The Secondary Mortgage Market In the secondary mortgage market: The major players, FNMA, FHLMC, and...

The Secondary Mortgage Market

• In the secondary mortgage market:• 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

The Secondary Mortgage Market

• Mortgage Descriptive Statistics

• IO/PO Combinations

• Collateralized Mortgage Obligations

• Mortgage Backed Futures

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.

Historic Origins

• The “classical” model was the “It’s 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.

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.

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.

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.

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.

Historic Origins

• During the 1940’s and 1950’s, interest rates remained non-volatile.

• Interest rates started becoming volatile in the 1960s (October 1979, Paul Adolph Volcker). 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.

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.

Historic Origins

• GSE status:• GSE’s 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).

Historic Origins

• GSE status:• GSE’s must meet Congressionally-set capital

standards. The Office of Federal Housing Enterprise Oversite (OFHEO) is responsible for determining GSE compliance.

Historic Origins

• The federal government started a wholly-owned government corporation within HUD. This entity is known as the Government National Mortgage Association (GNMA, 1968).– GNMA is tasked with creating and maintaining

a secondary market for FHA-insured mortgages.

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.

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.)

Historic Origins

• Lenders were getting squeezed badly. • By the early 1980’s 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.

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 S&Ls are well-suited for originating mortgages, they are not well suited to holding mortgages in portfolio.

Market Innovation

• As early as the mid-1960’s 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).

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

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.


• 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.


• 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.


• 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.

1

1i )1(

*)1(

r)(1 PriceT

iTr

ParCC * Par


MBB Example - 9% Coupon, 20 years to maturity price at origination

$0.00

$5,000.00

$10,000.00

$15,000.00

$20,000.00

$25,000.00

$30,000.00

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

Yield

Pri

ce


• 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.


• 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:


MBB Example - 9% Coupon, 20 years to maturity price at origination

($30,000.00)

($20,000.00)

($10,000.00)

$0.00

$10,000.00

$20,000.00

$30,000.00

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

Yield

Pri

ce


• 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.


Hedging Properties of Financing a Mortgage Portfolio (Blue Line) with an MBB (Orange line). The Black line is the net position.

($30,000.00)

($20,000.00)

($10,000.00)

$0.00

$10,000.00

$20,000.00

$30,000.00

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

Yield

Pri

ce

MBB Mortgages Net Position

Mortgage Pass-Throughs

• For now, we will be discussing MBS as FNMA and FHLMC issue them. GNMA’s 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.


• 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 month’s principal and interest paid by the individual mortgagors. This is known as a “pass-through” security.


• 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.


• 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


• 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.


• 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).


Amortization differences between 10% and 10.5% mortgage

$0.00

$25,000.00

$50,000.00

$75,000.00

$100,000.00

0 60 120 180 240 300 360

Month

Bal

ance

10% mortgage balance 10.5% mortgage balance


• 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.


• 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.


• 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.


• 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.


• We are going to need a way to build in our expectations about prepayments into our pricing model.

• Before we do that, however, let’s run through an example of an MBS to explain the cash flows.


• Let’s 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.

• Let’s further assume that each year one of the mortgages will prepay completely.


• 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.


MonthMortgages Outstanding

Aggregate Payment

Aggregate Interest

Aggregate Principal

Aggregage Ending Balance Prepayments Final Balance

1 10 $8,775.72 8333.333333 $442.38 $999,557.62 $0.00 $999,557.622 10 $8,775.72 $8,329.65 $446.07 $999,111.55 $0.00 $999,111.553 10 $8,775.72 $8,325.93 $449.79 $998,661.76 $0.00 $998,661.764 10 $8,775.72 $8,322.18 $453.53 $998,208.23 $0.00 $998,208.235 10 $8,775.72 $8,318.40 $457.31 $997,750.91 $0.00 $997,750.916 10 $8,775.72 $8,314.59 $461.12 $997,289.79 $0.00 $997,289.797 10 $8,775.72 $8,310.75 $464.97 $996,824.82 $0.00 $996,824.828 10 $8,775.72 $8,306.87 $468.84 $996,355.98 $0.00 $996,355.989 10 $8,775.72 $8,302.97 $472.75 $995,883.23 $0.00 $995,883.23

10 10 $8,775.72 $8,299.03 $476.69 $995,406.54 $0.00 $995,406.5411 10 $8,775.72 $8,295.05 $480.66 $994,925.88 $0.00 $994,925.8812 10 $8,775.72 $8,291.05 $484.67 $994,441.21 $99,444.12 $894,997.0913 9 $7,898.14 $7,458.31 $439.84 $894,557.26 $0.00 $894,557.2614 9 $7,898.14 $7,454.64 $443.50 $894,113.76 $0.00 $894,113.7615 9 $7,898.14 $7,450.95 $447.20 $893,666.56 $0.00 $893,666.5616 9 $7,898.14 $7,447.22 $450.92 $893,215.64 $0.00 $893,215.6417 9 $7,898.14 $7,443.46 $454.68 $892,760.96 $0.00 $892,760.9618 9 $7,898.14 $7,439.67 $458.47 $892,302.49 $0.00 $892,302.4919 9 $7,898.14 $7,435.85 $462.29 $891,840.20 $0.00 $891,840.2020 9 $7,898.14 $7,432.00 $466.14 $891,374.06 $0.00 $891,374.0621 9 $7,898.14 $7,428.12 $470.03 $890,904.03 $0.00 $890,904.0322 9 $7,898.14 $7,424.20 $473.94 $890,430.09 $0.00 $890,430.0923 9 $7,898.14 $7,420.25 $477.89 $889,952.19 $0.00 $889,952.1924 9 $7,898.14 $7,416.27 $481.88 $889,470.32 $98,830.04 $790,640.28


Outstanding Balance by Month

$0.00

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

$700,000.00

$800,000.00

$900,000.00

$1,000,000.00

1 21 41 61 81 101


Monthly Payments to Investors A and B

0

20000

40000

60000

80000

100000

120000

1 7 13

19

25

31

37

43

49

55

61

67

73

79

85

91

97

103

109

115

Month

Do

llars

Investor A Payment Investor B Payment

M


Monthly Servicing and Guarantee Fee Amounts

0

50

100

150

200

250

300

350

400

450

1 7 13

19

25

31

37

43

49

55

61

67

73

79

85

91

97

103

109

115

Month

Am

ou

nt

Servicing Cash Flow s Guarantee Fee


• 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.


• 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.

The Secondary Mortgage Market In the secondary mortgage market: The major players, FNMA, FHLMC, and...

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