PowerPoint class 9: Mortgage backed securities

Question 1

Primary Mortgage Market

Answer 1

Lenders that originate loans directly to borrowers

Question 2

where does income come from in the Primary Mortgage Market?

Answer 2

finance charges

interest payments

loan serving fees (e.g., mortgage)

Question 3

Secondary Mortgage Market

Answer 3

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?

Question 4

Opportunities for Secondary Mortgage Market

Answer 4

Availability of default insurance (FMA) and loan guarantees (VA)

Development of standardized loan underwriting, processing, and servicing

Availability of hazard and title insurance

Question 5

Fannie Mae

Answer 5

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

Question 6

primary originators of FHA and VA loans

Answer 6

mortgage originators

Question 7

Ginnie Mae

Answer 7

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

Question 8

Freddie Mac

Answer 8

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

Question 9

Major Types of Mortgage-backed Securities (MBS)

Answer 9

Mortgage-backed bonds (MBB)

Mortgage pass-through securities (MPTS)

Mortgage pay-through bonds (MPTB)

Collateralized mortgage obligations (CMO)

Question 10

Mortgage-backed Bonds (MBB)

Answer 10

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

Question 11

overcollaterizing a mortgage-backed bond

Answer 11

Outstanding loan balances > Dollar amount of the securities issued

Question 12

Investment rating

Answer 12

Quality of the mortgages

Geographic diversification

Interest rate

Prepaid likelihood

Overcollateralization

Question 13

Mortgage-backed Bonds (MBB) - Pricing

Answer 13

Same as Coupon bonds, can be issued at premium, at discount, or at par.

Question 14

Mortgage-backed Bonds (MBB) - Pricing

Sub-sequent price

Answer 14

Two years after issue, the interest rate stays constant at a particular interest rate

Question 15

Interest Rate Risk

Answer 15

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

Question 16

bond duration

Answer 16

measures of interest rate risk as a change in price for a given change in interest rates

Question 17

what does a higher bond duration mean

Answer 17

the more sensitive its price is to changes in interest rates

Question 18

what will make a duration higher?

Answer 18

YTM is lower

Term to maturity is longer

Coupon is lower

Question 19

Determinants of mortgage value

Answer 19

Interest rates of each mortgages

Principal balance of each mortgages (prepayment)

Maturities of each mortgages

Default on loans

Question 20

Mortgage Pass-through Securities (MPTS)

Answer 20

Issued by a mortgage originator (e.g., mortgage company, thrift)

represent an undivided ownership interest in a pool of mortgages

Question 21

who issues Mortgage Pass-through Securities (MPTS)?

Answer 21

mortgage originator (e.g., mortgage company, thrift)

Question 22

Mortgage Pass-through Securities (MPTS) - Pricing

what influences the pricing?

Answer 22

Interest rate risk

Default risk

Risk of delayed payment of principal and interest

Prepayment risk

Question 23

Interest rate risk in Mortgage Pass-through Securities (MPTS)

when is it greatest?

Answer 23

This risk is generally greatest for pools containing fixed interest rate loans

Question 24

Default risk in Mortgage Pass-through Securities (MPTS)

Answer 24

generally higher for ARM or mortgages with Variable interest

Question 25

delayed payment of principal and interest risk in Mortgage Pass-through Securities (MPTS)

Answer 25

Ability of the guarantor to perform on the guarantee

Question 26

Prepayment risk in Mortgage Pass-through Securities (MPTS)

Answer 26

(e.g., # of (seasoned) mortgages, interest rates, geographic location, borrower characteristics, hazard)

Question 27

The coupon rate (C) on Mortgage Pass-through Securities (MPTS) compared to interest rate of mortgages in the pool

Answer 27

lower than the lowest rate of interest (I) on any mortgage in the pool I > C

Question 28

Servicing fee (guarantor fee + loan services fee) in MPTSs

Answer 28

I – C

Question 29

Weighted Average Coupon (WAC) in MPTSs

Answer 29

Servicing fee (guarantor fee + loan services fee)= WAC – C

Question 30

The stated maturity date of the pass-through pool

Answer 30

longest maturity date for any mortgage in the pool, assuming no prepayments occur

Question 31

MPTS Payment delays by servicer

Answer 31

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

Question 32

MPTS Pool factor

Answer 32

outstanding Principal Balance / original pool balance

Question 33

what happens when the pool factor becomes smaller

Answer 33

the remaining balances on mortgages in the pool are also becoming smaller --> the likelihood of prepayment becomes greater (holding all else constant)

Question 34

MBB vs MPTS

Answer 34

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

Question 35

why should MBBs be priced to provide lower yields than MPTs?

Answer 35

because the MBB issuer bears prepayment risk

Question 36

As market interest rates change, do the price of MBBs reflect accelerated prepayment rates?

Answer 36

nah