Last week’s column noted how a mortgage banker like Dominion Bankshares Mortgage Corp. (DBMC) of Virginia, in an effort to build a portfolio of as many mortgage loans as possible and earn fees for servicing them, concentrates on originating loans and selling them quickly — either to a broker who will resell them to investors, or to a mortgage credit lending agencies. (Insurance companies, thrifts and commercial banks are among others that create mortgage loans.) Now we will examine how mortgages are priced and how points evolve.When DBMC agrees to an interest rate with the borrower, it immediately turns to the secondary mortgage market to obtain a bid on the mortgage it expects to result from the loan application. In our example, Paine Webber Inc. gives DMBC a bid for future delivery of mortgages, in the form of a mortgage-backed security, usually in three months. In today’s market, if the mortgages in the pool carry a loan rate of 8.50 percent, the mortgage-backed security will bear an interest rate 0.5 percentage point lower. In this case, the coupon rate on the mortgage-backed security will be 8 percent.That 0.5 percentage point difference goes to DBMC as its servicing fee. DBMC must pay part of this fee to whichever of the three mortgage credit agencies provides the mortgage-backed security with its “corporate guarantee,” a guarantee for the full and timely payment of the principal and interest. The guarantee of the agencies also acts as an enhancement to the mortgage-backed security that is eventually issued; if it were rated, the security would certainly qualify for a AAA rating from the credit rating agencies.From the 0.5 percentage point servicing fee, the Government National Mortgage Association (Ginnie Mae) receives 6 basis points. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) usually receive half, or 25 basis points, for their corporate guarantees.When the mortgages are delivered to, say, Fannie Mae, DBMC is in effect stating that the mortgages, individually and totally, meet the requirements established by Fannie Mae. Dominion Bankshares Mortgage Corp. packages these mortgages into a mortgage-backed security, and in return, Fannie Mae attaches its corporate guarantee.Since the coupon on our mortgage-backed security is 8 percent, the bid given by Paine Webber closely reflects the actual yield that investors will receive when they purchase the newly created mortgage-backed security. That yield is reflected in the price of the 8 percent mortgage-backed security, which in the current market requires a price discount from par. Dominion Bankshares Mortgage must charge that discount, known as “discount points” (a point is 1 percentage point of the loan balance), to the borrower.Because Paine Webber pays DBMC 98/$ 980 for the mortgage loan, the borrower will receive at closing $ 1,000 minus the two points ($ 20), or $ 980 for each $ 1,000 of principal for the mortgage. The investor, on the other side, buys the mortgage-backed security also at 98, plus a slight markup (2/32nds), or $ 980.65 per bond. In actuality, the mortgage-backed securities generally come in $ 1 million minimums.When the mortgages backing the mortgage-backed securities are paid, they do so at par plus accrued interest. The two points that are charged to the borrower are used to make up the difference between the purchase price paid by the investor (98/$ 980), and the redemption price of par ($ 1,000). In effect, over the life of the loan, discount points are passed on to the investor owning the mortgage-backed security.Contrary to what many borrowers believe, points evolve from market forces and are not set by lenders to gouge the public. The pricing of the 8.50 percent mortgage begins with the bid given by the broker to the mortgage banker. That bid is determined by a certain yield spread off of a Treasury issue.In a simplistic example, on Wednesday, an 8 percent mortgage-backed security was priced by adding 90 basis points (a basis point is 1/100th of a percentage point) to the yield on the 10-year Treasury note (7.50 percent), which resulted in an 8.40 percent yield for the mortgage-backed security. Since the 0.5 percentage point difference must be maintained between the 8.50 percent mortgage for the borrower, and the 8 percent mortgage-backed security for the investor, the 0.5 point (50 basis points) is added to the yield on the mortgage-backed security (8.40 .50 equals 8.90 percent) to obtain the yield (8.90 percent) on the 30-year 8.50 percent mortgage. The price on the mortgage at 8.90 percent, is 98 ($ 980/$ 1,000).Again, the difference between 98 and par is two points, and those two points ($ 20 per $ 1,000 of principal) are deducted from the proceeds disbursed to the borrower at the closing. Over the life of the mortgage-backed security, the points are passed on to the investor, who purchased the mortgage-backed security also at 98, plus a slight markup (2/32nds), or $ 980.65 per bond. The lender could “swallow” part of the discount himself, just to make his mortgage offering more competitive, and more attractive to borrowers.Mortgage-backed securities are popular among investors because of their high credit quality, a yield that surpasses Treasury yields, the guaranteed monthly payment of principal and interest, quality servicing by the lenders approved by the three agencies and excellent liquidity (there is $ 1.2 trillion in mortgage-backed securities outstanding).
