The Secondary Mortgage Market for Real Estate Loans

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 govt 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
• FNMAs 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 PI on the
  CMO

8
GNMAs 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 CMOs
• 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
• CMOs

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 PI 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
  issuers source of payment

17
Collateralized Mortgage Obligations CMOs

• 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
• gt 70 billion
• 4 of total mortgages outstanding
• Non-government Commercial Mortgage Backed
  Securities ? CMBS
• gt 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 Moodys and
  SP
• 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 issuers 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