MT481 Unit 8 Mortgage Market Chain Case Example

Lock, Pool, Portfolio: An MT481 Unit 8 Mortgage Market Case Following One Loan and One Monthly Payment

[Student Name]

Purdue University Global

MT481: Financial Markets

Unit 8 Mortgage Market Case

[Instructor Name]

[Date]

The borrower, lender, loan and figures are composite; the market institutions and the sources cited are real.

The Borrower and the Lock

A composite borrower buying a house in Columbus, Ohio applies for a thirty-year fixed-rate mortgage of $380,000 through a mortgage lender. On the day of application the lender quotes 6.50 percent, and the borrower locks the rate for forty-five days. The monthly payment of principal and interest is $2,401.86. The lock is a promise by the lender, not yet backed by any money, and it exposes the lender to a risk: if rates rise before closing, the loan will be worth less when the lender sells it.

Hedging the Lock in the TBA Market

At the moment of the lock, the lender protects itself by selling a matching amount of mortgage-backed securities forward in the to-be-announced market, known as TBA. In a TBA trade, the buyer and seller agree on the issuer, coupon, maturity, face amount, price and settlement month, but not on the specific loans that will be delivered. If rates rise before closing, the loan loses value, but the forward sale gains, because the lender has already agreed to sell at the higher price. Vickery and Wright (2013) describe the TBA market as one of the most liquid fixed-income markets in the world precisely because its standardized contracts let lenders hedge locks in this way.

Funding the Loan

The loan closes thirty days later. The lender funds it with a warehouse line, a short-term credit line from a bank secured by the loans themselves. Most independent mortgage lenders have little capital of their own; they borrow to make each loan and repay the warehouse line when they sell it. The warehouse lender bears the risk that the loan cannot be sold, which is why it advances only about 98 percent of the loan's value and requires the lender to cover the rest.

Fannie Mae and the Security

Within a few weeks, the lender sells the loan to Fannie Mae, which places it in a pool with other similar loans and issues a Uniform Mortgage-Backed Security with a 5.50 percent coupon. The lender delivers the security to the TBA buyer, settling the forward sale. Fannie Mae guarantees investors that they will receive principal and interest on time even if the borrower defaults, in exchange for a guarantee fee.

Who Gets the Payment

The first monthly payment of $2,401.86 contains $2,058.33 of interest, one month at 6.50 percent on $380,000, and $343.53 of principal. The interest divides four ways, each share set as an annual rate on the balance.

The servicer, which collects payments, handles escrow and deals with late payments, keeps a base servicing fee of 0.25 percent a year, $79.17 this month. Fannie Mae keeps a guarantee fee, assumed here at 0.50 percent, $158.33. Investors receive the security's 5.50 percent coupon, $1,741.67. The remaining 0.25 percent, $79.17, is excess servicing, a strip of interest the lender retained when it sold the loan and often sells separately.

Of each month's interest, about five-sixths reaches investors; the rest pays for collection, the guarantee and the lender's retained strip.

The $343.53 of principal passes through entirely to investors, reducing their balance.

The Servicer's Work Behind the Fee

The servicer's quarter point looks small, but it pays for most of what the borrower actually experiences. The servicer collects each payment, holds escrow for property taxes and insurance and pays those bills on time, answers questions, sends year-end tax statements and, if the borrower falls behind, works through payment plans or foreclosure under Fannie Mae's rules. It also advances payments to investors when a borrower is late, recovering them later. The right to collect the servicing fee is itself an asset, called mortgage servicing rights, which lenders often sell to large servicing companies. Its value falls when rates drop, because refinancing ends the loan and with it the stream of fees, so servicers face the same prepayment risk as investors in a sharper form.

Prepayment and the Investor's Uncertainty

The investor's main risk is not default, which Fannie Mae guarantees, but timing. Borrowers can repay early, by refinancing, selling the house or paying extra. Early repayment returns principal sooner, which the investor must reinvest, often at lower rates when refinancing is most common.

A prepayment table shows how timing changes the investment. With no prepayments at all, the loan's principal would be repaid on average about 19.6 years after origination. At a 6 percent annual prepayment rate, the weighted average life falls to about 6.8 years. At 10 percent, to about 5.0 years. At 20 percent, typical of a refinancing wave, to about 3.0 years. The investor who bought a thirty-year security may in practice hold a three-year one, and does not know which in advance. Fabozzi (2015) calls this negative convexity: when rates fall, prepayments speed up and limit the security's price gain, and when rates rise, prepayments slow and extend its life just when the investor would want money back.

Contrast With 2008

The chain described here differs from the private-label securitization that failed in 2008. Those securities carried no agency guarantee, rested on loans often made with little documentation and were repackaged into structures whose risks investors could not easily see. In this case, the loan meets Fannie Mae's underwriting standards, the guarantee removes default risk for investors and the TBA market's standard terms make prices visible every day. Mishkin (2019) traces the 2008 crisis partly to incentives in a chain where each party passed on risk it did not bear, and the guarantee fee is the agency system's attempt to price that risk explicitly.

What the Case Shows

Following one loan shows that the mortgage market is a chain of specialists, each paid a slice of the interest for one job: the lender for origination and the lock, the warehouse bank for short-term funding, the servicer for collection, Fannie Mae for the guarantee and investors for funding over the long term and bearing prepayment risk. The borrower sees one payment each month; the market sees five separate businesses behind it.

Limits

The guarantee fee is assumed, and actual fees vary by loan. Prepayment rates depend on future rates and on borrower behavior that is hard to forecast, so the average lives in the table are illustrations rather than predictions.

References

Fabozzi, F. J. (2015). Bond markets, analysis, and strategies (9th ed.). Pearson.

Mishkin, F. S. (2019). The economics of money, banking, and financial markets (12th ed.). Pearson.

Vickery, J., & Wright, J. (2013). TBA trading and liquidity in the agency MBS market. Economic Policy Review, 19(1), 1-18.