Mortgage-backed securities

According The Reference material I uploaded.The Question: Despite the criticism against mortgage-backed securities, MBSs provide real benefits to the mortgage market and to investors. Discuss its role in the growth of the mortgage market, and in portfolio management as a potential diversification tool.Requirement: Instructions: Follow the formatting of this document: font size 12, 1.5 line space, “normal” margin. Answer to each question is about 1 full page long (or at least 1 page, but do not exceed that length too much). Answers that are too short will not get full credit. Bibliography, graphs, and tables are not counted toward main text. Include them at the end of each essay.Bullet points copied from lecture slides are not accepted; you need to expand and explain them in details. Please think carefully and write your answers in a clear and logical way. Also for most questions, you want to support your arguments using dataCopying other people’s work is considered as plagiarism and will be penalized. Format of external citations: Example for in-text journal publications: “Chevalier & Ellison (J. Finance, 1999) found that the funds whose managers attended colleges with higher-SAT scores performed better.” You do not need to provide the full citation of this paper. Example for citing online articles: “In 2014, 85% of active large-cap stock funds failed to beat or match their benchmark index[1].”No need to cite the lecture slides.
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Markets for Residential Mortgages
and Mortgage-Backed Securities
Chapter 22, 23
Mortgage
? Mortg a g e s a re s e c ure d loa ns to individua ls
or b us ine s s e s to purc h a s e h om e s , la nd, or
oth e r re a l prope rty
? A ple dg e of re a l e s ta te prope rty to s e c ure
payment of a debt.
? Lender has right to foreclose the loan and seize the property
the property
? Acceptable collateral: residential or commercial
2
Mortgage Markets
Mortgage Primary and Secondary
Markets
3
Mortgage Markets
Mortgage Characteristics:
Credit Classification
? Prime, subprime, and alt-A loans
? Borrower’s credit quality
? Loan-to-value ratio
? A good predictor of default: higher LTV, greater chance to
default
? Private mortgage insurance (PMI) is generally required
when the loan-to-value ratio is more than 80%; in case of
default, PMI issuer pays the difference between property
value and remaining balance on mortgage.
4
Mortgage Markets
Mortgage Characteristics:
Credit Guarantees
? Guaranty provided by federal government, GSE or
private entity.
? Federal-insured loans (FHA- or VA-insured)
? guaranteed by the full faith and credit of the U.S. government
? eligible applicants (low income, veterans), size limit on
mortgage
? Conventional mortgages
? Maybe insured by primate mortgage insurer, or by GSEs when
securitized
5
Mortgage Markets
Mortgage Characteristics
? Amortized vs. balloon payment mortgages
? Fixed monthly payment consists of repayment toward
the principal and interest
? Balloon payment: fixed monthly interest payments +full
payment of the principal at maturity
? Fixed-rate mortgages vs ARM
? Fixed rate: fixed monthly payments; lenders assume
interest rate risk
? ARM: variable monthly payments; tie to market rate;
yearly interest rate changes are often capped; borrowers
assume interest rate risk; can increase default risk
6
Mortgage Markets
Mortgage history
? 1920s:
? Exclusively private sector and little federal involvement
? High down-pay, typical LVT ~60%
? Short maturity loan; interest only+ balloon payment
? 1930:
? Unemployment rate rise to 25%; 25% of home mortgages
in default
? 1933: HOLC (Home Owner’s Loan Corporation)
? financed by US congress, refinanced existing home
mortgages in default or at risk; assisted lenders by
providing them capital and refi problematic loans
? 15-year amortizing loan
7
Mortgage Markets
Mortgage history
? 1934: FHA
? guaranteeing mortgages for low-income people and it
was a vision that Roosevelt had to bring more and more
people into owning homes in this country.
? 1950s: 30-year mortgage
? 1990s: new kinds of mortgages; ARM; NINJA loans
8
Mortgage Markets
Mortgage history
? In general over time mortgages got more easy on
loan-to-value ratio and also on maturity
? Early time- more government intervention in the
mortgage.
? Since the 1990s, we’ve seen a proliferation of new kinds of
mortgages that especially are offered to low-income people
by certain lenders.
? Post economic recession of 2008 saw tighter
standards among mortgage lenders
9
Mortgage Markets
Mortgage Origination
? Income generated from mortgage origination
? Origination fee
? Sale of mortgage in secondary market
? Mortgage servicing fees
? Process
? Evaluating Credit Risk (primary underwriting standards:
payment-to-income ratio, loan-to-value ratio)
? Send commitment letter
? Choosing of type of mortgage
10
Mortgage Markets
11
Mortgage Markets
12
Mortgage Markets
Use of Mortgages by Originators
? Mortgage originators can either:
? hold the mortgage in their portfolio
? sell the mortgage to an investor
? use the mortgage as collateral for the issuance of a security
called s e c uritiz a tion
? Sale of mortgage
?
Conforming loans that meet agency underwriting standards
are more likely to be purchased by GSEs and be packaged to
create MBS; therefore conforming loans have lower interest
rates than nonconforming loans.
13
Mortgage Markets
Risks Associated with Mortgage
Origination
? Price Risk
? Risk of adverse effect on value if mortgage rates rise
? Originator should hedge against interest rate changes before
selling mortgages
? Fallout Risk
? risk that applicants with commitment letters will not close
(borrow has right to cancel)
? Originator can buy an option for optional delivery of mortgage
14
Mortgage Markets
Risks for Mortgage Investors
? Credit risk:
? Minimal if federal insured; depends on credit rating of private
insurers if privately insured
? Depends on credit quality of borrower and LTV for
conventional mortgage
? Liquidity risk
? Price risk
? Prepayment risk: risk associated with cash flows
15
Mortgage Markets
Secondary Mortgage Markets
? Market created by US gov’t to boost economy during
the great depression.
? After FIs originate mortgages, they either sell or
securitize them in the secondary market
? U.S. government deliberately involved in the
development of the secondary mortgage market
? Does gov’t sponsoring induces excessive risktaking behavior? Is fully privatizing a better option?
16
Mortgage Markets
Secondary Mortgage Markets
? Federal Home Loan Banks (FHLBs)
? Serve as a reserve credit system to support housing finance;
provide relief to troubled homeowners and lenders
? Federal Housing Administration (FHA)
? Insure certain mortgages against default risk
? Ginnie Mae: part of DHUD; guarantees MBS; carry
full faith and credit of U.S.
? Fannie Mae and Freddie Mac supports the liquidity
and stability of the mortgage market by
? Buying and selling mortgages; creating pass-through and
guarantee them
17
Mortgage Markets
Government Sponsored Entity
(GSE)
? Created by Congress to increase supply of capital to residential
mortgage market; were privately owned, publicly chartered
entities to fulfill a public mission;
? The securities issued by GSEs are not backed by full faith and
credit of U.S. government
? People are willing to lend to them at low rates since they are
sponsored by the government.
? Cost billions of taxpayer money, taken over by U.S. in 2008
(control over 80% ownership)
18
Mortgage Markets
Government Sponsored Entity
(GSE)
? Fannie Mae (1938 as a federal agency; 1968 became GSE):
originally act as a secondary mortgage market facility that could
purchase, hold, and sell FHA-insured loans.
? Freddie Mac (1970): initially to purchase long-term mortgages
from thrifts, increasing their capacity to fund additional
mortgages and reducing their interest rate risk; buy mortgages,
pool them and sell as MBS to investors; increases the supply of
money available for mortgage lending.
? Between 2004-2007, the GSEs purchased large volumes of AltA mortgages and private-label MBS collateralized by subprime
mortgages.
19
Mortgage Markets
Mortgage Securitization
? $6.93 trillion in outstanding securitization pool in 2007;
$10.24 in 2nd quarter of 2008
? Pool group of mortgages with similar characteristics, insure
pool of mortgages, and sell securities collateralized by
mortgages to investors
? Add capital to the mortgage markets and resulted in lower
rates and fees to mortgage borrowers.
? Reduce liquidity risk, interest rate risk, and credit risk of their
loan portfolios for investors (compared to investing in
mortgages).
20
Mortgage Markets
21
Mortgage Markets
22
Mortgage Markets
23
Mortgage Markets
Sectors of Residential MortgageBacked Securities
? Agency MBS (MBS)
? Loans that satisfy the underwriting standard of the agencies
used to create RMBS
? Represents 45% of the investment-grade securities market
(2008)
? Includes agency mortgage pass-through; agency CMOs and
stripped MBS (created based on pass-through)
? Non-agency MBS (NA MBS)
? private label MBS: where prime loans are collateral
? subprime MBS: where subprime loans are collateral
24
Mortgage Markets
25
Mortgage Markets
MBS as Diversification Tool
? For fixed-income investors, diversification can be hard to find if
confined to the Barclays U.S. Aggregate Bond Index.
? Credit categories have been highly correlated since 2008
? Recession cleared the ground of weaker credits.
? Since then, corporations have conservatively managed their balance sheets,
which has kept default rates near historic lows
? 4 subsectors or strategies within the securitized markets:
? non-agency residential mortgage-backed securities (NA RMBS),
prepayment strategies (Prepay), commercial mortgage-backed
securities (CMBS credit), and agency MBS (MBS)
26
Mortgage Markets
27
Mortgage Markets
Agency Pass-Through Securities
? The first mortgage pass-through security was created
in 1968.
? Issuers
? Guaranteed by Ginnie Mae and issued by approved lenders
? Freddie Mac
? Fannie Mae
? Each pass-through security represents a pro-rata share
of principal and interest payment cash flows in the
pool.
28
Mortgage Markets
Agency Pass-through Securities:
Cash Flow Characteristics
? Cash flow on the security depends on cash flow of the
underlying mortgages.
? Monthly mortgage payments: interest, principal
repayment, any prepayments
? Monthly cash flow for pass-through securities is less, due to
servicing and other fees
? Delay in passing through monthly cash flows from
mortgages
29
Mortgage Markets
Yields on Mortgage-Backed
Securities
? Yields are a function of prepayment risk
? As rates fall, it gives borrow incentive to prepay the loan and
refinance at a lower rate
? Yield calculation
? Projection of cash flow requires making assumptions about the
prepayment rate
? PSA benchmark: assumes prepayment rates are low for newly
originated mortgages, and then speed up as mortgages become
seasoned.
30
Mortgage Markets
Collateralized Mortgage Obligations
(CMO)
? The problem with MBS is that you never know when you are
going to get your principal back (prepayment risk)
? Repackaging the cash flows from mortgages in a different way
? Create different bonds from the same mortgage to please different
kinds of investors
? E.g., package 30-year mortgage into bonds of different length;
principal only and interest only bonds
? Retire mortgage prepayments only one tranche at a time, so all
other tranches are sequentially prepayment protected
31
Mortgage Markets
Collateralized Mortgage Obligations
(CMO)
? Mitigate risk exposure in pass-through by redirecting
cash flows to different bond classes (“tranches”)
? Different risk/return pattern than the underlying pass-
through
? Can not eliminate prepayment risk; only redistribute risk
among different classes of bondholders
? More closely satisfy the needs of institutional investors
? First CMO was created in 1983 as sequential-pay
CMOs
? Each class of bond retired sequentially
32
Mortgage Markets
34
Mortgage Markets
Sequential-Pay CMO
? Each tranche receives periodic coupon payment based
on the beginning balance.
? Tranche 1 pays off, then disburse principal payment to
Tranche 2.
? Usually exact amount of principal payment is not known,
depends on if there is any prepayment.
35
Mortgage Markets
The Case of Goldman Sachs Fraud
? On April 16th 2010 the SEC charged Goldman Sachs for
defrauding investors by misstating and omitting key facts about a
financial product tied to subprime mortgages as the U.S. housing
market was beginning to falter.
? Goldman failed to disclose to investors vital and relevant
information about the CDO.
? Paulson & Co., paid Goldman Sachs to structure a transaction in
which Paulson & Co. could take short positions against mortgage
securities chosen by Paulson & Co. based on a belief that the
securities would experience credit events.
? Goldman wrongly permitted a client (Paulson & Co.) that was
betting against the mortgage market to heavily influence which
mortgage securities to include in an investment portfolio, while
telling other investors that the securities were selected by an
independent, objective third party.
36
Mortgage Markets
The Case of Goldman Sachs Fraud
? Investors lost more than $1 Billion dollars due to Goldman’s
involvement and lack of transparency.
? Goldman Sachs pays $550 million dollars to settle the suit
(the largest in SEC history up to 2010), Goldman also
promised to reform its business practices.
? $250 million would be returned to harmed investors through a
Fair Fund distribution and $300 million would be paid to the
U.S. Treasury.
? The landmark settlement also requires remedial action by
Goldman in its review and approval of offerings of certain
mortgage securities.
37
Mortgage Markets
Subprime MBS Meltdown
? Causes?
? Housing bubble
? Unsavory practices by mortgage lenders
? Securitization and over-rated ratings
? As a legitimate financial tool, the benefits of
securitization are real and substantial
? Risk spreading
? Increasing supply of capital to mortgage market
? Increased home ownership
38
Mortgage Markets
Subprime MBS Meltdown
“But do not expect a rush back to the ways of the 1960s.
Securitization has become far too important for that. Indeed, it has
not yet fulfilled its promise. Wall Street eggheads may be licking
their wounds at present, but they will soon be coming up with
even more products. And, given time, there will no doubt be
another wave of buying. More importantly, the transformation of
sticky debt into something more tradable, for all its imperfections,
has forged hugely beneficial links between individual borrowers
and vast capital markets that were previously out of reach. As it
comes under scrutiny, the debate should be about how this system
can be improved, not dismantled.” (The Economist, September 20,
2007)
39
Mortgage Markets
U.S. Home Prices
40
Mortgage Markets
U.S. Home Prices
41
Mortgage Markets
U.S. Home Prices
42
Mortgage Markets
Housing and Economic Recovery
Act of 2008
? Designed to restore confidence in the domestic mortgage
?
?
?
?
43
industry
Provide insurance for $300 billion in mortgages (400,000
homeowners)
Establish a new regulator (FHFA) to supervise operation of the
GSEs and FHLBs.
Raise the dollar limit of the mortgages the GSEs can purchase.
Provide loans to help refinance of mortgages to those at risk of
foreclosure.
Mortgage Markets
New Provisions on Mortgage
Lending
? “Qualified Mortgage Rule” (CFPB, Jan 2014):
? a borrower may not have a debt-to-income ratio of greater than 43
percent
? fees and points may not exceed 3 percent of the loan amount
? lenders must verify a borrower’s income
? no mortgages greater than thirty years, no interest-only or negative
amortization loans
44
Mortgage Markets
Dodd Frank Act (2010)
? Effect of loose lending during the last housing boom, nearly 8
million U.S. homes fell into foreclosure
? Response
? Highly risky loan products (negative amortization mortgages)
are now banned
? Borrowers must document their employment and debt levels
? Lenders must disclose all the costs involved in each loan and
also must verify a borrower’s ability to repay the mortgage
? Result: a credit lockdown that is still going on today, nearly
five years after the legislation was enacted
45
Mortgage Markets
Dodd Frank Act (2010)
46
Mortgage Markets
Dodd Frank Act (2010)- 5 Years
Later
? Adds significant costs in time and labor; It now takes far longer for
lenders to process the most basic loans
? May also stifle innovation in mortgage lending
? The home loans being made today are arguably the most pristine
in history; new default rates are at record lows
? Everything mentioned above comes at a cost to lenders,
borrowers and the overall health of the housing market itself
47
Mortgage Markets

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