Chapter 10
The Secondary
Mortgage Market
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Chapter 10 Learning Objectives
 Understand the workings of the secondary mortgage
market
 Understand why the secondary mortgage market is
important for a more efficient allocation of funds in
the real estate market, and what the major secondary
mortgage market agencies are
 Understand how agency problems and the sub-prime
mortgage crisis of 2007 to 2010 affected the major
secondary mortgage market entities
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Secondary Mortgage Market
 Market where existing mortgages are bought and sold
 Mortgages are used as collateral for mortgage related
securities
 Reduces reliance on deposits
 Agencies and firms that purchase mortgages in the
secondary market often raise funds by issuing bonds or
other debt instruments, pledging the mortgages as
collateral (mortgage-backed securities)
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Cash Flows in a Simple Secondary
Mortgage Market Transaction
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Why Does the Secondary Mortgage
Market Exist?
 Until late 1960s:
 Difficult for thrifts to sell mortgages as mortgage assets were not
homogeneous
 Potential buyers concerned with default risk
 Inability to buy and sell mortgages – led to persistent mismatch in supply
and demand for capital
Regional mismatch
Institutional mismatch
• The secondary mortgage market developed to solve the mismatch
problem
• The federal government stimulated the development of the
secondary mortgage market by overriding state laws hindering its
development
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Characteristics of Mortgage-Backed
Securities
 Have some form of credit enhancement
 Implies less default risk than the underlying mortgages
serving as collateral
 Avoid double taxation
 Interest revenue from MBSs is passed through to the
investors; Revenues to the issuer and cash flows to the
investors are not both taxed
 Tailor cash flows of MBS to appeal to investors
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MBS Credit Enhancements
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Types of Mortgage-Backed Securities
 There are four principal types of MBS:
 Mortgage pass-through securities
 Mortgage-backed bonds
 Mortgage pay-through bonds
 Collateralized mortgage obligations (CMO’s)
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Mortgage Pass-Through Securities
(MPTs)
 Fist popular MBS promoted by GNMA
 The investor has an undivided interest in the pool of
mortgages
 The investor has an “ownership” position in the mortgages
 Mortgage principal and interest and any prepayment is
passed-through to the investor on a pro-rata basis
 Mortgage originators sells the MPT at a slightly lower yield
than the interest rate of the underlying mortgages.
 The difference is shared by the originator who services the loan
and the agency which provides the credit enhancement
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Mortgage-Backed Bonds (MBBs)
 MBSs that promise payments similar to corporate bonds
 Semiannual payments of interest only until maturity
 Face value due at maturity
 Mortgages are owned by the issuer of the MBB
 Maturity of the bonds is less than that of the underlying
mortgages
 Yield is slightly below that on the mortgages
 Mortgages are placed with a trustee who marks-to-market any
changes in their value and ensures that the agreed-on
overcollateralization is maintained
 MBBs rated by rating agencies
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Cash Flows for a MBB
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Mortgage Pay-Through Bonds (MPTBs)
 A cross between pass-throughs and MBBs
 Issuer retains ownership in the pool and issues MPTB as a
debt obligation
 Cash flows to the investors are based on the coupon rate
of interest, while principal from amortization and
prepayment is passed through as received from the pool
 Rated by agencies, based on the same factors associated
with MBBs
 Less overcollateralization than with MBBs due to passing
prepayment risk to the investors
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Collateralized Mortgage Obligations
(CMOs)
 Rearrange cash flows from the pool of mortgages into
several different bond-like securities with different
maturities
 Different bond classes called tranches
 A typical CMO has three or four tranches
 A residual tranche (Tranche Z) often owned by the
issuer where all residual cash flows accrue
 Implies equity interest of the issuer in the CMO
 Cash flows accruing to residual represent return-on-equity.
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Example Structure of a CMO
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Swaps
 A SMM transaction where the lender sells mortgages to an
agency that in turn issues an MBS back to the lender
 Swaps are attractive due to the liquidity advantage of MBS
over loans
 Thrifts can use MBS as collateral to borrow funds
 MBS can be sold quicker than mortgage loans if there is
need for cash
 Even if they sell the MBS, the lenders are likely to retain
the servicing and receive a servicing fee
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Real Estate Synthetic Investment
Securities (RESIs)
 Pass all of the credit risk through to the bondholders
 Rated by agencies
 Losses from default are passed to the lowest rated
classes first
 Securities are backed by, primarily, jumbo loans
 High return – high risk
 In 2004 when mortgage rates approx. 6%, 15% yield on
lower-grade RESIs
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Commercial Mortgage Backed
Securities
 Started with S&L crisis of 1980s when RTC packaged
commercial loans of failed thrifts and sold CMBSs
 Senior tranche received all principal payments
including prepayments
 Subordinated tranche bore all losses from defaults
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CMBS (Cont.)
 Securitization process is same as for CMOs with
different tranches
 May be backed up by many mortgages on many
properties, a single loan on a very large property, or a
single loan on many properties
 Loans are credit rated and contributed to a REMIC
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REMICs
 An entity that could issue CMOs and not be subject to
double taxation
 A partnership, trust, or other corporation may elect
REMIC status
 For tax purposes, income is recorded as received from
the mortgage pool and deductions are allowed for
interest paid (on the CMO tranches); The net income
can be passed-through to the owner of the residual as
income or loss
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REMICs
 Can maintain favorable tax status as long as they don't
engage in the following transactions:
 Receive income from non-qualifying mortgages
 Receive fees or compensation for services (other than
servicing income from the mortgage portfolio)
 Buying or selling mortgages out of the pool (except as
the pool is liquidated if all proceeds are disbursed
within 90 days)
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Cash Flows for a REMIC
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Secondary Mortgage Market Agencies
and Firms
 Federal National Mortgage Association (Fannie Mae,
FNMA)
 Established in 1938 to buy FHA loans
 Re-chartered in 1954 and became a private corporation
 As of 1970, allowed to buy FHA,VA, and conventional
mortgages
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Secondary Mortgage Market Agencies
and Firms
 Government National Mortgage Association (Ginnie
Mae, GNMA)
 Created in 1968 within HUD
 Does not purchase mortgages or issue securities
 Market focus is to guarantee FHA and VA pass-through
securities
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Secondary Mortgage Market Agencies
and Firms
 Federal Home Loan Mortgage Corporation (Freddie
Mac)
 Established in 1970 to create a secondary mortgage market
for conventional mortgages
 Operates as a private corporation
 Currently buys FHA, VA, and conventional mortgages
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Federal Home Loan Mortgage
Corporation (Freddie Mac)
 Freddie Mac purchases both newly issued and
seasoned (those with some expired term) mortgages
 Freddie Mac will also purchase
construction/permanent loans that are FRMs, ARMs,
or balloon/reset. These must be new dwellings and
not rehabs.
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Freddie Mac (Cont.)
 Freddie Mac issues a wide variety of securities:
 Discount Notes and Debentures
 Mortgage Participation Certificates (Pass-throughs) on
FRMs, ARMs, and multifamily
 Collateralized Mortgage Obligations in several classes or
tranches
 Guaranteed Mortgage Certificates – not sold since 1979
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Secondary Mortgage Market
 Federal credit agencies that support the primary and
secondary mortgage markets:
 Farm Credit System consolidated three agricultural agencies
to make direct loans for agricultural purposes
 Federal Agricultural Mortgage Corporation (Farmer Mac) to
underwrite pools of farm mortgages through pass-throughs
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Secondary Mortgage Market Agencies and
Firms
 Federal credit agencies that support the primary and
secondary mortgage markets:
 Rural Housing Service extends loans to rural areas for farms,
houses, and community facilities
 Financing Corporation formed in 1987 to recapitalize the
FSLIC
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Government-Sponsored Enterprises
 GSEs are not officially part of the federal government
 They appear to enjoy the backing of the federal
government
 Federal government does not guarantee these
agency’s obligations but Congress has shown that
federal funds would be used to “bail” them out of
financial stress
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Government-Sponsored Enterprises
 GSEs operate similarly to thrifts in purchasing longterm mortgages
 They face interest rate risk, default risk, and
management/operating risk
 Office of Federal Housing Enterprise and Oversight
(OFHEO) oversees the operations of the GSEs
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