PowerPoint class 9: Mortgage backed securities Flashcards
Primary Mortgage Market
Lenders that originate loans directly to borrowers
where does income come from in the Primary Mortgage Market?
finance charges
interest payments
loan serving fees (e.g., mortgage)
Secondary Mortgage Market
Provide a mechanism for replenishing funds used by mortgage operators such as mortgage banking companies
Why banks sell the loan?
Who wants to buy the loan?
Opportunities for Secondary Mortgage Market
Availability of default insurance (FMA) and loan guarantees (VA)
Development of standardized loan underwriting, processing, and servicing
Availability of hazard and title insurance
Fannie Mae
Provide liquidity to the home finance system when needed
would assume the interest rate risk associated with its role as an intermediary between mortgage originators (primary originators of FHA and VA loans) and investors in its bonds
primary originators of FHA and VA loans
mortgage originators
Ginnie Mae
Guarantee the timely payment of principal and interest on securities backed or secured by pools of mortgages insured by the FHA and the Farmers Home Administration (FmHA) or guaranteed by the VA
Freddie Mac
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
Major Types of Mortgage-backed Securities (MBS)
Mortgage-backed bonds (MBB)
Mortgage pass-through securities (MPTS)
Mortgage pay-through bonds (MPTB)
Collateralized mortgage obligations (CMO)
Mortgage-backed Bonds (MBB)
The bond issuer establishes a pool of mortgages
The issuer retains ownership of the mortgages, but they are pledged as security and are usually placed in trust with a third-party trustee
Like corporate bonds, MBBs are usually issued with fixed-coupon rates and specific maturities
The issuer usually “overcollateralizes” the bond issue
overcollaterizing a mortgage-backed bond
Outstanding loan balances > Dollar amount of the securities issued
Investment rating
Quality of the mortgages
Geographic diversification
Interest rate
Prepaid likelihood
Overcollateralization
Mortgage-backed Bonds (MBB) - Pricing
Same as Coupon bonds, can be issued at premium, at discount, or at par.
Mortgage-backed Bonds (MBB) - Pricing
Sub-sequent price
Two years after issue, the interest rate stays constant at a particular interest rate
Interest Rate Risk
The sensitivity of a bond’s price to change in interest rates is a measure of the bond’s interest rate risk
affected by yield to maturity, term to maturity and size of coupon
bond duration
measures of interest rate risk as a change in price for a given change in interest rates
what does a higher bond duration mean
the more sensitive its price is to changes in interest rates
what will make a duration higher?
YTM is lower
Term to maturity is longer
Coupon is lower
Determinants of mortgage value
Interest rates of each mortgages
Principal balance of each mortgages (prepayment)
Maturities of each mortgages
Default on loans
Mortgage Pass-through Securities (MPTS)
Issued by a mortgage originator (e.g., mortgage company, thrift)
represent an undivided ownership interest in a pool of mortgages
who issues Mortgage Pass-through Securities (MPTS)?
mortgage originator (e.g., mortgage company, thrift)
Mortgage Pass-through Securities (MPTS) - Pricing
what influences the pricing?
Interest rate risk
Default risk
Risk of delayed payment of principal and interest
Prepayment risk
Interest rate risk in Mortgage Pass-through Securities (MPTS)
when is it greatest?
This risk is generally greatest for pools containing fixed interest rate loans
Default risk in Mortgage Pass-through Securities (MPTS)
generally higher for ARM or mortgages with Variable interest
delayed payment of principal and interest risk in Mortgage Pass-through Securities (MPTS)
Ability of the guarantor to perform on the guarantee
Prepayment risk in Mortgage Pass-through Securities (MPTS)
(e.g., # of (seasoned) mortgages, interest rates, geographic location, borrower characteristics, hazard)
The coupon rate (C) on Mortgage Pass-through Securities (MPTS) compared to interest rate of mortgages in the pool
lower than the lowest rate of interest (I) on any mortgage in the pool
I > C
Servicing fee (guarantor fee + loan services fee) in MPTSs
I – C
Weighted Average Coupon (WAC) in MPTSs
Servicing fee (guarantor fee + loan services fee)= WAC – C
The stated maturity date of the pass-through pool
longest maturity date for any mortgage in the pool, assuming no prepayments occur
MPTS Payment delays by servicer
Time lags between the date homeowners make their mortgage payments and the date that the servicing agent pays the investors holding the pass-through securities
MPTS Pool factor
outstanding Principal Balance / original pool balance
what happens when the pool factor becomes smaller
the remaining balances on mortgages in the pool are also becoming smaller
–> the likelihood of prepayment becomes greater (holding all else constant)
MBB vs MPTS
MBB issuers bear prepayment risk by virtue of the overcollateralization requirement
–> As prepayments accelerate and mortgages are prepaid, more mortgages must be replaced in the pool
Security holders of MPTS bear prepayment risk because all prepayments are passed through to investors
–> should be priced to provide lower yields than MPTs because the MBB issuer bears prepayment risk
–> As market interest rates change, the price of MBBs will not reflect accelerated prepayment rates
why should MBBs be priced to provide lower yields than MPTs?
because the MBB issuer bears prepayment risk
As market interest rates change, do the price of MBBs reflect accelerated prepayment rates?
nah
