Transcript Document

The Secondary Mortgage Market
• In the secondary mortgage market:
•
•
•
•
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 loanto-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 (October 1979, Paul Adolph
Volcker). 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 whollyowned government corporation within
HUD. This entity is known as the
Government National Mortgage
Association (GNMA, 1968).
– 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 longterm 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:
C * Par (1  C ) * Par
Price 

i
T
(1

r)
(
1

r
)
i 1
T 1
• 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
Price
$20,000.00
$15,000.00
$10,000.00
$5,000.00
$0.00
0
0.02
0.04
0.06
0.08
0.1
Yield
0.12
0.14
0.16
0.18
0.2
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
Price
$10,000.00
$0.00
0
0.02
0.04
0.06
0.08
0.1
($10,000.00)
($20,000.00)
($30,000.00)
Yield
0.12
0.14
0.16
0.18
0.2
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
Price
$10,000.00
$0.00
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
($10,000.00)
($20,000.00)
($30,000.00)
Yield
MBB
Mortgages
Net Position
0.18
0.2
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
Balance
$75,000.00
$50,000.00
$25,000.00
$0.00
0
60
120
180
240
Month
10% mortgage balance
10.5% mortgage balance
300
360
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
Month
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
Aggregage
Mortgages
Aggregate
Aggregate
Aggregate Ending
Outstanding Payment
Interest
Principal
Balance
Prepayments Final Balance
10
$8,775.72
8333.333333
$442.38
$999,557.62
$0.00
$999,557.62
10
$8,775.72
$8,329.65
$446.07
$999,111.55
$0.00
$999,111.55
10
$8,775.72
$8,325.93
$449.79
$998,661.76
$0.00
$998,661.76
10
$8,775.72
$8,322.18
$453.53
$998,208.23
$0.00
$998,208.23
10
$8,775.72
$8,318.40
$457.31
$997,750.91
$0.00
$997,750.91
10
$8,775.72
$8,314.59
$461.12
$997,289.79
$0.00
$997,289.79
10
$8,775.72
$8,310.75
$464.97
$996,824.82
$0.00
$996,824.82
10
$8,775.72
$8,306.87
$468.84
$996,355.98
$0.00
$996,355.98
10
$8,775.72
$8,302.97
$472.75
$995,883.23
$0.00
$995,883.23
10
$8,775.72
$8,299.03
$476.69
$995,406.54
$0.00
$995,406.54
10
$8,775.72
$8,295.05
$480.66
$994,925.88
$0.00
$994,925.88
10
$8,775.72
$8,291.05
$484.67
$994,441.21
$99,444.12
$894,997.09
9
$7,898.14
$7,458.31
$439.84
$894,557.26
$0.00
$894,557.26
9
$7,898.14
$7,454.64
$443.50
$894,113.76
$0.00
$894,113.76
9
$7,898.14
$7,450.95
$447.20
$893,666.56
$0.00
$893,666.56
9
$7,898.14
$7,447.22
$450.92
$893,215.64
$0.00
$893,215.64
9
$7,898.14
$7,443.46
$454.68
$892,760.96
$0.00
$892,760.96
9
$7,898.14
$7,439.67
$458.47
$892,302.49
$0.00
$892,302.49
9
$7,898.14
$7,435.85
$462.29
$891,840.20
$0.00
$891,840.20
9
$7,898.14
$7,432.00
$466.14
$891,374.06
$0.00
$891,374.06
9
$7,898.14
$7,428.12
$470.03
$890,904.03
$0.00
$890,904.03
9
$7,898.14
$7,424.20
$473.94
$890,430.09
$0.00
$890,430.09
9
$7,898.14
$7,420.25
$477.89
$889,952.19
$0.00
$889,952.19
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
60000
M
40000
20000
Month
Investor A Payment
Investor B Payment
115
109
103
97
91
85
79
73
67
61
55
49
43
37
31
25
19
13
7
0
1
Dollars
80000
Mortgage Pass-Throughs
Monthly Servicing and Guarantee Fee Am ounts
450
400
350
250
200
150
100
50
Month
Servicing Cash Flow s
Guarantee Fee
115
109
103
97
91
85
79
73
67
61
55
49
43
37
31
25
19
13
7
0
1
Amount
300
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.