Mortgages & MBS

Introduction
• In most developed countries the right to own a home is
virtually a fundamental right
• But few people can pay the full purchase price from their own
funds
• So most of the required funds are borrowed
• A mortgage loan is a loan collateralized by real estate
• The lender is the mortgagee
• The borrower is the mortgagor
• In the event of default the lender can seize the property and
sell it to recover his dues
– This is called the Right of Foreclosure
 Market Participants
• There are three categories of players
– Mortgage originators
– Mortgage servicers
– Mortgage insurers
 Mortgage Origination
• Who is an originator?
– The original lender or the party who first extends a
loan to the acquirer of the property
• Originators include:
– Thrifts or S&Ls
– Commercial Banks
– Mortgage Bankers
– Life Insurance Companies
– Pension Funds
 Income for the Originator
• The originator gets income from various sources
• When a loan is granted he will levy an
Origination Fee
– This is expressed in terms of points
– Each point is 1% of the borrowed amount
– So a fee of 1.5 points on a loan of $200,000 will
amount to $3,000
• Most originators will also levy an application fee
and certain processing fee
 Income (Cont…)
• The second source is the profit that can be
earned if and when the loan is sold to another
party
• A mortgage loan is a type of debt
• It is therefore vulnerable to interest rate
fluctuations
• If rates were to decline the sale of a loan will
result in a gain for the seller
 Income (Cont…)
• This is called a Secondary Marketing Profit
• However if rates were to rise after the loan is
disbursed there will be a loss
• If the originator decides to hold the loan as an
asset he will earn periodic income in the form
of interest
 Mortgage Servicing
• Every loan has to be serviced
• This includes the following activities
– Collection of monthly payments and forwarding
the proceeds to the owner of the loan
– Sending payment notices to mortgagors
– Reminding mortgagors whose payments are
overdue
– Maintaining records of principal balances
 Servicing (Cont…)
– Administering escrow balances for real estate
taxes and insurance purposes
– Initiating foreclosure proceedings if necessary
– Furnishing tax information to mortgagors when
applicable
• Servicers include
– Bank related entities
– Thrift related entities
– Mortgage bankers
 Escrow Accounts
• An escrow account is a trust account held in
the name of the mortgagor to pay statutory
levies such as
– Property taxes
– Insurance premia
• The maintenance of such accounts helps
ensure that payments are made when due
– Because it becomes the lender’s responsibility to
do so
 Escrow (Cont…)
• In most cases the borrower makes monthly
deposits
– Along with the loan payment
– The payments accrue at the lender
• The monthly deposit required is a function of
– The cost of insurance
– And the tax assessment of the property
– Consequently it fluctuates from year to year
 Income for the Servicer
• The primary income is the Servicing Fee
– This is fixed percentage of the outstanding
mortgage balance
– Since the loan is amortized the outstanding
principal will steadily decline
– So the revenue from servicing in dollar terms will
steadily decline
 Income (Cont…)
• The second source of income is the interest
that is earned from the escrow accounts
maintained by the borrowers
• The third source is the float on the monthly
mortgage payment
– This is because a delay is permitted from the time
the servicer receives the monthly payment and
the time that it has to be forwarded to the lender
 Mortgage Insurance
• There are two types of mortgage related insurance
– The first type is originated by the lender
– To insure against default by the borrower
– This is called Mortgage Insurance or Private Mortgage
Insurance
– It is usually required by lenders on loans with a LTV
ratio greater than 80%
– The amount insured will be a percentage of the loan
– It may decline as the LTV declines
 Insurance (Cont…)
• What is the LTV ratio?
• Every borrower has to make a Down Payment
– The difference between the price of the property
and the loan amount
• The LTV ratio is determined by dividing the
loan amount by the market value of the
property
– The lower the LTV ratio more is the protection for
the lender in the event of default
 Insurance (Cont…)
• The second type of insurance is acquired by
the borrower usually through a life insurance
company and is called CREDIT LIFE
– This is not required by the lender
– These policies provide for continuation of monthly
payments after the death of the borrower so that
the survivors can continue to occupy the property
 Government Insurance and PMI
• Lenders insist on insurance if he LTV ratio is less
than 20%
• However low to middle income borrowers may
not be in a position to make a 20% down payment
• At the same time their credit rating makes them
ineligible for private insurance
• To help such borrowers there are government
agencies that provide loan guarantees in lieu of
insurance
 Government…(Cont…)
• These agencies are
– The Federal Housing Administration (FHA)
– Department of Veterans’ Affairs (VA)
– Department of Agriculture’s Rural Housing Service
(RHS)
• A borrower who is not eligible for a loan from
any of these agencies must obtain private
mortgage insurance or PMI
 Secondary Sales
• Once the loan is granted the originator can
hold it as an asset or sell it to an investor
• An investor may wish to hold it as an
investment
• Or seek pool individual loans and use them as
collateral for the issuance of securities
– This is called SECURITIZATION
– Of course this may be done by the originator
himself
 Secondary Sales (Cont…)
• Two federally sponsored credit agencies and
many private agencies
– Buy mortgage loans
– Pool them
– And issue securities backed by the pool
– Such agencies are referred to as CONDUITS
• The two federal agencies are
• Federal National Mortgage Association – Fannie Mae
• Federal Home Loan Mortgage Corporation – Freddie Mac
 Secondary Sales (Cont…)
• These agencies buy CONFORMING
MORTGAGES
• What is a conforming mortgage?
– It is one that meets the underwriting criteria set
by them from the standpoint of being eligible to
be included in a pool for subsequent securitization
 Conforming Mortgages
• A conforming mortgage must satisfy three
criteria
• They must have a maximum Payment to
Income (PTI) ratio
• The PTI ratio is the ratio of monthly payments –
loan payment + tax payment – to the
borrower’s monthly income
– Obviously the lower the ratio the lower is the
chance of default
 Conforming (Cont…)
• A maximum LTV ratio
• A maximum loan amount
• Mortgages which are non-conforming because
they are for amounts in excess of the purchasing
limit set by the agencies are called JUMBO
Mortgages
• Those which are non-conforming because of
credit quality or LTV ratio are termed as SUB-
PRIME mortgages
 Risks in Mortgage Lending
• Investors who invest in mortgage loans are
exposed to 4 main risks
– Default risk
– Liquidity risk
– Interest rate risk
– Pre-payment risk
 Default Risk
• This is the risk that the borrower may default
• For government insured mortgages the risk is
minimal because the insurance agencies are
government sponsored
• For privately insured mortgages the risk depends
on the credit rating of the insurance company
• For uninsured mortgages it would depend on the
credit quality of the borrower
 Liquidity Risk
• Mortgage loans are LARGE and INDIVISIBLE
• So while an active secondary market exists for
such loans Bid-Ask spreads are high relative to
other debt securities
 Interest Rate Risk
• The price of a mortgage loan moves inversely
with interest rates just like other Debt
securities
• Since these loan are for long time periods the
price impact of an interest rate change can be
significant
 Pre-payment Risk
• Most homeowners pay all or a part of their
mortgage balance prior to the maturity date
• Payments in excess of scheduled principal
repayments are called PREPAYMENTS
• Such premature payments can occur for
several reasons
 Pre-payments (Cont…)
• Borrowers tend to prepay the entire mortgage
when they sell their home
• The sale may be due to:
– A change of employment that necessitates moving
– The purchase of a more expensive home
– A divorce in which the settlement requires sale of
the marital residence
 Pre-payments (Cont…)
• Second if market rates decline below the loan rate the
borrower may prepay since he can refinance at a
lower rate
• Third in the case of homeowners who cannot meet
their obligations, the property will be repossessed and
sold
• The proceeds from the sale will be used to payoff the
mortgage in the case of uninsured mortgages
• For an insured mortgage the insurance company will
pay off the balance
 Pre-payments (Cont…)
• Finally if a property is destroyed by an Act of
God the insurance proceeds will be used to
payoff the mortgage
• The effect of prepayments, whatever may be
the reason, is that the cash flows from the
mortgage becomes unpredictable.
 Illustration of Re-financing
• Cindy has taken a loan of $800,000
• It is 10 year mortgage with a rate of 12% per
annum
• Installments are due every six months
• Interest is compounded semi-annually
• At the end of the first year, just after paying
the second installment the interest on home
loans drops to 10.8%
 Illustration (Cont…)
• The refinancing fee is 1.75% of the amount
being refinanced.
• Cindy’s opportunity cost of funds is 9.8% per
annum
• Is refinancing attractive?
Illustration (Cont…)
Features of a Traditional Mortgage
• A traditional mortgage is known as a Level
Payment Mortgage.
– Borrowers make fixed monthly payments
consisting partly of principal repayment and partly
of interest on the outstanding balance.
– Loans which are paid off in such a fashion are
called Amortized Loans.
 Features of Amortized Loans
• Mortgages are usually for 20 years (240
months) or for 30 years (360 months).
– The interest component is equal to one twelfth
the annual rate of interest multiplied by the
amount outstanding at the beginning of the
previous month.
– With the payment of each installment, the interest
component will keep declining and the principal
component will keep increasing.
 Amortization
– It refers to the process of repaying a loan by
means of equal installments at periodic intervals.
– The installment payments form an annuity whose
present value is equal to the original loan amount.
– A Amortization Schedule is a table that shows the
division of each payment into principal and
interest, and the outstanding loan balance after
each payment.
 Calculating The Installment
• Consider a loan to be of $L to be repaid by
way of N installments of $A each.
– Let the periodic interest rate be `r’.
– L = A x PVIFA(r,N) =

A 1
x [1  ]
r (1  r ) N
 Example
• A person has taken a loan of $10,000.
• It has to be paid back in 5 equal annual
installments.
• Interest rate is 10% per annum.
– L = A x PVIFA(10,5) = A x 3.7908
– A = 2,637.97
 Amortization Schedule
Year Payment Interest Principal Outstanding
Repayment Principal

0 10,000
1 2637.97 1000 1637.97 8362.03
2 2637.97 836.20 1801.77 6560.26
3 2637.97 656.03 1981.94 4578.32
4 2637.97 457.83 2180.14 2398.18
5 2637.97 239.82 2398.15 .03
 Prepayments
• The mortgagor has a right to payoff the mortgage
prematurely either in part or in full without
significant penalties.
– Thus the borrower has a Call Option.
– For the lender it introduces cash flow uncertainty.
– The uncertainty about when and how a borrower will
prepay is called Prepayment Risk.
– Because of this risk the valuation of mortgages and
mortgages related securities is more complex.
 Reasons For Prepayment
– The borrower may be selling the house because
he is changing jobs.
– He may be scaling up to a more expensive place.
– He may be getting a divorce.
– Interest rates may have declined. If so he can pay
off the existing loan and take a fresh loan at a
lower rate.
 Reasons for Prepayment
– The lender may be selling the property due to non
payment of dues.
– There could be a fire or a natural calamity which
destroys the property. If so, the insurance
company will pay.
 Pooling of Mortgages
• Mortgage originators do not usually hold on to
the loans made by them, but rather sell them.
• In order to sell these loans, many small loans
are put together as a collection, called a
Mortgage Pool.
 Rationale for Pooling
• Consider ten separate loans of $100,000 each.
• Assume that each loan has been made by a separate
lender.
– Every lender therefore faces prepayment risk.
– It is not easy for a lender to forecast prepayments, since
each is dealing with an individual borrower.
– Prepayment behaviour will obviously differ from borrower
to borrower.
 Rationale for Pooling
– If these ten loans were to be pooled, then the
average prepayment is likely to be more
predictable and statistical tools of analyses can be
used.
– However it is expensive for one party to own the
pool since it would entail an investment of 10MM.
– However the pooled loans can be used as
collateral to issue securities in large numbers to
enable individual investors to invest.
 Securitization
• Securitization is a process of converting a pool of
illiquid assets into liquid financial instruments.
– In the case of mortgages, the pool serves as the source for
the payments which have to be made on the assets which
are issued with the pool as collateral.
– Because of the ability to securitize, lenders can repeatedly
rollover their investments in mortgages and the country as
a whole gets greater access to housing finance.
 Standardization
• Before pooling mortgage loans care is taken to
standardize the loans.
• This means that all the pooled loans will have:
– The same rate of interest.
– The same period to maturity.
– The same kind of insurance.
– The same kind of property.
– And will come from the same geographical location.
 Standardization
• The advantage of standardization is that the cash
flows from the pool are easier to predict.
• Although each mortgage loan is insured individually,
some times the pool as a whole is additionally
insured.
• A mortgage pool is therefore like a large loan with a
coupon rate and term to maturity.
 Special Purpose Vehicles (SPVs)
• Before securitization, the pool of mortgages is
transferred to an SPV.
– An SPV is a separate legal entity that is set up for the
purpose of issuing mortgage backed securities.
– The objective is to ensure that there is a distance between
the originators and the pool.
– Thus even if the originators were to go bankrupt, it would
not affect the pool held by the SPV.
 Mortgage Backed Securities
• The net result of securitization is the creation
of assets which are backed by the underlying
pool of mortgages.
• These assets are claims on the cash flows that
are generated by the underlying pool.
 Federal Agencies
• These are organization which are essentially
private, but are sponsored by the U.S.
government.
– Their mandate is to serve as intermediaries in
specified sectors of the economy.
– They were created to enable special interest
groups like homeowners, farmers, and students to
borrow at affordable rates.
 Major Agencies
• Federal Home Loan Bank.
• Federal National Mortgage Association –
Fannie Mae.
• Federal Home Loan Mortgage Corporation –
Freddie Mac
• Student Loan Marketing Association – Sallie
Mae
 Major Agencies
• Freddie Mac and Fannie Mae operate in the
mortgage market.
– They were set up to promote a liquid secondary
market for mortgages.
• Sallie Mae was set up to promote a market for
student loans.
– All three are listed on the NYSE and are publicly
owned.
 Ginnie Mae
• The Government National Mortgage
Association – Ginnie Mae also promotes a
liquid secondary market for mortgages by
guaranteeing mortgage backed securities.
– However it is not a private agency, but is a
government owned corporation.
– Thus all securities guaranteed by Ginnie Mae are
effectively guaranteed by the Federal
Government.
 Pass-throughs
• A pass-through is a type of mortgage backed
security.
– It is formed by pooling mortgages and creating
undivided interests.
– Undivided, means that each holder of a pass-
through has a proportionate interest in each cash
flow that is generated from the underlying pool.
 Illustration
• Consider 10 loans of $100,000 each that are pooled
together.
• Assume that an agency purchases these loans and
issues fresh securities using these loans as collateral.
– This is the function of Ginnie Mae, Fannie Mae, Freddie
Mac etc.
• Assume that 40 units of such securities are sold.
 Illustration
– Thus each security will be worth $25,000.
– Each security will be entitled to
1/40 th or 2.5% of each cash flow emanating from the
underlying pool.
– The net result is that by investing $25,000 an investor gains
exposure to the total pre-payment risk of all ten loans
rather than to the risk of a single loan.
– This is appealing from the point of risk reduction.
 Collateralized Mortgage
Obligations (CMOs)
• Now consider the case where the ten loans are
pooled to issue three categories of securities.
– Class A Bonds: Par Value of $400,000
– Class B Bonds: Par Value of $350,000
– Class C Bonds: Par Value of $250,000
• For each class, multiple units of a security that
represents that particular class are issued.
 CMOs
• For instance if 50 units of class A bonds are
issued, then each will have a face value of
$8000.
– Each will be entitled to 2% of the cash flows
receivable by the class as a whole.
• Assume that the cash flows are distributed
according to certain pre-decided rules.
 Example Of Distribution Rules
– Class A securities will receive all principal payments – both
scheduled and unscheduled until the entire par value is
paid off.
– Once class A securities have been fully retired, class B
bondholders will start receiving principal payments –
scheduled and unscheduled, until the entire par value is
paid off.
– After class B securities are retired, class C security holders
will start receiving principal payments.
 CMOs
• All security holders will receive interest every period,
based on the amount of the par value that is
outstanding for that particular class.
• This is an example of a CMO.
• In this case certain categories of securities will
receive payments before others.
• Unlike a pass-through, all securities are not equally
exposed to pre-payment risk.
 CMOs
• Class A bonds will absorb prepayments first,
followed by class B, and then by class C.
– Class A bonds will have a shorter term to maturity
than the other two categories.
– Class C securities will have the longest maturity.
 A Pass-Through
A Detailed Illustration
• A person has borrowed $4800 to buy a house.
– He agrees to pay $100 every month as principal
repayment, and to pay interest every month on the
outstanding principal at the rate of 6% per annum.
– A total of 48 payments are due.
– The first payment will be $124 which consists of $100 by
way of principal repayment and $24 by way of interest.
 Illustration Cont…
– The last payment due will be $100.50 which will
consist of $100 by way of principal repayment and
$0.50 by way of interest.
– We will assume that there are 4 owners who
agree to share each payment equally.
– If payments are made as per schedule, each party
will receive $31 after the first month, and $25.125
in the last month.
 Illustration Cont…
– Assume that at the end of three months the mortgagor
pays an extra $40 by way of principal.
– So each of the four owners will get an extra payment of
$10.
– Since $10 is prepaid the monthly interest in subsequent
months will go down by 20 cents.
– In the last month (48th) the mortgagor will pay $60 by way
of principal and 30 cents by way of interest.
 Illustration of CMO
• Assume that instead of agreeing to share the
payments equally, the four owners want the
following system.
– Party A wants his principal back by the end of the first year.
– Party B wants his principal by the end of the second year.
– Party C wants his principal by the end of the third year.
– Party D wants his principal during the last year.
 CMO Illustration Cont…
• So every month all the investors will get
interest on the amount outstanding to them.
– But all principal payments will go first to A.
– Once A is fully paid, B will start receiving principal
payments.
– After B is fully paid, C will start receiving principal
payments.
– Finally D will start getting principal payments.
 CMO Illustration Cont…
• In the first year A will get $100 every month plus
interest on the outstanding balance.
– The other three will get interest of $6 per month.
• From the 13th month B will start receiving $100 per
month plus interest on the outstanding balance.
• From the 25th month C will start receiving $100 per
month.
• From the 37th month D will start receiving $100 per
month.
 CMO Illustration Cont…
• Each class of ownership is called a tranche.
• A CMO must obviously have a minimum of 2
tranches.
• Now assume that in the third month the mortgagor
makes an extra payment of $40.
– This will entirely go to party A.
– In subsequent months he will continue to get $100 by way
of principal repayments, but will receive 20 cents less by
way of interest.
 CMO Illustration Cont…
– In the 12th month he will get only $60.
– The remaining $40 will go to B.
– In the 24th month, B will get $60 and C will get
$40.
– In the 36th month, C will get $60 and D will get
$40.
• Such a distribution principle is called
Sequential Pay Prepayment.
 Differences Between Conventional Bonds
and Mortgage Backed Securities
• In a conventional bond the principal is returned in
one lump sum at maturity.
• Holders of mortgage backed securities receive their
principal back in installments, as the underlying loans
are paid off.
• Since the speed and timing of principal repayments
can vary, the cash flows on mortgage backed
securities can be very irregular.
 Mortgage Backed Securities
• When a homeowner prepays, the remaining stake of
the holders of the mortgage backed securities will be
reduced by the same amount.
• Since the principal outstanding will reduce, the
interest income will also decrease.
• The monthly cash flow for a mortgage backed
security will be less than the monthly amount paid by
the mortgagors.
• The difference is equal to the servicing and
guaranteeing fees.
 Categories of Pass-throughs
– Ginnie Maes
– Fannie Maes
– Freddie Macs
– Private Label
 Features of Ginnie Maes
• They are backed by the full faith and credit of
the U.S. government.
• The underlying mortgage pools are assembled
by private parties, but are approved by Ginnie
Mae before sale to the public.
• The U.S. Treasury guarantees interest and
principal payments on Ginnie Maes.
 Freddie Mac
• Freddie Mac issues participation certificates or
PCs.
• These are not guaranteed by the Treasury.
• FHLMC itself provides the guarantee.
• Consequently yields on Freddie Mac PCs are
higher than those on Ginnie Maes.
 Fannie Maes
• These are similar to Freddie Mac PCs.
• The guarantee to holders is provided by FNMA and
not by the Treasury.
• Yields are higher than those on Ginnie Maes but are
comparable to the yields on Freddie Mac PCs.
• Common perception is that the U.S. government will
never allow FNMA to default.
• Thus there is an implicit guarantee.
 Private Label Pass-throughs
• These are issued by independent
organizations like commercial banks.
• They have no connection with the
government.
• Consequently the yields on them tend to be
higher.
 Asset Backed Securities
• These are similar to mortgage backed
securities.
• But the assets which are pooled are not home
loans.
• Examples of such assets include credit card
receivables, automobile loan receivables etc.