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34 Cards in this Set
- Front
- Back
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Ways in which the federal government protects mortgage investors from losses (residential)
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1. default insurance (FHA)
2. loan guarantees (VA - "veterans administrations") *given the (1) availability of default insurance and loan guarantees, (2) the development of standardized loan underwriting, processing, and servicing, and (3) the availability of hazard and title insurance, investors in mortgages could acquire a large quantity of loans and expect too receive interest and principal payments with little or no risk. |
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Federal National Mortgage Association (FNMA) - three separate and distinct activities assigned in the 1954 recharter by Congress
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1. Enhancement of secondary market operations in federally insured and guaranteed mortgages,
2. Management of direct loans previously made and, where necessary, liquidation of properties and mortgages acquired by default 3. Management of special-assistance programs, including support for subsidized mortgage loan programs. *each function was carried out as though it was operated as a separate corporation *FHA and VA loan interest rates were originally regulated |
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Government National Mortgage Association (GNMA) - created for what purposes?
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*organized as part of the Housing and Urban Development Act of 1968 to perform three principal functions:
1. management and liquidation of mortgages previously acquired by FNMA - the liquidation of the portfolio acquired from FNMA at the time of its partition comes through regular principal repayments and sales 2. Special-assistance lending in support of certain federal subsidized housing programs. GNMA is authorized to guarantee mortgages that are originated under various housing programs designed by FHA, to provide housing in areas where it cannot be provided by conventional market lending 3. Provision of a guarantee for FHA-VA mortgage pools, which would provide a timely payment of principal and interest guarantee for mortgage-backed securities. *Its operations are financed through funds from the U.S. Treasury and from public borrowing. *GNMA would make timely payments to the security purchaser, and then take responsibility for settling accounts with the servicer. This would relieve investors from administrative problems and delays in receiving mortgage payments. *For this guarantee, the buyer was charged a guarantee fee, which provided GNMA with operating funds to perform this function. *As a result of this GNMA guarantee program, a virtual explosion in the secondary market occurred. |
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Pass-through securities (related to GNMA)
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The GNMA guarantee enabled originators of FHA and VA mortgages to pool or package mortgages and to issue securities, called pass-through securities, which were collateralized by the mortgages and were based on the notion of investors buying an undivided security interest in a pool of mortgages with interest and principal passed through to investors as received from borrowers.
*These securities would be underwritten by investment banking firms and sold to investors in markets that were not reached prior to this innovation. *Funds received by originators from the sales of pass-through securities would e used to originate new mortgages |
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Pass-through securities ATTRACTION TO INVESTORS
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*Default risk on them was minimalized as a result of either FHA insurance or a VA guarantee.
*Securities issued against such pools were viewed by investors as virtually riskless or very similar to an investment in a government security. *With the added guarantee of timely payment of interest and principal by GNMA, these securities also took on the repayment characteristics of a bond, although repayment of the outstanding principal could occur at any time. *Repayment could occur when a borrower defaulted, refinanced, or repaid the outstanding loan balance. (could also occur if a property was sold and the loan was not assumed by the buyer, or in the event of a hazard (fire, etc.), if proceeds from hazard insurance were used to repay the mortgage rather than to reconstruct the improvement. |
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Purposes of the Federal Home Loan Mortgage Corporation (FHLMC) - "freddie mac"
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*Charted by Congress under Title II of the Emergency Home finance Act of 1970 (thrifts (savings and loans), which originated the majority of conventional loans at the time, had incurred liquidity problems as a result of periods of intermittent interest rate volatility)
*Primary Purpose - provide a secondary market and, hence, liquidity for conventional mortgage originators just as Fannie Mae and Ginnie Mae did for originators of FHA - VA mortgages. |
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Title III of the Emergency Home Finance Act of 1970
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*authorized Freddie Mac to purchase and make commitments to puchase first lien, fixed rate conventional residential mortgage loans and participations.
*Also allowed Fannie Mae to purchase conventional mortgages *Freddie Mac was given the authority to purchase FHA - VA loans as well *This provision would allow both organizations to compete for all mortgage loans. However, the vast majority of Freddie Mac's business was, and continues to be, conventional mortgages, and FNMA continues to be the dominant purchaser of FHA - VA mortgages, although its acquisition of conventional loans now exceeds its FHA - VA acquisition volume. |
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conservatorship
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Concerns about Freddie mac's solvency int he midst of the subprime mortgage crisis of 2008 caused the federal government to assume control of Freddie Mac, just as it did with FNMA.
The Federal Housing Finance Agency (FHFA) was appointed as conservator of Freddie Mac in September of 2008. Given the continuing economic uncertainty, more changes to Freddie Mac in the future would not be unexpected. |
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Primary function of the Secondary Mortgage Market
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replenish funds used by mortgage originators.
This,in turn, enables them to maintain a flow of new mortgage originations during periods of rising and falling interest rates. *The originators may accomplish this by selling mortgages directly to Fannie Mae, Freddie Mac, or other private entitities. *Or they may form mortgage pools and issue various securities, thereby attracting funds form investors who may not otherwise make investments directly in mortgage loans. *Hence, much like any corporation raising funds for doing business, the primary goal of mortgage originators in today's market is to replenish funds by reaching broader investor markets. |
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The four major types of mortgage-backed securities currently in use:
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1. Mortgage-backed bonds (MBBs)
2. Mortgage pass-through securities (MPTs) 3. Mortgage pay-through bonds (MPTBs) 4. Collateralized mortgage obligations (CMOs) |
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Mortgage-Backed Bonds (MBBs)
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issuer establishes a pool of mortgages and issues bonds to investors. The issuer retains ownership of the mortgages, but they are pledged as security and are usually placed in trust with a third-party trustee. This trustee makes certain that the provisions of the bond issue are adhered to on behalf ot he security owners.
MBBs are usually issued with fixed-coupon rates and specific maturities. the issuer usually "overcollateralizes" the bond issue. This is done by placing mortgages in the pool with outstanding loan balances in excess of the dolalr amount of the securities issued (usually 125 - 240% in mortgage collateral in excess of the par value of securities issued) Trustee usually "marks all mortgage collateral to the market" - this is done periodically to make sure that the market values of mortgages used for overcollateralization are maintained at the level agreed upon at the time of issue. *Usually underwritten by investment banks, like all mortgage-related securities *Given an investment rating by an independent bond-rating agency (moody's or Standard & Poor's Corporation) *rating depends on: - the qulaity of the mortgages in the underlying pool (types of mortgages, LTVs, and insured or guaranteed against default?) - Geographic diversity - interest rates on mortgages in the pool - likelihood of prepayment - extent of overcollateralization - (For Commercial Mortgages) - the appraised value and debt coverage ratios Potential Credit Enhancements *Letters of Credit from a bank (based on the issuer's credit standing and deposit requirements maintained at the bank issuing the letter *some types of surety in the form of an insurance or other agreement negotiated with a creditworthy thrd party for a fee. The quality of the enhancement will generally affect the amount of overcollateralization required or the coupon rate offered on the bonds. |
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Mortgage Pass-Through Securities (MPTs)
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Issued by a mortgage originator (e.g., mortgage company, thrift)
Represents an undivided ownership interest in a pool of mortgages. The usual minimum size of such a pool is $100 million, which could represent 1,000 or more residential mortgages Each mortgage placed in the pool continues to be serviced by its origniator or an approved servicer. A trustee is designated as the owner of the mortgages in the pool and ensures that all payments are made to individual security owners. Cash flows from the pool, which consist of principal and interest, less servicing and guarantee fees, are distributed to security holders. That is why the securities are called pass-throughs, because cash flows are "passed-through" to the investors by the mortgage servicer. Steps 1. Mortgage Loan Originination (Mortgage Company, Commercial Bank, Thrifts, Others) 2. Create Pools (originator could pool the loans themselves or sell them to FNMA or FHLMC) 3. Issue Securities (if originator pooled them themselves, then they would would with a securities underwriter to issue securities 4. Underwriting and Security Sales (Securities Dealer) - Investors Sources of Funds = Mutual Funds, IRAs, KEOGHs, Life Insurance Companies, Pension Funds, and others) **In addition to this pass-through process there are a number of other programs related to this process that have evolved over time. These include the participation certificate (PC) program and the "swap" program, among others. |
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Important Characteristics of Mortgage Pools
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*pay particular attention to how the market value of a pass-through security will respond to general changes in market interest rates.
The change in market value of a particular security depends on the characteristics of the mortgages in the underlying pool, the response of borrowers to changes in interest rates, and the changes in borrower behavior in response to changes affecting their demand for housing, employment opportunities, and other influences. 1. Security Issuers and Guarantors 2. Default Insurance 3. Payment Patterns and Security for Mortgages in Pools 4. Coupon Rates, Interest Rates, and Number of Seasoned Mortgages in Pools 5. Number of Mortgages and Geographic Distribution 6. Borrower Characteristics and Loan Prepayment 7. Nuisance Calls |
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1. Security Issuers and Guarantors
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• GNMA pass-throughs
o Usually issued by mortgage companies, thrifts, commercial banks, and other organizations that originate FHA and VA mortgages. • Participation certificates o Issued by FHLMC (participation certificates) Acts as an intermediary, purchasing smaller quantities of mortgages from many originators, and then accumulating larger pools against which they issue securities • Mortgage-backed securities o Issued by FNMA (mortgage-backed securities) Acts as an intermediary, purchasing smaller quantities of mortgages from many originators, and then accumulating larger pools against which they issue securities |
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2. Default Insurance
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• GNMA pass-throughs
o Backed with FHA-VA mortgages that carry either insurance or a guarantee against default losses • FNMA (participation certificates) & FHLMC (mortgage-backed securities) Pass-throughs o May be based on separate pools of either FHA-VA backing or conventional mortgages In conventional mortgage-backed programs, both FNMA and FHLMC require conventional mortgages with loan-to-value ratios greater than 80% to carry private mortgage insurance |
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3. Payment Patterns and Security for Mortgages in Pools
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• Most mortgage varieties may be individually pooled for a pass-through security issue.
o Adjustable rate mortgages (ARMs) o Graduated payment mortgages (GPMs) o Mortgages secured by single family, multifamily, and mobile homes o Second-lien mortgages o VAST MAJORITY = fixed interest rate loans secured by mortgages on single family houses • Rule about not mixing FHA-VA and conventional mortgages in the same pool o Generally applies to the payment patterns and the nature of loan security and loan maturity o Mortgage pools are generally grouped according to Payment patterns (e.g., ARMs) Maturity (e.g., second mortgage with a 10-year term) Security (e.g., single family homes VS mobile homes) • REASON o Investors must be able to predict the cash flow pattern that they can expect to receive in a pass –through security with some confidence |
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4. Coupon Rates, Interest Rates, and Number of Seasoned Mortgages in Pools
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• Pass-through securities issues guaranteed by Fannie and Freddie have allowed for a mixture of interest rates on mortgages included in a pool to enable a faster accumulation of larger pools for securitization. This pattern has been followed by security issuers, who believe that the variation in cash flows caused by mixing such mortgages is not large enough to offset the lower issuance costs on very large mortgage pools (i.e., economies of scale).
• Variations of interest rates of mortgages in pools o FNMA & FHLMC = 200 basis points o GNMA = 100 basis points • The coupon rate promised to investors purchasing securities is generally based on the LOWEST interest rate on any mortgage in the pool, less servicing and guarantees fees. o Pools with mortgages with different interest rates will be less variable than cash flows to investors in pools with mortgages with the same interest rate Mortgages with one interst rate are ALL more likely to be prepaid, should interest rates decline. • MATURITY DISTRIBUTION o The scheduled maturity date for a pass-through security issue is generally the date on which the mortgage with the longest remaining maturity in the pool is scheduled to be repaid, assuming no prepayment. o Each guarantor places limitations on the number of seasoned mortgages allowed in a pool o The likelihood that borrowers will sell houses, change job locations, and so on, increases with the length of time the mortgage has been outstanding. o On the other hand, the risk of default is greatest in the early years of the life of a mortgage. o However, more variation in cash flow results with the inclusion of more seasoned mortgages. |
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5. Number of Mortgages and Geographic Distribution
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• The larger the dollar amount of the pool issue, the more individual mortgages will be contained in the pool; and the larger the number of mortgages in the pool, all else being equal, the more predictable the monthly cash flow.
o Most mortgage pools underlying pass-throughs are in minimum denominations of $100 million. If the average mortgage size is about $100,000, most pools of residential mortgages will contain at least 1,000 mortgages. • Geographic Factors o Important because location may affect the likelihood of prepayment and default |
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6. Borrower Characteristics and Loan Prepayment
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• Socioeconomic make-up of individuals who have made the mortgage loans and are the ultimate source of cash flows for the mortgage pool.
o Prepay due to adjustment in consumption of housing due to changes in income, family size, and tastes o Refinancing in low interest rate environments and postponing adjustments in housing consumption when interest rates rise. o Defaults due to loss of job, divorce, and so on • Not much information about borrower characteristics for individual loans in an underlying mortgage pool is made available to investors in pass-through securities. |
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7. Nuisance Calls
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• When the prepayment rate reaches the point where diminishing number and amount of mortgages remain in the pool, say 10% of the initial pool amount, the servicer may call the remainder of the securities. This call is referred to as a nuisance or cleanup call and is used when the cost of servicing begins to become large relative to servicing income.
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Price Influences of Mortgage Pass-Throughs
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1. Interest Rate Risk - reduction in market value due to and unanticipated rise in interest rates. This risk is generally greatest for pools containing fixed interest rate loans.
2. Default Risk - losses due to borrower default. For single family loans, the likelihood of default losses is lowest for FHA-insured mortgages, slightly greater for VA-guaranteed mortgages, and generally greater for privately insured mortgages. This source of risk is also generally higher for variable payment mortgages. 3. Risk of delayed payment of principal and interest - related to the financial strength of the guarantor. GNMA & now FNMA and FHLMC are backed by the full faith and credit of the US government. 4. Prepayment Risk - In the case of fixed interest rate mortgage pools, the impact of prepayment on cash flows passed through to investors will vary according to: 1. # of mtgs in the pool 2. Distribution of interest rates on such mtgs 3. Number of seasoned mortgages included in the pool 4. Geographic location of borrowers 5. Household (borrower) characteristics 6. Unanticipated events (flood, earthquake) |
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Weighted Average Coupon (WAC)
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a measure of the homogeneity of the coupon rates on mortgages in a pool. It is calculated as the average of the underlying mortgage interest rates weighted by the dollar balance of each mortgage as of the security issue date. WACs are meaningful only for pools that allow a variance in interest rates on mortgages.
In most instances, the servicing and guarantee fee can be approximated as the difference between the WAC and the pass-through coupon rate. |
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Stated Maturity Date of Pool
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the longest maturity date for any mortgage in the pool, assuming that no prepayments occur.
GNMA generally imposes more restrictions on the variance in mortgage maturities allowed in pools than does FNMA and FHLMC |
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Weighted Average Maturity
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Is calculated as the average remaining term of the underlying mortgages as of the pass-through issue date, with the principal balance of the mortgage as the weighting factor
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Payment Delays by servicer
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The time lag between the time that the homeowners make teir mortgage payments and the date that the servicing agent actually pays the investors holding the pass-through securities.
This delay may range from 14-55 days. Delays in payments received by investors obviously reduce yields. |
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Pool Factor
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The outstanding principal balance divided by the original pool balance. This balance changes every month as mortgages are amortized and balances prepaid. The pool factor starts out at 1 and usually declines.
Measure at one point in time. As the pool factor becomes smaller, the remaining balances on mortgages in the pool are also becoming smaller; hence, the likelihood of prepayment becomes greater (holding all else constant). |
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Prepayment Assumption Methods
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1. Average Maturity
2. Constant Rate of Prepayment 3. FHA prepayment experience 4. The PSA prepayment model |
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1. Average maturity
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Assuming a prepayment (balloon payment) of all mortgages in a pool after some average period of time.
Advantage - simplicity. facilitates comparison with traditional bonds Disadvantages - far outweigh the advantages * will usually result in an under- or overestimation of yield * Using an average maturity may not reflect changes underlying the characteristics affecting prepayment such as interest rate changes and household characteristics. |
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2. Constant Rate of Prepayment
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Assumes that a constant percentage of the total mortgages in the pool will be paid off every year.
Advantages - simple to understand and prepayments are easy to compute. Also, may be preferable to an average maturity Disadvantages - tend to understate prepayment in earlier years due to default and overstate prepayments in later years. * it is also not likely to reflect underlying pool characteristics |
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3. FHA prepayment experience
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Prepayment assumptions based on empirical evidence form actual prepayment experince collected by the FHA over several decades
The FHA has developed an extensive database on mortgage terminations as a part of its insurance program. The database contains the total number of mortgage terminations during a single policy year, including information on the number resulting from defaults and repayments. Example - greater than or less than 100% of FHA experience. Disadvantages - the precise causes of prepayment (e.g., changes in interest rates of borrowers' employment) over time are difficult to determine. There is no assurance that this pattern will continue in the future. The FHA does not keep enough detailed data on each mortgage and borrower to enable a systematic investigation into the causes of prepayment behavior. |
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The PSA prepayment model
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Developed by the Public Securities Association to simplify the FHA prepayment experience model.
same disadvantages as the FHA prepayment experience model However, it has become an industry standard for prepayment assumptions used by most issuers of mortgage-backed securities. The model is based on monthly prepayment rates, which vary during the life of a mortgage pool underlying the security. At present, the standard PSA prepayment rate curve (referred to as 100 percent PSA) begins at .2% per month for the first year, and then increases by 0.2% each month until month 30. It then remains at .5% per month, or 6% per year, for the remaining stated maturity period of the pool. The model combines both FHA experience and the constant rate of repayment approach. The PSA assumption is widely used to convey both price and yield information to investors at the time of issue. To provide additional information about the sensitivity of yields to different prepayment rates at the time of issue, a series of yield quotes based on various PSA repayment rates (e.g., 75 percent PSA, 150 percent PSA) are placed on the prospectus. |
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Prepayment rate effect on pass-through value
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In the event that the market rate of return demanded by investors is equal to the coupon rate on the pass-through security, the security will always sell at par value regardless of the prepayment rate.
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Convexity
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A measure of the sensitivity of duration to changes in interest rates.
MPTs usually exhibit negative convexity resulting from a decelaration in prepayments in response to increasing interest rates (increased duration) |
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Price compression
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the limit on premiums that results from MPTs negative convexity.
Further, as interest rates decline and prepayments accelerate, all cash flows received by investors must be reinvested at lower interest rates. This price compression is perhaps the most serious problem that investors perceive when investing in MPTs. It is this problem, coupled with other problems that has given rise to collateralized mortgage obligations (CMOs). |
