The Secondary Mortgage Market

1
The Secondary Mortgage Market

• Chapters 10 and 11 present an introduction to
  several key items in the secondary mortgage
  market. These include
• The major players, FNMA, FHLMC, and GNMA.
• Basic idea of a pass-through security.
• Prepayments and their effect on MBS cash flows.
• Prepayment Models
• Static vs. Dynamic

2
The Secondary Mortgage Market

• Mortgage Descriptive Statistics
• IO/PO Combinations
• Collateralized Mortgage Obligations
• Mortgage Backed Futures

3
Historic Origins

• The US mortgage markets are one of the most
  well-developed aspects in the overall financial
  system.
• The last 30 years has seen a major change in the
  organization of that system.

4
Historic Origins

• The classical model was the Its a Wonderful
  Life model a savings institution borrowed money
  from depositors and lent them to mortgage
  borrowers.
• The problem was that savings institutions faced a
  maturity mismatch.

5
Historic Origins

• Lenders limited borrowing to 5 year IO loans.
  Thus borrowers had to refinance every five years.
• Under the New Deal, the Federal government set
  increasing homeownership as a national goal. One
  way to do this was to go to fully amortizing
  loans.

6
Historic Origins

• Fully amortizing loans required longer
  maturities. Lenders demanded help managing
• Credit risk done initially through low
  loan-to-value (LTV) loans and through FHA
  insurance.
• Interest Rate Risk The government attempted to
  control rates by Regulation Q.

7
Historic Origins

• Additionally, the federal government determined
  that starting a secondary mortgage market was
  probably a good way to provide liquidity to
  mortgage lenders.
• 1939, the Federal National Mortgage Association
  (FNMA, pronounced Fannie Mae) was started as part
  of HUD.

8
Historic Origins

• FNMA standardized mortgage contract terms and
  underwriting methods.
• Interstate banking laws still made transferring
  loans difficult.
• The transaction costs associated with selling
  mortgage loans, and the information asymmetry
  between lenders largely prevented the formation
  of a secondary market.

9
Historic Origins

• During the 1940s and 1950s, interest rates
  remained non-volatile.
• Interest rates started becoming volatile in the
  1960s. In addition, the Eurodollar market
  created a method for US savers to earn more than
  the regulation Q limited rates.
• Disintermediation occurred on a large scale.

10
Historic Origins

• By the late 1960s the need for a national
  mortgage market had become clear.
• The federal government quasi-privatized FNMA. It
  became a Government Sponsored Enterprise (GSE).
• FNMA was tasked with creating a secondary market
  for FHA or non-FHA insured loans.
• The federal government formed a second GSE, the
  Federal Home Loan Mortgage Corporation (FHLMC) to
  compete with FNMA.

11
Historic Origins

• GSE status
• GSEs debt are implicitly backed by the US
  government. They are able to borrow at between
  15 and 30 basis points above the Treasury rate.
• In return for this preferred borrowing rate, they
  agree to a high level of regulation. The
  President and 1/3 of the board are appointed by
  the US President (and confirmed by Congress).

12
Historic Origins

• GSE status
• GSEs must meet Congressionally-set capital
  standards. The Office of Federal Housing
  Enterprise Oversite (OFHEO) is responsible for
  determining GSE compliance.

13
Historic Origins

• The federal government started a wholly-owned
  government corporation within HUD. This entity
  is known as the Government National Mortgage
  Association (GNMA).
• GNMA is tasked with creating and maintaining a
  secondary market for FHA-insured mortgages.

14
Historic Origins

• By 1971, Congress had established the three major
  secondary mortgage market entities, FNMA, FHMLC,
  and GNMA. Creating the market would take some
  time.
• During the 1970s and into the early 1980s,
  interest rate volatility kept increasing.

15
Historic Origins

• Lenders were getting squeezed badly.
• When rates rose, the average deposit which
  financed mortgages rose quickly, since the
  maturity on these deposits were rarely more than
  5 years.
• Their average rate on their loan portfolio,
  however, rose very slowly, since mortgages are
  such long-term assets (note that the marginal
  rates rose quickly, however.)

16
Historic Origins

• Lenders were getting squeezed badly.
• By the early 1980s most Savings and Loans (the
  primary mortgage originators) were paying more,
  on average, for deposits than they were earning,
  on average, from loans.
• When rates fell, borrowers refinanced their newly
  issued, high interest rate mortgages.
• The deposit rate, however, staid relatively high
  since depositors were in no hurry to invest at
  the new lower rate.

17
Historic Origins

• Lenders were getting squeezed badly.
• The net effect is that lenders lost money when
  rates rose, and the lost money when rate fell.
• To profitably hold mortgages in their portfolio
  (in the absence of hedging tools), financial
  institutions need stable, non-volatile interest
  rates.
• Banks and SLs are well-suited for originating
  mortgages, they are not well suited to holding
  mortgages in portfolio.

18
Market Innovation

• As early as the mid-1960s it was clear that
  major innovation was needed in the mortgage
  markets.
• GNMA, FNMA, and FHLMC provided that innovation
  through the creation of a financial instrument
  known generically as a Mortgage Backed Security
  (MBS).

19
Market Innovation

• We are going to examine a total of six types of
  MBS. They are
• Mortgage Backed Bonds
• Mortgage Pass-through Securities
• Mortgage Pay-Through Securities
• IO/PO Combinations
• Collateralized Mortgage Obligations
• Mortgage Backed Futures

20
Mortgage Backed Bonds

• These are the simplest of the MBS that we will
  examine. These are basically standard corporate
  bonds with mortgages serving as their collateral.
• The issuer retains all liability for making the
  payments to the investors.
• The bonds typically have a par value of 10,000
  and have annual coupon payments.

21
Mortgage Backed Bonds

• Why would a company issue an MBB?
• The collateral may allow them to obtain a higher
  credit rating (or lower contract rate) than they
  would otherwise be able to get.
• The use of collateral will reduce to some degree
  the drain on the debt capacity of the firm.

22
Mortgage Backed Bonds

• The market prices this bonds like any other
  corporate debt
• Determine the cash flows and then discount them
  back to today at the appropriate discount rate.
• The cash flows are annual interest payments until
  the maturity date when a final interest payment
  is made along with the return of the par
  principal amount.

23
Mortgage Backed Bonds

• This works out to the following formula
• The next page shows prices at origination for a
  20 year MBB with coupon of 9 at different
  discount rates.

24
Mortgage Backed Bonds
25
Mortgage Backed Bonds

• Issuing MBBs is one method through which a lender
  could raise the capital they need to finance the
  mortgages they originate.
• There is a problem, however. Since the cash
  flows from the MBB are not dependent directly on
  the underlying mortgages, they will not exhibit
  the negative convexity that the mortgages will.
• This means the MBB will not naturally hedge the
  prepayment risk embedded in the mortgage.

26
Mortgage Backed Bonds

• To see this, first consider that the lender is
  issuing the MBB, so to them the value of this
  liability is the exact opposite of how we
  normally look at it

27
Mortgage Backed Bonds
28
Mortgage Backed Bonds

• Now if you consider that the portfolio of
  mortgages that the lender holds does exhibit
  negative convexity, you can see why the MBB does
  not provide the best hedging of the prepayment
  risk.

29
Mortgage Backed Bonds
30
Mortgage Pass-Throughs

• For now, we will be discussing MBS as FNMA and
  FHLMC issue them. GNMAs are different, so
  ignore them for now.
• An MBS is simply a bond issued by FNMA or FHLMC
  that is collateralized by a pool of underlying
  mortgages.

31
Mortgage Pass-Throughs

• Here is how they work
• A bank or series of banks originates a lot of
  mortgages (several hundred million worth).
• FNMA or FHLMC buys those mortgages from the bank
  and creates a pool.
• FNMA then creates creates a bond which is
  collateralized by the pool of mortgages. The
  investors in this pool will receive the
  proportionate share of each months principal and
  interest paid by the individual mortgagors. This
  is known as a pass-through security.

32
Mortgage Pass-Throughs

• Here is how they work
• FNMA or FHLMC guarantees to the MBS investors
  that if a borrower defaults, FNMA or FHLMC will
  pay the investor both the principal and interest
  they are owed.
• FNMA and FHLMC will then foreclose upon the
  defaulted borrower.
• FNMA and FHLMC charge a fee for this insurance.
  They typically charge 25-30 basis points per year
  for this insurance.

33
Mortgage Pass-Throughs

• Here is how they work
• FNMA and FHLMC do not on a monthly basis deal
  with the borrowers. They hire outside firms
  called servicers (frequently the originating
  bank) to collect the monthly checks, answer
  questions from the borrower, etc.
• For servicing the loan, the servicer is able to
  earn about 25 basis points a year.
• The net effect is that between the servicer and
  the insurance, 50 basis points are charged
  against the pool

34
Mortgage Pass-Throughs

• Here is how they work
• Thus, if an MBS were formed from a series of 10
  loans, by the time the servicing and insurance
  fees were taken out, it would in essence have a
  9.5 coupon.
• Most MBS have stated coupons that are 50 basis
  points lower than their underlying collateral.

35
Mortgage Pass-Throughs

• Here is how they work
• In some sense then, to an investor, buying an MBS
  with a 10 coupon rate, it is like buying a
  mortgage with a contract rate of 10, but
  principal amortizes as if it were a 10.5
  mortgage (since the underlying mortgage would in
  fact be 10.5 mortgages).

36
Mortgage Pass-Throughs
37
Mortgage Pass-Throughs

• Here is how they work
• Since the investors essentially have just a type
  of bond, they are free to trade that bond in the
  secondary market. This market is now huge.
• The MBS market is roughly 4 Trillion in size.
• There is more outstanding mortgage debt that US
  Treasury debt.
• Only the currency markets have higher daily
  volume than the secondary mortgage market.

38
Mortgage Pass-Throughs

• MBS are especially popular with banks and other
  financial institutions, because they can hold
  mortgage assets, but then liquidate them easily
  if they need to raise capital.
• FNMA and FHLMC have become wildly successful
  companies through this operation.

39
Mortgage Pass-Throughs

• Like any other financial asset, the way to
  determine price a mortgage backed security is to
  simply determine its cash flows, and then
  discount them back at the appropriate discount
  rate.
• This is more difficult because the cash flows
  themselves are a function of interest rates.

40
Mortgage Pass-Throughs

• This is because of prepayments. We know that
  some people will choose to pay off their loans
  early. Thus, the MPT passes through all
  cashflows to the investors, the investors receive
  these prepayments.
• Prepayments obviously increase as the market rate
  falls below the contract rate.

41
Mortgage Pass-Throughs

• We are going to need a way to build in our
  expectations about prepayments into our pricing
  model.
• Before we do that, however, lets run through an
  example of an MBS to explain the cash flows.

42
Mortgage Pass-Throughs

• Lets assume that there is a MPT that consists of
  10 mortgages. Each mortgage has a coupon of 10,
  there is a 25 basis point servicing fee and a 25
  basis point guarantee fee.
• Lets further assume that each year one of the
  mortgages will prepay completely.

43
Mortgage Pass-Throughs

• The following spreadsheet shows the cash flows
  that the mortgages would (in aggregate) create,
  how much cash would flow to the investors, and
  how much cash would flow to the servicer and the
  guarantying agency.

44
Mortgage Pass-Throughs
45
Mortgage Pass-Throughs
46
Mortgage Pass-Throughs
47
Mortgage Pass-Throughs
48
Mortgage Pass-Throughs

• Our ultimate goal is to be able to develop a
  pricing mechanism for the MPT. This is not an
  easy prospect
• Clearly we have to consider prepayments.
• We must also consider how to aggregate all of
  these individual loans into a single MPT.
• Finally, we must consider the impact of interest
  rates on the mortgage cashflows and discounting.

49
Mortgage Pass-Throughs

• To get at this we will have to examine how to
  aggregate mortgage data.
• We also need to understand how Freddie and Fannie
  use underwriting to control the credit risk in
  these pools.