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The Secondary Mortgage
Market
Chapters 10 and 11 present an
introduction to several key items in the
secondary mortgage market. These
include:
The major players, FNMA, FHLMC, and GNMA.
Basic idea of a pass-through security.
Prepayments and their effect on MBS cash
flows.
Prepayment Models
Static vs. Dynamic
The Secondary Mortgage
Market
Mortgage Descriptive Statistics
IO/PO Combinations
Collateralized Mortgage Obligations
Mortgage Backed Futures
Historic Origins
The US mortgage markets are one of
the most well-developed aspects in the
overall financial system.
The last 30 years has seen a major
change in the organization of that
system.
Historic Origins
The “classical” model was the “It’s a
Wonderful Life” model: a savings
institution borrowed money from
depositors and lent them to mortgage
borrowers.
The problem was that savings
institutions faced a maturity mismatch.
Historic Origins
Lenders limited borrowing to 5 year IO
loans. Thus borrowers had to refinance
every five years.
Under the “New Deal”, the Federal
government set increasing
homeownership as a national goal.
One way to do this was to go to fully
amortizing loans.
Historic Origins
Fully amortizing loans required longer
maturities. Lenders demanded help
managing:
Credit risk – done initially through low
loan-to-value (LTV) loans and through FHA
insurance.
Interest Rate Risk – The government
attempted to control rates by Regulation
Q.
Historic Origins
Additionally, the federal government
determined that starting a secondary
mortgage market was probably a good
way to provide liquidity to mortgage
lenders.
1939, the Federal National Mortgage
Association (FNMA, pronounced Fannie
Mae) was started as part of HUD.
Historic Origins
FNMA standardized mortgage contract
terms and underwriting methods.
Interstate banking laws still made
transferring loans difficult.
The transaction costs associated with
selling mortgage loans, and the
information asymmetry between
lenders largely prevented the formation
of a secondary market.
Historic Origins
During the 1940’s and 1950’s, interest
rates remained non-volatile.
Interest rates started becoming volatile
in the 1960s. In addition, the
Eurodollar market created a method for
US savers to earn more than the
regulation Q limited rates.
Disintermediation occurred on a large
scale.
Historic Origins
By the late 1960s the need for a
national mortgage market had become
clear.
The federal government quasi-privatized
FNMA. It became a Government Sponsored
Enterprise (GSE).
FNMA was tasked with creating a secondary
market for FHA or non-FHA insured loans.
The federal government formed a second GSE,
the Federal Home Loan Mortgage Corporation
(FHLMC) to compete with FNMA.
Historic Origins
GSE status:
GSE’s debt are implicitly backed by the US
government. They are able to borrow at
between 15 and 30 basis points above the
Treasury rate.
In return for this preferred borrowing rate,
they agree to a high level of regulation. The
President and 1/3 of the board are appointed
by the US President (and confirmed by
Congress).
Historic Origins
GSE status:
GSE’s must meet Congressionally-set capital
standards. The Office of Federal Housing
Enterprise Oversite (OFHEO) is responsible for
determining GSE compliance.
Historic Origins
The federal government started a
wholly-owned government corporation
within HUD. This entity is known as
the Government National Mortgage
Association (GNMA).
GNMA is tasked with creating and
maintaining a secondary market for FHA-
insured mortgages.
Historic Origins
By 1971, Congress had established the
three major secondary mortgage
market entities, FNMA, FHMLC, and
GNMA. Creating the market would take
some time.
During the 1970s and into the early
1980s, interest rate volatility kept
increasing.
Historic Origins
Lenders were getting squeezed badly.
When rates rose, the “average” deposit which
financed mortgages rose quickly, since the
maturity on these deposits were rarely more
than 5 years.
Their average rate on their loan portfolio,
however, rose very slowly, since mortgages
are such long-term assets (note that the
marginal rates rose quickly, however.)
Historic Origins
Lenders were getting squeezed badly.
By the early 1980’s most Savings and Loans
(the primary mortgage originators) were
paying more, on average, for deposits than
they were earning, on average, from loans.
When rates fell, borrowers refinanced their
newly issued, high interest rate mortgages.
The deposit rate, however, staid relatively high
since depositors were in no hurry to invest at
the new lower rate.
Historic Origins
Lenders were getting squeezed badly.
The net effect is that lenders lost money when
rates rose, and the lost money when rate fell.
To profitably hold mortgages in their portfolio
(in the absence of hedging tools), financial
institutions need stable, non-volatile interest
rates.
Banks and S&Ls are well-suited for
originating mortgages, they are not
well suited to holding mortgages in
portfolio.
Market Innovation
As early as the mid-1960’s it was clear
that major innovation was needed in
the mortgage markets.
GNMA, FNMA, and FHLMC provided that
innovation through the creation of a
financial instrument known generically as a
Mortgage Backed Security (MBS).
Market Innovation
We are going to examine a total of six
types of MBS. They are:
Mortgage Backed Bonds
Mortgage Pass-through Securities
Mortgage Pay-Through Securities
IO/PO Combinations
Collateralized Mortgage Obligations
Mortgage Backed Futures
Mortgage Backed Bonds
These are the simplest of the MBS that
we will examine. These are basically
standard corporate bonds with
mortgages serving as their collateral.
The issuer retains all liability for making
the payments to the investors.
The bonds typically have a par value of
$10,000 and have annual coupon
payments.
Mortgage Backed Bonds
Why would a company issue an MBB?
The collateral may allow them to obtain a
higher credit rating (or lower contract rate)
than they would otherwise be able to get.
The use of collateral will reduce to some
degree the drain on the debt capacity of
the firm.
Mortgage Backed Bonds
The market prices this bonds like any
other corporate debt:
Determine the cash flows and then
discount them back to today at the
appropriate discount rate.
The cash flows are annual interest
payments until the maturity date when a
final interest payment is made along with
the return of the par principal amount.
Mortgage Backed Bonds
This works out to the following formula:
T 1
C * Par (1 C ) * Par
Price
i 1 (1 r) i
(1 r )T
The next page shows prices at origination for
a 20 year MBB with coupon of 9% at
different discount rates.
Mortgage Backed Bonds
MBB Example - 9% Coupon, 20 years to maturity price at origination
$30,000.00
$25,000.00
$20,000.00
Price
$15,000.00
$10,000.00
$5,000.00
$0.00
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
Yield
Mortgage Backed Bonds
Issuing MBBs is one method through
which a lender could raise the capital
they need to finance the mortgages
they originate.
There is a problem, however. Since the cash flows
from the MBB are not dependent directly on the
underlying mortgages, they will not exhibit the
negative convexity that the mortgages will.
This means the MBB will not naturally hedge the
prepayment risk embedded in the mortgage.
Mortgage Backed Bonds
To see this, first consider that the
lender is issuing the MBB, so to them
the “value” of this liability is the exact
opposite of how we normally look at it:
Mortgage Backed Bonds
MBB Example - 9% Coupon, 20 years to maturity price at origination
$30,000.00
$20,000.00
$10,000.00
Price
$0.00
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
($10,000.00)
($20,000.00)
($30,000.00)
Yield
Mortgage Backed Bonds
Now if you consider that the portfolio of
mortgages that the lender holds does
exhibit negative convexity, you can see
why the MBB does not provide the best
hedging of the prepayment risk.
Mortgage Backed Bonds
Hedging Properties of Financing a Mortgage Portfolio (Blue Line) with an MBB (Orange
line). The Black line is the net position.
$30,000.00
$20,000.00
$10,000.00
Price
$0.00
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
($10,000.00)
($20,000.00)
($30,000.00)
Yield
MBB Mortgages Net Position
Mortgage Pass-Throughs
For now, we will be discussing MBS as
FNMA and FHLMC issue them. GNMA’s
are different, so ignore them for now.
An MBS is simply a bond issued by
FNMA or FHLMC that is collateralized by
a pool of underlying mortgages.
Mortgage Pass-Throughs
Here is how they work:
A bank or series of banks originates a lot of
mortgages (several hundred million worth).
FNMA or FHLMC buys those mortgages from
the bank and creates a “pool”.
FNMA then creates creates a bond which is
collateralized by the pool of mortgages. The
investors in this pool will receive the
proportionate share of each month’s principal
and interest paid by the individual mortgagors.
This is known as a “pass-through” security.
Mortgage Pass-Throughs
Here is how they work:
FNMA or FHLMC guarantees to the MBS
investors that if a borrower defaults, FNMA or
FHLMC will pay the investor both the principal
and interest they are owed.
FNMA and FHLMC will then foreclose upon the
defaulted borrower.
FNMA and FHLMC charge a fee for this
insurance. They typically charge 25-30 basis
points per year for this insurance.
Mortgage Pass-Throughs
Here is how they work:
FNMA and FHLMC do not on a monthly basis
deal with the borrowers. They hire outside
firms called servicers (frequently the
originating bank) to collect the monthly checks,
answer questions from the borrower, etc.
For servicing the loan, the servicer is able to
earn about 25 basis points a year.
The net effect is that between the servicer and
the insurance, 50 basis points are charged
against the pool
Mortgage Pass-Throughs
Here is how they work:
Thus, if an MBS were formed from a series of
10% loans, by the time the servicing and
insurance fees were taken out, it would in
essence have a 9.5% coupon.
Most MBS have stated coupons that are 50
basis points lower than their underlying
collateral.
Mortgage Pass-Throughs
Here is how they work:
In some sense then, to an investor, buying
an MBS with a 10% coupon rate, it is like
buying a mortgage with a contract rate of
10%, but principal amortizes as if it were a
10.5% mortgage (since the underlying
mortgage would in fact be 10.5%
mortgages).
Mortgage Pass-Throughs
Amortization differences between 10% and 10.5% mortgage
$100,000.00
$75,000.00
Balance
$50,000.00
$25,000.00
$0.00
0 60 120 180 240 300 360
Month
10% mortgage balance 10.5% mortgage balance
Mortgage Pass-Throughs
Here is how they work:
Since the investors essentially have just a type
of bond, they are free to trade that bond in the
secondary market. This market is now huge.
The MBS market is roughly $4 Trillion in size.
There is more outstanding mortgage debt that
US Treasury debt.
Only the currency markets have higher daily
volume than the secondary mortgage market.
Mortgage Pass-Throughs
MBS are especially popular with banks
and other financial institutions, because
they can hold mortgage assets, but
then liquidate them easily if they need
to raise capital.
FNMA and FHLMC have become wildly
successful companies through this
operation.
Mortgage Pass-Throughs
Like any other financial asset, the way
to determine price a mortgage backed
security is to simply determine its cash
flows, and then discount them back at
the appropriate discount rate.
This is more difficult because the cash
flows themselves are a function of
interest rates.
Mortgage Pass-Throughs
This is because of prepayments. We
know that some people will choose to
pay off their loans early. Thus, the
MPT passes through all cashflows to
the investors, the investors receive
these prepayments.
Prepayments obviously increase as the
market rate falls below the contract
rate.
Mortgage Pass-Throughs
We are going to need a way to build in
our expectations about prepayments
into our pricing model.
Before we do that, however, let’s run
through an example of an MBS to
explain the cash flows.
Mortgage Pass-Throughs
Let’s assume that there is a MPT that
consists of 10 mortgages. Each
mortgage has a coupon of 10%, there
is a 25 basis point servicing fee and a
25 basis point guarantee fee.
Let’s further assume that each year one
of the mortgages will prepay
completely.
Mortgage Pass-Throughs
The following spreadsheet shows the
cash flows that the mortgages would
(in aggregate) create, how much cash
would flow to the investors, and how
much cash would flow to the servicer
and the guarantying agency.
Mortgage Pass-Throughs
Aggregage
Mortgages Aggregate Aggregate Aggregate Ending
Month Outstanding Payment Interest Principal Balance Prepayments Final Balance
1 10 $8,775.72 8333.333333 $442.38 $999,557.62 $0.00 $999,557.62
2 10 $8,775.72 $8,329.65 $446.07 $999,111.55 $0.00 $999,111.55
3 10 $8,775.72 $8,325.93 $449.79 $998,661.76 $0.00 $998,661.76
4 10 $8,775.72 $8,322.18 $453.53 $998,208.23 $0.00 $998,208.23
5 10 $8,775.72 $8,318.40 $457.31 $997,750.91 $0.00 $997,750.91
6 10 $8,775.72 $8,314.59 $461.12 $997,289.79 $0.00 $997,289.79
7 10 $8,775.72 $8,310.75 $464.97 $996,824.82 $0.00 $996,824.82
8 10 $8,775.72 $8,306.87 $468.84 $996,355.98 $0.00 $996,355.98
9 10 $8,775.72 $8,302.97 $472.75 $995,883.23 $0.00 $995,883.23
10 10 $8,775.72 $8,299.03 $476.69 $995,406.54 $0.00 $995,406.54
11 10 $8,775.72 $8,295.05 $480.66 $994,925.88 $0.00 $994,925.88
12 10 $8,775.72 $8,291.05 $484.67 $994,441.21 $99,444.12 $894,997.09
13 9 $7,898.14 $7,458.31 $439.84 $894,557.26 $0.00 $894,557.26
14 9 $7,898.14 $7,454.64 $443.50 $894,113.76 $0.00 $894,113.76
15 9 $7,898.14 $7,450.95 $447.20 $893,666.56 $0.00 $893,666.56
16 9 $7,898.14 $7,447.22 $450.92 $893,215.64 $0.00 $893,215.64
17 9 $7,898.14 $7,443.46 $454.68 $892,760.96 $0.00 $892,760.96
18 9 $7,898.14 $7,439.67 $458.47 $892,302.49 $0.00 $892,302.49
19 9 $7,898.14 $7,435.85 $462.29 $891,840.20 $0.00 $891,840.20
20 9 $7,898.14 $7,432.00 $466.14 $891,374.06 $0.00 $891,374.06
21 9 $7,898.14 $7,428.12 $470.03 $890,904.03 $0.00 $890,904.03
22 9 $7,898.14 $7,424.20 $473.94 $890,430.09 $0.00 $890,430.09
23 9 $7,898.14 $7,420.25 $477.89 $889,952.19 $0.00 $889,952.19
24 9 $7,898.14 $7,416.27 $481.88 $889,470.32 $98,830.04 $790,640.28
Mortgage Pass-Throughs
Outstanding Balance by Month
$1,000,000.00
$900,000.00
$800,000.00
$700,000.00
$600,000.00
$500,000.00
$400,000.00
$300,000.00
$200,000.00
$100,000.00
$0.00
1 21 41 61 81 101
Mortgage Pass-Throughs
Monthly Paym ents to Investors A and B
120000
100000
80000
Dollars
60000
M
40000
20000
0
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
103
109
115
Month
Investor A Payment Investor B Payment
Mortgage Pass-Throughs
Monthly Servicing and Guarantee Fee Am ounts
450
400
350
300
Amount
250
200
150
100
50
0
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
103
109
115
Month
Servicing Cash Flow s Guarantee Fee
Mortgage Pass-Throughs
Our ultimate goal is to be able to
develop a pricing mechanism for the
MPT. This is not an easy prospect:
Clearly we have to consider prepayments.
We must also consider how to “aggregate”
all of these individual loans into a single
MPT.
Finally, we must consider the impact of
interest rates on the mortgage cashflows
and discounting.
Mortgage Pass-Throughs
To get at this we will have to examine
how to aggregate mortgage data.
We also need to understand how
Freddie and Fannie use underwriting to
control the credit risk in these pools.
