Mortgage Markets-1

MORTGAGE MARKETS

Finance 421

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The Unique Nature of Mortgage 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.

Weak Secondary Market for Original Mortgages– Little standardization of contracts and terms.– Traditionally issued and held by lender.

Relatively strong secondary for mortgage-backed securities Mortgage markets are highly regulated and supported by

federal government policies.

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Standard Fixed-Rate Mortgage (FRM) Amortized loan with periodic payments that exceed the

interest due. Payment in excess of interest is credited toward repayment of the principal.

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. When mortgage is fully paid, the lien is removed and the

borrower obtains a clear title to the property.

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FRM Balance and Payments

Principal and interest Payments on a 9%, 15-year, $100,000 mortgage with payments of

$1,015 per month

$0

$200

$400

$600

$800

$1,000

$1,200

0 12 24 36 48 60 72 84 96 108 120 132 144 156 168

Month

Pay

men

t

Interest PaymentPrincipal Payment

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FRM Balance and Payments(concluded)

Principal and interest Payments on a 9%, 30-year, $100,000 mortgage with payments of

$805 per month

$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

$700.00

$800.00

$900.00

0 36 72 108 144 180 216 252 288 324

Month

Pay

men

t

Interest PaymentPrincipal Payment

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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).– Downpayment and rates may be lower.

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Private Mortgage Insurance

Conventional mortgage borrowers with low downpayments must usually buy private mortgage insurance (PMI).

PMI premiums are added to mortgage payments until the value of the mortgage is less than 75% of the value of the house.

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Private Mortgage Insurance

$112,500mortgage at10% plusinsurancepremium = 10¼to 10½% APRon $112,500balance

Insured Risk $12,500 mortgageinsurance

UninsuredMortgage

Equity

Privately Insuredconventional mortgage

$100,000mortgage at10% APR.

Equity$25,000 downpayment

$12,500 downpayment

UninsuredMortgage

Uninsured conventionalmortgage

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Adjustable Rate Mortgage (ARM)

Fixed-rate mortgages are not attractive to lenders in high inflation periods.

With adjustable rate contracts, borrowers' costs vary with inflation and interest rate levels.

Lenders shift interest rate risk to the borrower. Caps on ARM interest rates limit interest rate risk to borrowers.

– Capped ARMs may have a “payment cap”, “rate cap”, or both.

– Payment caps limit the maximum amount the payment can go up by in any year and over the life of the loan.

– Interest rate caps or rate caps limit the size of the increase in the loan rate in any year and over the loan’s life. Typically, the annual cap is 1-2%, and the lifetime cap is 5%.

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Methods of Adjustment for ARMs

Rate may vary in a prescribed range (caps) or without limit.

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. The market prices (difference between fixed and variable

rates) the extent of interest rate risk (impact of varying interest rates) assumed by borrower and lender.

Common rate indices include Treasury rates, fixed rate mortgage indices, prime rate, and the LIBOR rate.

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Fixed and Adjustable Mortgage Rates

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Other Mortgage Instruments Balloon Payment Mortgages

– Traditional loan where interest is paid until a time when the principal was due.

– Terms can be 3, 5 or 7 years.– Loan is amortized over 15 or 30 year period so that monthly

payments are no different than a FRM of equal maturity.– Rate is fixed over the contract term.– Popular with borrowers who may either sell or refinance

prior to maturity. Rollover Mortgage (ROMs)

– Refinanced at new rate every few years.– Adjustment period is longer than traditional ARMs.– Payment is fixed

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Other Mortgage Instruments (continued)

Renegotiated Rate Mortgages (RRMs) – Loan terms renegotiated periodically at terms prevailing in

the market.– Adjustment period is longer than traditional ARMs.– Payment is fixed.

Interest Only Mortgages– Low payments in initial years (10 to 15 years) – only

includes interest on borrowed amount.– After initial period, payments increase such that entire loan

amount is amortized by the end of 30 years.– Borrower pays interest for a considerable period on the

entire loan balance, but avoids having to pay down balance in initial years.

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Other Mortgage Instruments (continued)

Construction-to Permanent Mortgages

– Bridge financing is provided by lender over the time frame required by the borrower to purchase land and construct the house.

– Only interest payment is made until construction is completed.

– Loan is financed in increments as construction payments have to be made.

– On completion of the construction, loan balance is rolled over into the type of mortgage contract desired by borrower.

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Other Mortgage Instruments (continued)

Reverse Annuity Mortgages (RAMs)– RAMs allow homeowners to borrow against the

equity on their homes at low rates.– Typically obtained by older people whose home

loans have been paid off, but can use income of the real estate investment they own.

– Typical term is no more than 20 years and could be for borrower’s lifetime as an annuity.

– Homeowners’ equity declines by amount borrowed.

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Other Mortgage Instruments (continued)

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.

Home equity loans and lines of credit allow home owners to borrow against the equity built up in their homes because of paying down the loan and/or because of the appreciation of the property.

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What Does it Take to Buy a Home?

Several factors influence a home buyer’s ability to secure a mortgage loans. – Borrower Income from all sources gives the

lender an idea of the ability of the borrower to meet the monthly mortgage commitment.

– Down Payment refers to the amount of cash the borrower can contribute towards the cost of the house as their equity.

– Mortgage Insurance is necessary for borrowers who are unable to come up with a 20 percent down payment.

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Payment to Income Ratio Examples

Annual Gross income

28% of monthly

30-year Fixed Rate (5%) Mortgage

Qualification36% of

monthly$20,000 $467 $59,985 $600 $30,000 $700 $89,913 $900 $40,000 $933 $119,841 $1,200 $50,000 $1,167 $149,897 $1,500 $60,000 $1,400 $179,826 $1,800 $80,000 $1,867 $239,810 $2,400

$100,000 $2,333 $299,667 $3,000 $150,000 $3,500 $449,564 $4,500

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Mortgage Origination

The original lender in a mortgage is called the mortgage originator. They generate income in one or more of the following ways:– They charge an origination fee

– They may sell the mortgage

– They may service the loan for the eventual owners of the loan in exchange for a servicing fee

– They may sell the servicing of the mortgage to another party.

– They may hold the mortgage in their investment portfolio.

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The Mortgage Origination Process A potential homeowner applies for a loan from a

mortgage originator. He/she specifies:– type of mortgage (FRM,ARM,etc.)– when the interest rate is set

The mortgage originator then performs a credit evaluation of the applicant

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The Mortgage Origination Process (continued) If the lender decides to lend the funds, it sends a

commitment letter to the applicant, and the applicant pays a commitment fee.

If the mortgage originator intends to sell the mortgage, it may obtain a commitment from the potential buyer.

At the closing date, if the borrower does not back out, the loan is made. If the borrower backs out, he loses the commitment fee.

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Pipeline Risk

is the risk associated with mortgage origination– Price risk

– Fallout risk

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Hedging Pipeline Risk

Obtain a commitment from a conduit to buy the mortgage

Obtain an agreement for the optional delivery of the mortgage

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Mortgage Holdings Over Time  1978 1985 1995 2005 2008 2010

Amount Outstanding $1,169.4 $2,312.3 $4,602.7 $11,942.2 $14,619.0 $14,020.1

($ in billions)

Percentage Held

Thrift institutions 45.1% 33.1% 13.0% 9.6% 5.9% 4.4%

Commercial banks 18.3 18.6 23.7 24.8 26.3% 26.4%

Insurance companies and pension funds 10.1 8.8 5.3 2.6 2.5% 2.4%

U.S. government 2.4 2.3 1.3 0.7 0.7% 0.8%

Government agencies (GSEs) 6.2 5.9 5.4 4.0 4.8% 35.9%

Mortgage pools, govt. agency 6.0 16.0 34.1 30.8 33.9% 7.6%

Mortgage pools, private — 0.6 6.4 18.0 17.7% 14.5%

Households 8.7 5.4 2.5 1.5 0.8% 0.7%

State and local governments 1.4 3.2 2.5 1.2 1.2% 1.3%

REITs 0.5 0.3 0.3 1.4 0.5% 0.4%

Credit unions 0.3 0.5 1.4 2.1 2.2% 2.3%

Finance companies — 1.2 1.6 2.4 3.1% 2.6%

Other 1.0 4.1 2.5 0.9 0.6% 0.5%

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Risks of Investing in Mortgages

Credit Risk Marketability Risk Price Risk Prepayment (or cash flow uncertainty) risk

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Prepayment Risk and the Price/Yield Relationship for Mortgages

Price

Yield

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Refinancing and Mortgage Rates

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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.

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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. Freddie Mac Guaranteed Mortgage Certificates -

promises regular repayment of principal and interest.

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Types of Pass-Through Securities (concluded) Fannie Mae pass-throughs - pools of

conventional or insured mortgages. Privately issued pass-throughs (PIP).

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Other Mortgage-backed Securities

Unit investment trusts -- Mortgage pools assembled by investment bankers in unit "trusts." Claims on trust is sold to investor.

Mortgage-backed mutual funds -- offer GNMA insurance but at yields higher than treasuries.

FHLMC, FNMA, and private mortgage-backed debt.

State/local government revenues bonds -- type of muni, tax-free bond.

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Derivative Mortgage Securities

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.

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Derivative Mortgage Securities

Floating rate CMOs

Inverse floating rate CMOs

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Derivative Mortgage Securities (continued)

Stripped MBSs– IO Strips

– PO Strips

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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.