Three Discussion Questions / Finance
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bru7735x_PPT_CH19.pptCopyright © 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
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Early Buyers of Mortgage Loans
- Provides an investment option for savers
- Mortgage companies and thrifts
- FHA insurance and VA guarantees
- Minimum underwriting standards
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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
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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
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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
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Exhibit 19-1
Funds Flow Analysis (Direct Purchase Programs)
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Operation of the Secondary Mortgage Market
- Operation
- Direct Sale Programs
- Mandatory Commitment
- Optional Delivery
- Mortgage-Related Security Pools
- Securitization
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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)
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Exhibit 19-3
Mortgage Pass-Through Securities: Issuance and Funds Flow
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Mortgage-Backed Bonds
- Issuer retains ownership of mortgages
- Mortgages held in trust
- Fixed coupon rate
- Specific maturity
- Overcollateralization
- Mark to market
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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
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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?
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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
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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%
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Mortgage-Backed Bonds
- Example 19-1:
= $10,000
= 15
= $1,050
= 12
= $8,978.37
n
i
CPT
FV
PMT
PV
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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
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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
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Mortgage Pass-Through Securities
- Issuers & guarantors
- Default insurance
- Prepayment patterns and security prices
- Coupon rate and interest rates
- Seasoned mortgages
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Mortgage Pass-Through Securities
- Number of mortgages
- Geographic distribution
- Borrower characteristics
- Loan prepayment
- Nuisance calls
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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
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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
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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?
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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 |
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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
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Secondary Mortgage Market
- Prepayment Assumptions
- Average Maturity Assumption
- Constant Prepayment Rate Assumption
- FHA Prepayment Experience
- PSA Prepayment Model
- Convexity
- Price Compression
