Chapter 10 The Secondary Mortgage MarketI. Nature of the Secondary Mortgage Market- A secondary mortgage market is one in which existing mortgages are bought and sold. - Thrifts and Mortgage bankers sell these loans in the secondary market. By definition, the owner of a mortgage that was purchased in the secondary market did not originate the loan.- The debt issue is termed mortgage backed security (MBS) because it is backed up, or collateralized, by mortgages. They are bought and sold and are considered part of the secondary mortgage market. - The ultimate source of the funds is the investors who purchase the bonds (MBSs) from the secondary market agency or firm. The agency or firm then uses the funds to purchase mortgages from, for example, a thrift. The thrift uses the funds to originate mortgages.- Investors supply the funds and homeowners use them to purchase residences.- The mortgage is an asset to the secondary market entity and is offset by a liability (MBS). The MBS is in turn an asset to the investor.- Up until recently as the late 1960s, it was very difficult for many thrifts to sell their mortgageassets for two reasons: -Their mortgage assets were not homogeneous-Potential buyers were concerned with the default risk - As a result of the inability to buy and sell mortgages, there was often a persistent mismatch of the supply and demand for capital. There was a regional mismatch and a secondary marketfor mortgages alleviated this mismatch by allowing thrifts in capital surplus areas to take their excess deposits and purchase mortgages from thrifts in capital deficit areas. - The secondary mortgage market offered a solution to this mismatch by facilitating the sale ofmortgages from the thrifts and banks to pension funds.- The federal government encouraged the development of the secondary mortgage market by overriding state laws that hindered its development by passing the Secondary Mortgage Market Enhancement Act in 1984.II. Characteristics of Mortgage Backed Securities- The key to a successful secondary market for mortgages is the creation of mortgage backed securities that are acceptable to investors. MBSs have 3 characteristics:1. MBSs will have some form of credit enhancement in which they will have less default risk than the underlying mortgages that serve as collateral. MBSs are rated bythe S&P and Moodys for their safety and thus a strong rating will broaden the market for the MBS and make it more liquid.2. MBSs need to avoid double taxation. MBS issuers must make sure that their revenuesand the cash flows to the investors are not both taxed. Otherwise, the double taxation will offset any benefits of the arrangement 3. MBSs need to tailor their cash flows so as to appeal to investors. Many investors do not desire to invest in securities whose cash flows exactly replicate that of a mortgage. III. Mortgage Pass-Through Securities- Pass-through securities were the first popular MBSs. With a pass-through, the investor is said to have an undivided interest in the pool of mortgages. The investor has an “ownership” position in the mortgages which means that he/she would receive the mortgage payments (principal and interest) and any prepayments as if he/she were the lender. - Investors are attracted to pass throughs because of their relatively high yield, liquidity, and risk free qualities. However, many investors do not like the uncertainty of the timing of the cash flows, due to unpredictable prepayments of mortgages.- Pool insurance is Private Mortgage Insurance on the entire pool, not the individual mortgages.- A pass through structure that allows for the loans’ securitization is the senior/subordinated pass-through. In this arrangement, the lender creates two securities from a pool of mortgages,one having the priority of receiving payments from the pool. From a $100 million pool of mortgages, the lender may create a senior pass through with a principal balance of $94 million. Since the $94 million is secured by $100 million in mortgages, it can be described asovercollateralized. - Credit risk is reduced by overcollaterization.IV. Mortgage-Backed Bonds- Mortgage backed bonds are mortgage backed securities that promise payments similar to corporate bonds. That is, they promise semiannual payments of interest only until maturity with the face value due at maturity. Investors have NO ownership interest in the mortgage. - The maturity on the bonds will be less than that on the mortgages, and the yield will be slightly below that on the mortgagees. - Credit enhancement is accomplished though overcollaterization, which means that the face value of the pool of mortgages will be greater than that of the bonds. The issuer makes up thedifference with the equity contribution. - Also, the maturity of the MBBs will be less than that of the mortgages, but likely longer than the average life of a mortgage. For example, the maturity on the MBBs may be 15 years and that on the mortgages 30. However, because of prepayments, the average life of the mortgages may be, say, 12 years.- The issuer will take the monthly interest and principal payments from the pool of mortgages and invest them in a fund that earns interest. Then, semiannually, the issuer will remit interestpayments to the bondholders from this fund. Any prepayments of mortgages are added to the fund. - Any residual left over will be returned to the issuer as a return on the $25 million equity investment.- Uncertainty surrounding the achievement of the above scenario is the reason for the overcollateralization.- Mark-to-market refers to valuing the mortgages on a frequent basis as a result of the changes in interest rates. A rise in rates, for example, will cause the market value of mortgages to fall and thus endangering the value of the collateral. - Rating Agencies such as Moody’s and S&P consider a number of factors:1. The quality of the mortgages in the pool2. The interest rate spread between that on the mortgages and that on the MBBs. The greaterthe spread, the greater the safety.3. The likely rate of prepayments of the mortgages.4. The geographic diversification of the mortgages in the pool 5. The amount of overcollateralizationV. Mortgage Pay-Through Bonds- Mortgage pay-through bonds (MPTBs) are mortgage backed securities that are a cross between pass-throughs and MBBs. - As with MBBs the issuer retains ownership of the pool of mortgages and issues the MPTB asa debt obligation. The issuer will also