Residential Mortgages and Mortgage-Backed Securities

1. Residential Mortgages and Mortgage-Backed Securities

2. Mortgage-Backed Securities

3. Mortgage-Backed Securities • A mortgage originator with a pool of mortgages has the option of holding the portfolio, selling it, or selling it to be used to securitize a MBS issue or deal. • Depending on the types of mortgages, the originator who sells mortgages to become a securitized asset can sell them to one of the three agencies (Fannie Mae, Ginnie Mae, or Freddie Mac) or to a private-sector conduit. • As noted in Chapter 7, Fannie Mae and Freddie Mac are Government-sponsored enterprises (GSEs), whereas Ginnie Mae is a federal agency. In our discussion of MBSs, we will refer to all three as being agencies.

4. Mortgage-Backed Securities • Agency MBSs are MBSs created by one of the agencies; they are collectively referred to as agency MBSs, • Nonagenecy MBS are MBS created by private conduits; also called private labels.

5. Mortgage-Backed Securities • Residential mortgages can be divided into prime and subprime mortgages. • Prime mortgages include those that are both conforming (meet the agency’s underwriting standards) and nonconforming but still meeting credit quality standards. • Subprime mortgages include those with low credit ratings.

6. Mortgage-Backed Securities Note: • Typically, agency residential MBSs are created from conforming loans. • In more recent periods, though, agency MBS issues backed by pools of lower quality mortgages were issued. • All other mortgages that are securitized are nonagency MBS.

7. Mortgage-Backed Securities • After the mortgages are sold to an agency or private conduit, the originator typically continues to service the loan for a service fee (that is, collect payments, maintain records, forward tax information, and the like). • The service fee is typically a fixed percentage (25 to 100 basis points) of the outstanding balance. • The originator can also sell the servicing to another party. • Investors who buy the MBSs receive a pro rata share from the cash flow of the pool of mortgages.

8. Ginnie Mae Mortgage-Backed Securities • Ginnie Mae (Government National Mortgage Association's (GNMA)) is a true federal agency. • As such, the MBSs that it guarantees are backed by the full faith and credit of the U.S. government.

9. Ginnie Mae Mortgage-Backed Securities Creation • Ginnie Mae MBSs are put together by a lender/originator (bank, thrift, or mortgage banker), who presents a block of mortgages that meets Ginnie Mae’s underwriting standards. • If Ginnie Mae finds them in order, it will issue a guarantee and assign a pool number that identifies the MBS that is to be issued. • The lender will then transfer the mortgages to a trustee, and then issue the pass-through securities as a Ginnie Mae pass-through security.

10. Ginnie Mae Mortgage-Backed Securities Features • Ginnie Mae provides the guarantee, but does not issue the Ginnie Mae MBS. • Thus, different from the standard MBS that is issued by the other agencies or a conduit, Ginnie Mae MBSs are issued by the lenders. • The minimum denomination on a Ginnie Mae pass-through is $25,000 and the minimum pool is $1 million.

11. Ginnie Mae Mortgage-Backed Securities Types • The mortgages underlying Ginnie Mae MBSs can be grouped into one of two Ginnie Mae MBS programs: Ginnie Mae I and Ginnie Mae II. • TheGinnie Mae I program consists of MBSs backed by single-family and multifamily mortgage loans that have a fixed note rate and are sold by only one issuer. • TheGinnie Mae II program consists of just single-family mortgage loans that can have either fixed or adjustable rates and have multiple issuers.

12. Fannie Mae and Freddie Mac Mortgage-Backed Securities • Fannie Mae and Freddie Macare Government-sponsored enterprises (GSE) initially created to provide a secondary market for mortgages. • Today, there activities include not only the buying and selling of mortgages, but also creating and guaranteeing mortgage-backed pass-through securities, as well as buying MBSs.

13. Fannie Mae and Freddie Mac Mortgage-Backed Securities Note: • Both GSEs are regulated by the Office of Federal Housing Enterprise Oversight (OFHEO) and both were placed in conservatorship in September 2008. • Prior to being placed in conservatorship, the Fannie Mae and Freddie Mac MBSs were guarantee by each of the companies, but not the government. • As part of the banking bailout in 2008, though, government backing was provided to their MBSs.

14. Fannie Mae and Freddie Mac Mortgage-Backed Securities • Freddie Mac issues MBSs that it refers to as participation certificates (PCs). • Freddie Mac and Fannie Mae have regular MBSs (also called a cash PC), which are backed by a pool of conforming mortgages that they have purchased from mortgage originators. • They also offer a pass-though formed through their Guarantor/Swap Program. In this program, mortgage originators can swap mortgages for a Fannie Mae or Freddie Mac pass-through.

15. Fannie Mae and Freddie Mac Mortgage-Backed Securities • Unlike Ginnie Mae, Fannie Mae’s and Freddie Mac's MBSs are formed with more heterogeneous mortgages. • The minimum denomination on a Freddie Mac and Fannie Mae pass-through is $100,000 and their mortgage pools range up to several hundred million dollars.

16. Nonagency MBS • Nonagency pass-throughs or private labels are sold by commercial banks, investment banks, other thrifts, and mortgage bankers. • As noted, nonagency pass-throughs are often formed with prime or subprime nonconforming mortgages. • Larger issuers of nonagency MBSs include Citigroup, Bank of America, and G.E. Capital Mortgage.

17. Nonagency MBS Features • Nonagency MBSs are often guaranteed against default through external credit enhancements, such as the guarantee of a corporation or a bank letter of credit or by private insurance from a monocline insurer. • Many are also guaranteed internally through the creation of senior and subordinate classes of bonds with different priority claims on the pool's cash flows in the case some of the mortgages in the pool default. • The more subordinate claims sold relative to the senior claims, the more secure the senior claims.

18. Nonagency MBS Features • Nonagency MBSs are rated by Moody's and Standard and Poor's. • They must be registered with the SEC when they are issued.

19. Nonagency MBS Features • Most financial entities that issue private-label MBSs or derivatives of MBSs are legally set up so that they do not have to pay taxes on the interest and principal that passes through them to their MBS investors. • The requirements that MBS issuers must meet to ensure tax-exempt status are specified in the Tax Reform Act of 1983 in the section on trusts referred to as Real Estate Mortgage Investment Conduits, REMIC. • Private-labeled MBS issuers who comply with these provisions are sometimes referred to as REMICs.

20. Nonagency MBS Features • Nonagency residential MBSs differ fundamentally from agency MBSs in that their cash flows are subject to default risk, whereas agency MBSs with their government and agency guarantees are considered default free.

21. Cash Flows • Cash flows from MBSs are generated from the cash flows from the underlying pool of mortgages, minus servicing and other fees. • Typically, fees for constructing, managing, and servicing the underlying mortgages (also referred to as the mortgage collateral) and the MBSs are equal to the difference between the rates associated with the mortgage pool and the rate that is paid to the MBS investors (pass-through (PT) rate).

22. Cash Flows: Terms • Weighted Average Coupon Rate, WAC: Mortgage portfolio's (collateral’s) weighted average rate. • Weighted Average Maturity, WAM: Mortgage portfolio's weighted average maturity. • Pass-Through Rate, PT Rate: Interest rate paid on the MBS; PT rate is lower than WAC—the difference going to the MBS issuer. • Prepayment Rate or Speed: Assumed prepayment rate.

23. Cash Flow from a MBS Example • The next slide shows the monthly cash flows for a MBS issue constructed from a $100 million mortgage pool with the following features: • Current balance = $100 million • WAC = 8% • WAM = 355 months • PT rate = 7.5% • Prepayment speed equal to 150% of the standard PSA model: PSA = 150

24. Projected Cash Flows from an Agency MBS IssueMortgage Portfolio = $100,000,000, WAC = 8%, WAM = 355 Months, PT Rate = 7.5%, Prepayment: 150 PSA

25. Cash Flow from a MBS Notes: • The first month's CPR for the MBS issue reflects a 5-month seasoning in which t = 6, and a speed that is 150% greater than the 100 PSA. For the MBS issue, this yields a first month SMM of .0015125 and a constant SMM of .0078284 starting in month 25. • The WAC of 8% is used to determine the mortgage payment and scheduled principal, whereas the PT rate of 7.5% is used to determine the interest. • The monthly fees implied on the MBS issue are equal to .04167% = (8% − 7.5%)/12 of the monthly balance.

26. Cash Flow from a MBS • First Month’s Payment:

27. Cash Flow from a MBS • From the $736,268 payment, $625,000 would go towards interest and $69,601 would go towards the scheduled principal payment:

28. Cash Flow from aMBS • Using 150% PSA model and seasoning of 5 months the first month SMM = .0015125:

29. Cash Flow from a MBS • Given the prepayment rate, the projected prepaid principal in the first month is $151,147

30. Cash Flow from a MBS • Thus, for the first month, the MBS would generate an estimated cash flow of $845,748 and a balance at the beginning of the next month of $99,779,252:

31. Cash Flow from a MBS • Second Month: Payment, Interest, Scheduled Principal, Prepaid Principal, and Cash flow:

32. Market • As noted, investors can acquire newly issued mortgage-backed securities from the agencies, originators, or dealers specializing in specific pass-through. • There is also a secondary market consisting of dealers who operate in the OTC market as part of the Mortgage-Backed Security Dealers Association. • These dealers form the core of the secondary market for the trading of existing pass-through.

33. Market • MBSs are normally sold in denominations ranging from $25,000 to $250,000, although some privately-placed issues are sold with denominations as high as $1 million.

34. Price Quotes • The prices of MBSs are quoted as a percentage of the underlying MBS issue’s balance. • The mortgage balance at time t, Ft, is usually calculated by the servicing institution and is quoted as a proportion of the original balance, F0. • This proportion is referred to as the pool factor, pf:

35. Price Quotes Example: • A MBS backed by a mortgage pool originally worth $100 million • Current pf of 0.92 • quoted at 95 - 16 (Note: 16 is 16/32) • The current balance, Ft, would be $92 million and the market value would be $87.86 million:

36. Price Quotes Note: • The market value is the clean price; it does not take into account accrued interest. • For MBS, accrued interest is based on the time period from the settlement date (typically two days after the trade) and the first day of the next month.

37. Price Quotes Example: • If the time period is 20 days, the month is 30 days, and the WAC = 9%, then the accrued interest is $460,000: • The full market value (clean price plus accrued interest) would be $88,320,000:

38. Price Quotes • The market price per share is the full market value divided by the number of shares. Example: • If the number of shares is 400, then the price of the MBS based on a 95 - 16 quote would be $220,800:

39. Extension Risk • Like other fixed-income securities, the value of a MBS is determined by the MBS's future cash flow (CF), maturity, default risk, and other features germane to fixed-income securities.

40. Extension Risk • In contrast to other bonds, MBSs are also subject to prepayment risk. • Prepayment affects the MBS’s CF. • Prepayment, in turn, is affected by interest rates.

41. Extension Risk • Thus, interest rates affects the MBS’s CFs:

42. Extension Risk • With the CF a function of rates, the value of a MBS is more sensitive to interest rate changes than those bonds whose CFs are not. • This sensitivity is known as extension risk.

43. Extension Risk • If interest rates decrease, then the prices of MBSs, like the prices of most bonds, would increase as a result of the lower discount rates. • However, the decrease in rates will also augment prepayment speed, causing the earlier cash flow of the mortgages to be larger which, depending on the level of rates and the maturity remaining, could also contribute to increasing the MBS’s price.

44. Extension Risk Rate Decrease

45. Extension Risk • If interest rates increase, then the prices of MBSs will decrease as a result of higher discount rates and possibly the smaller earlier cash flow resulting from lower prepayment speeds.

46. Extension Risk Rate Increase

47. Average Life • The average life of a MBS or mortgage portfolio is the weighted average of the security’s time periods, with the weights being the periodic principal payments (scheduled and prepaid principal) divided by the total principal:

48. Average Life • The average life for the MBS issue with WAC = 8%, WAM = 355, PT Rate = 7.5%, and PSA = 150 is 9.18 years

49. Average Life • The average life of a MBS depends on prepayment speed: • If the PSA speed of the $100 million MBS issue were to increase from 150 to 200, the MBS’s average life would decrease from 9.18 to 7.55, reflecting greater principal payments in the earlier years. • If the PSA speed were to decrease from 150 to 100, then the average life of the MBS would increase to 11.51.

50. Average Life and Prepayment Risk • For MBSs and mortgage portfolios, prepayment risk can be evaluated in terms of how responsive a MBS's or mortgage portfolio’s average life is to changes in prepayment speeds: