1 Chapter 9 Mortgage Markets © 2001 South-Western College Publishing Company

2 Chapter Objectives nDescribe characteristics of residential mortgages nDescribe the common types of creative mortgage financing nExplain how mortgage-backed securities are used

3 Background on Mortgages nMortgage debt outstanding varies over time nResidential mortgages dominate the market and are the focus of the chapter nMortgage debt increases over time but not at a constant rate nRecession affects the level of mortgage debt

4 Residential Mortgage Characteristics nMortgage contract specifies characteristics determined by borrower preferences nInsured versus conventional mortgages 4Federal and private insurance guarantees repayment in the event of borrower default 4Limits on amounts, borrower requirements 4Borrower pays premiums 4Federal insurers include Federal Housing Administration and Veterans Administration

5 Residential Mortgage Characteristics nFixed rate versus adjustable rate mortgages nFixed rate loans have a constant, unchanging rate 4Interest rate risk can hurt lender profits If interest rates rise in the market, lender’s cost of funds increases No matching increase in fixed rate mortgage return 4Borrowers lock in their cost and have to refinance to benefit from lower market rates

6 Residential Mortgage Characteristics nAdjustable rate mortgages 4Rates and the size of payments can change Maximum allowable fluctuation over year and life of loan Upper and lower boundaries for rate changes 4Lenders stabilize profits 4Uncertainty for borrowers whose mortgage payments can change over time

7 Residential Mortgage Characteristics nMortgage maturities nTrend shows increased popularity of 15-year loans 4Lender has lower interest rate risk if the term or maturity of the loan is lower 4Borrower saves on interest expense over loan’s life but monthly payments higher

8 Residential Mortgage Characteristics nBalloon payments 4Principal not paid until maturity 4Forces refinancing at maturity nAmortizing mortgages 4Monthly payments consist of interest and principal 4During loan’s early years, most of the payment reflects interest

9 Creative Mortgage Financing nSecond mortgage used in conjunction with first or primary mortgage 4 Shorter maturity typical for 2nd mortgage 41st mortgage paid first if default occurs so 2nd mortgage has a higher rate 4If used by sellers, makes a home with an assumable loan more affordable

10 Institutional Use of Mortgage Markets nSavings institutions 4Primarily residential mortgages 4Hold 29.6% of all mortgages as of 1999 nCommercial banks 4Dominate commercial mortgage market 4Hold 60.4% of all mortgages as of 1999 nLife insurance companies 4Commercial mortgages 4Hold 10% of all mortgages as of 1999

11 Institutional Use of Mortgage Markets nMortgage companies 4Originate and quickly sell loans 4Do not maintain large portfolios nGovernment agencies including Fannie Mae and Freddie Mac nBrokerage firms nInvestment banks

12 Valuation of Mortgages nPeriodic payment commonly includes payment of interest and principal nRequired rate of return determined by risk-free rate, credit risk and liquidity nRisk-free interest rate components and affects 4+ inflationary expectations 4+ economic growth 4- change in the money supply 4+ budget deficit

13 Valuation of Mortgages nEconomic growth affects the risk premium 4Strong growth improves borrowers’ income and cash flows and reduces default risk 4Weak growth has the opposite affect nPotential changes in mortgage prices monitored by reviewing inflation, economic growth, deficits and housing

14 Use of Mortgage-Backed Securities nCommon types of mortgage pass-through securities nGinnie Mae mortgage-backed securities 4Government National Mortgage Association 4Guarantees timely interest and principal payments to investors 4Pool of loans with the same interest rate 4Purchasers receive slightly lower rate than that on the loans to cover service and guarantee

15 Use of Mortgage-Backed Securities nFannie Mae mortgage-backed securities 4Uses funds from mortgage-backed pass- through securities to purchase mortgages 4Channel funds from investors to institutions that want to sell mortgages 4Guarantee timely payments to investors 4Some securities strip off interest and principal payment streams for separate sale

16 Globalization of Mortgage Markets nMortgage market activity not confined to just one country nMarket participants follow global economic conditions