Three Discussion Questions / Finance
Discussion 1 (150-200 words): What is the secondary mortgage market? List three reasons why it is important. Please elaborate by expressing your thoughts about your findings in at least 3 – 4 sentences.
Discussion 2 (150-200 words): Please visit National Mortgage News at
http://www.nationalmortgagenews.com/technology (Links to an external site.)
. Explore the site. Bring back an article or something that interest you and share it.
Discussion 3 (150-200 words): Please visit the National Association of Real Estate Investment Trusts (NAREIT) at https://www.reit.com/nareit. What is the purpose of the organization? What resources are available to real estate professionals? Bring back something that interests you and share it with the class?
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
CHAPTER 19: THE SECONDARY MORTGAGE MARKET:
PASS-THROUGH SECURITIES
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Evolution of the Secondary Mortgage Market
Allows originators to replenish funds
Facilitates geographic flow of funds
Provides an investment option for savers
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Early Buyers of Mortgage Loans
Provides an investment option for savers
Mortgage companies and thrifts
FHA insurance and VA guarantees
Minimum underwriting standards
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
The Secondary Market after 1954
1954 Charter Act: FNMA or “Fannie Mae”
Enhance secondary market operations
FHA and VA mortgages
Manage prior direct loans
Manage special assistance programs
FNMA transforms into a private organization
FNMA issues securities
The “Treasury backstop”
As of 2008, Fannie Mae is under government control
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
The Government National Mortgage Association
HUD Act 1968: GNMA or “Ginnie Mae”
GNMA manages and liquidates FNMA loan portfolio
Special assistance functions
Guarantee timely payment of principal and interest for FHA-VA mortgage pools
Eliminated any default delay in payments to investors. This led to virtual explosion in secondary market and rise of pass-through securities
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
The Federal Home Loan Mortgage Corporation
Emergency Home Finance Act 1970: FHLMC or “Freddie Mac”
Provide a secondary market for conventional loans
Allowed FNMA to purchase conventional mortgages
FHLMC allowed to purchase FHA and VA mortgages
Fannie Mae and Freddie Mac compete for all mortgage loans but they do tend to still focus on their original lines of business
As of 2008, Freddie Mac is under government control
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Exhibit 19-1
Funds Flow Analysis (Direct Purchase Programs)
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Operation of the Secondary Mortgage Market
Operation
Direct Sale Programs
Mandatory Commitment
Optional Delivery
Mortgage-Related Security Pools
Securitization
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
The Development of Mortgage-Related Security Pools
In this chapter and the next, we’ll cover the major types of mortgage-backed securities including:
Mortgage-backed bonds (MBBs)
Mortgage pass-through securities (MPTs)
Mortgage pay-through bonds (MPTBs)
Collateralized mortgage obligations (CMOs)
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Exhibit 19-3
Mortgage Pass-Through Securities: Issuance and Funds Flow
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
Issuer retains ownership of mortgages
Mortgages held in trust
Fixed coupon rate
Specific maturity
Overcollateralization
Mark to market
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
Investment Rating
Mortgage Quality
Geographic Diversification
Interest Rates on Mortgages
Prepayment Probability
Overcollateralization
Appraised value and debt coverage ratio if commercial mortgages
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
Example 19-1: Mortgage Bond Valuation
20-year to maturity
Par value of $10,000
10.5% annual coupon.
At issue, bond market investors require an 11% interest rate.
What is the initial price of the bond?
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
Example 19-1:
= $10,000
= 20
= .105 x $10,000 = $1,050
= 11
= $9,601.83
n
i
CPT
FV
PMT
PV
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
In Example 19-1, what would be the price of the bond 5 years later if investors required a 12% return?
n is 15 years
i is 12%
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
Example 19-1:
= $10,000
= 15
= $1,050
= 12
= $8,978.37
n
i
CPT
FV
PMT
PV
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage-Backed Bonds
Zero Coupon Bond
The only cash flow to an investor is a lump sum at maturity
No interim coupon payments
Also called “deep discount” bonds
Analysis is just computing the present value of a lump sum
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage Pass-Through Securities
Ownership interest in a pool of mortgages
Trustee is owner of the mortgages in the pool
Principal and interest are passed through
Servicing and guarantee fees
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage Pass-Through Securities
Issuers & guarantors
Default insurance
Prepayment patterns and security prices
Coupon rate and interest rates
Seasoned mortgages
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage Pass-Through Securities
Number of mortgages
Geographic distribution
Borrower characteristics
Loan prepayment
Nuisance calls
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage Pass-Through Securities
A General Approach to Pricing
Interest Rate Risk
Default Risk
Risk of Delayed Payment of Principal and Interest
As of 2008, Ginnie, Fannie, and Freddie are all under government control
Prepayment Risk
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage Pass-Through Securities
A General Approach to Pricing
Coupon rate vs. yield to maturity
Servicing Fee
Weighted Average Coupon (“WAC”)
Stated Maturity Date
Weighted Average Maturity
Payment Delays
Pool Factors
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Secondary Mortgage Market
Example 19-2:
A mortgage pool consists of the following:
$500,000 of 30-year 7% Fixed Rate Mortgages
$200,000 of 29-year 6.5% Fixed Rate Mortgages
$300,000 of 28-year 6% Fixed Rate Mortgages
What is the weighted average coupon and average maturity of the mortgage pool? If there is a servicing fee of 0.5%, what is the quoted maturity and quoted coupon rate?
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Secondary Mortgage Market
Example 19-2:
Quoted Maturity = 30 Years
Quoted Coupon Rate = 6% – 0.5% = 5.5%
Amount Maturity Interest Rate Weight W x M W x I
$500,000 30 7% .5 15 3.5
$200,000 29 6.5% .2 5.8 1.3
$300,000 28 6% .3 8.4 1.8
$1,000,000 WAM = 29.2 WAC = 6.6
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Secondary Mortgage Market
Pricing Issues
Mortgage-Backed Bonds
Specified maturity
Specified coupon payment and face value
Pricing methodology is relatively straight forward
Mortgage Pass-Through Securities
Cannot define a specific maturity
Cannot define specific cash flows
Pricing is based on prepayment assumptions
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Secondary Mortgage Market
Prepayment Assumptions
Average Maturity Assumption
Constant Prepayment Rate Assumption
FHA Prepayment Experience
PSA Prepayment Model
Convexity
Price Compression
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
CHAPTER 20: THE SECONDARY MORTGAGE MARKET: CMOS AND DERIVATIVE SECURITIES
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Mortgage Pay-Through Bonds (MPTBs)
Bond, not an equity ownership interest
Debt obligation of issuer
Pass-through of interest and principal
Credit rating derives from three things
Riskiness of mortgages
Extent of over collateralization
Whether or not there are US gov’t bonds or agency obligations as excess collateral
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Collateralized Mortgage Obligations
Collateralized Mortgage Obligations (CMOs)
Debt instrument
Mortgage pool owned by issuer
Pass-through of interest and principal
Multiple classes of securities issued
Different maturity classes
Different priority for payment of principal and interest
Tranches
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Collateralized Mortgage Obligations
Overcollateralization
Represents equity interest of issuer
Residual cash flow is return to issuer
Cash flow = interest earned – interest paid
Prepayment problem
Reinvestment problem
Calamity call
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Collateralized Mortgage Obligations
Sequential Payout Tranche Structure
Tranche Z: Paid Last
Tranche A: Principal, Prepayments, & Interest Received First
Tranche B: Interest Only Until Tranche A is Paid
And so on for any additional tranches
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Collateralized Mortgage Obligations
Expected Maturities
Pricing & Prepayment
Tranche Variations
Sinking Fund Structure
Planned amortization class tranche
Targeted amortization class
Pricing speed
Companion tranche
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Collateralized Mortgage Obligations
Floating Rate Tranches
Floater Tranche
Coupon rates adjust periodically
Inverted Floating Rate Tranche
Coupon rate adjusts opposite to its index
Scaling
Used as a Hedge
Yield Enhancement
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Collateralized Mortgage Obligations
Principal-Only Tranches
Similar to a Zero Coupon Bond
Interest-Only Tranches
Convexity
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Exhibit 20-15
Summary of Important Investment Characteristics of Mortgage-Related Securities
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Commercial Mortgage-Backed Securities (CMBSs)
Similar in form to residential MBSs
Default risk differs significantly
Assets in mortgage pool
Often interest-only
Lump sum principal payment
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Commercial Mortgage-Backed Securities (CMBSs)
Senior Tranche (A piece)
Subordinate Tranche (B piece)
Prepayment is less likely than residential mortgages
Lockouts
Yield Maintenance
Extension Risk
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Commercial Mortgage-Backed Securities (CMBSs)
First Loss Position
Credit Ratings
Credit Enhancements
Issuer or 3rd party guarantee
Surety bonds and letters of credit
Advance payment agreements
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Commercial Mortgage-Backed Securities (CMBSs)
Credit Enhancements
Loan substitutions and repurchase agreements
Lease assignments
Over collateralization
Cross-collateralization and cross-default
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Commercial Mortgage-Backed Securities (CMBSs)
Collateralized Debt Obligations (CDOs)
Broader range of collateral
B notes (subordinated position of mortgage)
Lower rated Commercial Mortgage-Backed Securities
Mezzanine Loans
Preferred Equity
While they are often well diversified, the underlying risk is still substantial. The assets are risky.
Managed Collateralized Debt Obligations
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Exhibit 20-19
Illustration of CDO Structure
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Commercial Mortgage-Backed Securities (CMBSs)
Real Estate Mortgage Investment Conduits (REMICs)
Creation of Tax Reform Act of 1986. All assets must be one of the four following:
Qualified Mortgages
Foreclosed Property
Interest Bearing Assets
Qualified Reserve Fund