1. Mortgage Loans Fixed Income Securities

2. Outline  What is a mortgage?  Major Originators  Alternative Mortgage Instruments  Prepayments and their impacts on cash flows  Risks of investing in mortgages  Factors that affect default on mortgage loans

3. What is a Mortgage?  A loan that is secured by the collateral of specified real estate property, which obliges the borrower to make a predetermined series of payments.  In the event of default by the borrower, the lender can sell off the property

4. General Features of a Mortgage Loan  Loan is based on the credit of the borrower and the collateral for the mortgage—Conventional Mortgage  Mortgage Insurance  Usually, amount of loan less than the market value of the property  Classified as one to four family homes (residential property) and income property (office space and apartment buildings)  Loan originators include: thrifts, mortgage companies, and commercial banks for income property

5.  Loan originators for income property include commercial banks, thrifts, and insurance companies  Usually, mortgage companies sell most of their mortgages in the secondary market  Two primary factors that determine whether loan should be extended or not: –The payment to income ratio –The loan to total value ratio

6. Alternative Mortgage Instruments  Standard Fixed-rate mortgage –A borrower would take out a mortgage loan for a principal amount P and repay in equal monthly installments of M  Adjustable Rate Mortgage –A loan in which the contract rate is reset periodically in accordance with some pre-chosen reference rate, typically one based on short-term interest rate.  Graduated Payment Mortgage  Growing Equity Mortgage

7. Fixed-Rate Mortgage and Interest Rate Risk  A rising term-structure can create a gap in the balance sheet of the lending institution

8. ARM and Default Risk  If reference rate rises too much, risk of default rises

9. Risks in Mortgage Loan Market  Default Risk –Loan to value ratio –Second mortgages behind first mortgage –Seasoning Effect  Liquidity Risk  Interest Rate Risk  Prepayment Risk