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The Secondary Mortgage Market for Real Estate Loans

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  1. The Secondary Mortgage Market for Real Estate Loans • Lecture Map • History of the market • The residential agencies • Types of mortgage pools • CMBS

  2. Market History • Market for publicly traded mortgage securities originated with federal gov’t involvement in the residential market • Government created a series of “alphabet soup” agencies to: • Facilitate flows of capital nationwide by creating liquidity in the market • Promote home ownership broadly, specifically among middle class

  3. Federal National Mortgage Association – “Fannie Mae” • Founded in 1938 • Initial federal agency designed to broaden the residential marketplace • Initial Objectives of the agency: • Create a secondary market for loans • A source of loan repayment besides amortization of outstanding mortgage loans • Manage outstanding loans • Provide special assistance programs for homeowners

  4. How Fannie Mae Works • FNMA actually issues its own debt in the public markets • Debt has a very low coupon • Even though private today, it is perceived as a quasi public/private entity • assumed to enjoy the full faith and credit backing of the U.S. government • Uses proceeds from these offering to purchase loans from loan originators • FNMA’s low issuance cost allows it to earn a spread between the interest expense on its debt and the yield on purchased mortgage loans

  5. Government National Mortgage Association – “Ginnie Mae” • Established in 1968 when FNMA was spun off as a private entity • Objectives: • Manage and liquidate mortgages previously acquired by FNMA • Offer federally subsidized housing programs • Private a federal guarantee for FHA and VA mortgage loans

  6. How Ginnie Mae Works • GNMA offers a guarantee of timely payment of principal and interest on FHA, VA and Farmer Mac residential loans • Guarantee allows these loans to be pooled into “pass-through” securities • The original collateralized mortgage obligations → “CMOs”

  7. What is a CMO? • A collateralized mortgage obligation is a separate security backed by a pool of mortgage loans • Allows investors to acquire an undivided interest in an underlying pool of mortgages • Creates a takeout for “whole” loans • Interest and principal payments on the underlying mortgages provide the cash to pay the P&I on the CMO

  8. GNMA’s role • When the pass through securities are issued, the purchasers pay a guarantee fee to GNMA • GNMA uses these fees to conduct its operations • GNMA takes timing and collection risk on the mortgages backing the CMO’s • FHA, VA and Farmer Mac provide guarantees against mortgage default on those loans • Guarantees are priced on the historical experience with default rates

  9. Distinction between FNMA and GNMA • FNMA actually purchases mortgages • Uses its own balance sheet to issue debt • Used proceeds of that debt to buy loans • GNMA is only issuing a guarantee • The guarantee backs a pooled mortgage security that allows the other agencies to raise capital so that they can effectively recycle their capital into new loans

  10. The Secondary Market for Conventional Loans • Federal Home Loan Mortgage Corporation – “Freddie Mac” • Freddie Mac mimics Fannie Mae • Issues debt to acquire conventional mortgage loans • Conventional loans are larger loans that do not qualify for FHA, VA status

  11. Value-Add of the Agencies • The agencies keep funds flowing into the residential mortgage market regardless of the level of interest rates • The public markets continually re-price these loans as the yield curve changes • Since lenders are passing long term interest rate, prepayment and default risks to the public markets, they can use their balance sheets over and over to originate new loans at current underwriting levels

  12. What Risks do Lenders Continue to Face? • Standard underwriting risk • Market and property conditions, borrower financial status, etc. • “Pricing” the original loan • Lenders must price into their spread the timing risk of holding the loans from the time of origination to sale • If rates rise in that time period, the market value of outstanding loans in the fixed income markets will fall

  13. Types of Mortgage Backed Pools • Mortgage backed bonds • Mortgage pass-through securities • Mortgage pay-through bonds • CMO’s

  14. Mortgage Backed Bonds • Issuer originates commercial loans • Issuer also issues a fixed rate bond on its balance sheet • Retains ownership of the mortgages • Pledges them as collateral for payment of the new bonds • New bonds have fixed coupon rates and maturities • Coupons are lower than the original mortgage rates, so the lender earns the spread • Lender uses the bond proceeds to create new loans to individual borrowers

  15. Mortgage Pass-Through Securities • Commercial mortgage equivalents of the GNMA guaranteed securities • The newly issued securities represent an undivided “equity” interest in a pool of mortgages • Payments of P&I on the pool are “passed through” directly to the holders

  16. Mortgage Pay-Through Bonds • Function similar to pass-throughs, but purchaser actually owns a bond, not an interest in a pool • Payment obligation is on the bond issuer, not the underlying mortgages • Even though the underlying mortgages are the issuer’s source of payment

  17. Collateralized Mortgage Obligations – CMO’s • Combine features of the mortgage backed bond and the pass through • Issuer retains ownerships of the mortgages, as in the mortgage-backed bond • But the underlying mortgage payments are passed directly through to investors • Investor assumes the prepayment risk

  18. Securitized Mortgage Market Today • Federally funded mortgage pools • > $70 billion • 4% of total mortgages outstanding • Non-government Commercial Mortgage Backed Securities → “CMBS” • > $250 billion today • Approximately 20% of total outstanding debt • Overall secondary market is still relatively small but growing in importance as a benchmark for the underwriting and pricing of all real estate debt

  19. Secondary Market for Commercial Mortgages • Market is less than 20 years old • Created to replicate the success of the secondary market for residential loans • Consists primarily of mortgage backed pools • One of three key drivers of the recovery from the late 1980, early 1990 real estate depression • The others? The RTC and the change in the REIT ownership rules

  20. Structure of CMBS • CMBS are issued in “tranches” • Tranches are called ‘A’, ‘B’, ‘C’, and so on • The “spread” is the difference between the value of the assets pledged and the size of the tranches • To help insure that payments are made, CMBS issues are typically “overcollateralized” • A $100 million issue will be backed by $125 - $240 million of par value mortgages • This is the public market equivalent of the DCR

  21. How Do the Tranches Work? • Tranches create a tier of claims on the cash flow from the mortgage payments • Tranche ‘A’ will have first claim • Effective collateral value and DCR ratio is much higher than average of the pool • Will have lowest coupon and minimal default risk • Tranche ‘B’ will be less secure • Higher coupon, lower debt coverage, higher risk • Tranche ‘C’ is effectively a junk bond • Highest coupon, first in line of default

  22. Rating CMBS • Bonds are underwritten and rated by Moody’s and S&P • Investment banks work with issuers to structure and price the tranches • Issuance and pricing will be based on the ratings assigned to each piece of the CMBS pool

  23. Basis for CMBS Ratings • Quality of issuer’s underwriting • Mortgage insurance • Geographic diversification • Interest rate • Size of collateral pool • Appraised value and underlying, blended mortgage debt coverage ratio

  24. Pricing the Bonds • Bonds may or may not be issued at par • Ie, may not be issued exactly at the average interest rate of the pool • Why would they priced differently? • Market rate has moved away from the original underwriting levels • Issuer wants to establish a certain pay rate • Will take more or less proceeds in exchange for the desired payment obligation

  25. CMBS example • $100 million issue, 8% stated interest rate, 10 year term • However, the market requires a 9% current yield, even though the issuer wants the 8% pay rate • The bonds will be priced at less than par to compensate for the higher yield requirement of prospective buyers

  26. CMBS example (cont.) • Step 1: Find the payments that will be made the stated interest rate • PV = - $100,000,000 • N = 10 • I = 8 (simple interest) • FV = $100,000,000 (bonds do not amortize) • PMT = $8,000,000

  27. CMBS Example (cont.) • Step 2: Discount those payments and the par value at maturity by the actual market rate • FV = $100,000,000 • N = 10 • I = 9% • PMT = $8,000,000 • PV = $93,582,342 = proceeds at issue

  28. Zero Coupon Bonds • Means that there are no interest payments made during the life of the bond • The entire yield is based on the residual par value of the bond • FV = $100,000,000 • I = 8% • N = 10 years • PMT = 0 • PV = -$46,319,350 = proceeds of the issue