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Secondary Mortgage Market


									Secondary Mortgage Market
Definition of Secondary Mortgage
Market (SMM)
A collection of institutions and individuals involved in
the trading of mortgages either in their primitive forms or
in transformed forms called Mortgage Passthrough
Securities (MPTS)
What are MPTS?
– bonds, notes or certificates -- issued against and
  collateralized by a pool of mortgages where the issuer passes
  mortgage payment from borrowers to investors who
  purchased the securities. Hence the name “passthroughs”
Function of the SMM
  – To provide liquidity to the primary market.
  – To correct geographical mismatch in mortgage
  – To correct institutional mismatch in the flow of
    funds in the primary mortgage
  – Management of interest rate risk
Facilitators of the Market or Market
• Broker
     • no risk
• Dealers
     • exposed to interest rate risk
• Conduits
     • transformation
     • standardization
Role of Conduits
 • Transform mortgages into more liquid mortgage
   pass through securities
 • Standardize whole mortgages to create sufficient
 • Examples
    – Federal National Mortgage Association (Fannie Mae),
      Federal Home Loan Mortgage Corporation (Freddie
      Mac), Government National Mortgage Association
      (Ginnie Mae), commercial banks, S&Ls, mortgage
      banks, investment banks
  GNMA or Ginnie Mae
• Guarantees the timely payment of interest and principal
  on MPTs backed by FHA, VA loans
• Has backing of the full faith and credit of the US
• Enables mortgage originators to package mortgages and
  issue securities backed by these mortgages
• The buyer of the security is charged a fee which
  provides GNMA with operating funds.
    FNMA or Fannie Mae
• Corporate instrumentality of the US government whose stocks are
  traded on the NYSE
• Primary function is to purchase and sell FHA, VA and Conventional
• Issues its own security collateralized by mortgages called Mortgage-
  Backed Securities (MBSs)
       • cash program and swap program
• Sources for capital for FNMA
       • non-voting preferred
       • non-voting common
       • notes and debentures
  Fannie Mae (Contd).
• The ACT setting up FNMA allows the agency to borrow
  from the Treasury up to $ 2.5 billion.
• In practice investors do not see the difference between
  Ginnie Mae and Fannie Mae guarantee.
• Should there be a yield differential between a Ginnie
  Mae and Fannie Mae security of similar maturity?
  Think about this !!!!!
FHLMC/ Freddie Mac
• Established to provide liquidity in conventional
• Currently its portfolio includes both conventional,
  FHA and VA loans
• Sells the mortgages either in whole, or in the form
  of MPTs called Participation Certificates (PCs)
   – Cash program
   – Swap program (1984)
      Outstanding Passthrough
As of September 1994
 Agency                 outstanding ($ billions)
    Ginnie Mae         $426.4
    Freddie Mac        $461.5
    Fannie Mae         $505.7
 Private               $179.5
  Total                $1,573.1
• About 49% of the estimated $3.2 trillion of single
  family mortgages outstanding have been
• From 1989 Fannie Mae and Freddie Mac issues
  outstripped Ginnie Maes.
• Roughly 88% of securitized residential mortgages
  have agency labels.
• In 1984 Fannie Mae created first MBS
  collateralized by multifamily mortgages
   Types of Mortgage Related Securities
• Mortgage pass-through securities (MPTs)
   –   Mortgage-backed security (MBS): FNMA
   –   Participation Certificates (PCs): FHLMC
   –   Ginnie Maes
   –   Private Pass-throughs
• Mortgage Backed Bonds (MBBs)
• Other Mortgage Derivative Securities
   – Collateralized Mortgage Obligations (CMOs)
   – Interest Only (IOs) and Principal Only (POs)
• Commercial Mortgage Backed Securities (CMBS)
    Operations in the Secondary Mortgage Market


       Originating lenders and services

1      2             3a           3b

    Brokers      Government            GSEs, Private   GSEs
    Dealers      Guarantee             conduits, HFA

                          Mortgage Backed Security     Notes

                                Security Dealers

Mortgage Pass Through Structure
    Collateral                       owns mortgages in pool
  Whole mortgages                    no overcollateralization

    Pass through issuer
    •sale of assets
    •not obligation of issuer
    •debt obligation of original borrower

   MPT Investor :Owns the right to receive cash
   flow from morgages in pool
                   The Mortgage Passthrough Security with
                   Government Guarantee (Ginnie Mae)

              Mortgages     Lenders
Borrowers                                             Insurance/guarantee
                           (Securities                (Government or PMI)
              Monthly       issuers)
                                           Seeks guarantee
     Whole loans
                            Mortgage      Guarantee Government
                            Pool                    Agency

                                         Mortgage documents

              Securities    Securities                 Custodian of
Investors                   Dealer                     mortgage
Creation of Ginnie Maes
    Smith          Lenders                 Investors
                   Thrift or               Thrifts,
    Mr./Ms.        Bank                    Banks,
    Jones                        GNMA      Others
Creation of other Agency Mortgage
Pass-Through (MPTs)
    Smith          Lenders
                   Thrift or
    Mr./Ms.        Bank
                               $         Investors
               Sell                 $
    Miller            Agencies           Thrifts,
                      FNMA               Banks,
                      FHLMC              Others
  Advantages of MPTs over Whole
• Diversification of prepayment risk
• Investment is made more liquid
• More efficient way to invest in mortgages than
  purchasing the primitive instrument
• Efficient management of interest rate risk
• Cheaper source of financing housing
• Guarantees eliminates default risk
Features of MPT
• Prepayment risk
  – Systematic risk
  – Unsystematic risk
• Default risk
   Nature of Cash Flow from MPT
• Monthly payments consisting of
   – Interest on the mortgage
   – Scheduled principal repayments.
   – Unscheduled principal repayments.
• The cash flow is reduced by servicing fee and guarantee
  fee of 50 basis points
• Cash flow and value of MPT security depends on the
  cash flow from underlying mortgage
                 Mortgage Cash Flows
                     Principal      No Prepayments
Cash Flow





                 0          100        200           300   360
            Pass-Through Cash Flows
                     Principal     Servicing
                                               No Prepayments
Cash Flow





                 0          100          200         300   360
  Timing of Cash Flow
• The first mortgage payment is always made in arrears
• There is another delay after receipt of cash flow from
  mortgage pool before the cash flow is passed on to the
   – Real or actual delay
   – Stated delay = normal delay + actual delay
  Payment Delay Illustration
   Month 1                            Month 2

         A               BC       D

                                       Stated Delay = 45 days
                                          Real Delay = 14 days
          A               BC          D

                                           Stated Delay = 50 days
                                            Real Delay = 19 days
 A: Investor Buys Security
 B: First Record Date
 C: First Payment Due
 D: First Payment Actually Made
  Payment Delay Illustration
   Month 1                        Month 2

       A                 BC       D

                                       Stated Delay = 55 days
                                        Real Delay = 24 days
        A                 BC                D

                                       Stated Delay = 75 days
 A: Investor Buys Security             Real Delay = 44 days
 B: First Record Date
 C: First Payment Due
 D: First Payment Actually Made
Nature of Promise on MPT cashflow
• Fully Modified e.g. Fannie Mae Mortgage
  Backed Security (MBS)
  – timely payment of both P and I
• Modified e.g. Freddie Mac Participation
  Certificate (PC)
  – timely payment of interest only
    Some salient Characteristics of
    MPTs affecting pricing
•   Characteristics of Pool, e.g. FHA/VA, conventional mortgage
•   Maximum size of Loan e.g. conforming loan versus jumbo
•   Amount of Seasoning
•   Assumability
•   Maturity e.g. 15, 20, 30 years
•   Net Interest Spread
•   Payment Procedure e.g. stated delay
•   Minimum Pool Size
 Private Passthroughs
• Issued by thrifts, commercial banks and
  investment banks
• Large-size loans
• Registered with SEC
• Rated by Moody’s and S&P
• FRM’s or ARM’s
• Market size around 6% of all MPTs
    Credit Enhancement on Private MPTs
• Corporate guarantee --
• Letters of credit -- issued by financial institutions.
• Bond insurance -- rating of insurance co.
• Senior/subordinate certificate --A/B passthrough
   – A has priority over B in terms of cash flow
   – A certificates are the once rated
• Additional safeguards to protect against shortfall in payment
   – reserve fund
       • divert principal from B to A
   – shifting interest
       • prepayment meant for B goes to A
   Differences between MBS and
   Traditional Bonds
• MBS pay-off monthly. Bonds typically pay-off semi-
• MBS payments consists of principal and interest, bond
  payments typical consists of interest only
• MBS have payment delays, Treasury bonds have no
  payment delay
• MBS has call risk due to borrower prepayment. Some
  bond have no call options
• Some MBS have default risk. Treasury bonds have no
  default risk
   Prepayment Basics: A Mobile Population

• The history of US has been of one migration, from overseas, east to
  west, north to south, etc
• 20% of US households will change their place of residence at least
  once in a given year (Census Bureau)
• 8.5% all homeowners will move in a normal year (Census Bureau)
• About 8% of all mortgages outstanding are likely to be prepared in
  any given year due to changes in residence
• Investors in diversified pool of mortgages can expect about 8% of
  their principal to be returned to them due to prepayments
• Not all moves results in prepayment since some mortgages are
   Prepayment are very important to
   Mortgage Investing
• Homeowner prepayments are the most important aspect of
  mortgage or mortgage passthrough investing
• Changes in prepayment rates are the most important risk facing
  mortgage securities investors.
• Fortunately, the basic forces driving prepayments are easy to
• Prepayments are driven by:
      • career changes
      • lifestyle changes
      • changes in interest rates
• Does this mean prepayments can be easily forecast?
   Measuring Prepayment Speeds
• There are four methods of measuring prepayment
     • Prepayment based on FHA experience
     • Constant Prepayment Rates (CPR)
     • Single Monthly Mortality (SMM)
     • PSA Standard Prepayment Benchmark
    FHA Prepayment Method
• This prepayment method is based on data collected by FHA
  tracking mortgage prepayments based on seasoning
• As figure 1B shows very few mortgages prepay in first year
• An increasing number prepay in the second year and still more
  prepay in the third year
• From third to 20th year prepayment is remarkable stable
• After 20th year it rises slightly every year until maturity
• Across the nation more than 6% but fewer than 8% of FHA/VA
  loans prepay during this stable period
• FHA mortality tables are not good predictors of other loan types
  because FHA/VA loans are assumable
 Constant Prepayment Rate (CPR) Method

• Assumes a constant percentage of the remaining principal in pool
  is prepaid each month for the remaining term of the mortgage
• A 10% CPR means we can expect 10% of the remaining
  mortgage balance to be prepaid each and every future year
• The CPR is based on the characteristics of the pool, current and
  expected future economic environment
• Its advantage is simplicity and ease of application
• It suffers from disadvantage that prepayments are treated as
• Figure A1 illustrates the CPR




            0        YEARS             20
  Single Mortality Rate (SMM) Method
• The CPR is annual prepayment rate. The annual rate is
  converted into monthly prepayment rate called the
  single monthly mortality rate (SMM) as follows

        SMM = 1 - (1 - CPR)1/12      (1)

• if the CPR is 6% the corresponding SMM is:
     SMM = 1 - (1 -.06)1/12 = .005143 or .51%
   Application of SMM to calculate
• Prepayment for month t = SMM times beginning
  mortgage balance for month t minus scheduled principal
  for month t)
• Mortgage has remaining balance of $50,525. With SMM
  of 0.5143% and the schedule principal payment of $67,
  the prepayment for the month t is
      = .005143 x ($50,523 - $67) = $260
   PSA Standard Prepayment Method
• Developed by Public Securities Association (PSA)
• Benchmark is expressed as monthly series of annual CPR.
   – assumes that prepayment will be low for newly originated
     mortgages and will then speed up as the mortgage seasons
   – the PSA captures the advantages of both CPR and FHA
   – like the CPR, the PSA provides easy- to- calculate and easy- to-
     understand method
   – like the FHA, the PSA includes gradual increase in prepayment
    PSA Prepayment Curve.
• The standard PSA prepayment curve, called 100% PSA is as
   – it assumes 0.2% CPR for the first month.
   – the rate increases by 0.2% per month until the 30th month (top
      of the ramp) when it reaches a CPR of 6% per year .
   – it remains at 6% per year for the remaining stated maturity of
      the pool

       if t  30, CPR = (6%)(t)/30,
         if t > 30, CPR = 6%
where t is the number of months since mortgage origination.
  PSA Prepayment Curve (Contd)
• Slower or faster prepayment are then stated as percent
  of standard PSA, e.g. 50% PSA (slower), 150% PSA
• The PSA is now the standard for quoting
  prepayment rate in the industry
• Figure 2 illustrates the PSA method

                          PSA RAMP & SPEEDS



 15%       RAMP
                                   200% PSA

                                   100% PSA
                                   50% PSA

       0      3   6   9     12      15    18    21   24   27   30

                                 SEASONING (years)
   Converting PSA to CPR and
   CPR to SMM
• Converting PSA to CPR during PSA Ramp period
       Monthly CPR = (PSA x .06 x n)/30
where n = mortgage loan age in months up 30
Example: mortgage age (n) = 5; PSA = 100%
Monthly CPR = (100% x.06 x 5)/30 = 1%

Converting CPR to SMM
        SMM = 1 - (1 - .01)1/12 = .000837
Thus 1% CPR = 0.0837% SMM; or 0.0837 of the mortgage pool
  principal balance is expected to prepay in month 5
  Converting PSA to CPR and
  CPR to SMM
Converting PSA to CPR after PSA Ramp period (months
      CPR = PSA x .06
Example: PSA = 100%
       CPR = 100% x .06 = 6%
Converting CPR to SMM
      SMM = 1 - (1 - CPR)1/12
      SMM = 1 - (1 - .06)1/12 = .005143
6% CPR = 0.51% SMM; 0.51 of the pool principal balance is
  expected to prepay each month until maturity (31 to 360 months)
   More Application of PSA
• If we assume 150% PSA (i. e. one and one-half
  times faster than standard PSA) the SMM for
  month 5, will be computed as follows:

  for month 5: CPR = (150 x .06 x 5)/30 = 1.5%
  SMM = 1 - (1 -.015)1/12 = .001259
Note: it is the CPR that is a multiple not the SMM
   Various Prepayment Issues to Consider
• Assumable and Nonassumable mortgages
• Wall Street projections and averages: most of the industry relies on
  the prepayment projections prepared by the major investment
  houses, available on-line as BLOOMBERG screens
• Burnout: after a pool has stayed in refinancing range for some
  time prepayments decrease. This is call burnout
• Seasoning: aging of mortgage loans and associated changes in
• Path Dependence: future prepayment for a mortgage pool are
  dependent on that pool’s past prepayments, which in turn are
  dependent on the path interest rates have taken since pool’s
  origination (See figure 5 )
   Factors Affecting Prepayment
• Prevailing mortgage rate and market conditions
   – spread between contract rate and prevailing mortgage rate
   – path dependence
   – refinancing burnout
   – level of mortgage rates
   – housing turnover and affordability
• Seasonal factors
   – home buying starts in spring and reaches its peak in summer
   – in fall and winter home buying declines
   Factors affecting prepayment (contd).
• Characteristics of the underlying mortgage Loans
   – contract rate
   – conventional versus FHA/VA
   – amount of seasoning
   – FRMs versus ARMs
   – pool factor
   – geographical location of underlying properties
• General economic activity
   – general economic activity affects prepayment through its
     effects on housing turnover as growing economy increases
     personal income and opportunities for worker migration
    What to remember about Prepayment
• The most important thing to remember about accurate long-term
  prepayment projections is that there aren’t any
       • prepayment projections remain inherently unreliable
• Interest rates must be forecast
       • to reliably predict future prepayments, we must first reliably
         predict future interest rates
       • if you can consistently predict future interest rate movement
         bond futures is your calling not prepayment projections
• Interest rates and prepayments change continually
  Pricing of MPT’s
• Estimate the necessary cash flow
• Discount the estimated cash flow at an appropriate
  interest rate.
• Problem:
  – cash flows of MPTs are not known with certainty.
  – appropriate discount rate is difficult to determine
       Basic Principles of valuation of MBS
                Current Coupon
                 Treasury Yield
                                                  Discount at
                    Treasury                    Treasury Rates
                                   Projected   Pertinent to Each   Market Price
                  Interest Rate
                                  Cash Flows    Cash Flow Plus

Non-Treasury Indices
  Generated from
 Treasury Scenarios

   Constructing MBS Cash Flows
• Project monthly Payment

MPt = MB t-1 [{i(1 + i)n-t+1}/{(1 + i)n-t+1 - 1}]

MPt = projected monthly mortgage payment for month t
MB t-1 = projected mortgage balance at the end of month t-1
    n = original number of months of mortgage
     i = simple monthly interest rate(annual rate/12)
   MPT Cash flow (Contd).
• Project Monthly Mortgage Interest, servicing and guarantee
          I t = MB t-1 . i
         NIt = MB t-1 (i - s - g)
          St = MB t-1 s
          Gt = MB t-1 g
  It = projected monthly interest for month t.
NIt = projected interest net of servicing and guarantee fee
 St = projected servicing fee for month t
 Gt = projected guarantee fee for month t
s = servicing fee rate
   MPT Cash flow (Contd).
• Projected Monthly Scheduled Principal and
     SPt= MPt - It
     PRt = SMMt(MB t-1 - SPt)

 PRt = monthly principal prepayment for month t
 SPt = monthly scheduled principal payment for month t
 SMMt = assumed single monthly mortality rate for month t
   MPT Cash flow (Contd)
• Investor's Cash Flow

       CFt = NIt + SPt + PRt

CFt = projected cash flow to investor for month t

NIt = interest net of servicing and guarantee fees
•   Original mortgage balance = $100,000
•   Mortgage rate = 9.5%
•   Servicing fee and guaranteed fee = 0.5%
•   360 months to maturity
•   Coupon rate = 9%.
•   Prepayment at 100% PSA
Note: The interest rate on passthrough is always less than that paid on
  the mortgage, usually by the amount of servicing and guarantee fee
  (.5% in the above case)
     Short Cut Approach to Calculate Cash

            bt = (1 - SMMt(1 - SMMt-1) ... (1 - SMM2)(1 - SMM1)
            MPt = b t-1 MP*
            SPt = b t-1 P t*

   bt = the projected mortgage balance in month t per $1
        of the principal given projected prepayments through
        month t (POOL FACTOR akin to earnings announcement)
MP* = monthly mortgage payment on the original principal
        assuming no prepayments.
MPt = projected monthly mortgage payment in month t
SPt = projected schedule principal payment
P t* = scheduled principal payments on the original
        balance assuming no prepayment.
    Illustration of short cut approach
Assuming a CPR of 6%, for month 210
MP210 = b209 MP*

Mortgage Constant at 9.5%, 360 months = 0.0084085
MP* = $100,000x.0.0084085 = $840.85

Since SMM is 0.005143 for each month after the 30th, 1- (1-CPR)1/2
b209 = (1-.005143)(1-.005143)...(1-.005143) = (1-.005143)209 = .34039
MP210 = (.34039)(840.85) = $286.
This is the projected monthly payment in month 210
    Illustration (contd).
The projected scheduled principal payment in month 210 is:
SP210 = b209 P*210

Scheduled principal payment in month 210 assuming no
prepayment is $255.62

The projected scheduled principal payment assuming prepayment for
month 210 is then:
SP210 = (.34039)($255.62) = $87
   Additional Pricing Concepts
• Weighted Average Coupon (WAC)
   – average of underlying mortgage rate weighted by dollar balance of each
     mortgage as of date of issue
• Stated Maturity Date of Pool
   – longest maturity date for any mortgage in the pool assuming zero
• Weighted Average Maturity (WAM)
   – remaining term of underlying mortgages weighted by principal balance
• Weighted Average Life (WAL)
   – average number of years until investors principal is returned weighted by
     each principal balance
• Pool Factor
   – outstanding balance divided by beginning balance
Price/Yield Relationship for Option-Free Bond

Price/Yield Relationship for Callable Bonds
    Price              a’
                             Noncallable bond

            Callable bond
                  a-b                           a

                        y*   Yield
Relationship between Prepayment and
Premium, Discount and Par Mortgages
• High coupon MPT at a premium
  – loses if prepayment is faster
  – gains if realized prepayment is slower
• Low coupon MPT at a discount
  – gains if prepayment is faster
  – loses if prepayment is slower
• At par MPT
  – unaffected
    Logic of Option Adjusted Spread
• Option Adjusted Spread analysis attempts to include the cost of
  prepayment option ( and other factor, delays) when calculating the
  spread the passthrough security offers above the Treasury yield
• The first step in calculating OAS is running a Monte Carlo
  simulation of numerous possible future interest rate paths
• Next future monthly cash flows are calculated based upon
  prepayment model for each interest rate path
• An average yield above Treasury yield is then calculated for each
• The OAS for a security is the average of individual spreads
  calculated for each future interest rate paths
    Meaning of OAS
• Often put forward as one method of identifying overpriced and
  underpriced mortgage backed securities
• Typically, OAS on securities with similar duration are compared.
• However that such comparison does not tell the investor which
  security to buy.
• Suppose the OAS > 0:
   – a risk neutral investor who does not demand compensation for
     variability in cash flows (prepayment) will find such an
     investment attractive.
   – for a risk averse investor this positive OAS will not provide
     enough information to determine whether or not the extra yield
     is enough to cover the investors desired risk premium
   An Equivalent way to view the
   ambiguity of OAS
• An equivalent way to view this ambiguity
   – two MBS have same expected cash flows but the variability of the second
     security is greater.
   – risk averse investors will bid a lower price for the second mortgage related
   – the result is that the second MBS will have a higher OAS
   – however, the meaning is clearly not that the second security is better one
    Establishing that the expected return on a risky security is
    greater than the Treasury rate, or even greater than the
    expected return of some security with comparable risk, does
    not imply that it is good buy, unless you happen to be risk
    neutral. OAS provides such risk neutral information.
  Cash Flow Yield
• Semiannual yield (IRR) = (1 + ym)6 - 1
• Bond Equivalent Yield (BEY)
       BEY = 2[(1 + ym)6 - 1], ym= monthly yield or IRR
• To convert the bond equivalent yield to a monthly yield
       ym = [1 + (0.5)(BEY)]1/6 - 1
• Suppose an investor requires a BEY of 8.13%, then the
  corresponding monthly interest rate is
  ym = [1 + (0.5)(.08130]1/6 - 1 = 0.006667
• The projected cash flow can then be discounted at ym = 0.6667%
• Price is simply the present value of the projected cash flow
    Market Making
• Substantial trading activity
   – daily average primary dealer transaction is $12.4 billion
   – Treasury is around $137 billion
• Several factors foster trading in secondary market
   – Large capital committed by investment banking firms and commercial banks
     to make market
   – Institutional investors more willing to trade in passthroughs due improved

• Improved Liquidity: narrow bid-ask spread
   – 3 cents to 12.5 cents
   – risk of market making and competition
   – turnover ratio (ratio of dollar volume to amount of issue outstanding) = 3.57
     Trading Mechanics
•   Quotation (same as treasury) 94 5/32 = $94.15
•   MPT identification (pool prefix)
•   TBA trade: trading may occur while pool is still not specified
•   Many Issues of same coupon (different pools)
•   Prepayment characteristics (generic MPT)
•   Moral Hazard Problem: some sellers may deliver poor paying pool
•   Under and Overdelivery (2.5% tolerance per million dollar traded)
     – $975,000 or $1,025,000 for MPT of $1,000,000
    Use of Dollar Rolls in MBS Trading
• Repos (repurchase agreements
   –   dealer use security to borrow from client (counterparty)
   –   dealer pays loan + interest at end of period
   –   identical collateral is returned by counterparty
   –   vehicle for covering short position
• Reverse Repo
   – Client borrows from dealer
• Dollar Roll Transaction
   – sustantially the same security is returned by borrower
   – help market for MBS to operate smoothly

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