CHAPTER 9 Mortgage Markets

Chapter Objectives n Describe characteristics of residential mortgages n Describe the common types of creative mortgage financing n Explain the role of the federal government in supporting the development of the secondary mortgage market n Relate the development and use of mortgage- backed securities

Residential Mortgage Characteristics l Federal and private insurance guarantees repayment in the event of borrower default l Limits on amounts, borrower requirements l Borrower pays insurance premiums l Federal insurers include Federal Housing Administration and Veterans Administration Insured vs. Conventional Mortgages

Residential Mortgage Characteristics n Fixed rate loans have a constant, unchanging rate l Interest rate risk can hurt lender rate of return u If interest rates rise in the market, lender’s cost of funds increases u No matching increase in fixed-rate mortgage return l Borrowers lock in their cost and have to refinance to benefit from lower market rates Fixed Rate vs. Adjustable Mortgages

Residential Mortgage Characteristics n Fixed monthly payment includes l Interest owed first l Balance to principal n Interest on the declining principal balance n Calculating monthly payment l Principal borrowed = PV l Number of months to maturity = years  12 = N l Rate/12 = I l Calculate PMT

Residential Mortgage Characteristics Calculate the monthly payment for a $330,000 home. The new owner has made a $70,000 down payment and plans to finance over 30 years at the current fixed rate of 7%.

Residential Mortgage Characteristics Calculate the monthly payment for a $330,000 home. The new owner has made a $70,000 down payment and plans to finance over 30 years at the current fixed rate of 7%. $330,000 – $70,000 = $260,000 PV (original investment of the financial institution) 30 x 12 = 360 N; 7/12 = I; Calculate PMT

Residential Mortgage Characteristics Calculate the monthly payment for a $330,000 new home. The new owner has made a $70,000 down payment and plans to finance for 30 years at the current fixed rate of 7%. $330,000 – $70,000 = $260,000 PV (original investment of the financial institution) 30  12 = 360 N; 7/12 = I; Calculate PMT PMT = $1,729.79

Residential Mortgage Characteristics n Adjustable-rate mortgages l Rates and the size of payments can change u Maximum allowable fluctuation over year and life of loan u Upper and lower boundaries for rate changes l Lenders stabilize profits as yields move with cost of funds l Uncertainty for borrowers whose mortgage payments can change over time Fixed-Rate vs. Adjustable Mortgages

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

Residential Mortgage Characteristics n Balloon payments l Principal not paid until maturity l Forces refinancing at maturity n Amortizing mortgages l Monthly payments consist of interest and principal l During loan’s early years, most of the payment reflects interest Mortgage Maturities

Creative Mortgage Financing n Graduated-payment mortgage (GPM) l Small initial payments l Payments increase over time then level off l Assumes income of borrower grows n Growing-equity mortgage l Like GPM low initial payments l Unlike GPM, payments never level off

Creative Mortgage Financing n Second mortgage used in conjunction with first or primary mortgage l Shorter maturity typically for 2nd mortgage l 1st mortgage paid first if default occurs so 2nd mortgage has a higher rate l If used by sellers, makes a home with an assumable loan more affordable n Shared-appreciation mortgage l Below market rate but lender shares in home’s price appreciation

Activities in the Mortgage Markets n How the secondary market facilitates mortgage activities n Selling loans l Origination, servicing and funding are separate business activities and may be “unbundled” l Secondary market exists for loans n Securitization l Pool and repackage loans for resale l Allows resale of loans not easily sold on an individual basis

Activities in the Mortgage Markets n Unbundling of mortgage activities provides for specialization in: l Loan origination l Loan servicing l Loan funding l Any combination of the above

Institutional Use of Mortgage Markets, December, 2002 n Federally related mortgage pools l 37% of all mortgages, mostly residential n Commercial banks l Dominate commercial mortgage market l Hold 23.3% of all mortgages n Savings institutions l Primarily residential mortgages l Hold 10% of all mortgages n Life insurance companies l Commercial mortgages l Hold 3% of all mortgages

Institutional Use of Mortgage Markets n Mortgage companies l Originate and quickly sell loans l Do not maintain large portfolios n Government agencies including Fannie Mae and Freddie Mac n Brokerage firms n Investment banks n Finance companies

Valuation of Mortgages n Market price of mortgages is present value of cash flows P M = Market price of a mortgage C = Interest payment and PRIN is principal k = Investor’s required rate of return t = maturity Where:

Valuation of Mortgages n Periodic payment commonly includes payment of interest and principal n Required rate of return determined by risk-free rate, credit risk and liquidity n Risk-free interest rate components and relationship l + inflationary expectations l + economic growth l – change in the money supply l + budget deficit

Valuation of Mortgages n Economic growth affects the risk premium l Strong growth improves borrowers’ income and cash flows and reduces default risk l Weak growth has the opposite affect n Potential changes in mortgage prices monitored by reviewing inflation, economic growth, deficits, housing, and other predictor economic statistics

Exhibit 9.8 a U.S. Fiscal Policy U.S. Monetary Policy U.S. Economic Conditions Prepayment Risk Premium of Issuer Price of Fixed-Rate Mortgage Risk Premium of Issuer Issuer’s Unique Conditions Long-Term Risk-Free Interest Rate (T-Bond Rate) Issuer’s Industry Commercial Mortgages) Conditions (for on the Fixed-Rate Mortgage Required Return

Risk from Investing in Mortgages n Interest rate risk n Present value of cash flows or value of mortgage changes as interest rate changes n Long-term fixed-rate mortgages financed by short-term funds results in risks n To limit exposure to interest rate risk l Sell mortgage shortly after origination (but rate may change in that short period of time) l Make adjustable rate mortgages

Risk from Investing in Mortgages n Prepayment risk l Borrowers refinance if rates drop by paying off higher rate loan and financing at a new, lower rate l Investor receives payoff but has to invest at the new, lower interest rate l Manage the risk with ARMs or by selling loans

Risk from Investing in Mortgages n Credit risk can range from default to late payments n Factors that affect default l Level of borrower equity u Loan-to-value ratio often used u Higher use of debt, more defaults l Borrowers income level l Borrower credit history n Lenders try to limit exposure to credit risk

Risk from Investing in Mortgages n Measuring risk l Use sensitivity analysis to review various “what if” scenarios covering everything from default to prepayments l Incorporate likelihood of various events l Review effect on cash flows l Institution tries to measure risks and use information to restructure or manage risk

Use of Mortgage-Backed Securities n Securitization is an alternative to the outright sale of a loan n Group of mortgages held by a trustee serves as collateral for the securities n Institution can securitize loans to avoid interest rate risk and credit risk while still earning service fees n Payments passed through to investors can vary over time

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

Use of Mortgage-Backed Securities n Fannie Mae mortgage-backed securities l Uses funds from mortgage-backed pass-through securities to purchase mortgages l Channel funds from investors to institutions that want to sell mortgages l Guarantee timely payments to investors l Some securities strip (securitize) interest and principal payment streams for separate sale

Use of Mortgage-Backed Securities n Publicly issued pass-through securities (PIPS) l Backed by conventional mortgages instead of FHA or VA mortgages l Private mortgage insurance n Participation certificates (PCs) l Freddie Mac sells and uses funds to finance origination of conventional mortgages from financial institutions

Use of Mortgage-Backed Securities n Collateralized mortgage obligations (CMOs) l Semi-annual payments differ from other securities’ monthly payments l Segmented into classes u First class has quickest payback u Any repaid principal goes first to investors in this class l Investors choose a class to fit maturity needs l One concern is payback speed when rates drop

Use of Mortgage-Backed Securities n CMOs (cont.) l Can be segmented into interest-only IO or principal-only PO classes l High return for IO reflect risks n Useful investment but be aware of the risks l 1992 failure of Coastal States Life Insurance due to CMO investments l Some CMO mutual funds l Regulators have increased scrutiny

Use of Mortgage-Backed Securities n Mortgage-backed securities for small investors l In the past, high minimum denominations l Unit trusts created to allow small investor participation l Mutual funds n Advantages l Can purchase in secondary market without purchasing the need to service loans l Insured l Liquid

Globalization of Mortgage Markets n Mortgage market activity not confined to just one country n Market participants follow global economic conditions