Description
This is a PPT explaining about mortgage and mortgage based securities.
Mortgages & MBS
Introduction
? In most developed countries the right to own a home ? ? ? ? ? ?
is virtually a fundamental right But few people can pay the full purchase price from their own funds So most of the required funds are borrowed A mortgage loan is a loan collateralized by real estate The lender is the mortgagee The borrower is the mortgagor In the event of default the lender can seize the property and sell it to recover his dues
? This is called the Right of Foreclosure
Market Participants
? There are three categories of players
? Mortgage originators ? Mortgage servicers ? Mortgage insurers
Mortgage Origination
? Who is an originator?
? The original lender or the party who first extends a
loan to the acquirer of the property
? Originators include:
? Thrifts or S&Ls
? Commercial Banks
? Mortgage Bankers ? Life Insurance Companies ? Pension Funds
Income for the Originator
? The originator gets income from various sources
? When a loan is granted he will levy an Origination
Fee
? This is expressed in terms of points ? Each point is 1% of the borrowed amount ? So a fee of 1.5 points on a loan of $200,000 will
amount to $3,000
? Most originators will also levy an application fee
and certain processing fee
Income (Cont…)
? The second source is the profit that can be
earned if and when the loan is sold to another party ? A mortgage loan is a type of debt ? It is therefore vulnerable to interest rate fluctuations ? If rates were to decline the sale of a loan will result in a gain for the seller
Income (Cont…)
? This is called a Secondary Marketing Profit
? However if rates were to rise after the loan is
disbursed there will be a loss ? If the originator decides to hold the loan as an asset he will earn periodic income in the form of interest
Mortgage Servicing
? Every loan has to be serviced
? This includes the following activities
? Collection of monthly payments and forwarding the
proceeds to the owner of the loan ? Sending payment notices to mortgagors ? Reminding mortgagors whose payments are overdue ? Maintaining records of principal balances
Servicing (Cont…)
? Administering escrow balances for real estate taxes
and insurance purposes ? Initiating foreclosure proceedings if necessary ? Furnishing tax information to mortgagors when applicable
? Servicers include
? Bank related entities ? Thrift related entities ? Mortgage bankers
Escrow Accounts
? An escrow account is a trust account held in the
name of the mortgagor to pay statutory levies such as
? Property taxes ? Insurance premia
? The maintenance of such accounts helps ensure
that payments are made when due
? Because it becomes the lender’s responsibility to do
so
Escrow (Cont…)
? In most cases the borrower makes monthly
deposits
? Along with the loan payment ? The payments accrue at the lender
? The monthly deposit required is a function of
? The cost of insurance ? And the tax assessment of the property ? Consequently it fluctuates from year to year
Income for the Servicer
? The primary income is the Servicing Fee
? This is fixed percentage of the outstanding
mortgage balance ? Since the loan is amortized the outstanding principal will steadily decline ? So the revenue from servicing in dollar terms will steadily decline
Income (Cont…)
? The second source of income is the interest that
is earned from the escrow accounts maintained by the borrowers ? The third source is the float on the monthly mortgage payment
? This is because a delay is permitted from the time
the servicer receives the monthly payment and the time that it has to be forwarded to the lender
Mortgage Insurance
? There are two types of mortgage related
insurance
? The first type is originated by the lender ? To insure against default by the borrower ? This is called Mortgage Insurance or Private
Mortgage Insurance ? It is usually required by lenders on loans with a LTV ratio greater than 80% ? The amount insured will be a percentage of the loan ? It may decline as the LTV declines
Insurance (Cont…)
? What is the LTV ratio?
? Every borrower has to make a Down Payment
? The difference between the price of the property
and the loan amount
? The LTV ratio is determined by dividing the loan
amount by the market value of the property
? The lower the LTV ratio more is the protection for
the lender in the event of default
Insurance (Cont…)
? The second type of insurance is acquired by the
borrower usually through a life insurance company and is called CREDIT LIFE
? This is not required by the lender ? These policies provide for continuation of monthly
payments after the death of the borrower so that the survivors can continue to occupy the property
Government Insurance and PMI
? Lenders insist on insurance if he LTV ratio is less
than 20% ? However low to middle income borrowers may not be in a position to make a 20% down payment ? At the same time their credit rating makes them ineligible for private insurance ? To help such borrowers there are government agencies that provide loan guarantees in lieu of insurance
Government…(Cont…)
? These agencies are
? The Federal Housing Administration (FHA) ? Department of Veterans’ Affairs (VA) ? Department of Agriculture’s Rural Housing Service
(RHS)
? A borrower who is not eligible for a loan from any
of these agencies must obtain private mortgage insurance or PMI
Secondary Sales
? Once the loan is granted the originator can hold it
as an asset or sell it to an investor ? An investor may wish to hold it as an investment ? Or seek pool individual loans and use them as collateral for the issuance of securities
? This is called SECURITIZATION ? Of course this may be done by the originator
himself
Secondary Sales (Cont…)
? Two federally sponsored credit agencies and
many private agencies
? Buy mortgage loans ? Pool them ? And issue securities backed by the pool
? Such agencies are referred to as CONDUITS
? The two federal agencies are
? Federal National Mortgage Association – Fannie Mae ? Federal Home Loan Mortgage Corporation – Freddie Mac
Secondary Sales (Cont…)
? These agencies buy CONFORMING
MORTGAGES ? What is a conforming mortgage?
? It is one that meets the underwriting criteria set by
them from the standpoint of being eligible to be included in a pool for subsequent securitization
Conforming Mortgages
? A conforming mortgage must satisfy three criteria
? They must have a maximum Payment to Income
(PTI) ratio ? The PTI ratio is the ratio of monthly payments – loan payment + tax payment – to the borrower’s monthly income
? Obviously the lower the ratio the lower is the
chance of default
Conforming (Cont…)
? A maximum LTV ratio
? A maximum loan amount
? Mortgages which are non-conforming because
they are for amounts in excess of the purchasing limit set by the agencies are called JUMBO Mortgages ? Those which are non-conforming because of credit quality or LTV ratio are termed as SUBPRIME mortgages
Risks in Mortgage Lending
? Investors who invest in mortgage loans are
exposed to 4 main risks
? Default risk ? Liquidity risk ? Interest rate risk
? Pre-payment risk
Default Risk
? This is the risk that the borrower may default
? For government insured mortgages the risk is
minimal because the insurance agencies are government sponsored ? For privately insured mortgages the risk depends on the credit rating of the insurance company ? For uninsured mortgages it would depend on the credit quality of the borrower
Liquidity Risk
? Mortgage loans are LARGE and INDIVISIBLE
? So while an active secondary market exists for
such loans Bid-Ask spreads are high relative to other debt securities
Interest Rate Risk
? The price of a mortgage loan moves inversely
with interest rates just like other Debt securities ? Since these loan are for long time periods the price impact of an interest rate change can be significant
Pre-payment Risk
? Most homeowners pay all or a part of their
mortgage balance prior to the maturity date ? Payments in excess of scheduled principal repayments are called PREPAYMENTS ? Such premature payments can occur for several reasons
Pre-payments (Cont…)
? Borrowers tend to prepay the entire mortgage
when they sell their home ? The sale may be due to:
? A change of employment that necessitates moving ? The purchase of a more expensive home ? A divorce in which the settlement requires sale of
the marital residence
Pre-payments (Cont…)
? Second if market rates decline below the loan
rate the borrower may prepay since he can refinance at a lower rate ? Third in the case of homeowners who cannot meet their obligations, the property will be repossessed and sold ? The proceeds from the sale will be used to payoff the mortgage in the case of uninsured mortgages ? For an insured mortgage the insurance company will pay off the balance
Pre-payments (Cont…)
? Finally if a property is destroyed by an Act of God
the insurance proceeds will be used to payoff the mortgage ? The effect of prepayments, whatever may be the reason, is that the cash flows from the mortgage becomes unpredictable.
Illustration of Re-financing
? Cindy has taken a loan of $800,000
? It is 10 year mortgage with a rate of 12% per
annum ? Installments are due every six months ? Interest is compounded semi-annually ? At the end of the first year, just after paying the second installment the interest on home loans drops to 10.8%
Illustration (Cont…)
? The refinancing fee is 1.75% of the amount being
refinanced. ? Cindy’s opportunity cost of funds is 9.8% per annum ? Is refinancing attractive?
Illustration (Cont…)
Features of a Traditional Mortgage
? A traditional mortgage is known as a Level
Payment Mortgage.
? Borrowers make fixed monthly payments consisting
partly of principal repayment and partly of interest on the outstanding balance. ? Loans which are paid off in such a fashion are called Amortized Loans.
Features of Amortized Loans
? Mortgages are usually for 20 years (240 months)
or for 30 years (360 months).
? The interest component is equal to one twelfth the
annual rate of interest multiplied by the amount outstanding at the beginning of the previous month. ? With the payment of each installment, the interest component will keep declining and the principal component will keep increasing.
Amortization
? It refers to the process of repaying a loan by means
of equal installments at periodic intervals. ? The installment payments form an annuity whose present value is equal to the original loan amount. ? A Amortization Schedule is a table that shows the division of each payment into principal and interest, and the outstanding loan balance after each payment.
Calculating The Installment
? Consider a loan to be of $L to be repaid by way of
N installments of $A each.
? Let the periodic interest rate be `r’. ? L = A x PVIFA(r,N) =
A 1 x[1 ? ] N r (1 ? r )
Example
? A person has taken a loan of $10,000.
? It has to be paid back in 5 equal annual
installments. ? Interest rate is 10% per annum.
? L = A x PVIFA(10,5) = A x 3.7908 ? A = 2,637.97
Amortization Schedule
Year Payment Interest Principal Repayment Outstanding Principal
0 1 2 3 4 5 2637.97 1000 2637.97 836.20 2637.97 656.03 2637.97 457.83 2637.97 239.82
10,000 1637.97 8362.03 1801.77 6560.26 1981.94 4578.32 2180.14 2398.18 2398.15 .03
Prepayments
? The mortgagor has a right to payoff the
mortgage prematurely either in part or in full without significant penalties.
? Thus the borrower has a Call Option. ? For the lender it introduces cash flow uncertainty. ? The uncertainty about when and how a borrower
will prepay is called Prepayment Risk. ? Because of this risk the valuation of mortgages and mortgages related securities is more complex.
Reasons For Prepayment
? The borrower may be selling the house because he
is changing jobs. ? He may be scaling up to a more expensive place. ? He may be getting a divorce. ? Interest rates may have declined. If so he can pay off the existing loan and take a fresh loan at a lower rate.
Reasons for Prepayment
? The lender may be selling the property due to non
payment of dues. ? There could be a fire or a natural calamity which destroys the property. If so, the insurance company will pay.
Pooling of Mortgages
? Mortgage originators do not usually hold on to the
loans made by them, but rather sell them. ? In order to sell these loans, many small loans are put together as a collection, called a Mortgage Pool.
Rationale for Pooling
? Consider ten separate loans of $100,000
each. ? Assume that each loan has been made by a separate lender.
? Every lender therefore faces prepayment risk. ? It is not easy for a lender to forecast prepayments,
since each is dealing with an individual borrower. ? Prepayment behaviour will obviously differ from borrower to borrower.
Rationale for Pooling
? If these ten loans were to be pooled, then the
average prepayment is likely to be more predictable and statistical tools of analyses can be used. ? However it is expensive for one party to own the pool since it would entail an investment of 10MM. ? However the pooled loans can be used as collateral to issue securities in large numbers to enable individual investors to invest.
Securitization
? Securitization is a process of converting a
pool of illiquid assets into liquid financial instruments.
? In the case of mortgages, the pool serves as the
source for the payments which have to be made on the assets which are issued with the pool as collateral. ? Because of the ability to securitize, lenders can repeatedly rollover their investments in mortgages and the country as a whole gets greater access to housing finance.
Standardization
? Before pooling mortgage loans care is taken
to standardize the loans. ? This means that all the pooled loans will have:
? The same rate of interest. ? The same period to maturity. ? The same kind of insurance. ? The same kind of property. ? And will come from the same geographical location.
Standardization
? The advantage of standardization is that the
cash flows from the pool are easier to predict. ? Although each mortgage loan is insured individually, some times the pool as a whole is additionally insured. ? A mortgage pool is therefore like a large loan with a coupon rate and term to maturity.
Special Purpose Vehicles (SPVs)
? Before securitization, the pool of mortgages is
transferred to an SPV.
? An SPV is a separate legal entity that is set up for
the purpose of issuing mortgage backed securities. ? The objective is to ensure that there is a distance between the originators and the pool. ? Thus even if the originators were to go bankrupt, it would not affect the pool held by the SPV.
Mortgage Backed Securities
? The net result of securitization is the creation of
assets which are backed by the underlying pool of mortgages. ? These assets are claims on the cash flows that are generated by the underlying pool.
Federal Agencies
? These are organization which are essentially
private, but are sponsored by the U.S. government.
? Their mandate is to serve as intermediaries in
specified sectors of the economy. ? They were created to enable special interest groups like homeowners, farmers, and students to borrow at affordable rates.
Major Agencies
? Federal Home Loan Bank.
? Federal National Mortgage Association – Fannie
Mae. ? Federal Home Loan Mortgage Corporation – Freddie Mac ? Student Loan Marketing Association – Sallie Mae
Major Agencies
? Freddie Mac and Fannie Mae operate in the
mortgage market.
? They were set up to promote a liquid secondary
market for mortgages.
? Sallie Mae was set up to promote a market for
student loans.
? All three are listed on the NYSE and are publicly
owned.
Ginnie Mae
? The Government National Mortgage Association
– Ginnie Mae also promotes a liquid secondary market for mortgages by guaranteeing mortgage backed securities.
? However it is not a private agency, but is a
government owned corporation. ? Thus all securities guaranteed by Ginnie Mae are effectively guaranteed by the Federal Government.
Pass-throughs
? A pass-through is a type of mortgage backed
security.
? It is formed by pooling mortgages and creating
undivided interests. ? Undivided, means that each holder of a passthrough has a proportionate interest in each cash flow that is generated from the underlying pool.
Illustration
? Consider 10 loans of $100,000 each that are
pooled together. ? Assume that an agency purchases these loans and issues fresh securities using these loans as collateral.
? This is the function of Ginnie Mae, Fannie Mae,
Freddie Mac etc.
? Assume that 40 units of such securities are
sold.
Illustration
? Thus each security will be worth $25,000. ? Each security will be entitled to
1/40 th or 2.5% of each cash flow emanating from the underlying pool. ? The net result is that by investing $25,000 an investor gains exposure to the total pre-payment risk of all ten loans rather than to the risk of a single loan. ? This is appealing from the point of risk reduction.
Collateralized Mortgage Obligations (CMOs)
? Now consider the case where the ten loans
are pooled to issue three categories of securities.
? Class A Bonds: Par Value of $400,000 ? Class B Bonds: Par Value of $350,000 ? Class C Bonds: Par Value of $250,000
? For each class, multiple units of a security that
represents that particular class are issued.
CMOs
? For instance if 50 units of class A bonds are
issued, then each will have a face value of $8000.
? Each will be entitled to 2% of the cash flows
receivable by the class as a whole.
? Assume that the cash flows are distributed
according to certain pre-decided rules.
Example Of Distribution Rules
? Class A securities will receive all principal payments
– both scheduled and unscheduled until the entire par value is paid off. ? Once class A securities have been fully retired, class B bondholders will start receiving principal payments – scheduled and unscheduled, until the entire par value is paid off. ? After class B securities are retired, class C security holders will start receiving principal payments.
CMOs
? All security holders will receive interest every
period, based on the amount of the par value that is outstanding for that particular class. ? This is an example of a CMO. ? In this case certain categories of securities will receive payments before others. ? Unlike a pass-through, all securities are not equally exposed to pre-payment risk.
CMOs
? Class A bonds will absorb prepayments first,
followed by class B, and then by class C.
? Class A bonds will have a shorter term to maturity
than the other two categories. ? Class C securities will have the longest maturity.
A Pass-Through A Detailed Illustration
? A person has borrowed $4800 to buy a house. ? He agrees to pay $100 every month as principal repayment, and to pay interest every month on the outstanding principal at the rate of 6% per annum. ? A total of 48 payments are due. ? The first payment will be $124 which consists of $100 by way of principal repayment and $24 by way of interest.
Illustration Cont…
? The last payment due will be $100.50 which will
consist of $100 by way of principal repayment and $0.50 by way of interest. ? We will assume that there are 4 owners who agree to share each payment equally. ? If payments are made as per schedule, each party will receive $31 after the first month, and $25.125 in the last month.
Illustration Cont…
? Assume that at the end of three months the
mortgagor pays an extra $40 by way of principal. ? So each of the four owners will get an extra payment of $10. ? Since $10 is prepaid the monthly interest in subsequent months will go down by 20 cents. ? In the last month (48th) the mortgagor will pay $60 by way of principal and 30 cents by way of interest.
Illustration of CMO
? Assume that instead of agreeing to share the
payments equally, the four owners want the following system.
? Party A wants his principal back by the end of the
first year. ? Party B wants his principal by the end of the second year. ? Party C wants his principal by the end of the third year. ? Party D wants his principal during the last year.
CMO Illustration Cont…
? So every month all the investors will get interest
on the amount outstanding to them.
? But all principal payments will go first to A. ? Once A is fully paid, B will start receiving principal
payments. ? After B is fully paid, C will start receiving principal payments. ? Finally D will start getting principal payments.
CMO Illustration Cont…
? In the first year A will get $100 every month
plus interest on the outstanding balance.
? The other three will get interest of $6 per month.
? From the 13th month B will start receiving
$100 per month plus interest on the outstanding balance. ? From the 25th month C will start receiving $100 per month. ? From the 37th month D will start receiving $100 per month.
CMO Illustration Cont…
? Each class of ownership is called a tranche.
? A CMO must obviously have a minimum of 2
tranches. ? Now assume that in the third month the mortgagor makes an extra payment of $40.
? This will entirely go to party A. ? In subsequent months he will continue to get $100
by way of principal repayments, but will receive 20 cents less by way of interest.
CMO Illustration Cont…
? In the 12th month he will get only $60. ? The remaining $40 will go to B. ? In the 24th month, B will get $60 and C will get $40. ? In the 36th month, C will get $60 and D will get $40.
? Such a distribution principle is called Sequential
Pay Prepayment.
Differences Between Conventional Bonds and Mortgage Backed Securities
? In a conventional bond the principal is
returned in one lump sum at maturity. ? Holders of mortgage backed securities receive their principal back in installments, as the underlying loans are paid off. ? Since the speed and timing of principal repayments can vary, the cash flows on mortgage backed securities can be very irregular.
Mortgage Backed Securities
? When a homeowner prepays, the remaining
stake of the holders of the mortgage backed securities will be reduced by the same amount. ? Since the principal outstanding will reduce, the interest income will also decrease. ? The monthly cash flow for a mortgage backed security will be less than the monthly amount paid by the mortgagors. ? The difference is equal to the servicing and guaranteeing fees.
Categories of Pass-throughs
? Ginnie Maes ? Fannie Maes ? Freddie Macs ? Private Label
Features of Ginnie Maes
? They are backed by the full faith and credit of the
U.S. government. ? The underlying mortgage pools are assembled by private parties, but are approved by Ginnie Mae before sale to the public. ? The U.S. Treasury guarantees interest and principal payments on Ginnie Maes.
Freddie Mac
? Freddie Mac issues participation certificates or
PCs. ? These are not guaranteed by the Treasury. ? FHLMC itself provides the guarantee. ? Consequently yields on Freddie Mac PCs are higher than those on Ginnie Maes.
Fannie Maes
? These are similar to Freddie Mac PCs.
? The guarantee to holders is provided by
FNMA and not by the Treasury. ? Yields are higher than those on Ginnie Maes but are comparable to the yields on Freddie Mac PCs. ? Common perception is that the U.S. government will never allow FNMA to default. ? Thus there is an implicit guarantee.
Private Label Pass-throughs
? These are issued by independent organizations
like commercial banks. ? They have no connection with the government. ? Consequently the yields on them tend to be higher.
Asset Backed Securities
? These are similar to mortgage backed securities.
? But the assets which are pooled are not home
loans. ? Examples of such assets include credit card receivables, automobile loan receivables etc.
doc_525595981.pptx
This is a PPT explaining about mortgage and mortgage based securities.
Mortgages & MBS
Introduction
? In most developed countries the right to own a home ? ? ? ? ? ?
is virtually a fundamental right But few people can pay the full purchase price from their own funds So most of the required funds are borrowed A mortgage loan is a loan collateralized by real estate The lender is the mortgagee The borrower is the mortgagor In the event of default the lender can seize the property and sell it to recover his dues
? This is called the Right of Foreclosure
Market Participants
? There are three categories of players
? Mortgage originators ? Mortgage servicers ? Mortgage insurers
Mortgage Origination
? Who is an originator?
? The original lender or the party who first extends a
loan to the acquirer of the property
? Originators include:
? Thrifts or S&Ls
? Commercial Banks
? Mortgage Bankers ? Life Insurance Companies ? Pension Funds
Income for the Originator
? The originator gets income from various sources
? When a loan is granted he will levy an Origination
Fee
? This is expressed in terms of points ? Each point is 1% of the borrowed amount ? So a fee of 1.5 points on a loan of $200,000 will
amount to $3,000
? Most originators will also levy an application fee
and certain processing fee
Income (Cont…)
? The second source is the profit that can be
earned if and when the loan is sold to another party ? A mortgage loan is a type of debt ? It is therefore vulnerable to interest rate fluctuations ? If rates were to decline the sale of a loan will result in a gain for the seller
Income (Cont…)
? This is called a Secondary Marketing Profit
? However if rates were to rise after the loan is
disbursed there will be a loss ? If the originator decides to hold the loan as an asset he will earn periodic income in the form of interest
Mortgage Servicing
? Every loan has to be serviced
? This includes the following activities
? Collection of monthly payments and forwarding the
proceeds to the owner of the loan ? Sending payment notices to mortgagors ? Reminding mortgagors whose payments are overdue ? Maintaining records of principal balances
Servicing (Cont…)
? Administering escrow balances for real estate taxes
and insurance purposes ? Initiating foreclosure proceedings if necessary ? Furnishing tax information to mortgagors when applicable
? Servicers include
? Bank related entities ? Thrift related entities ? Mortgage bankers
Escrow Accounts
? An escrow account is a trust account held in the
name of the mortgagor to pay statutory levies such as
? Property taxes ? Insurance premia
? The maintenance of such accounts helps ensure
that payments are made when due
? Because it becomes the lender’s responsibility to do
so
Escrow (Cont…)
? In most cases the borrower makes monthly
deposits
? Along with the loan payment ? The payments accrue at the lender
? The monthly deposit required is a function of
? The cost of insurance ? And the tax assessment of the property ? Consequently it fluctuates from year to year
Income for the Servicer
? The primary income is the Servicing Fee
? This is fixed percentage of the outstanding
mortgage balance ? Since the loan is amortized the outstanding principal will steadily decline ? So the revenue from servicing in dollar terms will steadily decline
Income (Cont…)
? The second source of income is the interest that
is earned from the escrow accounts maintained by the borrowers ? The third source is the float on the monthly mortgage payment
? This is because a delay is permitted from the time
the servicer receives the monthly payment and the time that it has to be forwarded to the lender
Mortgage Insurance
? There are two types of mortgage related
insurance
? The first type is originated by the lender ? To insure against default by the borrower ? This is called Mortgage Insurance or Private
Mortgage Insurance ? It is usually required by lenders on loans with a LTV ratio greater than 80% ? The amount insured will be a percentage of the loan ? It may decline as the LTV declines
Insurance (Cont…)
? What is the LTV ratio?
? Every borrower has to make a Down Payment
? The difference between the price of the property
and the loan amount
? The LTV ratio is determined by dividing the loan
amount by the market value of the property
? The lower the LTV ratio more is the protection for
the lender in the event of default
Insurance (Cont…)
? The second type of insurance is acquired by the
borrower usually through a life insurance company and is called CREDIT LIFE
? This is not required by the lender ? These policies provide for continuation of monthly
payments after the death of the borrower so that the survivors can continue to occupy the property
Government Insurance and PMI
? Lenders insist on insurance if he LTV ratio is less
than 20% ? However low to middle income borrowers may not be in a position to make a 20% down payment ? At the same time their credit rating makes them ineligible for private insurance ? To help such borrowers there are government agencies that provide loan guarantees in lieu of insurance
Government…(Cont…)
? These agencies are
? The Federal Housing Administration (FHA) ? Department of Veterans’ Affairs (VA) ? Department of Agriculture’s Rural Housing Service
(RHS)
? A borrower who is not eligible for a loan from any
of these agencies must obtain private mortgage insurance or PMI
Secondary Sales
? Once the loan is granted the originator can hold it
as an asset or sell it to an investor ? An investor may wish to hold it as an investment ? Or seek pool individual loans and use them as collateral for the issuance of securities
? This is called SECURITIZATION ? Of course this may be done by the originator
himself
Secondary Sales (Cont…)
? Two federally sponsored credit agencies and
many private agencies
? Buy mortgage loans ? Pool them ? And issue securities backed by the pool
? Such agencies are referred to as CONDUITS
? The two federal agencies are
? Federal National Mortgage Association – Fannie Mae ? Federal Home Loan Mortgage Corporation – Freddie Mac
Secondary Sales (Cont…)
? These agencies buy CONFORMING
MORTGAGES ? What is a conforming mortgage?
? It is one that meets the underwriting criteria set by
them from the standpoint of being eligible to be included in a pool for subsequent securitization
Conforming Mortgages
? A conforming mortgage must satisfy three criteria
? They must have a maximum Payment to Income
(PTI) ratio ? The PTI ratio is the ratio of monthly payments – loan payment + tax payment – to the borrower’s monthly income
? Obviously the lower the ratio the lower is the
chance of default
Conforming (Cont…)
? A maximum LTV ratio
? A maximum loan amount
? Mortgages which are non-conforming because
they are for amounts in excess of the purchasing limit set by the agencies are called JUMBO Mortgages ? Those which are non-conforming because of credit quality or LTV ratio are termed as SUBPRIME mortgages
Risks in Mortgage Lending
? Investors who invest in mortgage loans are
exposed to 4 main risks
? Default risk ? Liquidity risk ? Interest rate risk
? Pre-payment risk
Default Risk
? This is the risk that the borrower may default
? For government insured mortgages the risk is
minimal because the insurance agencies are government sponsored ? For privately insured mortgages the risk depends on the credit rating of the insurance company ? For uninsured mortgages it would depend on the credit quality of the borrower
Liquidity Risk
? Mortgage loans are LARGE and INDIVISIBLE
? So while an active secondary market exists for
such loans Bid-Ask spreads are high relative to other debt securities
Interest Rate Risk
? The price of a mortgage loan moves inversely
with interest rates just like other Debt securities ? Since these loan are for long time periods the price impact of an interest rate change can be significant
Pre-payment Risk
? Most homeowners pay all or a part of their
mortgage balance prior to the maturity date ? Payments in excess of scheduled principal repayments are called PREPAYMENTS ? Such premature payments can occur for several reasons
Pre-payments (Cont…)
? Borrowers tend to prepay the entire mortgage
when they sell their home ? The sale may be due to:
? A change of employment that necessitates moving ? The purchase of a more expensive home ? A divorce in which the settlement requires sale of
the marital residence
Pre-payments (Cont…)
? Second if market rates decline below the loan
rate the borrower may prepay since he can refinance at a lower rate ? Third in the case of homeowners who cannot meet their obligations, the property will be repossessed and sold ? The proceeds from the sale will be used to payoff the mortgage in the case of uninsured mortgages ? For an insured mortgage the insurance company will pay off the balance
Pre-payments (Cont…)
? Finally if a property is destroyed by an Act of God
the insurance proceeds will be used to payoff the mortgage ? The effect of prepayments, whatever may be the reason, is that the cash flows from the mortgage becomes unpredictable.
Illustration of Re-financing
? Cindy has taken a loan of $800,000
? It is 10 year mortgage with a rate of 12% per
annum ? Installments are due every six months ? Interest is compounded semi-annually ? At the end of the first year, just after paying the second installment the interest on home loans drops to 10.8%
Illustration (Cont…)
? The refinancing fee is 1.75% of the amount being
refinanced. ? Cindy’s opportunity cost of funds is 9.8% per annum ? Is refinancing attractive?
Illustration (Cont…)
Features of a Traditional Mortgage
? A traditional mortgage is known as a Level
Payment Mortgage.
? Borrowers make fixed monthly payments consisting
partly of principal repayment and partly of interest on the outstanding balance. ? Loans which are paid off in such a fashion are called Amortized Loans.
Features of Amortized Loans
? Mortgages are usually for 20 years (240 months)
or for 30 years (360 months).
? The interest component is equal to one twelfth the
annual rate of interest multiplied by the amount outstanding at the beginning of the previous month. ? With the payment of each installment, the interest component will keep declining and the principal component will keep increasing.
Amortization
? It refers to the process of repaying a loan by means
of equal installments at periodic intervals. ? The installment payments form an annuity whose present value is equal to the original loan amount. ? A Amortization Schedule is a table that shows the division of each payment into principal and interest, and the outstanding loan balance after each payment.
Calculating The Installment
? Consider a loan to be of $L to be repaid by way of
N installments of $A each.
? Let the periodic interest rate be `r’. ? L = A x PVIFA(r,N) =
A 1 x[1 ? ] N r (1 ? r )
Example
? A person has taken a loan of $10,000.
? It has to be paid back in 5 equal annual
installments. ? Interest rate is 10% per annum.
? L = A x PVIFA(10,5) = A x 3.7908 ? A = 2,637.97
Amortization Schedule
Year Payment Interest Principal Repayment Outstanding Principal
0 1 2 3 4 5 2637.97 1000 2637.97 836.20 2637.97 656.03 2637.97 457.83 2637.97 239.82
10,000 1637.97 8362.03 1801.77 6560.26 1981.94 4578.32 2180.14 2398.18 2398.15 .03
Prepayments
? The mortgagor has a right to payoff the
mortgage prematurely either in part or in full without significant penalties.
? Thus the borrower has a Call Option. ? For the lender it introduces cash flow uncertainty. ? The uncertainty about when and how a borrower
will prepay is called Prepayment Risk. ? Because of this risk the valuation of mortgages and mortgages related securities is more complex.
Reasons For Prepayment
? The borrower may be selling the house because he
is changing jobs. ? He may be scaling up to a more expensive place. ? He may be getting a divorce. ? Interest rates may have declined. If so he can pay off the existing loan and take a fresh loan at a lower rate.
Reasons for Prepayment
? The lender may be selling the property due to non
payment of dues. ? There could be a fire or a natural calamity which destroys the property. If so, the insurance company will pay.
Pooling of Mortgages
? Mortgage originators do not usually hold on to the
loans made by them, but rather sell them. ? In order to sell these loans, many small loans are put together as a collection, called a Mortgage Pool.
Rationale for Pooling
? Consider ten separate loans of $100,000
each. ? Assume that each loan has been made by a separate lender.
? Every lender therefore faces prepayment risk. ? It is not easy for a lender to forecast prepayments,
since each is dealing with an individual borrower. ? Prepayment behaviour will obviously differ from borrower to borrower.
Rationale for Pooling
? If these ten loans were to be pooled, then the
average prepayment is likely to be more predictable and statistical tools of analyses can be used. ? However it is expensive for one party to own the pool since it would entail an investment of 10MM. ? However the pooled loans can be used as collateral to issue securities in large numbers to enable individual investors to invest.
Securitization
? Securitization is a process of converting a
pool of illiquid assets into liquid financial instruments.
? In the case of mortgages, the pool serves as the
source for the payments which have to be made on the assets which are issued with the pool as collateral. ? Because of the ability to securitize, lenders can repeatedly rollover their investments in mortgages and the country as a whole gets greater access to housing finance.
Standardization
? Before pooling mortgage loans care is taken
to standardize the loans. ? This means that all the pooled loans will have:
? The same rate of interest. ? The same period to maturity. ? The same kind of insurance. ? The same kind of property. ? And will come from the same geographical location.
Standardization
? The advantage of standardization is that the
cash flows from the pool are easier to predict. ? Although each mortgage loan is insured individually, some times the pool as a whole is additionally insured. ? A mortgage pool is therefore like a large loan with a coupon rate and term to maturity.
Special Purpose Vehicles (SPVs)
? Before securitization, the pool of mortgages is
transferred to an SPV.
? An SPV is a separate legal entity that is set up for
the purpose of issuing mortgage backed securities. ? The objective is to ensure that there is a distance between the originators and the pool. ? Thus even if the originators were to go bankrupt, it would not affect the pool held by the SPV.
Mortgage Backed Securities
? The net result of securitization is the creation of
assets which are backed by the underlying pool of mortgages. ? These assets are claims on the cash flows that are generated by the underlying pool.
Federal Agencies
? These are organization which are essentially
private, but are sponsored by the U.S. government.
? Their mandate is to serve as intermediaries in
specified sectors of the economy. ? They were created to enable special interest groups like homeowners, farmers, and students to borrow at affordable rates.
Major Agencies
? Federal Home Loan Bank.
? Federal National Mortgage Association – Fannie
Mae. ? Federal Home Loan Mortgage Corporation – Freddie Mac ? Student Loan Marketing Association – Sallie Mae
Major Agencies
? Freddie Mac and Fannie Mae operate in the
mortgage market.
? They were set up to promote a liquid secondary
market for mortgages.
? Sallie Mae was set up to promote a market for
student loans.
? All three are listed on the NYSE and are publicly
owned.
Ginnie Mae
? The Government National Mortgage Association
– Ginnie Mae also promotes a liquid secondary market for mortgages by guaranteeing mortgage backed securities.
? However it is not a private agency, but is a
government owned corporation. ? Thus all securities guaranteed by Ginnie Mae are effectively guaranteed by the Federal Government.
Pass-throughs
? A pass-through is a type of mortgage backed
security.
? It is formed by pooling mortgages and creating
undivided interests. ? Undivided, means that each holder of a passthrough has a proportionate interest in each cash flow that is generated from the underlying pool.
Illustration
? Consider 10 loans of $100,000 each that are
pooled together. ? Assume that an agency purchases these loans and issues fresh securities using these loans as collateral.
? This is the function of Ginnie Mae, Fannie Mae,
Freddie Mac etc.
? Assume that 40 units of such securities are
sold.
Illustration
? Thus each security will be worth $25,000. ? Each security will be entitled to
1/40 th or 2.5% of each cash flow emanating from the underlying pool. ? The net result is that by investing $25,000 an investor gains exposure to the total pre-payment risk of all ten loans rather than to the risk of a single loan. ? This is appealing from the point of risk reduction.
Collateralized Mortgage Obligations (CMOs)
? Now consider the case where the ten loans
are pooled to issue three categories of securities.
? Class A Bonds: Par Value of $400,000 ? Class B Bonds: Par Value of $350,000 ? Class C Bonds: Par Value of $250,000
? For each class, multiple units of a security that
represents that particular class are issued.
CMOs
? For instance if 50 units of class A bonds are
issued, then each will have a face value of $8000.
? Each will be entitled to 2% of the cash flows
receivable by the class as a whole.
? Assume that the cash flows are distributed
according to certain pre-decided rules.
Example Of Distribution Rules
? Class A securities will receive all principal payments
– both scheduled and unscheduled until the entire par value is paid off. ? Once class A securities have been fully retired, class B bondholders will start receiving principal payments – scheduled and unscheduled, until the entire par value is paid off. ? After class B securities are retired, class C security holders will start receiving principal payments.
CMOs
? All security holders will receive interest every
period, based on the amount of the par value that is outstanding for that particular class. ? This is an example of a CMO. ? In this case certain categories of securities will receive payments before others. ? Unlike a pass-through, all securities are not equally exposed to pre-payment risk.
CMOs
? Class A bonds will absorb prepayments first,
followed by class B, and then by class C.
? Class A bonds will have a shorter term to maturity
than the other two categories. ? Class C securities will have the longest maturity.
A Pass-Through A Detailed Illustration
? A person has borrowed $4800 to buy a house. ? He agrees to pay $100 every month as principal repayment, and to pay interest every month on the outstanding principal at the rate of 6% per annum. ? A total of 48 payments are due. ? The first payment will be $124 which consists of $100 by way of principal repayment and $24 by way of interest.
Illustration Cont…
? The last payment due will be $100.50 which will
consist of $100 by way of principal repayment and $0.50 by way of interest. ? We will assume that there are 4 owners who agree to share each payment equally. ? If payments are made as per schedule, each party will receive $31 after the first month, and $25.125 in the last month.
Illustration Cont…
? Assume that at the end of three months the
mortgagor pays an extra $40 by way of principal. ? So each of the four owners will get an extra payment of $10. ? Since $10 is prepaid the monthly interest in subsequent months will go down by 20 cents. ? In the last month (48th) the mortgagor will pay $60 by way of principal and 30 cents by way of interest.
Illustration of CMO
? Assume that instead of agreeing to share the
payments equally, the four owners want the following system.
? Party A wants his principal back by the end of the
first year. ? Party B wants his principal by the end of the second year. ? Party C wants his principal by the end of the third year. ? Party D wants his principal during the last year.
CMO Illustration Cont…
? So every month all the investors will get interest
on the amount outstanding to them.
? But all principal payments will go first to A. ? Once A is fully paid, B will start receiving principal
payments. ? After B is fully paid, C will start receiving principal payments. ? Finally D will start getting principal payments.
CMO Illustration Cont…
? In the first year A will get $100 every month
plus interest on the outstanding balance.
? The other three will get interest of $6 per month.
? From the 13th month B will start receiving
$100 per month plus interest on the outstanding balance. ? From the 25th month C will start receiving $100 per month. ? From the 37th month D will start receiving $100 per month.
CMO Illustration Cont…
? Each class of ownership is called a tranche.
? A CMO must obviously have a minimum of 2
tranches. ? Now assume that in the third month the mortgagor makes an extra payment of $40.
? This will entirely go to party A. ? In subsequent months he will continue to get $100
by way of principal repayments, but will receive 20 cents less by way of interest.
CMO Illustration Cont…
? In the 12th month he will get only $60. ? The remaining $40 will go to B. ? In the 24th month, B will get $60 and C will get $40. ? In the 36th month, C will get $60 and D will get $40.
? Such a distribution principle is called Sequential
Pay Prepayment.
Differences Between Conventional Bonds and Mortgage Backed Securities
? In a conventional bond the principal is
returned in one lump sum at maturity. ? Holders of mortgage backed securities receive their principal back in installments, as the underlying loans are paid off. ? Since the speed and timing of principal repayments can vary, the cash flows on mortgage backed securities can be very irregular.
Mortgage Backed Securities
? When a homeowner prepays, the remaining
stake of the holders of the mortgage backed securities will be reduced by the same amount. ? Since the principal outstanding will reduce, the interest income will also decrease. ? The monthly cash flow for a mortgage backed security will be less than the monthly amount paid by the mortgagors. ? The difference is equal to the servicing and guaranteeing fees.
Categories of Pass-throughs
? Ginnie Maes ? Fannie Maes ? Freddie Macs ? Private Label
Features of Ginnie Maes
? They are backed by the full faith and credit of the
U.S. government. ? The underlying mortgage pools are assembled by private parties, but are approved by Ginnie Mae before sale to the public. ? The U.S. Treasury guarantees interest and principal payments on Ginnie Maes.
Freddie Mac
? Freddie Mac issues participation certificates or
PCs. ? These are not guaranteed by the Treasury. ? FHLMC itself provides the guarantee. ? Consequently yields on Freddie Mac PCs are higher than those on Ginnie Maes.
Fannie Maes
? These are similar to Freddie Mac PCs.
? The guarantee to holders is provided by
FNMA and not by the Treasury. ? Yields are higher than those on Ginnie Maes but are comparable to the yields on Freddie Mac PCs. ? Common perception is that the U.S. government will never allow FNMA to default. ? Thus there is an implicit guarantee.
Private Label Pass-throughs
? These are issued by independent organizations
like commercial banks. ? They have no connection with the government. ? Consequently the yields on them tend to be higher.
Asset Backed Securities
? These are similar to mortgage backed securities.
? But the assets which are pooled are not home
loans. ? Examples of such assets include credit card receivables, automobile loan receivables etc.
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