Mortgage Markets and Mortgage Backed

Securities

Finance 119

History info from "Mortgage Backed Securites: by History info from "Mortgage Backed Securites: by William BartlettWilliam Bartlett

Brief History of Mortgages

5,000 years ago Babylonians used land as security to encourage the building of dikes and damsEgyptians used surveys to describe land plots ranked by fertility from flooding of the NileRomans introduced the fiducia a document that was a title to land. Roman Law defined a hypotheca or “pledge” that resembled lien theory today

Brief History of Mortgages

Following the decline of Roman empire, Germanic law developed the idea to use land as security in borrowers agreements, this practice was referred to as a gageWilliam of Normandy introduced the Germanic gage system into early English law. The French word mort (dead or frozen) was combined with gage to produce a locked pledge or mort-gage on property.

The US mortgage market

Establishment of mortgage companies in the the 1800’s to finance land purchases by farmers in the Midwest.By 1900 there were approximately 200 mortgage companies with outstanding loan values totaling $4 billion

Early mortgages paid interest semiannually, nonamortizing with a balloon payment at the end (as short as 3 to 5 years)

The Mortgage Market

The Primary MarketMortgage Originators

Thrifts, Commercial banks and mortgage brokers

Origination income

Origination Fee - expressed in terms of points -- each point represents 1% of the borrowed funds -- Origination fee of 3 points on 100,000 mortgage is $3,000Secondary market profit -- selling the mortgage obligation at a price higher than it originally cost.Servicing Fee - Collecting monthly payments, forwarding proceeds to owners of the loan, sending payment notices, maintaining records, furnishing tax info etc… 

The mortgage origination process

Applicant submits info relating to the property and income. Originator performs credit report and looks at the probability of repayment. PTI -- payment to income ratio (monthly payment / monthly income)LTV -- loan to value ratio (Loan amount / Valuation)Commitment letter-- outlines the terms available for the next 30 to 60 days. The borrower pays a commitment fee which will be lost if no loan is taken out.

Post Loan Options

After making the loan the originator has one of three options

Hold the mortgage in their portfolio

Sell the mortgage to an investor (who will either hold the mortgage or use it as collateral)

Use the mortgage as collateral to issue a security (securitizing the mortgage)

Origination Risks

Price Risk If rates increase the originator has already committed to charging lower rates --  

Can protect against price risk with a second commitment from a secondary market participant that agrees to buy the given loan at a futures point in time for a given price.However this brings a second risk -- if rates decline the borrower may not close and the originator is locked into providing the above market return.

Fall out Risk. Risk that some individuals issued commitment letters will not close

Mortgage Construction

Traditional Fixed Rate MortgagePrincipal and interest are amortized over the life of the mortgage.The payment is determined with the basic PV of an annuity formula

Amortization of a Loan

You want to borrow 1,000 and pay it off over three years. Assume that you are charged 6% each year. How much will your payment be?

1,000 = PV PMT =????1,000 = PMT (PVIFA6%,3) =

1,000 = PMT(2.67)PMT = 374.11

Amortization

You pay a total of 374.11(3) = $1,122.33A portion of each payment represents interest charges.You can find the amount of interest by multiplying the beginning balance each payment period by the interest rate. At the beginning the balance is $1,000 so there is 1,000(.06) = 60 in interest.

Amortization

Beginning Ending

Year Balance Payment Interest Principal Balance1 1,000 374.11 60.00 314.11 685.89

2 685.89 374.11 41.15 332.96 352.93

3 352.93 374.11 21.18 352.93 0.00

Amortization 30 yr Mortgage$150,000 5.85%

Beginning Ending

Year Balance Payment Interest Principal Balance

1 150,000884.91 731.25153.6614149,846.34

2 149,846 884.91 730.50 154.41 149691.93

359 1756.97884.91 8.57 876.35 880.62

360

880.62 884.91 4.29 880.62 0

Problems

Mismatch Institutions are borrowing short and lending long)Tilt The real burden of the loan to the borrower is in the early years of the loan. Since inflation decreases the real burden of their payments over time.

Adjustable Rate Mortgages

The loan rte is reset periodically using a base or reference rate.The rate might reset every month, year, 2 years 5 years etc..Reference Rate

Market determinedCost of Funds

ARM Features

Usually offer an initial rate less than prevailing fixed rate 9teaser rate).At reset date reference rate plus a spread determines the rate.There may be caps and floors on the rates, both periodic and lifetime.

Balloon & Two Step Mortgages

Allows for rollover and renegotiation of the loan at periodic intervals. Different from ARM the future rate is not set from base rate.Loan is extended if certain requirements are met.30 due in 5 is a thirty year mortgage where the remaining principal is due (or refinanced) after five years.Two step rates once based upon a specified rate

Solutions to the tilt problem:

ARMs address the mismatch problem by allowing for longer term lending at a short term rate.The tilt problem has creates the market for other types of productsGraduated Payment MortgagesPrice -level Adjusted Mortgage. Dual Rate Mortgage 

Graduated Payment Mortgages

The mortgage payment increases each year at the beginning of the loan then hits a level amount for the remainder of the loan.This actually produces negative amortization since in the beginning the total amount does not cover the interest on the loan.Specified in the loan are The fixed rate, the rate of growth for the first few years, the number of years over which the payment will increase

Graduated Payment Mortgages

Example: 30 year, 10% mortgage on $100,000 with the payment growing at 7.5% each year for the first 5 years.Fixed rate payment would be $877.5715

GPM PaymentsYear Payment Year Payment1 $667.04 2 $717.063 $770.84 4 $828.665 $890.80 6-30 $957.62

Price Level Adjusted Mortgages

Monthly payment is designed to be level in purchasing power. The fixed rate of interest is a real rate of interest.The monthly payment is then calculated using the real rate just as a regular mortgage would be.The actual payment is then adjusted based upon the rate of inflation.

Dual Rate Mortgages

Similar to the PLAM except the amount owed is based on a floating short term rate. To establish the mortgage you need

1. the payment rte (the real rate of interest that is fixed for the life of the loan),

2. the effective or debiting rate that changes periodically and

3. the maturity of the mortgage.

Other plans

Growing Equity Mortgage: Similar to the GPM except there is no negative amortization. The increase in payment will serve to pay off the principal quicker than a traditional mortgage.

Lenders will be willing to lend a t a lower rate (if the yield curve slopes up) and borrowers increase payment solving tilt problem

High LTV loans eliminates high down payments by financing up to 100%of the value of the home plus closing costs.

Other Plans

Alt-A loans: Requires alternate documentation of income for special cases such as self employed individuals. Rtes are generally 75 basis points to 125 basis points above other ratesSub Prime Loans: Borrowers who have had credit problems. Rates based upon different risk grades

Risks Faced by Mortgage Investors

Credit RiskRisk of default by the borrowerLiquidity riskEven with the secondary markets, individual loans are relatively illiquidPrice RiskValue moves opposite changes in interest ratesPrepayment RiskThe borrower may prepay early

Mortgage Pass through Securities

Interest and Principle are collected by the issuer of the pass through who then transfers (passes through) the payments to the owners of new securities backed by the mortgages. Neither the amount or timing of the cash flows actually matches the cash flows on the pool of mortgages.

Securitization

Loan Bank B

Financial IntermediaryBuys Loans, Forms a “Pool”

and Issues MBS

Loan Bank A Loan Bank Z

Insurance Firm, Banks, Pension Funds etc.Buy MBS – Cash Flows “Guaranteed” by Original Mortgages

WAC, WAM and WARM

WAC = weighted average coupon rateWeighting the mortgage rate of each mortgage in the pool by the outstanding principal balanceWAM weighted average maturityWeighting the number of months to maturity of each mortgage in the pool by the outstanding principal balanceWARM weighted average remaining maturityAfter prepayments start the maturity changes.

Guarantee Types

Fully Modified Pass Throughs: Guarantees that the principal and interest will be paid regardless of whether the borrower is late.

Modified Pass Through: Guarantees the timely payment of interest, the principal is passed through when it is received.

Ginnie Mae

Ginnie Mae pass throughs are guaranteed by the US treasury. Issue Mortgage backed securities which are fully modified pass throughsAll mortgages are FHA, VA or Farmers Home Administration loans

Fannie Mae

Sells mortgage backed securities and channels the funds to lenders by buying mortgages. The institution may continue to service the original mortgage.

 All are fully modified pass throughs, but there is no government guarantee of payment

Freddie Mac (FHLMC)

Participation Certificates sold by the agency are used to finance the origination of conventional mortgages. Usually PC only guarantee that the interest payment will be made. The principle payment is passed through as it is received. The guarantee is not backed by the federal government as is the case in Ginnie Mae. Most are fully modified (new issues are)

 Participation Certificates

Two main programsCash program FHLMC buys mortgages from the issuer and issues PC's based on the mortgages. Guarantor / Swap program -- Allows thrifts to swap mortgages for PC's based on the mortgages. The institution can swap mortgages selling below par for without recognizing an accounting loss! The PC is then:

Held as an investmentused as collateral for borrowingsold

Comparison of rates

The pass through rate is less than that of the mortgage pool. The difference accounts for service and guaranteeing fees.The timing is also different to allow for the payment of the mortgages (on the first of the month) prior to the pass through occurring.

Sundaresan 2002Sundaresan 2002

Creation of a GNMA pass through

The loan pool must have standard features in terms of single family or mutli family, maturity etc.The originators forward the pool to GNMA with supporting documentation requesting GNMA to guarantee the securities to be backed by the pool After review a pool number is assigned if the pool is accepted

Creation of a GNMA pass through

The originators transfer the mortgage documents to custodial agents and send pool documents to GNMAOriginators look for investors (dealers, investment banks etc) willing to buy a given amount at a specified price

Creation continued

GNMA issues the guarantee following review of the documentation.Originators continue to service the loans.The GNMA is not a debt of the issuer, it is a representation f the loan pool with payments guaranteed by Ginnie Mae

Sundaresan 2002Sundaresan 2002

Fees for a typical GNMA pool

44 basis points are retained by the servicer for servicing feesGinnie Mae received 6 basis points for the guarantee. The issuer is guaranteeing Ginnie Mae against defaults by the homeowner and Ginnie Mae guarantees against defaults by the issuer.The investor then receives approximately 50 basis points less than the coupon of the loan portfolio.

Sundaresan 2002Sundaresan 2002

Price Quotes

GNMA’s are quoted in 1/32 of a pointQuotes depend upon a pool factor pf(t)

blanace original theis P

tdateat balance theisB

: where

)(

t

P

Btp t

f

Sundaresan 2002Sundaresan 2002

Market Value

Consider an investor with $20 million of a $100 million issue with a pool factor of .9 and a price of 9316/

32

Par value remaining = 20 (.9) = 18millionMarket Value = 18 (.9350) = 16.38 Million

You would need to also account for accrued interest to find the actual cash price.

Sundaresan 2002Sundaresan 2002

Accrued interest

Assume a coupon rate of 9% and 20 days into the month

balance B ratecoupon c

month ofday first theis M Date, settlement SD

where12

1

30

BcMSD

ait

000,90)000,000,18(12

1)09(.

30

20

tai

Non Agency Pass Through Securities

Often non agency mortgage pass throughs will attempt to increase their ratingExternal Credit Enhancement

third party guarantees of losses up to a predetermined amount. Often these are in the form of a corporate guarantee , a letter of credit, pool insurance or bond insurance

Internal Credit EnhancementReserve fundsOver collateralizationSenior/subordinated structure

Measuring prepayment

Constant Monthly MortalityAssume that there is a 0.5% chance that the mortgage will be prepaid after the first year. The 0.5% is the single month mortality rate (or SMM)Given the SMM it is easy to compute the probability that the mortgage will be retired in the next month.The probability that the mortgage survived the first month is 1-0.005 = .995 or 99.5%

Measuring Prepayment

Given a 99.5% chance that the mortgage survived the first month, and a 0.5% SMM for the second month the probability that the mortgage will be retired in the second month is: 0.50%(.995) = 0.4975%Continuing in the same manner the yearly prepayment rate could be found.

Conditional Prepayment Rate

Let CPR be the conditional prepayment rate. The probability that the mortgage survives one year is (1-SMM)12 which should equal the (1-CPR) or

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

this assumes that prepayments will be the same through time which is not consistent with the

empirical evidence

Conditional Prepayment Rate (CPR)

The industry convention is to use an annual prepayment rate based upon the historical prepayment observed by the FHA. The CPR can then be easily transferred back to a monthly rate (the single month mortality rate (SMM))

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

  If the CPR is 6% the SMM is equal to 1 - (1-.06)1/12 =.005143

Market Convention

The CPR has been shown to level off after thirty months. The standard CPR used is .2% for the first month then increasing at .2% each month until 6% is reached for the thirtieth month and every month thereafter.

month tfor payment

principal scheduled

month tfor

balance mortgage begSMM

 Calculations

Prepayment based upon the SMM Estimated Prepayment for month t

Using the SMM above assume we own a pass through with a beginning balance of 290 million and principal repayment of 3 million scheduledEstimated Prepayment would be:

.005143(290,000,000-3,000,000)=$1,476,041

The PSA benchmark

 The Public Securities Association prepayment benchmark is expressed as a monthly series of prepayment rates.

 

100 PSA

100 PSA assumes the following CPR’s for a 30 year mortgage. Using the convention of a CPR of 0.2% for the first month increased by 0.2% each month for the next 30 monthsAfter 30 periods a CPR of 6% for the remaining years of the mortgage

PSA is then expressed as a percentage of 100 PSA benchmark.  

PSA benchmark

For Example a PSA of 150 means that the pool prepays at an expected rate 1.5 times as fast as the PSA benchmarkNotice the CPR is a multiple of the PSA not the SMM

Monthly cash flow construction(exhibit 24-1 in book)

Assume that you have a $400 Million 7.5% pass through with a WAC of 8.125% and a WAM of 357 months assuming 100PSANote: the pass through has been seasoned three months this makes the CPR = 0.8%

Table 24-1

The SMM for the first month is then: SMM=1-(1-CPR)1/12=1-(1-

0.008)1/12=0.000669124The scheduled mortgage payment would be400,000,000=PMT(PVIFA357,8.125%/

12)=2,975,868.24

(this changes with each payment due to prepayment)

Monthly cash flow construction

Interest is found from the pass through rate of 7.5% $400,000,000(.075)/12 = $2,500,000The scheduled principal is found using the WAC and the payment calculated earlier.Total interest scheduled from the pool is = 400,000,000(.08125)/12 = 2,708,333.333Given a payment of 2,975,868.24 the scheduled principal is: 2,975,868.24 - 2,708,333.333=

267,534.91

Monthly Cash Flow Construction

The expected prepayment for the month is then found using:

For the first month this is equal to :.000669124(400,000,000-267,534.91)

=267,470.58total principal is then equal to

267,534.91+267,470.58=535,005.49

month tfor payment

principal scheduled

month tfor

balance mortgage begSMM

Monthly Cash Flow Construction

Total Cash Flow is then the sum of the interest paid to the pass through investor and the total principal

=2,500,000+ 535,005.49=3,035,005.49the next months outstanding balance is then reduced by the amount of principal

=400,000,000-535,005.49 =399,464,994.51the next month would proceed the same way with

the exception of the scheduled mortgage payment.

Note

The PSA convention is the result of past experience on FHA prepayments. The empirical evidence suggests a level CPR after 30 months of 6%. The first 29 months are just a linear approximation starting at zero months and ending at 29.The same method is used regardless of the maturity of the pass through, and the rate (ARM or fixed.) It is at best an quick and easy estimate.

Non Agency CPR convention

Defaults and other problems characterize the nonagency pass throughs, therefore there is a PSA standard default assumption (SDA)

0.02% fro the first month increasing by 0.02% each month up to .6% at 30 months.6% from 30 to 60 months61 months to 120 months default rates decline to 0.03%120 to maturity default rates remain at 0.03%

Factors Influencing Prepayment

Prevailing Mortgage RatesSpread between Original Rate and Prevailing rate

Path of Rates

Factors Influencing Prepayment

Prevailing Mortgage RatesLevel of ratesAs the level of rates declines turnover increases as more homes become affordable.

Factors Influencing Prepayment

Characteristics of Underlying Mortgage Loans

Seasonality (more in the Spring and summer less in the winter)Age of Mortgage Prepayments are higher during the early stages of the mortgage and the final periods prior to maturityType of Loan (ARM, balloon etc)

Factors Influencing Prepayment

Other FactorsHousing CostsGeographic LocationFamily CircumstancesEconomic Activity

Collateralized Mortgage Obligations.

Provide semiannual paymentsThe payment of principle is allocated among different tranches that represent the repayment of principle.Allows investors to attempt to match their willingness to accept prepayment risk to a security

 

Sequential pay CMO

The first Tranche receives principle until the total principle in the tranche is paid off. The CMO will be explained by a Weighted average maturity and a weighted average coupon that represents the mortgages in the CMO. The actual timing of the payoff will depend upon the prepayment rate. The speed of prepayment can be estimated, but it will not be know in advance.

Example: Same starting point as before

Assume that you have a $400 Million 7.5% pass through with a WAC of 8.125% and a WAM of 357 months assuming 100PSAFour payment tranches

Tranche Par Amount Coupon A 194,500,000 7.5

B 36,000,000 7.5 C 96,500,000 7.5

D 73,000,000 7.5

Example continued

Each tranche received interest upon the outstanding principal in the tranche. Tranche B receives no principal until Tranche A has received all of its principal likewise tranche C follows B and D follows C.Therefore after the fist period, tranche B receives $36,000,000(.075)/12 = $225,000Tranche B continues to receive 225,000 each period until the principal has been paid off to tranche A. The pay down of principal is calculated as before…

CMO

The CMO has allowed investors to choose a tranche that best matches their desire to accept prepayment risk (match the timing of cash flows to their needs). However, there is still variability in the actual timing of the tranches since prepayments may not occur at the estimated speed.,

Accrual Tranches

In the example all the tranches receive interest payments. Often this is not the case. It is possible for one or more tranches to be an accrual bond.The interest that would have been paid on the tranche now goes to paying down the debt on the earlier tranche. This shortens the maturity of the other tranches.

Planned Amortization classes

Includes a set principal payment schedule which must be followed (if the actual prepayments fall within a given window then a schedule of principal payments is followed). PAC bondholders have priority over the other classes within a CMO. Therefore PAC bonds come at the expense of support or companion bonds which absorb the prepayment risk (they forego principal)   

Planned Amortization Class Tranche (PAC) CMO’s

If prepayments are within a specified range, the cash flow pattern is known. PAC bondholders have priority over the other tranches in the issue.The non PAC bonds are termed support or companion bonds.The minimum is based off of a range of PSA assumes an upper and lower collar.

PAC Bonds

The guaranteed principal payment is the minimum of the principal repayments of the two possible PSA’s.The prepayment can occur even if prepayment occurs at a rate different than the original collars

PAC bonds

The support bonds provide protection against both extension and contraction risk. Therefore the PAC will not shorten even outside of the initial PAC bands.The wider band of guaranteed prepayments creates an effective collar in which the prepayments stay constant.

PAC Bonds

The support bond will not receive any principal until the PAC has received all of the scheduled prepayment. If the prepayment is slower than scheduled any principal that might have gone to the support bond (if the schedule was met) will now go tot the PAC.

PAC Bonds

If the prepayment is faster than originally planned the support bond will receive faster prepayments, eliminating the PAC paying off quicker.If the principal of the support bond is paid off early then the PAC will decrease in maturity.

Quick Question

Will the schedule of principal repayments be satisfied if prepayments are faster than the initial upper collar?It depends upon when the prepayments occur…. The initial assumption was that the support would be eliminated at the upper collar. It repayments were initially slow, there is extra support available.

Quick Question 2

Will the schedule of principal repayment be satisfied as long as prepayments stay within the initial collar?Not always the initial structure only guarantees that the schedule will be met if it is at either of the extremes. If prepayment varies there is a possibility that the PAC is busted.

Answer continued

IF the PAC has been prepaying at the faster PSA the amount of support decreases and the lower collar of the effective collar increases above the initial collar.

Final Question

Given the first two questions does a wider initial collar imply that there is less risk that the repayment will not fit the schedule?No the actual prepayment experience once the PAC is seasoned is what is important.Given prepayment experience, the effective collar is what should be investigated.

Increasing Prepayment Protection

Lockout Structure: Eliminating the earlier or shorter PAC from the package creating more support bonds

Changing the prepayment rules in the event that all support bonds are paid off. One possible structure: reverse PAC -- requires any extra principal to go to the longer maturity PAC’s

Targeted Amortization Class

Instead of guaranteeing a range of rates initially a TAC bond guarantees a specific targeted rate. The bond is therefore only protected against contraction risk, not extension risk.

Interest Only and Principal Only

Another structure is to allocate only interest or only principal to a given tranche. The IO investor will want the prepayments to be slow since it extends the life of the CMO. The PO investor will prefer that the prepayments arrive quickly

Notional IO classes

This is a class that receives the excess coupon interest. It has no par value, only a notional value upon which the payments are based.

Stripped Mortgage Backs

1) Synthetic coupon pass throughsresults in a cash flow different than the underlying coupon

2) IO and PO stripsPrincipal is at a discount from par. IO has a notional value.

3) CMO strips