The Secondary Mortgage

Market for Real Estate Loans

 Lecture Map
 History of the market
 The residential agencies
 Types of mortgage pools
 CMBS
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
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
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
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
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”
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
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
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
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
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
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
Types of Mortgage Backed
Pools
 Mortgage backed bonds
 Mortgage pass-through securities
 Mortgage pay-through bonds
 CMO’s
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
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
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
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
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
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
 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
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
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
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
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
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
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
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
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