Lecture: 2/15/2011
We discussed the differences between calculating the spot rate curve from the par yield curve, or
from actual observed prices. We did an example and calculated the 3rd spot rate given a 6 month
T-Bill price, a 12 month T-Bill price, and an 18 month to maturity coupon bearing instrument. I
emphasized the fact that when the Treasury Yield Curve is upward sloping that the theoretical
spot rate curve will always be above the yield curve, and below it when the yield curve is
downward sloping. Ironically, calculating the spot rate curve from the par yield curve or from
the actual observed prices makes a very small difference in the spot rate calculation – I have
confirmed in this in excel – approximately .001% difference in the spot rate estimate.
Next, we discussed the government sponsored enterprises – Fannie Mae and Freddie Mac. I
defined a GSE as a shareholder-owned company created by Congress to serve a public purpose. I
explained to them that the only difference between the two companies is when they were charted.
I pointed out the GSE’s two primary lines of business: (1) they purchase mortgages and
mortgage related products in the secondary market, securitizes these mortgages and sell them to
investors as mortgage backed securities; (2) they also maintain a mortgage investment portfolio.
The combined size of the portfolio for the two GSEs is $1.5 trillion. I also talked about Ginnie
Mae and how they guarantee investors of MBS the timely payment of interest and principle by
federally issued or guaranteed loans. Also, unlike Freddie and Fannie, Ginnie does not purchase
mortgages from lenders nor does it buy, sell, or issue mortgage related securities.
When was “Frannie” put into conservatorship? Freddie and Fannie were placed into
conservatorship by its regulators, the Federal Housing Finance Agency in Sept. 2008. This was
done to restore confidence in the company and enhance their ability to continue to conduct
business. Define conservatorship: The concept of conservatorship comes from the FDIC. The
FDIC becomes a conservator, takes over, when a bank is to big to sale or it fails to quickly. I
also discussed the difference between “receivership”, the liquidation of the institution, versus
“conservatorship”, the take-over with the hope of preserving it for sale. I told them that the FDIC
rarely uses “conservatorship” and mainly uses “receivership.”
We discussed the two articles: White House Plans to Revamp the Mortgage Market // The End of
Fannie Mae. I focused on the following:
What are the three options for Fannie and Freddie currently under review by Congress? Option
1: The government would wind down the GSEs over the next five to seven years, and federal
guarantees would be limited to Federal Housing Administration loans. The benefits of this
option would be to reduce moral hazard in mortgage lending. The cons are that it would
potentially led to higher borrowing rates and reduce access to credit. It is believed that this
option would put significant stress on an already fragile market. Option 2: introduces a new GSE
that would stay small in normal times, but would stand ready to step in if a future housing crisis
came about. Option 3: the administration envisages a group of tightly regulated, well
capitalized mortgage insurers whose policies would be backstopped by the backing of the
government and the government would charge premiums for the insurance.
The articles claim that some 92% of all new mortgages are currently underwritten or guaranteed
by the government.
I defined the following terms: LTV, curtailment, PMI, and overcollateralized.
Then, I should the video about “Strategic Default.” - An excellent video.
Lecture 2/17/2011
In this lecture, I used power point slides and an excel file for mortgage valuation, which I have
attached to the email. I was unable to cover the Mortgage Portfolio valuation, but I did spend a
lot of time discussing negative convexity. I told them that you would post my lecture slides and
the mortgage calculator excel file on your website.
Here is a brief recap of what we discussed:
In finance, we have three basic types of loans: a pure discount loan, an interest-only loan and
amortized loans. I told them that a great example of a pure discount loan was a Treasury Bill –
borrower receives $X today and agrees to pay back $Y ($X + $I) in the future. Interest only
loans do exist in the mortgage market and they are equivalent to treasury bonds, where the
coupon payments represent the interest payments and the principal is all due at maturity. Most
mortgages are amortized loans – meaning that the payments include both principal and interest. I
emphasized that the interest portion of the monthly payment decreases at an increasing rate and
that the principal portion of the monthly payment increases at an increasing rate. This fact can be
observed in the excel file.
We focused on the components of the mortgage loan: (1) the collateral and (2) the agreement.
We also discussed the implications of the lien on a home. We also discussed the four types of
mortgage loans: (1) residential, (2) multifamily, (3) commercial, and (4) farm. I pointed out that
most residential mortgages are standardized, based on acceptable credit levels; whereas
multifamily and commercial loans are like other bank loans – the terms of the agreement can
vary wildly from one borrower to the next.
Next, we examined the Federal Reserve’s Release Date (the web link is in my power point
slides). The key finding from the data:

Total mortgage debt outstanding in the United Stats has been declining since 2008. The
amount is now approximately $13.947 trillion.



Most of the outstanding debt is owned by either Financial institution or Federal and
Related Agencies.
Of the four types of mortgages (listed above), residential mortgages represent the largest
share of outstanding debt.
The most interesting finding … We noticed an interesting trend that the amount of
Federal and Related Agency ownership jumped from approximately 0.816 Trillion by the
end of 2009 to 5.211 Trillion by Q1 2010. This jump in ownership was off-set by a
decrease in Mortgage pools and trusts from 7.581 trillion at the end of 2009 to 3.114
trillion by Q1 2010. This suggests that securitization of mortgage loans has diminished
with the agencies more likely to hold the mortgage.
I revisited the loan-to-value ratio and its relationship with borrower default rates. I did this to
discuss the importance of an escrow account (insurance and taxes) and distressed collateral.
Next, I tied this discussion in with the video that we watched from the previous class.
A substantial portion of the class was spent discussing the prepayment option. I told them that
the prepayment option was an embedded option built into the contractual agreement between the
borrower and the lender. We discussed the two reasons for prepayment: (1) the liquidity
motivation, and (2) the financial motivation.
I revisited financial intermediation, DSU and SSU and tied this into the mortgage lending
process, which includes origination, servicing and investment. I told them that textbook suggests
that it would be inefficient for a single financial institution to engage in all three components and
that it is more advantageous to specialize in one or two of the three components. The idea of not
having to be responsible for all three major aspects of a mortgage loan is referred to as
disintermediation. Accordingly, disintermediation has led to substantial growth in the mortgage
market.
We spent a lot of time discussing securitization and how it has facilitated disintermediation in
financial markets. I also discussed the process of securitization in the creation of mortgage
backed securities and collateralized mortgage obligations. I explained the process for create both
the MBS and the CMO; I connected this to the risk of prepayment.
Using my Mortgage Calculator (Excel File), I was able to make a mortgage loan and see the
effect of parameter value changes. I should them the difference between the total payments of a
15 year fixed rate mortgage and a 30 year fixed rate mortgage, all else constant. We also
examined the effect of curtailment, additional monthly payments.
Next we examined the adjustable rate mortgage. We talked about the potential rate changes and
the effect on the borrowers monthly payment, as well as the many different indexes used in the
market place. I told them that an ARM consists of two major components: (1) the index value –
either the Libor, 1-Year Constant Maturity Treasury or the cost of funds index, and (2) the
margin – the perceived riskiness of the borrower. I explained to them that a 7/1 ARM will have
a fixed rate for seven years, and then it will re-price annually for the reminder of the loans life.
Moreover, most ARMs contain a rate cap and a rate floor to protect both the borrower and the
lender from significant changes in interest rates. We also briefly talked about the teaser rate and
worked problem 22. A concluded this section by discussing a balloon mortgage and interest-only
mortgage.
**I skipped the mortgage valuation section. You may want to go back and briefly discuss this
section.
I finished class with mortgage duration and mortgage convexity in comparison to a bond with no
embedded options. (I did not use the power points slides for this section). I drew the mortgage
value to interest rate graph on the board – discussed the duration and the implications of the
negative convexity. I told them that it was important to understand the economic rationale
behind the shape of this graph.
The End.