in required monthly payments
  over the life of the mortgage
• Discount points - interest payments made when the
  loan is issued (at closing). One discount point
  1 percent of the principle value of the mortgage

5
Traditional Mortgage

• Traditional mortgages
• Long term typically 30 years
• Fixed rate
• Borrower can pre-pay some or all of the loan at
  any time without penalty

6
Risks of Investing in Traditional Mortgages

• Interest Rate Risk
• Prepayment Risk
• Contraction Risk rates fall
• Extension Risk rates rise
• Credit Risk
• Liquidity Risk

7
Factors Affecting Prepayments

• Mortgage Rates
• Spread between contract rate and market rate
• Path of market rates
• Level of market rates
• Characteristics of Underlying Mortgages
• Seasonal Factors
• General Economic Activity

8
Mortgage Businesses

• Today there are three distinct businesses
  associated with mortgages
• Origination
• Servicing
• Investing
• In the past savings associations dominated the
  mortgage market and they performed all of these
  functions

9
Secondary Mortgage Market

• Advantages for FI to securitize
• reduces prepayment risk, liquidity risk, interest
  rate risk, and credit risk of FIs portfolio
• FI retains income from origination fees and
  service fees
• FIs remove mortgages from their balance sheet
  through one of two mechanisms
• pool recently originated mortgages together and
  sell them in the secondary market
• issue mortgage-backed securities that are backed
  by their newly originated mortgages

10
History of Secondary Mortgage Markets

• Federal National Mortgage Association (FNMA or
  Fannie Mae) created during the Great Depression
• FHA and VA insured loans also created during this
  time
• Government National Mortgage Association (GNMA or
  Ginnie Mae) and Federal Home Loan Mortgage
  Corp. (FHLMC or Freddie Mac) created during
  1960s
• Wide variety of mortgage-backed securities have
  been developed and in 1999, approximately 50 of
  mortgages are securitized

11
Mortgage Sales

• Mortgage sale - sale of a mortgage originated by
  a bank with or without recourse to an outside
  buyer
• Allow FIs to manage prepayment risk, interest
  rate risk and credit risk, achieve better asset
  diversification and improve their liquidity risk
• FIs encouraged to sell loans for economic
  (generation of fee income) and regulatory reasons
  (reducing cost of reserve requirements)
• Major buyers of mortgage loans are domestic
  banks, foreign banks, insurance companies and
  pension funds, closed end bank loan mutual funds,
  and nonfinancial corporations
• Major sellers of mortgage loans are money center
  banks, small regional or community banks, foreign
  banks, investment banks

12
Securitization of Mortgages

• Pass-through mortgage securities -
  mortgage-backed securities that pass-through
  promised payments of principal and interest on
  pools of mortgages created by financial
  institutions to secondary market participants
  holding interests in the pools
• Issued in standard denominations, usually 25,000
  with increments of 5,000 beyond the minimum
• Three government owned or sponsored agencies
  involved - Ginnie Mae (GNMA), Fannie Mae (FNMA,
  and Freddie Mac (FHLMC)

13
Stripped Mortgage Securities

• Principal Only (PO) investor receives all
  principal payments from the underlying pool of
  mortgages
• Interest Only (IO) investor receives all
  interest payments form the underlying pool of
  mortgages

14
Collateralized Mortgage Obligations

• CMO - a mortgage-backed bond issued in multiple
  classes or tranches
• tranches - a bond holder class associated with a
  CMO
• Created by packaging and securitizing whole
  mortgage loans or resecuritizing pass-through
  securities
• Attractive to secondary mortgage market investors
  because they can choose a particular CMO class
  that fits their maturity needs

15
CMO Tranches

• Sequential Pay
• Accrual
• Floating Rate
• Floater
• Inverse Floater
• Planned Amortization Class
• Companion or Support