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Mortgage Markets-1
MORTGAGE MARKETS
Finance 421
Mortgage Markets-2
The Unique Nature of Mortgage Markets
Mortgage loans are secured by the pledge of real property as collateral.
Mortgage loans are made for varied amounts - no standard denomination.
Issuers of mortgages are usually small family or business entities.
Weak Secondary Market for Original Mortgages– Little standardization of contracts and terms.– Traditionally issued and held by lender.
Relatively strong secondary for mortgage-backed securities Mortgage markets are highly regulated and supported by
federal government policies.
Mortgage Markets-3
Standard Fixed-Rate Mortgage (FRM) Amortized loan with periodic payments that exceed the
interest due. Payment in excess of interest is credited toward repayment of the principal.
Interest is usually computed on the declining balance. The mortgage is a lien on the property used as collateral
for the loan. If the contract is broken, the lender may use the property
to pay the loan. When mortgage is fully paid, the lien is removed and the
borrower obtains a clear title to the property.
Mortgage Markets-4
FRM Balance and Payments
Principal and interest Payments on a 9%, 15-year, $100,000 mortgage with payments of
$1,015 per month
$0
$200
$400
$600
$800
$1,000
$1,200
0 12 24 36 48 60 72 84 96 108 120 132 144 156 168
Month
Pay
men
t
Interest PaymentPrincipal Payment
Mortgage Markets-5
FRM Balance and Payments(concluded)
Principal and interest Payments on a 9%, 30-year, $100,000 mortgage with payments of
$805 per month
$0.00
$100.00
$200.00
$300.00
$400.00
$500.00
$600.00
$700.00
$800.00
$900.00
0 36 72 108 144 180 216 252 288 324
Month
Pay
men
t
Interest PaymentPrincipal Payment
Mortgage Markets-6
Conventional and Insured Mortgages Conventional mortgages represent
lending/borrowing in the private markets. Insured and/or guaranteed mortgages are
supported by federal and state agencies.– Federal Housing Administration (FHA).– Veterans Administration (VA).– Downpayment and rates may be lower.
Mortgage Markets-7
Private Mortgage Insurance
Conventional mortgage borrowers with low downpayments must usually buy private mortgage insurance (PMI).
PMI premiums are added to mortgage payments until the value of the mortgage is less than 75% of the value of the house.
Mortgage Markets-8
Private Mortgage Insurance
$112,500mortgage at10% plusinsurancepremium = 10¼to 10½% APRon $112,500balance
Insured Risk $12,500 mortgageinsurance
UninsuredMortgage
Equity
Privately Insuredconventional mortgage
$100,000mortgage at10% APR.
Equity$25,000 downpayment
$12,500 downpayment
UninsuredMortgage
Uninsured conventionalmortgage
Mortgage Markets-9
Adjustable Rate Mortgage (ARM)
Fixed-rate mortgages are not attractive to lenders in high inflation periods.
With adjustable rate contracts, borrowers' costs vary with inflation and interest rate levels.
Lenders shift interest rate risk to the borrower. Caps on ARM interest rates limit interest rate risk to borrowers.
– Capped ARMs may have a “payment cap”, “rate cap”, or both.
– Payment caps limit the maximum amount the payment can go up by in any year and over the life of the loan.
– Interest rate caps or rate caps limit the size of the increase in the loan rate in any year and over the loan’s life. Typically, the annual cap is 1-2%, and the lifetime cap is 5%.
Mortgage Markets-10
Methods of Adjustment for ARMs
Rate may vary in a prescribed range (caps) or without limit.
Payments, maturity, or principal may vary. Rates may vary based on a previously determined interest
rate index or the cost of the funds of the lender. The market prices (difference between fixed and variable
rates) the extent of interest rate risk (impact of varying interest rates) assumed by borrower and lender.
Common rate indices include Treasury rates, fixed rate mortgage indices, prime rate, and the LIBOR rate.
Mortgage Markets-11
Fixed and Adjustable Mortgage Rates
Mortgage Markets-12
Other Mortgage Instruments Balloon Payment Mortgages
– Traditional loan where interest is paid until a time when the principal was due.
– Terms can be 3, 5 or 7 years.– Loan is amortized over 15 or 30 year period so that monthly
payments are no different than a FRM of equal maturity.– Rate is fixed over the contract term.– Popular with borrowers who may either sell or refinance
prior to maturity. Rollover Mortgage (ROMs)
– Refinanced at new rate every few years.– Adjustment period is longer than traditional ARMs.– Payment is fixed
Mortgage Markets-13
Other Mortgage Instruments (continued)
Renegotiated Rate Mortgages (RRMs) – Loan terms renegotiated periodically at terms prevailing in
the market.– Adjustment period is longer than traditional ARMs.– Payment is fixed.
Interest Only Mortgages– Low payments in initial years (10 to 15 years) – only
includes interest on borrowed amount.– After initial period, payments increase such that entire loan
amount is amortized by the end of 30 years.– Borrower pays interest for a considerable period on the
entire loan balance, but avoids having to pay down balance in initial years.
Mortgage Markets-14
Other Mortgage Instruments (continued)
Construction-to Permanent Mortgages
– Bridge financing is provided by lender over the time frame required by the borrower to purchase land and construct the house.
– Only interest payment is made until construction is completed.
– Loan is financed in increments as construction payments have to be made.
– On completion of the construction, loan balance is rolled over into the type of mortgage contract desired by borrower.
Mortgage Markets-15
Other Mortgage Instruments (continued)
Reverse Annuity Mortgages (RAMs)– RAMs allow homeowners to borrow against the
equity on their homes at low rates.– Typically obtained by older people whose home
loans have been paid off, but can use income of the real estate investment they own.
– Typical term is no more than 20 years and could be for borrower’s lifetime as an annuity.
– Homeowners’ equity declines by amount borrowed.
Mortgage Markets-16
Other Mortgage Instruments (continued)
Second Mortgage - extended at time of purchase or later as equity is borrowed from property.
Home equity lines of credit became popular after the 1986 federal tax law.
Home equity loans and lines of credit allow home owners to borrow against the equity built up in their homes because of paying down the loan and/or because of the appreciation of the property.
Mortgage Markets-17
What Does it Take to Buy a Home?
Several factors influence a home buyer’s ability to secure a mortgage loans. – Borrower Income from all sources gives the
lender an idea of the ability of the borrower to meet the monthly mortgage commitment.
– Down Payment refers to the amount of cash the borrower can contribute towards the cost of the house as their equity.
– Mortgage Insurance is necessary for borrowers who are unable to come up with a 20 percent down payment.
Mortgage Markets-18
Payment to Income Ratio Examples
Annual Gross income
28% of monthly
30-year Fixed Rate (5%) Mortgage
Qualification36% of
monthly$20,000 $467 $59,985 $600 $30,000 $700 $89,913 $900 $40,000 $933 $119,841 $1,200 $50,000 $1,167 $149,897 $1,500 $60,000 $1,400 $179,826 $1,800 $80,000 $1,867 $239,810 $2,400
$100,000 $2,333 $299,667 $3,000 $150,000 $3,500 $449,564 $4,500
Mortgage Markets-19
Mortgage Origination
The original lender in a mortgage is called the mortgage originator. They generate income in one or more of the following ways:– They charge an origination fee
– They may sell the mortgage
– They may service the loan for the eventual owners of the loan in exchange for a servicing fee
– They may sell the servicing of the mortgage to another party.
– They may hold the mortgage in their investment portfolio.
Mortgage Markets-20
The Mortgage Origination Process A potential homeowner applies for a loan from a
mortgage originator. He/she specifies:– type of mortgage (FRM,ARM,etc.)– when the interest rate is set
The mortgage originator then performs a credit evaluation of the applicant
Mortgage Markets-21
The Mortgage Origination Process (continued) If the lender decides to lend the funds, it sends a
commitment letter to the applicant, and the applicant pays a commitment fee.
If the mortgage originator intends to sell the mortgage, it may obtain a commitment from the potential buyer.
At the closing date, if the borrower does not back out, the loan is made. If the borrower backs out, he loses the commitment fee.
Mortgage Markets-22
Pipeline Risk
is the risk associated with mortgage origination– Price risk
– Fallout risk
Mortgage Markets-23
Hedging Pipeline Risk
Obtain a commitment from a conduit to buy the mortgage
Obtain an agreement for the optional delivery of the mortgage
Mortgage Markets-24
Mortgage Holdings Over Time 1978 1985 1995 2005 2008 2010
Amount Outstanding $1,169.4 $2,312.3 $4,602.7 $11,942.2 $14,619.0 $14,020.1
($ in billions)
Percentage Held
Thrift institutions 45.1% 33.1% 13.0% 9.6% 5.9% 4.4%
Commercial banks 18.3 18.6 23.7 24.8 26.3% 26.4%
Insurance companies and pension funds 10.1 8.8 5.3 2.6 2.5% 2.4%
U.S. government 2.4 2.3 1.3 0.7 0.7% 0.8%
Government agencies (GSEs) 6.2 5.9 5.4 4.0 4.8% 35.9%
Mortgage pools, govt. agency 6.0 16.0 34.1 30.8 33.9% 7.6%
Mortgage pools, private — 0.6 6.4 18.0 17.7% 14.5%
Households 8.7 5.4 2.5 1.5 0.8% 0.7%
State and local governments 1.4 3.2 2.5 1.2 1.2% 1.3%
REITs 0.5 0.3 0.3 1.4 0.5% 0.4%
Credit unions 0.3 0.5 1.4 2.1 2.2% 2.3%
Finance companies — 1.2 1.6 2.4 3.1% 2.6%
Other 1.0 4.1 2.5 0.9 0.6% 0.5%
Mortgage Markets-25
Mortgage Markets-26
Mortgage Markets-27
Risks of Investing in Mortgages
Credit Risk Marketability Risk Price Risk Prepayment (or cash flow uncertainty) risk
Mortgage Markets-28
Prepayment Risk and the Price/Yield Relationship for Mortgages
Price
Yield
Mortgage Markets-29
Refinancing and Mortgage Rates
Mortgage Markets-30
Mortgage-Backed Securities -- One way to develop a secondary market for mortgages.
Mortgage pass-through securities pass through payments of principal and interest on pools of mortgages to holder of the securities.
Other Mortgage backed securities use pools of mortgages as collateral for debt securities.
Mortgage Markets-31
Types of Pass-Through Securities Ginnie Mae Pass-Throughs - pools of
government insured mortgages. Freddie Mac Participation Certification - pools of
conventional mortgages. Freddie Mac Guaranteed Mortgage Certificates -
promises regular repayment of principal and interest.
Mortgage Markets-32
Types of Pass-Through Securities (concluded) Fannie Mae pass-throughs - pools of
conventional or insured mortgages. Privately issued pass-throughs (PIP).
Mortgage Markets-33
Other Mortgage-backed Securities
Unit investment trusts -- Mortgage pools assembled by investment bankers in unit "trusts." Claims on trust is sold to investor.
Mortgage-backed mutual funds -- offer GNMA insurance but at yields higher than treasuries.
FHLMC, FNMA, and private mortgage-backed debt.
State/local government revenues bonds -- type of muni, tax-free bond.
Mortgage Markets-34
Derivative Mortgage Securities
Collateralized mortgage obligations (CMOs) -- fixed maturity date and interest payments similar to bonds.
REMICS -- real estate mortgage investment conduit; Investor pays taxes. Type of CMO.
Mortgage Markets-35
Derivative Mortgage Securities
Floating rate CMOs
Inverse floating rate CMOs
Mortgage Markets-36
Derivative Mortgage Securities (continued)
Stripped MBSs– IO Strips
– PO Strips
Mortgage Markets-37
Advantages of Mortgage-backed Securities over Individual Mortgages Issued in standardized denominations and are
negotiable. Issued or backed by quality borrowers. Usually insured and highly collateralized. Repayment schedules vary, but many are similar
to other bonds.
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