The Secondary Mortgage Market • Chapters 19 and 20 present an introduction to several key items in the secondary mortgage market. These include: • 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 loan-to-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. 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 wholly-owned government corporation within HUD. This entity is known as the Government National Mortgage Association (GNMA). • 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 long-term 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: • The next page shows prices at origination for a 20 year MBB with coupon of 9% at different discount rates.
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 • 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 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 • 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 • 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. • First, though, we need to figure out how to describe pools of loans.