CHAPTER 11

MORTGAGE MARKETS

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.

The Unique Nature ofMortgage Markets (concluded)

• Weak Secondary Market– Little standardization of contracts and

terms.– Traditionally issued and held by lender.

• Mortgage markets are highly regulated and supported by federal government policies.

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.

Mortgage Balance and Payments

A. Balance due on 15-year, 9%, $100,000 mortgage with payments of $1,015 per monthmade promptly.Balance after payment number:

1 2 3 4 5 6 In99,735.00 99,468.01 99,199.02 98,928.02 98,654.98 98,379.89 Year 184,377.69 83,995.52 83,610.49 83,222.57 82,831.74 82,437.97 Year 555,553.05 54,954.70 54,351.86 53,744.50 53,132.58 52,516.07 Year 1010,422.85 9,486.03 8,542.17 7,591.24 6,633.17 5,667.92 Year 15

7 8 9 10 11 12 In98,102.74 97,823.51 97,542.18 97,258.75 96,973.19 96,685.49 Year 182,041.26 81,641.57 81,238.88 80,833.17 80,424.42 80,012.60 Year 551,894.94 51,269.16 50,638.67 50,003.46 49,363.49 48,718.72 Year 104,695.43 3,715.65 2,728.51 1,733.98 731.98 -277.53 Year 15

Initial mortgage $100,000 Monthly payments $1,015 Total payments $182,400+Interest rate 9% First payment interest $750 Total interest $82,400+Maturity 15 years First payment principal $265 Total principal $100,000

Mortgage Balance and Payments (continued)

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

Mortgage Balance and Payments(continued)A. Balance due on 30-year, 9%, $100,000 mortgage with payments of $805 per month

made promptly.Balance after payment number:

1 2 3 4 5 6 In99,945.00 99,889.59 99,833.76 98,777.51 99,720.84 99,663.75 Year 196,757.63 96,678.32 96,598.40 96,517.89 96,436.78 96,355.05 Year 590,775.16 90,650.97 90,525.86 90,399.80 90,272.80 90,144.85 Year 1081,408.52 81,214.08 81,018.19 80,820.82 80,621.98 80,421.64 Year 1554,215.43 53,817.04 53,415.67 53,011.29 52,603.87 52,193.40 Year 207,832.77 7,086.51 6,334.66 5,577.17 4,814.00 4,045.11 Year 30

7 8 9 10 11 12 In99,606.23 99,548.28 99,489.89 99,431.06 99,371.79 99,312.08 Year 199,272.71 96,189.76 96,106.18 96,021.98 95,937.14 95,851.67 Year 590,015.93 89,886.05 89,755.20 89,623.36 89,490.54 89,356.71 Year 1080,219.81 80,016.45 79,811.58 79,605.16 79,397.20 79,187.68 Year 1551,779.85 51,363.20 50,943.42 50,520.50 50,094.40 49,665.11 Year 203,270.44 2,489.97 1,703.65 911.42 113.26 -690.89 Year 30

Initial mortgage $100,000 Monthly payments $805 Total payments $289,100+Interest rate 9% First payment interest $750 Total interest $189,100+Maturity 30 years First payment principal $55 Total principal $100,000

Mortgage 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

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.

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.

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

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.

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. (Not Guaranteed)

• Renegotiated Rate Mortgages (RRMs) -- Loan terms renegotiated periodically at terms prevailing in the market. (Guaranteed w/caps)

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.

Other Mortgage Instruments Emerging in High Interest (Inflation) Periods

• Graduated Payment Mortgage (GPM) -- Payments increase with income expectations.

• Growing Equity Mortgage (GEM) -- Increasing payments to pay off loan quickly.

Other Mortgage Instruments Emerging in High Interest (Inflation) Periods (concluded)

• 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.

Rate Difference Needed for Borrowers to Take the Risk of an Adjustable-Rate Mortgage

Mortgage Interest Rates for FRMs and Capped and Uncapped ARMsJanuary 1985 - January 1991

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. (CMBS, IO/PO’s)

• Other Mortgage backed securities use pools of mortgages as collateral for debt securities. (CMO’s)

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.

Types of Pass-Through Securities (concluded)

• Collateralized mortgage obligations (CMOs) -- fixed maturity date and interest payments similar to bonds.

• REMICS -- real estate mortgage investment conduit; Investor pays taxes like a REIT. Type of CMO.

• Fannie Mae pass-throughs - pools of conventional or insured mortgages.

• Privately issued pass-throughs (PIP) non conforming mortgages.

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.

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.

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 1998.

Participants in the Mortgage Markets (concluded)

• 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.

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.

Other Participants (concluded)

• Mortgage bankers originate mortgages, sell them, and often service the mortgage.

• Mortgage Brokers assist with the placement of funding sources with borrowers (intermediation)