Understanding the Secondary Market
Basic Review January 2019
Genworth Mortgage Insurance Corporation ©2018 Genworth Financial, Inc. All rights reserved. Secondary Market 101 Outline –Credit –The Markets –Money Market Risk –Mortgage Loan Cycle –What is the Secondary Market? –Functions of the Secondary Market –Main Players in the Market –Size of the Secondary Market –Share of the Secondary Market –Mortgage Origination Income
Secondary Market 2 The Market
The real estate mortgage market actually consists of two separate sections: the Primary Market and the Secondary Market.
The Primary Market is where loans are originated; mortgage lenders and banks loan money to borrowers for the purpose of financing real estate transactions. These lenders make their profit on the fees and interest rate that they charge. They then bundle these loan notes together in a package and sell them in the secondary market.
The Secondary Market, is where mortgages originated in the Primary Market are bought and sold. The secondary market consists of investors, both public and private, who buy the mortgage notes. This allows the mortgage lenders to replenish the cash reserves, so that they can originate more mortgages to more consumers. The investors profit from the interest that the mortgages charge.
Secondary Market 3 Money Markets Short-Term Credit Long-Term Credit
Federal Funds Mortgages
Discount Window Treasury Bonds
Certificates of Deposit Municipal Bonds
Treasury Bills Corporate Bonds
Commercial Paper Corporate Stock
Secondary Market 4 Expected Return Investment- Grade Junk High Corporate Bonds Bonds ● Privately ● Issued MBS Preferred Stock GSE ● MBS Asset-Backed Money- ● Securities Market GSE Securities Debt ●
● T-bills
Low Difficult Risk High
Secondary Market 5 Basic Mortgage Loan Cycle
Portfolio
Loan Consumer Originator Sells To Secondary Market • Aggregator • GSE/Ginnie Mae • Private Label
Secondary Market 6 Originators Of Mortgage Loans
Types of Originators – Mortgage Bankers ▪Originate mortgage loans ▪ May originate both Retail and Wholesale ▪Close loans in their name with borrowed funds from a warehouse line ▪ They may not have a savings base to lend from ▪Rely on quick turnover of funds from the sale of the loans ▪Sell at best execution ▪May service the loans
Secondary Market 7 Originators of Mortgage Loans
Types of Originators – Mortgage Brokers ▪Originate loan applications and collect documentation from the applicant ▪Loans are underwritten, closed and funded by a Bank or Mortgage Banker ▪Can never service a loan ▪Make simple fee income ▪Brokers’ share of overall industry employment peaked at 29% between 2005 and 2007 ▪ Once the subprime bubble burst, the number of mortgage brokers declined significantly ▪ Brokers made somewhat of a comeback in 2015 when the annual average number of broker employees was at its highest level since 2007 ▪Brokers originated only ~10% of the industry’s total originations in 2016, down from ~68% in 2004
Secondary Market 8 Originators of Mortgage Loans
Types of Originators – Correspondent Lenders ▪Deliver closed loans to Mortgage Bankers or Investment Bankers
– Banks ▪Depository institutions that take deposits and lend money out ▪Hold loans in portfolio or sell on the secondary market ▪When business cycle is down, geared toward residential lending ▪Have CRA requirements
– Credit Unions ▪Service driven, not profit driven ▪Serve Members ▪Most lending is for their own portfolio ▪Becoming more involved in the secondary market
Secondary Market 9 Mortgage Industry Specialties
Originators • Find Borrowers • Write Loans • Nationwide • Mortgage Bankers • Mortgage Brokers • Savings and Loans/Thrifts • Correspondent Lenders • Banks • Wholesalers • Credit Unions Investors Servicers • Purchase Existing Loans From Originators • Manage Collection of Payments, • Assume Rights to Payments From Borrowers Customer Service Questions, etc. • Two Types of Investors • Receive Servicing Fees • Government (GSEs and Ginnie Mae) • Dominated by Large Lenders • Private Investors • Investment Bankers • Pension Funds • Life Insurance Companies • State Housing Agencies • Large Financial Institutions • Foreign Investors
Secondary Market 10 Mortgage Origination Income
Fee Income – Origination fees – Points – Processing and Underwriting fees
Cross Selling – Additional consumer loans – Financial products – Deposit accounts
Rate Differentials – Spread is earned over time when a loan is held in portfolio – YSP is the amount over Par (100%) that is earned by a lender when they sell a loan in the secondary market.
Secondary Market 11 Mortgage Origination Income (continued)
Servicing Income - Largest source of income in the industry – Servicing Retained - Servicer usually retains a portion of the interest and any late fees charged – Servicing Released - Relinquishes the rights to service the loan and receives an up-front fee. This is called SRP (Service Release Premium).
Escrow Accounts – Interest earned on escrow funds held by the servicer however, some states require that interest be paid back to the borrower.
Secondary Market 12 Mortgage Loan Flow
Post Secondary Originating Processing Underwriting Closing Servicing Closing Marketing
Loan Officer Loan Processor Underwriter Lender Lender Lender Servicer • Markets Lender’s • Collects Additional • Evaluates Risk • Loan Request • Reviews • Sells Loan to • Collects Loan Products Information from Associated Becomes a Documentation Investor on the Monthly • Assesses Borrowers, with Each Mortgage Lien to Ensure Secondary Payments Borrower’s Employers, Banks, Loan • Closing Completeness Market from Eligibility etc. • Approves or Documents for Sale Into Borrowers • Completes Loan • Evaluates Denies Loan Signed Secondary • Takes Application Market Accuracy and • Funds are Servicing Fees • Collects Initial Completeness of Dispersed • Makes and Passes Documentation Application Corrections to Remaining • Fees are Paid • Educates • Makes Preliminary Loan Principle and Applicants About Decision Documents if Interest on to Products/Process Regarding Necessary Investor • Provides Borrower’s • Pays Tax Borrower with Eligibility Collectors and Legally Required Insurance Lending Disclosures Companies out of Escrow
Secondary Market 13 Risk Allocation As Per Loan Placement Portfolio FHLB GSE Aggregator Portfolio FHLB GSE Aggregator Interest Rate Risk
Bank FHLB & *Bank GSE Aggregator Credit Default Risk
Bank Bank **Originating **Originating Underwriting/ Entity Entity Misrepresentation Risk
*With certain FHLB programs the originating Bank shares in the Credit Default Risk **The Originating Entity is responsible for Underwriting/Misrepresentation Risk. However, in certain cases It may be limited to a specific period of time.
Secondary Market 14 Do You Want To Increase Mortgage Production Or Reallocate Your Risk? • Economy ‒National ‒Local • Rate Environment • Loan Product Environment • Purchase or Refinance Market • Staffing • Accounting and Regulatory Issues • Technology Capabilities • Internal Budget
Secondary Market 15 Loan Placement Options • Create different options for best execution • Become an Approved Seller/Servicer • Become an Approved Correspondent Lender • Become an Approved Mortgage Broker
Secondary Market 16 What Is The Secondary Market?
It is an informal market where lenders and investors buy and sell existing loans as whole loans, participations, and mortgage-backed securities. – Whole Loans - The purchase of an entire loan, as opposed to the purchase or sale of a participation or share in a loan. – Participations - A mortgage made by one lender, known as the lead lender, in which other lenders or investors, known as participants, own a part interest. – Mortgage-Backed Securities (MBS) - Investment securities representing an undivided interest in a pool of loans secured by mortgages or trust deeds. Principle and interest payments on the underlying mortgages are used to pay the P&I on the securities.
Secondary Mortgage Market = Liquidity
Secondary Market 17 Functions Of The Secondary Market • Allows Lenders to generate money to create mortgage loans • Sale of loans on the secondary market allows lenders to transfer portions of risk to the investor • Typically, there are two types of risk: ‒Risk of loss due to borrower default ‒Risk of loss due to interest rate changes • Sale of loans help banks manage the risk associated with negative cash flow • Sale of loans on the secondary market can create additional fee income
Liquidity = Increased Capacity And Potential Profit
Secondary Market 18 “Players” In The Secondary Market
The Players or Investors in the secondary mortgage market are typically divided into two categories: – The Organized Market – The Private Market
Organized Market = Government Private Market = “Unorganized”
Secondary Market 19 Players - Government
Government Sponsored Enterprises (GSEs) – Federal National Mortgage Association (Fannie Mae) ▪Federally-chartered, publicly-owned corporation ▪Provides secondary-market outlet for conventional loans ▪Largest single purchaser/owner of loans
– Federal Home Loan Mortgage Corporation (Freddie Mac) ▪Also federally-chartered, publicly-owned corporation ▪Also provides secondary-market outlet for conventional loans ▪Second-largest single purchaser/owner of loans
Fannie Mae and Freddie Mac are exempt from paying state and local income taxes. They are also exempt from filing with the Securities and Exchange Commission. *Both companies had a line of credit with the US Treasury available to them in the amount of $2.25 billion. (Neither company has ever needed to take advantage of this line.) Each company has a board of directors, and a portion of those directors are appointed by the President of the United States. **Prior to conservatorship Organized Market = Government
Secondary Market 20 Players - Government
GSE Basics After a homeowner has borrowed money to buy a home, the original lender likely resold that loan to Fannie or Freddie. The GSE in turn collected some of those mortgages in a pool, which was sold in the form of mortgage- backed securities (MBS) to private investors, for which the GSE’s collect a fee in exchange for guaranteeing payment on the MBS.
The two, Fannie Mae and Freddie Mac, either own or guarantee about half of the $10 trillion in outstanding US one-to-four family home mortgage loans, or about $4.9 trillion.
Secondary Market 21 Secondary Market 22 Players - Government
Government Sponsored Enterprises (GSEs) – Federal Home Loan Banks (FHLBs) ▪Federally-chartered but owned by member banks ▪Also provides secondary-market outlet of conventional loans ▪Smallest GSE
Organized Market = Government
Secondary Market 23 Players - Government Government Owned Enterprise – Government National Mortgage Association (Ginnie Mae) ▪Provides secondary-market outlet for Federal Housing Authority (FHA) and Veterans Authority (VA) loans ▪Federally chartered and owned corporation
Organized Market = Government
Secondary Market 24 Players - Private
Private Investors – Investment Bankers – Large Financial Institutions – Pension Funds – Life Insurance Companies – State Housing Agencies (HFAs)
Private Market = “Unorganized”
Secondary Market 25 Mortgage Origination Market - Rates
Interest Rate • Price paid by a borrower for the use of funds for a specified period of time
Interest Rate Determinants • Supply of Funds • Demand for Funds • Inflation • Risk (Default, Prepayment, Liquidity) • Taxes
Secondary Market 26 Jumbo And Conventional 30 Year Mortgage Rates
Conv. vs. Jumbo Effective Mortgage Rates 4.8 4.6 4.4 4.2 4.0 3.8
3.6 Interest Rate (%) Rate Interest 3.4 3.2 3.0 A M J J A S O N D 16 F M A M J J A S O N D 17 F M
30-year Conventional 30-year Jumbo Source: MortgageNarrow Bankers Spread Association Between Jumbo and Conventional Rates
Secondary Market 27 Mortgage Originations … FHA/VA Space
Originations Shift… …Driving Higher GSE Share of MBS
FHA/VA % of Total Mortgage Originations GNMA % of MBS
30.0% 40%
35% 25.0% 30% 20.0% 25%
15.0% 20%
15% 10.0% 10% 5.0% 5%
0.0% 0%
1Q11
2Q11
3Q11
4Q11
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16 3Q16
4Q16
1Q11
2Q11
3Q11
4Q11
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16 4Q16
Source: Inside Mortgage Finance Source: Inside MBS & ABS
Secondary Market 28 Impact Of Interest Rate Movement
On Closed Loans – Rates up, value goes down – Rates down, value goes up
On Rate Locks – Same effects as above on the underlying instrument, but with an additional dynamic: • As rates go down, close less loans • As rates rise, close more loans
On Servicing Portfolios – Rates up, value up – Rates down, value down
Secondary Market 29 Mortgage Originations Quarterly % of Mortgage Originations 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 Govt 57 69 76 75 83 117 116 100 99 134 160 152 GSE 152 193 215 207 244 272 248 203 200 277 318 322 Non-Conf Jumbo 44 59 65 67 72 93 85 78 77 103 101 100 Subprime 1 1 1 1 1 2 2 1 1 2 2 2 Alt-A * 3 4 5 5 5 6 4 3 3 4 4 4 * Total 257 326 362 355 405 490 455 385 380 520 585 580
GovtMortgageGSE Non-Conf OriginationsSubprime Alt-A % ofGovt MortgageGSE Non-Conf OriginationsSubprime Alt-A Jumbo Jumbo
$1,600 100.0% 12% 11% 15% $1,400 90.0% 18% 19% 18% 80.0% $1,200 70.0% $1,000 60.0% * 67% 69% 54% $800 50.0% 64% 59% 56%
$600 40.0% 30.0% $400 20.0% $200 26% 10.0% 20% 19% 20% 21% 24% $0 0.0% 2011 2012 2013 2014 2015 2016 2011 2012 2013 2014 2015 2016
Ttl Mtg $1.4T $2.1T $1.8T $1.3T $1.7T $2.1T Origs Source: Inside Mortgage Finance
Secondary Market 30 Reasons For Issuing Mortgage-Backed Securities There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities: 1. Transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments. 2. Allow mortgage originators to replenish their funds, which can then be used for additional origination activities. 3. Can be used by wall street banks to monetize an arbitrage between the originating credit spread of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction). 4. Are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives. 5. Allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing. 6. Allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk- based capital standards.
Secondary Market 31 Basic MBS Cash Flow
Homeowners make monthly Homeowners payments of principal and Monthly P&I at interest at the mortgage rate. $ the mortgage rate (e.g. 6.5%) The servicer retains a portion of the interest component of Servicer each monthly payment as the Monthly P&I at "servicing fee.“ $ the pass-through rate (e.g. 6.0%)
The pass-through rate is the Investors mortgage rate net of the servicing fee rate.
Secondary Market 32 Why an MBS
When you invest in an MBS, you are buying the rights to receive the value of a bundle of mortgages. That includes the monthly payments and the repayment of the principal.
Since it is a security, you can buy just a part of the mortgage. You receive an equivalent portion of the payments.
An MBS is a derivative, because it derives its value from the underlying asset.
Secondary Market 33 Value
A mortgage backed security works the same way as a traditional bond. The rate moves inversely to the price. – A higher rate MBS pays more to the investor • More likely to pay off early through a refinance – A lower rate MBS pays less to the investor • More likely to be held all the way to maturity
Servicing values of lower rate mortgages are typically a more valuable asset, due to the low chances of an early payoff. When a loan pays off the servicer loses the fee income from the investor.
Secondary Market 34 Quarterly MBS
($MM) GNMA FHLMC FNMA Non-Agency
$250,000
$200,000
$150,000
$100,000
$50,000
$0
1Q11
2Q11
3Q11
4Q11
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16 3Q16 4Q16
Source: Inside MBS & ABS
Secondary Market 35 Ginnie Mae MBS • Guarantees securities that are issued by banks and mortgage banks that participate in Ginnie Mae programs • HUD • Consists of FHA (federally insured) loans and VA (federally guaranteed) loans • Government full faith and credit guarantee • GN l: All loans have same interest rate • GN ll: Loan rates in 0.5%
Secondary Market 36 Fannie Mae and Freddie Mac MBS • Government conservatorship, federally chartered • Directly issue MBS • Accept conventional mortgage loans (Conforming and Jumbo Conforming) • Guarantees its own MBS against credit losses on the underlying loans • Loan Interest Rates historically in 1.75% band
Secondary Market 37 Private-Label MBS • Issued by private companies • No GSE guarantee • Rated securities with subordination or other credit support ‒ Subordinate tranches absorb losses before senior tranches ‒ Mortgage loan credit quality ▪Collateral - LTV ▪Credit - FICO ▪Capacity - DTI • Jumbo Loans • Alt-A: Loans that contain non-standard income verification features, but are “A” credit • Securities backed by sub-prime mortgage loans, were classified as “home equity ABS” rather than MBS
Secondary Market 38 Fannie Mae
Secondary Market 39 Step #1 Originate AAA First claim to Step #2 Pool cash flow from P&I payments
Pool of Mortgages
Step #3 CDO’s AA Next claim… Tranche A Next claim… BBB
BB
Secondary Market 40 Secondary Market 41 CMOs And REMICs • Time tranching of cash flows • Underlying assets can be GSE MBS, whole mortgage loans, or other Real Estate Mortgage Investment Conduit (REMIC) securities • GSEs issue Collateralized Mortgage Obligations (CMOs) and REMICs • Private MBS issuers typically structure all their deals as CMOs and REMICs
Secondary Market 42 Credit Default Swaps (CDS) • Credit Default Swaps are contracts that insure against default of municipal bonds, corporate debt, and MBSs • Banks, insurance companies, and hedge funds all sell them. A premium is collected for providing the insurance.
Secondary Market 43 Mark to Market
In accounting and finance, mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes, it is assigned the value that it would fetch in the open market currently.
Example: If an investor owns 100 shares of a stock purchased for $40 per share, and that stock now trades at $60, the "mark-to-market" value of the shares is equal to (100 shares × $60), or $6,000, whereas the book value might (depending on the accounting principles used) only equal $4,000. Similarly, if the stock falls to $30, the mark-to-market value is $3,000 and the investor has lost $1,000 of the original investment. If the stock was purchased on margin, this might trigger a margin call and the investor would have to come up with an amount sufficient to meet the margin requirements for his account.
Secondary Market 44 FASB 157
A Federal Accounting Standards Board (FASB) Statement that requires all publicly-traded companies in the U.S. to classify their assets based on the certainty with which fair values can be calculated. This statement created three asset categories: Level 1, Level 2 and Level 3. Level 1 assets are the easiest to value accurately based on standard market- based prices and Level 3 are the most difficult. FASB 157 was passed to help investors and regulators understand how accurate a given company's asset estimates truly were. Many firms (including some of the largest in terms of assets) had to write down billions of dollars in hard-to-value Level 3 assets following the subprime meltdown and related credit crisis, which began in late 2006. By making companies report to investors the breakdown of assets, they allow investors to potentially see what percentage of the balance sheet could be open to revaluation or susceptible to sudden write-downs.
Secondary Market 45 Detailed Mortgage Loan Cycle
Retains whole loans Directly Who sells Through securities Guaranteed dealers or FNMA To Fannie Mae MBS’s trading desk Which sells Through securities Sells whole loans Participation Cert’s dealers or FHLMC or participations To Freddie Mac trading desk
Who sells loan Through securities To Investors To a Conduit packages, dealers or private pass-throughs conduits
(Issuer) Converts mortgages
to MBS As GNMA MBSs Mortgage Lender Mortgage
As Fannie Mae MBSs And sells through dealers, FNMA or FHLMC trading desk or As Freddie Mac PCs private placement
Sells CMOs or As “Private Label” REMICs Through I.B.’s or Securities Private placements
Secondary Market 46 Genworth Underwriting Guidelines
Secondary Market 47 Genworth Rate Express®
Secondary Market 48 LOS Connections
Secondary Market 49 Training Tools and Information
Secondary Market 50 Training Tools and Information
Secondary Market 51 Additional MI Site Information
Secondary Market 52 Your Genworth Resources
➢ ActionCenter®: 800 444.5664 ➢ Your Local Genworth Regional Underwriter ➢ Your Genworth Sales Representative
Secondary Market 53 Legal Disclaimer
Genworth Mortgage Insurance is happy to provide you with these training materials. While we strive for accuracy, we also know that any discussion of laws and their application to particular facts is subject to individual interpretation, change, and other uncertainties. Our training is not intended as legal advice, and is not a substitute for advice of counsel. You should always check with your own legal advisors for interpretations of legal and compliance principles applicable to your business.
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Secondary Market 54