Secondary Mortgage Market

Definition of Secondary Mortgage Market (SMM)

A collection of institutions and individuals involved in the trading of mortgages either in their primitive forms or in transformed forms called Mortgage Passthrough Securities (MPTS)

What are MPTS?– bonds, notes or certificates -- issued against and collateralize

d by a pool of mortgages where the issuer passes mortgage payment from borrowers to investors who purchased the securities. Hence the name “passthroughs”

Function of the SMM

– To provide liquidity to the primary market.– To correct geographical mismatch in mortgage

markets.– To correct institutional mismatch in the flow of

funds in the primary mortgage– Management of interest rate risk

Facilitators of the Market or Market Makers

• Broker• no risk

• Dealers• exposed to interest rate risk

• Conduits• transformation

• standardization

Role of Conduits• Transform mortgages into more liquid mortgage pa

ss through securities• Standardize whole mortgages to create sufficient vo

lume• Examples

– Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Government National Mortgage Association (Ginnie Mae), commercial banks, S&Ls, mortgage banks, investment banks

GNMA or Ginnie Mae• Guarantees the timely payment of interest and principal

on MPTs backed by FHA, VA loans• Has backing of the full faith and credit of the US gover

nment• Enables mortgage originators to package mortgages and

issue securities backed by these mortgages • The buyer of the security is charged a fee which provide

s GNMA with operating funds.

FNMA or Fannie Mae

• Corporate instrumentality of the US government whose stocks are traded on the NYSE

• Primary function is to purchase and sell FHA, VA and Conventional mortgages

• Issues its own security collateralized by mortgages called Mortgage-Backed Securities (MBSs)

• cash program and swap program

• Sources for capital for FNMA

• non-voting preferred

• non-voting common

• notes and debentures

Fannie Mae (Contd).• The ACT setting up FNMA allows the agency to borrow

from the Treasury up to $ 2.5 billion. • In practice investors do not see the difference between G

innie Mae and Fannie Mae guarantee.• Should there be a yield differential between a Ginnie Ma

e and Fannie Mae security of similar maturity? Think about this !!!!!

FHLMC/ Freddie Mac• Established to provide liquidity in conventional m

ortgages • Currently its portfolio includes both conventional,

FHA and VA loans • Sells the mortgages either in whole, or in the form

of MPTs called Participation Certificates (PCs)– Cash program– Swap program (1984)

Outstanding Passthrough

As of September 1994

Agency outstanding ($ billions)

Ginnie Mae $426.4

Freddie Mac $461.5

Fannie Mae $505.7

Private $179.5

Total $1,573.1

FACT

• About 49% of the estimated $3.2 trillion of single family mortgages outstanding have been securitized.

• From 1989 Fannie Mae and Freddie Mac issues outstripped Ginnie Maes.

• Roughly 88% of securitized residential mortgages have agency labels.

• In 1984 Fannie Mae created first MBS collateralized by multifamily mortgages

Types of Mortgage Related Securities

• Mortgage pass-through securities (MPTs)– Mortgage-backed security (MBS): FNMA

– Participation Certificates (PCs): FHLMC

– Ginnie Maes

– Private Pass-throughs

• Mortgage Backed Bonds (MBBs)• Other Mortgage Derivative Securities

– Collateralized Mortgage Obligations (CMOs)

– Interest Only (IOs) and Principal Only (POs)

• Commercial Mortgage Backed Securities (CMBS)

Borrowers

Originating lenders and services

Swaps

BrokersDealers

GovernmentGuarantee

GSEs, Private conduits, HFA

GSEs

Mortgage Backed Security NotesBonds

Security Dealers

Investors

Insu

ranc

eOperations in the Secondary Mortgage Market

1 2 3a 3b

45

Mortgage Pass Through Structure

CollateralWhole mortgages

Trustee/Custodianowns mortgages in poolno overcollateralization

Pass through issuer•sale of assets•not obligation of issuer•debt obligation of original borrower

MPT Investor :Owns the right to receive cash flow from morgages in pool

Borrowers Lenders(Securities issuers)

Insurance/guarantee(Government or PMI)

Mortgage Pool

Investors Securities Dealer

Custodian of mortgage documents

Mortgages

Monthlypayments

Securities

Mortgages

Guarantee

Seeks guarantee

Mortgage documents

The Mortgage Passthrough Security with Government Guarantee (Ginnie Mae)

GovernmentAgency

Whole loans

Creation of Ginnie Maes

Mr./Ms.Smith

Mr./Ms.Jones

Mr./Ms.Miller

Lenders

Thrift orBank

GNMA

Investors

Thrifts,Banks,OthersGNMA

$

Mortgages

$

Fee Guarantee

Creation of other Agency Mortgage Pass-Through (MPTs)

Mr./Ms.Smith

Mr./Ms.Jones

Mr./Ms.Miller

Lenders

Thrift orBank

AgenciesFNMAFHLMC

Investors

Thrifts,Banks,Others

MBS

$

Mortgages

$

Sell $

Advantages of MPTs over Whole Mortgages

• Diversification of prepayment risk

• Investment is made more liquid

• More efficient way to invest in mortgages than purchasing the primitive instrument

• Efficient management of interest rate risk

• Cheaper source of financing housing

• Guarantees eliminates default risk

Features of MPT

• Prepayment risk– Systematic risk – Unsystematic risk

• Default risk

Nature of Cash Flow from MPT

• Monthly payments consisting of– Interest on the mortgage

– Scheduled principal repayments.

– Unscheduled principal repayments.

• The cash flow is reduced by servicing fee and guarantee fee of 50 basis points

• Cash flow and value of MPT security depends on the cash flow from underlying mortgage

Mortgage Cash FlowsPrincipal

Interest

0 100 200 300 360

MONTHS

0

2

4

6

8

10

Cas

h F

low

No Prepayments

Pass-Through Cash FlowsPrincipal

Interest

0 100 200 300 360

MONTHS

0

2

4

6

8

10

Cas

h F

low

No PrepaymentsServicing

Timing of Cash Flow• The first mortgage payment is always made in arrears• There is another delay after receipt of cash flow from

mortgage pool before the cash flow is passed on to the investor– Real or actual delay– Stated delay = normal delay + actual delay

Payment Delay Illustration

A B C D

Month 1 Month 2

Stated Delay = 45 days

Real Delay = 14 days

A: Investor Buys SecurityB: First Record DateC: First Payment DueD: First Payment Actually Made

A B C D

Stated Delay = 50 days

Real Delay = 19 days

GNMA-I

GNMA-II

Payment Delay Illustration

A B C D

Month 1 Month 2

Stated Delay = 55 daysReal Delay = 24 days

A: Investor Buys SecurityB: First Record DateC: First Payment DueD: First Payment Actually Made

A B C D

Stated Delay = 75 daysReal Delay = 44 days

FNMAMBS

FHLMC PC

Nature of Promise on MPT cashflow

• Fully Modified e.g. Fannie Mae Mortgage Backed Security (MBS)– timely payment of both P and I

• Modified e.g. Freddie Mac Participation Certificate (PC)– timely payment of interest only

Some salient Characteristics of MPTs affecting pricing

• Characteristics of Pool, e.g. FHA/VA, conventional mortgage

• Maximum size of Loan e.g. conforming loan versus jumbo

• Amount of Seasoning

• Assumability

• Maturity e.g. 15, 20, 30 years

• Net Interest Spread

• Payment Procedure e.g. stated delay

• Minimum Pool Size

Private Passthroughs

• Issued by thrifts, commercial banks and investment banks

• Large-size loans

• Registered with SEC

• Rated by Moody’s and S&P

• FRM’s or ARM’s

• Market size around 6% of all MPTs

Credit Enhancement on Private MPTs

• Corporate guarantee --

• Letters of credit -- issued by financial institutions.

• Bond insurance -- rating of insurance co.

• Senior/subordinate certificate --A/B passthrough

– A has priority over B in terms of cash flow

– A certificates are the once rated

• Additional safeguards to protect against shortfall in payment

– reserve fund

• divert principal from B to A

– shifting interest

• prepayment meant for B goes to A

Differences between MBS and Traditional Bonds

• MBS pay-off monthly. Bonds typically pay-off semi-annually

• MBS payments consists of principal and interest, bond payments typical consists of interest only

• MBS have payment delays, Treasury bonds have no payment delay

• MBS has call risk due to borrower prepayment. Some bond have no call options

• Some MBS have default risk. Treasury bonds have no default risk

Prepayment Basics: A Mobile Population

• The history of US has been of one migration, from overseas, east to west, north to south, etc

• 20% of US households will change their place of residence at least once in a given year (Census Bureau)

• 8.5% all homeowners will move in a normal year (Census Bureau)

• About 8% of all mortgages outstanding are likely to be prepared in any given year due to changes in residence

• Investors in diversified pool of mortgages can expect about 8% of their principal to be returned to them due to prepayments

• Not all moves results in prepayment since some mortgages are assumable

Prepayment are very important to Mortgage Investing

• Homeowner prepayments are the most important aspect of mortgage or mortgage passthrough investing

• Changes in prepayment rates are the most important risk facing mortgage securities investors.

• Fortunately, the basic forces driving prepayments are easy to understand

• Prepayments are driven by:

• career changes

• lifestyle changes

• changes in interest rates

• Does this mean prepayments can be easily forecast?

Measuring Prepayment Speeds

• There are four methods of measuring prepayment speeds

• Prepayment based on FHA experience• Constant Prepayment Rates (CPR)• Single Monthly Mortality (SMM)• PSA Standard Prepayment Benchmark

FHA Prepayment Method• This prepayment method is based on data collected by FHA

tracking mortgage prepayments based on seasoning

• As figure 1B shows very few mortgages prepay in first year

• An increasing number prepay in the second year and still more prepay in the third year

• From third to 20th year prepayment is remarkable stable

• After 20th year it rises slightly every year until maturity

• Across the nation more than 6% but fewer than 8% of FHA/VA loans prepay during this stable period

• FHA mortality tables are not good predictors of other loan types because FHA/VA loans are assumable

Constant Prepayment Rate (CPR) Method

• Assumes a constant percentage of the remaining principal in pool is prepaid each month for the remaining term of the mortgage

• A 10% CPR means we can expect 10% of the remaining mortgage balance to be prepaid each and every future year

• The CPR is based on the characteristics of the pool, current and expected future economic environment

• Its advantage is simplicity and ease of application

• It suffers from disadvantage that prepayments are treated as constant

• Figure A1 illustrates the CPR

0%

6%

12%

0%

6%

12%

6% CPR PREPAYMENTS

100% FHA PREPAYMENTS

YEARS

0 20YEARS

FIGURE 1B

FIGURE A1

Single Mortality Rate (SMM) Method

• The CPR is annual prepayment rate. The annual rate is converted into monthly prepayment rate called the single monthly mortality rate (SMM) as follows

SMM = 1 - (1 - CPR)1/12 (1)

• if the CPR is 6% the corresponding SMM is:

SMM = 1 - (1 -.06)1/12 = .005143 or .51%

Application of SMM to calculate prepayment

• Prepayment for month t = SMM times beginning mortgage balance for month t minus scheduled principal for month t)

• Mortgage has remaining balance of $50,525. With SMM of 0.5143% and the schedule principal payment of $67, the prepayment for the month t is

= .005143 x ($50,523 - $67) = $260

PSA Standard Prepayment Method

• Developed by Public Securities Association (PSA)• Benchmark is expressed as monthly series of annual CPR.

– assumes that prepayment will be low for newly originated mortgages and will then speed up as the mortgage seasons

– the PSA captures the advantages of both CPR and FHA methods

– like the CPR, the PSA provides easy- to- calculate and easy- to- understand method

– like the FHA, the PSA includes gradual increase in prepayment frequency

PSA Prepayment Curve.

• The standard PSA prepayment curve, called 100% PSA is as follows:– it assumes 0.2% CPR for the first month.

– the rate increases by 0.2% per month until the 30th month (top of the ramp) when it reaches a CPR of 6% per year .

– it remains at 6% per year for the remaining stated maturity of the pool

if t 30, CPR = (6%)(t)/30,

if t > 30, CPR = 6%

where t is the number of months since mortgage origination.

PSA Prepayment Curve (Contd)• Slower or faster prepayment are then stated as percent

of standard PSA, e.g. 50% PSA (slower), 150% PSA (faster)

• The PSA is now the standard for quoting prepayment rate in the industry

• Figure 2 illustrates the PSA method

18%

15%

12%

9%

6%

3%

0%

200% PSA

100% PSA

50% PSA

0 3 6 9 12 15 18 21 24 27 30

SEASONING (years)

RAMP

CPR SPEED

PSA RAMP & SPEEDS

FIGURE 2

Converting PSA to CPR and CPR to SMM

• Converting PSA to CPR during PSA Ramp period Monthly CPR = (PSA x .06 x n)/30

where n = mortgage loan age in months up 30

Example: mortgage age (n) = 5; PSA = 100%

Monthly CPR = (100% x.06 x 5)/30 = 1%

Converting CPR to SMM

SMM = 1 - (1 - .01)1/12 = .000837

Thus 1% CPR = 0.0837% SMM; or 0.0837 of the mortgage pool principal balance is expected to prepay in month 5

Converting PSA to CPR and CPR to SMM

Converting PSA to CPR after PSA Ramp period (months 31-360)

CPR = PSA x .06

Example: PSA = 100%

CPR = 100% x .06 = 6%

Converting CPR to SMMSMM = 1 - (1 - CPR)1/12

SMM = 1 - (1 - .06)1/12 = .005143

6% CPR = 0.51% SMM; 0.51 of the pool principal balance is expected to prepay each month until maturity (31 to 360 months)

More Application of PSA

• If we assume 150% PSA (i. e. one and one-half times faster than standard PSA) the SMM for month 5, will be computed as follows:

for month 5: CPR = (150 x .06 x 5)/30 = 1.5%

SMM = 1 - (1 -.015)1/12 = .001259

Note: it is the CPR that is a multiple not the SMM

Various Prepayment Issues to Consider

• Assumable and Nonassumable mortgages

• Wall Street projections and averages: most of the industry relies on the prepayment projections prepared by the major investment houses, available on-line as BLOOMBERG screens

• Burnout: after a pool has stayed in refinancing range for some time prepayments decrease. This is call burnout

• Seasoning: aging of mortgage loans and associated changes in prepayments

• Path Dependence: future prepayment for a mortgage pool are dependent on that pool’s past prepayments, which in turn are dependent on the path interest rates have taken since pool’s origination (See figure 5 )

Factors Affecting Prepayment

• Prevailing mortgage rate and market conditions

– spread between contract rate and prevailing mortgage rate

– path dependence

– refinancing burnout

– level of mortgage rates

– housing turnover and affordability

• Seasonal factors

– home buying starts in spring and reaches its peak in summer

– in fall and winter home buying declines

Factors affecting prepayment (contd).

• Characteristics of the underlying mortgage Loans

– contract rate

– conventional versus FHA/VA

– amount of seasoning

– FRMs versus ARMs

– pool factor

– geographical location of underlying properties

• General economic activity

– general economic activity affects prepayment through its effects on housing turnover as growing economy increases personal income and opportunities for worker migration

What to remember about Prepayment Projections

• The most important thing to remember about accurate long-term prepayment projections is that there aren’t any

• prepayment projections remain inherently unreliable

• Interest rates must be forecast

• to reliably predict future prepayments, we must first reliably predict future interest rates

• if you can consistently predict future interest rate movement bond futures is your calling not prepayment projections

• Interest rates and prepayments change continually

Pricing of MPT’s

• Estimate the necessary cash flow

• Discount the estimated cash flow at an appropriate interest rate.

• Problem:– cash flows of MPTs are not known with certainty.– appropriate discount rate is difficult to determine

Current CouponTreasury Yield

Curve

Current CouponTreasury Yield

Curve

ProjectedCash Flows

ProjectedCash Flows

Market PriceMarket Price

Discount atTreasury Rates

Pertinent to EachCash Flow Plus

Spread

Discount atTreasury Rates

Pertinent to EachCash Flow Plus

Spread

PrepaymentModel

PrepaymentModel

Non-Treasury IndicesGenerated from

Treasury Scenarios

Non-Treasury IndicesGenerated from

Treasury Scenarios

TreasuryInterest Rate

Scenarios

TreasuryInterest Rate

Scenarios

Basic Principles of valuation of MBS

Constructing MBS Cash Flows• Project monthly Payment

MPt = MB t-1 [{i(1 + i)n-t+1}/{(1 + i)n-t+1 - 1}]

MPt = projected monthly mortgage payment for month t

MB t-1 = projected mortgage balance at the end of month t-1

n = original number of months of mortgage

i = simple monthly interest rate(annual rate/12)

MPT Cash flow (Contd).• Project Monthly Mortgage Interest, servicing and guarantee

I t = MB

t-1 . i

NIt = MB t-1 (i - s - g)

St = MB t-1 s

Gt = MB t-1 g

It = projected monthly interest for month t.

NIt = projected interest net of servicing and guarantee fee

St = projected servicing fee for month t

Gt = projected guarantee fee for month t

s = servicing fee rate

MPT Cash flow (Contd).

• Projected Monthly Scheduled Principal and Prepayment

SPt= MPt - It

PRt = SMMt(MB t-1 - SPt)

PRt = monthly principal prepayment for month t

SPt = monthly scheduled principal payment for month t

SMMt = assumed single monthly mortality rate for month t

MPT Cash flow (Contd)

• Investor's Cash Flow

CFt = NIt + SPt + PRt

CFt = projected cash flow to investor for month t

NIt = interest net of servicing and guarantee fees

Illustration

• Original mortgage balance = $100,000

• Mortgage rate = 9.5%

• Servicing fee and guaranteed fee = 0.5%

• 360 months to maturity

• Coupon rate = 9%.

• Prepayment at 100% PSANote: The interest rate on passthrough is always less than that paid on

the mortgage, usually by the amount of servicing and guarantee fee (.5% in the above case)

Short Cut Approach to Calculate Cash Flows

bt = (1 - SMMt(1 - SMMt-1) ... (1 - SMM2)(1 - SMM1)

MPt = b t-1 MP*

SPt = b t-1 P t*

bt = the projected mortgage balance in month t per $1

of the principal given projected prepayments through

month t (POOL FACTOR akin to earnings announcement)

MP* = monthly mortgage payment on the original principal

assuming no prepayments.

MPt = projected monthly mortgage payment in month t

SPt = projected schedule principal payment

P t* = scheduled principal payments on the original

balance assuming no prepayment.

Illustration of short cut approachAssuming a CPR of 6%, for month 210

MP210 = b209 MP*

Mortgage Constant at 9.5%, 360 months = 0.0084085

MP* = $100,000x.0.0084085 = $840.85

Since SMM is 0.005143 for each month after the 30th, 1- (1-CPR)1/2

b209 = (1-.005143)(1-.005143)...(1-.005143) = (1-.005143)209 = .34039

MP210 = (.34039)(840.85) = $286.

This is the projected monthly payment in month 210

Illustration (contd).The projected scheduled principal payment in month 210 is:

SP210 = b209 P*210

Scheduled principal payment in month 210 assuming no

prepayment is $255.62

The projected scheduled principal payment assuming prepayment for

month 210 is then:

SP210 = (.34039)($255.62) = $87

Additional Pricing Concepts• Weighted Average Coupon (WAC)

– average of underlying mortgage rate weighted by dollar balance of each mortgage as of date of issue

• Stated Maturity Date of Pool– longest maturity date for any mortgage in the pool assuming zero

prepayment

• Weighted Average Maturity (WAM)– remaining term of underlying mortgages weighted by principal balance

• Weighted Average Life (WAL)– average number of years until investors principal is returned weighted by

each principal balance

• Pool Factor– outstanding balance divided by beginning balance

Price/Yield Relationship for Option-Free BondPrice

Yield

Price/Yield Relationship for Callable Bonds

Yield

Noncallable bond

Callable bond

Price a’

b

y*

aa-b

a-a’

Relationship between Prepayment and Premium, Discount and Par Mortgages

• High coupon MPT at a premium– loses if prepayment is faster

– gains if realized prepayment is slower

• Low coupon MPT at a discount– gains if prepayment is faster

– loses if prepayment is slower

• At par MPT – unaffected

Logic of Option Adjusted Spread• Option Adjusted Spread analysis attempts to include the cost of

prepayment option ( and other factor, delays) when calculating the spread the passthrough security offers above the Treasury yield curve.

• The first step in calculating OAS is running a Monte Carlo simulation of numerous possible future interest rate paths

• Next future monthly cash flows are calculated based upon prepayment model for each interest rate path

• An average yield above Treasury yield is then calculated for each path

• The OAS for a security is the average of individual spreads calculated for each future interest rate paths

Meaning of OAS• Often put forward as one method of identifying overpriced and un

derpriced mortgage backed securities

• Typically, OAS on securities with similar duration are compared.

• However that such comparison does not tell the investor which security to buy.

• Suppose the OAS > 0:

– a risk neutral investor who does not demand compensation for variability in cash flows (prepayment) will find such an investment attractive.

– for a risk averse investor this positive OAS will not provide enough information to determine whether or not the extra yield is enough to cover the investors desired risk premium

An Equivalent way to view the ambiguity of OAS

• An equivalent way to view this ambiguity– two MBS have same expected cash flows but the variability of the second

security is greater.

– risk averse investors will bid a lower price for the second mortgage related security

– the result is that the second MBS will have a higher OAS

– however, the meaning is clearly not that the second security is better one

• BOTTOM LINE

Establishing that the expected return on a risky security is greater than the Treasury rate, or even greater than the expected return of some security with comparable risk, does not imply that it is good buy, unless you happen to be risk neutral. OAS provides such risk neutral information.

Cash Flow Yield• Semiannual yield (IRR) = (1 + ym)6 - 1

• Bond Equivalent Yield (BEY)

BEY = 2[(1 + ym)6 - 1], ym= monthly yield or IRR

• To convert the bond equivalent yield to a monthly yield

ym = [1 + (0.5)(BEY)]1/6 - 1

• Suppose an investor requires a BEY of 8.13%, then the corresponding monthly interest rate is

ym = [1 + (0.5)(.08130]1/6 - 1 = 0.006667

• The projected cash flow can then be discounted at ym = 0.6667%

• Price is simply the present value of the projected cash flow

Market Making • Substantial trading activity

– daily average primary dealer transaction is $12.4 billion

– Treasury is around $137 billion

• Several factors foster trading in secondary market– Large capital committed by investment banking firms and commercial banks

to make market

– Institutional investors more willing to trade in passthroughs due improved liquidity

• Improved Liquidity: narrow bid-ask spread – 3 cents to 12.5 cents

– risk of market making and competition

– turnover ratio (ratio of dollar volume to amount of issue outstanding) = 3.57

Trading Mechanics• Quotation (same as treasury) 94 5/32 = $94.15

• MPT identification (pool prefix)

• TBA trade: trading may occur while pool is still not specified

• Many Issues of same coupon (different pools)

• Prepayment characteristics (generic MPT)

• Moral Hazard Problem: some sellers may deliver poor paying pool

• Under and Overdelivery (2.5% tolerance per million dollar traded)

– $975,000 or $1,025,000 for MPT of $1,000,000

Use of Dollar Rolls in MBS Trading

• Repos (repurchase agreements– dealer use security to borrow from client (counterparty)

– dealer pays loan + interest at end of period

– identical collateral is returned by counterparty

– vehicle for covering short position

• Reverse Repo– Client borrows from dealer

• Dollar Roll Transaction

– sustantially the same security is returned by borrower

– help market for MBS to operate smoothly