Our goal in this chapter is to examine the investment characteristics of mortgage pools .
Mortgage pools are simply sets of home mortgages, which are "bonds" issued by home owners.
A Brief History of Mortgage-Backed Securities
Traditionally, local banks wrote most home mortgages and then held the mortgages in their portfolios of interest-earning assets.
Then, when market interest rates climbed to near 20% in the early 1980s, bank customers flocked to withdraw funds from their savings deposits to invest in money market funds.
Today, a mortgage originator usually sells the mortgage to a mortgage repackager, who accumulates them into mortgage pools .
A Brief History of Mortgage-Backed Securities, Cont.
Financed by mortgage-backed bonds (also called mortgage pass-throughs ), each mortgage pool is set up as a trust fund.
A servicing agent collects the mortgage payments from the home-owners and then passes the cash flows through to the bondholders.
The transformation from mortgages to mortgage-backed securities (MBSs) is called mortgage securitization .
A Fixed-Rate Mortgage is a loan that specifies constant monthly payments at a fixed interest rate over the life of the mortgage.
The size of the monthly payment is determined by the requirement that the present value of all monthly payments , based on the financing rate specified in the mortgage contract, be equal to the original loan amount .
Fixed-Rate Mortgage, Monthly Payments
The equation to calculate the payment required to “retire” a fixed rate mortgage is:
In the equation, r is the annual mortgage financing rate, and T is the number of years in the mortgage term.
Mortgage Payments, by Rate and Time
Fixed-Rate Mortgage Amortization
Each monthly mortgage payment has two separate components:
Payment of interest on outstanding mortgage principal
Pay-down, or amortization , of mortgage principal
The relative amounts of each component change throughout the life of the mortgage.
Example: Fixed-Rate Mortgage Amortization
Suppose a 30-year $100,000 mortgage loan is financed at a fixed interest rate of 8%.
Mortgage amortization can be described by an amortization schedule .
An amortization schedule states the scheduled principal payment, interest payment, and remaining principal owed in any month.
Mortgage Amortization Schedule
Mortgage Interest and Principal, by Age of Mortgage
Fixed-Rate Mortgage Prepayment and Refinancing
A mortgage borrower has the right to pay off all or part of the mortgage ahead of its amortization schedule. This is similar to the call feature of corporate bonds and is known as mortgage prepayment .
During periods of falling interest rates, mortgage refinancings are an important reason for mortgage prepayments.
This means that mortgage investors face the risk of a reduced rate of return.
Government National Mortgage Association
The Government National Mortgage Association ( GNMA ), or “ Ginnie Mae ,” is a government agency charged with the mission of promoting liquidity in the secondary market for home mortgages.
GNMA mortgage pools are based on mortgages issued under programs administered by
The Federal Housing Administration (FHA)
The Veteran’s Administration (VA), and
The Farmer’s Home Administration (FmHA).
Government National Mortgage Association
Mortgages in GNMA pools are said to be fully modified because GNMA guarantees bondholders full and timely payment of both principal and interest.
Although investors in GNMA pass-throughs do not face default risk, they still face prepayment risk.
Prepayments are passed through to bondholders.
If a default occurs, GNMA fully “prepays” the bondholders.
Besides GNMA, there are two other significant mortgage repackaging sponsors.
Federal Home Loan Mortgage Corporation ( FHLMC ), or “ Freddie Mac ,” and
Federal National Mortgage Association ( FNMA ), or “ Fannie Mae .”
Both are government-sponsored enterprises (GSEs) and trade on the New York Stock Exchange.
GNMA Clones, Cont.
Like GNMA, both FHLMC and FNMA operate with qualified underwriters who accumulate mortgages into pools financed by an issue of bonds.
However, because FHLMC and FNMA are only GSEs, their fully modified pass-throughs do not carry the same default protection as GNMA fully modified pass-throughs.
That is, Congress may or may not be willing to rescue a financially strapped GSE.
PSA Mortgage Prepayment Model, I.
Mortgage prepayments are typically described by stating a prepayment rate , which is the probability that a mortgage will be prepaid in a given year.
Conventional industry practice states prepayment rates using a model specified by the Public Securities Association (PSA).
Prepayment rates are stated as a percentage of a PSA benchmark.
PSA Mortgage Prepayment Model, II.
In the PSA model, the rates are conditional on the age of the mortgages in the pool. They are conditional prepayment rates (CPRs) .
For seasoned ( > 30 months old) mortgages , the CPR is constant at 6% annually for 100% of the PSA benchmark (100 PSA).
For unseasoned (< 30 months old) mortgages , the CPR rises steadily in each month until it reaches an annual rate of 6% in month 30 (for 100 PSA).
PSA Mortgage Prepayment Model, III.
PSA Mortgage Prepayment Model, SMM
By convention, the probability of prepayment in a given month is stated as a single monthly mortality (SMM) .
The SMM is based on the conditional prepayment rate, CPR.
The equation for an SMM is:
SMM = 1 – (1 – CPR ) 1/12
PSA Mortgage Prepayment Model, Average Life
The average life of a mortgage in a pool is the average time for a single mortgage in the pool to be paid off , either by prepayment or by making scheduled payments until maturity .
For a pool of 30-year mortgages:
Prepayment Schedule Average Mortgage Life (years) 50 PSA 20.40 100 PSA 14.68 200 PSA 8.87 400 PSA 4.88