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Mortgage loans and

mortgage-backed securities

Mortgages

• A mortgage loan is a loan secured by the collateral of some specificreal estate property which obliges the borrower to make apredetermined series of payments.• A mortgage design is a specification of the interest rate, term of themortgage, and manner in which the borrowed funds are repaid.• Mortgage originator (original lender) can either

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hold the mortgage in their portfolio

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sell the mortgage to an investor or

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use the mortgage as collateral for the issuance of a security(mortgage backed security).

Fixed rate, level payment, fully amortized mortgage

The borrower pays interest and repays principal in equal instalmentsover an agreed upon period of time (term of the mortgage). Thefrequency of payment is typically monthly.The servicing fee is a portion of the mortgage rate. The interest ratethat the investor receives is called the

net coupon

• • Growing equity mortgages •

It is a fixed-rate mortgage whose monthly mortgage paymentsincrease over time.

Amortization schedule for a level-payment

fixed-rate mortgage

Mortgage loan:

Mortgage rate:

Monthly payment:

Term of loan:

30 years (360 months)

1 (^

ni ni

i

monthly payment = mortgage balance

where

i^ is the simple monthly interest rate.

Examplen^

= 360, mortgage balance = $100,000,

i^

Mortgage payment = $742.50.

Month

BeginningMortgageBalance

MonthlyPayment

MonthlyInterest

PrincipalRepayment

1

100,000.

2

99,934.

3

99,868.

358

2,197.

359

1,470.

360

M^

M^

M^

M^

M

-^

Interest portion declines and repayment portion increases.

Adjustable rate mortgages

The mortgage rate is reset periodically in accordance withsome chosen reference rate.^ Other terms^ •^

Rate caps limit the amount that the contract rate mayincrease or decrease at the reset date.

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A lifetime cap sets the maximum contract rate over theterm of the loan.

Factors affecting prepayment behaviors^ 1.

Prevailing mortgage rate – the current level of mortgage ratesrelative to the borrower’s contract rate.•

The spread should be wide enough to cover the costs

2. Path history of rate spread is important
   • depends on whether there have been prior opportunities torefinance since the underlying mortgages were originated. 3.^

Presence of prepayment penalty.

4.^

Macroeconomic factors e.g. growing economy results in a rise inpersonal income and in opportunities for worker migration.

5.^

Seasonal factor: Home buying increases in the Spring and reachesa peak in the late Summer. Since there are delays in passing throughprepayments, the peak may not be observed until early Fall.

Interest rate path dependence

Prepayment burnout – Prepayments are path dependent since thismonth’s prepayment rate depends on whether there have been prioropportunities to refinance once the underlying mortgages wereoriginated.^ Example

• path of interest rates in the past 3 years

First path: 11%

Second path: 11%

More refinancing occurs now when the interest rates follow thesecond path.

Mortgage-backed securities

are securities backed by a pool

of mortgage loans.1.

Mortgage passthrough securities;

Collateralized mortgage obligations;

Stripped mortgage-backed securities.

The last two types are called

derivative mortgage-backed

securities since they are created from the first type.

MBS versus fixed income investments

•^

Virtually no default risk since the mortgages in a pool areguaranteed by a government related agency, such as GNMA(Government National Mortgage Association) or FNMA (FederalNational Mortgage Association).

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Prepayment riskPrepayment privileges given to the householder to put themortgage back to the lender at its face value.

Mortgage passthrough securities^ •^

A mortgage passthrough security is a security created when one ormore holders of mortgages form a pool of mortgages and sell sharesor participation certificates in the pool.

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The cash flows consists of monthly mortgage payments representinginterest, the scheduled repayment of principal, and any prepayments.

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Payments are made to security holders each month. The monthlycash flows for a passthrough are less than the monthly cash flows ofthe underlying mortgages by an amount equal to servicing and otherfees.

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Not all of the mortgages that are included in the pool that aresecuritized have the same mortgage rate and the same maturity.A weighted average coupon rate and a weighted average maturityare determined.

Contraction risk

Suppose an investor buys a 10% coupon Ginnie Mae at a timewhen mortgages are 10%. What would be the impact onprepayments if mortgage rates decline to 6%.•^

The price of an option free bond will rise, but in the caseof passthrough security the rise in price is less because thereis a higher prepayment. The upside price potential istruncated due to prepayments. The cash flows fromprepayments are reinvested at a lower rate.

Expansion risk

What happen if the mortgage rates rise to 15%?• The price of the passthrough, like the price of any bond,will decline.• It declines more because the higher rates will tend to slowdown the rate of prepayment, in effect increasing theamount invested at the coupon rate, which is lower than themarket rate.