Mortgage Markets and
Mortgage Backed Securities
Finance 119
Brief History of Mortgages
5,000 years ago Babylonians used land as
security to encourage the building of dikes and
dams
Egyptians used surveys to describe land plots
ranked by fertility from flooding of the Nile
Romans introduced the fiducia a document that
was a title to land. Roman Law defined a
hypotheca or “pledge” that resembled lien
History info from "Mortgage Backed Securites: by William
theory today
Bartlett
Brief History of Mortgages
Following the decline of Roman empire,
Germanic law developed the idea to use land as
security in borrowers agreements, this practice
was referred to as a gage
William of Normandy introduced the Germanic
gage system into early English law. The French
word mort (dead or frozen) was combined with
gage to produce a locked pledge or mort-gage
on property.
The US mortgage market
Establishment of mortgage companies in the
the 1800’s to finance land purchases by farmers
in the Midwest.
By 1900 there were approximately 200
mortgage companies with outstanding loan
values totaling $4 billion
Early mortgages paid interest semiannually,
nonamortizing with a balloon payment at the
end (as short as 3 to 5 years)
The Mortgage Market
The Primary Market
Mortgage Originators
Thrifts, Commercial banks and mortgage
brokers
Origination income
Origination Fee - expressed in terms of points -each point represents 1% of the borrowed funds -Origination fee of 3 points on 100,000 mortgage is
$3,000
Secondary market profit -- selling the mortgage
obligation at a price higher than it originally cost.
Servicing Fee - Collecting monthly payments,
forwarding proceeds to owners of the loan, sending
payment notices, maintaining records, furnishing
tax info etc…
The mortgage origination process
Applicant submits info relating to the property and
income. Originator performs credit report and looks
at the probability of repayment.
PTI -- payment to income ratio (monthly payment /
monthly income)
LTV -- loan to value ratio (Loan amount / Valuation)
Commitment letter-- outlines the terms available for
the next 30 to 60 days. The borrower pays a
commitment fee which will be lost if no loan is taken
out.
Post Loan Options
After making the loan the originator has one of
three options
Hold the mortgage in their portfolio
Sell the mortgage to an investor (who will
either hold the mortgage or use it as collateral)
Use the mortgage as collateral to issue a
security (securitizing the mortgage)
Origination Risks
Price Risk If rates increase the originator has
already committed to charging lower rates -Can protect against price risk with a second
commitment from a secondary market participant that
agrees to buy the given loan at a futures point in time
for a given price.
However this brings a second risk -- if rates decline
the borrower may not close and the originator is
locked into providing the above market return.
Fall out Risk. Risk that some individuals
issued commitment letters will not close
Mortgage Construction
Traditional Fixed Rate Mortgage
Principal and interest are amortized over the
life of the mortgage.
The payment is determined with the basic
PV of an annuity formula
Amortization of a Loan
You want to borrow 1,000 and pay it off over
three years. Assume that you are charged 6%
each year. How much will your payment be?
1,000 = PV PMT =????
1,000 = PMT (PVIFA6%,3) =
1,000 = PMT(2.67)
PMT = 374.11
Amortization
You pay a total of 374.11(3) = $1,122.33
A portion of each payment represents interest
charges.
You can find the amount of interest by
multiplying the beginning balance each
payment period by the interest rate.
At the beginning the balance is $1,000 so there
is 1,000(.06) = 60 in interest.
Amortization
Beginning
Ending
Year Balance Payment Interest Principal Balance
1
1,000
374.11
60.00
314.11
685.89
2
685.89
374.11
41.15
332.96
352.93
3
352.93
374.11
21.18
352.93
0.00
Amortization 30 yr Mortgage
$150,000
5.85%
Beginning
Year Balance Payment
1
150,000 884.91
Interest Principal
Ending
Balance
731.25 153.6614 149,846.34
2 149,846 884.91
730.50
154.41
149691.93
359
1756.97 884.91
8.57
876.35
880.62
360
880.62 884.91
4.29
880.62
0
Problems
Mismatch
Institutions are borrowing short and lending
long)
Tilt
The real burden of the loan to the borrower is
in the early years of the loan. Since inflation
decreases the real burden of their payments
over time.
Adjustable Rate Mortgages
The loan rte is reset periodically using a base
or reference rate.
The rate might reset every month, year, 2
years 5 years etc..
Reference Rate
Market determined
Cost of Funds
ARM Features
Usually offer an initial rate less than
prevailing fixed rate 9teaser rate).
At reset date reference rate plus a spread
determines the rate.
There may be caps and floors on the rates,
both periodic and lifetime.
Balloon & Two Step Mortgages
Allows for rollover and renegotiation of the loan at
periodic intervals.
Different from ARM the future rate is not set from
base rate.
Loan is extended if certain requirements are met.
30 due in 5 is a thirty year mortgage where the
remaining principal is due (or refinanced) after
five years.
Two step rates once based upon a specified rate
Solutions to the tilt problem:
ARMs address the mismatch problem by
allowing for longer term lending at a short
term rate.
The tilt problem has creates the market for
other types of products
Graduated Payment Mortgages
Price -level Adjusted Mortgage.
Dual Rate Mortgage
Graduated Payment Mortgages
The mortgage payment increases each year at
the beginning of the loan then hits a level
amount for the remainder of the loan.
This actually produces negative amortization
since in the beginning the total amount does
not cover the interest on the loan.
Specified in the loan are The fixed rate, the rate
of growth for the first few years, the number of
years over which the payment will increase
Graduated Payment Mortgages
Example: 30 year, 10% mortgage on $100,000
with the payment growing at 7.5% each year for
the first 5 years.
Fixed rate payment would be $877.5715
GPM
Year Payment
1
$667.04
3
$770.84
5
$890.80
Payments
Year
2
4
6-30
Payment
$717.06
$828.66
$957.62
Price Level Adjusted Mortgages
Monthly payment is designed to be level in
purchasing power. The fixed rate of interest is
a real rate of interest.
The monthly payment is then calculated using
the real rate just as a regular mortgage would
be.
The actual payment is then adjusted based
upon the rate of inflation.
Dual Rate Mortgages
Similar to the PLAM except the amount owed
is based on a floating short term rate.
To establish the mortgage you need
1. the payment rte (the real rate of interest that
is fixed for the life of the loan),
2. the effective or debiting rate that changes
periodically and
3. the maturity of the mortgage.
Other plans
Growing Equity Mortgage: Similar to the GPM
except there is no negative amortization. The
increase in payment will serve to pay off the
principal quicker than a traditional mortgage.
Lenders will be willing to lend a t a lower rate (if
the yield curve slopes up) and borrowers
increase payment solving tilt problem
High LTV loans eliminates high down payments by
financing up to 100%of the value of the home plus
closing costs.
Other Plans
Alt-A loans: Requires alternate documentation
of income for special cases such as self
employed individuals. Rtes are generally 75
basis points to 125 basis points above other
rates
Sub Prime Loans: Borrowers who have had
credit problems. Rates based upon different
risk grades
Risks Faced by Mortgage Investors
Credit Risk
Risk of default by the borrower
Liquidity risk
Even with the secondary markets, individual
loans are relatively illiquid
Price Risk
Value moves opposite changes in interest rates
Prepayment Risk
The borrower may prepay early
Mortgage Pass through Securities
Interest and Principle are collected by the
issuer of the pass through who then transfers
(passes through) the payments to the owners
of new securities backed by the mortgages.
Neither the amount or timing of the cash
flows actually matches the cash flows on the
pool of mortgages.
Securitization
Loan Bank A Loan Bank B
Loan Bank Z
Financial Intermediary
Buys Loans, Forms a “Pool”
and Issues MBS
Insurance Firm, Banks, Pension Funds etc.
Buy MBS – Cash Flows “Guaranteed” by Original Mortgages
WAC, WAM and WARM
WAC = weighted average coupon rate
Weighting the mortgage rate of each mortgage in
the pool by the outstanding principal balance
WAM weighted average maturity
Weighting the number of months to maturity of
each mortgage in the pool by the outstanding
principal balance
WARM weighted average remaining maturity
After prepayments start the maturity changes.
Guarantee Types
Fully Modified Pass Throughs: Guarantees that
the principal and interest will be paid regardless
of whether the borrower is late.
Modified Pass Through: Guarantees the timely
payment of interest, the principal is passed
through when it is received.
Ginnie Mae
Ginnie Mae pass throughs are guaranteed by
the US treasury.
Issue Mortgage backed securities which are
fully modified pass throughs
All mortgages are FHA, VA or Farmers Home
Administration loans
Fannie Mae
Sells mortgage backed securities and channels
the funds to lenders by buying mortgages. The
institution may continue to service the original
mortgage.
All are fully modified pass throughs, but there is
no government guarantee of payment
Freddie Mac (FHLMC)
Participation Certificates sold by the agency
are used to finance the origination of
conventional mortgages. Usually PC only
guarantee that the interest payment will be
made. The principle payment is passed
through as it is received. The guarantee is
not backed by the federal government as is
the case in Ginnie Mae.
Most are fully modified (new issues are)
Participation Certificates
Two main programs
Cash program FHLMC buys mortgages from the
issuer and issues PC's based on the mortgages.
Guarantor / Swap program -- Allows thrifts to
swap mortgages for PC's based on the mortgages.
The institution can swap mortgages selling below
par for without recognizing an accounting loss!
The PC is then:
Held as an investment
used as collateral for borrowing
sold
Comparison of rates
The pass through rate is less than that of the
mortgage pool. The difference accounts for
service and guaranteeing fees.
The timing is also different to allow for the
payment of the mortgages (on the first of the
month) prior to the pass through occurring.
Creation of a GNMA pass through
The loan pool must have standard features in
terms of single family or mutli family, maturity
etc.
The originators forward the pool to GNMA with
supporting documentation requesting GNMA to
guarantee the securities to be backed by the
pool
After review a pool number is assigned if the
pool is accepted
Sundaresan 2002
Creation of a GNMA pass through
The originators transfer the mortgage
documents to custodial agents and send pool
documents to GNMA
Originators look for investors (dealers,
investment banks etc) willing to buy a given
amount at a specified price
Creation continued
GNMA issues the guarantee following review of
the documentation.
Originators continue to service the loans.
The GNMA is not a debt of the issuer, it is a
representation f the loan pool with payments
guaranteed by Ginnie Mae
Fees for a typical GNMA pool
44 basis points are retained by the servicer for
servicing fees
Ginnie Mae received 6 basis points for the
guarantee. The issuer is guaranteeing Ginnie Mae
against defaults by the homeowner and Ginnie Mae
guarantees against defaults by the issuer.
The investor then receives approximately 50 basis
points less than the coupon of the loan portfolio.
Sundaresan 2002
Price Quotes
GNMA’s are quoted in 1/32 of a point
Quotes depend upon a pool factor pf(t)
Bt
p f (t ) 
P
where :
Bt is the balance at date t
P is the original blanace
Sundaresan 2002
Market Value
Consider an investor with $20 million of a $100
million issue with a pool factor of .9 and a price
of 9316/32
Par value remaining = 20 (.9) = 18million
Market Value = 18 (.9350) = 16.38 Million
You would need to also account for accrued
interest to find the actual cash price.
Sundaresan 2002
Accrued interest
SD  M
1
ait 
c  B
30
12
where
SD  settlement Date, M is the first day of month
c  coupon rate B  balance
Assume a coupon rate of 9% and 20 days into
the month
20
1
ait  (.09) (18,000,000)  90,000
30
 12 
Sundaresan 2002
Non Agency Pass
Through Securities
Often non agency mortgage pass throughs will
attempt to increase their rating
External Credit Enhancement
third party guarantees of losses up to a predetermined
amount. Often these are in the form of a corporate
guarantee , a letter of credit, pool insurance or bond
insurance
Internal Credit Enhancement
Reserve funds
Over collateralization
Senior/subordinated structure
Measuring prepayment
Constant Monthly Mortality
Assume that there is a 0.5% chance that the
mortgage will be prepaid after the first year.
The 0.5% is the single month mortality rate (or
SMM)
Given the SMM it is easy to compute the
probability that the mortgage will be retired in
the next month.
The probability that the mortgage survived the
first month is 1-0.005 = .995 or 99.5%
Measuring Prepayment
Given a 99.5% chance that the mortgage
survived the first month, and a 0.5% SMM for
the second month the probability that the
mortgage will be retired in the second month
is: 0.50%(.995) = 0.4975%
Continuing in the same manner the yearly
prepayment rate could be found.
Conditional Prepayment Rate
Let CPR be the conditional prepayment rate.
The probability that the mortgage survives one
year is (1-SMM)12 which should equal the (1CPR)
or
(1-SMM)12=(1-CPR)
CPR = 1-(1-SMM)12
this assumes that prepayments will be the same
through time which is not consistent with the
empirical evidence
Conditional Prepayment Rate (CPR)
The industry convention is to use an annual
prepayment rate based upon the historical
prepayment observed by the FHA. The CPR
can then be easily transferred back to a
monthly rate (the single month mortality rate
(SMM))
SMM = 1 - (1-CPR)1/12
If the CPR is 6% the SMM is equal to
1 - (1-.06)1/12 =.005143
Market Convention
The CPR has been shown to level off after thirty
months. The standard CPR used is .2% for the
first month then increasing at .2% each month
until 6% is reached for the thirtieth month and
every month thereafter.
Calculations
Prepayment based upon the SMM
Estimated Prepayment for month t
 beg mortgage balance scheduled principal
 SMM

for month t
payment for month t




Using the SMM above assume we own a pass
through with a beginning balance of 290 million
and principal repayment of 3 million scheduled
Estimated Prepayment would be:
.005143(290,000,000-3,000,000)=$1,476,041
The PSA benchmark
The Public Securities Association prepayment
benchmark is expressed as a monthly series
of prepayment rates.
100 PSA
100 PSA assumes the following CPR’s for a 30
year mortgage.
Using the convention of a CPR of 0.2% for the
first month increased by 0.2% each month for
the next 30 months
After 30 periods a CPR of 6% for the remaining
years of the mortgage
PSA is then expressed as a percentage of 100
PSA benchmark.
PSA benchmark
For Example a PSA of 150 means that the pool
prepays at an expected rate 1.5 times as fast as
the PSA benchmark
Notice the CPR is a multiple of the PSA not the
SMM
Monthly cash flow construction
(exhibit 24-1 in book)
Assume that you have a $400 Million 7.5%
pass through with a WAC of 8.125% and a
WAM of 357 months assuming 100PSA
Note: the pass through has been seasoned
three months this makes the CPR = 0.8%
Table 24-1
The SMM for the first month is then:
SMM=1-(1-CPR)1/12=1-(10.008)1/12=0.000669124
The scheduled mortgage payment would be
400,000,000=PMT(PVIFA357,8.125%/12)=2,975,868
.24
(this changes with each payment due to
prepayment)
Monthly cash flow construction
Interest is found from the pass through rate of
7.5% $400,000,000(.075)/12 = $2,500,000
The scheduled principal is found using the WAC
and the payment calculated earlier.
Total interest scheduled from the pool is =
400,000,000(.08125)/12 = 2,708,333.333
Given a payment of 2,975,868.24 the scheduled
principal is: 2,975,868.24 - 2,708,333.333=
267,534.91
Monthly Cash Flow Construction
The expected prepayment for the month is then
found using:
 beg mortgage balance scheduled principal
 SMM

for month t
payment for month t

For the first month this is equal to :
.000669124(400,000,000-267,534.91)
=267,470.58
total principal is then equal to
267,534.91+267,470.58=535,005.49



Monthly Cash Flow Construction
Total Cash Flow is then the sum of the interest
paid to the pass through investor and the total
principal
=2,500,000+ 535,005.49=3,035,005.49
the next months outstanding balance is then
reduced by the amount of principal
=400,000,000-535,005.49 =399,464,994.51
the next month would proceed the same way with
the exception of the scheduled mortgage payment.
Note
The PSA convention is the result of past
experience on FHA prepayments. The empirical
evidence suggests a level CPR after 30 months
of 6%. The first 29 months are just a linear
approximation starting at zero months and
ending at 29.
The same method is used regardless of the
maturity of the pass through, and the rate
(ARM or fixed.) It is at best an quick and easy
estimate.
Non Agency CPR convention
Defaults and other problems characterize the
nonagency pass throughs, therefore there is a
PSA standard default assumption (SDA)
0.02% fro the first month increasing by 0.02%
each month up to .6% at 30 months
.6% from 30 to 60 months
61 months to 120 months default rates decline
to 0.03%
120 to maturity default rates remain at 0.03%
Factors Influencing Prepayment
Prevailing Mortgage Rates
Spread between Original Rate and Prevailing rate
Path of Rates
Factors Influencing Prepayment
Prevailing Mortgage Rates
Level of rates
As the level of rates declines turnover increases
as more homes become affordable.
Factors Influencing Prepayment
Characteristics of Underlying Mortgage Loans
Seasonality (more in the Spring and summer less
in the winter)
Age of Mortgage Prepayments are higher during
the early stages of the mortgage and the final
periods prior to maturity
Type of Loan (ARM, balloon etc)
Factors Influencing Prepayment
Other Factors
Housing Costs
Geographic Location
Family Circumstances
Economic Activity
Collateralized Mortgage Obligations.
Provide semiannual payments
The payment of principle is allocated among
different tranches that represent the repayment
of principle.
Allows investors to attempt to match their
willingness to accept prepayment risk to a
security
Sequential pay CMO
The first Tranche receives principle until the
total principle in the tranche is paid off. The
CMO will be explained by a Weighted average
maturity and a weighted average coupon that
represents the mortgages in the CMO.
The actual timing of the payoff will depend
upon the prepayment rate. The speed of
prepayment can be estimated, but it will not be
know in advance.
Example: Same starting point as before
Assume that you have a $400 Million 7.5% pass
through with a WAC of 8.125% and a WAM of
357 months assuming 100PSA
Four payment tranches
Tranche
A
B
C
D
Par Amount
194,500,000
36,000,000
96,500,000
73,000,000
Coupon
7.5
7.5
7.5
7.5
Example continued
Each tranche received interest upon the
outstanding principal in the tranche. Tranche B
receives no principal until Tranche A has
received all of its principal likewise tranche C
follows B and D follows C.
Therefore after the fist period, tranche B
receives $36,000,000(.075)/12 = $225,000
Tranche B continues to receive 225,000 each
period until the principal has been paid off to
tranche A. The pay down of principal is
calculated as before…
CMO
The CMO has allowed investors to choose a
tranche that best matches their desire to accept
prepayment risk (match the timing of cash
flows to their needs).
However, there is still variability in the actual
timing of the tranches since prepayments may
not occur at the estimated speed.,
Accrual Tranches
In the example all the tranches receive interest
payments. Often this is not the case. It is
possible for one or more tranches to be an
accrual bond.
The interest that would have been paid on the
tranche now goes to paying down the debt on
the earlier tranche. This shortens the maturity
of the other tranches.
Planned Amortization classes
Includes a set principal payment schedule
which must be followed (if the actual
prepayments fall within a given window then a
schedule of principal payments is followed).
PAC bondholders have priority over the other
classes within a CMO. Therefore PAC bonds
come at the expense of support or companion
bonds which absorb the prepayment risk (they
forego principal)
Planned Amortization Class Tranche
(PAC) CMO’s
If prepayments are within a specified range, the
cash flow pattern is known.
PAC bondholders have priority over the other
tranches in the issue.
The non PAC bonds are termed support or
companion bonds.
The minimum is based off of a range of PSA
assumes an upper and lower collar.
PAC Bonds
The guaranteed principal payment is the
minimum of the principal repayments of the
two possible PSA’s.
The prepayment can occur even if prepayment
occurs at a rate different than the original
collars
PAC bonds
The support bonds provide protection against
both extension and contraction risk. Therefore
the PAC will not shorten even outside of the
initial PAC bands.
The wider band of guaranteed prepayments
creates an effective collar in which the
prepayments stay constant.
PAC Bonds
The support bond will not receive any principal
until the PAC has received all of the scheduled
prepayment.
If the prepayment is slower than scheduled any
principal that might have gone to the support
bond (if the schedule was met) will now go tot
the PAC.
PAC Bonds
If the prepayment is faster than originally
planned the support bond will receive faster
prepayments, eliminating the PAC paying off
quicker.
If the principal of the support bond is paid off
early then the PAC will decrease in maturity.
Quick Question
Will the schedule of principal repayments be
satisfied if prepayments are faster than the
initial upper collar?
It depends upon when the prepayments
occur…. The initial assumption was that the
support would be eliminated at the upper collar.
It repayments were initially slow, there is extra
support available.
Quick Question 2
Will the schedule of principal repayment be
satisfied as long as prepayments stay within the
initial collar?
Not always the initial structure only guarantees
that the schedule will be met if it is at either of
the extremes. If prepayment varies there is a
possibility that the PAC is busted.
Answer continued
IF the PAC has been prepaying at the faster
PSA the amount of support decreases and the
lower collar of the effective collar increases
above the initial collar.
Final Question
Given the first two questions does a wider initial
collar imply that there is less risk that the
repayment will not fit the schedule?
No the actual prepayment experience once the
PAC is seasoned is what is important.
Given prepayment experience, the effective
collar is what should be investigated.
Increasing Prepayment Protection
Lockout Structure: Eliminating the earlier or
shorter PAC from the package creating more
support bonds
Changing the prepayment rules in the event
that all support bonds are paid off. One possible
structure: reverse PAC -- requires any extra
principal to go to the longer maturity PAC’s
Targeted Amortization Class
Instead of guaranteeing a range of rates initially
a TAC bond guarantees a specific targeted rate.
The bond is therefore only protected against
contraction risk, not extension risk.
Interest Only and Principal Only
Another structure is to allocate only interest or
only principal to a given tranche.
The IO investor will want the prepayments to
be slow since it extends the life of the CMO.
The PO investor will prefer that the
prepayments arrive quickly
Notional IO classes
This is a class that receives the excess coupon
interest. It has no par value, only a notional
value upon which the payments are based.
Stripped Mortgage Backs
1) Synthetic coupon pass throughs
results in a cash flow different than the
underlying coupon
2) IO and PO strips
Principal is at a discount from par. IO has a
notional value.
3) CMO strips