CHAPTER 9 MORTGAGE MARKETS. Copyright© 2003 John Wiley and Sons, Inc. The Unique Nature of Mortgage...

CHAPTER 9

MORTGAGE MARKETS

Copyright© 2003 John Wiley and Sons, Inc.

The Unique Nature ofMortgage 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.

Copyright© 2003 John Wiley and Sons, Inc.

The Unique Nature ofMortgage Markets (concluded)

Weak Secondary MarketLittle standardization of contracts and terms.Traditionally issued and held by lender.

Mortgage markets are highly regulated and supported by federal government policies.

Copyright© 2003 John Wiley and Sons, Inc.

The Mortgage Contract

Borrower Signs a Note and Mortgage, and Title Is Conveyed to BorrowerThe note is the borrowing agreement.Payments amortized over time.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.

Copyright© 2003 John Wiley and Sons, Inc.

Mortgage Balance and Payments

A. Balance due on 15-year, 9%, $100,000 mortgage with payments of $1,015 per monthmade promptly.Balance after payment number:

1 2 3 4 5 6 In99,735.00 99,468.01 99,199.02 98,928.02 98,654.98 98,379.89 Year 184,377.69 83,995.52 83,610.49 83,222.57 82,831.74 82,437.97 Year 555,553.05 54,954.70 54,351.86 53,744.50 53,132.58 52,516.07 Year 1010,422.85 9,486.03 8,542.17 7,591.24 6,633.17 5,667.92 Year 15

7 8 9 10 11 12 In98,102.74 97,823.51 97,542.18 97,258.75 96,973.19 96,685.49 Year 182,041.26 81,641.57 81,238.88 80,833.17 80,424.42 80,012.60 Year 551,894.94 51,269.16 50,638.67 50,003.46 49,363.49 48,718.72 Year 104,695.43 3,715.65 2,728.51 1,733.98 731.98 -277.53 Year 15

Initial mortgage $100,000 Monthly payments $1,015 Total payments $182,400+Interest rate 9% First payment interest $750 Total interest $82,400+Maturity 15 years First payment principal $265 Total principal $100,000

Copyright© 2003 John Wiley and Sons, Inc.

Mortgage Balance and Payments (continued)

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

Copyright© 2003 John Wiley and Sons, Inc.

Mortgage Balance and Payments, cont.

A. Balance due on 30-year, 9%, $100,000 mortgage with payments of $805 per monthmade promptly.Balance after payment number:

1 2 3 4 5 6 In99,945.00 99,889.59 99,833.76 98,777.51 99,720.84 99,663.75 Year 196,757.63 96,678.32 96,598.40 96,517.89 96,436.78 96,355.05 Year 590,775.16 90,650.97 90,525.86 90,399.80 90,272.80 90,144.85 Year 1081,408.52 81,214.08 81,018.19 80,820.82 80,621.98 80,421.64 Year 1554,215.43 53,817.04 53,415.67 53,011.29 52,603.87 52,193.40 Year 207,832.77 7,086.51 6,334.66 5,577.17 4,814.00 4,045.11 Year 30

7 8 9 10 11 12 In99,606.23 99,548.28 99,489.89 99,431.06 99,371.79 99,312.08 Year 199,272.71 96,189.76 96,106.18 96,021.98 95,937.14 95,851.67 Year 590,015.93 89,886.05 89,755.20 89,623.36 89,490.54 89,356.71 Year 1080,219.81 80,016.45 79,811.58 79,605.16 79,397.20 79,187.68 Year 1551,779.85 51,363.20 50,943.42 50,520.50 50,094.40 49,665.11 Year 203,270.44 2,489.97 1,703.65 911.42 113.26 -690.89 Year 30

Initial mortgage $100,000 Monthly payments $805 Total payments $289,100+Interest rate 9% First payment interest $750 Total interest $189,100+Maturity 30 years First payment principal $55 Total principal $100,000

Copyright© 2003 John Wiley and Sons, Inc.

Mortgage Balance and Payments

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

Copyright© 2003 John Wiley and Sons, Inc.

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).Down payment and rates may be lower.

Copyright© 2003 John Wiley and Sons, Inc.

Private Mortgage Insurance

Conventional mortgage borrowers with low down payments 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.

Copyright© 2003 John Wiley and Sons, Inc.

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

Copyright© 2003 John Wiley and Sons, Inc.

Adjustable Rate Mortgage (ARM)

Fixed-rate mortgages are not acceptable to lenders in high inflation periods.With adjustable rate contracts, borrowers' costs vary with inflation and interest rate levels.Caps on ARM interest rates limit interest rate risk to borrowers.

1 to 2 % cap per year.5 % cap over the life of the loan.

Copyright© 2003 John Wiley and Sons, Inc.

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.

Copyright© 2003 John Wiley and Sons, Inc.

Other Mortgage Instruments

Began in high interest/inflation periodsGraduated Payment Mortgage (GPM) -- Payments increase with income expectations.Growing Equity Mortgage (GEM) -- Increasing payments to pay off loan quickly.

Copyright© 2003 John Wiley and Sons, Inc.

Other Mortgage Instruments

Reverse Annuity Mortgage (RAM) -- Borrower receives monthly loan proceeds. Interest and principal paid at time of sale of home.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.

Copyright© 2003 John Wiley and Sons, Inc.

Rate Difference Needed for Borrowers to Take the Risk of an Adjustable-Rate Mortgage

Copyright© 2003 John Wiley and Sons, Inc.

Exhibit 9.4 Fixed and Adjustable Mortgage Rates

Copyright© 2003 John Wiley and Sons, Inc.

Mortgage-Backed Securities

One way to develop a secondary market for mortgagesMortgage 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.

Copyright© 2003 John Wiley and Sons, Inc.

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.

Copyright© 2003 John Wiley and Sons, Inc.

Types of Pass-Through Securities (concluded)

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.Fannie Mae pass-throughs - pools of conventional or insured mortgages.Privately issued pass-throughs (PIP).

Copyright© 2003 John Wiley and Sons, Inc.

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.

Copyright© 2003 John Wiley and Sons, Inc.

Participants in the Mortgage Markets

Thrifts -- dominated and increased share of market until 1970s.Banks -- Increased share of market and increased powers to make mortgage loans.Insurance Companies and Pension Funds.Pools -- Pass-through certificates have become an important source of funds. Pools represented the largest component of mortgage investment in 2001.

Copyright© 2003 John Wiley and Sons, Inc.

Participants in the Mortgage Markets (concluded)

Government Holdings -- All Levels of Government

FNMA, FHLMC, Federal Land Banks (now Farm Credit), Farmers Home Administration.State and local housing authorities issue bonds and buy subsidized, lower-rate mortgages, often for first-time home-buyers.

Copyright© 2003 John Wiley and Sons, Inc.

Other ParticipantsMortgage Insurers

Developed in 1930s to enhance acceptability of mortgages and to encourage more risky low equity/loan lending.FHA insurance guaranteed payment to lender in case of default.VA guarantee (1944) for mortgage loans to veterans.Private mortgage insurance covered low down payment conventional mortgages.Mortgage insurance has enhanced the development of secondary markets.

Copyright© 2003 John Wiley and Sons, Inc.

Other Participants (concluded)

Mortgage bankers originate mortgages, sell them, and often service the mortgage

Mortgage origination, servicing, and funding are three separate components bought and soldMortgage servicing very competitive—economies of scale