McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER19CHAPTER19 CHAPTER19CHAPTER19 The Secondary Mortgage Market: Pass-Through Securities

19-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Allows originators to replenish funds Facilitates geographic flow of funds Provides an investment option for savers Early buyers of mortgages  Mortgage companies and thrifts FHA insurance and VA guarantees  Minimum underwriting standards

19-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market 1954 Charter Act: FNMA  Enhance secondary market operations FHA and VA mortgages  Manage prior direct loans  Manage special assistance programs  FNMA transforms into a private organization  FNMA issues securities

19-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market HUD Act 1968: GNMA  GNMA manages and liquidates FNMA loan portfolio  Special assistance functions  Guarantee timely payment of principal and interest for FHA-VA mortgage pools  Eliminated any default delay in payments to investors

19-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Emergency Home Finance Act 1970: FHLMC  Provide a secondary market for conventional loans  Allowed FNMA to purchase conventional mortgages  FHLMC allowed to purchase FHA and VA mortgages  Fannie Mae and Freddie Mac compete for all mortgage loans

19-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Operation  Direct Sale Programs Mandatory Commitment Optional Delivery Mortgage-Related Security Pools  Securitization

19-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  Issuer retains ownership of mortgages  Mortgages held in trust  Fixed coupon rate  Specific maturity  Over collateralization  Mark to market

19-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  Investment Rating Mortgage Quality Geographic Diversification Interest Rates on Mortgages Prepayment Probability Over collateralization Appraised value and debt coverage ratio if commercial mortgages

19-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  Example 19-1: Mortgage Bond Valuation  20-year to maturity  Par value of $10,000  10.5% annual coupon.  At issue, bond market investors require an 11% interest rate.  What is the initial price of the bond?

19-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  Example 19-1: = $10,000 = 20 =.105 x $10,000 = $1,050 = 11 = $9, n i CPT FV PMT PV

19-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  In Example 19-1, what would be the price of the bond 5 years later if investors required a 12% return?  N is 15 years  I is 12%

19-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  Example 19-1: = $10,000 = 15 = $1,050 = 12 = $8, n i CPT FV PMT PV

19-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage-Backed Bonds  Zero-Coupon Bond The only cash flow to an investor is a lump sum at maturity No interim coupon payments Also called “deep discount” bonds Analysis is just computing the present value of a lump sum

19-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage Pass-Through Securities  Ownership interest in a pool of mortgages  Trustee is owner of the mortgages in the pool  Principal & interest are passed through  Servicing & guarantee fees

19-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage Pass-Through Securities  Issuers & guarantors  Default insurance  Payment patterns and security  Coupon rate and interest rates  Seasoned mortgages

19-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Mortgage Pass-Through Securities  Number of mortgages  Geographic distribution  Borrower characteristics  Loan prepayment  Nuisance calls

19-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market General Pricing of MPTs  Interest Rate Risk  Default Risk  Risk of Delayed Payment of Principal and Interest  Prepayment Risk

19-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market General Pricing of MPTs  Coupon Rate  Yield to maturity  Servicing Fee  Weighted Average Coupon & Maturity  Stated Maturity Date  Payment Delays  Pool Factors

19-19 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Example 19-2:  A mortgage pool consists of the following: $500,000 of 30-year 7% Fixed Rate Mortgages $200,000 of 29-year 6.5% Fixed Rate Mortgages $300,000 of 28-year 6% Fixed Rate Mortgages  What is the weighted average coupon and average maturity of the mortgage pool? If there is a servicing fee of.5%, what is the quoted maturity and quoted coupon rate?

19-20 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Example 19-2: Quoted Maturity = 30 Years Quoted Coupon Rate = 6% -.5% = 5.5% AmountMaturityInterest Rate WeightW x MW x I $500,000307% $200, % $300,000286% $1,000,000WAM = 29.2WAC = 6.6

19-21 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Pricing Issues  Mortgage-Backed Bonds Specified maturity Specified coupon payment and face value Pricing methodology is relatively straight forward  MPTs Can not define a specific maturity Can not define specific cash flows Pricing is based on prepayment assumptions

19-22 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Secondary Mortgage Market Prepayment Assumptions  Average Maturity Assumption  Constant Prepayment Rate Assumption  FHA Prepayment Experience  PSA Prepayment Model Convexity  Price Compression