Mortgages

1

• Mortgages
• Mortgage-Backed Securities
• Part-1

2
Definition of a Mortgage

• What is a mortgage?
• It is a loan that is secured by the pledge of a
  specific piece of real estate property.
• The borrower called the mortgager pledges the
  property on account of the loan taken from the
  lender, who is known as the mortgagee.

3
Title vs Lien

• When the property is pledged is the title to the
  property transferred to the lender.
• It depends.
• In some states in the U.S., this is actually the
  case.
• In other states, the lender merely has lien on
  the property that is pledged.

4
Mortgage Markets

• These are markets where funds are borrowed to
  finance the acquisition of houses.
• A mortgage is a pledge of property to secure
  payment of a debt.
• Such loans are made by banks and financial
  institutions, and are collateralized by the
  property so acquired.

5
Mortgages

• In 1990 the mortgage finance market in the U.S.
  was larger than the markets for U.S government
  securities and U.S. corporate bonds combined.

6
Importance

• Why is the market for home loans important?
• One of the most important goals for many families
  is the acquisition of a home.
• Typically, such real estate purchases are
  financed by partly borrowing the funds required.

7
Importance (Cont)

• Why do people aspire to own homes?
• An investment in a home serves as a long-term
  hedge against inflation.
• It has been observed that the market value of
  homes has risen substantially faster than the
  rate of inflation in the long run.
• Besides the interest paid on home loans is tax
  deductible.
• This reduces the after-tax interest cost.

8
Disadvantages?

• Owning a home is not without its negatives
  however.
• Homes are difficult to sell, that is the market
  is relatively illiquid compared to security
  markets.
• A home typically constitutes a familys largest
  investment.
• This makes diversification of wealth difficult.
• Home values tend to fluctuate with the economy
  and with changes in their age and condition.

9
The Mortgage Loan Market
YEAR Total Mortgage Debt Outstanding in billions of USD
1950 72.80
1960 206.80
1970 451.70
1980 1451.80
1990 3807.30
1998 5642.90
10
Market (Cont)

• In 1982 residential mortgages accounted for 82.1
  of the loans that were outstanding.
• The balance 17.9 was on account of loans secured
  by business and farm properties.

11
A Standard Mortgage

• The traditional mortgage loan is characterized
  by
• A 30 year period (in the U.S.)
• A constant or level monthly payment (EMI)
• Such mortgages are called
• Level payment, fixed rate mortgages (FRM)

12
A Standard Mortgage (Cont)

• A standard mortgage is repaid by a series of
  constant monthly payments during its life.
• Each payment consists partly of principal and
  partly of interest repayment.
• The process of repayment in this fashion is
  called Amortization.

13
A Standard Mortgage (Cont)

• For a given loan amount, the higher the mortgage
  rate the greater will be the monthly payment.
• In the initial years most of the EMI consists of
  interest payment.
• As the mortgage progresses however, the EMIs will
  consist mainly of principal repayments.

14
Features of Amortized Loans

• Mortgages are usually for 30 years (360 months).
• The interest component is equal to one twelfth
  the annual rate of interest multiplied by the
  amount outstanding at the beginning of the
  previous month.
• With the payment of each installment, the
  interest component will keep declining and the
  principal component will keep increasing.

15
Features(Cont)

• The installment payments form an annuity whose
  present value is equal to the original loan
  amount.
• A Amortization Schedule is a table that shows the
  division of each payment into principal and
  interest, and the outstanding loan balance after
  each payment.

16
Calculating The Installment

• Consider a loan of L to be repaid by way of N
  installments of A each.
• Let the periodic interest rate be r.
• L A x PVIFA(r,N)

17
Example

• A person has taken a loan of 10,000.
• It has to be paid back in 5 equal annual
  installments.
• Interest rate is 10 per annum.
• L A x PVIFA(10,5) A x 3.7908
• A 2,637.97

18
Amortization Schedule
Year Payment Interest Principal Repayment Outstanding Principal
0 10,000
1 2637.97 1000 1637.97 8362.03
2 2637.97 836.20 1801.77 6560.26
3 2637.97 656.03 1981.94 4578.32
4 2637.97 457.83 2180.14 2398.18
5 2637.97 239.82 2398.15 .03
19
Illustration

• A lender has advanced 227,150 for the purchase
  of a home.
• The annual interest rate is 7.77
• The term of the loan is 25 years.
• What is the monthly amount?
• 227,500 A x (1 1 )
• ________ ___ ____
• 0.006475 (1.006475)300
• 1721.36

20
Illustration (Cont)

• The EMI on a mortgage of 155,000 is 1550.
• What is the annual interest rate.
• 155,000 1 (1 - 1 )
• _________ ______x ______
• 1550 i (1i)360
• i 0.96875

21
Illustration (Cont)

• A mortgage loan for 235,000 has been made.
• The interest rate is 7.875 per annum and the EMI
  is 2093.44.
• How long will it take to fully amortize the loan?

22
Illustration (Cont)

• 235,000 2093.44 (1 - 1 )
• _______ X __________
• 0.0065625 (1.0065625)N
• N 204 months

23
Amortization (Cont)

• Let UPBn be the unpaid balance at the end of n
  periods.
• The loan is for a total of N periods.
• The monthly payment is MP.
• The principal component of the nth EMI is Pn.
• The interest component of the nth EMI is In.

24
Amortization (Cont)

• UPBn MP 1 - 1
• ______ x ______
• r
  (1r)N-n
• Pn UPB0 x r x (1r)n-1
• _________________
• (1r)N - 1
• In UPB0 x r x (1r)N - (1r)n-1
• _________________
• (1r)N - 1

25
Illustration

• Consider a 30 year 8.88 loan for 225,000.
• Calculate the principal and interest components
  of the 180th payment.
• P180 471.57
• I180 1319.44

26
Bi-weekly Payment Mortgages

• Americans get paid on a bi-weekly basis, that is,
  once a fortnight.
• In a bi-weekly mortgage the EMI is calculated
  assuming that payments are made monthly.
• Half of the calculated EMI is the bi-weekly
  payment.
• Since there are 26 fortnights in a year the
  bi-weekly interest rate is 6/13 of the monthly
  rate.

27

• The life of the mortgage is then calculated as
  follow.
• MP x PVIFA(r,M) MP
• ___ x PVIFA(ra, N)
• 2
• N 545 fortnights ? 21 years

28
Alternative Mortgage Structures

• One alternative to a standard 30 year mortgage is
  a 15 year fixed rate mortgage.
• In this case the interest rate continues to be
  fixed.
• But the amortization period is 50 of that of a
  30 year mortgage.

29
Alternative(Cont)

• Due to the shorter amortization period, the EMIs
  of the 15 year mortgage contain a larger
  percentage by way of principal repayments as
  compared to a 30 year mortgage.
• The faster repayment and the shorter maturity
  makes such 15 year loans attractive for lenders.

30
Alternative (Cont)

• Hence 15 year mortgages tend to be offered at a
  lower rate as compared to a 30 year mortgage.
• Tax reforms in the U.S. also had an impact.
• When the marginal tax rate is lowered the
  deductibility of mortgage interest payments for
  tax purposes becomes less attractive.
• Thus the advantage of 30 year loans over 15 year
  loans was reduced.

31
Alternative(Cont)

• The 1980s in the U.S. were characterized by high
  inflation.
• Consequently, mortgage lending rates were also
  high.
• Due to high and uncertain inflation, lenders
  could not offer 30 year fixed rate loans.

32
Alternative(Cont)

• It must be remembered that most lenders like
  banks were financing long-term mortgage loans
  with short-term deposits.
• Thus there was a asset-liability mismatch.
• Lenders therefore wanted to offer loans with
  shorter maturities.

33
Alternative(Cont)

• From the borrowers perspective, due to higher
  interest rates, the EMIs were becoming large and
  unaffordable.
• This lead to the creation of ARMs or adjustable
  rate mortgages.
• In general an ARM has a 30 year amortization
  period
• But interest rates are adjustable usually on an
  annual basis.

34
Alternative(Cont)

• The interest rate adjustment is based on an index
  rate plus a spread called margin.
• The index may be a
• T-bill rate
• Or a cost of fund index

35
Alternative(Cont)

• Although rates can be adjusted, usually there is
  a band within which changes can be made.
• A majority of ARMs have a cap

36
Alternative(Cont)

• A Graduated Payment Mortgage (GPM) is also an
  alternative to an FRM.
• A GPM has a 30 year maturity.
• But a lower EMI in the initial years as compared
  to an FRM.
• The interest rate on the loan will steadily rise
  for a specified period (so will the EMI) and will
  then level off.

37
Alternative(Cont)

• Because of lower payments in the earlier years,
  GPMs exhibit negative amortization.
• That is, in the earlier years, the EMIs are
  inadequate to cover even the interest that is
  due.
• Consequently, instead of declining, the principal
  amount actually increases.

38
ARMs (Cont)

• To induce borrowers to accept an ARM and to
  compensate them partially for future payment
  uncertainty, lenders offer them at a lower
  interest rate as compared to fixed rate
  mortgages.
• The initial rate is known as a Teaser Rate.
• It is typically 50-100 b.p below the rate for a
  fixed rate mortgage.

39
ARMs (Cont)

• Periodic interest rate caps and floors limit the
  amount by which the rate on the ARM may change.
• A cap fixes the upper limit while a floor fixes
  the lower limit.
• There are two types of Caps
• Periodic caps
• Lifetime caps

40
ARMs (Cont)

• There are two types of periodic caps
• Rate caps and payment caps
• Rate caps limit the amount that the contract rate
  may increase or decrease at the reset date.
• The most common rate cap on an annual reset loan
  is 2

41
ARMs (Cont)

• Payment caps are less common
• These limit the change in the monthly mortgage
  payment rather than in the interest rate on the
  reset date.
• Payment caps may lead to negative amortization.

42
ARMs (Cont)

• Lifetime caps and floors.
• These impose upper and lower limits on the
  contract rate that could be charged over the life
  of the loan.
• The lifetime cap is expressed in terms of the
  interest rate
• The cap is typically 5-6.
• Thus if the initial rate is 7 and the cap is 5
  the maximum rate chargeable is 12.

43
Mortgage Originators

• The entity that initiates the mortgage loan is
  called the Originator.
• Originators include
• Commercial Banks
• Life Insurance Companies
• Pension Funds
• Savings Loan Institutions or Thrifts

44
Origination (Cont)

• What does an originator look for?
• He considers the following
• Debt-to-Income Ratio
• The current income of the borrower is compared
  with the monthly expense incurred in connection
  with owning the house.
• These expenses are referred to as PITI.
• That is
• Monthly payment of principal plus interest
• Property taxes
• Insurance premia
• As a rule of thumb, the debt to income ratio
  should not exceed 25.

45
Origination (Cont)

• In addition, the originator will consider the
  other long-term as well as short-term liabilities
  of the borrower.
• A party who is substantially in debt would be
  offered a loan only if he were to have a lower
  debt to income ratio.

46
Origination (Cont)

• The credit history of the borrower is also a
  factor.
• This usually includes the payment history of the
  credit cards owned by the borrower, and other
  short-term loans taken by him.
• Property Appraisal is yet another factor.
• The appraised market value of the house is also a
  key decision variable.
• As part of the loan application the value of the
  house as appraised by a professional property
  appraiser should be supplied.
• This value should be significantly higher than
  the amount that is sought to be borrowed.

47
Origination (Cont)

• The down payment is a key factor as well.
• Typically the lender will finance only 80-90 of
  the cost of acquisition.
• The ratio of the loan amount to the purchase
  price is called the LTV Loan to Value ratio.

48
Major Mortgage Lenders

• Originators can be divided into three categories
• Commercial Banks
• Savings Loans or Thrifts
• Mortgage Bankers

49
Lenders(Cont)

• Commercial banks and thrifts are known as
  depository lenders
• That is they accept deposits from the public and
  make loans to homeowners
• Mortgage bankers are non-depository lenders
• They fund originations from short-term lines of
  credit obtained from commercial banks
• These loans are repaid by selling the newly
  originated mortgages.

50
Primary vs. Secondary Markets

• The market where the lenders or the originators
  deal with borrowers is called the Primary
  Mortgage market.
• The market where newly originated loans are sold
  to investors is called the Secondary Mortgage
  market.

51
Lenders(Cont)

• The three categories of lenders account for
  virtually all of the loans that are originated.
• Mortgage banks have become increasingly
  important.
• They account for more than 50 of the loans that
  are originated in the U.S.

52
Mortgage Bankers

• They act as a channel through which builders or
  contractors in need of long-term funds can find
  mortgage financing.
• The funds required for this purpose are obtained
  from commercial banks.
• But within a short period after extending these
  loans, the mortgages are sold to long-term
  institutional investors.

53
Sources of Income For The Originator

• They charge an origination fee.
• This is expressed in terms of points.
• A point is 1 of the borrowed funds.
• For instance a fee of 2 points on a loan of
  100,000 is 2,000.
• The originators can subsequently sell the loans
  in the secondary market.
• If interest rates have declined they will make a
  capital gain.

54
Income For The Originator

• If the originator chooses to hold the loan as an
  asset, he will earn interest income.

55
Mortgage Servicing

• Once a loan is made, it has to be serviced.
• Servicing can be done by the lender himself, or
  can be contracted out to an external agency.

56
Servicing

• Servicing involves the following activities.
• Collection of monthly payments.
• Sending payment notices to the mortgagors.
• Sending reminders for overdue payments.
• Maintaining records of outstanding principal.
• Initiating foreclosure proceedings if required.

57
Sources of Income For The Servicer

• He gets a servicing fee.
• The fee is a fixed percentage of the outstanding
  mortgage balance.
• As each installment is made, the outstanding
  balance will decline.
• Hence so will the servicing fee.

58
Servicing Income

• Servicers also earn a float on the monthly
  mortgage payment.
• This is because there is a delay between the time
  they receive the payment and the time they pass
  it on to the lender.
• They also earn a late fee if payments are overdue.

59
Mortgage Insurance

• Lenders require mortgage insurance as a safeguard
  against default.
• The cost is borne by the borrowers in the form of
  a higher rate of interest.
• Why is insurance required?
• A mortgage is a debt instrument.
• And like any other private debt is subject to
  credit risk.
• A mortgage is generally considered to be in
  default if the borrower fails to pay the EMI in
  three consecutive months.

60
Insurance (Cont)

• The incidence of default is positively related to
  the LTV ratio.
• The risk tends to be particularly high if the LYV
  exceeds 80.
• Thus to originate mortgages with LTVs exceeding
  80, originators normally insist that the
  mortgage be insured.

61
Insurance(Cont)

• In the case of default the insurer has two
  options
• Pay the lender the insured amount and let him
  take the title to the house
• Or else reimburse the lender for the entire loan
  amount and take over the title by itself

62
Insurance(Cont)

• In the U.S insurance is provided by
• Federal Housing Administration
• It provides insurance mainly to promote home
  ownership for low and moderate-income families.
• The FHA charges a premium which is borne by the
  borrower.

63
Insurance(Cont)

• Veterans Administration
• It guarantees mortgage loans made to eligible
  veterans
• There is no premium charged
• Private Mortgage Insurance
• Mortgages that are not insured by government
  agencies are called conventional mortgages.
• Depending on the LTV they may be insured by a
  private company or else may remain uninsured.

64
Insurance(Cont)

• There are 7 major private insurance providers.

65
Insurance(Cont)
COMPANY Credit Rating New Insurance ( bn in 1999) Market Share age
Mortgage Guaranty Insurance AA 45.90 24.30
Radian Guaranty AA 33.20 17.60
PMI Mortgage Insurance AA 30.1 16.2
General Electric Mortgage Insurance AAA 28.70 15.20
Republic Mortgage Insurance AA 18.80 9.90
Triad Guaranty Insurance AA 4.40 2.30
66
Insurance(Cont)

• Most privately insured mortgages have LTVs of 90
  to 95.
• But companies only insure about 25-30 of the
  face amount of the loans.
• In the case of default the insurer can
• Pay the insurance coverage to the lender and let
  him retain the property for liquidation
• Reimburse him for the entire loan amount and take
  the title for liquidation

67
Insurance (Cont)

• Many mortgagors acquire Credit Life Insurance
  from life insurance companies.
• Such insurance provides for a continuation of
  monthly payments even if the mortgagor were to
  die.
• Thus dependents will not lose possession of the
  property.

68
Prepayment

• What is prepayment?
• While a mortgage is intended to be a long-term
  loan, the mortgager has the right to retire the
  debt before maturity.
• Such premature retirement is called prepayment.
• In The U.S, mortgages are almost always
  pre-payable at par without penalties

69
Prepayment (Cont)

• Since most mortgagors prepay, the outstanding
  principal balance of a mortgage diminishes much
  more rapidly than its scheduled amortization.
• The term pre-payment refers to only the paydown
  of the outstanding balance of a mortgage that is
  in excess of its scheduled amortization.

70
Prepayment (Cont)

• The speed of the excess paydown is referred to as
  the prepayment rate.
• Why do homeowners prepay?
• There are two main reasons
• Refinancing
• Housing Turnover

71
Refinancing

• When interest rates are declining, borrowers have
  a tendency to borrow at the prevailing rate of
  interest and prepay the high cost loan taken
  earlier.
• Refinancing will obviously lead to a lower EMI.

72
Housing Turnover

• However, even in a stable interest rate regime,
  homeowners tend to prepay.
• This occurs due to a change in the ownership of
  the collateral, which is of course the house that
  was mortgaged.
• Ownership changes could occur on account of one
  of the following reasons.

73
Housing Turnover (Cont)

• Home sale
• A homeowner may sell his home for reasons like
• Upgrading to a better property
• Changing his job
• Divorce
• Conventional mortgages have a due-on-sale clause
• That is, the mortgagor has to prepay when the
  house is sold.

74
Housing Turnover (Cont)

• Default
• The financial condition of the borrower may
  deteriorate to an extent that he is unable to
  make the monthly payment.
• If the condition is temporary, the mortgage is
  said to be in delinquency.
• However if EMIs are not paid for more than 3
  months the mortgage is said to be in default.

75
Housing Turnover (Cont)

• In the case of default, the lender can enforce
  foreclosure proceedings
• This will cause the house to be liquidated
• But the actual incidence of default in the U.S.
  is fairly low
• It is currently less than 0.5

76
Housing Turnover (Cont)

• Disaster
• A mortgage may be prepaid because of severe
  damage to the property due to
• Fire
• Flood
• Earthquake
• Now we should add Tsunami

77
Housing Turnover (Cont)

• Since the house is the collateral, severe damage
  eliminates the collateral.
• If the house has casualty insurance the mortgage
  will be prepaid.
• Else it will end up in default.
• Death
• In the case of death the executor of the will
  usually sell the property and prepay
• Else if the mortgage becomes defaulted the lender
  will launch foreclosure proceedings which also
  tantamounts to prepayment.

78
Prepayments

• The mortgagor has a right to payoff the mortgage
  prematurely either in part or in full without
  significant penalties.
• Thus the borrower has a Call Option.
• For the lender it introduces cash flow
  uncertainty.
• The uncertainty about when and how a borrower
  will prepay is called Prepayment Risk.
• Because of this risk the valuation of mortgages
  and mortgages related securities is more complex.

79
The Role of the Government

• There are three key parties in the housing market
• Those who demand funds for buying homes
  borrowers
• Those who supply funds by investing in mortgage
  loans or mortgage related products investors
• Those who supply housing - builders

80
Role(Cont)

• The amount of housing construction and the funds
  demanded for purchasing housing are determined by
  the combined actions of these three groups.
• The government has influenced the behaviour of
  all three groups by creating government agencies
  or government sponsored entities.

81
Role(Cont)

• The actions take by these agencies include
• Insuring or guaranteeing mortgage loans against
  default
• Thereby enabling weaker sections of society to
  acquire homes
• These guarantees also made such loans attractive
  for investors to invest in

82
Role(Cont)

• Introduced various types of mortgage designs that
  are more attractive to borrowers and investors
• Developed mortgage backed securities such as
  pass-throughs and CMOs and guaranteed them
  against default risk to enable institutional
  investors to supply funds to the mortgage market

83
Role(Cont)

• Standardized mortgage loan terms and
  documentation
• Provided liquidity to the mortgage market by
  buying mortgage loans
• Provided credit facilities to certain lenders in
  the housing market
• Granted loans at below market rates to encourage
  the construction of low income housing

84
The Early Mortgage Market

• In the first few decades of the post World War-II
  period
• The bulk of mortgage loans were originated by
  depository institutions
• And were held by them as assets
• Thus the supply of funds to the mortgage market
  was dependent on the ability of depository
  institutions to raise funds.

85
Early(Cont)

• However most institutions were constrained by law
  to confine their deposit seeking and lending
  activities to their local markets.
• Thus the allocation mechanism was poor
• Some regions had excess supply and low rates
• Others had excess demand and high rates

86
Early(Cont)

• This situation lead to the emergence of the
  mortgage banker and the mortgage broker
• Mortgage bankers do not provide funds from
  deposit taking
• They originate mortgages and sell them
• To life insurance companies
• And to depository institutions in cash rich
  regions

87
Early(Cont)

• The 1960s were characterized by high inflation
  and interest rates.
• Government ceilings on interest rates lead to
  reduced deposits with banks and SLs.
• Even when funds were available
• FRMs were not preferred
• Because of an asset-liability mismatch

88
Early(Cont)

• To mitigate the problem, a mortgage market that
  was not dependent on depository institutions had
  to be developed.
• This required a strong secondary market where
• Non-depository financial institutions and life
  insurance companies would find it attractive to
  make investments.

89
Building a Secondary Market

• The Federal Housing Administration (FHA) was set
  up in 1934.
• It did two things following the war
• It reduced credit risk for investors by offering
  insurance against mortgage default
• Not all mortgages could be insured
• To get insurance the applicant had to satisfy the
  underwriting standards of the FHA.
• Thus the FHA standardized mortgage design

90
Building(Cont)

• Prior to the formation of the FHA, only balloon
  mortgages were available.
• Borrowers in these cases paid only interest over
  the term of the mortgage
• At the maturity date, after 5-10 years, the
  entire principal was repaid as a bullet.
• To repay the original mortgage, typically a fresh
  loan was taken.

91
Building(Cont)

• This structure encouraged default
• If the borrower could not take a fresh loan at
  the time of maturity, he would obviously default
• The FHA developed the self-amortizing long-term
  loans that we have today

92
Building(Cont)

• The question arose who would invest in these
  mortgages?
• To encourage investment there was a need to
  develop a liquid market where loans could be
  traded.
• The government created the Federal National
  Mortgage Association (FNMA) to provide liquidity.

93
Fannie Mae

• Fannie Mae was mandated to create a liquid
  secondary market for mortgages by buying FHA
  insured mortgages.
• But the secondary market did not take off.
• Origination was still dependent on depository
  institutions.

94
Fannie Mae (Cont)

• In response, the government divided Fannie Mae
  into two organizations
• The Fannie Mae that we know today
• And the Government National Mortgage Association
  Ginnie Mae
• Ginnie Maes function was to use the full faith
  and credit of the government to
• Support FHA insured loans
• And loans insured by VA and the Farmers Home
  Administration

95
Fannie Mae (Cont)

• In 1970 Fannie Mae was authorized to buy
  conventional mortgage loans
• And the Federal Home Loan Mortgage Corporation
  (Freddie Mac) was created to support conventional
  as well as FHA/VA loans.

96
Agencies

• Fannie Mae and Freddie Mac are referred to as
  agencies of the U.S. government.
• They are both listed on the NYSE
• Thus they are quasi-private
• They do not receive any subsidies from the
  government
• They are taxed like any other corporation

97
Agencies (Cont)

• They are most appropriately referred to as
• Government Sponsored Entities
• Their guarantees are not backed by the full faith
  or credit of the U.S government
• In contrast Ginnie Mae is a government related
  agency
• Its guarantees have federal backing

98
Securitization

• Ginnie Mae guarantees securities issued by
  private entities that pool FHA, VA mortgages
  together using the mortgages as collateral for
  the security.
• Freddie Mac and Fannie Mae purchase and pool
  conventional mortgages and then issue securities
  using the pool as collateral.

99
Securitization (Cont)

• These mortgage backed securities are then bought
  by investors who were typically unprepared to buy
  individual mortgage loans.

100
Pooling of Mortgages

• Mortgage originators do not usually hold on to
  the loans made by them, but rather sell them.
• In order to sell these loans, many small loans
  are put together as a collection, called a
  Mortgage Pool.

101
Rationale for Pooling

• Consider ten separate loans of 100,000 each.
• Assume that each loan has been made by a separate
  lender.
• Every lender therefore faces prepayment risk.
• It is not easy for a lender to forecast
  prepayments, since each is dealing with an
  individual borrower.
• Prepayment behaviour will obviously differ from
  borrower to borrower.

102
Rationale for Pooling

• If these ten loans were to be pooled, then the
  average prepayment is likely to be more
  predictable and statistical tools of analyses can
  be used.
• However it is expensive for one party to own the
  pool since it would entail an investment of 10MM.
• However the pooled loans can be used as
  collateral to issue securities in large numbers
  to enable individual investors to invest.

103
Securitization

• Securitization is a process of converting a pool
  of illiquid assets into liquid financial
  instruments.
• In the case of mortgages, the pool serves as the
  source for the payments which have to be made on
  the assets which are issued with the pool as
  collateral.
• Because of the ability to securitize, lenders can
  repeatedly rollover their investments in
  mortgages and the country as a whole gets greater
  access to housing finance.

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Standardization

• Before pooling mortgage loans care is taken to
  standardize the loans.
• This means that all the pooled loans will have
• The same rate of interest.
• The same period to maturity.
• The same kind of insurance.
• The same kind of property.
• And will come from the same geographical location.

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Standardization

• The advantage of standardization is that the cash
  flows from the pool are easier to predict.
• Although each mortgage loan is insured
  individually, some times the pool as a whole is
  additionally insured.
• A mortgage pool is therefore like a large loan
  with a coupon rate and term to maturity.

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Special Purpose Vehicles (SPVs)

• Before securitization, the pool of mortgages is
  transferred to an SPV.
• An SPV is a separate legal entity that is set up
  for the purpose of issuing mortgage backed
  securities.
• The objective is to ensure that there is a
  distance between the originators and the pool.
• Thus even if the originators were to go bankrupt,
  it would not affect the pool held by the SPV.

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Mortgage Backed Securities

• The net result of securitization is the creation
  of assets which are backed by the underlying pool
  of mortgages.
• These assets are claims on the cash flows that
  are generated by the underlying pool.

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Pass-throughs

• A pass-through is a type of mortgage backed
  security.
• It is formed by pooling mortgages and creating
  undivided interests.
• Undivided, means that each holder of a
  pass-through has a proportionate interest in each
  cash flow that is generated from the underlying
  pool.

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Illustration

• Consider 10 loans of 100,000 each that are
  pooled together.
• Assume that an agency purchases these loans and
  issues fresh securities using these loans as
  collateral.
• This is the function of Ginnie Mae, Fannie Mae,
  Freddie Mac etc.
• Assume that 40 units of such securities are sold.

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Illustration

• Thus each security will be worth 25,000.
• Each security will be entitled to
• 1/40 th or 2.5 of each cash flow emanating from
  the underlying pool.
• The net result is that by investing 25,000 an
  investor gains exposure to the total pre-payment
  risk of all ten loans rather than to the risk of
  a single loan.
• This is appealing from the point of risk
  reduction.

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Collateralized Mortgage Obligations (CMOs)

• Now consider the case where the ten loans are
  pooled to issue three categories of securities.
• Class A Bonds Par Value of 400,000
• Class B Bonds Par Value of 350,000
• Class C Bonds Par Value of 250,000
• For each class, multiple units of a security that
  represents that particular class are issued.

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CMOs

• For instance if 50 units of class A bonds are
  issued, then each will have a face value of
  8000.
• Each will be entitled to 2 of the cash flows
  receivable by the class as a whole.
• Assume that the cash flows are distributed
  according to certain pre-decided rules.

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Example Of Distribution Rules

• Class A securities will receive all principal
  payments both scheduled and unscheduled until
  the entire par value is paid off.
• Once class A securities have been fully retired,
  class B bondholders will start receiving
  principal payments scheduled and unscheduled,
  until the entire par value is paid off.
• After class B securities are retired, class C
  security holders will start receiving principal
  payments.

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CMOs

• All security holders will receive interest every
  period, based on the amount of the par value that
  is outstanding for that particular class.
• This is an example of a CMO.
• In this case certain categories of securities
  will receive payments before others.
• Unlike a pass-through, all securities are not
  equally exposed to pre-payment risk.

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CMOs

• Class A bonds will absorb prepayments first,
  followed by class B, and then by class C.
• Class A bonds will have a shorter term to
  maturity than the other two categories.
• Class C securities will have the longest maturity.

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A Pass-ThroughA Detailed Illustration

• A person has borrowed 4800 to buy a house.
• He agrees to pay 100 every month as principal
  repayment, and to pay interest every month on the
  outstanding principal at the rate of 6 per
  annum.
• A total of 48 payments are due.
• The first payment will be 124 which consists of
  100 by way of principal repayment and 24 by way
  of interest.

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Illustration Cont

• The last payment due will be 100.50 which will
  consist of 100 by way of principal repayment and
  0.50 by way of interest.
• We will assume that there are 4 owners who agree
  to share each payment equally.
• If payments are made as per schedule, each party
  will receive 31 after the first month, and
  25.125 in the last month.

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Illustration Cont

• Assume that at the end of three months the
  mortgagor pays an extra 40 by way of principal.
• So each of the four owners will get an extra
  payment of 10.
• Since 10 is prepaid the monthly interest in
  subsequent months will go down by 20 cents.
• In the last month (48th) the mortgagor will pay
  60 by way of principal and 30 cents by way of
  interest.

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Illustration of CMO

• Assume that instead of agreeing to share the
  payments equally, the four owners want the
  following system.
• Party A wants his principal back by the end of
  the first year.
• Party B wants his principal by the end of the
  second year.
• Party C wants his principal by the end of the
  third year.
• Party D wants his principal during the last year.

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CMO Illustration Cont

• So every month all the investors will get
  interest on the amount outstanding to them.
• But all principal payments will go first to A.
• Once A is fully paid, B will start receiving
  principal payments.
• After B is fully paid, C will start receiving
  principal payments.
• Finally D will start getting principal payments.

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CMO Illustration Cont

• In the first year A will get 100 every month
  plus interest on the outstanding balance.
• The other three will get interest of 6 per
  month.
• From the 13th month B will start receiving 100
  per month plus interest on the outstanding
  balance.
• From the 25th month C will start receiving 100
  per month.
• From the 37th month D will start receiving 100
  per month.

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CMO Illustration Cont

• Each class of ownership is called a tranche.
• A CMO must obviously have a minimum of 2
  tranches.
• Now assume that in the third month the mortgagor
  makes an extra payment of 40.
• This will entirely go to party A.
• In subsequent months he will continue to get 100
  by way of principal repayments, but will receive
  20 cents less by way of interest.

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CMO Illustration Cont

• In the 12th month he will get only 60.
• The remaining 40 will go to B.
• In the 24th month, B will get 60 and C will get
  40.
• In the 36th month, C will get 60 and D will get
  40.
• Such a distribution principle is called
  Sequential Pay Prepayment.

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Differences Between Conventional Bonds and
Mortgage Backed Securities

• In a conventional bond the principal is returned
  in one lump sum at maturity.
• Holders of mortgage backed securities receive
  their principal back in installments, as the
  underlying loans are paid off.
• Since the speed and timing of principal
  repayments can vary, the cash flows on mortgage
  backed securities can be very irregular.

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Mortgage Backed Securities

• When a homeowner prepays, the remaining stake of
  the holders of the mortgage backed securities
  will be reduced by the same amount.
• Since the principal outstanding will reduce, the
  interest income will also decrease.
• The monthly cash flow for a mortgage backed
  security will be less than the monthly amount
  paid by the mortgagors.
• The difference is equal to the servicing and
  guaranteeing fees.

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Categories of Pass-throughs

• Ginnie Maes
• Fannie Maes
• Freddie Macs
• Private Label

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Asset Backed Securities

• These are similar to mortgage backed securities.
• But the assets which are pooled are not home
  loans.
• Examples of such assets include credit card
  receivables, automobile loan receivables etc.