Chapter 9 Mortgage Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline Background on mortgages Residential mortgage characteristics Creative mortgage financing Institutional use of mortgage markets Valuation of mortgages Risk from investing in mortgages Mortgage-backed securities Globalization of mortgage markets

Background on Mortgages A mortgage is a form of debt that finances investment in property The debt is secured by the property The mortgage is the difference between the down payment and the value to be paid for the property Financial institutions such as savings institutions and mortgage companies originate mortgages They accept mortgage applications and assess the creditworthiness of the applicants The mortgage contract specifies the mortgage rate, the maturity, and the collateral that is backing the loan The originator charges an origination fee The originator may earn a profit from the difference between the mortgage rate and the rate that it paid to obtain funds

Background on Mortgages (cont’d) The level of mortgage debt has risen over time Mortgage debt rises at a slower rate during recessions The majority of mortgage debt outstanding is on one- to four-family properties

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

Residential Mortgage Characteristics (cont’d) 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

Residential Mortgage Characteristics (cont’d) Fixed-rate versus adjustable-rate mortgages A fixed-rate mortgage locks in the borrower’s 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

Residential Mortgage Characteristics (cont’d) Fixed-rate versus adjustable-rate mortgages (cont’d) An adjustable-rate mortgage (ARM) allows the mortgage rate to adjust to market conditions The formula and frequency of adjustment vary among mortgage contracts A common ARM uses a one-year adjustment with the interest rate tied to the average T-bill rate over the previous year Some ARMs contain an option that allows mortgage holders to switch to a fixed rate within a specified period Most ARMs specify a maximum allowable fluctuation in the mortgage rate per year and over the mortgage life Borrowers with ARMs face uncertainty about future interest rates

Residential Mortgage Characteristics (cont’d) Fixed-rate versus adjustable-rate mortgages (cont’d) Using ARMs, financial institutions: Can stabilize their profit margins Face less interest rate risk than with fixed-rate mortgages

Residential Mortgage Characteristics (cont’d) 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

Residential Mortgage Characteristics (cont’d) Mortgage maturities (cont’d) 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

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.

Writing an Amortization Schedule (cont’d) Payment Number of Interest of Principal Total Remaining Loan Balance 1 $1,500.00 $528.53 $2,028.53 $199,471.47 2 1,496.04 532.50 2,028.53 198,938.97 3 1,492.04 536.49 198,402.48 . 179 30.09 1,998.44 2,013.43 180 15.10 0.00

Creative Mortgage Financing Graduated-payment mortgages Growing-equity mortgages Second mortgages Shared-appreciation mortgages

Creative Mortgage Financing (cont’d) 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: Results in continually increasing payments over time Results in a relatively short payoff time

Creative Mortgage Financing (cont’d) 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

Institutional Use of Mortgage Markets Development of a secondary mortgage market: Allows institutions that originate mortgages to sell them Allows institutional investors to invest in mortgages even if they have no desire to originate or service them Allows institutional investors to sell mortgages Financial institutions that originate mortgages Mortgage companies: Originate mortgages and quickly sell the mortgages they originate Do not maintain large mortgage portfolios Are not as exposed to interest rate risk as other financial institutions Commercial banks and thrift institutions are the primary originators of mortgages

Institutional Use of Mortgage Markets (cont’d) Participation in the secondary market Financial institutions sell mortgages they cannot finance in the secondary market Buyers are savings institutions, pension funds, life insurance companies, and mutual funds

Institutional Use of Mortgage Markets (cont’d) Roles of Ginnie Mae, Fannie Mae, and Freddie Mac Fannie Mae: Issues debt securities and uses the proceeds to purchase mortgages in the secondary market Has more than $800 billion of securities outstanding Is exempt from state income tax and has credit lines from the Treasury Is commonly perceived to be backed by the government Ginnie Mae: Is a wholly-owned corporation by the federal government Supplies funds to low- and moderate-income homeowners indirectly by facilitating the flow of funds into the secondary mortgage market Has more than $600 billion of securities outstanding

Institutional Use of Mortgage Markets (cont’d) Roles of Ginnie Mae, Fannie Mae, and Freddie Mac (cont’d) Freddie Mac: Ensures that sufficient funds flow into the mortgage market Is exempt from state income tax and has lines of credit with the Treasury Has more than $600 billion in debt securities outstanding As a result of these three entities, the secondary mortgage market: Is very liquid Has a lot of funding

Institutional Use of Mortgage Markets (cont’d) Roles of Ginnie Mae, Fannie Mae, and Freddie Mac (cont’d) The Freddie Mac accounting scandal Since 2000, Freddie Mac invested in corporate bonds, strip malls, and hotels The company used irregular accounting techniques to stabilize earnings and hide its increased risk Freddie Mac was required to restate its 2000-2002 earnings and replaced its CEO and other senior managers

Institutional Use of Mortgage Markets (cont’d) Securitization is the pooling and repackaging of loans into securities Investors in these securities become the owners of the represented loans Allows for the sale of smaller mortgage loans that cannot be easily sold individually Can reduce a financial institution’s exposure to default risk or interest rate risk

Institutional Use of Mortgage Markets (cont’d)

Institutional Use of Mortgage Markets (cont’d) Unbundling of mortgage activities Financial institutions can: Function as mortgage originators and then sell them in the secondary market Sell originated mortgages by maintain the servicing Focus on servicing mortgages originated by other institutions Focus on investing in mortgages Invest in mortgages that it is allowed to service Brokerage firms participate by matching up sellers and buyers of mortgages in the secondary market Investment banking firms participate by helping institutional investors hedge their mortgage holdings against interest rate risk

Valuation of Mortgages The market price of mortgages should equal the present value of their future cash flows: The required rate of return on a mortgage is influenced by the risk-free rate, credit risk, and the lack of liquidity:

Valuation of Mortgages (cont’d) Factors that affect the risk-free interest rate The risk-free rate is driven by inflationary expectations, economic growth, the money supply, and the budget deficit: Inflationary expectations Higher expected inflation places upward pressure on interest rates and on the required return

Valuation of Mortgages (cont’d) Factors that affect the risk-free interest rate (cont’d) Economic growth An increase in economic growth causes an increase in the risk-free rate and in the required rate of return Money supply growth A high level of money supply growth places downward pressure on interest rates and on the required rate of return Budget deficit An increase in the budget deficit increases government demand for loanable funds and places upward pressure on the risk-free rate and the required rate of return

Valuation of Mortgages (cont’d) Factors that affect the risk premium The average risk premium can change in response to a change in economic growth: Strong economic growth improves income or cash flows and reduces default risk

Valuation of Mortgages (cont’d) Summary of factors affecting mortgage prices Price movements in a mortgage can be modeled as:

Valuation of Mortgages (cont’d) Summary of factors affecting mortgage prices (cont’d) Impact of the September 11 attack on mortgage rates Short-term rates declined by a full percentage point within one month Long-term interest rates declined only slightly The 30-year conventional mortgage declined by only about .25 percentage point over the next month

Valuation of Mortgages (cont’d) Indicators of changes in mortgage prices Mortgage market participants monitor indicators that may signal future changes in the strength of the economy: Inflation indicators Announcements about the budget deficit Indicators of economic growth in the real estate sector

Risk from Investing in Mortgages Interest rate risk Mortgage prices decline in response to an increase in interest rates Mortgages are commonly financed by financial institutions with short-term deposits Mortgages can generate high returns when interest rates fall, but gains are limited because borrowers tend to refinance

Risk from Investing in Mortgages (cont’d) Interest rate risk (cont’d) Limiting exposure to interest rate risk Financial institutions can: Sell mortgages shortly after originating them Maintain adjustable-rate residential mortgages Invest in fixed-rate mortgages with a short time remaining to maturity

Risk from Investing in Mortgages (cont’d) Prepayment risk Prepayment risk is the risk that a borrower may prepay the mortgage in response to a decline in interest rates The investor receives payment and has to reinvest at the lower interest rate Limiting exposure to prepayment risk Financial institutions can sell loans shortly after originating them or invest in adjustable-rate mortgages

Risk from Investing in Mortgages (cont’d) Credit risk Credit risk is the possibility that borrowers will make late payments or even default The probability of default is influenced by economic conditions and by: The level of equity invested by the borrower The borrower’s income level The borrower’s credit history Limiting exposure to credit risk Financial institutions can purchase insurance Financial institutions can maintain the mortgages they originate

Risk from Investing in Mortgages (cont’d) Measuring risk Financial institutions attempt to estimate the future cash flows to be generated from mortgage portfolios in various future periods Prepayment risk and credit risk create uncertainty about future payments Sensitivity analysis can be used to forecast cash flows for different scenarios Review of financial statements to monitor risk When interest rates rise, the reported value of mortgage-backed securities are not revised A loss in the value of mortgage-backed securities is only recognized when the financial institution sells them at a loss

Mortgage-Backed Securities Mortgage-backed securities are securities backed by mortgage loans Issuing mortgage-backed securities is an alternative to selling mortgages outright in the secondary market The most common are mortgage pass-through securities A group of mortgages held by trustee serves as collateral Interest and principal on the mortgages are sent to the financial institution, which passes them through to the owners of the mortgage-backed securities Financial institutions earn fees from servicing the mortgages while avoiding exposure to interest rate risk and credit risk

Mortgage-Backed Securities (cont’d) Interest rate risk on mortgage-backed securities Payments received from pass-through securities are tied to the payments sent to security owners Institutions can insulate their profit margin from interest rate fluctuations

Mortgage-Backed Securities (cont’d) Prepayment risk on mortgage-backed securities Owners of pass-through securities are exposed to prepayment risk because of the borrower’s right to prepay in part or in full without penalty Owners of mortgage-backed securities are also subject to the possibility that prepayments are decelerated in response to rising interest rates

Mortgage-Backed Securities (cont’d) Ginnie Mae mortgage-backed securities Ginnie Mae guarantees time payment of principal and interest to investors in FHA or VA mortgages All mortgages pooled together must have the same interest rate The interest rate received by purchasers is about 50 basis points less Fannie Mae mortgage-backed securities Fannie Mae issues mortgage-backed securities and uses the funds to purchase mortgages Channels funds from investors to financial institutions that desire to sell their mortgages Receives a fee for guaranteeing timely payment of principal and interest to the holders of the mortgage-backed securities Some mortgage-backed securities are stripped by separating the principal and interest payments

Mortgage-Backed Securities (cont’d) Publicly issued pass-through securities (PIPs) Similar to Ginnie Mae mortgage-backed securities Backed by conventional rather than FHA or VA mortgages Insured through private insurance companies Participation certificates (PCs) Freddie Mac sells participation certificates (PCs) and uses the proceeds to finance the origination of conventional mortgages from financial institutions

Mortgage-Backed Securities (cont’d) Collateralized mortgage obligations (CMOs): Have semiannual interest payments Are segmented into tranches, with the first tranch having the quickest payback Are attractive because investors can choose a class that fits their maturity desires Are sometimes segmented into interest-only (IO) and principal-only (PO) classes

Mortgage-Backed Securities (cont’d) Mortgage-backed securities for small investors Unit trusts have been created that allow small investors to participate e.g., a portfolio of Ginnie Mae pass-through securities is sold in $1,000 pieces Some mutual funds offer Ginnie Mae funds

Globalization of Mortgage Markets Non-U.S. financial institutions hold mortgages on U.S. property and vice versa The use of interest rate swaps to hedge mortgages in the U.S. often involves a non-U.S. counterpart Mortgage market participants closely follow international economic conditions because of the potential impact on interest rates A weaker dollar leads to higher inflation and higher interest rates