1. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-1 McGraw-Hill/Irwin Chapter Seven Mortgage Markets

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-2 McGraw-Hill/Irwin 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 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

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-3 McGraw-Hill/Irwin Mortgage Loans Outstanding, 2004 ($Bn)

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-4 McGraw-Hill/Irwin In 2004 there were over $10 trillion of mortgages outstanding. About 77% of mortgages are single family (1-4 family) mortgages. The rest are divided between commercial mortgages (16%), multifamily dwelling mortgages (6%) and a small amount of farm mortgages (under 1%). In 2004 there were over $10 trillion of mortgages outstanding. About 77% of mortgages are single family (1-4 family) mortgages. The rest are divided between commercial mortgages (16%), multifamily dwelling mortgages (6%) and a small amount of farm mortgages (under 1%).

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-5 McGraw-Hill/Irwin secondary market for mortgages There is a well developed and active secondary market for mortgages, unlike most other loan types. This is because the government is heavily involved in the single family secondary mortgage market to promote securitization. There is a well developed and active secondary market for mortgages, unlike most other loan types. This is because the government is heavily involved in the single family secondary mortgage market to promote securitization.

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-6 McGraw-Hill/Irwin Securitization Securitization is the process of transforming individual loan contracts into marketable securities. About 60% of single family mortgages are securitized

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-7 McGraw-Hill/Irwin The saleable contract Mortgage contracts by themselves would not be particularly saleable because they have nonstandard, fairly small denominations and unique, potentially substantial credit risk. A saleable contract should have a standard, large denomination to appeal to institutional buyers, a low cost method of assessment of credit risk, good collateral, a standard maturity, and a standard interest rate. Standardization improves salability. Standard terms improve the ability to market an issue to buyers because they are more familiar with the terms and risks of the investment Mortgage contracts by themselves would not be particularly saleable because they have nonstandard, fairly small denominations and unique, potentially substantial credit risk. A saleable contract should have a standard, large denomination to appeal to institutional buyers, a low cost method of assessment of credit risk, good collateral, a standard maturity, and a standard interest rate. Standardization improves salability. Standard terms improve the ability to market an issue to buyers because they are more familiar with the terms and risks of the investment

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-8 McGraw-Hill/Irwin Mortgages have generally good collateral, standard lengthy maturities and standard interest rates. The small and variable denomination of individual mortgages implies that mortgages should be pooled to create a typical large denomination. Mortgages have generally good collateral, standard lengthy maturities and standard interest rates. The small and variable denomination of individual mortgages implies that mortgages should be pooled to create a typical large denomination.

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-9 McGraw-Hill/Irwin What about credit risk Credit risk analysis of the many individual borrowers in the pool would be quite costly and would severely limit the usefulness of the securitization process if not alleviated. Thus, for most mortgages that are securitized either the government provides insurance for mortgages, or an 80% loan to value ratio is required, or the mortgage must be privately insured. Credit risk analysis of the many individual borrowers in the pool would be quite costly and would severely limit the usefulness of the securitization process if not alleviated. Thus, for most mortgages that are securitized either the government provides insurance for mortgages, or an 80% loan to value ratio is required, or the mortgage must be privately insured.

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-10 McGraw-Hill/Irwin Why Securitization Securitization brings many benefits to FIs. Securitization allows FIs to a) become more liquid, b) reduce interest rate and credit risk, c) reduce capital and reserve requirements, d) generate fee income from servicing more mortgages than they could otherwise. Securitization brings many benefits to FIs. Securitization allows FIs to a) become more liquid, b) reduce interest rate and credit risk, c) reduce capital and reserve requirements, d) generate fee income from servicing more mortgages than they could otherwise.

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-11 McGraw-Hill/Irwin Saudi to be soon, so you may wish to consider pursuing careers in mortgage related areas. The mortgage markets are huge (they are larger than the corporate debt market), rapidly growing (from 1992 through 2004 the amount of home mortgages grew by about 133%) becoming increasingly sophisticated. Even with the slower economic growth of the 2000s the mortgage markets have continued to grow, in some areas home prices have advanced more rapidly than income growth, generating some concerns that housing prices could fall precipitously if housing becomes unaffordable The mortgage markets are huge (they are larger than the corporate debt market), rapidly growing (from 1992 through 2004 the amount of home mortgages grew by about 133%) becoming increasingly sophisticated. Even with the slower economic growth of the 2000s the mortgage markets have continued to grow, in some areas home prices have advanced more rapidly than income growth, generating some concerns that housing prices could fall precipitously if housing becomes unaffordable

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-12 McGraw-Hill/Irwin Was Greenspan wrong Nevertheless, Greenspan has indicated that he does not foresee problems of this nature in the housing market. However Greenspan did indicate that rapid growth in two housing related government sponsored enterprises, FNMA and FHLMC, was generating systemic risk to the economy. Nevertheless, Greenspan has indicated that he does not foresee problems of this nature in the housing market. However Greenspan did indicate that rapid growth in two housing related government sponsored enterprises, FNMA and FHLMC, was generating systemic risk to the economy.

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-13 McGraw-Hill/Irwin In other countries and in USA past, severe collapses in housing prices have triggered prolonged periods of low economic growth or even a prolonged recession.

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-14 McGraw-Hill/Irwin The Primary Mortgage Market It should be emphasized that the starting and financing of mortgages are now largely separate functions. One of the primary purposes of the government’s presence in the mortgage markets is to ensure the availability of mortgage credit wherever it is needed. Government mortgage insurance and the securitization process have created a national market for financing mortgages. It should be emphasized that the starting and financing of mortgages are now largely separate functions. One of the primary purposes of the government’s presence in the mortgage markets is to ensure the availability of mortgage credit wherever it is needed. Government mortgage insurance and the securitization process have created a national market for financing mortgages.

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-15 McGraw-Hill/Irwin The separation of creation and financing of mortgages. The financing of mortgages is national, or even international, in scope. The origination (creation) of mortgages is still primarily a local market, for instance, typically one does not go to another state to obtain a mortgage. The originators however often sell the mortgage (individually or in a pool). The origination market is itself however becoming increasingly national because mortgage companies (a local originating institution) often obtain mortgage financing from institutions around the country. The financing of mortgages is national, or even international, in scope. The origination (creation) of mortgages is still primarily a local market, for instance, typically one does not go to another state to obtain a mortgage. The originators however often sell the mortgage (individually or in a pool). The origination market is itself however becoming increasingly national because mortgage companies (a local originating institution) often obtain mortgage financing from institutions around the country.

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-16 McGraw-Hill/Irwin Electronic mortgage Electronic mortgage origination however has not grown as dramatically as predicted. Applying for a mortgage online remains a troublesome task, hurting this area of business. Electronic mortgage origination however has not grown as dramatically as predicted. Applying for a mortgage online remains a troublesome task, hurting this area of business.

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-17 McGraw-Hill/Irwin Politics or theft or stupid Government involvement has done two things. One, it has allowed younger, less wealthy people to own homes by eliminating the large down payment, thus facilitating a part of the “American dream” of home ownership. Second, it has helped poorer regions of the country such as West Virginia, Montana, etc that would not have had enough mortgage credit available to meet the demand for funds. Government involvement has done two things. One, it has allowed younger, less wealthy people to own homes by eliminating the large down payment, thus facilitating a part of the “American dream” of home ownership. Second, it has helped poorer regions of the country such as West Virginia, Montana, etc that would not have had enough mortgage credit available to meet the demand for funds.

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-18 McGraw-Hill/Irwin Why home ownership For many people, home ownership is one of the most satisfying assets they obtain. It is a person’s major hedge against personal disasters and inflation. Even in low inflation times it is usually (but not always) an appreciating asset and, unlike automobiles, should be considered an investment. It is however an illiquid investment and living in the wrong house for you in the wrong area can make you miserable for a long time, so please shop wisely. For many people, home ownership is one of the most satisfying assets they obtain. It is a person’s major hedge against personal disasters and inflation. Even in low inflation times it is usually (but not always) an appreciating asset and, unlike automobiles, should be considered an investment. It is however an illiquid investment and living in the wrong house for you in the wrong area can make you miserable for a long time, so please shop wisely.

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-19 McGraw-Hill/Irwin Mortgage Characteristics Although mortgages can have unique terms, the demands of the secondary market increasingly determine the guidelines for accepting or rejecting a mortgage application. Lien Down payment Private mortgage insurance Federally insured mortgages Conventional mortgages Amortized Balloon payment mortgages Although mortgages can have unique terms, the demands of the secondary market increasingly determine the guidelines for accepting or rejecting a mortgage application. Lien Down payment Private mortgage insurance Federally insured mortgages Conventional mortgages Amortized Balloon payment mortgages (continued)

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-20 McGraw-Hill/Irwin Fixed-rate mortgage Adjustable-rate mortgage Discount points Amortization schedule Fixed-rate mortgage Adjustable-rate mortgage Discount points Amortization schedule

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-21 McGraw-Hill/Irwin Collateral & lien All mortgage loans are backed by collateral that will have a lien placed against it. A lien is a public record attached to the title of the property that gives the financial institution the right to sell the property if the mortgage borrower defaults. A lien prevents sale of the property until the mortgage is paid off and the lien removed. All mortgage loans are backed by collateral that will have a lien placed against it. A lien is a public record attached to the title of the property that gives the financial institution the right to sell the property if the mortgage borrower defaults. A lien prevents sale of the property until the mortgage is paid off and the lien removed.

22. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-22 McGraw-Hill/Irwin Down Payment In the absence of government insurance, a down payment is required to minimize default risk. An 80% loan to value ratio is standard. If a borrower cannot pay the required 20% down payment they may obtain FHA insurance. (Federal Housing Administration) FHA insurance has a maximum borrowing amount that varies according to regional housing costs. The borrower may instead apply for private mortgage insurance (PMI). In the absence of government insurance, a down payment is required to minimize default risk. An 80% loan to value ratio is standard. If a borrower cannot pay the required 20% down payment they may obtain FHA insurance. (Federal Housing Administration) FHA insurance has a maximum borrowing amount that varies according to regional housing costs. The borrower may instead apply for private mortgage insurance (PMI).

23. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-23 McGraw-Hill/Irwin PMI Most PMI requires a monthly payment that is added to the principle and interest payment. Although it can vary from lender to lender, the typical monthly mortgage insurance payment if the borrower pays only 10% down can be found by multiplying the loan amount times a constant factor equal to 0.0051 and then dividing the result by 12. Most PMI requires a monthly payment that is added to the principle and interest payment. Although it can vary from lender to lender, the typical monthly mortgage insurance payment if the borrower pays only 10% down can be found by multiplying the loan amount times a constant factor equal to 0.0051 and then dividing the result by 12.

24. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-24 McGraw-Hill/Irwin Example For instance, on a $100,000 mortgage with 10% down, the monthly PMI premium would be ($100,000*0.0051)/12 = $42.50. If you finance 97% the constant is 0.0090 and the monthly PMI payment would be $75. For instance, on a $100,000 mortgage with 10% down, the monthly PMI premium would be ($100,000*0.0051)/12 = $42.50. If you finance 97% the constant is 0.0090 and the monthly PMI payment would be $75.

25. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-25 McGraw-Hill/Irwin Tip Once the homeowner reduces the principle amount to 80% or less of the house value, either through payments and/or appreciation of the value of the home, the homeowner may wish to have the house reappraised and apply for termination of the mortgage insurance. The appraisal cost may be as low as $500-$600.

26. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-26 McGraw-Hill/Irwin Insured vs Conventional Mortgages Conventional mortgages are mortgages not insured by the Federal government. The term insured mortgages refers to mortgages insured by the Federal government, not privately insured mortgages. Conventional mortgages are mortgages not insured by the Federal government. The term insured mortgages refers to mortgages insured by the Federal government, not privately insured mortgages.

27. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-27 McGraw-Hill/Irwin Mortgage Maturities The two standard maturities are 15 year and 30 year, with 30 year mortgages predominating. Some contracts call for balloon payments at the end of three to five years. These contracts may require interest only payments during the interim period. Most borrowers will not be able to pay off the balloon so the borrower is essentially agreeing to refinance the mortgage when the balloon is due. The two standard maturities are 15 year and 30 year, with 30 year mortgages predominating. Some contracts call for balloon payments at the end of three to five years. These contracts may require interest only payments during the interim period. Most borrowers will not be able to pay off the balloon so the borrower is essentially agreeing to refinance the mortgage when the balloon is due.

28. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-28 McGraw-Hill/Irwin Tip A balloon payment mortgage is riskier to the borrower because there is no guarantee that refinancing will be granted. An injury or illness, a layoff, etc. can endanger an individual’s primary asset, their home. A balloon payment mortgage is riskier to the borrower because there is no guarantee that refinancing will be granted. An injury or illness, a layoff, etc. can endanger an individual’s primary asset, their home.

29. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-29 McGraw-Hill/Irwin Interest Rates Mortgage rates are a function of: the fed funds rate, discount points paid, whether the loan is FHA or a conventional mortgage, maturity, whether the mortgage is fixed or adjustable rate, regional demand for funds and the level of competition of suppliers of mortgage credit. Regional credit availability is not an issue due to the national financing market. Mortgage rates are a function of: the fed funds rate, discount points paid, whether the loan is FHA or a conventional mortgage, maturity, whether the mortgage is fixed or adjustable rate, regional demand for funds and the level of competition of suppliers of mortgage credit. Regional credit availability is not an issue due to the national financing market.

30. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-30 McGraw-Hill/Irwin Fixed versus Adjustable Rate Mortgages (FRMs) remain the most popular mortgage type, although a significant number of mortgages are adjustable rate. With the low rates of the early 2000s, adjustable rate mortgages (ARMs) have not been as popular as in prior periods. (at one point several years ago 50% of new originations were adjustable rate). (FRMs) remain the most popular mortgage type, although a significant number of mortgages are adjustable rate. With the low rates of the early 2000s, adjustable rate mortgages (ARMs) have not been as popular as in prior periods. (at one point several years ago 50% of new originations were adjustable rate).

31. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-31 McGraw-Hill/Irwin prepayment penalties The index used cannot be the lender’s cost of funds and is often an index of lenders’ fund costs (termed a COFI or cost of funds index). The rate change per year and over the life of the mortgage is capped and prepayment penalties are not allowed on ARMs. (A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest. Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed in any one year without a penalty. A penalty that applies to a home sale as well as a refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a "soft" penalty.) The index used cannot be the lender’s cost of funds and is often an index of lenders’ fund costs (termed a COFI or cost of funds index). The rate change per year and over the life of the mortgage is capped and prepayment penalties are not allowed on ARMs. (A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest. Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed in any one year without a penalty. A penalty that applies to a home sale as well as a refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a "soft" penalty.)

32. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-32 McGraw-Hill/Irwin The cap With a fixed rate mortgage the lender bears the interest rate risk, with an ARM the borrower bears the interest rate risk. (implies that even in an ARM the lender still bears some interest rate risk) ARMs result in higher default risk for lenders in periods of rising interest rates. When rates rise, borrowers have more difficulty making the payments on their mortgage. With a fixed rate mortgage the lender bears the interest rate risk, with an ARM the borrower bears the interest rate risk. (implies that even in an ARM the lender still bears some interest rate risk) ARMs result in higher default risk for lenders in periods of rising interest rates. When rates rise, borrowers have more difficulty making the payments on their mortgage.

33. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-33 McGraw-Hill/Irwin Discount Points A borrower can buy a lower interest rate by paying points up front. A discount point is 1% of the loan amount. Lenders periodically establish point schedules that show what interest rate they are willing to offer if the borrower pays a certain amount of points. A simple breakeven analysis can be used to determine whether the borrower should pay the points. A borrower can buy a lower interest rate by paying points up front. A discount point is 1% of the loan amount. Lenders periodically establish point schedules that show what interest rate they are willing to offer if the borrower pays a certain amount of points. A simple breakeven analysis can be used to determine whether the borrower should pay the points.

34. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-34 McGraw-Hill/Irwin Other Fees A homebuyer will normally face a host of fees (payable at closing or before) including: Application fee Title search fee Title insurance fee Appraisal fee Loan origination fee (usually 1% of the loan amount) Closing agent/review fee Costs to obtain mortgage insurance (FHA, VA or private) if needed Tip: Closing costs average from 3%-5% of the mortgage amount (excluding points), with 3% the most common. A homebuyer will normally face a host of fees (payable at closing or before) including: Application fee Title search fee Title insurance fee Appraisal fee Loan origination fee (usually 1% of the loan amount) Closing agent/review fee Costs to obtain mortgage insurance (FHA, VA or private) if needed Tip: Closing costs average from 3%-5% of the mortgage amount (excluding points), with 3% the most common.

35. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-35 McGraw-Hill/Irwin Mortgage Refinancing Due to low interest rates in the early 2000s, mortgage refinancing business has boomed. A typical rule of thumb is that the new mortgage rate should be 200 basis points below the old rate, but with ARMs and reduced refinancing costs refinancings can be worthwhile at smaller rate reductions. A breakeven analysis can be used to determine if refinancing is worthwhile Due to low interest rates in the early 2000s, mortgage refinancing business has boomed. A typical rule of thumb is that the new mortgage rate should be 200 basis points below the old rate, but with ARMs and reduced refinancing costs refinancings can be worthwhile at smaller rate reductions. A breakeven analysis can be used to determine if refinancing is worthwhile

36. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-36 McGraw-Hill/Irwin Mortgage amortization The typical mortgage is fully amortized at the original maturity so that the principle is reduced with each payment and no balloon remains at maturity. Amortizing payments are calculated using the present value of annuity formula. An amortization schedule depicts the amount of each payment that goes to principle and to interest. The typical mortgage is fully amortized at the original maturity so that the principle is reduced with each payment and no balloon remains at maturity. Amortizing payments are calculated using the present value of annuity formula. An amortization schedule depicts the amount of each payment that goes to principle and to interest.

37. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-37 McGraw-Hill/Irwin Example A borrower agrees to a $200,000, thirty year fixed rate mortgage with a 5.75% quoted interest rate. What is the payment amount and how much of each payment goes to principle and interest? 30years =360 payment Payment = $200,000 / (1-1.004792^-360)/0.004792 = $1,167.15 The amortization schedule provides the breakdown of each payment into principle and interest on a dollar and a percentage basis. Notice that the total interest paid on this mortgage ($220,172.46) is greater than the original balance. A borrower agrees to a $200,000, thirty year fixed rate mortgage with a 5.75% quoted interest rate. What is the payment amount and how much of each payment goes to principle and interest? 30years =360 payment Payment = $200,000 / (1-1.004792^-360)/0.004792 = $1,167.15 The amortization schedule provides the breakdown of each payment into principle and interest on a dollar and a percentage basis. Notice that the total interest paid on this mortgage ($220,172.46) is greater than the original balance.

38. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-38 McGraw-Hill/Irwin Calculation of Monthly Mortgage Payments PV = PMT(PVIFA r,t ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity r = interest rate, i, divided by 12 (months/year) t = number of months (payments) over life of the mortgage PV = PMT(PVIFA r,t ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity r = interest rate, i, divided by 12 (months/year) t = number of months (payments) over life of the mortgage

39. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-39 McGraw-Hill/Irwin 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 = $120,000/136.2835 = $880.52 $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/104.6406 = $1146.78 $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/136.2835 = $880.52 $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/104.6406 = $1146.78

40. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-40 McGraw-Hill/Irwin Other Types of Mortgages Automatic rate-reduction mortgages Graduated-payment mortgages Growing-equity mortgages Second mortgages Home equity loan Shared-appreciation mortgage (SAM) Equity-participation mortgage Reverse-annuity mortgage Automatic rate-reduction mortgages Graduated-payment mortgages Growing-equity mortgages Second mortgages Home equity loan Shared-appreciation mortgage (SAM) Equity-participation mortgage Reverse-annuity mortgage

41. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-41 McGraw-Hill/Irwin Automatic Rate-Reduction Mortgages When interest rates fall the lender automatically lowers the existing mortgage interest rate; however the rate is never adjusted upward. This type of mortgage is designed to discourage refinancing with another lender if rates fall. When interest rates fall the lender automatically lowers the existing mortgage interest rate; however the rate is never adjusted upward. This type of mortgage is designed to discourage refinancing with another lender if rates fall.

42. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-42 McGraw-Hill/Irwin Graduated Payment Mortgages GPMs GPMs allow borrowers to initially make low monthly payments which rise for the next 5 to 10 years before leveling off. GPMs are designed to allow homebuyers to purchase more house than they can currently afford under the assumption that their income will rise to match the growing house payment. Relative to a standard fixed rate mortgage, the borrower will pay more interest overall. This type of mortgage is riskier than a standard fixed rate mortgage with a payment that the borrower can currently afford. GPMs allow borrowers to initially make low monthly payments which rise for the next 5 to 10 years before leveling off. GPMs are designed to allow homebuyers to purchase more house than they can currently afford under the assumption that their income will rise to match the growing house payment. Relative to a standard fixed rate mortgage, the borrower will pay more interest overall. This type of mortgage is riskier than a standard fixed rate mortgage with a payment that the borrower can currently afford.

43. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-43 McGraw-Hill/Irwin Growing Equity Mortgages (GEMs) GEMs are mortgages where the payments increase according to a fixed schedule over the entire life of the mortgage. GEMs result in faster amortization which shortens the maturity of the mortgage; thus they are a way to more quickly pay down the debt. GEMs are mortgages where the payments increase according to a fixed schedule over the entire life of the mortgage. GEMs result in faster amortization which shortens the maturity of the mortgage; thus they are a way to more quickly pay down the debt.

44. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-44 McGraw-Hill/Irwin alternative to a GEM. Without commit it A fifteen year mortgage is an alternative to a GEM. Also, a borrower could simply take out a 30 year fixed rate mortgage and make extra payments each year. The latter strategy is probably the least risky alternative for the borrower if they have the discipline to stick to the extra payments. In any case, GEMs are increasingly being replaced with 5 year interest only (IO) loans. A fifteen year mortgage is an alternative to a GEM. Also, a borrower could simply take out a 30 year fixed rate mortgage and make extra payments each year. The latter strategy is probably the least risky alternative for the borrower if they have the discipline to stick to the extra payments. In any case, GEMs are increasingly being replaced with 5 year interest only (IO) loans.

45. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-45 McGraw-Hill/Irwin Second Mortgages Second mortgages are subordinated claims to senior mortgages. Home equity loans allow customers to borrow on a line of credit secured with a second mortgage. Interest on home equity loans is normally tax deductible whereas credit card interest is not. Home equity loans have been running about 160 basis points above the 15 year fixed rate, but this varies. Second mortgages are subordinated claims to senior mortgages. Home equity loans allow customers to borrow on a line of credit secured with a second mortgage. Interest on home equity loans is normally tax deductible whereas credit card interest is not. Home equity loans have been running about 160 basis points above the 15 year fixed rate, but this varies.

46. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-46 McGraw-Hill/Irwin Tip Be careful advising individuals to use a home equity loan to pay off credit card debt. Theoretically, an expensive vacation or even a shopping spree could endanger your home ownership if the buyer cannot manage credit properly. Citigroup and Household International came under fire in 2002 for their aggressive marketing tactics used in selling mortgages to subprime borrowers. Be careful advising individuals to use a home equity loan to pay off credit card debt. Theoretically, an expensive vacation or even a shopping spree could endanger your home ownership if the buyer cannot manage credit properly. Citigroup and Household International came under fire in 2002 for their aggressive marketing tactics used in selling mortgages to subprime borrowers.

47. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-47 McGraw-Hill/Irwin Shared Appreciation Mortgages (SAMs) SAMs allow home owners to obtain a loan at up to 200 basis points below market rates. In exchange, the homeowner must give a portion of the appreciation in value of the home to the lender upon sale or refinancing of the home. Many SAMs have a refinancing requirement in 5 to 7 years if the home has not already been sold. SAMs are another form of mortgage that allows a homebuyer to buy more house than they can afford at current interest rates. They have not been very popular in recent years; they were primarily used in the 1980s. SAMs allow home owners to obtain a loan at up to 200 basis points below market rates. In exchange, the homeowner must give a portion of the appreciation in value of the home to the lender upon sale or refinancing of the home. Many SAMs have a refinancing requirement in 5 to 7 years if the home has not already been sold. SAMs are another form of mortgage that allows a homebuyer to buy more house than they can afford at current interest rates. They have not been very popular in recent years; they were primarily used in the 1980s.

48. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-48 McGraw-Hill/Irwin Equity Participation Mortgages An equity participation mortgage is the same as a SAM except that a third party (other than the lender) gets a share in the appreciation of the house.

49. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-49 McGraw-Hill/Irwin Reverse Annuity Mortgages (RAMs) RAMs are for homeowners with a substantial amount of equity in their home who wish to supplement their income, usually retirees. With a RAM the FI makes a monthly payment to the homeowner. The FI is in effect buying out the homeowner’s equity over time. At maturity the house is sold and the proceeds are used to pay off the FI. RAM maturities are usually set up so that the homeowner will die before maturity. As the population ages and health care costs increase RAMs are likely to grow in popularity. RAMs are for homeowners with a substantial amount of equity in their home who wish to supplement their income, usually retirees. With a RAM the FI makes a monthly payment to the homeowner. The FI is in effect buying out the homeowner’s equity over time. At maturity the house is sold and the proceeds are used to pay off the FI. RAM maturities are usually set up so that the homeowner will die before maturity. As the population ages and health care costs increase RAMs are likely to grow in popularity.

50. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-50 McGraw-Hill/Irwin New Types of Mortgages 40 year mortgages Negative Amortization Mortgage Flex-ARM mortgage Piggyback Mortgage or Combo loan 103s and 107s Most of these alternative mortgage types are riskier for home buyers, they are generally methods to buy more house than you could otherwise afford. 40 year mortgages Negative Amortization Mortgage Flex-ARM mortgage Piggyback Mortgage or Combo loan 103s and 107s Most of these alternative mortgage types are riskier for home buyers, they are generally methods to buy more house than you could otherwise afford.

51. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-51 McGraw-Hill/Irwin 40-Year Mortgage These products are similar to 30-year fixed-rate mortgages, except that borrowers stretch the payments out for an extra 10 years. Lenders, however, charge a slightly higher interest rate, up to half a percentage point, says Greg McBride of Bankrate.com. This type of loan is good for first-time buyers who don't plan on staying in the house for more than a few years, and are looking for lower monthly payments. Pros: A 40-year mortgage offers lower monthly payments than a 30-year loan, while locking in today's attractive rates. On a $300,000 mortgage at today's prevailing rates -- 6% for a 30-year and 6.25% for a 40-year -- a home buyer could save nearly $95 each month. Cons: By extending the length of the mortgage, the borrower increases the amount of interest paid over the life of the loan. On that $300,000 mortgage, it would mean an additional $170,030.42. These products are similar to 30-year fixed-rate mortgages, except that borrowers stretch the payments out for an extra 10 years. Lenders, however, charge a slightly higher interest rate, up to half a percentage point, says Greg McBride of Bankrate.com. This type of loan is good for first-time buyers who don't plan on staying in the house for more than a few years, and are looking for lower monthly payments. Pros: A 40-year mortgage offers lower monthly payments than a 30-year loan, while locking in today's attractive rates. On a $300,000 mortgage at today's prevailing rates -- 6% for a 30-year and 6.25% for a 40-year -- a home buyer could save nearly $95 each month. Cons: By extending the length of the mortgage, the borrower increases the amount of interest paid over the life of the loan. On that $300,000 mortgage, it would mean an additional $170,030.42.

52. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-52 McGraw-Hill/Irwin Negative Amortization Mortgage This interest-only product allows buyers to pay less than the full amount of interest necessary to cover the costs of the mortgage. The difference between the full amount and the amount paid each month is added to the balance of the loan. This loan is best for borrowers with large cash reserves who want the flexibility of lower payments during certain parts of the year but plan to pay off loans in large chunks during other parts. Pros: An even smaller monthly payment than an interest-only mortgage in the first few years. Cons: Should housing prices stagnate or fall, buyers would find themselves in "negative equity," meaning they would owe money to the lender if they sold their homes. This interest-only product allows buyers to pay less than the full amount of interest necessary to cover the costs of the mortgage. The difference between the full amount and the amount paid each month is added to the balance of the loan. This loan is best for borrowers with large cash reserves who want the flexibility of lower payments during certain parts of the year but plan to pay off loans in large chunks during other parts. Pros: An even smaller monthly payment than an interest-only mortgage in the first few years. Cons: Should housing prices stagnate or fall, buyers would find themselves in "negative equity," meaning they would owe money to the lender if they sold their homes.

53. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-53 McGraw-Hill/Irwin Flex-ARM Mortgage Each month the lender sends the borrower a payment coupon that calculates four payment options: negative amortization, interest only, 30-year fixed and 20-year fixed. The homeowner decides how much to pay. (Some mortgages offer only an interest-only and a 30- year-fixed option.) This structure is recommended for people who like options and have large cash reserves for when payments increase in the later portion of the loan. Pros: The bank does all the thinking. Each month it recalculates the balance and tells the borrower how much he or she would owe under different scenarios. Cons: Borrowers could end up owing more on the mortgage than they can fetch for their homes Each month the lender sends the borrower a payment coupon that calculates four payment options: negative amortization, interest only, 30-year fixed and 20-year fixed. The homeowner decides how much to pay. (Some mortgages offer only an interest-only and a 30- year-fixed option.) This structure is recommended for people who like options and have large cash reserves for when payments increase in the later portion of the loan. Pros: The bank does all the thinking. Each month it recalculates the balance and tells the borrower how much he or she would owe under different scenarios. Cons: Borrowers could end up owing more on the mortgage than they can fetch for their homes

54. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-54 McGraw-Hill/Irwin Piggyback Mortgage This is really two mortgages, also known as a combo loan. The first covers 80% of the property's value. The second, with a slightly higher rate, covers the remaining balance. Young professionals with high salaries but little savings would benefit most from this loan type. Pros: In most cases, homeowners save money since the second loan allows them to avoid paying costly private-mortgage insurance when buying a home with less than a 20% down payment. Cons: Rates on the second mortgage are higher. And rates can vary greatly depending on credit scores. Also, since the borrower has little equity in the home, should its value fall when it is time to sell, the borrower would need to pay the difference in cash. This is really two mortgages, also known as a combo loan. The first covers 80% of the property's value. The second, with a slightly higher rate, covers the remaining balance. Young professionals with high salaries but little savings would benefit most from this loan type. Pros: In most cases, homeowners save money since the second loan allows them to avoid paying costly private-mortgage insurance when buying a home with less than a 20% down payment. Cons: Rates on the second mortgage are higher. And rates can vary greatly depending on credit scores. Also, since the borrower has little equity in the home, should its value fall when it is time to sell, the borrower would need to pay the difference in cash.

55. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-55 McGraw-Hill/Irwin 103s and 107s. These loans have no down payment and allow people to borrow 3% to 7% more than the house is worth. They are best for people with large cash reserves who prefer to invest in, say, the stock market rather than tying up assets in real estate. Pros: Minimal up-front costs. Cons: Rates tend to be high. And borrowers run the risk of negative equity if the house loses value. These loans have no down payment and allow people to borrow 3% to 7% more than the house is worth. They are best for people with large cash reserves who prefer to invest in, say, the stock market rather than tying up assets in real estate. Pros: Minimal up-front costs. Cons: Rates tend to be high. And borrowers run the risk of negative equity if the house loses value.

56. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-56 McGraw-Hill/Irwin 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

57. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-57 McGraw-Hill/Irwin History And Background Of Secondary Mortgage Markets In 2004 over 60% of all residential mortgages were securitized. Originators often keep the servicing contract. Servicing fees range from ¼% to ½% of the loan amount. Securitization also allows FIs to remove the mortgages from the balance sheet which improves liquidity, reduces interest rate risk and reduces capital and other regulatory costs. More details and calculations of savings are provided in Chapter 24. In 2004 over 60% of all residential mortgages were securitized. Originators often keep the servicing contract. Servicing fees range from ¼% to ½% of the loan amount. Securitization also allows FIs to remove the mortgages from the balance sheet which improves liquidity, reduces interest rate risk and reduces capital and other regulatory costs. More details and calculations of savings are provided in Chapter 24.

58. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-58 McGraw-Hill/Irwin Mortgage Sales outline Mortgage sale Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk FIs are encouraged to sell loans for economic and regulatory reasons Major buyers of mortgage loans Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks Mortgage sale Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk FIs are encouraged to sell loans for economic and regulatory reasons Major buyers of mortgage loans Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks

59. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-59 McGraw-Hill/Irwin Mortgage Sales1 Traditionally, mortgage and loan sales were conducted between correspondent banks. Correspondent banks are banks that have ongoing service, loan and deposit relationships with each other. Prototypically, a small bank has a correspondent relationship with a larger bank. The small bank keeps deposits at the larger bank and uses the larger bank to clear checks, obtain loans and invest extra funds. Small banks often also create loans too large for them to finance and they may sell all or part of the loan to their correspondent bank. The large bank may also sell loan participations to the small bank if local loan demand is weak at the smaller bank’s locale. This practice improves diversification at the smaller bank. Traditionally, mortgage and loan sales were conducted between correspondent banks. Correspondent banks are banks that have ongoing service, loan and deposit relationships with each other. Prototypically, a small bank has a correspondent relationship with a larger bank. The small bank keeps deposits at the larger bank and uses the larger bank to clear checks, obtain loans and invest extra funds. Small banks often also create loans too large for them to finance and they may sell all or part of the loan to their correspondent bank. The large bank may also sell loan participations to the small bank if local loan demand is weak at the smaller bank’s locale. This practice improves diversification at the smaller bank.

60. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-60 McGraw-Hill/Irwin Mortgage Sales2 Mortgage (or other loan) sales may be with or without recourse, most are without recourse and may or may not lead to securitization. If a loan is sold with recourse the loan seller remains liable to the loan buyer if the borrower defaults. The five major buyers of mortgages are banks, insurance firms, pension funds, closed end bank loan funds and nonfinancial corporations. A major advantage of selling the mortgages is the reduction in capital required by the selling institution. A bank that finances a mortgage must hold 2.8¢ in equity capital per dollar of mortgage loans. Selling the loan reduces the required equity. The seller may keep the servicing contract or may not, preferring to earn origination fees on new mortgages. Mortgage (or other loan) sales may be with or without recourse, most are without recourse and may or may not lead to securitization. If a loan is sold with recourse the loan seller remains liable to the loan buyer if the borrower defaults. The five major buyers of mortgages are banks, insurance firms, pension funds, closed end bank loan funds and nonfinancial corporations. A major advantage of selling the mortgages is the reduction in capital required by the selling institution. A bank that finances a mortgage must hold 2.8¢ in equity capital per dollar of mortgage loans. Selling the loan reduces the required equity. The seller may keep the servicing contract or may not, preferring to earn origination fees on new mortgages.

61. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-61 McGraw-Hill/Irwin Mortgage-Backed Securities Securitization is the process of transforming individual loan contracts into marketable securities. This is accomplished by depositing a pool of mortgages with a trustee and then selling some type of marketable security to investors. It is a form of intermediation. Mortgage backed bonds and CMOs (REMICs) are examples of asset transformations. As of 2004, there were $4.73 trillion of mortgage securities outstanding. Securitization is the process of transforming individual loan contracts into marketable securities. This is accomplished by depositing a pool of mortgages with a trustee and then selling some type of marketable security to investors. It is a form of intermediation. Mortgage backed bonds and CMOs (REMICs) are examples of asset transformations. As of 2004, there were $4.73 trillion of mortgage securities outstanding.

62. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-62 McGraw-Hill/Irwin The main types of Securitization of Mortgages Pass-through mortgage securities Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC) Pass-through mortgage securities Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC)

63. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-63 McGraw-Hill/Irwin Pass-Through Securities On a pass-through security, the pool organizer simply passes through all mortgage payments made by the homeowners, including prepayments, to the holders of the pass-through securities on a pro-rata basis. Payments are thus monthly, and are variable based on how many homeowners pay off their mortgages early. The pool organizer or the government usually provides insurance for the mortgages in the pool. Default risk is not generally a worry for a government backed pass-through security holder (such as a GNMA pass-through). These securities carry substantial prepayment risk however. On a pass-through security, the pool organizer simply passes through all mortgage payments made by the homeowners, including prepayments, to the holders of the pass-through securities on a pro-rata basis. Payments are thus monthly, and are variable based on how many homeowners pay off their mortgages early. The pool organizer or the government usually provides insurance for the mortgages in the pool. Default risk is not generally a worry for a government backed pass-through security holder (such as a GNMA pass-through). These securities carry substantial prepayment risk however.

64. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-64 McGraw-Hill/Irwin Prepayment risk Prepayment risk can be illustrated with a simple example. If an investor holds a relatively high interest rate pass-through it will be priced above par. The investor is willing to pay a premium above par because the claim pays a high level of interest relative to current rates. If the mortgages are prepaid the investor will receive the par amount but they will have paid a premium over par that will be lost because the investor will be cashed out at par. Prepayment risk can be illustrated with a simple example. If an investor holds a relatively high interest rate pass-through it will be priced above par. The investor is willing to pay a premium above par because the claim pays a high level of interest relative to current rates. If the mortgages are prepaid the investor will receive the par amount but they will have paid a premium over par that will be lost because the investor will be cashed out at par.

65. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-65 McGraw-Hill/Irwin GNMA The Government National Mortgage Association (GNMA) is a government agency that was formed in 1968 to provide mortgage credit to veterans, farmers and lower income individuals. Rather than provide direct financing for mortgages, GNMA will guarantee payment on mortgage pools that are created by private pool organizers. Originators submit a pool of mortgages for GNMA approval. All mortgages in the pool must have the same interest rate and maturity and have FHA, FmHA or VA insurance so GNMA insurance is really only timing insurance (ensures that the payments are made in a timely fashion). The government places caps on the insurable amount of an individual mortgage. These caps vary according to the cost of housing in a given area and housing costs through time, but the maximum was $359,650 in 2004. The Government National Mortgage Association (GNMA) is a government agency that was formed in 1968 to provide mortgage credit to veterans, farmers and lower income individuals. Rather than provide direct financing for mortgages, GNMA will guarantee payment on mortgage pools that are created by private pool organizers. Originators submit a pool of mortgages for GNMA approval. All mortgages in the pool must have the same interest rate and maturity and have FHA, FmHA or VA insurance so GNMA insurance is really only timing insurance (ensures that the payments are made in a timely fashion). The government places caps on the insurable amount of an individual mortgage. These caps vary according to the cost of housing in a given area and housing costs through time, but the maximum was $359,650 in 2004.

66. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-66 McGraw-Hill/Irwin GNMA2 GNMA does not form mortgage pools but allows pool organizers to sell securities which use the pool as collateral and carry GNMA's name. These are called GNMA pass-throughs. These securities have minimum denominations of $25,000. The pass-through holders receive the amounts paid in by the homeowners minus a 50 basis point fee. GNMA and the mortgage servicers share those basis points. Mortgage companies are the largest issuer of GNMA pass-throughs. GNMA does not form mortgage pools but allows pool organizers to sell securities which use the pool as collateral and carry GNMA's name. These are called GNMA pass-throughs. These securities have minimum denominations of $25,000. The pass-through holders receive the amounts paid in by the homeowners minus a 50 basis point fee. GNMA and the mortgage servicers share those basis points. Mortgage companies are the largest issuer of GNMA pass-throughs.

67. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-67 McGraw-Hill/Irwin Fannie Mae FNMA was formed in 1938 as a government agency and charged with creating a secondary market for FHA and VA insured mortgages. FNMA did so by making and honoring forward commitments to purchase mortgages from originators. FNMA raises money by issuing its own securities to the public. FNMA has an emergency line of credit with the Treasury if needed although FNMA was privatized in 1968. Privatization occurred so that FNMA could expand into conventional mortgages and because they were profitable on their own and no longer needed government support. FNMA was formed in 1938 as a government agency and charged with creating a secondary market for FHA and VA insured mortgages. FNMA did so by making and honoring forward commitments to purchase mortgages from originators. FNMA raises money by issuing its own securities to the public. FNMA has an emergency line of credit with the Treasury if needed although FNMA was privatized in 1968. Privatization occurred so that FNMA could expand into conventional mortgages and because they were profitable on their own and no longer needed government support.

68. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-68 McGraw-Hill/Irwin Freddie Mac Freddie Mac was created in 1970 as a private company with the purpose of improving the liquidity of mortgages originated by thrifts. FHLMC buys both FHA, VA and conventional mortgages, puts the mortgages into pools, and then sells claims (securities) collateralized by the mortgage pool. Thus FHLMC does not provide the ultimate financing for the bulk of their mortgages. Freddie Mac was created in 1970 as a private company with the purpose of improving the liquidity of mortgages originated by thrifts. FHLMC buys both FHA, VA and conventional mortgages, puts the mortgages into pools, and then sells claims (securities) collateralized by the mortgage pool. Thus FHLMC does not provide the ultimate financing for the bulk of their mortgages.

69. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-69 McGraw-Hill/Irwin Government Sponsorship of FNMA and Freddie Mac and recent problems at both Both FNMA and FHLMC are implicitly backed by the U.S. government, indeed both have a credit line with the Treasury. The government backing reduces FNMA’s and FHLMC’s borrowing costs and both companies have been consistently profitable. Because the government backing lowers these government sponsored enterprises’ (GSEs) funding costs, either the GSEs can consistently generate monopoly profits and/or more funds are channeled into mortgage investments that otherwise would have gone elsewhere, probably to corporate bond or equity investments. A second concern is the government’s liability that would occur if these GSEs experienced financial difficulties, as both organizations are quite large. Both FNMA and FHLMC are implicitly backed by the U.S. government, indeed both have a credit line with the Treasury. The government backing reduces FNMA’s and FHLMC’s borrowing costs and both companies have been consistently profitable. Because the government backing lowers these government sponsored enterprises’ (GSEs) funding costs, either the GSEs can consistently generate monopoly profits and/or more funds are channeled into mortgage investments that otherwise would have gone elsewhere, probably to corporate bond or equity investments. A second concern is the government’s liability that would occur if these GSEs experienced financial difficulties, as both organizations are quite large.

70. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-70 McGraw-Hill/Irwin Problems with derivatives positions The Office of Federal Housing Enterprise Oversight (OFHEO) regulates both corporations. OFHEO has indicated that both organizations are at risk from large positions in derivatives, supposedly designed to hedge their interest rate risk. If these institutions are hedging appropriately, then the derivatives positions should not add to bankruptcy risk to the organizations. However, hedging reduces both return and risk and few hedgers can resist the temptation to use derivatives to try to increase return rather than to reduce risk. In 2003, Freddie Mac experienced a 52% drop in income due to derivatives losses. The Office of Federal Housing Enterprise Oversight (OFHEO) regulates both corporations. OFHEO has indicated that both organizations are at risk from large positions in derivatives, supposedly designed to hedge their interest rate risk. If these institutions are hedging appropriately, then the derivatives positions should not add to bankruptcy risk to the organizations. However, hedging reduces both return and risk and few hedgers can resist the temptation to use derivatives to try to increase return rather than to reduce risk. In 2003, Freddie Mac experienced a 52% drop in income due to derivatives losses.

71. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-71 McGraw-Hill/Irwin Other problems that have recently arisen Both institutions have been accused of overcharging lenders for mortgage insurance. Freddie and Fannie constitute an oligopoly. Oligopolistic competition should prevent the firms from earning monopoly rents unless implicit or explicit price fixing is occurring. Because these are GSEs and have subsidized funds costs, they may not be aggressively pricing their services. Both institutions have been accused of overcharging lenders for mortgage insurance. Freddie and Fannie constitute an oligopoly. Oligopolistic competition should prevent the firms from earning monopoly rents unless implicit or explicit price fixing is occurring. Because these are GSEs and have subsidized funds costs, they may not be aggressively pricing their services.

72. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-72 McGraw-Hill/Irwin Cooking the Books In 2003 both institutions restated earnings or equity. Fannie Mae restated equity by $1.1 billion. Freddie Mac restated earnings by $4.5 billion. Both were claimed to be computational errors. Both have since been found to have been manipulating accounts to smooth earnings and in one case increase a bonus to an executive. In 2003 both institutions restated earnings or equity. Fannie Mae restated equity by $1.1 billion. Freddie Mac restated earnings by $4.5 billion. Both were claimed to be computational errors. Both have since been found to have been manipulating accounts to smooth earnings and in one case increase a bonus to an executive.

73. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-73 McGraw-Hill/Irwin Alan Greenspan In February 2004, Alan Greenspan stated that both institutions pose serious risks to the U.S. financial system. His concern is that their status as GSEs allows Fannie and Freddie to borrow excessively. The result is that the Treasury department must now approve new debt issues by both institutions. A new regulator of the industry has also been proposed. In February 2004, Alan Greenspan stated that both institutions pose serious risks to the U.S. financial system. His concern is that their status as GSEs allows Fannie and Freddie to borrow excessively. The result is that the Treasury department must now approve new debt issues by both institutions. A new regulator of the industry has also been proposed.

74. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-74 McGraw-Hill/Irwin Private Mortgage Pass-Throughs A limited number of private mortgage pass- through issuers deal with nonconforming mortgages that do not qualify for government insurance. Prudential Home, Residential Funding Corporation, GE Capital Mortgages, Countrywide and a few other companies create private mortgage pass–throughs. The acronym for private mortgage pass- throughs is Privately Issued Pass-Throughs or PIPs. PIPs must be registered with the SEC and normally are rated by one or more of the ratings agencies. A limited number of private mortgage pass- through issuers deal with nonconforming mortgages that do not qualify for government insurance. Prudential Home, Residential Funding Corporation, GE Capital Mortgages, Countrywide and a few other companies create private mortgage pass–throughs. The acronym for private mortgage pass- throughs is Privately Issued Pass-Throughs or PIPs. PIPs must be registered with the SEC and normally are rated by one or more of the ratings agencies.

75. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-75 McGraw-Hill/Irwin Mortgage Backed Pass-Through Quotes Mortgage instruments are priced according to some assumed level of prepayments. The Public Securities Association (PSA) has developed what is known as the “Standard Prepayment Model:” The PSA model of prepayments on home mortgages is 0.2% initially with prepayments rising at 0.2% per month until month 30, after which prepayments remain at 6% per year. Mortgage instruments are priced according to some assumed level of prepayments. The Public Securities Association (PSA) has developed what is known as the “Standard Prepayment Model:” The PSA model of prepayments on home mortgages is 0.2% initially with prepayments rising at 0.2% per month until month 30, after which prepayments remain at 6% per year.

76. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-76 McGraw-Hill/Irwin prepayment models See www.psa.com/publications/igabs/prepay ment.htm for various prepayment models on different loan types. www.psa.com/publications/igabs/prepay ment.htm If 25% higher prepayments than the standard are expected (usually due to falling interest rates) the mortgage instrument may be priced with expected prepayments of “125% of PSA.” See www.psa.com/publications/igabs/prepay ment.htm for various prepayment models on different loan types. www.psa.com/publications/igabs/prepay ment.htm If 25% higher prepayments than the standard are expected (usually due to falling interest rates) the mortgage instrument may be priced with expected prepayments of “125% of PSA.”

77. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-77 McGraw-Hill/Irwin Tip It is important to understand that with a pass- through the investor bears all the prepayment risk and the pool organizer has no prepayment risk. GNMA pass-through securities are often sold as ‘guaranteed’ because of the government backing but investors should understand that the rate of return on the pass-through is not guaranteed and can vary widely with different prepayment patterns. It is important to understand that with a pass- through the investor bears all the prepayment risk and the pool organizer has no prepayment risk. GNMA pass-through securities are often sold as ‘guaranteed’ because of the government backing but investors should understand that the rate of return on the pass-through is not guaranteed and can vary widely with different prepayment patterns.

78. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-78 McGraw-Hill/Irwin 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

79. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-79 McGraw-Hill/Irwin Government-Related Mortgage-Backed Pass-Through Securities Outstanding ($Bn)

80. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-80 McGraw-Hill/Irwin 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

81. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-81 McGraw-Hill/Irwin Collateralized Mortgage Obligations (CMOs) CMOs were created to allow investors to better choose and control the level of prepayment risk they face. CMOs are a hybrid between a pass-through and a bond. CMOs have different payment classes called tranches. Suppose the CMO has three classes, A, B and C. The Class A CMO holder would receive all the initial principal payments (on the entire pool), including all prepayments, whenever they occur, until all the Class A holders have been paid off. Buyers of Class A CMOs are interested in short duration investments.مثل الأول في الجمعية Initially, Class B and C holders would receive no principle, just interest payments until all of the principle of Class A holders has been paid off. Likewise, Class C is not affected by any prepayments until Class B holders have been paid off. The multiple classes allow investors to better choose the level of prepayment risk desired. The REMIC (Real Estate Mortgage Investment Conduit) is essentially a legal form of CMO that avoids tax complications. The IRS normally does not allow an intermediary to transform cash flows without taxing the activity. In 1986 Congress set up the REMIC as a trust form that is exempt from IRS taxation. CMOs were created to allow investors to better choose and control the level of prepayment risk they face. CMOs are a hybrid between a pass-through and a bond. CMOs have different payment classes called tranches. Suppose the CMO has three classes, A, B and C. The Class A CMO holder would receive all the initial principal payments (on the entire pool), including all prepayments, whenever they occur, until all the Class A holders have been paid off. Buyers of Class A CMOs are interested in short duration investments.مثل الأول في الجمعية Initially, Class B and C holders would receive no principle, just interest payments until all of the principle of Class A holders has been paid off. Likewise, Class C is not affected by any prepayments until Class B holders have been paid off. The multiple classes allow investors to better choose the level of prepayment risk desired. The REMIC (Real Estate Mortgage Investment Conduit) is essentially a legal form of CMO that avoids tax complications. The IRS normally does not allow an intermediary to transform cash flows without taxing the activity. In 1986 Congress set up the REMIC as a trust form that is exempt from IRS taxation.

82. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-82 McGraw-Hill/Irwin Mortgage Backed Bonds (MBBs) With MBBs, mortgages are pledged as collateral backing the bond issue. The MBB is in all other respects similar to standard corporate bonds. In this case the bond issuer bears the prepayment risk, and as a result the bonds normally have to be significantly overcollateralized to obtain a favorable bond rating. MBBs are not technically a method of securitization in that the bond issuer does not remove the mortgages from their balance sheet; thus, issuing MBBs does not provide some of the aforementioned benefits of securitization to the FI. With MBBs, mortgages are pledged as collateral backing the bond issue. The MBB is in all other respects similar to standard corporate bonds. In this case the bond issuer bears the prepayment risk, and as a result the bonds normally have to be significantly overcollateralized to obtain a favorable bond rating. MBBs are not technically a method of securitization in that the bond issuer does not remove the mortgages from their balance sheet; thus, issuing MBBs does not provide some of the aforementioned benefits of securitization to the FI.

83. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-83 McGraw-Hill/Irwin Participants in the Mortgage Markets Who originates single family mortgages? (2004) Banks 27% Thrifts28% Mortgage Companies 28% Other17% Who finances mortgages? Depository Institutions36% Held in pools52% Life Insurers 3% Mortgage companies<1% Other 8% Who originates single family mortgages? (2004) Banks 27% Thrifts28% Mortgage Companies 28% Other17% Who finances mortgages? Depository Institutions36% Held in pools52% Life Insurers 3% Mortgage companies<1% Other 8%

84. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-84 McGraw-Hill/Irwin Mortgages Outstanding by Type of Holder(%), 2004

85. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-85 McGraw-Hill/Irwin One- to Four-Family Mortgage Originations, 2004

86. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-86 McGraw-Hill/Irwin Issuers of Ginnie Mae Securities, 2004

87. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-87 McGraw-Hill/Irwin mortgage companies There is a very large difference in the amount of mortgages originated by mortgage companies and the amount financed. Most mortgage companies quickly sell the mortgages they originate.

88. ©2007, The McGraw-Hill Companies, All Rights Reserved 7-88 McGraw-Hill/Irwin International Trends in Securitization –Demand by international investors for U.S. mortgage backed securities –International Mortgage Securitization Foreign banks hold an insignificant amount of U.S. mortgages. Outside the U.S., Europe has engaged in the most securitization. The conversion to the Euro has increased the growth of securitization in Euroland. Securitization is running at about $200 billion per year in Europe. The United Kingdom has more securitization than any other European country. France and Germany have not progressed in securitization to the same degree. –Demand by international investors for U.S. mortgage backed securities –International Mortgage Securitization Foreign banks hold an insignificant amount of U.S. mortgages. Outside the U.S., Europe has engaged in the most securitization. The conversion to the Euro has increased the growth of securitization in Euroland. Securitization is running at about $200 billion per year in Europe. The United Kingdom has more securitization than any other European country. France and Germany have not progressed in securitization to the same degree.