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CHAPTER

The Secondary Mortgage Market:

Pass-Through Securities

Secondary Mortgage MarketSecondary 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

• 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

• 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

• 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

• Operation Direct Sale Programs

• Mandatory Commitment

• Optional Delivery

• Mortgage-Related Security Pools Securitization

• Mortgage-Backed Bonds Issuer retains ownership of mortgages Mortgages held in trust Fixed coupon rate Specific maturity Over collateralization Mark to 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

• 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?

• Mortgage-Backed Bonds Example 19-1:

= $10,000

= .105 x $10,000 = $1,050

= $9,601.83

• 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%

• Mortgage-Backed Bonds Example 19-1:

= $10,000

= $1,050

= $8,978.37

• 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

• 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

Mortgage Pass-Through Securities: Mortgage Pass-Through Securities: Issuance and Funds FlowIssuance and Funds Flow

• Mortgage Pass-Through Securities Issuers & guarantors Default insurance Payment patterns and security Coupon rate and interest rates Seasoned mortgages

• Mortgage Pass-Through Securities Number of mortgages Geographic distribution Borrower characteristics Loan prepayment Nuisance calls

Selected Characteristics of Pass-Selected Characteristics of Pass-Through SecuritiesThrough Securities

• General Pricing of MPTs Interest Rate Risk Default Risk Risk of Delayed Payment of Principal and

Interest Prepayment Risk

• General Pricing of MPTs Coupon Rate Yield to maturity Servicing Fee Weighted Average Coupon & Maturity Stated Maturity Date Payment Delays Pool Factors

• 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?

• Example 19-2:

• Quoted Maturity = 30 Years• Quoted Coupon Rate = 6% - .5% = 5.5%

Amount Maturity

Interest Rate

Weight W x M W x I

$500,000 30 7% .5 15 3.5

$200,000 29 6.5% .2 5.8 1.3

$300,000 28 6% .3 8.4 1.8

$1,000,000 WAM = 29.2

WAC = 6.6

• Prepayment Assumptions Average Maturity Assumption Constant Prepayment Rate Assumption FHA Prepayment Experience PSA Prepayment Model

Mortgage Pass-Through Securities Mortgage Pass-Through Securities With Differing ROR and PrepaymentWith Differing ROR and Prepayment

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