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    Unit 7

    Mortgage Market Mortgage and mortgage backed securities

    Primary and secondary mortgage markets

    Participants in mortgage market Mortgage sales

    International trends in securitization.

    Sitaram Dhakal

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    Mortgage and mortgage backed securities

    A mortgage is a form of debt that finances investment in property

    The debt is secured by the property The mortgage is the difference between the down payment and the value

    to be paid for the property

    An alternative to selling mortgages directly to investors creating

    mortgage pool.

    A trustee, such as a bank or a government agency, holds the

    mortgage pool, which serves as collateral for the new security.

    This process is calledsecuritization.

    The most common type of mortgage-backed security is themortgage pass-through.

    It isa security that has the borrowers mortgage payments pass

    through the trustee before being disbursed to the investors in the

    mortgage pass-through.

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    Mortgage and mortgage backed securities If borrowers prepay their loans, investors receive more principal than

    expected. For example, investors may buy mortgage-backed securities on which the

    average interest rate is 6%. If interest rates fall and borrowers refinance atlower rates, the securities will pay off early.

    The possibility that mortgages will prepay and force investors to seekalternative investments, usually with lower returns, is calledprepayment risk.

    The reason that mortgage pools have become so popular is that they permit the

    creation of new securities (like mortgage pass-through) that make investing in

    mortgage loans much more efficient.

    For example, an institutional investor can invest in one large mortgage pass-

    through secured by a mortgage pool rather than investing in many small and

    dissimilar mortgage contracts.

    There are several types of mortgage pass-through securities:

    GNMA pass-through,

    FHLMC pass-through, and

    Private pass-through.

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    GNMA pass-through

    Government National Mortgage Association (GNMA)

    Began guaranteeing pass-through securities in 1968. A variety of financial intermediaries, including commercial banks and

    mortgage companies, originate Ginnie Mae mortgages.

    Ginnie Mae aggregates these mortgages into a pool and issues pass-through

    securities that are collateralized by the interest and principal payments from

    the mortgages.

    Ginnie Mae also guarantees the pass-through securities against default.

    The usual minimum denomination for pass-through is $25,000.

    The minimum pool size is $1 million. One pool may back up many pass-

    through securities.

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    FHLMC pass-through

    Federal Home Loan Mortgage Corporation (FHLMC)

    Created to assist savings and loan associations, which are not

    eligible to originate Ginnie Maeguaranteed loans.

    Freddie Mac purchases mortgages for its own account and also

    issues pass-through securities similar to those issued by Ginnie

    Mae.

    Pass-through securities issued by Freddie Mac are called

    participation certificates (PCs).

    Freddie Mac pools are distinct from Ginnie Mae pools in that

    they contain conventional (nonguaranteed) mortgages, are notfederally insured, contain mortgages with different rates, are

    larger (ranging up to several hundred million dollars), and have a

    minimum denomination of $100,000.

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    Private pass-through

    Private Pass-Through (PIPs)

    In addition to the agency pass-through,

    intermediaries in the private sector have offered

    privately issued pass-through securities.

    The first of these PIPs was offered by Bank of

    America in 1977.

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    Primary and secondary mortgage markets

    Primary Mortgage market

    In the primary market four basic categories of mortgages are

    issued by financial institutions such as home, multifamily

    dwelling, commercial and farm.

    Home mortgages are used one to four family dwellings.

    Multi-family dwellings mortgages are used to finance the

    purchase of apartment complexes, townhouses, and

    condominiums.

    Commercial mortgages are used to finance the purchase of real

    estate for business purposes such as office buildings, shoppingmalls etc.

    Farm mortgages are used to finance the purchase the farms.

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    Primary and secondary mortgage markets

    Secondary Mortgage market

    The federal government founded the secondary market for mortgages.

    To help the nations economic activity, the government established several

    agencies to buy mortgages.

    The Federal National Mortgage Association (Fannie Mae) was set up to buy

    mortgages from thrifts so that these institutions could make more mortgage

    loans.

    This agency would fund these purchases by selling bonds to the public.

    At about the same time, the Federal Housing Administration was established

    to insure certain mortgage contracts.

    This made it easier to sell the mortgages because the buyer did not have tobe concerned with the borrowers credit history or the value of the collateral.

    A similar insurance program was set up through the Veterans Administration

    to insure loans to veterans after World War II.

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    Secondary mortgage markets

    One advantage of the insured loans was that they were required to be written

    on a standard loan contract. This standardization was an important factor in the growth of the secondary

    market for mortgages.

    As the secondary market for mortgage contracts took shape, a new

    intermediary, the mortgage bank, emerged.

    Because this firm did not accept deposits, it was able to open offices across thecountry.

    The mortgage bank originated the loans, funding them initially with its own

    capital.

    Because of their size, they were able to capture economies of scale in loan

    origination and servicing.

    They were also able to bundle loans from different regions together, which

    helped reduce their risk.

    The increased competition for loans among these intermediaries led to lower

    rates for borrowers.

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    Participants in mortgage market

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    Mortgage sales

    It is a sale of mortgage originated by a bank with

    or without to an outside buyers.

    Resource represents the ability of a loan buyer

    to sell the loan back to the originator should it

    go bad.

    In another word, a mortgage sale is a part of

    correspondent banking which is a relationship

    between small bank and a large bank in whichthe large bank provides a number of deposits,

    lending and other services.

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    International trends in securitization.

    Intermediaries still faced several problems when trying

    to sell mortgages.

    The first was that mortgages are usually too small to be

    wholesale instruments. Many institutional investors do

    not want to deal in such small denominations. The second problem with selling mortgages in the

    secondary market was that they were not standardized.

    They have different times to maturity, interest rates, and

    contract terms. That makes it difficult to bundle a largenumber of mortgages together.

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    International trends in securitization.

    Third, mortgage loans are relatively costly to service. Compare

    the servicing a mortgage loan requires to that of a corporatebond.

    The lender must collect monthly payments; often pay property

    taxes and insurance premiums, and service reserve accounts.

    None of this is required if a bond is purchased. Finally, mortgages have unknown default risk.

    Investors in mortgages do not want to spend a lot of time

    evaluating the credit of borrowers.

    These problems inspired the creation of the mortgage-backedsecurity, also known as a securitized mortgage.

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    Thank You


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