Clauretie Sirmans Chapter 10 - OnCourse Learning Publishing
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Transcript Clauretie Sirmans Chapter 10 - OnCourse Learning Publishing
Chapter 10
The Secondary
Mortgage Market
© OnCourse Learning
Chapter 10 Learning Objectives
Understand the workings of the secondary mortgage
market
Understand why the secondary mortgage market is
important for a more efficient allocation of funds in
the real estate market, and what the major secondary
mortgage market agencies are
Understand how agency problems and the sub-prime
mortgage crisis of 2007 to 2010 affected the major
secondary mortgage market entities
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Secondary Mortgage Market
Market where existing mortgages are bought and sold
Mortgages are used as collateral for mortgage related
securities
Reduces reliance on deposits
Agencies and firms that purchase mortgages in the
secondary market often raise funds by issuing bonds or
other debt instruments, pledging the mortgages as
collateral (mortgage-backed securities)
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Cash Flows in a Simple Secondary
Mortgage Market Transaction
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Why Does the Secondary Mortgage
Market Exist?
Until late 1960s:
Difficult for thrifts to sell mortgages as mortgage assets were not
homogeneous
Potential buyers concerned with default risk
Inability to buy and sell mortgages – led to persistent mismatch in supply
and demand for capital
Regional mismatch
Institutional mismatch
• The secondary mortgage market developed to solve the mismatch
problem
• The federal government stimulated the development of the
secondary mortgage market by overriding state laws hindering its
development
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Characteristics of Mortgage-Backed
Securities
Have some form of credit enhancement
Implies less default risk than the underlying mortgages
serving as collateral
Avoid double taxation
Interest revenue from MBSs is passed through to the
investors; Revenues to the issuer and cash flows to the
investors are not both taxed
Tailor cash flows of MBS to appeal to investors
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MBS Credit Enhancements
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Types of Mortgage-Backed Securities
There are four principal types of MBS:
Mortgage pass-through securities
Mortgage-backed bonds
Mortgage pay-through bonds
Collateralized mortgage obligations (CMO’s)
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Mortgage Pass-Through Securities
(MPTs)
Fist popular MBS promoted by GNMA
The investor has an undivided interest in the pool of
mortgages
The investor has an “ownership” position in the mortgages
Mortgage principal and interest and any prepayment is
passed-through to the investor on a pro-rata basis
Mortgage originators sells the MPT at a slightly lower yield
than the interest rate of the underlying mortgages.
The difference is shared by the originator who services the loan
and the agency which provides the credit enhancement
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Mortgage-Backed Bonds (MBBs)
MBSs that promise payments similar to corporate bonds
Semiannual payments of interest only until maturity
Face value due at maturity
Mortgages are owned by the issuer of the MBB
Maturity of the bonds is less than that of the underlying
mortgages
Yield is slightly below that on the mortgages
Mortgages are placed with a trustee who marks-to-market any
changes in their value and ensures that the agreed-on
overcollateralization is maintained
MBBs rated by rating agencies
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Cash Flows for a MBB
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Mortgage Pay-Through Bonds (MPTBs)
A cross between pass-throughs and MBBs
Issuer retains ownership in the pool and issues MPTB as a
debt obligation
Cash flows to the investors are based on the coupon rate
of interest, while principal from amortization and
prepayment is passed through as received from the pool
Rated by agencies, based on the same factors associated
with MBBs
Less overcollateralization than with MBBs due to passing
prepayment risk to the investors
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Collateralized Mortgage Obligations
(CMOs)
Rearrange cash flows from the pool of mortgages into
several different bond-like securities with different
maturities
Different bond classes called tranches
A typical CMO has three or four tranches
A residual tranche (Tranche Z) often owned by the
issuer where all residual cash flows accrue
Implies equity interest of the issuer in the CMO
Cash flows accruing to residual represent return-on-equity.
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Example Structure of a CMO
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Swaps
A SMM transaction where the lender sells mortgages to an
agency that in turn issues an MBS back to the lender
Swaps are attractive due to the liquidity advantage of MBS
over loans
Thrifts can use MBS as collateral to borrow funds
MBS can be sold quicker than mortgage loans if there is
need for cash
Even if they sell the MBS, the lenders are likely to retain
the servicing and receive a servicing fee
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Real Estate Synthetic Investment
Securities (RESIs)
Pass all of the credit risk through to the bondholders
Rated by agencies
Losses from default are passed to the lowest rated
classes first
Securities are backed by, primarily, jumbo loans
High return – high risk
In 2004 when mortgage rates approx. 6%, 15% yield on
lower-grade RESIs
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Commercial Mortgage Backed
Securities
Started with S&L crisis of 1980s when RTC packaged
commercial loans of failed thrifts and sold CMBSs
Senior tranche received all principal payments
including prepayments
Subordinated tranche bore all losses from defaults
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CMBS (Cont.)
Securitization process is same as for CMOs with
different tranches
May be backed up by many mortgages on many
properties, a single loan on a very large property, or a
single loan on many properties
Loans are credit rated and contributed to a REMIC
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REMICs
An entity that could issue CMOs and not be subject to
double taxation
A partnership, trust, or other corporation may elect
REMIC status
For tax purposes, income is recorded as received from
the mortgage pool and deductions are allowed for
interest paid (on the CMO tranches); The net income
can be passed-through to the owner of the residual as
income or loss
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REMICs
Can maintain favorable tax status as long as they don't
engage in the following transactions:
Receive income from non-qualifying mortgages
Receive fees or compensation for services (other than
servicing income from the mortgage portfolio)
Buying or selling mortgages out of the pool (except as
the pool is liquidated if all proceeds are disbursed
within 90 days)
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Cash Flows for a REMIC
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Secondary Mortgage Market Agencies
and Firms
Federal National Mortgage Association (Fannie Mae,
FNMA)
Established in 1938 to buy FHA loans
Re-chartered in 1954 and became a private corporation
As of 1970, allowed to buy FHA,VA, and conventional
mortgages
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Secondary Mortgage Market Agencies
and Firms
Government National Mortgage Association (Ginnie
Mae, GNMA)
Created in 1968 within HUD
Does not purchase mortgages or issue securities
Market focus is to guarantee FHA and VA pass-through
securities
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Secondary Mortgage Market Agencies
and Firms
Federal Home Loan Mortgage Corporation (Freddie
Mac)
Established in 1970 to create a secondary mortgage market
for conventional mortgages
Operates as a private corporation
Currently buys FHA, VA, and conventional mortgages
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Federal Home Loan Mortgage
Corporation (Freddie Mac)
Freddie Mac purchases both newly issued and
seasoned (those with some expired term) mortgages
Freddie Mac will also purchase
construction/permanent loans that are FRMs, ARMs,
or balloon/reset. These must be new dwellings and
not rehabs.
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Freddie Mac (Cont.)
Freddie Mac issues a wide variety of securities:
Discount Notes and Debentures
Mortgage Participation Certificates (Pass-throughs) on
FRMs, ARMs, and multifamily
Collateralized Mortgage Obligations in several classes or
tranches
Guaranteed Mortgage Certificates – not sold since 1979
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Secondary Mortgage Market
Federal credit agencies that support the primary and
secondary mortgage markets:
Farm Credit System consolidated three agricultural agencies
to make direct loans for agricultural purposes
Federal Agricultural Mortgage Corporation (Farmer Mac) to
underwrite pools of farm mortgages through pass-throughs
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Secondary Mortgage Market Agencies and
Firms
Federal credit agencies that support the primary and
secondary mortgage markets:
Rural Housing Service extends loans to rural areas for farms,
houses, and community facilities
Financing Corporation formed in 1987 to recapitalize the
FSLIC
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Government-Sponsored Enterprises
GSEs are not officially part of the federal government
They appear to enjoy the backing of the federal
government
Federal government does not guarantee these
agency’s obligations but Congress has shown that
federal funds would be used to “bail” them out of
financial stress
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Government-Sponsored Enterprises
GSEs operate similarly to thrifts in purchasing longterm mortgages
They face interest rate risk, default risk, and
management/operating risk
Office of Federal Housing Enterprise and Oversight
(OFHEO) oversees the operations of the GSEs
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