Chapter 19: The Secondary Mortgage Market: Pass-Through Securities

1. Chapter 19: The Secondary Mortgage Market: Pass-Through Securities

2. Secondary Mortgage Market Allows originators to replenish funds Facilitates geographic flow of funds Provides an investment option for savers Early buyers of mortgages Mortgage companies and thrifts FHA insurance and VA guarantees Minimum underwriting standards

3. Secondary Mortgage Market 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

4. Secondary Mortgage Market 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

5. Secondary Mortgage Market 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

6. Exhibit 19-1Funds Flow Analysis (direct purchase programs)

7. Secondary Mortgage Market Operation Direct Sale Programs Mandatory Commitment Optional Delivery Mortgage-Related Security Pools Securitization

8. Secondary Mortgage Market 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)

9. Exhibit 19-3Mortgage Pass-Through Securities: Issuance and Funds Flow

10. Secondary Mortgage Market Mortgage-Backed Bonds Issuer retains ownership of mortgages Mortgages held in trust Fixed coupon rate Specific maturity Over collateralization Mark to market

11. Secondary Mortgage Market Mortgage-Backed Bonds Investment Rating Mortgage Quality Geographic Diversification Interest Rates on Mortgages Prepayment Probability Over collateralization Appraised value and debt coverage ratio if commercial mortgages

12. Secondary Mortgage Market 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?

13. Secondary Mortgage Market Mortgage-Backed Bonds Example 19-1: = $10,000 = 20 = .105 x $10,000 = $1,050 = 11 = $9,601.83 FV n PMT i CPT PV

14. Secondary Mortgage Market 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%

15. Secondary Mortgage Market Mortgage-Backed Bonds Example 19-1: = $10,000 = 15 = $1,050 = 12 = $8,978.37 FV n PMT i CPT PV

16. Secondary Mortgage Market 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

17. Secondary Mortgage Market 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

18. Secondary Mortgage Market Mortgage Pass-Through Securities Issuers & guarantors Default insurance Payment patterns and security Coupon rate and interest rates Seasoned mortgages

19. Secondary Mortgage Market Mortgage Pass-Through Securities Number of mortgages Geographic distribution Borrower characteristics Loan prepayment Nuisance calls

20. Secondary Mortgage Market General Pricing of MPTs 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

21. Secondary Mortgage Market General Pricing of MPTs Coupon rate vs. yield to maturity Servicing Fee Weighted Average Coupon (“WAC”) Stated Maturity Date Weighted Average Maturity Payment Delays Pool Factors

22. 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 .5%, what is the quoted maturity and quoted coupon rate?

23. Secondary Mortgage Market Example 19-2: Quoted Maturity = 30 Years Quoted Coupon Rate = 6% - .5% = 5.5%

24. Secondary Mortgage Market Pricing Issues Mortgage-Backed Bonds Specified maturity Specified coupon payment and face value Pricing methodology is relatively straight forward MPTs Cannot define a specific maturity Cannot define specific cash flows Pricing is based on prepayment assumptions

25. Secondary Mortgage Market Prepayment Assumptions Average Maturity Assumption Constant Prepayment Rate Assumption FHA Prepayment Experience PSA Prepayment Model Convexity Price Compression