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CHAPTER 19

CHAPTER 19. The Secondary Mortgage Market: Pass-Through Securities. Secondary Mortgage Market. Allows originators to replenish funds Facilitates geographic flow of funds Provides an investment option for savers Early buyers of mortgages Mortgage companies and thrifts

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CHAPTER 19

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  1. CHAPTER19 The Secondary Mortgage Market: Pass-Through Securities

  2. Secondary Mortgage Market • Allows originators to replenish funds • Facilitates geographic flow of funds • Provides an investment option for savers • Early buyers of mortgages • Mortgage companies and thrifts • FHA insurance and VA guarantees • Minimum underwriting standards

  3. Secondary Mortgage Market • 1954 Charter Act: FNMA • Enhance secondary market operations • FHA and VA mortgages • Manage prior direct loans • Manage special assistance programs • FNMA transforms into a private organization • FNMA issues securities

  4. Secondary Mortgage Market • HUD Act 1968: GNMA • GNMA manages and liquidates FNMA loan portfolio • Special assistance functions • Guarantee timely payment of principal and interest for FHA-VA mortgage pools • Eliminated any default delay in payments to investors

  5. Secondary Mortgage Market • Emergency Home Finance Act 1970: FHLMC • Provide a secondary market for conventional loans • Allowed FNMA to purchase conventional mortgages • FHLMC allowed to purchase FHA and VA mortgages • Fannie Mae and Freddie Mac compete for all mortgage loans

  6. Secondary Mortgage Market • Operation • Direct Sale Programs • Mandatory Commitment • Optional Delivery • Mortgage-Related Security Pools • Securitization

  7. Secondary Mortgage Market • Mortgage-Backed Bonds • Issuer retains ownership of mortgages • Mortgages held in trust • Fixed coupon rate • Specific maturity • Over collateralization • Mark to market

  8. Secondary Mortgage Market • Mortgage-Backed Bonds • Investment Rating • Mortgage Quality • Geographic Diversification • Interest Rates on Mortgages • Prepayment Probability • Over collateralization • Appraised value and debt coverage ratio if commercial mortgages

  9. Secondary Mortgage Market • Mortgage-Backed Bonds • Example 19-1: Mortgage Bond Valuation • 20-year to maturity • Par value of $10,000 • 10.5% annual coupon. • At issue, bond market investors require an 11% interest rate. • What is the initial price of the bond?

  10. Secondary Mortgage Market • Mortgage-Backed Bonds • Example 19-1: = $10,000 = 20 = .105 x $10,000 = $1,050 = 11 = $9,601.83 FV n PMT i PV CPT

  11. Secondary Mortgage Market • Mortgage-Backed Bonds • In Example 19-1, what would be the price of the bond 5 years later if investors required a 12% return? • N is 15 years • I is 12%

  12. Secondary Mortgage Market • Mortgage-Backed Bonds • Example 19-1: = $10,000 = 15 = $1,050 = 12 = $8,978.37 FV n PMT i PV CPT

  13. Secondary Mortgage Market • Mortgage-Backed Bonds • Zero-Coupon Bond • The only cash flow to an investor is a lump sum at maturity • No interim coupon payments • Also called “deep discount” bonds • Analysis is just computing the present value of a lump sum

  14. Secondary Mortgage Market • Mortgage Pass-Through Securities • Ownership interest in a pool of mortgages • Trustee is owner of the mortgages in the pool • Principal & interest are passed through • Servicing & guarantee fees

  15. Secondary Mortgage Market • Mortgage Pass-Through Securities • Issuers & guarantors • Default insurance • Payment patterns and security • Coupon rate and interest rates • Seasoned mortgages

  16. Secondary Mortgage Market • Mortgage Pass-Through Securities • Number of mortgages • Geographic distribution • Borrower characteristics • Loan prepayment • Nuisance calls

  17. Secondary Mortgage Market • General Pricing of MPTs • Interest Rate Risk • Default Risk • Risk of Delayed Payment of Principal and Interest • Prepayment Risk

  18. Secondary Mortgage Market • General Pricing of MPTs • Coupon Rate • Yield to maturity • Servicing Fee • Weighted Average Coupon & Maturity • Stated Maturity Date • Payment Delays • Pool Factors

  19. Secondary Mortgage Market • Example 19-2: • A mortgage pool consists of the following: • $500,000 of 30-year 7% Fixed Rate Mortgages • $200,000 of 29-year 6.5% Fixed Rate Mortgages • $300,000 of 28-year 6% Fixed Rate Mortgages • What is the weighted average coupon and average maturity of the mortgage pool? If there is a servicing fee of .5%, what is the quoted maturity and quoted coupon rate?

  20. Secondary Mortgage Market • Example 19-2: • Quoted Maturity = 30 Years • Quoted Coupon Rate = 6% - .5% = 5.5%

  21. Secondary Mortgage Market • Pricing Issues • Mortgage-Backed Bonds • Specified maturity • Specified coupon payment and face value • Pricing methodology is relatively straight forward • MPTs • Can not define a specific maturity • Can not define specific cash flows • Pricing is based on prepayment assumptions

  22. Secondary Mortgage Market • Prepayment Assumptions • Average Maturity Assumption • Constant Prepayment Rate Assumption • FHA Prepayment Experience • PSA Prepayment Model • Convexity • Price Compression

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