1. Mortgage Markets
Chapter 7

2. 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

3. 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.

4. 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

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

6. 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

7. 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

8. 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

9. 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?

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

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

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

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

20. 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

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

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

23. 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

24. 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

25. Other Types of Mortgages

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

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

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

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

47. 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

48. 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

49. 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

50. 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

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

52. 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

53. 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

54. 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