1. All Rights Reserved Dr. David P Echevarria 1 MORTGAGE MARKETS CHAPTER 9

2. All Rights Reserved 2Dr. David P Echevarria REAL ESTATE MORTGAGES A.The Traditional Game 1.Fixed rate 30 year FHA/VA insured mortgages a.FHA, VA: 3% down, zero down (respectively) b.Federal agency is guarantor of last resort 2.Conventional mortgages (35 – 50% of all mortgages) – fixed or variable rate a.Minimum cash in from 10% to 20% (w/ 20% typical) b.Banker - Brokers do not retain the mortgages c.May require Insurance or larger down payments d.Large Secondary Market e.Fannie Mae and Freddie Mac guarantee or hold approx. 62.5% of all mortgages (2013). GNMA holds 19.2%

3. All Rights Reserved 3Dr. David P Echevarria REAL ESTATE MORTGAGES B.Mortgage Instruments that deal with Interest-rate Volatility 1.Adjustable Rate Mortgage (ARM) 2.Graduated Payment (GPM) 3.Growing Equity Mortgage (GEM) C.Equity-Based Financing 1.Second Mortgages; fixed loan amounts, rates and terms 2.Home Equity Loans / Revolving Lines of Credit a.Competitive Equality Banking Act (1987); lifetime rate caps on HEL b.Home Equity Loan Consumer Protection Act (1988); rules for disclosure, limit flexibility on changing terms

4. All Rights Reserved 4Dr. David P Echevarria REAL ESTATE MORTGAGES D.Desirable Features for a Mortgage (Lender) 1.Yield flexibility: Responsiveness to changing market rates 2.Constant real payments; keeping pace with inflation 3.Payment stability; minimize late payment/default problems 4.Full security: market value greater than loan amount 5.Servicing simplicity a.Collecting principal and interest when rates are changing b.For mortgages allowing negative amortization, tracking changing principal and interest payments can be difficult 6.Marketability a.Ability to sell in a secondary market b.Sales of mortgage backed securities (MBS) help control total lender risk c.Substituting capital market funds for financial institution's funds

5. All Rights Reserved 5Dr. David P Echevarria MORTGAGE-BACKED SECURITIES A.Government Agencies Re-organized as Public Corporations 1.FNMA (1938) (Fannie Mae) organized as government agency. Re- chartered in 1968 as public company. Provide funds to assist in homeownership. 2.GNMA (1968) (Ginnie Mae); insured pass through because GNMA guarantees investors of mortgage-backed securities will receive timely payment of P&I. Re-chartered in 1970 as public company.  GNMA backed by full faith and credit of US Government makes it marketable! Initial pass-through were fixed rate mortgages More recent ones include variable rate. The latter typically have shorter payoff times 3.FHLMA (1970) (Freddie Mac) More funds for mortgage market Public in 1989

6. All Rights Reserved 6Dr. David P Echevarria MORTGAGE-BACKED SECURITIES B.Standard Pass-Through Securities 1.FNMA, GNMA (FHA, VA), FHLMA Mortgage-backed securities 2.PIP: (Privately Issued Pass-through): backed by non-conforming mortgages a.Not insured by any Agency of the US Govt – may be commercially insured 3.Collateralized Mortgage Obligations (CMO); developed by Freddie Mac a.Investors can purchase mortgage assets without having to service loans b.Transforms otherwise illiquid mortgages into highly marketable securities c.Also allows investors to sell part of the "option risk" to other investors: Accomplished by rebundling the cash flow pool

7. All Rights Reserved 7Dr. David P Echevarria MORTGAGE-BACKED SECURITIES C.Mortgage Pools - Sources of Risk 1.Interest Rate (market value behaves like bonds) 2.Prepayment (reduces yields) 3.Credit (sub-prime mortgage problem)

8. All Rights Reserved 8Dr. David P Echevarria Supplemental Information on Mortgages See Phase 2 Lecture Notes A.Conforming Loans B.Securitization C.Collateralized Debt Obligation (CDO) D.Pass-Through Rates E.Mortgage-Backed Securities (MBS) F.Asset-Backed Securities (ABS) G.VA Loans

9. All Rights Reserved 9Dr. David P Echevarria HOMEWORK QUESTIONS A.What are the desirable features of a mortgage? B.What are the general features of an Adjustable rate mortgage? C.What are pass-through securities? D.What factors contributed to growth of second mortgages? E.Why are CMO such good investments from the default point of view? F.Why do mortgage investors want good loan-to- market value ratios?