Part-22

Mortgages &
Mortgage-Backed Securities
Mortgage Markets
 These are markets where funds are
borrowed to finance the acquisition
of houses.
 A mortgage is a pledge of property to
secure payment of a debt.
 Such loans are made by banks and
financial institutions, and are
collateralized by the property so
acquired.
Mortgages
 The borrower is the mortgagor.
 The lender is the mortgagee.
 In 1990 the mortgage finance
market in the U.S. was larger than
the markets for U.S government
securities and U.S. corporate bonds
combined.
Mortgage Originators
 The entity that initiates the
mortgage loan is called the
Originator.
 Originators include:
 Commercial Banks
 Life Insurance Companies
 Pension Funds
 Savings & Loan Institutions or Thrifts
Sources of Income For The
Originator
 They charge an origination fee.
 This is expressed in terms of points.

A point is 1% of the borrowed funds.

For instance a fee of 2 points on a loan of
$100,000 is $2,000.
 The originators can subsequently sell
the loans in the secondary market.
 If interest rates have declined they
will make a capital gain.
Income For The Originator
 If the originator chooses to hold the
loan as an asset, he will earn interest
income.
Credit Evaluation
 Before extending a loan the originator
will make a credit check.
 There are two main factors to be
evaluated.
 The Payment to Income Ratio (PTI)
 It is the ratio of the monthly installment due
from the mortgage to the applicant’s monthly
income.
 The lower the PTI the better the chances of
getting the loan.
Credit Evaluation
 Loan to Value Ratio (LTV)
 It is the ratio of the loan amount to the
market value of the property.
 The lower the ratio, the more is the
protection for the lender.
Mortgage Servicing
 Once a loan is made, it has to be
serviced.
 Servicing can be done by the
lender himself, or can be
contracted out to an external
agency.
Servicing
 Servicing involves the following activities.
 Collection of monthly payments.
 Sending payment notices to the mortgagors.
 Sending reminders for overdue payments.
 Maintaining records of outstanding principal.
 Initiating foreclosure proceedings if required.
Sources of Income For The
Servicer
 He gets a servicing fee.
 The fee is a fixed percentage of the
outstanding mortgage balance.
 As each installment is made, the
outstanding balance will decline.
 Hence so will the servicing fee.
Servicing Income
 Servicers also earn a float on the
monthly mortgage payment.
 This is because there is a delay
between the time they receive the
payment and the time they pass it on
to the lender.
 They also earn a late fee if
payments are overdue.
Mortgage Insurance
 Lenders require mortgage insurance as a
safeguard against default.
 The cost is borne by the borrowers in the form
of a higher rate of interest.
 Many mortgagors acquire Credit Life
Insurance from life insurance companies.
 Such insurance provides for a continuation of
monthly payments even if the mortgagor were
to die.
 Thus dependents will not lose possession of
the property.
Features of a Traditional
Mortgage
 A traditional mortgage is known as
a Level Payment Mortgage.
 Borrowers make fixed monthly
payments consisting partly of
principal repayment and partly of
interest on the outstanding balance.
 Loans which are paid off in such a
fashion are called Amortized Loans.
Features of Amortized
Loans
 Mortgages are usually for 20 years (240 months)
or for 30 years (360 months).
 The interest component is equal to one twelfth the
annual rate of interest multiplied by the amount
outstanding at the beginning of the previous month.
 With the payment of each installment, the interest
component will keep declining and the principal
component will keep increasing.
Amortization
 It refers to the process of repaying a loan
by means of equal installments at periodic
intervals.
 The installment payments form an annuity
whose present value is equal to the
original loan amount.
 A Amortization Schedule is a table that
shows the division of each payment into
principal and interest, and the
outstanding loan balance after each
payment.
Calculating The
Installment
 Consider a loan to be of $L to be
repaid by way of N installments of
$A each.
 Let the periodic interest rate be `r’.
 L = A xAPVIFA(r,N)1=
x[1 − ]
r (1 +r ) N
Example
 A person has taken a loan of
$10,000.
 It has to be paid back in 5 equal
annual installments.
 Interest rate is 10% per annum.
 L = A x PVIFA(10,5) = A x 3.7908
 A = 2,637.97
 Amortization Schedule
Year Payment Interest Principal Outstandin
Repayment g Principal

0 10,000
1 2637.97 1000 1637.97 8362.03

2 2637.97 836.20 1801.77 6560.26

3 2637.97 656.03 1981.94 4578.32

4 2637.97 457.83 2180.14 2398.18

Prepayments
 The mortgagor has a right to payoff the
mortgage prematurely either in part or in full
without significant penalties.
 Thus the borrower has a Call Option.
 For the lender it introduces cash flow uncertainty.
 The uncertainty about when and how a borrower will
prepay is called Prepayment Risk.
 Because of this risk the valuation of mortgages and
mortgages related securities is more complex.
Reasons For Prepayment
 The borrower may be selling the
house because he is changing jobs.
 He may be scaling up to a more
expensive place.
 He may be getting a divorce.
 Interest rates may have declined. If
so he can pay off the existing loan
and take a fresh loan at a lower rate.
Reasons for Prepayment
 The lender may be selling the
property due to non payment of dues.
 There could be a fire or a natural
calamity which destroys the property.
If so, the insurance company will pay.
Pooling of Mortgages
 Mortgage originators do not
usually hold on to the loans made
by them, but rather sell them.
 In order to sell these loans, many
small loans are put together as a
collection, called a Mortgage Pool.
Rationale for Pooling
 Consider ten separate loans of $100,000 each.
 Assume that each loan has been made by a
separate lender.
 Every lender therefore faces prepayment risk.
 It is not easy for a lender to forecast prepayments,
since each is dealing with an individual borrower.
 Prepayment behaviour will obviously differ from
borrower to borrower.
Rationale for Pooling
 If these ten loans were to be pooled, then
the average prepayment is likely to be
more predictable and statistical tools of
analyses can be used.
 However it is expensive for one party to
own the pool since it would entail an
investment of 10MM.
 However the pooled loans can be used as
collateral to issue securities in large
numbers to enable individual investors to
invest.
Securitization
 Securitization is a process of converting a
pool of illiquid assets into liquid financial
instruments.
 In the case of mortgages, the pool serves as the
source for the payments which have to be made
on the assets which are issued with the pool as
collateral.
 Because of the ability to securitize, lenders can
repeatedly rollover their investments in
mortgages and the country as a whole gets
greater access to housing finance.
Standardization
 Before pooling mortgage loans care is taken
to standardize the loans.
 This means that all the pooled loans will
have:
 The same rate of interest.
 The same period to maturity.
 The same kind of insurance.
 The same kind of property.
 And will come from the same geographical
location.
Standardization
 The advantage of standardization is that
the cash flows from the pool are easier
to predict.
 Although each mortgage loan is insured
individually, some times the pool as a
whole is additionally insured.
 A mortgage pool is therefore like a large
loan with a coupon rate and term to
maturity.
Special Purpose Vehicles
(SPVs)
 Before securitization, the pool of mortgages
is transferred to an SPV.
 An SPV is a separate legal entity that is set up for
the purpose of issuing mortgage backed
securities.
 The objective is to ensure that there is a distance
between the originators and the pool.
 Thus even if the originators were to go bankrupt,
it would not affect the pool held by the SPV.
Mortgage Backed
Securities
 The net result of securitization is
the creation of assets which are
backed by the underlying pool of
mortgages.
 These assets are claims on the
cash flows that are generated by
the underlying pool.
Federal Agencies
 These are organization which are
essentially private, but are sponsored by
the U.S. government.
 Their mandate is to serve as intermediaries
in specified sectors of the economy.
 They were created to enable special interest
groups like homeowners, farmers, and
students to borrow at affordable rates.
Major Agencies
 Federal Home Loan Bank.
 Federal National Mortgage
Association – Fannie Mae.
 Federal Home Loan Mortgage
Corporation – Freddie Mac
 Student Loan Marketing
Association – Sallie Mae
Major Agencies
 Freddie Mac and Fannie Mae
operate in the mortgage market.
 They were set up to promote a liquid
secondary market for mortgages.
 Sallie Mae was set up to promote a
market for student loans.
 All three are listed on the NYSE and
are publicly owned.
Ginnie Mae
 The Government National Mortgage
Association – Ginnie Mae also promotes a
liquid secondary market for mortgages by
guaranteeing mortgage backed securities.
 However it is not a private agency, but is a
government owned corporation.
 Thus all securities guaranteed by Ginnie Mae are
effectively guaranteed by the Federal
Government.
Pass-throughs
 A pass-through is a type of
mortgage backed security.
 It is formed by pooling mortgages and
creating undivided interests.
 Undivided, means that each holder of
a pass-through has a proportionate
interest in each cash flow that is
generated from the underlying pool.
Illustration
 Consider 10 loans of $100,000 each that
are pooled together.
 Assume that an agency purchases these
loans and issues fresh securities using
these loans as collateral.
 This is the function of Ginnie Mae, Fannie
Mae, Freddie Mac etc.
 Assume that 40 units of such securities
are sold.
Illustration
 Thus each security will be worth $25,000.
 Each security will be entitled to
1/40 th or 2.5% of each cash flow
emanating from the underlying pool.
 The net result is that by investing $25,000
an investor gains exposure to the total pre-
payment risk of all ten loans rather than to
the risk of a single loan.
 This is appealing from the point of risk
reduction.
Collateralized Mortgage
Obligations (CMOs)
 Now consider the case where the ten
loans are pooled to issue three
categories of securities.
 Class A Bonds: Par Value of $400,000
 Class B Bonds: Par Value of $350,000
 Class C Bonds: Par Value of $250,000
 For each class, multiple units of a
security that represents that particular
class are issued.
CMOs
 For instance if 50 units of class A
bonds are issued, then each will have
a face value of $8000.
 Each will be entitled to 2% of the cash
flows receivable by the class as a whole.
 Assume that the cash flows are
distributed according to certain pre-
decided rules.
Example Of Distribution
Rules
 Class A securities will receive all principal
payments – both scheduled and unscheduled until
the entire par value is paid off.
 Once class A securities have been fully retired,
class B bondholders will start receiving principal
payments – scheduled and unscheduled, until the
entire par value is paid off.
 After class B securities are retired, class C security
holders will start receiving principal payments.
CMOs
 All security holders will receive interest every
period, based on the amount of the par value that
is outstanding for that particular class.
 This is an example of a CMO.
 In this case certain categories of securities will
receive payments before others.
 Unlike a pass-through, all securities are not
equally exposed to pre-payment risk.
CMOs
 Class A bonds will absorb
prepayments first, followed by
class B, and then by class C.
 Class A bonds will have a shorter term
to maturity than the other two
categories.
 Class C securities will have the
longest maturity.
A Pass-Through
A Detailed Illustration
 A person has borrowed $4800 to buy a
house.
 He agrees to pay $100 every month as
principal repayment, and to pay interest
every month on the outstanding principal at
the rate of 6% per annum.
 A total of 48 payments are due.
 The first payment will be $124 which
consists of $100 by way of principal
repayment and $24 by way of interest.
Illustration Cont…
 The last payment due will be $100.50 which
will consist of $100 by way of principal
repayment and $0.50 by way of interest.
 We will assume that there are 4 owners who
agree to share each payment equally.
 If payments are made as per schedule, each
party will receive $31 after the first month, and
$25.125 in the last month.
Illustration Cont…
 Assume that at the end of three months the
mortgagor pays an extra $40 by way of
principal.
 So each of the four owners will get an extra
payment of $10.
 Since $10 is prepaid the monthly interest in
subsequent months will go down by 20 cents.
 In the last month (48th ) the mortgagor will pay
$60 by way of principal and 30 cents by way of
interest.
Illustration of CMO
 Assume that instead of agreeing to share the payments
equally, the four owners want the following system.
 Party A wants his principal back by the end of the first year.
 Party B wants his principal by the end of the second year.
 Party C wants his principal by the end of the third year.
 Party D wants his principal during the last year.
CMO Illustration Cont…
 So every month all the investors will get
interest on the amount outstanding to them.
 But all principal payments will go first to A.
 Once A is fully paid, B will start receiving principal
payments.
 After B is fully paid, C will start receiving principal
payments.
 Finally D will start getting principal payments.
CMO Illustration Cont…
 In the first year A will get $100 every month plus
interest on the outstanding balance.
 The other three will get interest of $6 per month.
 From the 13th month B will start receiving $100
per month plus interest on the outstanding
balance.
 From the 25th month C will start receiving $100
per month.
 From the 37th month D will start receiving $100
per month.
CMO Illustration Cont…
 Each class of ownership is called a tranche.
 A CMO must obviously have a minimum of 2
tranches.
 Now assume that in the third month the mortgagor
makes an extra payment of $40.
 This will entirely go to party A.
 In subsequent months he will continue to get $100 by way
of principal repayments, but will receive 20 cents less by
way of interest.
CMO Illustration Cont…
 In the 12th month he will get only $60.
 The remaining $40 will go to B.
 In the 24th month, B will get $60 and C
will get $40.
 In the 36th month, C will get $60 and D
will get $40.
 Such a distribution principle is
called Sequential Pay Prepayment.
Differences Between
Conventional Bonds and
Mortgage Backed Securities
 In a conventional bond the principal is
returned in one lump sum at maturity.
 Holders of mortgage backed securities
receive their principal back in installments,
as the underlying loans are paid off.
 Since the speed and timing of principal
repayments can vary, the cash flows on
mortgage backed securities can be very
irregular.
Mortgage Backed
Securities
 When a homeowner prepays, the remaining
stake of the holders of the mortgage backed
securities will be reduced by the same amount.
 Since the principal outstanding will reduce, the
interest income will also decrease.
 The monthly cash flow for a mortgage backed
security will be less than the monthly amount
paid by the mortgagors.
 The difference is equal to the servicing and
guaranteeing fees.
Categories of Pass-
throughs
 Ginnie Maes
 Fannie Maes
 Freddie Macs
 Private Label
Features of Ginnie Maes
 They are backed by the full faith and
credit of the U.S. government.
 The underlying mortgage pools are
assembled by private parties, but
are approved by Ginnie Mae before
sale to the public.
 The U.S. Treasury guarantees
interest and principal payments on
Ginnie Maes.
Freddie Mac
 Freddie Mac issues participation
certificates or PCs.
 These are not guaranteed by the
Treasury.
 FHLMC itself provides the guarantee.
 Consequently yields on Freddie Mac PCs
are higher than those on Ginnie Maes.
Fannie Maes
 These are similar to Freddie Mac PCs.
 The guarantee to holders is provided by FNMA
and not by the Treasury.
 Yields are higher than those on Ginnie Maes
but are comparable to the yields on Freddie
Mac PCs.
 Common perception is that the U.S.
government will never allow FNMA to default.
 Thus there is an implicit guarantee.
Private Label Pass-
throughs
 These are issued by independent
organizations like commercial
banks.
 They have no connection with the
government.
 Consequently the yields on them
tend to be higher.
Asset Backed Securities
 These are similar to mortgage
backed securities.
 But the assets which are pooled
are not home loans.
 Examples of such assets include
credit card receivables, automobile
loan receivables etc.