An investments text of 30 years ago probably would not include a section on mortgage loans, because investors could not invest in these loans. Now, because of the explosion in
42 PART I Introduction mortgage-backed securities, almost anyone can invest in a portfolio of mortgage loans, and these securities have become a major component of the fixed-income market.
Until the 1970s, almost all home mortgages were written for a long term (15- to 30-year maturity), with a fixed interest rate over the life of the loan, and with equal fixed monthly payments. These so-called conventional mortgages are still the most popular, but a diverse set of alternative mortgage designs has developed.
Fixed-rate mortgages have posed difficulties to lenders in years of increasing interest rates. Because banks and thrift institutions traditionally issued short-term liabilities (the deposits of their customers) and held long-term assets such as fixed-rate mortgages, they suffered losses when interest rates increased and the rates paid on deposits increased while mortgage income remained fixed.
The adjustable-rate mortgage was a response to this interest rate risk. These mortgages require the borrower to pay an interest rate that varies with some measure of the current market interest rate. For example, the interest rate might be set at 2 percentage points above the current rate on one-year Treasury bills and might he adjusted once a year. Usually, the contract sets a limit, or cap, on the maximum size of an interest rate change within a year and over the life of the contract. The adjustable-rate contract shifts much of the risk of fluctuations in interest rates from the lender to the borrower.
Because of the shifting of interest rate risk to their customers, lenders are willing to offer lower rates on adjustable-rate mortgages than on conventional fixed-rate mortgages. This can be a great inducement to borrowers during a period of high interest rates. As interest rates fall, however, conventional mortgages typically regain popularity.
A mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. These claims represent securitization of mortgage loans. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. Specifically, they sell their claim to the cash inflows from the mortgages as those loans are paid off. The mortgage originator continues to service the loan, collecting principal and interest payments, and passes these payments along to the purchaser of the mortgage. For this reason, these mortgage-backed securities are called pass-throughs.
For example, suppose that ten 30-year mortgages, each with a principal value of $100,000, are grouped together into a million-dollar pool. If the mortgage rate is 10%, then the first month's payment for each loan would be $877.57, of which $833.33 would be interest and $44.24 would be principal repayment. The holder of the mortgage pool would receive a payment in the first month of $8,775.70, the total payments of all 10 of the mortgages in the pool.1 In addition, if one of the mortgages happens to be paid off in any month, the holder of the pass-through security also receives that payment of principal. In future months, of course, the pool will comprise fewer loans, and the interest and principal payments will be lower. The prepaid mortgage in effect represents a partial retirement of the pass-through holder's investment.
Mortgage-backed pass-through securities were first introduced by the Government National Mortgage Association (GNMA, or Ginnie Mae) in 1970. GNMA pass-throughs carry a guarantee from the U.S. government that ensures timely payment of principal and interest, even if the borrower defaults on the mortgage. This guarantee increases the marketability of the pass-through. Thus investors can buy or sell GNMA securities like any other bond.
Other mortgage pass-throughs have since become popular. These are sponsored by FNMA (Federal National Mortgage Association, or Fannie Mae) and FHLMC (Federal
1 Actually, the institution that services the loan and the pass-through agency that guarantees the loan each retain a portion of the monthly payment as a charge for their services. Thus the interest rate received by the pass-through investor is a bit less than the interest rate paid by the borrower. For example, although the 10 homeowners together make total monthly payments of $8,775.70, the holder of the pass-through security may receive a total payment of only $8,740.
CHAPTER 2 Markets and Instruments 43
Figure 2.9 Mortgage-backed securities outstanding, 1979-2000.
Source: Flow of Funds Accounts: Flows and Outstandings, Washington D.C.: Board of Governors of the Federal Reserve System, September 2000.
Home Loan Mortgage Corporation, or Freddie Mac). As of the second quarter of 2000, roughly $2.3 trillion of mortgages were securitized into mortgage-backed securities. This makes the mortgage-backed securities market bigger than the $2.1 trillion corporate bond market and two-thirds the size of the $3.4 trillion market in Treasury securities. Figure 2.9 illustrates the explosive growth of mortgage-backed securities since 1979.
The success of mortgage-backed pass-throughs has encouraged introduction of pass-through securities backed by other assets. For example, the Student Loan Marketing Association (SLMA, or Sallie Mae) sponsors pass-throughs backed by loans originated under the Guaranteed Student Loan Program and by other loans granted under various federal programs for higher education.
Although pass-through securities often guarantee payment of interest and principal, they do not guarantee the rate of return. Holders of mortgage pass-throughs therefore can be severely disappointed in their returns in years when interest rates drop significantly. This is because homeowners usually have an option to prepay, or pay ahead of schedule, the remaining principal outstanding on their mortgages.
This right is essentially an option held by the borrower to "call back" the loan for the remaining principal balance, quite analogous to the option held by government or corporate issuers of callable bonds. The prepayment option gives the borrower the right to buy back the loan at the outstanding principal amount rather than at the present discounted value of the scheduled remaining payments. When interest rates fall, so that the present value of the scheduled mortgage payments increases, the borrower may choose to take out a new loan at today's lower interest rate and use the proceeds of the loan to prepay or retire the outstanding mortgage. This refinancing may disappoint pass-through investors, who are liable to "receive a call" just when they might have anticipated capital gains from interest rate declines.
44 PART I Introduction
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