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Chapter 10

The Secondary Mortgage Market

In any discussion of securities markets, it is helpful to distinguish primary markets from secondary markets.

In a primary market, new securities are issued (new money is directed to a party that puts the funds to a direct use).

In a secondary market, previously issued securities are sold among parties that “invest” in securities.

In the primary mortgage market, money is channeled from surplus savings units into the hands of parties wishing to buy, improve, or refinance real estate.

In the secondary mortgage market, previously issued notes are purchased by parties whose portfolio choices lead them to seek to collect payments on mortgage loans. They may purchase individual loans, or they may purchase claims on a pool of loans in the form of mortgage-related securities (or mortgage-backed securities, MBS).

Mortgage-backed securities can come in many forms, under the broad headings of residential MBS (a fairly standardized market due to the dominance of two large government-related organizations) and commercial MBS (a much less standardized market).

[A practical definition of security is a reallocation of rights involving assets.]

Why is there a secondary mortgage market? Recall that mortgage lending is characterized by three activities or functions:




The secondary mortgage market allows an organization to specialize in one of these areas, toward becoming more efficient and producing greater value for mortgage borrowers, and in turn for the organizations’ owners.

I. The Market Itself

Specialization is important, especially with regard to intermediation, because of:

Regional mismatches – capital deficits in rapidly growing areas would prevent buyers from being able to finance their home purchases if they had to rely solely on local savings deposits. The secondary mortgage market channels money to where it is needed.

Institutional mismatches

  • Thrift institutions accepted short-term deposit liabilities, then lent long-term to real estate buyers. This arrangement ultimately led to the demise of savings and loans.

Through the secondary mortgage market, investors with long-term liabilities (e.g., pension funds) can purchase notes from originators and thereby provide a better matching of asset/liability maturities.

  • In fact, the traditional role of depository institutions as home lenders has changed from largely one of earning an interest spread (the intermediation function) to largely one of collecting fees as loan originators and servicers (the brokerage and servicing functions). Thrifts have suffered disintermediation (the loss of deposits) both through regulatory reasons (Regulation Q in the 1980s introduced people to money market and other mutual funds) and through demographic reasons (older people save through their IRA, 401-k, traditional pension, or other retirement saving arrangements).

  • The investment focus of some institutions has changed; for example, life insurance companies have become less active as direct real estate lenders, while becoming more active as purchasers of mortgage-backed securities. (Life insurers also have become less active as direct real estate owners, and more active as holders of REIT shares.)

II. Secondary Mortgage Market Agencies and Firms

A. Federal Housing Administration (FHA) – created during the 1930s to provide long-term fixed-rate home loans. Role today is providing payment insurance (borrowers pay a premium) so lenders will make loans on moderately-priced homes with low down-payments (as little as 3%).

B. Department of Veterans’ Affairs (VA) – the forerunner Veterans’ Administration was created in 1944 to assist WWII veterans in buying homes. Its role today is providing payment guarantees (veterans pay no fees for this) so that military veterans can obtain loans for moderately-priced homes with low down-payments (zero in some cases).

Note: FHA and VA are not direct participants in the secondary mortgage market; not all FHA and VA loans are sold by their originators. But the standardization and payment assurances present in FHA and VA loans were essential to the growth of the secondary mortgage market.

C. Federal National Mortgage Association (FNMA, or “Fannie Mae”) – established in 1938. We can think of it as being essentially an organization that buys loans from originators, then bundles together a group of loans, then sells to investors the rights to payments on these loan “pools.”

Its original role was to buy FHA loans at face value from originators (when interest rates had risen). If it could not ride out the interest rate cycle and resell at face value, then the federal government absorbed the loss.

In 1954 FNMA was “privatized” through the issuance of nonvoting stock. But it retains ties to the government (as a GSE, or government-sponsored enterprise, with government borrowing privileges and federal officials on its board). In 1970 FNMA was authorized to buy conventional loans (meaning not FHA or VA) as well as FHA & VA.

During the 1970s, FNMA held most of the loans that it purchased “in portfolio.” It faced the same types of problems that S&Ls did: it was selling short-term bonds to get money, then buying long-term notes.

In the 1980s it reduced this interest rate risk in a couple of ways: 1) buying adjustable rate loans, and 2) reselling the loans in the secondary market (by issuing mortgage-backed securities).

Today FNMA earns money through its interest revenues (net of interest expenses on the bonds

it issues) and through fees it earns on guarantees. Its ability to borrow from the US Treasury provides an additional assurance to parties that buy FNMA securities.

D. Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac) – established in 1970. We can think of it as being, like FNMA, essentially an organization that buys loans from originators, then bundles together a group of loans, then sells to investors the rights to payments on these loan “pools.”

Why was FHLMC created, when there was already a FNMA? In 1970, most of the loans originated by banks and thrifts were not of the FHA/VA variety. In fact, 65% of all home loans were originated without government insurance or guarantees. So Congress created FHLMC to provide a secondary market for conventional loans (which FNMA could buy also, but tended not to). Today, in fact, both FNMA and FHLMC (both of which are privately-owned GSEs) can buy both conventional and FHA/VA loans, but FNMA has specialized over the years in FHA/VA loans and FHLMC has specialized in conventional loans.

Like FNMA, FHLMC holds some loans in portfolio while also issuing mortgage-backed securities (including collateralized mortgage obligations, the use of which was pioneered by FHLMC).

Note: During the recent housing and financial markets crisis, the federal Treasury Department placed Fannie Mae and Freddie Mac in conservatorship, essentially treating them as bankrupt/ unable to pay their obligations without federal assistance. In the process the government made explicit the implicit guarantee on Fannie Mae and Freddie Mac debt that long has allowed the two GSE’s to borrow at below-market interest rates unavailable to other home lending organizations.

This advantage over their competitors was controversial even before the crisis, not only because it placed other lenders at a competitive disadvantage, but also because it allowed Fannie Mae and Freddie Mac to grow to sizes that many critics saw as dangerous. Added controversy arose from huge salaries paid to the pair’s top management. Also controversial was the Fannie and Freddie purchase of notes originated by banks and mortgage brokers who retained no risk for loans that were not repaid, thus shifting the default risk to the secondary mortgage market – and, due to Fannie/Freddie’s special status, to the taxpayers. (In 2011 the Federal Housing Finance Agency, Fannie and Freddie’s regulator, tried to sue several large banks for selling bonds backed by poor quality loans to the GSEs.) The Federal Crisis Inquiry Commission’s report quoted an FHFA examiner calling Fannie “the worst-run financial institution” he had encountered in 30 years. Even before the crisis the Bush administration had tried to more strongly regulate the GSE’s, including attempts to impose risk-based capital standards.

E. Government National Mortgage Association (GNMA, or “Ginnie Mae”) – established in 1968. We can think of it as being essentially a government agency that provides payment guarantees on securities backed by FHA and VA loans. It is an agency of the federal government, and its obligations carry the full faith and credit of the United States.

In fact, this guarantee is so important that the instruments are called “GNMAs” even though GNMA is not the issuer.

Why is a GNMA guarantee needed when the loans are already government-backed? A couple of potential problems for investors: administrative delays (if the security issuer can not make timely payment, GNMA will) and possible shortfalls (for example, VA does not guarantee the full amount of a loan, but GNMA does).

GNMA will provide a guarantee on a pool of loans if:

  • the loans all have the same maturities (within 1 year),

  • the loans all carry the same contract interest rates (within 1%),

  • the loans all are FHA-insured or VA-guaranteed, and

  • the issuer pays the appropriate application fee

The issuer then sells “pass-through” securities that carry an interest rate 50 basis points less than on the loans. The originator (or other servicer) gets 44 basis points, and GNMA receives 6 basis points for its guarantee.

A couple of other agencies worth noting:

F. Rural Housing Service (formerly the Farmers Home Administration, or FmHA, part of the U.S. Department of Agriculture) – in a way like FHA, but for low/moderate income homes in rural communities (areas with population less than 10,000). But the agency has a broader mandate than FMA, in that it is both a guarantor of loans made by banks (to low or moderate income buyers, since 1990) and a direct lender that lends at below-market rates (to low income buyers). It absorbs the losses from selling the low-rate notes at discounted prices. Like FHA and VA loans, those made or backed by RHS can be included in GNMA-guaranteed pools. RHS’s home mortgage lending activity grew in the wake of the recent housing and lending crisis, but it is still a comparatively small player in the home mortgage market, accounting in 2012 for only about 1% of outstanding U.S. residential mortgage debt.

G. Federal Agricultural Mortgage Corporation (FAMC, or “Farmer Mac”) – in a way, FAMC

is like GNMA or FHLMC, but for farm loans. Like GNMA, it provides guarantees on payments (90%, not 100% of interest and principal). Like FHLMC or FNMA, FAMC is a GSE that has been privatized through the sale of stock but retains a Treasury line of credit.

Private firms also create mortgage loan pools, often backed by “nonconforming” loans (those that do not meet FNMA/FHLMC guidelines, such as “jumbo” loans above $417,000). These pools typically must have private guarantees if they are to be attractive to investors.

III. Mortgage-Related Securities

The most commonly-discussed types of mortgage-backed securities are

  • Pass-throughs

  • Mortgage-backed bonds

  • Mortgage pay-through bonds

  • Collateralized mortgage obligations (CMOs)

Important characteristics of some mortgage-related securities include:

  • Credit enhancement (the assurance that the provider of money will be able to collect the promised interest and principal payments). Credit enhancement typically is in the form of a letter of credit (guaranteed right to borrow) from a bank or one of the following:

Guarantees – third-party (private or government) promises to pay

Overcollateralization – more in assets than is issued in securities (it's as though Caterpillar borrowed $10 million and then pledged $15 million worth of equipment as collateral)

  • Rearrangement of cash flows

  • Need to avoid double-taxation

A. Pass-Throughs

Investor has an undivided interest in a pool of mortgage loans. Receives periodic interest and principal (including prepayments) as they are received; servicer simply passes through anything received (minus small servicing fee).

Borrowers pay a higher rate (e.g., 7%) than investors receive (e.g., 6.5%). The difference goes to the servicer and to credit enhancement (often in the form of a fee to GNMA). Just as bonds are rated by credit-worthiness, pass-throughs are rated (by Moody’s, Standard & Poor’s, Duff & Phelps).

Note: the cash flows on a pass-through are very uncertain. We should not view these instruments as “risk-free” simply because of GNMA’s backing. Because prepayments often

are motivated by lower interest rates, prepayments tend do be received just when the investor does not want them (and will not be received when the investor hopes for them), so there is considerable reinvestment risk.

It is difficult to securitize a pool of loans if there is no guarantee of payments through FHA or VA (or private mortgage insurance, PMI). One solution is to issue as a “senior/subordinated” pass-through. The credit-enhancement here is overcollateralization; for example, investors have a $94 million claim on $100 million of loans. The originator or other subordinated party collects the other $6 million only after the senior position has been satisfied. But because the risk is so low, the $94 million claim may sell for $95 million (discounting the expected cash flows at a low required rate). The originator thereby earns $1 million if it collects all payments (the originator is “putting its money where its mouth is”).

B. Mortgage-Backed Bonds – securities with payments similar to those on corporate bonds: interest-only (semiannually) until maturity. Usually they are overcollateralized. The issuer (loan originator) earns money through borrowing at a low interest rate and reinvesting (in mortgage loans) at a higher interest rate.

If the collateral value falls because market interest rates rise, a trustee will take action (as with a corporate bond issue), such as forcing the issuer to buy additional loans to serve as collateral.

Mortgage-backed bonds are rated as corporate bonds are: based on quality of issuer and credit enhancement.

C. Pay-throughs – a cross between pass-throughs and mortgage-backed bonds. A pay-through pays like a pass-through, but the instrument is a debt obligation of the originator rather than the home-buying borrowers. Credit enhancement is provided through overcollateralization.

D. Collateralized Mortgage Obligations (CMOs) – in a CMO, we rearrange the cash flows, which are very uncertain overall, into individual “slices” called “tranches,” to allow for more certainty, at least to some providers of funds.

CMOs were first issued in 1983 (by FHLMC). Within a few years their use had become widespread. Issuers included banks, thrifts, insurance companies, and investment bankers (especially Salamon Brothers and First Boston).

Whereas pass-throughs provide a pro-rata distribution of money collected on the underlying loans, CMOs provide a sequential distribution. The CMO issuer creates a series of bonds with varying maturities. The issuer collects interest at the mortgage loan rate, but pays out interest at

a rate just a little over the Treasury rate. The pattern can vary, but it often looks something like this:

Think of four debt classes (A, B, C, and Z), plus an equity position.

A-Tranche: gets regular interest plus all principal (regular and prepayments) and the Z-Tranche interest until all principal has been received and the bonds are retired.

(Typical investor might be a bank or thrift institution.)

B-Tranche: before A-Tranche is retired, B-Tranche holders just get interest. After A-Tranche is retired, B-Tranche holders get regular interest plus all principal (regular and prepayments) and the Z-Tranche interest until all principal has been received and the bonds are retired. (Typical investor might be an insurance company.)

C-Tranche: before B-Tranche is retired, C-Tranche holders just get interest. After B-Tranche is retired, C-Tranche holders get regular interest plus all principal (regular and prepayments) and the Z-Tranche interest until all principal has been received and the bonds are retired. (Typical investor might be a pension fund.)

Z-Tranche – receive no regular cash flows (principal or even interest) until all earlier classes are retired. But interest not received is accrued and added to the principal owed.

(Typical investor for this residual tranche might be an aggressive long-term bond mutual fund, or the CMO issuer.)

Equity – the overcollateralization provided by the CMO issuer. This cushion helps to assure the Tranche investors that they will receive the promised payments in a timely manner. Earlier tranches agree to accept lower interest rates if there is more issuer equity (lower risk for investors).

CMOs can be backed by pools of loans or by mortgage-backed securities (in which case there is a “layering” of MBS cash flows).

A special type of CMO is the Interest only/Principal only (or IO/PO) strip. This arrangement is a useful tool in managing interest rate risk. The IO portion has negative duration. The PO portion has what we might think of as a super-positive duration.

E. Swaps – a loan originator trades loans for a mortgage-related security backed by the same loans just sold. What is the purpose?

  • Liquidity – securities are more liquid than individual loans

  • Alter intermediation position while retaining servicing rights

  • Reduced capital requirements for lender (mortgage loans are 50% risk class; GNMAs are 0% risk class)

IV. The Bond Rating Agencies

A mortgage-backed security, including a tranche carved out of another MBS, is a type of bond, a piece of paper that gives evidence of a borrower’s obligation to repay a lender. A longstanding practice in the bond market has been for objective, independent financial firms to assign letter grade types of “ratings” (such as super-strong AAA, fairly weak BB, or already-in-default D)

to existing or proposed bonds so that current and potential lenders will have reliable information on the borrowers’ ability to repay their debts. The bond rating “agencies” are said to provide an efficient means for market participants to judge borrowers’ credit quality; it would be impractical for each investor willing to buy a small number of bonds to undergo its own careful analysis of a borrower’s likely ability to repay. (A lender’s ability to collect is enhanced if the individual or organization borrowing the money is financially strong; if there are added levels of protection such as collateral or third party guarantors; and if the lender has the right to be paid before other, subordinate lenders can collect.)

Critics of the bond rating process have long complained that the rating agencies operate under a constant conflict of interest, in that they are paid for their ratings by the issuers (sellers) of the bonds rather than by bond buyers, such that a rating agency that gives a low rating to a bond might not be hired to rate future bonds created by that issuer (or by other bond issuers that see what has occurred). To have their bonds sold in the public markets, bond issuers traditionally have been required by law to obtain ratings from at least two major ratings agencies, but there are more than two prominent rating firms – the best known are Standard & Poor, Moody, and Fitch; Chicago-based Duff & Phelps became especially active as a rater of mortgage-backed securities in the 1990s. So while a rating agency that awarded unrealistically high ratings could see its credibility suffer, the assigning of low ratings, even if deserved, could impair access to future business among issuers that are said to “ratings shop.” The simple solution of having bond buyers pay for ratings reports is more problematic than it might, at first glance, seem; once the agency did the hard work to analyze and write a rating report on a bond, if it charged a low price from each buyer it might not cover its costs, while if it charged a high price from each buyer then only one buyer might pay, and defray its cost by reselling the report. The imperfect but practical solution has been for the analysis to be paid for by the bond issuer, which covers (recoups) the cost by paying a lower interest rate to lenders who are reassured by the existence of the rating.

Securities issued by Fannie Mae/Freddie Mac (or guaranteed by Ginnie Mae) have been seen by the bond market as carrying federal repayment guarantees, and thus not in need of ratings. But securities backed by mortgage loans on income-producing real estate (“commercial mortgage-backed securities,” or CMBS), and home mortgage loan-backed securities issued by private investment firms with no federal government involvement, have needed ratings to be marketable. The rating of mortgage-backed securities was especially controversial during the housing and lending crisis of the past decade. Payment obligations on pools of home mortgage loans, many of which were of poor (“subprime”) credit quality, were rearranged into “tranches;” a simple application could be ten groups running from most senior to most subordinate. Think of $100 million worth of home mortgage notes with payments reconfigured into ten equal tranches, with holders of most-senior tranche #1 able to collect their full $10 million (plus applicable interest) in full from the payments generated by all $100 million of loans, with tranche 2 holders next in line to receive their $10 million, etc. Tranche 1 seems to be quite safe; as long as even 10% of the home-owning borrowers make full and timely payments (or all borrowers pay even just 10% of what they owe) the tranche 1 investors would seem assured of being paid what they have been promised (we are ignoring administrative costs). As long as the pool delivers even 20% of the promised payments there should be no concerns that the tranche 2 holders could suffer a default.

So the rating agencies were correctly assigning AAA ratings to bonds like tranche 1, and perhaps even tranches 2 and 3 deserved to be AAA. But it became easy for the ratings agencies – lulled by the widely held view that “housing values always rise” – to be optimistic and keep giving the vaunted AAA rating to lower and lower tranches in the hierarchy. Investors ended up losing money on many AAA rated bonds that had poor quality mortgage notes backing them as collateral; a high percentage of subprime borrowers ended up making some late or partial payments, or defaulting in full. An interesting irony is that some types of institutional investors were required, by law or by their prospectuses, to invest in AAA rated bonds, and as the economy continued to drag and borrowing entities weakened there were increasingly fewer AAA possibilities to choose from. So these institutions were forced to buy whatever they could find that carried AAA ratings, and on those instruments they ended up suffering losses – perhaps while knowing that the AAA ratings were undeserved.

It is not surprising that the major rating agencies were publicly shamed and widely criticized. S&P, Moody, and Fitch actually had enjoyed oligopoly benefits through their designation by the federal government as “Nationally Recognized Statistical Reporting Agencies,” whose ratings were required for certain government related bond transactions. As part of Dodd-Frank, the financial regulation overhaul law, the three firms lost their protected status; other companies started (or expanded existing) bond rating operations. One was the Kroll investigation/security company – which tried to carve out a niche by charging buyers for its reports, but ended up having to charge issuers, like the other raters long have done. It also should not be surprising that after the crisis the rating agencies were accused of trying to regain their credibility by assigning unduly conservative ratings, which made borrowing more difficult in an already weak economy.

V. Tax Issues

If special provisions are not made, then the taxable portion of cash flows (interest and capital gains) is taxed both at the issuer level and at the investor level.

Issuers of early mortgage-backed securities avoided this double taxation by creating trusts to hold the notes and mortgages. Called “grantor trusts,” these had to meet certain standards (limited life, self-liquidating, no active management of assets) to qualify for tax-exemption at the issuer level.

But problems arose as conventional loans were pooled with overcollateralization as credit enhancement, because:

  • the FASB had ruled that an issuer with a significant residual interest (the overcollateralized portion) had to show the issue on its balance sheet (this caused capital problems), and

  • the IRS ruled that the trust was taxable because of active management (reinvestment, for example).

So under the 1986 Tax Reform Act, Congress created REMIC (Real Estate Mortgage Investment Conduit) status. A trust, partnership, or corporation that sells participations in a pool of mortgage loans can elect to be treated as a REMIC for tax purposes if it receives income only from mortgage loan cash flows & servicing fees and if it does not buy or sell notes once the pool has been established.

V. A few final points: note the impact that the secondary mortgage market has had.

  • Provision of money for home loans where it is needed

  • Standardization of instruments. Primary mortgage market instruments are designed to conform with secondary market’s needs (adjustable rate loans provide a good example).

  • Risk is shifted to parties better able to bear it than loan originators are

  • A wide range of mixes of cash flows is available. By the mid-1980s we had seen commercial mortgage-backed securities, mortgage-backed securities denominated in foreign currencies, mortgage-backed securities backed by balloon notes, and even futures and options on mortgage-backed securities.


FIL 360/Trefzger

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