1. Dr. Lakshmi Kalyanaraman
The Mortgage Markets
Chapter 14
Dr. Lakshmi Kalyanaraman

2. Dr. Lakshmi Kalyanaraman
What are mortgages?
Long-term loan secured by real estate.
Loan to finance construction of an office building or purchase of a home
Dr. Lakshmi Kalyanaraman

3. Dr. Lakshmi Kalyanaraman
Amortized mortgage
Borrower pays off the loan over time in some combination of principal and interest payments that result in full payment of the debt by maturity.
Dr. Lakshmi Kalyanaraman

4. Dr. Lakshmi Kalyanaraman
Balloon mortgage
Only interest is paid over the life of the mortgage
Principal is paid at maturity
High default risk
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5. Characteristics of residential mortgages
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6. Mortgage interest rates
Determined by three factors:
1. current long-term market rates
2. life of the mortgage
3. number of discount points paid
Dr. Lakshmi Kalyanaraman

7. Dr. Lakshmi Kalyanaraman
Market rates
Determined by the supply of and demand for long-term funds
Determined by a number of global, national and regional factors
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8. Dr. Lakshmi Kalyanaraman
Term
Usually the lifetime is 15 or 30 years
Lenders also offer 20 years
Longer-term mortgages have higher interest rate than shorter-term mortgages
Interest rate risk falls as the term to maturity decreases
Dr. Lakshmi Kalyanaraman

9. Dr. Lakshmi Kalyanaraman
Discount points
Interest payments made at the beginning of a loan
A loan with one discount point means that the borrower pays 1% of the loan amount at closing
Closing is when the borrower signs the loan paper and receives the proceeds of the loan
Dr. Lakshmi Kalyanaraman

10. Dr. Lakshmi Kalyanaraman
Discount points
Lender reduces the interest rate on the loan
Dr. Lakshmi Kalyanaraman

11. Dr. Lakshmi Kalyanaraman
Discount points
Borrower evaluates
Reduced interest rate over the life of the loan
Versus
Increased up-front expense
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12. Dr. Lakshmi Kalyanaraman
Discount points
Depends on how long the borrower will hold on to the loan
May not be feasible if borrower repays in 5 years or less
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13. Dr. Lakshmi Kalyanaraman
Loan terms
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14. Dr. Lakshmi Kalyanaraman
Collateral
Real estate bought with the mortgage loan is pledged as collateral
Lending institution will place a lien against the property till the loan is repaid
Lien is a public record that attaches to the title of the property
Dr. Lakshmi Kalyanaraman

15. Dr. Lakshmi Kalyanaraman
Collateral
Lender gets the right to sell the property if the underlying loan defaults
No one can buy the property and obtain clear title to it without paying off this lien
Existence of liens against real estate explains why title search is important part of mortgage loan
Dr. Lakshmi Kalyanaraman

16. Dr. Lakshmi Kalyanaraman
Down payment
Borrower pays a portion of purchase price
Balance of purchase price is paid by the loan proceeds
Down payment reduces default risk
Dr. Lakshmi Kalyanaraman

17. Private mortgage insurance
Insurance contract purchased by FI paid by the borrower
guaranteeing to pay the FI
Difference between the value of the property and the balance remaining in the mortgage, in case of default
Dr. Lakshmi Kalyanaraman

18. Mortgage loan amortization
Borrower agrees to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity
‘Fully amortize’ means that the payments will pay off the outstanding indebtedness by the time the loan matures
During early years of the loan, the lender applies most of payment to interest and small amount to outstanding principal balance
Dr. Lakshmi Kalyanaraman

19. Types of mortgage loans
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20. Insured and conventional mortgages
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21. Dr. Lakshmi Kalyanaraman
Insured mortgages
Originated by banks or other mortgage lenders but are guaranteed by government agencies
Applicants either served in the military or having income below a given level
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22. Dr. Lakshmi Kalyanaraman
Insured mortgages
Can borrow only up to a certain amount
Very low or zero down payment
Agency guarantees the payment of mortgage loan if the borrower defaults
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23. Conventional mortgages
Not guaranteed
Most lenders require that borrowers to obtain private mortgage insurance on all loans with loan-to-value exceeding 80%
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24. Fixed and adjustable-rate mortgages
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25. Dr. Lakshmi Kalyanaraman
Fixed rate mortgages
Interest rate and the monthly payment do not vary over the life of the mortgage
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26. Adjusted-rate mortgages
Tied to some market interest rate
Changes over time
ARMs usually have limits
Caps, how high the interest rate can move in one year and during the term of the loan
For example 2% in one year and 6% over the life of the loan
Dr. Lakshmi Kalyanaraman

27. Dr. Lakshmi Kalyanaraman
Fixed versus ARM
Borrowers prefer fixed as ARMs may cause financial hardship if interest rate rises
However, fixed rate borrowers lose if interest rate falls
Borrowers are risk-averse means that fear of hardship most often overwhelms anticipation of savings
Dr. Lakshmi Kalyanaraman

28. Dr. Lakshmi Kalyanaraman
Fixed versus ARM
Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk
Interest-rate risk is the risk that rising interest rates will cause the value of debt instruments to fall.
The effect on the value of the debt is greatest when the debt has a long term to maturity.
Dr. Lakshmi Kalyanaraman

29. Dr. Lakshmi Kalyanaraman
Fixed versus ARM
Since mortgages are usually long-term, their value is very sensitive to interest-rate movements
Lending institutions can reduce the sensitivity of their portfolios by making ARMs instead of standard fixed-rate loans.
Dr. Lakshmi Kalyanaraman

30. Dr. Lakshmi Kalyanaraman
Fixed versus ARM
Seeing that lenders prefer ARMs and borrowers prefer fixed-rate mortgages
Lenders must entice borrowers by offering lower initial interest rates on ARMs than on fixed-rate loans
Dr. Lakshmi Kalyanaraman

31. Other types of mortgages
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32. Graduated payment mortgages
Useful for home buyers who expect their incomes to rise
Has lower payments in the first few years, may not even cover interest
Then payments rise
Advantage is borrowers qualify a higher loan than conventional mortgage
Buyers can buy adequate house now
Payments escalate later when income does or not
Dr. Lakshmi Kalyanaraman

33. Growing equity mortgages
Growing equity mortgage helps to pay off loan in short period
Initial payments like conventional mortgage
Over time payment increases to reduce principal quickly
No prepayment penalty
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34. Graduated versus growing
Difference between graduated payment and growing equity mortgages is that the graduated is to qualify for a higher loan by reducing the initial payments and loan paid in 30 years. But growing is to help prepayment
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35. Second mortgages (piggyback)
On same real estate like first mortgage
Second mortgage junior to the original loan
In case of default, the original loan will be paid off first and the second mortgage holder from the left over funds
Dr. Lakshmi Kalyanaraman

36. Second mortgages (piggyback)
Borrowers use the equity they have in their homes as security for another loan
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37. Second mortgages (piggyback)
An alternative to the second mortgage would be to refinance the home at a higher loan amount than is currently owed.
The cost of obtaining a second mortgage is often much lower than refinancing.
Dr. Lakshmi Kalyanaraman

38. Reverse annuity mortgages
Innovative method for retired people to live on the equity they have in their homes
The contract for a RAM has the bank advancing funds on a monthly schedule.
This increasing-balance loan is secured by the real estate
borrower does not make any payments against the loan.
When the borrower dies, the borrower’s estate sells the property to retire the debt.
Dr. Lakshmi Kalyanaraman

39. Reverse annuity mortgages
The advantage of the RAM is that it allows retired people to use the equity in their homes without the necessity of selling it.
For retirees in need of supplemental funds to meet living expenses, the RAM can be a desirable option.
Dr. Lakshmi Kalyanaraman

40. Mortgage institutions
Many institutions making mortgage loans do not want to hold long-term
Short-term sources used for long-term loans
Many lenders sell the loans immediately to another investor
Borrower may not be aware
Originator frees the funds and gets loan origination fees normally 1%

41. Loan servicing Some originators provide loan servicing
Collect payments from borrowers, passes principal and interest to the investor, keeps record and reserve account for payment of insurance and taxes
Earn a fee of around 0.5% of loan amount every year for servicing

42. Dr. Lakshmi Kalyanaraman
Loan servicing
1. Originator packages the loan for an investor.
2. Investor holds the loan.
3. Servicing agent handles the paperwork.
Dr. Lakshmi Kalyanaraman

43. Secondary mortgage market
Problems in selling mortgages:
1. Mortgages are too small to be wholesale instruments.
Mortgages value around $250,000 while commercial paper is around $5 million
Dr. Lakshmi Kalyanaraman

44. Secondary mortgage market
Second problem with selling mortgages in the secondary market was that they were not standardized.
They have different times to maturity, interest rates, and contract terms.
That makes it difficult to bundle a large number of mortgages together
Dr. Lakshmi Kalyanaraman

45. Secondary mortgage market
Third, mortgage loans are relatively costly to service
The lender must collect monthly payments, often pay property taxes and insurance premiums, and service reserve accounts.
Finally, mortgages have unknown default risk
These problems inspired the creation of the mortgage-backed security, also known as a securitized mortgage
Dr. Lakshmi Kalyanaraman

46. Dr. Lakshmi Kalyanaraman
Securitization
Process of taking an illiquid asset, or group of assets and through financial engineering transforming them into a security
Dr. Lakshmi Kalyanaraman

47. Mortgage backed security
Large number of mortgages are pooled into mortgage pool
A trustee, a bank or government agency, holds mortgage pool as collateral for new security
This process is called securitization

48. Major types of MBS Pass-through security
Collateralized Mortgage Obligations (CMO)
Mortgage Backed Bond

49. Pass-through Mortgage Securities
FIs pool mortgages and offer interest in the pool in the form of pass-through certificates
Each pass through security represents fractional ownership in mortgage pool
Pass through promised payments of principal and interest on pools of mortgages to secondary market investors
No guaranteed annual coupon
Originating FI or third party servicer takes a fee

50. Collateralized Mortgage Obligations (CMO)
Multiclass pass-through with multiple bond holder classes or tranches
Pass through a pro-rata of mortgage pool but CMO multi-class pass-through with a number of different bond holder classes or tranches
Pass-through no guaranteed coupon, but CMO, each class has a different guaranteed coupon
Mortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protected

51. Mortgage Backed Bonds (MBBs)
MBBs allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheets
Group of mortgage is pledged as collateral against MBB
MBB issues have excess collateral
Pass-through and CMO are securitization, while MBB is collateralization
Pass-through and CMO remove mortgage from Balance sheet, MBB does not

52. Mortgage Backed Bonds (MBBs)
A group of mortgage assets is pledged as collateral against a MBB issue, but there is no direct link between the cash flows of the mortgages and the cash flows on the MBB