Mortgage markets – by keara


									Chapter 8 Municipal Securities Municipal bonds are issued by state and local governments and by government entities such as school districts, public works agencies, etc. Source of cash to repay debt (bond’s security) varies widely. Some municipals are secured by tax revenues of the issuer Some municipals are secured by use revenue for the project financed Some municipals are secured by other government income. Exemption of interest from Federal income taxation is the most significant feature of municipal bonds. The tax exempt status municipal interest income makes municipals more attractive. However changes in the tax code can have dramatic impact on the value of this tax exemption. ytmmunicipal = ytmtaxable (1- t) where t is the marginal tax for investors in municipal securities. Individual investors are the largest single holder of municipal securities.

Federal Tax Tables
Federal Income Tax
SingleRate $0 - $7,000 10.000% $7,001 - $28,400 15.000% $28,401 - $68,800 25.000% $68,801 - $143,500 28.000% $143,501 - $311,950 33.000% $311,951 + 35.000% JointRate $0 - $14,000 10.000% $14,001 - $56,800 15.000% $56,801 - $114,650 25.000% $114,651 - $174,700 28.000% $174,701 - $311,950 33.000% $311,951 + 35.000%

SingleRate $10,000 + 7.000% JointRate $21,000 + 7.000%

General obligation bonds – municipal securities secured by taxing power of the issuer. Property tax = assessed property value * millage rate Revenue bond –secured by revenues generated from operating project.


Issuer Rating

STILLWATER OKLA MED CTR AUTH HOSP REV FORMERLY STILLWATER OK BBB S BAA2 M 860815CY3 OK 5.63% 5/15/2023 5/15/2014 5/15/2016 100 5.63% 102 100

CUSIP Coupon Maturity First Call

Price ytm

Volume of $400,000 for 3 trades.

Issuer Rating

MBIA UNIVERSITY OKLA REVS TULSA CAMPUS - SER A MBIA - BOOK ENTRY ONL AAA M AAA F 914760ZN6 OK 4.50% 1/1/2018 102.12 99.62 4.298 4.536

CUSIP Coupon Maturity Price High Price Low

Volume of $20,000 for 2 trades


Redemption features of municipal bonds -Sinking fund or serial bonds. -Typical term maturity bonds. Examples of large defaults 1975 State of New York’s Urban Development Corporation, $100 million 1986 Washington Public Power Supply System (WPPSS) Credit ratings available from Moody’s and Standard and Poor’s Chapter 10 Mortgage Loans – A mortgage loan is a loan secured by the collateral of some specified real estate which obliges the borrower to make a predetermined series of payments. Conventional mortgage - loan secured by borrower’s credit and collateral Parties to a mortgage transaction can include; Borrower Originator Servicer Insurer -

original source of funds, application, credit evaluation, fund transfer record keeping, collecting, escrow account administration guarantees repayment of a portion of loan principal

Key measures of credit quality – Payment to Income ratio (PTI) Loan to Value ration (LTV) PTI is generally measured as the gross monthly payment including taxes and insurance. LTV can be measured with the property’s market value or assessed value. Mortgage originators – Income – origination fees (points), application and processing fees, profit on sale. Hold mortgage as investment Sell mortgage to investor Securitize mortgage


Mortgage servicing – Income – servicing fee (slice of loan rate), interest earned on escrow balance, float on monthly payment, late payment charges, marketing income. Servicing is a part of every mortgage. The servicing fee is included in the contract rate. The mortgage rate is 8.125% and the servicing fee is 50 basis points the net interest received by the investor is 7.625%. Mortgages are either conventional or insured Government provided mortgage insurance – Federal Housing Administration Veterans Administration Federal Farmer’s Administration

Private mortgage insurance Mortgage insurance – insures against default by borrower. Mortgage insurance is usually required if LTV > 80%. Private mortgage insurance companies will insure the amount of the mortgage above the 80% LTV ratio. For instance a borrower who has $5,000 down payment on a $100,000 home, needs a $95,000 loan. The originator will require the borrower to purchase mortgage insurance. The private mortgage insurance company will guarantee $15,000 of the loan to the originator (mortgage holder). The borrower will pay for the mortgage insurance either through a higher loan rate or a monthly payment in addition to the loan payment, taxes and insurance. Mortgage insurance is notoriously expensive.

Government agencies involved with secondary mortgage market Federal National Mortgage Association (private company originally a government sponsored enterprise) Purchases mortgages insured by FHA, VA, Federal Farmer’s Administration and conventional mortgages Issues common stock, debentures, structured notes, mortgage backed securities Holds mortgages or sells mortgage pools to private mortgage pool operators, invests in MBS.


Government National Mortgage (backed by Treasury) Purchases mortgages insured by FHA, VA, Federal Farmer’s Administration. Holds mortgages, sells mortgage backed securities. Federal Home Loan Mortgage Corporation (private company originally a government sponsored enterprise) Purchases conventional mortgages Issues common stock, debentures, structured notes, mortgage backed securities Holds mortgages, sells mortgages to private mortgage pool operators. A conforming mortgage meets underwriting standards of Federal Home Loan Mortgage Corporation (Freddie Mac) or Federal National Mortgage Corporation (Fannie Mae). The underwriting standards include 1. Maximum PTI 2. Maximum LTV 3. Maximum loan amount For FNMA – (2003) maximum loan limits Loan type Loan limits Single family $332,700 mortgage Multi-family 413,100 mortgage 3-family 499,300 4-family 620,500 Second Mortg. 161,350 Maximum amount in Alaska, Hawaii, and U.S. Virgin Islands are 50% greater Conforming mortgages can be sold to an agency. The agency then sells mortgage passthrough securities based on the mortgage pool or sells mortgage pool to private mortgage operators. Non-conforming mortgages are purchased by private conduits.


Features of state foreclosure laws that influence the likelihood and cost of loan default. 1. Foreclosure procedures (judicial or non-judicial) 2. Statutory right of redemption – window of opportunity after foreclosure for original owner to redeem property through payment. 3. Deficiency judgement – right of lender to recover deficiencies from borrower through lien on other personal assets. Price Down payment Principal $100,000 $20,000 $80,000 Fixed rate 30 12 8.00% $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587 $587

Total $211,324

Interest $131,324

i Cash flow 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

interest Principal paid $533 $54 $532.98 $54.04 $532.62 $54.40 $532.25 $54.76 $531.89 $55.12 $531.52 $55.49 $531.15 $55.86 $530.78 $56.23 $530.40 $56.61 $530.03 $56.99 $529.65 $57.37 $529.26 $57.75 $528.88 $58.13 $528.49 $58.52 $528.10 $58.91 $527.71 $59.30 $527.31 $59.70 $526.91 $60.10 $526.51 $60.50 $526.11 $60.90 $525.70 $61.31 $525.30 $61.72 $524.88 $62.13 $524.47 $62.54

Balance $79,946 $79,892.29 $79,837.89 $79,783.13 $79,728.01 $79,672.51 $79,616.65 $79,560.42 $79,503.81 $79,446.82 $79,389.46 $79,331.71 $79,273.58 $79,215.05 $79,156.14 $79,096.84 $79,037.14 $78,977.04 $78,916.54 $78,855.64 $78,794.34 $78,732.62 $78,670.49 $78,607.95

LTV 0.799463 0.798923 0.798379 0.797831 0.79728 0.796725 0.796167 0.795604 0.795038 0.794468 0.793895 0.793317 0.792736 0.792151 0.791561 0.790968 0.790371 0.78977 0.789165 0.788556 0.787943 0.787326 0.786705 0.786079

Fixed rate (contract rate) level payment contracts are one mortgage design –



1  (1  i) n  MB0  MP  i  
Note the contract rate is adjusted by 1/12 and the number of periods is also increased by a factor of 12 when considering a fixed rate - fixed term – monthly pay - self amortizing loan contract.

Variable rate mortgage contract – reference rate (index), reset period, margin, periodic caps, lifetime caps, floors. Caps limit the possible change in the contract rate. The actual rate charge will change by the full amount. Which can produce negative amortization. Other mortgage contract types: Balloon mortgage - Lender agrees to refinance the remaining balance at specified intervals over the term of the loan. Two-step mortgage – one reset date during life of mortgage Growing equity mortgages Graduated payment mortgages Tiered payment mortgages Fixed / adjustable rate hybrids


Mortgage backed securities include    Mortgage passthroughs Collateralized mortgage obligations Stripped mortgage backed securities

The latter two securities are created from mortgage passthrough securities. Three government agencies issue mortgage passthrough securities – Government National Mortgage Association (GNMA), FHLMC and FNMA. (government sponsored enterprises) Mortgage guarantors provide one of two guarantees Fully modified – principal and interest will be paid when due. Modified – timely payment of interest, principal will be paid when collected .

Characteristics of Agency passthroughs – Only the guarantees of GNMA are backed by the full faith and credit of the U.S. Treasury. Fully modified passthroughs. GNMA I – single lender pools, servicing spread 50 basis points, payment delay 45 days GNMA II – multiple lender pools, servicing spread 50-150 basis points, payment delay 50 days GNMA underwriting standards – GNMA restricts loans purchased to those that are insured by FHA, VA or RHS. Only new mortgages issued within last 24- months can be included Assumable mortgages are not permitted.


FHLMC – issues participation certificates (PCs) Cash program – Cash PCs – multiple lender pools Guarantor/Swap program – Swap PCs – single and multiple lender pools Both modified and fully modified passthroughs Conventional mortgages - fixed rate, variable rate and balloon are used as collateral No limits on mortgage seasoning. No assumable mortgages permitted. FNMA – MBS programs Fully modified passthroughs Only multiple lender pools No limits on seasoning No assumable mortgages permitted Net interest spread can be 50 – 250 basis points.


Valuing a passthrough security – The passthrough coupon rate is less than the contract rate of the mortgages in the pool by an amount that reflects the servicing fee and guarantee fee. Weighted average coupon rate (WAC) – Sum of the weighted contract rate of each mortgage in the pool. Weights determined like portfolio weights - proportion of total outstanding balance. Weighted average maturity (WAM) – Sum of the weighted maturity of each mortgage in the pool. Cash flows of a mortgage passthrough security depend on the cash flows of the underlying mortgages net of servicing fees and guarantee fees and include both scheduled principal repayment and prepayments. To place a value on mortgage pools it is essential to treat the expected prepayment pattern of the mortgages in the pool. One method is the Public Securities Association (PSA) prepayment benchmark CPR = annual prepayment rate SMM = Single monthly mortality rate SMM = 1 – (1-CPR)1/12 A SMM of w% means that approximately w% of the remaining mortgage balance at the beginning of the month, less the scheduled principal payment, will prepay that month. Prepayment for month t = SMM x (beginning mortgage balance (t) – scheduled principal payment (t)). Assume a remaining balance of $290 million at the beginning of the month, a SMM of 0.5143% and a scheduled principal payment of $3,000,000. 0.005143 x (290,000,000 – 3,000,000) = $1,476,041


The PSA benchmark assumes the following prepayment rates for 30-year mortgages; 1. A CPR of 0.2% for the first month, increase by 0.2% per year per month for the next 30-months when it peaks at 6% per year. (if t<=30 then CPR=(6%*t)/30 . 2. 6% CPR for the remaining years. (if t >30 then CPR = 6%). A prepayment assumption will determine the expected cash flow to be received by the owners of the passthrough certificates. Given the projected cash flows based on some prepayment assumption and the market price of a pass through, the yield to maturity of a passthrough can be calculated. This is referred to as the cash flow yield.

The Wall Street Journal reports the cash flow yield on passthrough securities of all three agencies. The Salomon Brother’s prepayment model is used (?).

Spreadsheet example of cash flow construction

Different assumptions of prepayment speed can be incorporated with adjustment to the assumed conditional prepayment rate. Exhibit 11-4 page 244 – Average time to move implied by PSA speed.


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