Chapter 19:

The Secondary Mortgage

Market: Pass-Through
Securities
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Secondary Mortgage Market
 Allows originators to replenish funds
 Facilitates geographic flow of funds
 Provides an investment option for savers
 Early buyers of mortgages
– Mortgage companies and thrifts
 FHA insurance and VA guarantees
– Minimum underwriting standards

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 Secondary Mortgage Market
 1954 Charter Act: FNMA or “Fannie Mae”
– Enhance secondary market operations
 FHA and VA mortgages
– Manage prior direct loans
– Manage special assistance programs
– FNMA transforms into a private organization
– FNMA issues securities
– The “Treasury backstop”
– As of 2008, Fannie Mae is under government control

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 Secondary Mortgage Market
 HUD Act 1968: GNMA or “Ginnie Mae”
– GNMA manages and liquidates FNMA loan
portfolio
– Special assistance functions
– Guarantee timely payment of principal and
interest for FHA-VA mortgage pools
– Eliminated any default delay in payments to
investors. This led to virtual explosion in
secondary market and rise of pass-through
securities

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 Secondary Mortgage Market
 Emergency Home Finance Act 1970: FHLMC or
“Freddie Mac”
– Provide a secondary market for conventional loans
– Allowed FNMA to purchase conventional mortgages
– FHLMC allowed to purchase FHA and VA mortgages
– Fannie Mae and Freddie Mac compete for all
mortgage loans but they do tend to still focus on their
original lines of business
– As of 2008, Freddie Mac is under government control

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 Exhibit 19-1
Funds Flow Analysis (direct purchase programs)

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 Secondary Mortgage Market
 Operation
– Direct Sale Programs
 Mandatory Commitment
 Optional Delivery
 Mortgage-Related Security Pools
– Securitization

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 Secondary Mortgage Market
In this chapter and the next, we’ll cover
the major types of mortgage-backed
securities including:
1. Mortgage-backed bonds (MBBs)
2. Mortgage pass-through securities
(MPTs)
3. Mortgage pay-through bonds (MPTBs)
4. Collateralized mortgage obligations
(CMOs)
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 Exhibit 19-3
Mortgage Pass-Through Securities: Issuance and Funds
Flow

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– Issuer retains ownership of mortgages
– Mortgages held in trust
– Fixed coupon rate
– Specific maturity
– Over collateralization
– Mark to market

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– Investment Rating
 Mortgage Quality
 Geographic Diversification
 Interest Rates on Mortgages
 Prepayment Probability
 Over collateralization
 Appraised value and debt coverage ratio if
commercial mortgages

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– Example 19-1: Mortgage Bond Valuation
– 20-year to maturity
– Par value of $10,000
– 10.5% annual coupon.
– At issue, bond market investors require an
11% interest rate.
– What is the initial price of the bond?

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– Example 19-1:
FV = $10,000
n = 20

PMT = .105 x $10,000 = $1,050

i
= 11
= $9,601.83
CPT PV

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– In Example 19-1, what would be the price of
the bond 5 years later if investors required a
12% return?
– n is 15 years
– i is 12%

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– Example 19-1:
FV = $10,000
n = 15
PMT = $1,050

i = 12
CPT PV = $8,978.37

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 Secondary Mortgage Market
 Mortgage-Backed Bonds
– Zero-Coupon Bond
 The only cash flow to an investor is a lump sum at
maturity
 No interim coupon payments
 Also called “deep discount” bonds
 Analysis is just computing the present value of a
lump sum

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 Secondary Mortgage Market
 Mortgage Pass-Through Securities
– Ownership interest in a pool of mortgages
– Trustee is owner of the mortgages in the pool
– Principal and interest are passed through
– Servicing and guarantee fees

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 Secondary Mortgage Market
 Mortgage Pass-Through Securities
– Issuers & guarantors
– Default insurance
– Payment patterns and security
– Coupon rate and interest rates
– Seasoned mortgages

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 Secondary Mortgage Market
 Mortgage Pass-Through Securities
– Number of mortgages
– Geographic distribution
– Borrower characteristics
– Loan prepayment
– Nuisance calls

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 Secondary Mortgage Market
 General Pricing of MPTs
– Interest Rate Risk
– Default Risk
– Risk of Delayed Payment of Principal and
Interest
 As of 2008, Ginnie, Fannie, and Freddie are all
under government control
– Prepayment Risk

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 Secondary Mortgage Market
 General Pricing of MPTs
– Coupon rate vs. yield to maturity
– Servicing Fee
– Weighted Average Coupon (“WAC”)
– Stated Maturity Date
– Weighted Average Maturity
– Payment Delays
– Pool Factors

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 Secondary Mortgage Market
 Example 19-2:
– A mortgage pool consists of the following:
 $500,000 of 30-year 7% Fixed Rate Mortgages
 $200,000 of 29-year 6.5% Fixed Rate Mortgages
 $300,000 of 28-year 6% Fixed Rate Mortgages
– What is the weighted average coupon and
average maturity of the mortgage pool? If
there is a servicing fee of .5%, what is the
quoted maturity and quoted coupon rate?

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 Secondary Mortgage Market
 Example 19-2:

Amount Maturit Interest Weight WxM WxI

y Rate
$500,000 30 7% .5 15 3.5

$200,000 29 6.5% .2 5.8 1.3

$300,000 28 6% .3 8.4 1.8

$1,000,000 WAM = WAC = 6.6

29.2
 Quoted Maturity = 30 Years
 Quoted Coupon Rate = 6% - .5% = 5.5%
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 Secondary Mortgage Market
 Pricing Issues
– Mortgage-Backed Bonds
 Specified maturity
 Specified coupon payment and face value
 Pricing methodology is relatively straight forward
– MPTs
 Cannot define a specific maturity
 Cannot define specific cash flows
 Pricing is based on prepayment assumptions

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 Secondary Mortgage Market
 Prepayment Assumptions
– Average Maturity Assumption
– Constant Prepayment Rate Assumption
– FHA Prepayment Experience
– PSA Prepayment Model
 Convexity
– Price Compression

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