1 Chapter 3 The Secondary Mortgage Market

2 Learning Objectives Explain why the secondary mortgage market exists and how it developed Describe how the secondary mortgage market works List the major secondary mortgage market agencies Indicate the size of this market relative to all real estate lending 3-1

3 Why Does the Secondary Mortgage Market Exist? Severe liquidity problems for financial institutions resulting from inability to sell assets quickly Mortgage assets were not homogeneous Buyers were concerned with default risk Regional mismatch of supply and demand of capital 3-2

4 Secondary Mortgage Market Con’t. Secondary mortgage market solved these problems The federal government encouraged development of the secondary market by overriding state laws 3-3

5 Mortgage-Related Securities Credit Enhancement Less default risk than underlying mortgages Double Taxation MRSs need to avoid double taxation Investor-Friendly Cash Flows MRSs need to tailor cash flows to fit investors needs 3-4

6 Types of Mortgage-Related Securities Mortgage Pass-Through Securities Mortgage-Backed Bonds Collateralized Mortgage Obligations 3-5

7 Mortgage Pass-Through Securities Investors have an undivided interest in the mortgage pool Investors receive mortgage payments and prepay rents the same as the lender Cash flows can be uncertain due to unpredictable prepayments 3-6

8 Mortgage Backed Bonds Payments are similar to corporate bonds: semiannual interest with face value paid at maturity Yield is less than the average yield of mortgage in the pool Bond rating is based on: –the quality of the mortgage in the pool –the interest rate spread of mortgages in pool and the MBB 3-7

9 Bonds Con’t. Bond Rating based on: –the likelihood of prepayment –the geographical diversification of mortgage in the pool –the amount of over-collateralization 3-8

10 Collateralized Mortgage Obligations Most drastic re-arrangement of the cash flows Different bond classes called tranches Stripped mortgage-backed security –Interest-only strip –Principal-only strip 3-9

11 Secondary Mortgage Markets Agencies and Firms Federal National Mortgage Association (Fannie Mae) Government National Mortgage Association (Ginnie Mae) Federal Home Loan Mortgage Corporation (Freddie Mae) Federal Credit Agencies State and Local Credit Agencies Private Firms 3-10

12 Federal National Mortgage Association Established in 1938 to provide secondary market support for FHA loans Re-charting in 1954 transformed Fannie Mae into private entity Purchases mortgages and issues mortgage- related securities Allowed to start purchasing conventional mortgages in

13 Government National Mortgage Association Established in 1968 and overseen by HUD Management and liquidation of previously originated (before 1968) Fannie Mae mortgages Subsidizes the cost of low-income housing Tandem plan makes low-interest loans to qualified families 3-12

14 GNMA Con’t. Guarantees pass-through securities in timely payment of interest and principal Does not purchase mortgages or issue securities 3-13

15 Federal Home Loan Mortgage Corportation Established in 1970 to create a secondary market for conventional mortgages Authorized to purchase conventional, FHA and VA mortgages Obtains funds by issuing –Discount notes and debentures –Mortgage participation certificates –Collateralized mortgage obligations –Guaranteed mortgage certificates 3-14

16 Federal Credit Agencies Farm Credit System Farm Credit Assistance Financial Corporation Federal Agricultural Mortgage Association Farmers Home Administration Financing Corporation Federal Financing Bank 3-15

17 State and Local Credit Agencies State housing finance agencies fund FHA and VIA mortgages Participate in affordable housing initiatives 3-16

18 Regulation of Government Sponsored Enterprises Government sponsored enterprises: –Fannie Mae –Freddie Mac Are not official departments of the U.S. government but enjoy the backing of the federal government Issue debt to purchase long-term mortgages 3-17