McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-1 Chapter Seven Mortgage Markets

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-2 Chapter Outline 1.Overview 2.Amortization Schedule 3.Secondary Market 4.Participants in Mortgage Markets 5.Collateralized Mortgage Obligations 1.Overview 2.Amortization Schedule 3.Secondary Market 4.Participants in Mortgage Markets 5.Collateralized Mortgage Obligations

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved 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 –home, multifamily dwelling, commercial, and farm 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 –home, multifamily dwelling, commercial, and farm

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-4 Mortgage Loans Outstanding, 2004 ($Bn)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-5 Mortgage Characteristics Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage (continued)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-6 Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Conventional mortgages - issued by FIs that are not federally insured Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Conventional mortgages - issued by FIs that are not federally insured Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage (continued)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-7 Balloon payment mortgages - requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest Balloon payment mortgages - requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest (continued)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Amortization schedule Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest (continued)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-9 Calculation of Monthly Mortgage Payments PV = PMT(PVIFA i/12, n  12 ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years PV = PMT(PVIFA i/12, n  12 ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved 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/ = $ $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/ = $ $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/ = $ $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/ = $

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Secondary Mortgage Market 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 (mortgage sales) –issue mortgage-backed securities that are backed by their newly originated mortgages (securitization) Benefits of secondary mortgage market –Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk –FIs are encouraged to sell loans for economic (generate fee income) and regulatory reasons (reducing reserve req’s) 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 (mortgage sales) –issue mortgage-backed securities that are backed by their newly originated mortgages (securitization) Benefits of secondary mortgage market –Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk –FIs are encouraged to sell loans for economic (generate fee income) and regulatory reasons (reducing reserve req’s)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Mortgage Sales Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, and nonfinancial firms Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, and nonfinancial firms

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Securitization of Mortgages Pass-through mortgage securities - mortgage-backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC) Pass-through mortgage securities - mortgage-backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved History of Secondary Mortgage Markets Federal National Mortgage Association (FNMA or “Fannie Mae”) created during the Great Depression FHA (Federal Housing Administration) and VA (Veterans Administration) 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 (Federal Housing Administration) and VA (Veterans Administration) 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

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Government-Related Mortgage-Backed Pass- Through Securities Outstanding ($Bn)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Mortgages Outstanding by Type of Holder(%), 2004

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved One- to Four-Family Mortgage Originations, 2004

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Issuers of Ginnie Mae Securities, 2004

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved 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

Sequential Pay Tranche CMO Several early tranches plus one accrual (zero) tranche Each early tranche receives interest payment at a specified coupon rate Extra payment then is used to pay the principle balance of the first tranche; when the first tranche is paid off, extra payment is to pay the principle balance of the next tranche, and so forth Zero tranche starts to get payment only until all the early tranches have been paid off Early tranches have more protection against extension risk; zero tranche has more protection against contraction risk Several early tranches plus one accrual (zero) tranche Each early tranche receives interest payment at a specified coupon rate Extra payment then is used to pay the principle balance of the first tranche; when the first tranche is paid off, extra payment is to pay the principle balance of the next tranche, and so forth Zero tranche starts to get payment only until all the early tranches have been paid off Early tranches have more protection against extension risk; zero tranche has more protection against contraction risk

PAC Tranche CMO PAC: Planned Amortization Class PAC tranches plus support tranche PAC tranches are guaranteed with preset payment schedule Excessive prepayment goes to the support tranche The certainty of PAC tranches payment comes at the expense of increased prepayment risk of support tranche PAC: Planned Amortization Class PAC tranches plus support tranche PAC tranches are guaranteed with preset payment schedule Excessive prepayment goes to the support tranche The certainty of PAC tranches payment comes at the expense of increased prepayment risk of support tranche