Chapter 5 : Mortgage

Markets

Financial Markets and

Chapter Objectives
Describe characteristics of residential
mortgages
Describe the common types of creative
mortgage financing
Explain how mortgage-backed securities
are used

Financial Markets and

What Is a Mortgage?
Mortgages are loans that are made for the
purpose of allowing the borrower to
purchase real estate.
They are used to finance residential home
purchases, office buildings, and even large
complexes such as shopping centers.

Financial Markets and

Flow of Savings

The Structure of the Mortgage

Market
Government loans
Builders & developers of residential
to mortgage
& commercial properties
lenders
Commercial banks
& bank holding
Conventional home
Private
co.
mortgage loans
mortgage
Savings & loan
Mortgage banks
pools
associations
(securitized
Government
Savings banks
loans)
guaranteed
home
Credit unions
loans
Federal &
Real estate
federally
Commercial
investment trusts
sponsored
mortgage loans
Insurance co.
mortgage
Farm & ranch
agencies
Pension plans
mortgage loans
Mutual funds
Individual
domestic investors
Home buyers, business firms, &
Foreign investors
recipients
Financialother
Markets
and of mortgage credit

Residential Mortgage
Characteristics
The mortgage contract should specify:

Whether the mortgage is federally insured

The amount of the loan
Whether the interest rate is fixed or adjustable
The interest rate to be charged
The maturity
Other special provisions

Financial Markets and

Mortgage Basics
A mortgage is a long-term loan secured by real estate.
Often for 15 or 30 years
The longer the term the higher the interest rate and the
greater the dollar amount of total interest paid.
Generally amortized
Equal payments, usually each month.
Amount of each payment that is principal repayment rises
each month.
A major factor to borrowers is the size of the interest payment.
The final rate that is applied to the mortgage loan depends on
three factors:
1) the current level of long-term interest rates,
2) the life of the mortgage, with longer terms having a higher rate,
and 3) the number of discount points paid at closing .

Financial Markets and

Mortgage Basics
Discount points are interest payments made at
the beginning of the loan.
They are expressed as a percent of the value
of the loan.
For example, two points on a $100,000
mortgage is 2 percent of the $100,000 or
$2,000.
The higher the points the lower the interest
rate, but points increase the amount of cash
that the buyer must have available at the time
the loan is made.
Financial Markets and

Average Mortgage Rates by Term

Year

15-year

30-year

1992

7.96

8.39

1993

6.83

7.31

1994

7.86

8.36

1995

7.48

7.93

1996

7.13

7.81

1997

7.13

7.60

1998

6.59

6.94

1999

7.06

7.44

2000

7.50

7.83

2001

6.09

6.61

Financial Markets and

Residential Mortgage Characteristics

Insured versus conventional mortgages
Federally insured mortgages guarantee loan
repayment to the lending financial institution

The insurance fee is 0.5 percent of the loan amount

The guarantor is either the FHA or the VA
The maximum mortgage amount is limited by law
The volume of FHA loans has consistently exceeded
that of VA loans

Conventional mortgages can be privately insured

The private insurance premium is typically passed to
the borrowers

Financial Markets and

Residential Mortgage Characteristics

Fixed-rate versus adjustable-rate mortgages
A fixed-rate mortgage locks in the borrowers interest rate
over the life of the mortgage
The periodic interest payment is constant
Financial institutions that hold fixed-rate mortgages are
exposed to interest rate risk if funds are obtained from
short-term sources
Borrowers with fixed-rate mortgages do not benefit from
declining rates

Fixed rates are the preferred method of financing

Interest rate risk can hurt lender profits
If interest rates rise in the market, lenders cost of
funds increases
Financial Markets and

Residential Mortgage Characteristics

Adjustable rate mortgages
The initial interest rate is usually lower than that for
a fixed-rate mortgage of the same length
The rate changes with some other market rate at
regular (Treasury bills rate, the cap is set)
Rates and the size of payments can change
Maximum allowable fluctuation over year and
life of loan
Lenders stabilize profits
Uncertainty for borrowers whose mortgage
payments can change over time
Financial Markets and

Fixed-Rate vs. Adjustable-Rate?

Adjustable-Rate
Which type do lenders prefer?
ARMs pass interest-rate risk on to borrower.
ARMs match loan assets with short-term
liabilities like deposits.
Which type do borrowers prefer?
Fixed-rate mortgage has lower interest rate risk.
If rates rise, borrower is locked in at a low rate.
If rates drop, always have option to refinance.
May prefer ARM if will resell before rate rises.
Financial Markets and

Residential Mortgage Characteristics

Mortgage maturities
Since the 1970s, 15-year mortgages have become
more popular because of savings in interest expenses
Interest rate risk for originators is lower on 15-year
mortgages
The mortgage rate on 15-year mortgages is typically lower

A balloon-payment mortgage requires interest

payments for a three- to five-year period when the
borrower must pay the full amount of the principal
No principal payments are made until maturity, so monthly
payments are lower

Financial Markets and

Residential Mortgage Characteristics

Mortgage maturities (contd)
Amortizing mortgages
An amortization schedule shows the monthly
payments broken down into principal and interest
During the early years of a mortgage, most of the
payment reflects interest
Over time, the interest proportion decreases
The lending institution for a fixed-rate mortgage will
receive a fixed amount of equal periodic payments
over a specified period of time
The payment amount depends on the principal,
interest rate, and maturity
Financial Markets and

Writing an Amortization
Schedule
Consider a 15-year (180-month) $200,000
mortgage at an annual interest rate of 9
percent. Develop an amortization schedule for
this mortgage showing all appropriate columns.
Show the first three payments and the last two
payments on the schedule. The monthly
.mortgage payment is $2,028.53

Financial Markets and

Writing an Amortization
Schedule (contd)
Payment
Number

Payment
of Interest

Payment
of Principal

Total
Payment

Remaining Loan
Balance

$1,500.00

$528.53

$2,028.53

$199,471.47

1,496.04

532.50

2,028.53

198,938.97

1,492.04

536.49

2,028.53

198,402.48

179

30.09

1,998.44

2,028.53

2,013.43

180

15.10

2,013.43

2,028.53

0.00

Financial Markets and

Creative Mortgage Financing

Graduated-payment mortgages
Growing-equity mortgages
Second mortgages
Shared-appreciation mortgages
Reverse annuity mortgage

Financial Markets and

Creative Mortgage Financing

A graduated-payment mortgage:
Allows the borrower to initially make small payments
Results in increased payments over the first 5 to 10
years, at which time payments level off
Is tailored for families who anticipate higher income
A growing-equity mortgage:
Allows the borrower to initially make small payments
Results in continually increasing payments over
time
Results in a relatively short payoff time
Financial Markets and

Creative Mortgage Financing

A second mortgage:
Can be used in conjunction with the primary or first
mortgage
Often has a shorter maturity than the first mortgage
Has a higher interest rate than the first mortgage
because of increased default risk
Is often offered by sellers of homes
A shared-appreciation mortgage:
Allows a home purchaser to obtain a mortgage at a
below-market interest rate
Allows the lender to share in the price appreciation of
the home

Financial Markets and

Creative Mortgage Financing

Reverse Annuity Mortgage (RAM)
The RAM is a financial innovation used by
retired people to convert the equity in their home
into a liquid asset.
The lending institution makes a monthly
payment to the homeowner. Each payment then
increases the lender's claim against the house.
When the person dies the house is sold, the
mortgage paid off, and any remaining funds
placed in the deceased's estate.
Financial Markets and

Activities in the Mortgage Markets

How the secondary market facilitates
mortgage activities
Selling loans
Origination, servicing and maintenance
separate business activities
Secondary market exists for loans

Securitization
Pool and repackage loans for resale
Allows resale of loans not easily sold on an
individual basis
Financial Markets and

Institutional Use of Mortgage Markets

Lenders
Thrifts - dominated and increased share of market until 1970s.
Banks - increased mkt share and powers to make mortgage loans
Insurance Companies and Pension Funds.
Government Sponsored Enterprises and Agencies
FNMA, FHLMC, Federal Land Banks, Farmers Home Administration.
State and local housing authorities issue bonds and buy subsidized,
lower-rate mortgages, often for first-time home-buyers.
Mortgage Insurers Developed in 1930s to encourage mortgage lending.
FHA guaranteed payment against default to lender for low income
borrowers.
VA insurance (1944) for mortgage loans to veterans.
Private mortgage ins covers low down pymts on conventional mortgages.
Mortgage Bankers Originate mortgages, collect fees for origination.
Do not fund mortgages but sell them (e.g., to GNMA).
Often retain servicing rights to mortgages, collecting payments, taxes,
Mortgage banking and loan servicing are very competitive as technology
applications decreasing expenses

Financial Markets and

Mortgage companies
The differences among Fannie Mae, Ginnie
Mae, and Freddie Mac are primarily the
specific loan markets they serve.
Fannie Mae (1930) - secondary market for
mortgages held by thrift organizations.
Ginnie Mae (1968) - secondary market for
insured mortgages held by commercial
banks and mortgage companies.
Freddie Mac (1970) assists savings and
loans with their mortgage market needs.
Financial Markets and

Valuation of Mortgages
Market price of mortgages is present value of cash flows

PM =

T=1

C + Prin
( 1+k)t

Where:

PM = Market price of a mortgage

C = Interest payment and Prin is principal
k = Investors required rate of return
t = maturity
Financial Markets and

Valuation of Mortgages
Periodic payment commonly includes payment
of interest and principal
Required rate of return determined by risk-free
rate, credit risk and liquidity
Risk-free interest rate components and affects
+ inflationary expectations
+ economic growth
- change in the money supply
+ budget deficit
Financial Markets and

Valuation of Mortgages
Economic growth affects the risk premium
Strong growth improves borrowers income
and cash flows and reduces default risk
Weak growth has the opposite affect

Potential changes in mortgage prices

monitored by reviewing inflation, economic
growth, deficits and housing
Financial Markets and

Risk From Investing In Mortgages

Interest rate risk
Longer term fixed rate mortgages financed by short-term funds
results in risks
To limit exposure to interest rate risk:
Sell mortgage shortly after origination (but rate may change
in that short period of time)
Make adjustable rate mortgages
Prepayment risk
Borrowers refinance if rates drop by paying off higher rate
loan and getting a new, lower rate
Investor receives payoff but has to invest at the new, lower
interest rate
Manage the risk with ARMs or by selling loans

Financial Markets and

Risk From Investing In Mortgages

Credit risk can range from default to late payments
Factors that affect default
Level of borrower equity
Borrowers income level
Borrower credit history

Lenders try to limit exposure to credit risk

Measuring risk
Use sensitivity analysis to review various what if scenarios
covering everything from default to prepayments
Incorporate likelihood of various events
Review affect on cash flows
Institution tries to measure risks and use information to
restructure or manage risk

Financial Markets and

Mortgage-Backed Securities
Securities that are secured by a portfolio of
mortgages.
Why do they exist?
Banks often dont want to hold these long term
assets (not safe to fund them with short term
deposits).
Reduce problems caused by regional lending
institutions sensitivity to local economic conditions.
Give borrowers access to a national capital market.
Give investors low-risk, long-term investments
without loan servicing cost
Financial Markets and

Mortgage-Backed Securities
Secondary market for mortgages
Mortgage pass-through securities pass through payments of principal and
interest on pools of mortgages to holders of MBS.
Other MBS use pools of mortgages as collateral for debt securities.
Advantages
Issued in standardized denominations and are negotiable.
Issued or backed by quality borrowers.
Development of secondary mortgage mkt
1934: U. S. Congress initiated development of secondary market for
mortgages by creating Federal Housing Admin (FHA).
1938: Federal National Mortgage Assoc (FNMA) created; authorized to buy
FHA insured loans.
1968: FNMA was split up into FNMA and GNMA (Government National
Mortgage Assoc). GNMA authorized to guarantee mortgage pools insured by
FHA, VA, and other federal agencies.
1970: Federal Home Loan Mortgage Corp (FHLMC) created to help
develop secondary market for conventional mortgages.

Financial Markets and

Financial Markets and

The securitization structure diagram shows the components of a typical securitization. It is

important to note that not all securitizations are identical. Nevertheless, the diagram generally
illustrates the roles of the various participants in a securitization structure.
the key elements to a typical securitization include the following:
Issuer - A bankruptcy-remote special purpose entity (SPE) formed to facilitate a securitization
and to issue securities to investors.
Lender - An entity that underwrites and funds loans that are eventually sold to the SPE for
inclusion in the securitization. Lenders are compensated by cash for the purchase of the loan
and by fees. In some cases, the lender might contract with mortgage brokers. Lenders can be
banks or non-banks.
Mortgage Broker - Acts as a facilitator between a borrower and the lender. The mortgage
broker receives fee income upon the loan's closing.
Servicer- The entity responsible for collecting loan payments from borrowers and for remitting
these payments to the issuer for distribution to the investors. The servicer is typically
compensated with fees based on the volume of loans serviced. The servicer is generally
obligated to maximize the payments from the borrowers to the issuer, and is responsible for
handling delinquent loans and foreclosures.
Investors - The purchasers of the various securities issued by a securitization. Investors
provide funding for the loans and assume varying degrees of credit risk, based on the terms
of the securities they purchase.
Rating Agency - Assigns initial ratings to the various securities issued by the issuer and
updates these ratings based on subsequent performance and perceived risk. Rating agency
criteria influence the initial structure of the securities.
Trustee - A third party appointed to represent the investors' interests in a securitization. The
trustee ensures that the securitization operates as set forth in the securitization documents,
which may include determinations about the servicer's compliance with established servicing
criteria.
Underwriter - Administers the issuance of the securities to investors.
Credit Enhancement Provider - Securitization transactions may include credit enhancement
(designed to decrease the credit risk of the structure) provided by an independent third party
in the form of letters of credit or guarantees.

Financial Markets and

Financial Markets and

Use of Mortgage-Backed Securities

Institution can securitize loans to avoid
interest rate risk and credit risk while still
earning service fees
MBS can be divided into three types
Mortgage pass-through securities
Collateralized mortgage obligations
Stripped mortgage-backed securities
Financial Markets and

Use of Mortgage-Backed Securities

Fannie Mae mortgage-backed securities
Uses funds from mortgage-backed passthrough securities to purchase mortgages
Channel funds from investors to institutions
that want to sell mortgages
Guarantee timely payments to investors
Some securities strip off interest and principal
payment streams for separate sale
Financial Markets and

Mortgage Pass-Through
A security that has the payments from the
mortgages in the pool pass through the
trustee before being disbursed to investors.
All payments are passed through as they are
made by borrowers.
This creates reinvestment risk for investors.

If interest rates drop, borrowers may prepay

and refinance their homes a lower rates.
This creates additional risk for investors,
known as prepayment risk
Financial Markets and

Use of Mortgage-Backed Securities

Collateralized mortgage obligations (CMOs)
Semi-annual payments differ from other
securities monthly payments
Segmented into classes
First class has quickest payback
Any repaid principal goes first to investors in
this class
Investors choose a class to fit maturity needs

Financial Markets and

Use of Mortgage-Backed Securities

Mortgage-backed securities for small investors
In the past, high minimum denominations
Unit trusts created to allow small investor
participation
Mutual funds

Advantages
Can purchase in secondary market without
purchasing the need to service loans
Insured
Liquid
Financial Markets and

Financial Markets and

Financial Markets and

Globalization of Mortgage Markets

Mortgage market activity not confined to
just one country
Market participants follow global economic
conditions

Financial Markets and