MORTGAGE MARKETS

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CHAPTER 9

• MORTGAGE MARKETS

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The Unique Nature ofMortgage Markets

• Mortgage loans are secured by the pledge of real
  property as collateral.
• Mortgage loans are made for varied amounts -- no
  standard denomination.
• Issuers of mortgages are usually small family or
  business entities.
• Most people in the United States own their own
  homes and finance them with mortgage debt.

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The Unique Nature ofMortgage Markets (concluded)

• Weak Secondary Market (in the past)
• Little standardization of contracts and terms.
• Traditionally issued and held by lender.
• Mortgage markets are highly regulated and
  supported by federal government policies.
• However, the securitization of mortgages, the
  innovative decoupling of principal and interest
  payments, the alteration of payment timing
  characteristics via mortgage backed securities
  have transformed the market.

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The Mortgage Contract

• Borrower Signs a Note and Mortgage, and Title Is
  Conveyed to Borrower
• The note is the borrowing agreement.
• Payments amortized over time.
• Interest is usually computed on the declining
  balance.
• The mortgage is a lien on the property used as
  collateral for the loan.
• If the contract is broken, the lender may use the
  property to pay the loan.

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Standard Fixed Rate Mortgages (FRMs)

• The lender takes a lien on real property
• The borrower agrees to make periodic payments of
  the money borrowed plus interest on the unpaid
  balance of the debt for a predetermined period of
  time.
• The interest rate is fixed, and the payments are
  typically monthly.

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Current Mortgage Rates

• The February 28th, 2005 issue of The Wall Street
  Journal (Page C 2) reported the following rates
• 30-year fixed rate mortgage 5.23
• 15-year fixed rate mortgage 4.80
• Jumbo Mortgage (over 359,650) 5.51
• One-year ARM 3.69
• Home-Equity loan 6.97

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Mortgage Balance and Payments
Please use your financial calculators to
determine the figures.
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Mortgage Balance and Payments (continued)
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Mortgage Balance and Payments, cont.
Notice the interest difference between the
15-year and 30-year mortgage.
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Mortgage Balance and Payments
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Conventional and Insured Mortgages

• Conventional mortgages represent
  lending/borrowing in the private markets.
• Insured and/or guaranteed mortgages are supported
  by federal and state agencies.
• Federal Housing Administration (FHA).
• Veterans Administration (VA).
• Down payment and rates may be lower.

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Private Mortgage Insurance

• Conventional mortgage borrowers with low down
  payments must usually buy private mortgage
  insurance (PMI).
• PMI premiums are added to mortgage payments until
  the value of the mortgage is less than 80 of the
  value of the house.

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Private Mortgage Insurance
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Adjustable Rate Mortgage (ARM)

• Fixed-rate mortgages are not acceptable to
  lenders in high inflation periods.
• With adjustable rate contracts, borrowers' costs
  vary with inflation and interest rate levels.
• Caps on ARM interest rates limit interest rate
  risk to borrowers.
• 1 to 2 cap per year.
• 5 cap over the life of the loan.

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Methods of Adjustment for ARMs

• Rate may vary in a prescribed range (caps) or
  without limit.
• ARMs use various measures for adjusting their
  rates, including Treasury security rates, the
  prime rate, LIBOR, and the savings and loan
  cost-of funds index.
• Payments, maturity, or principal may vary.
• Rates may vary based on a previously determined
  interest rate index or the cost of the funds of
  the lender.

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Rate Difference Needed for Borrowers to Take the
Risk of an Adjustable-Rate Mortgage
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Fixed and Adjustable Mortgage Rates
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Early Payoff Mortgages

• Balloon Payment Mortgages -- Traditional loan
  where interest is paid until a time when the
  principal was due.
• Rollover Mortgage (ROMs) -- refinanced at new
  rate every few years.
• Renegotiated Rate Mortgages (RRMs) -- Loan terms
  renegotiated periodically at terms prevailing in
  the market.

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Other Mortgage Instruments

• Reverse Annuity Mortgage (RAM) -- Borrower
  receives monthly loan proceeds. Interest and
  principal paid at time of sale of home.
• Second Mortgage -- extended at time of purchase
  or later as equity is borrowed from property.
• Home equity lines of credit became popular after
  the 1986 federal tax law.

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Mortgage-Backed Securities

• One way to develop a secondary market for
  mortgages
• Mortgage pass-through securities pass through
  payments of principal and interest on pools of
  mortgages to holder of the securities.
• Other Mortgage backed securities use pools of
  mortgages as collateral for debt securities.
• Prepayment Risk
• Extension Risk

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Mortgage-Backed Securities - continued

• Government National Mortgage Association (GNMA)
• Ginnie Mae Pass-Throughs pass through all
  payments of interest and principal received on a
  pool of federally insured mortgage loans.
• Once a pool of mortgages is assembled,
  pass-through securities are issued that are
  collateralized by interest and principal payments
  from the mortgages in the pool.
• Guaranteed by GNMA

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Mortgage-Backed Securities - continued

• Federal Home Loan Mortgage Corporation (FHLMC)
• Established in 1970 to provide a secondary market
  for conventional mortgages
• Freddie Macs PCs (Participation Certificates)
• Contain conventional mortgages
• Mortgages are not federally insured
• Pools are assembled by the FHLMC
• Mortgages in the pool may have more than one
  interest rate
• Minimum denomination is 100,000

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Mortgage-Backed Securities - continued

• Guaranteed Mortgage Certificates
• Issued by the FHLMC
• Represent an ownership interest in a particular
  pool of mortgages
• Similar to conventional bonds in that they
  guarantee repayment of principal and interest on
  a regular basis
• Interest - semiannual
• Principal - annually
• Guaranteed by FHLMC

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Types of Pass-Through Securities

• Ginnie Mae Pass-Throughs - pools of government
  insured mortgages.
• Freddie Mac Participation Certification - pools
  of conventional mortgages.
• Privately issued pass-through (PIP)
• Privately insured
• Pools of conventional mortgages

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Mortgage-Backed Bonds

• Collateralized mortgage obligations (CMOs) --
  fixed maturity date and interest payments similar
  to bonds.
• REMICS -- real estate mortgage investment
  conduit Investor pays taxes. Type of CMO.
• Fannie Mae (FNMA) - pools of conventional or
  insured mortgages.

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Collateralized Mortgage Obligations (CMOs)

• Fixed maturity date and interest payments similar
  to bonds.
• CMOs consist of a series of related debt
  obligations, called tranches, which divide up the
  principal and interest payments made on a pool of
  mortgages and pay principal and interest to
  various borrowers with different priorities.
• The first tranche would receive all payments
  toward principal, whether scheduled or
  prepayment.

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Collateralized Mortgage Obligations (CMOs) -
Continued

• Each obligation in the debt series except the
  residual series has a fixed maturity priority
  and interest payments similar to a corporate
  bond.
• The Z tranche is the final tranche and receives
  all remaining principal payments after every
  other tranche has been paid off. It receives no
  other interest payments in the interim.
• The major advantage of CMOs is that the size and
  value of their payments is more certain than on
  their underlying mortgages unless prepayments
  vary unexpectedly.

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Collateralized Mortgage Obligations (CMOs) -
Concluded

• Recent CMOs feature as many as 30 separate
  tranches.
• Popularity of CMOs are due to
• They allow investors to have mortgage securities
  tailored to their maturity preferences
• They often have high book yields relative to debt
  instruments of similar quality
• They have high credit ratings owing to their
  backing by mortgage pools issued by GNMA, FHLMC
  and FNMA.

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Real Estate Mortgage Investment Conduit (REMIC)

• Passes through all interest and principal
  payments before taxes are levied
• Investor pays taxes
• Type of CMO but legally different

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Advantages of Mortgage-backed Securities over
Individual Mortgages

• Issued in standardized denominations and are
  negotiable.
• Issued or backed by quality borrowers.
• Usually insured and highly collateralized.
• Repayment schedules vary, but many are similar to
  other bonds.

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Prepayment Risk

• The problem with mortgage-backed securities is
  that their payment patterns change substantially
  when interest rates change.
• If interest rates fall a great deal, the present
  value of a pool of high-interest rate mortgages
  will fall as people refinance their homes at the
  new lower rates and repay their old mortgages.
  The owner will not receive the high interest
  rates promised on the mortgages.

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Extension Risk

• Conversely, if interest rates rise by a large
  amount, people will be reluctant to move or
  refinance their homes at the new high mortgage
  rates. Prepayments of existing mortgages will
  fall and cash flows from a pool of mortgages will
  be lower in the short run than they would have
  been if interest rates had not risen.
• PSA (Public Securities Association) repayment
  rates from past mortgage repayment experiences.

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Participants in the Mortgage Markets

• Thrifts -- dominated and increased share of
  market until 1970s.
• Banks -- Increased share of market and increased
  powers to make mortgage loans.
• Insurance Companies and Pension Funds.
• Pools -- Pass-through certificates have become an
  important source of funds. Pools represented the
  largest component of mortgage investment in 2001.

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Participants in the Mortgage Markets (continued)

• Government Holdings -- All Levels of Government
• FNMA, FHLMC, Federal Land Banks, Farmers Home
  Administration.
• State and local housing authorities issue bonds
  and buy subsidized, lower-rate mortgages, often
  for first-time home-buyers.

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Other Participants

• Mortgage Insurers
• Developed in 1930s to enhance acceptability of
  mortgages and to encourage more risky low
  equity/loan lending.
• FHA guaranteed payment to lender in case of
  default.
• VA insurance (1944) for mortgage loans to
  veterans.
• Private mortgage insurance covered low down
  payment conventional mortgages.
• Mortgage insurance has enhanced the development
  of secondary markets.

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Other Participants (concluded)

• Mortgage bankers originate mortgages, sell them,
  and often service the mortgage.
• Mortgage bankers do not hold mortgage loans in
  their portfolio for long.
• Obtain their income from originating mortgages

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Underwriting Standards

• In order to reduce the chance of default,
  mortgage lenders must ensure that the property,
  loan amount, and borrower conform to the lenders
  underwriting standards.
• FHA and FHLMC underwriting standards determine
  the maximum credit risk that a mortgage
  originator can take when making a mortgage loan.
• Fannie and Freddie have automated underwriting
  systems that allow for quick approval of
  mortgages.

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Conclusion

• Mortgage Markets
• Mortgage Calculations
• Types of Mortgages
• Conventional vs. Insured
• FRM vs. ARM
• Mortgage Backed Securities
• Pass Throughs
• CMO, REMIC