Problem Description: A mortgage lender called Buy-Home, originates 2 loans, X and Y. The loans have Principal amounts of $500,000 and $300,000, respectively and both have a term of 30 years, with a fixed interest rate of 6%.
Please use attached Word document to calculate your answers.
Requirements: correct answer
Risk Regulations in Finance- Spring 2023 Exercise #1 GSE
Due: Feb 7th by 6 pm
Submission: submit Word doc via Canvas
Problem Description: A mortgage lender called Buy-Home, originates 2 loans, X and Y. The loans have Principal amounts of $500,000 and $300,000, respectively and both have a term of 30 years, with a fixed interest rate of 6%.
Buy-Home securitizes these loans with Fannie Mae. Fannie Mae creates a pass-through Mortgage Backed Security (MBS) for the lender and charges a guarantee-fee (G-Fee) of 25 basis points / per annum to guaranty the credit risk on each of the loans. The loans are serviced by a mortgage servicer called Give-Me-Payment, who charges a servicing fee of 40bps/annum for each of the loans, X and Y. Buy-Home sells the MBS to a fixed-income mutual fund run by an asset manager called Blue-Rock. Please calculate the following.
Fill the table below to answer questions 1, 2 and 3:
1. G-Fee received by Fannie Mae for the first month, for each of loans X & Y
Loan X-
Loan Y-
2. Servicing fee received by Give-Me-Payment for the first month, for each of loans X & Y
Loan X-
Loan Y-
3. Net payment received by Blue-Rock’s mutual fund for the first month, which purchased the MBS securities.
4. For the lender, Buy-Home, what are the benefits derived by securitizing the loans?
1Risk Regulations in FinanceGSEs and Federal AgenciesSession 3Sept. 22, 2023Instructor- Dr. Michael LeibrockAssociate- Tom Ouyang
2∙History of Government Sponsored Enterprises (GSEs)∙Regulatory Oversight of GSEs∙Federal Home Loan Bank System∙Impact of housing crisis on individuals∙Preview Exercise-1AGENDA
3Lecture Topics
4▪A government-sponsored enterprise is a financial services corporation created by the U.S. Congress. ▪Its intended function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent, and to reduce the risk to investors and other suppliers of capital. ▪The desired effect of the GSEs is to enhance the availability and reduce the cost of credit to the targeted borrowing sectors primarily by reducing the risk of capital losses to investors: agriculture, home finance, and education.▪The two best-known GSEs are the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). ▪Fannie Mae was founded in 1938 by the Reconstruction Finance Corporation during the Great Depression to buy mortgages insured by the Federal Housing Administration (FHA). History of the GSEs
5∙The Federal National Mortgage Association Charter Act of 1954 (Charter Act) transformed Fannie Mae from a government agency into a public/private mixed ownership corporation.∙The Charter Act also exempted Fannie Mae from all state and local taxes, except real property taxes.∙The Housing and Urban Development Act of 1968 reorganized Fannie Mae from a mixed ownership corporation to a for profit, shareholder-owned company. ∙This reorganization removed Fannie Mae from the federal budget, and Fannie Mae began funding its operations through the stock and bond markets. ∙The 1968 HUD Act also gave HUD regulatory authority over Fannie Mae, including authority to require that it devote a reasonable portion of mortgage purchases to low- and moderate-income housing.History of the GSEs
6∙In 1970, the secondary mortgage market was expanded when Congress passed the Emergency Home Finance Act, which established Freddie Mac. ∙A key reason for Freddie Mac’s creation was to help thrifts manage the challenges associated with interest rate risk. ∙The FHLBanks originally capitalized Freddie Mac with a $100 million contribution.∙Freddie Mac began to purchase long-term mortgages from thrifts, increasing their capacity to fund additional mortgages and reducing their interest rate risk. ∙The Act also authorized Fannie Mae and Freddie Mac to buy and sell mortgages not insured or guaranteed by the federal government. ∙In 1971, Freddie Mac issued the first conventional loan MBS. History of the GSEs
7▪Fannie and Freddie were authorized to buy “conventional” fixed-rate mortgages that had to conform to the GSE’s underwriting standards that had limits on debt-to-income, loan size, and minimum down payments, among other criteria▪Fannie Mae and Freddie Mac’s primary mission was to purchase residential mortgages from banks operating in all 50 U.S. states. ▪As such, the GSEs did not originate mortgages but rather purchased them in the secondary mortgage market by providing ongoing liquidity to support homeownership.▪The GSEs purchased mortgage loans from banks, thrifts, and mortgage companies and held them in their portfolios. History of the GSEs
8▪As individual banks across the country booked new individual mortgage loans, they sold many of these loans to the GSEs relatively quickly, freeing up capital to write more loans.▪Laws enacted between 1968 and 1970 gave the GSEs the option of securitizing mortgages rather than holding all loans on their respective balance sheets. ▪Now the GSEs could assemble a pool of mortgages and issue securities backed by them.▪ Ginnie Mae was the first GSE to securitize mortgages, followed by Freddie Mac in 1971 and Fannie Mae in 1981. ▪Throughout most of their histories, the GSEs’ residential mortgage business and closely related RMBS securitization activities were both focused on generally low-risk fixed-rate mortgages that were subject to national underwriting standards that stipulated, among other criteria, conservative minimum down payments. History of the GSEs
9▪“Securitization” is a powerful and broadly-applied financial technology. It has undergone constant innovation and reevaluation since its launch in the early 1980’s.▪Each of the concept’s “constituencies” (sponsors, underwriters, traders, investors, quants, rating agencies, regulators) formulates and continually revisits analytic toolkits for the securitized-products asset class.▪These models are essential in efficient dissemination of structural specifics, decision-making for sponsors and investors, and accurate communication of return/risk profiles. ▪The “from-the-ground-up” perspective on this asset class focuses on the connection of “collateral performance” with bond cash flows. In a sense the “holy grail” in market-risk coverage is a uniformly-applied and robust quantification of the collateral-performance “uncertainty.” ▪One important indication of the regulator’s view of product complexity is the decision to “carve out” securitized products from the suite of fixed-income sectors for which “risk-based” internal capital models are permitted (with conditions).Securitization
10▪Given ongoing concerns about regulatory oversight of Fannie Mae and Freddie Mac, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992▪This act created the Office of Federal Housing Enterprise Oversight (OFHEO) as an independent regulator within HUD. ▪OFHEO had the authority to conduct routine safety and soundness examinations of Fannie Mae and Freddie Mac and to take enforcement actions. ▪Further, the measure amended Fannie Mae’s and Freddie Mac’s charters, requiring them to meet an “affirmative obligation to facilitate the financing of affordable housing for low-income and moderate-income families.” ▪In 1995, HUD began to require Fannie Mae and Freddie Mac to meet certain mortgage purchase goals each year.GSE Regulatory Oversight
11∙Congress granted Fannie Mae and Freddie Mac certain benefits such as exemptions from state and local taxes and substantial lines of credit to support ongoing activities.▪In 1995, President Bill Clinton announced an initiative to boost home ownership from 65.1% to 67.5% of U.S. families by 2000. ▪Also in 1995, Clinton loosened housing rules by rewriting the Community Reinvestment Act, which put added pressure on banks to lend in low-income neighborhoods.▪The political drive to increase homeownership increased under the George W. Bush administration by the introduction of the Zero Down Payment Initiative, which in certain cases removed the minimum 3% required down payment on FHA mortgages that carried U.S. government guaranty.History of the GSEs
12•In the early 2000s, there was a rapid increase in U.S. homeownership, combined with a significant increase in competition among banks, mortgage companies, and other entities for new business. •During this period of increased home ownership, subprime loan origination jumped from 7.6% of all mortgage origination to a peak of 23.5% between 2001-2006. •This decline in credit standards occurred during the same period in which U.S. home prices soared. •Between 1997 and their peak in 2006 the average home price jumped 152%, more than in any decade since the 1920sHistory of the GSEs
13•Another contributing factor to the growing asset bubble in the residential mortgage sector was the easy credit conditions that existed in the early 2000s. •For example, from 2000 to 2003 the Federal Reserve lowered the Fed Funds target rate from 6.5% to 1%, making mortgages much more accessible to millions of additional Americans.•Moving into early 2008, the U.S. economy continued to suffer, with GDP falling to an annual rate of just 0.7%, which was the worst result recorded in the United States since the 1990s. •Meanwhile, the unemployment rate increased to 5% in the first quarter from 4.4% in the Spring of 2007.History of the GSEs
14•Given that Fannie Mae and Freddie Mac were a key national source of liquidity in the mortgage market, the U.S. government feared that a potential failure of the GSEs would cause a systemic event. •Trillions of dollars of GSE debt was owned across the globe and a tremendous amount of MBS carried guaranties from the GSEs.•On September 4, the FHFA agreed with Treasury that the GSEs needed to be placed into conservatorship.•On September 6 the management of Fannie Mae and Freddie Mac received notification from the FHFA recommending that the regulator be appointed conservator of the companies.History of the GSEs
15•The amount of funds injected by the U.S. Treasury via numerous bailout programs or directly to certain financial institutions totaled $609 billion.•Table 3.2 presents the allocation of bailout funds disbursed by the U.S government to a total of 935 individual firm recipients under various bailout programs because of the Credit Crisis. •Note that approximately 40% of the total funds were received by banks and other financial institutions, followed by government-sponsored entities at 31%.History of the GSEs
16History of the GSEs
17▪The FHLBank System was created by the Federal Home Loan Bank Act of 1932 as a government sponsored enterprise to support mortgage lending and community investment. ▪The System is composed of 11 regional banks which are privately capitalized and owned as cooperatives by their members. ▪Their regional distribution enables each bank to focus on the distinct needs of their individual communities.▪Each FHLBank is operated independently. ▪Each FHLBank is registered with the SEC and is supervised and regulated by the Federal Housing Finance Agency (FHFA). Federal Home Loan Banks (FHLBs)
18▪FHLBanks provide liquidity to lenders by raising funds in the global financial markets, then lending that money in the form of “advances” (loans) to members.▪Only financial institutions may have membership to a FHLBank▪FHLBs’ Office of Finance serves as the fiscal agent for the FHLBanks. Itsprimary function is to issue and service all debt securities for the regional FHLBanks, while obtaining the most cost-effective terms possible given current market conditions.▪Each year, the FHLBanks provide access to billions of dollars in low-cost funding to nearly 7,000 (or 80%) of America’s banks, credit unions, insurance companies and community development financial institutions. Federal Home Loan Banks (FHLBs)
19Funding▪FHLBanks provide members with loans secured by mortgage-related collateral and other credit products.▪Loans (often referred to as advances) are available in a wide variety of maturities and structures, enabling members to conservatively match their assets with their liabilities.▪The FHLBanks raise money to fund member lending through the daily sale of debt securities (known as Consolidated Obligations) in the global capital markets. Federal Home Loan Banks (FHLBs)
20Funding▪The FHLBanks’ Office of Finance acts as the central debt issuance facility forthe regionalFHLBanks. Available fixed-income debt products include discount notes, bonds with fixed rates and fixed maturities, callable bonds, puttable bonds, variable rate bonds, and Global bonds.– These are sold through a broad, international network of dealers, or as direct placements. Proceeds enable member financial institutions to extend mortgage credit to U.S. homebuyers, and fund economic development projects at the local level.▪Buyers of FHLBank debt securities represent the entire spectrum of fixed-income investors including commercial banks, central banks, mutual funds, major corporations, pension funds, government agencies, and individuals.▪Joint and several liability among the FHLBanks for debt issued.Federal Home Loan Banks (FHLBs)
21RatingsUS Govt. equivalent ratings allow for low cost of borrowing▪On July 28, 2021, Moody’s Investors Service (Moody’s) affirmed the Aaa long term rating and Prime-1 short-term deposit rating of the FHLBank System. The outlook on the FHLBank System is “stable”, reflecting the stable outlook on the U.S. Government.▪On August 5, 2021, Standard & Poor’s Ratings Services (S&P) affirmed the AA+ long-term senior debt rating of the Federal Home Loan Bank System. They also affirmed the A-1+ short-term debt ratings of the System. The outlook on the FHLBank System is”stable”, reflecting the stable outlook on the U.S. Government.▪Obligations of the FHLBanks are not obligations of the United States and are not guaranteed by the United States.Federal Home Loan Banks (FHLBs)
22▪Lower credit risk in key business activity–Credit guaranty vs Secured Lending–High collateral requirements–Losses only if a member defaults, and collateral insufficient▪Lower balance-sheet risk–Limited direct investment in mortgages/MBS▪Not publicly traded▪No competition for market share▪Higher Capital (~4% FHLBs vs ~2% for Fannie/Freddie)▪Joint liability acts as a check to aggressive risk-takingSuperior Performance of FHLBs during Credit Crisis vs. Fannie/Freddie
23Impact of housing crisis on individuals•The financial crisis that unfolded rapidly in the latter part of 2008 developed into a recession that stands out from other recessions of the post-World War II era in several important ways. •The stock market began to decline in October 2007. At first moderate, the pace of the decline increased rapidly, coinciding with the troubles in the financial sector that began in September 2008. •By March 2009, the S&P 500 had lost more than 50 percent from its peak 2007 level (Coronado and Dynan, 2012). •The swings in the economic environment have been unequalled since the Great Depression, and the crisis has also affected several markets simultaneously (housing, stock and labor market).•Consequently providing a number of channels through which individuals and their households might be affected. The economic crisis and the subsequent increase in the unemployment rate operated through several channels, affecting people of different ages in differing ways.
24Impact of housing crisis on individuals
25Impact of housing crisis on individuals•The 2007-09 recession imposed substantial losses in stocks and housing on the older U.S. population•These losses particularly affect the retirement security of those at or nearing retirement. •While stock values recovered relatively quickly since March 2009, house prices did not. •For the majority of older households, housing is the most important asset. •Both actual losses pessimism about potential losses, led many households to reduce spending with a stronger effect on households age 50–64.
26Impact of housing crisis on individuals•Product and labor market channel Available evidence indicates a substantial deterioration in output and employment conditions since 2007.•Although the extent of deterioration varies across regions. Economic growth plunged over the course of the crisis from 2007 to 2009 globally, and after a brief period of recovery in 2010, it tapered off before a subsequent dip in 2012 as the crisis resumed in the form of a sovereign debt crisis in Europe in fall 2011 (figure 1). •While the crisis hit hardest the developed countries and members of the European Union (EU) that were at the epicenter of the global financial turmoil and sovereign debt crisis, the weakening of aggregate demand spilled over to developing and emerging countries through economic, trade, and financial linkages, resulting in a sharp turn in economic growth since 2010. •It has affected particularly the countries in emerging Europe and Central Asia, Latin America and the Caribbean, and Middle East and North Africa
27Impact of housing crisis on individuals
28Impact of housing crisis on individuals•Depressed aggregate demand and weak economic activity have severely weakened labor market conditions around the world. •About 28 million people have lost jobs since 2007, bringing the pool of globally unemployed to an estimated 197 million in 2012, as deteriorating macroeconomic and financial conditions have dampened economic prospects and opportunities for job creation worldwide. •The rise in unemployment rates has been most severe in high- and upper-middle income countries that are either at the epicenter of the crisis (North America and western Europe) or are linked to them (Central and South-Eastern Europe, Latin America and the Caribbean, and advanced countries in Asia) (figure 3). •The rate in developed countries rose on average from 5.8 percent from 2007 to an estimated 8.6 percent in 2012, reaching 12.1 percent on average for the Euro Area countries in mid-2013.
29 Preview Exercise-1
30
31▪A residential mortgage-backed security (MBS) is a bond or debt secured by a collection of home loans. ▪MBS investors get a share of principal and interest payments from a pool of underlying mortgages. ▪Majority of MBS are issued by one of two government-sponsored enterprises (Fannie Mae or Freddie Mac) or guaranteed by Ginnie Mae, a government-owned agency. ▪Pass-Through Securities: As the name suggests, the issuer or servicer of mortgage pass-through securities collects monthly payments from the mortgagees whose loans are in a given pool and “passes through” the cash flow to investors in monthly payments that represent both interest and repayment of principal.Lifecycle of a Mortgage
32▪Guaranty Fee: Fannie Mae and Freddie Mac guarantee the payment of principal and interest on their MBS and charges a fee for providing that guarantee. The guarantee fee (g-fee),covers projected credit losses from borrower defaults over the life of the loans, administrative costs, and a return on capital. ▪Servicing Fee: Mortgage servicerscollect homeowners’ mortgage payments and passon those payments to investors, tax authorities, and insurers. If homeowners fall behind on their payments, the servicer’s role is to work with the homeowner and help them get back on track. A servicing fee is a fee paid to the mortgage serviceras compensation . Servicing fees generally range from 0.25% to 0.5% of the outstanding mortgage balance.Lifecycle of a Mortgage
33The goal of the example is to provide a high-level perspective only, and not address every complexity in the securitization process▪Lender A is a mortgage lender originates 2 loans:–Loan X: $400,000 @ 5%pa, with a term of 30 years–Loan Y: $200,000 @ 5% pa, with a term of 30 years▪Lender pools the loans and securitizes the loans with Fannie Mae.–Fannie Mae now guarantee’s the credit risk –Lender receives the MBS securities–Fannie Mae charges a guaranty fee – say 25 bps/per annum for the credit guaranty▪If average MBS pool size: $600K–Guaranty Fee collected by Fannie (month 1) – .25%/12 x 600K = $125 (annually approx. $1500)•Loan X – $83.33•Loan Y – $41.66–As outstanding principal balance declines, g-fee will decline–G-Fee typically collected monthlyGuaranty Fee Calculation – Example
34Lender B is a mortgage servicer and is servicing the loans in the mortgage pool, with a servicing fee of 50 bps/ per annum.–Loan X = $400K•Servicing Fee = 0.5% x 400K = $2000oTypically calculated and collected monthly -2000/12 = $166.67–Loan Y = $200K•Servicing Fee = 0.5% x 200K = $1000oTypically calculated and collected monthly -1000/12 = $83.33The calculation of g-fee and servicing fee in the slides do not factor in monthly amortization, for simplification purposes Servicing Fee – Example
35▪Coupon for Loan X = 5% Guaranty Fee – 0.25% Servicing Fee -0.50%–Net interest income available to investors = 4.25%▪Lender may choose to sell the MBS to other investors and generate liquidity–Lender is in the business of originating loans and needs the liquidity▪Typically, yield for Fannie Mae MBS in slightly above US treasuries, and lower than investment-grade corporate bonds, as they as considered safer than corporate bondsNet Payment Available to Investors
36Net Payment Available to Investors
37Net Payment Available to Investors$PrincipalBalanceG-fee (monthly)Servicing Fee (monthly)Monthly Installment paid by borrowerPayment available to MBS InvestorsLoan X400,00083.33166.672,1471,897Loan Y200,00041.6783.331,074949
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