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 gage • William 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)
History of US Mortgage Market 1900 - 1950 • Fast growth form 1900 to 1930 was slowed by large number of foreclosures in early 1930’s. • Federal Government started trying to support the mortgage market especially the secondary mortgage market with formation of Federal National Mortgage Association (Fannie Mae) in 1938 • Post WWII fast expansion of housing market due to liquidity of private sector.
History of US Mortgage Market 1950 - 1980 • 1954 Fannie Mae was reorganized. New charter made it part private part federal owned • 1968 Fannie Mae becomes entirely privately held. Ginnie Mae is established to oversee special assistance (FHA and VA) programs. Guarantees backed by “full faith and credit” of US Treasury. • 1970 Establishment of “Freddie Mac” • 1977 First private pass through issued
History of US Mortgage Market 1980 - 2004 • 1980’s growing use of Adjustable Rate Mortgages • First Collateralized Mortgage Obligations offered • Dramatic growth of Mortgage backed securities market.
The Current Mortgage Market • The Primary Market – The issue of Mortgages to individuals by financial institutions. • Mortgage 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 $3,000 • Secondary 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…
Servicing Fees • Servicing fees are generally a portion of the mortgage rate and is often referred to as servicing spread.
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), possibly continuing to service the mortgage. • 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 Mortgage (fixed-rate level-payment, fully amortized mortgage) • Principal 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) = $1,122.33 • A 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 Balance 1 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 150,000 884.91 731.25 153.6614 1 149,846.34 154.41 2 149,846 884.91 730.50 149691.93 1756.97 359 884.91 8.57 876.35 880.62 0 880.62 880.62 360 884.91 4.29
Servicing Fee Revisited • Since the servicing fee is generally a portion of the interest payment the actual fee income will decline throughout the life of the mortgage as interest decline.
Prepayments and CF Uncertainty • Generally there is not a penalty for prepaying the principle early. When a prepayment is made for less the entire balance it is referred to as a curtailment. • Some mortgages however do have a lock out period or penalty period which can limit or prohibit prepayment.
Origination Problems • Mismatch Institutions are borrowing short and lending long, They must manage the different timing of their cash flows. • 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. Therefore individuals may not enter the market, even though they are able to given their future income.
Adjustable Rate Mortgages • The loan rate is reset periodically using a base or reference rate. • The rate might reset every month, year, 2 years 5 years etc.. • Reference Rate • Market determined • Cost of Funds
ARM Features • Usually offer an initial rate less than prevailing fixed rate (teaser 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 products • Graduated Payment Mortgages • Price -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 Payments Year Payment Year Payment 1 $667.04 2 $717.06 3 $770.84 4 $828.66 5 $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 • the payment rte (the real rate of interest that is fixed for the life of the loan), • the effective or debiting rate that changes periodically and • 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 rates • Sub Prime Loans: Borrowers who have had credit problems. Rates based upon different risk grades
Risks Faced by Investors in the Secondary Mortgage Market • Credit Risk Risk of default by the borrower • Liquidity risk Even with the secondary markets, individual loans are relatively illiquid • Price Risk Value moves opposite changes in interest rates • Prepayment Risk The borrower may prepay early
Mortgage Pass Through Securities • Interest and Principle are collected by the issuer of the pass through on a pool of mortgages 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. • When a mortgage is included in a pool it is said to be securitized.
Cash Flows • Neither the amount or timing of the cash flows actually matches the cash flows on the pool of mortgages. • Servicing and other fees are removed from the cash flows received from the mortgage prior to being passed through to the holder of the pass through security. There is also a delay in the pass through process.
Terminology • The pool of mortgages will have a variety of different rtes and maturities. Therefore, the description of the pass through is based upon weighted averages of the coupon and maturity.
WAC, WAM and WARM • WAC = weighted average coupon rate Weighting the mortgage rate of each mortgage in the pool by the outstanding principal balance • WAM = weighted average maturity Weighting the number of months to maturity of each mortgage in the pool by the outstanding principal balance • WARM = weighted average remaining maturity After prepayments have started 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. • Issues Mortgage backed securities which are fully modified pass throughs • All 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 • Both Ginnie Mae and Fannie Mae securities are commonly referred to as “Mortgage Backed Securities”
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 programs • Cash 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 investment • used as collateral for borrowing • sold
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.
Size of Mortgage Backed Securities Market • The MBS market has grown dramatically in the last 20 years. • Currently there is a political debate surrounding whether Fannie Mae, Ginnie Mae and Freddie Mac are too large. • Part of their growth is based upon the market believing that all three have a government guarantee, even though Fannie Mae and Fredie Mac do not.
% of Outstanding Debt Market Bond Market Association 2003 is as of Sept 30,2003
Average Daily Trading Volume ($Billions) Bond Market Association 2003 as of Sept 30,2003
Issuance by GSE’s ($ Billions) Bond Market Associattion 2003 as of Sept 30, 2003
Recent Study by Federal Reserve • Wayne Passmore, an economist at the Federal Reserve Bank has recently completed a study on the impact of GSE’s • The GSE’s have a funding advantage • Slightly lower mortgage rtes for a few borrowers • Implicit subsidy from government relationship • Implicit subsidy responsible for much of GSE Market Value • MBS have not increased homebuilding
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 Sundaresan 2002
Creation of a GNMA pass through • The originators transfer the mortgage documents to custodial agents and send pool documents to GNMA • Originators 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 MBS is not a debt of the issuer, it is a representation of the loan pool with payments guaranteed by Ginnie Mae
Fees for a typical GNMA pool • 44 basis points are retained by the servicer for servicing fees • Ginnie Mae receives 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 2002