McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-1 Chapter Seven Mortgage Markets

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-2 Mortgages and Mortgage-Backed Securities Mortgages are loans to individuals or businesses to purchase a home, land, or other real property Many mortgages are securitized –mortgages are packaged and sold as assets backing a publicly traded or privately held debt instrument Four basic categories of mortgages issued –home, multifamily dwelling, commercial, and farm Mortgages are loans to individuals or businesses to purchase a home, land, or other real property Many mortgages are securitized –mortgages are packaged and sold as assets backing a publicly traded or privately held debt instrument Four basic categories of mortgages issued –home, multifamily dwelling, commercial, and farm

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-3 Mortgage Loans Outstanding, 2001 ($Bn)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-4 Mortgage Characteristics Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage (continued)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-5 Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Conventional mortgages - issued by FIs that are not federally insured Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Balloon payment mortgages: requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Conventional mortgages - issued by FIs that are not federally insured Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Balloon payment mortgages: requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period (continued)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-6 Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-7 Calculation of Monthly Mortgage Payments PV = PMT(PVIFA i/12, n  12 ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years PV = PMT(PVIFA i/12, n  12 ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-8 Comparison of Monthly Mortgage Payments $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/ = $ $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/ = $ $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/ = $ $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/ = $

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-9 Other Types of Mortgages Automatic rate-reduction mortgages - where the lender automatically lowers the rate on an existing mortgage when prevailing rates fall Graduated-payment mortgages - where borrowers make small payments early in the life of the mortgage, increased payments over the first 5-10 years and level off at the end of the mortgage period Growing-equity mortgages - where the initial payments are the same as a conventional mortgage but increase over a portion or the entire life of the mortgage Automatic rate-reduction mortgages - where the lender automatically lowers the rate on an existing mortgage when prevailing rates fall Graduated-payment mortgages - where borrowers make small payments early in the life of the mortgage, increased payments over the first 5-10 years and level off at the end of the mortgage period Growing-equity mortgages - where the initial payments are the same as a conventional mortgage but increase over a portion or the entire life of the mortgage (continued)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Second mortgages - loans secured by a piece of real estate already used to secure a first mortgage Home equity loan - loans that let customers borrow on a line of credit secured with a second mortgage Shared-appreciation mortgage (SAM) - allows a home buyer to obtain a mortgage at an interest rate below current rates in exchange for a share in any appreciation of the property Equity-participation mortgage - similar to SAM except that an outside investor shares in the appreciation Reverse-annuity mortgage - where mortgage borrower receives regular monthly payments from a FI Second mortgages - loans secured by a piece of real estate already used to secure a first mortgage Home equity loan - loans that let customers borrow on a line of credit secured with a second mortgage Shared-appreciation mortgage (SAM) - allows a home buyer to obtain a mortgage at an interest rate below current rates in exchange for a share in any appreciation of the property Equity-participation mortgage - similar to SAM except that an outside investor shares in the appreciation Reverse-annuity mortgage - where mortgage borrower receives regular monthly payments from a FI

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Secondary Mortgage Market Advantages for FI to securitize –reduces liquidity risk, interest rate risk, and credit risk of FIs portfolio –FI retains income from origination fees and service fees FI’s remove mortgages from their balance sheet through one of two mechanisms –pool recently originated mortgages together and sell them in the secondary market –issue mortgage-backed securities that are backed by their newly originated mortgages Advantages for FI to securitize –reduces liquidity risk, interest rate risk, and credit risk of FIs portfolio –FI retains income from origination fees and service fees FI’s remove mortgages from their balance sheet through one of two mechanisms –pool recently originated mortgages together and sell them in the secondary market –issue mortgage-backed securities that are backed by their newly originated mortgages

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved History of Secondary Mortgage Markets Federal National Mortgage Association (FNMA or “Fannie Mae”) created during the Great Depression FHA and VA insured loans also created during this time Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created during 1960’s Wide variety of mortgage-backed securities have been developed and in 1999, approximately 50% of mortgages are securitized Federal National Mortgage Association (FNMA or “Fannie Mae”) created during the Great Depression FHA and VA insured loans also created during this time Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created during 1960’s Wide variety of mortgage-backed securities have been developed and in 1999, approximately 50% of mortgages are securitized

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Mortgage Sales Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk FIs are encouraged to sell loans for economic (generate fee income) and regulatory reasons (reducing reserve req’s) Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, closed end bank loan funds, and nonfinancial firms Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk FIs are encouraged to sell loans for economic (generate fee income) and regulatory reasons (reducing reserve req’s) Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, closed end bank loan funds, and nonfinancial firms Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Securitization of Mortgages Pass-through mortgage securities - mortgage-backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC) Pass-through mortgage securities - mortgage-backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Government-Related Mortgage-Backed Pass-Through Securities Outstanding ($Bn)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Collateralized Mortgage Obligations CMO - a mortgage-backed bond issued in multiple classes or tranches –tranches - a bond holder class associated with a CMO Created by packaging and securitizing whole mortgage loans or resecuritizing pass-through securities Attractive to secondary mortgage market investors because they can choose a particular CMO class that fits their maturity needs CMO - a mortgage-backed bond issued in multiple classes or tranches –tranches - a bond holder class associated with a CMO Created by packaging and securitizing whole mortgage loans or resecuritizing pass-through securities Attractive to secondary mortgage market investors because they can choose a particular CMO class that fits their maturity needs