CHAPTER 9 1

1.A mortgage is a form of debt to finance a real estate investment 2.The mortgage contract specifies: a.Mortgage rate b.Maturity c.Collateral 3.The originator charges an origination fee when providing the mortgage 4.Most mortgages have maturities of 30 years, but 15- year maturities are also available.

The Traditional Game  Fixed rate 30 year FHA/VA insured mortgages  FHA, VA: 3% down, zero down (respectively)  Federal agency is guarantor of last resort  Conventional mortgages (35 – 50% of all mortgages) – fixed or variable rate  Minimum cash in from 10% to 20% (w/ 20% typical)  Banker - Brokers do not retain the mortgages  May require Insurance or larger down payments  Large Secondary Market  Fannie Mae and Freddie Mac guarantee or purchase approx. 90% of all mortgages (2010). 3

1.Prime versus Subprime Mortgages a.Prime: borrower meets traditional lending standards b.Subprime: borrower does not quality for prime loan i.Relatively lower income ii.High existing debt iii.Can make only a small down payment 2.Insured versus Conventional Mortgages a.Insured: loan is insured by FHA or VA b.Conventional: loan is not insured by FHA or VA but can be privately insured

B. Mortgage Instruments that deal with Interest-rate Volatility  Adjustable Rate Mortgage (ARM) Advantage to lender?  Graduated Payment (GPM)  Growing Equity Mortgage (GEM – never a GPM!)  Balloon Mortgage C. Equity-Based Financing  Second Mortgages; fixed loan amounts, rates and terms  Home Equity Loans / Revolving Lines of Credit 5

D. Desirable Features for a Mortgage (Lender)  Yield flexibility: Responsiveness to changing market rates  Constant real payments; keeping pace with inflation  Payment stability; minimize late payment/default problems  Full security: market value greater than loan amount  Servicing simplicity  Collecting principal and interest when rates are changing  For mortgages allowing negative amortization, tracking changing principal and interest payments can be difficult  Marketability  Ability to sell in a secondary market  Sales of mortgage backed securities (MBS) help control total lender risk  Substituting capital market funds for financial institution's funds 6

1.Securitization: ■ the pooling and repackaging of loans into securities. ■ Securities are then sold to investors, who become the owners of the loans represented by those securities. 2.The Securitization Process a.A financial institution such as a securities firm or commercial bank combine individual mortgages together into packages. b.The issuer of the MBS assigns a trustee to hold the mortgages as collateral for the investors who purchase the securities. c.After the securities are sold, the financial institution that issued the MBS receives interest and principal payments on the mortgages and then transfers (passes through) the payments to investors that purchased the securities.

Government Agencies Re-organized as Public Corporations  FNMA (1938) (Fannie Mae) organized as government agency. Re- chartered in 1968 as public company. Provide funds to assist in homeownership.  GNMA (1968) (Ginnie Mae); insured pass through because GNMA guarantees investors of mortgage-backed securities will receive timely payment of P&I. Re-chartered in 1970 as public company.  GNMA backed by full faith and credit of US Government makes it marketable! Initial pass-through were fixed rate mortgages More recent ones include variable rate. The latter typically have shorter payoff times 3.FHLMA (1970) (Freddie Mac) More funds for mortgage market Public in

B. Standard Pass-Through Securities  FNMA, GNMA (FHA, VA), FHLMA Mortgage-backed securities  PIP: (Privately Issued Pass-through): backed by non-conforming mortgages  Not insured by any Agency of the US Govt – may be commercially insured  Collateralized Mortgage Obligations (CMO); developed by Freddie Mac  Investors can purchase mortgage assets without having to service loans  Transforms otherwise illiquid mortgages into highly marketable securities  Also allows investors to sell part of the "option risk" to other investors: Accomplished by rebundling the cash flow pool 9

C. Mortgage Pools - Sources of Risk  Interest Rate (market value behaves like bonds)  Prepayment (reduces yields)  Credit (sub-prime mortgage problem) 10

What are the desirable features of a mortgage? What are the general features of an Adjustable rate mortgage? What are pass-through securities? What factors contributed to growth of second mortgages? Why are CMO such good investments from the default point of view? Why do mortgage investors want good loan-to- market value ratios? Q&A: 1, 2, 5, 6, 12, 16, 17 Interp: a, b, c 11