REAL ESTATE FINANCE
Ninth Edition
John P. Wiedemer and J. Keith Baker
Chapter 5
Mortgage Money: The Secondary Market
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LEARNING OBJECTIVES
At the conclusion of this chapter, students will be able to:
• Describe the changes that caused most primary lenders to cease to be
permanent investors in residential mortgage loans.
• Describe how the development of uniform loan origination documents
and expansion of the private mortgage insurance market impacted the
growth of the secondary mortgage market.
• Understand how yield on mortgages and market yield requirements
affect the pricing of mortgages and mortgage securities.
• Explain the basic differences between mortgages purchased for
portfolio purposes and those purchased for underwriting.
• Describe the concept of federal underwriting.
• Understand the specific details of the major federal loan programs.
• Describe the evolution of loan pooling and its importance to the other
primary sources of securitization in facilitating real estate
mortgage financing.
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Introduction
• Using deposits to fund mortgage loans worked fairly well for about four
decades following the Great Depression of the 1930s.
• During this time there was a federal limit on interest rates that never
exceeded 5.5% paid to depositors.
• Lenders could make loans at around 8% with a reasonable return.
• Access to this low-cost source of funds ended when interest rates
exceeded 16% in the 1970’s.
• The secondary market began with loan purchasers who normally
invested in mortgage loans.
• It was not until the development of the mortgage-backed security,
which converted mortgage loans into a more acceptable type of
security, that the secondary market was opened to investors
throughout the international financial markets.
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Expansion of the Secondary Market
• Other problems limited the mortgage market prior to the 1970s.
• It was difficult to sell mortgage loans for two important reasons.
• First, the documents used for conventional loans were not uniform;
second, there was no acceptable insurance protection against default.
• Only the FHA and VA were able to overcome these problems.
• Both offered uniform documentation that enabled an investor anywhere
to know in exactly how a note and mortgage instrument would be
worded, and both offered an underwriting guarantee or insurance.
• In 1972 steps were taken to create a class of conventional loans
offering similar advantages to the FHA/VA loans.
• The move was made by Fannie Mae in an effort to increase its market
since FHA/VA comprised only 20% of the market.
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Introduction of Uniform Documentation
• In 1968 Fannie Mae was partitioned by Congress; one part became
Ginnie Mae and the other remained Fannie Mae but converted to a
federally chartered private corporation.
• Obviously, conventional loans with 80% of the market offered a big
opportunity for expansion for a private corporation.
• Thus Fannie Mae and Freddie Mac began devising uniform documents
acceptable for conventional loans.
• Together these three government-sponsored enterprises (GSEs)
introduced new uniform documentation.
• The result was the conforming loan, with uniform documents and loan
qualification parameters is readily marketable throughout the country.
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Private Mortgage Insurance (PMI)
• In 1972 the problem posed by lack of default insurance was resolved.
• At that time, the Fed approved the writing of 95% loans.
• Loans with a LTVs higher than 90% required insurance against default.
• Prior to that time there had been no default insurance requirement.
• Within months, the private mortgage insurance industry came alive.
• With uniform documentation and private mortgage insurance, the
secondary market was able to expand beyond trading in FHA/VA loans.
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Selling Mortgage Loans
• So what is the secondary market?
• The secondary market is where loan originators are able to sell loans,
thus recovering their cash for the purpose of originating more loans.
• Secondary market investors do not “lend” money; they “purchase”
mortgage notes as investments to earn a return.
• The return is called yield and is the money earned on an investment.
• Yield is the combination of interest earned over the life of the loan plus
the discount taken at loan origination.
• These are combined and expressed as an annual return.
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Procedures Used in Secondary Markets
• Note the difference in terminology at this point.
• The originator speaks in terms of loaning money, and expresses the
cost of the borrowed money as interest plus points and fees.
• Once the originator closes the loan, the note and mortgage become
marketable paper that can be assigned—and the terminology changes.
• The mortgage note is now a salable commodity and negotiated as such.
• The originator is now a seller and the secondary market the purchaser.
• The secondary market is interested in only one factor, the net yield.
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Pricing Loans to Adjust Yields
• Since the interest rate on the loan has already been established, the
only way a seller can change the yield is to adjust the price of the loan.
• If the mortgage note is $10,000 at 7% interest, the yield would be 7%.
• If the seller must offer a yield higher than 7% to attract a purchaser, the
loan must be sold for less than $10,000.
• By selling the $10,000 loan for $9,500, the purchaser puts up less cash
but still collects the originally agreed interest and principal payment.
• The result is a greater return, or yield, for the $9,500.
• So the price on a mortgage note is quoted as a percentage figure.
• The price is that percentage of the loan balance for which the loan is
sold.
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Yield and Discount
• Yield is the return to the investor expressed in a percentage of the price
paid for the note.
• Discount is the difference between the face value of the note and the
price the investor paid for the note.
• Yield includes both the interest earned and the discount taken.
• So to express the discount as a part of the yield, it must be converted
to an annual percentage rate.
• The discount is a one-time charge taken at the time the loan is funded.
• To determine how much it adds to each year’s yield, the discount must
be converted to an annual amount spread over the life of the loan.
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Yield and Discount
• While most residential loans are for 30 years, the realistic life of a loan
is about 12 years and then paid off.
• Fannie Mae and Freddie Mac use a time span of 12 years to determine
the yield value of a discount.
• In round figures, this means that one-twelfth of the discount amount
would be considered as earned each year.
• The purchase requirements for Fannie Mae to buy a loan are expressed
in terms of a net yield usually carried to two decimal places.
• The mortgage banking industry uses Fannie Mae’s and Freddie Mac’s
daily posting of required yields on which to base its own loans.
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Points
• A point is one percent of the loan amount.
• In mortgage lending, discounts are sometimes identified as “points.”
• But the two words, point and discount, are not synonymous.
• A point is frequently used to identify other costs such as mortgage
insurance premiums, an origination fee, a finance charge, and others.
• The IRS allows a buyer to take a tax deduction on all discount points
paid, regardless of the purpose, whether paid by buyer or seller.
• To identify fractions of a point there is a finer measure.
• A basis point is one one-hundredth of 1% (not of the loan amount).
• A servicing fee of 0.25%, can also be called “25 basis points.”
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Loan Purchasers
Loan purchasers operate in two different ways:
1. Purchase for portfolio.
2. Acquisition for underwriting.
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Purchase for Portfolio
• The secondary market originated with the idea of purchasing mortgage
loans to be held in portfolio.
• The largest group of loan purchasers was savings institutions.
• Their cost of funds had been protected by the federal limitation on
interest rates paid to their savings account depositors.
• The federal limit was removed in 1986.
• To hold deposits, savings associations had to pay higher rates to their
depositors, as they could not call in their long-term mortgage loans.
• The result was devastating losses for savings institutions and a general
dissatisfaction with the “portfolio approach” to mortgage loans.
• Nevertheless, there remains a substantial market for mortgage loans
purchased by those who hold them as investments.
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Purchase for Underwriting
• “Purchase for underwriting” are loans purchased for the express
purpose of creating mortgage loan pools.
• A mortgage pool is a block of loans.
• The pool can be made up of a particular kind of loan distinguished by
collateral, geographically, all FHA/ VA, or a block of commercial loans.
• Purchasers are mostly investment bankers, commercial banks, Fannie
Mae, and Freddie Mac.
• These purchasers then issue a series of securities that are backed by
the mortgage pool.
• The securities are then sold to various investors.
• Payments are received on the individual loans and the cash flow is then
“passed through” to the investors who bought the securities.
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Purchase for Underwriting
• How do participants in the creation of mortgage pools make money?
• Think of it as selling the cash flows rather than the mortgages.
• The mortgages are not delivered to the buyer of a mortgage-backed
security; just the cash flows generated by the mortgages.
• There must be a margin between what the mortgages deliver in cash
flows and what is passed on to the holders of the securities.
• That margin is generated by three factors:
1. Investors in high-grade securities accept lower interest rates than
those produced by the mortgages because of the lower risk.
2. Larger investments are made for lesser rates than are small ones.
3. By segmenting the cash flows to the security holders, issuers can
attract even lower cost money from the short-term money market.
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Purchase for Underwriting
• There are two factors that account for the attraction of mortgagebacked securities over holding mortgages themselves.
• First, a security is more easily sold than a mortgage loan, thus
providing greater liquidity should cash be needed.
• Second, the security can carry an additional protection against loss
that was not available for the individual mortgage loan.
• The additional protection is an underwriting guarantee of the
mortgage-backed security by a federal agency.
• About half of the mortgage-backed securities backed by residential
mortgage loans have this protection.
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Federal Underwriting of Mortgage Pools
• A trend that has enhanced the wide acceptance of mortgage-backed securities
has been the rapid growth of federal agency underwriting.
• Remember that the issuers of mortgage-backed securities earn a margin
between what the individual mortgages pay each month and what the issuers
have to pay the holders of the securities.
• Therefore, the larger the margin, the greater the profit and the lower the risk,
the lower the rate that has to be paid security investors.
• What federal underwriting has added is an element of reduction in the risk for
holders of mortgage-backed securities.
• Since reducing the risk for the investor encourages lower interest rates, the
long-range results are not only slightly higher margins for the issuers, but also
lower interest rates for home buyers.
• The federal underwriters are Ginnie Mae, Freddie Mac, Fannie Mae, and Farmer
Mac.
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Government National Mortgage Association (Ginnie Mae)
• Created by partitioning Fannie Mae in 1968 and assigned to HUD.
• Ginnie Mae belongs to the government and carries unique powers.
• Ginnie Mae must (1) implement special assistance for housing as may be
required by Congress or the president, and (2) manage the portfolio of loans
assigned to it by the partition from Fannie Mae.
• To liquidate some of the loans Ginnie Mae created pools and issued a
guarantee certificate backed by the pools as a type of security.
• Ginnie Mae pools are limited to FHA, VA, and RSA loans.
• Ginnie Mae does not purchase mortgage loans to create its pools.
• It approves poolers who purchase mortgage loans from originators.
• Ginnie Mae is the only one authorized to issue a government guarantee, backed
by the full faith and credit of the U.S.
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Federal Home Loan Mortgage Corporation (Freddie Mac)
• A federally chartered corporation owned primarily by the savings
association industry.
• It functions in a similar manner to Fannie Mae and is subject to HUD.
• Freddie Mac favors securitizing loans rather than purchasing loans.
• Freddie Mac raises money by sale of mortgage participation certificates
• The certificates are unconditionally guaranteed by Freddie Mac.
• This is an “agency” guarantee, not a federal government guarantee.
• But investors assume the government will not allow it to default.
• But there is no legal obligation for the government to do so.
• Most of its purchases are conventional loans that carry
private mortgage insurance there is less than 20% down.
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Federal National Mortgage Association (Fannie Mae)
• Fannie Mae began in 1938 as a government agency responsible for
purchasing only FHA loans.
• In 1968 it was converted to a federally chartered private corporation.
• It is subject to HUD and its policies must conform to government
requirements.
• Fannie Mae expanded its purchases from FHA/VA loans to conventional
• Fannie Mae has long followed the policy of selling short-term
securities, and using the proceeds to buy loans for its own portfolio.
• In 1982 it undertook the guarantee of mortgage-backed securities.
• The guarantee is an “agency” guarantee, like Freddie Mac’s.
• Fannie Mae began assembling its own blocks of loans to
use as collateral for other mortgage-backed securities.
22
Federal Agricultural Mortgage Corporation (Farmer Mac)
• Created to improve the ability of agricultural lenders to provide credit to
America’s farmers and rural homeowners, businesses, and
communities.
• Originally an underwriting agency for pools of farm loans.
• Farmer Mac granted approval for loan poolers and the loans that were
permitted in its pools.
• It can now purchase agricultural loans directly from originators and
issue its own 100% guaranteed mortgage-backed securities.
• Individual loans may not exceed $2.5 million, a measure intended to
preserve smaller, family-run farms.
• Loan pools may also consist of rural housing loans, defined as those
made to finance single-family residential dwellings in rural areas and
communities with populations of no more than 2,500.
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Mortgage Partnership Finance Program (MPF )
• In 1997 the Federal Home Loan Bank System started the Mortgage
Partnership Finance program to fund mortgage loans.
• The MPF program allows the FHL Bank to purchase mortgages from, or
fund them through, its participating member institutions.
• The program is limited to fixed-rate mortgages on one- to four-family
residences originated by these member institutions.
• The size of eligible loans is limited to conforming loan limits.
• The FHL Bank manages the funding, interest rate, liquidity, and
prepayment risks associated with the loans.
• Participating lenders eliminate the interest rate risk of their fixed-rate
loans while fully maintaining their customer relationships.
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Loan Pools
• Assembling a block of loans into a loan pool can be arranged by a
number of different types of companies.
• Loan pools serve as the collateral for a class of securities generally
identified as mortgage-backed securities.
• Three of the federal underwriters, Fannie Mae, Freddie Mac, and Farmer
Mac, serve a dual function.
• They may form their own pools and issue guarantee certificates for
themselves, or they may approve pools assembled by others.
• Either way, the guarantee enables those who pool loans to sell the
securities more readily and at slightly lower interest rates.
• The guarantee provides credit enhancement that reduces the risk.
• However, not all loan pools are guaranteed by a federal
agency, nor are all mortgage loans assigned to pools.
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Assembling a Loan Pool
• Two methods are used, one is to acquire the loans first; the other is to
first sell securities that provide cash for the purchase of loans.
• If acquiring the loans first, this may be done by either outright purchase
or by internal origination of the loans.
• Or one may first sell securities, then use the proceeds of the sale to
purchase the mortgage loans.
• This method is often implemented by the sale of tax-exempt bonds.
• Often by states and cities to fund various housing agency programs.
• If the originator later wants to sell them, the loans must comply with
that federal underwriter’s requirements.
• Once underwriting approval is obtained, a fee is paid to the federal
agency underwriter for the guarantee certificate.
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Tax-Exempt Bonds
• A tax-exempt bond is a type of security sold by states and cities paying
interest that is not subject to federal income taxes.
• Properties financed with tax-exempt bond money may be subject to a
recapture tax if sold during the early years of ownership.
• “Bond money” is available to consumers at lower cost because the
associated tax savings are generally passed on to the borrower.
• People in upper tax brackets are generally the ones attracted to
purchase these tax-exempt bonds.
• There is often an upper-income limitation for home buyers so as to
direct the money primarily to lower- and middle-income families.
• Another use of tax-exempt bonds is in financing industrial development
projects.
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Mortgage-Backed Securities (MBS)
• Mortgage loans carry certain problems as investments, such as a need
for long-term supervision of each individual loan and an uncertain
return caused by unpredictable prepayments.
• Most major investors are more comfortable dealing in securities, a type
of investment that can be bought and sold with greater ease than
mortgage loans.
• By packaging a block of mortgage loans to be held as collateral for an
issue of securities, mortgage loans are in effect converted to securities
and become more acceptable to investors.
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Mortgage Pass-Through
• Assemble a block of loans then issue securities backed by the loans.
• The issuer of the securities may or may not guarantee them.
• If the securities are issued by a private institution, they are seldom
guaranteed, and they are more difficult to sell.
• A government guarantee certificate made the security easy to sell.
• At first the purpose was to simply pass on the risk.
• Income from the block of loans was passed on to the security holders.
• If a loan was paid off early, the principal was passed through, thus
repaying a portion of the principal itself.
• If interest rates increased, payments on the loans remained unaffected.
• The pass-through created some uncertainty in its cash flows.
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Collateralized Mortgage Obligations
• Another variation on the mortgage-backed security is the Collateralized
Mortgage Obligation (CMO).
• The first CMO was issued by the Federal Home Loan Mortgage
Corporation in June 1983.
• It has several advantages over the mortgage pass-throughs that are
attractive to traditional investors in corporate-type bonds.
• By early 1986 securities dealers (investment bankers), home builders,
mortgage bankers, thrift institutions, commercial banks, and insurance
companies had also begun issuing CMOs.
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Differences between CMOs and Mortgage Pass-Throughs
• The innovation of the CMO structure lies in its segmentation of the
mortgage cash flows.
• The older pass-through type offers its holders an irregular cash flow.
• Whatever the particular pool produces in principal payments and
interest is then passed directly through to the security holders.
• The CMO investor owns bonds that are collateralized by a pool of
mortgages or by a portfolio of mortgage-backed securities.
• The variability and unpredictability of the underlying cash flows remain,
but the CMO substitutes a sequential distribution process.
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Structure of a CMO
The CMO structure creates a series of bonds with varying maturities that
appeal to a wider range of investors than do mortgage pass-throughs.
1. Several classes of bonds are issued against a pool of mortgage
collateral. The most common CMO structure contains four classes of
bonds. The first three pay interest at their stated rates from date of
issue; the final one is usually an accrual-class bond.
2. The cash flows from the underlying mortgages are applied first to
pay interest and then to retire bonds.
3. The classes of bonds are retired sequentially. All principal
payments are directed first to the shortest-maturity Class A bonds.
When these bonds are completely retired, all principal payments are
then directed to the next shortest– maturity bonds—the B class. This
process continues until all the classes of bonds have been paid off.
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Structure of a CMO
• One of the attractions of CMOs for investors is that some of the bonds
offer shorter maturities.
• Many investors prefer to make short-term investments.
• For the issuers of the securities, tapping the short-term money market
means they can pay a lower interest rate for the money used to buy
mortgage loans, thus enlarging the margin.
• Short-term money almost always receives lower interest rates than
long-term money.
• The first-priority Class A bonds offer maturities as short as two years.
• Class B and C bonds may offer maturities from four to ten years.
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Real Estate Mortgage Investment Conduits (REMIC)
• Does the issuer of a mortgage-backed security owe income taxes on
the interest income that is passed through to a security holder?
• To clarify the situation and avoid double taxation Congress approved
the Real Estate Mortgage Investment Conduit concept.
• A REMIC is a tax device that allows cash flows from an underlying
block of mortgages to be passed through to security holders without
being subject to income taxes at that level.
• Thus the interest income is taxed only to the security holder, not to the
trustee or agent handling the pass-through of cash.
• As a result most residential mortgage-backed securities adopt either
the pass-through or REMIC status, and by default most CMOs are
generally structured for tax purposes as REMICs.
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Questions for Discussion
1. Without a national mortgage exchange, how are mortgages traded in the United
States?
2. Explain the relationship between the price and the yield on a loan.
3. Define the term point and explain how it is used, and list the different charges
that can be quoted in points.
4. What market does Freddie Mac serve, and how does it raise money for the
purchase of mortgage loans?
5. How can tax-exempt bonds offer lower-cost mortgage money and how is this
money generally used?
6. Explain the two basic kinds of mortgage pools used to back securities and the
two different methods used to generate the securities.
7. Describe the impact of the originate-to-distribute model on the growth of the
subprime mortgage market.
8. Explain the differences between a CMO and a mortgage pass-through type of
security.
9. Define a mortgage purchase “for portfolio.”
10. Discuss the purpose and operation of Ginnie Mae.
11. What would be the price of a $100,000 loan if discounted by three points?
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