Mortgage-Related Securities

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1 Raymond James Michael West, CFP, WMS Vice President Investments 101 West Camperdown Way Suite 600 Greenville, SC x Mortgage-Related Securities

2 Mortgage-Related Securities What is it? Mortgage-related securities represent an ownership interest in mortgage loans made by financial institutions such as savings and loans, commercial banks, or mortgage companies to finance borrowers' purchases of homes or other real estate. The most basic mortgage securities, known as pass-throughs, or participation certificates (PCs), represent a direct ownership interest in a trust consisting of a pool of mortgage loans. Examples of pass-throughs include Government National Mortgage Association securities (GNMA or Ginnie Mae), Federal Home Loan Mortgage Corporation securities (FHLMC or Freddie Mac), Federal National Mortgage Association securities (FNMA or Fannie Mae), and adjustable rate mortgage (ARM) funds. These mortgage-backed securities may be pooled again to create collateral for more complex types of mortgage securities known as collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs). Although these securities share similarities, each has different advantages and disadvantages. Lenders sell groups of mortgages with similar characteristics into the secondary mortgage market to issuers, or guarantors, of mortgage securities--primarily Ginnie Mae, Freddie Mac, and Fannie Mae. These guarantors pool qualified loans together and convert these packages into securities known as mortgage-backed securities, which they then guarantee. As the borrowers whose loans are in the pool make their loan payments, the money is distributed on a pro rata basis to the holders of the securities (the investors). The value or price of a mortgage security is determined by several factors: the type of mortgages backing the security, the level of market interest rates, the coupon rate on the security, liquidity, and the prepayment assumptions. Mortgage securities are subject to greater market or price risk than are other fixed income securities because of the relationship between interest rates and prepayments. Because interest rates and prepayments are virtually impossible to predict, it is not possible to forecast with certainty the actual returns over time on most mortgage investments. These investments offer a number of advantages, however. What are Government National Mortgage Association pass-through securities? The Government National Mortgage Association (GNMA or Ginnie Mae) is a wholly owned U.S. government corporation established in It is under the jurisdiction of the Department of Housing and Urban Development. Ginnie Mae guarantees mortgage-backed securities (groupings of mortgages that are resold to investors) that are issued by other corporations. It does not loan funds for the underlying mortgages but ensures that investors receive as income the payments on mortgages. The underlying mortgages are insured by other federal government agencies. A Ginnie Mae pass-through certificate represents ownership of a proportionate interest in a fixed pool of Federal Housing Administration, Farmers Home Administration insured, or Department of Veterans Affairs (formerly known as the Veterans Administration) insured or guaranteed mortgages. The activities of the GNMA help make mortgages more readily available. Ginnie Maes are predominantly backed by single-family fixed rate 30- or 15-year mortgages and 1-year adjustable rate mortgages. The mortgages in a pool have the same interest rate, term to maturity and type of dwelling. The certificates call for payment by the issuer of specified monthly installments based on the amortization schedules of the mortgages in the pool. In addition, the certificates provide for payment of a proportionate share of prepayments or other early recoveries of principal. An amount is withheld each month by the issuer to discharge the certificate holder's obligation to pay servicing, custodian, and guarantee fees. Pass-through certificates may be either fully modified or straight. Timely payment of the principal and interest, whether or not collected, is guaranteed to the fully modified pass-through certificate holder by Ginnie Mae. Straight pass-through certificates provide for the payment by the issuer of a proportionate share of proceeds, as collected, on the pool of mortgages, less servicing fees and other costs. Straight pass-through certificates are guaranteed by Ginnie Mae only as to proper servicing of the mortgages by the issuer (i.e., payment of interest and principal actually collected or collectible through due diligence). The full faith and credit of the United States is pledged to the payment of all amounts guaranteed by Ginnie Mae. Page 2 of 7, see disclaimer on final page

3 Certificates are issued in registered form and are fully transferable and assignable. They are marketable in the secondary market. They are available in minimum denominations of $25,000 and in $5,000 increments and may be available for less in the secondary market. The maximum maturity is 30 years; however, experience has shown that the average life is shorter. What are Federal Home Loan Mortgage Corporation pass-through securities? The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) was created in 1970 to establish and service a secondary market for conventional mortgages and to make mortgages more readily available. Until 2008, Freddie Mac was both a private stockholder-owned corporation and a government-sponsored enterprise (GSE). However, because of increased defaults on mortgages held or guaranteed by both Freddie Mac and Fannie Mae (see below), both are now in conservatorship and being operated by the Federal Housing Finance Agency (FHFA). As a result, the U.S. government's support of GSE securities, which had long been assumed by the markets, has been made explicit. Freddie Mac supports the mortgage market primarily by buying mortgages from lenders, packaging the mortgages into securities, and selling the securities--guaranteed by Freddie Mac--to investors. Mortgage lenders use the proceeds from selling loans to Freddie Mac to fund new mortgages, constantly replenishing the pool of funds available for lending to homebuyers and apartment owners. Freddie Mac purchases most of its mortgages from savings and loan associations; however, other thrift institutions, commercial banks, and mortgage bankers also sell mortgages to the agency. Freddie Mac then resells some mortgages to investors. As part of the conservatorship agreement, the U.S. Treasury agreed to buy Freddie Mac and Fannie Mae mortgage-backed securities on the open market, and accepts existing mortgage-backed securities the two GSEs hold as collateral for loans to them. What are Federal National Mortgage Association pass-through securities? The Federal National Mortgage Association (FNMA or Fannie Mae) was established in 1938 to help provide liquidity in the secondary market for residential mortgages. In 1968, Fannie Mae became a private but federally sponsored corporation, retaining some of the advantages of a federal government agency and, to some extent, remaining under federal oversight. Like Freddie Mac, Fannie Mae is a GSE and now operates under the authority of the FHFA as a result of a conservatorship agreement with the U.S. Treasury, which has agreed to support Fannie Mae's mortgage lending activities. Fannie Mae income comes from a return on mortgages it owns and sells and from lender fees paid for Fannie Mae guaranteeing mortgage-backed securities. Fannie Mae was not a mortgage pass-through guarantor until Before then, it basically assisted the mortgage market by purchasing mortgages; it funded the purchases by issuing its own debt. In 1981, however, Fannie Mae entered the pass-through market. Now, Fannie Maes are essentially backed by newly originated conventional mortgages of various types, including 30- and 15-year fixed rate mortgages, 7-year balloon mortgages, and adjustable rate mortgages of a variety of indexes. What are the advantages to investing in mortgage-related securities? There are several advantages to investing in mortgage-related securities, such as Ginnie Maes, Freddie Macs, and Fannie Maes. These include the following: Governmental support: Issuers of mortgage-related securities screen the mortgages that comprise their pools. The federal government insures the payment of principal and interest regarding Ginnie Mae mortgage-backed securities. Thus, if a mortgage payer were to default, the federal government would make the required payments. This guarantee virtually assures the timely payment of interest and principal to the holder of the Ginnie Mae. Freddie Macs and Fannie Maes are now supported financially by the federal government, which has a purchasing program to buy the mortgage-backed securities of both organizations, and also accepts them as collateral for loans made to the two organizations. Yield: Ginnie Maes, Freddie Macs, and Fannie Maes have historically offered yields that exceed what may be obtained through the purchase of federal government securities and corporate bonds. Since the yields are ultimately related to the mortgages acquired by the pool, they depend on mortgage rates rather Page 3 of 7, see disclaimer on final page

4 than on the yields of federal government bills and bonds. This yield differential can be as great as 2 percent over the return offered by long-term federal government bonds. The opportunities for profit are also greater than with Treasury and corporate bonds. Income: Mortgage-related securities are desirable to investors seeking a monthly flow of payments since interest and principal repayments are distributed monthly. The mortgage repayment schedules define the minimum amount of the anticipated payments. Liquidity: Historically, a strong market has existed for the purchase and sale of Ginnie Maes, Freddie Macs, and Fannie Maes. The federal government's support also has provided liquidity to that market. What risks are associated with investing in mortgage-related securities? Several risks are associated with investing in mortgage-related securities. These include the following: Inflation: There is the risk of loss of purchasing power through inflation. Naturally, you should not purchase Ginnie Maes, Freddie Macs, or Fannie Maes if the anticipated yield is less than the anticipated rate of inflation. Default risk: If there are a large number of defaults on the mortgages underlying a mortgage-related security, its market value and the income it produces can suffer. Rise in interest rates: You could lose money if interest rates rise. All of the mortgages in a particular pool have the same interest rate. If you invest in a fixed-income debt security, the price of the security will fluctuate inversely with interest rates. Higher interest rates will drive down the price of the security. If you sell the security in the secondary market prior to maturity or redemption, you could sustain a capital loss resulting from the rise in interest rates. Uncertainty of prepayment timing: Homeowners can repay their mortgages prematurely. This is particularly true when interest rates fall and homeowners refinance at the lower rates. Thus, the timing and amount of principal repayments that the investor will receive is not certain. If a large number of homeowners rapidly pay off their mortgage loans, these payments will quickly retire your mortgage-related securities. This uncertainty of future payments can lead to differences in the estimated yields. Return of capital: The investor who purchases a mortgage-related security should be aware that the payment received represents both earned interest income and return of invested funds. If you spend all of the payment, you are depleting your principal. Principal should be spent only if there is a reason for you to consume it. Even though an investor is made fully aware of this issue at the time of investment, it is human nature to lose sight of this over time. Changes in governmental regulation: There is no guarantee the U.S. Treasury's support of Fannie Mae and Freddie Mac securities will continue or take the same form in future years. What are the tax consequences of investing in mortgage-related securities? Payments on pass-through certificates to certificate holders are made monthly. Each payment represents part interest and part principal (i.e., payments on the underlying portfolio of mortgages passed through to certificate holders). The issuer provides each certificate holder with a monthly statement indicating what part of the distribution represents scheduled principal amortization, what part is interest, and what part represents unscheduled collection of principal. Interest and other items of income, including prepayment penalties, assumption fees, and late payment charges, must be included in gross income in the year received. Principal payments are tax free to the extent they represent recovery of capital. To the extent that payments represent discount on purchase of the mortgages, they must be included as ordinary income. As owners of undivided interests in the entire pool, pass-through certificate owners must include as ordinary income their ratable shares of any discount income realized on purchase of each of the mortgages in the pool. Discount on mortgages that are taxable obligations of corporations, governments, or their political subdivisions is included in income as original issue discount. Page 4 of 7, see disclaimer on final page

5 What are adjustable rate mortgage (ARM) pass-throughs? ARMs are mortgages with coupons that adjust periodically based on the terms of the mortgage and the applicable value of a specified index. They first originated in the 1970s. The typically lower initial rates (called teaser rates) of ARMs compared with the rates of fixed rate mortgages are one of the main reasons for their appeal. Securities backed by ARMs are typically purchased by investors looking for assets to match short-term liabilities and liabilities with floating rates. The benefits include safety, liquidity, and reduced interest-rate risk. Ginnie Mae ARMs In 1983, Ginnie Mae introduced a mortgaged-backed securities program in which the securities are backed by ARMs. The program offers investors the benefits of an annually adjusted interest rate, coupled with the safety and liquidity of a government-guaranteed instrument. Unlike fixed rate mortgage-backed securities, rates on ARM securities move with the market, based on a nationally recognized index (subject to a cap). Individual lender firms originate mortgages to create loan packages, which are then combined with other loan packages to form a larger pool and back a single issue of securities. Each month, the individual issuer/servicer firms remit principal and interest payments to Ginnie Mae's central paying agent, which in turn pays the holders. Pooled mortgages must meet several requirements, including mortgage rate and homogeneity. Freddie Mac ARMs Freddie Mac purchases ARMs from mortgage lenders and pools them into securities known as ARM participation certificates. These securities are recommended for investors seeking an investment with high credit quality and an interest rate tied to market levels. Fannie Mae ARMs Fannie Mae offers an adjustable rate mortgage-backed securities program. A Fannie Mae-backed ARM is supported by a pool of ARMs that share the same index and other similar contract features. These ARM securities bear a pass-through rate or accrual rate that will determine the interest passed on to the investor. The investor's rate equals an index plus a net margin or security margin (mortgage servicing and security fees are included here). Advantages of ARMs There are several advantages to investing in ARM pools: Fast payment pass-through Fast interest-rate adjustments Issuer guarantees of principal and interest Variety of products and programs Information and disclosure Program simplicity Liquidity Tradeoffs involved with ARMS If you're considering investing in an ARM pool, you need to think about the following factors: Because the interest rate is tied to market levels, you have less certainty about the amount of income you'll receive. A rise in rates on the adjustable-rate mortgages that underlie the ARM increases the likelihood that mortgagees may default on their mortgages, which would affect the ARM's return. Page 5 of 7, see disclaimer on final page

6 The guarantees of Freddie Mac and Fannie Mae rely at least in part on the support of the federal government. However, there is no guarantee that federal support will always be available or take the same form. What are collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs)? CMOs and REMICs are similar in allowing cash flows to be split so that different classes of securities (tranches) with different maturities and coupons may be created. They may be collateralized by mortgage loans as well as by securitized pools of loans, and pay slightly lower yields than straight pass-throughs with comparable risk characteristics. CMOs became extremely popular for investors in the early 1980s. However, their popularity among issuers did not last long, owing to tax consequences. Through the Tax Reform Act of 1986, Congress allowed the issuance of multiclass pass-throughs. This act created the REMIC, a nontaxable entity in the eyes of the IRS (unlike the previous grantor trust arrangement). Most CMOs created after 1986 are structured as REMICs for tax and accounting reasons, though many people still refer to them simply as CMOs. CMOs CMOs attempt to provide investors some degree of protection against the risk of an early call resulting from faster prepayments. The undesirable aspects of long maturity and cash flow uncertainty (due to prepayments) make traditional mortgage pass-throughs unattractive to some investors. These problems could be addressed if issuers of pass-throughs were allowed to actively manage the mortgage cash flow. They would be able to segment the cash flow in various maturity classes and allocate the prepaid cash flow (and uncertainty) among these classes. Issuers soon learned that they could assemble pass-throughs as collateral and segment their cash flows. They issued CMOs to satisfy the various maturity demands of investors. CMOs can now be purchased through securities broker-dealers. When a CMO is created, it is subdivided into classes or tranches. Each tranche is characterized by its interest rate, average maturity, risk level, and sensitivity to mortgage prepayments. Neither the rate of return nor the maturity date of a CMO tranche is guaranteed. For example, a $100 million CMO may be divided into four tranches of $25 million each. The principal repayments received by the CMO are initially paid to the first class until that tranche has been entirely retired. Once the first class has been paid off, mortgage principal repayments are directed to the holders of the CMOs in the second class. This process is repeated until all of the tranches have been repaid. When an investor purchases a CMO, an estimated principal repayment window is known. This schedule gauges when the investor can expect to receive principal repayments and when a particular tranche will be entirely redeemed. The CMO payment schedule is based on historical repayment data, but the actual timing of the repayments cannot be known with certainty. Lower interest rates in the marketplace will tend to speed up payments as homeowners refinance, while higher interest rates will tend to retard principal repayments. CMOs are issued as debt, not as asset sales. A CMO's yield and average life will fluctuate depending on the actual rate at which mortgage holders prepay the mortgages underlying the CMO, as well as changes in current interest rates. REMICs REMICs are fixed mortgage pools with multiple classes of investment interests. REMICs are treated as partnerships; the REMIC itself is not subject to federal income taxes. REMIC securities restructure interest and principal payments into separately traded securities. The issuer can create a security having several classes, also called tranches, that may carry different coupon rates, prepayment sensitivities, and final maturities. Fannie Mae, Freddie Mac, and Ginnie Mae all issue and guarantee REMICs. As with other mortgage-backed securities, risk exists regarding prepayment and market conditions. Page 6 of 7, see disclaimer on final page

7 Raymond James Michael West, CFP, WMS Vice President Investments 101 West Camperdown Way Suite 600 Greenville, SC x This information was developed by Broadridge, an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates, Inc. member New York Stock Exchange/SIPC does not provide advice on tax, legal or mortgage issues. These matters should be discussed with an appropriate professional. Page 7 of 7 Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2012

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