Mortgage Markets Chapter 7

Mortgages Loans to individuals or businesses to purchase a home, land or other real property. Categories of mortgages Home mortgages Multifamily dwelling mortgages Commercial mortgages Farm mortgages

Mortgages differ from bonds and stocks Stocks and bonds Backed by specific piece of real property. If borrower defaults, FI can take ownership of property Give a general claim on borrowers assets Only mortgage bonds are backed by a specific piece of property that allows the lender to take ownership in the event of a default.

Mortgages differ from bonds and stocks Stocks and bonds Primary mortgages have no set size or denomination. Size of each mortgage depends on the borrower’s needs and ability to repay Bonds denomination $1,000 or multiple of $1,000 per bonds Shares of stock $1 per share

Mortgages differ from bonds and stocks Stocks and bonds Primary mortgages generally involve only a single investor Bonds and stock issues by many investors

Mortgages differ from bonds and stocks Stocks and bonds Comparatively little information exists on mortgage borrowers, since borrowers are individuals Bonds and stocks are issued by publicly traded corporations, hence subject to extensive rules and regulations Hence information is available

Mortgage characteristics Capital market instruments Contract between a financial institution and a borrower Contract specifies characteristics of the mortgage agreement When a FI receives mortgage application, it must determine whether the applicant qualifies for a loan

Collateral Backed by a specific property serves as a collateral FI will place lien against property until loan is fully paid off Nobody can buy the property and obtain a clear title Lien is a public record attached to the title of the property with public recorder’s office that gives the FI the right to sell the property if the borrower defaults or falls into arrears

Down payment Mortgage borrower pays a portion of purchase price of the property on the day mortgage is closed. Balance of the purchase price is the face value of mortgage (Loan proceeds) Decreases default risk for the FI How?

Down payment A mortgage borrower who makes a large down payment invests more personal wealth into the home Less likely to default if the property value falls Value of the property is more than the mortgage loan

Down payment Size of down payment depends on the financial position of the borrower Generally 20% is down payment Loan to Value ratio may not be more than 80% Borrowers who pay less than 20% purchase private mortgage insurance

Private mortgage insurance (PMI) Purchased by the lender (FI) and paid by the borrower as part of monthly payment In the event of default, PMI issuer guarantees to pay the FI the difference between value of the property and the balance remaining on the mortgage. If the property value increases or mortgage is paid PMI may be removed by the FI

Federally insured Originated by FI Repayment guaranteed (fee 0.5% of loan amount) by Federal Housing Administration (FHA) or Veterans Administration (VA) Loan applicants to meet specific requirements set by these govt. agencies Available only to individuals from military services Maximum size of the mortgage is limited depending on location and cost of living Require either a very low (3%) or zero down payment

Conventional mortgage Not federally insured If down payment less than 20%, privately insured Secondary market mortgage buyers will not buy conventional mortgages if Loan-to-value ratio more than 80% Not privately insured

Mortgage maturities Generally 15 or 30 years 15-year more popular 15-year mortgage offers potential savings in interest paid However, monthly payments are higher

Mortgage amortization Fixed principal and interest payments fully pay off mortgage by its maturity date. During the early years of mortgage, most of the fixed monthly payment represents interest on the outstanding principal and a small amount represents payoff of the outstanding principal As mortgage reaches maturity, most of the payment represents payoff of the outstanding principal and a small amount represents interest Reduces default risk

Amortization schedule Shows how the monthly mortgage payments are split into principal and interest

Balloon payment Interest payment for 3 to 5 years Full payment of mortgage principal at the end of the period Default risk is high

Interest Rates Most important characteristics Mortgage borrowers choose how much to borrow and from whom based on interest rates

Interest Rates FIs base their quoted mortgage rates on several factors 1. Market rates at which FIs borrow (rate on certificate of deposit or Federal funds rate) 2. Rate on specific mortgage loan depends on whether it is a fixed or variable rate of interest or loan specifies discount points

Fixed Rate Mortgage Locks in interest rate, regardless of market rate changes

Adjustable rate mortgage Interest rate tied to some market rate Required monthly payments can change over the life of mortgage

Discount points Payment made when mortgage loan is issued One discount point paid up front is equal to 1% of the principal FI reduces interest rate in exchange of discount point Borrower weighs reduced interest payment over the life of loan versus upfront payment Decision depends on the period of time the borrower expects to hold the mortgage

Mortgage refinancing Borrower takes a new mortgage and uses the proceeds to pay off the current mortgage Done when interest rate falls Decision involves balancing the savings of a lower monthly payment against the costs (fees) of refinancing Thumb rule interest rate should fall by 2 percentage points of more

Other Types of Mortgages

Automatic rate reduction mortgages When prevailing rates fall, rate on an existing mortgage lowers automatically Unlike variable rate mortgages, in this mortgage type interest rate only falls and does not increase This is to keep off from refinancing when interest rates fall

Graduated payment mortgages Small payments early in the life of mortgage Payments increase over first 5 to 10 years Final payments level off at the end of the mortgage Used by borrowers who expect their income to rise Or quickly refinance Default risk high

Growing Equity Mortgages Initial payments same as conventional Increase over a portion or entire life of the mortgage Increase in monthly payments reduces the principal quickly and reduces the actual life of mortgage In contrast to Graduated payment mortgages, which do not affect the time until the mortgage is paid off, in GEM incremental increase in monthly payments reduces the actual life of the mortgage Dr. Lakshmi Kalyanaraman

Second mortgage Already a security in first mortgage Loan is secured again Should a default occur, the second mortgage holder is paid only after the first mortgage is paid off Interest rates on second mortgages are generally higher than the first mortgages

Second mortgage Second mortgage only from home equity built Home equity loan – line of credit secured with a second mortgage by customers Home equity = current market value of the home-outstanding mortgage balance

Shared Appreciation Mortgages Mortgage interest at a rate less than the current market rate in exchange for share in property value appreciation If property sold for more than the original purchase price, FI shares the gain Dr. Lakshmi Kalyanaraman

Equity Participation Mortgages Similar to Share appreciation mortgage Instead of FI, an outside investor share the appreciation The investor either provides a portion of the down payment on the property or Provides monthly payments Dr. Lakshmi Kalyanaraman

Reverse Annuity Mortgages Borrower receives regular monthly payments from a FI When RAM matures or borrower dies, property is sold and debt retired Dr. Lakshmi Kalyanaraman

Secondary Mortgage Markets After FIs originate mortgages, they sell or securitize them in secondary mortgage market. Reduces liquidity risk, interest rate risk and credit risk of their portfolios Dr. Lakshmi Kalyanaraman

Secondary Mortgage Markets Liquidity Risk: Depository institutions obtain majority of their funds from short-term deposits. Mortgage maturities are of 15 or 30 years Dr. Lakshmi Kalyanaraman

Secondary Mortgage Markets Interest Rate Risk: Holding long-term fixed rate mortgages subject them to interest rate risk, if interest rates are expected to rise Dr. Lakshmi Kalyanaraman

Secondary mortgage markets Credit Risk: (Default Risk) Since mortgage maturities are of 15 or 30 years, FIs face the risk that promised cash flows from loans may not be paid in full

Secondary mortgage markets FIs prefer servicing mortgages rather than long-term financing Long-term financing mortgages are in Balance sheet Loan originator acts as Servicer Servicer – collect payments from mortgage borrowers and pass the required interest and principal payments through to the secondary market investor Dr. Lakshmi Kalyanaraman

Secondary Mortgage Markets Servicer keeps formal records of mortgage transaction For the service, FI collects a monthly fee Fee ranges from ¼ to ½ percent of the mortgage balance Dr. Lakshmi Kalyanaraman

Secondary Mortgage Markets FIs remove mortgages by 1. pooling all recently originated mortgages together and sell them in the secondary mortgage market 2. issuing mortgage backed securities i.e. securitization of mortgages Dr. Lakshmi Kalyanaraman

Secondary Mortgage Markets The U.S. government established the Federal National Mortgage Association (FNMA or Fannie Mae) in the 1930s to buy mortgages from thrifts so they could make more mortgage loans FHA and VA insured loans make securitization easier Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created in the 1960s encouraged continued expansion of the housing market provided direct and indirect guarantees that allow for the creation of mortgage-backed securities Dr. Lakshmi Kalyanaraman

Mortgage Sales FI originates a mortgage and sells to an outside buyer With recourse – loan buyer sells back the loan back to the originator if it goes bad contingent credit risk liability for the originator Without recourse – buyer bears credit risk Dr. Lakshmi Kalyanaraman

Mortgage sales FI sells loans to manage their credit risk better Removes assets (and credit risk) from the balance sheet Allows FI to achieve better asset diversification Allows FI to better manage interest rate risk and liquidity risk Generates fee income Reduces the cost of reserve requirement Reduces the cost of holding capital requirements against mortgages

Major Mortgage Buyers Domestic banks Foreign banks Insurance companies Pension funds Closed-end bank loan mutual funds Nonfinancial corporations Dr. Lakshmi Kalyanaraman

Major Mortgage Sellers Money center banks Small regional or community banks Foreign banks Investment banks Dr. Lakshmi Kalyanaraman

Major types of MBS 1. Pass-through security 2. Collateralized Mortgage Obligations (CMO) 3. Mortgage Backed Bonds Dr. Lakshmi Kalyanaraman

Securitization Pass through securities and Collateralized Mortgage Obligations (CMO) are securitized mortgages. Securitization of mortgages involves pooling of a group of mortgages with similar characteristics Removal of these mortgages from Balance sheet Subsequent sale of interests in the mortgage pool to secondary market investors Securitization results in the creation of mortgage backed securities, traded in the secondary markets

Advantages of Securitization FIs asset portfolios more liquid Reduces interest rate risk and credit risk Source of fee income Reduces the effect of regulatory constraints such as capital requirement Dr. Lakshmi Kalyanaraman

Pass-through Mortgage Securities FIs pool mortgages and offer interest in the pool in the form of pass-through certificates Each pass through security represents fractional ownership in mortgage pool Dr. Lakshmi Kalyanaraman

Pass-through Mortgage Securities 1% share of a pass-through mortgage security issue is entitled to a 1% share of the principal and interest payments made over the life of the mortgages underlying the pool of securities Pass through promised payments of principal and interest on pools of mortgages to secondary market investors No guaranteed annual coupon Dr. Lakshmi Kalyanaraman

Pass-through Mortgage Securities Originating FI or third party servicer takes a fee Dr. Lakshmi Kalyanaraman

Mortgage Backed Securities Three agencies are directly involved in the creation of pass-through securities Ginnie Mae Fannie Mae Freddie Mac Private mortgage pass-through issuers create pass-through from nonconforming mortgages (mortgages that exceed the size limit set by government agencies) Dr. Lakshmi Kalyanaraman

Collateralized Mortgage Obligations (CMO) Multiclass pass-through with multiple bond holder classes or tranches Pass through a pro-rata of mortgage pool but CMO multi-class pass-through with a number of different bond holder classes or tranches Pass-through no guaranteed coupon, but CMO, each class has a different guaranteed coupon Mortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protected Dr. Lakshmi Kalyanaraman

Mortgage Backed Bonds (MBBs) MBBs allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheets Group of mortgage is pledged as collateral against MBB MBB issues have excess collateral Pass-through and CMO are securitization, while MBB is collateralization Pass-through and CMO remove mortgage from Balance sheet, MBB does not a group of mortgage assets is pledged as collateral against a MBB issue, but there is no direct link between the cash flows of the mortgages and the cash flows on the MBB Dr. Lakshmi Kalyanaraman