MORTGAGE MARKETS

CHAPTER 23

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• Definition: The mortgage market is a collection of markets, which includes a primary(or origination) and a secondary market where mortgages trade. A mortgage is a pledge of property to secure payment of a debt.– Property pledged as collateral is real estate, which

is often in the form of a house. – Debt is the loan given to the buyer of the house by

a lender.– If a homeowner (the mortgagor) fails to pay the

lender (the mortgagee), the lender has the right to foreclose the loan and seize the property in order to ensure that is repaid.

MORTGAGE MARKETS

Dr.Ismat Ara Huq

Unique Nature of the Mortgage Market• Secured by the pledge of real property.• Made for varying amounts and maturities.• Issuers are typically small, unknown entities.• Secondary market growing• Highly regulated and supported by the federal

government.

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MORTGAGE MARKETS

Dr.Ismat Ara Huq

Mortgages and Mortgage-Backed Securities

• Mortgages are loans to individuals or businesses to purchase a home, land, or other real property

• A mortgage is a form of debt that finances investment in property.

• Many mortgages are securitized– securities are packaged and sold as assets backing a

publicly traded or privately held debt instrument• Four basic categories of mortgages issued

– home, multifamily dwelling, commercial, and farm

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Conventional Mortgage• Financial institutions provide conventional

mortgage. • Conventional Mortgages means when the loan is

based is solely on the credit of the borrower and on the collateral for the mortgage.

• It is not federally insured, they can be privately insured so that the lending financial institutions can still a void exposure to credit risk.

• The insurance premium paid for such private insurance will likely be passed on to the borrowers.

Insured Mortgage• Insured mortgages guarantee loan repayment

to the lending financial institution, thereby covering it against the possibility of default by the borrower.

• An insurance fee of 0.5 percent of the loan amount is applied to cover the cost of insuring the mortgage.

• Mortgage Insurance• U.S. Government Mortgage Insurers: There

are three forms of mortgage insurance :– Federal Housing Administration (FHA)– Veterans Administration (VA)– Rural Housing Service (RHS)

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MORTGAGE MARKETS

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Mortgage Insurance• Private Mortgage Insurers (PMI) – insures against

default for borrowers with less than a 20% down payment. Historically, there has been no penalty for prepayment. However, this is not always the case.– Mortgage Guarantee Insurance Company (owned

by Northwestern Mutual)– PMI Mortgage Insurance Company (owned by

Sears, Reobuck)The cost of mortgage insurance is paid to the

guarantor by the mortgage originator but passed along to the borrower in the form of higher mortgage payments.

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• The real estate properties that can be mortgage can be divided into two broad categories :

Single family (one – to –four – family) residential - house, - Condominiums - cooperatives, - apartments Commercial properties:⁻ Multifamily properties e.g.- apartment buildings, ⁻ Office buildings, industrial properties, warehouse,

shopping centers, hotels, and health care facilities etc. 9

Acceptable Collateral for Mortgages

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Mortgage Characteristics

• Collateral /Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults

• Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front

• Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage

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• Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA)

• Conventional mortgages - issued by FIs that are not federally insured

• Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date

• Balloon payment mortgages - requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period

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• Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes

• Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage

• Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage

• Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest

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Mortgage Originator• The original lender is called mortgage

originator. Principal originators of residential mortgage loans are: – Thrifts– Commercial banks– Mortgage banks

• Other private mortgage originators– Life insurance companies– Pension funds

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Revenue Sources• Mortgage originators may generate income from

mortgage activity . The origination Functions are: – Origination fee: expressed in terms of points,

where each point represents 1% of the borrowed funds. Originators may also charge application fees and certain processing fees.

– Secondary marketing profits: profits that might be generated from selling a mortgage at a higher price than it originally costs.

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Other Revenue Sources– Servicing fee: servicing of the mortgage involves

the collecting monthly payments from mortgagors and forwarding proceeds to owners of the loan , sending payment notices to mortgagors, reminding mortgagors when payments are overdue, etc.

– Income from holding mortgages in an investment portfolio.

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Various types of Fees of Mortgage

Application fee• Title search fee• Title insurance fee• Appraisal fee• Loan origination fee

(usually 1% of the loan amount)

• Closing agent/review fee

Costs to obtain mortgage insurance (FHA, VA or private) if needed

• Closing costs average from 3%-5% of the mortgage amount (excluding points), with 3% the most common

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A homebuyer will normally face a host of fees (payable at closing or before) including:

Mortgage Origination Process• Evaluating Credit Risk

– Payment-To-Income Ratio– Loan-To-Value Ratio

• Commitment Letter form Lender• Choice of Type of Mortgage

– Fixed-rate mortgage– Adjustable-rate mortgage

Mortgage Origination Process• At first the potential homeowner completes an

application form, which provides financial information about the applicant and pays an application fee;

• Then the mortgage originator evaluating Credit Risk by using the following ratios:– Payment-To-Income Ratio (PTI) = monthly

payments/monthly income- measures the ability of the applicant to make monthly payments,

– So, the lower the ratio, the greater the applicant will be able to meet the required payments.

Mortgage Origination Process– Loan-To-Value Ratio (LTV) : the ratio of the amount of

the loan to the market (or appraised) value of the property.

– So, the lower the ratio, the greater the protection for the lender if the applicant defaults on the payments and the lender must repossess and sell the property.

Commitment Letter form Lender: If the lenders decides to lend the funds it sends a commitment letter to the applicant.

The length of time of the commitment varies between 30 to 60 days.

commitment latters obligates the lender not to the applicant.

Choice of Type of MortgageAt the time the application is submitted , the mortgage originator will give the applicant a choice among the various types of mortgages. These are: –Fixed-rate mortgage–Adjustable-rate mortgage

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Fixed rate Mortgage• A fixed rate mortgage looks in the borrower’s interest

rate over the life of the mortgage. Thus the periodic

interest payment received by the lending financial

institution is constant, regardless of how market interest

rates change over time. (Balloon Payment mortgage)

• The lender typically gives the applicant a further choice

of when the interest rate on the mortgage will be

determined.

Fixed rate Mortgage• The three choices are:

– At the time the loan application is submitted.– At the time a commitment letter is issued and– At the date when the property is purchased.

• These choices granted the applicant – the right to decide whether or not to close on the property and the right to select when to set the interest rate

Adjustable rate mortgage (ARM)• An adjustable rate mortgage allows the

mortgage interest rate to adjust to market conditions.

• Its contract will specify a precise formula for this adjustment.

• The formula and the frequency of adjustment can vary among mortgage contracts. (Capital recovery)

• Now, mortgage originator can either • - i) hold the mortgage in their portfolio,• -ii) sell the mortgage to an investor that

wishes to hold the mortgage in its portfolio or that will place the mortgage in a pool of mortgages to be used as collateral for the issuance of the security , or

• -iii) use the mortgage themselves as collateral for the issuance of the security.

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Mortgage Origination Process (contd.)

Securitization of Mortgages

• Pass-through mortgage securities - mortgage-backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools

• Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum

• Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC)

REAL ESTATE MORTGAGES• Desirable Features for a Mortgage (Lender)

– Yield flexibility: Responsiveness to changing market rates

– Constant real payments; keeping pace with inflation– Payment stability; minimize late payment/default

problems– Full security: market value greater than loan amount– Servicing simplicity

• Collecting principal and interest when rates are changing

• For mortgages allowing negative amortization, tracking changing principal and interest payments can be difficult

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• Desirable Features for a Mortgage (Lender)– Marketability

• Ability to sell in a secondary market• Sales of mortgage backed securities (MBS) help

control total lender risk• Substituting capital market funds for financial

institution's funds

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REAL ESTATE MORTGAGES

Calculation of Monthly Mortgage Payments

PV = PMT(PVIFA i/12, n 12)

Where:

PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage paymentPVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years

Comparison of Monthly Mortgage Payments

$150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30 12 )

PMT = $120,000/136.2835 = $880.52

$150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15 12 )

PMT = $120,000/104.6406 = $1146.78

Risk from investing in MortgagesIn mortgages three types of risk. That are-• 1. Interest rate risk:• Financial institutions that hold mortgages are

subject to interest rate risk because the values of mortgages tend to decline in response to an increase in interest rates.

• 2. Prepayment risk:• Prepayment risk is the risk that a borrower

may prepay the mortgage in response to a decline in interest rates.

• 3. Credit risk:• Credit risk or default risk is the possibility that

borrowers will make late payments or even default. Whether investors sell their mortgages prior to maturity or hold them until maturity, they are subject to credit risk.

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Risk from investing in Mortgages

The various sources of default risk can be classified into the following four broad categories

1. Normal (or auctorial) risks: • Insurers expect that a certain percentage of the

borrowers will default due to unique circumstances not directly attributable to any of the other categories of default risk.

2. Originator underwriting risk:• At one time mortgage originators such as banks and

thrifts would retain the mortgage loan in their portfolio. As a consequence they kept underwriting standards tight.

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Default risks associated with mortgage insurance underwriting

3. National economic risks: • Default rates are positively related to national

economic conditions. As national unemployment levels increase claims increase.

4. Local economic risks: • While the national economy may be thriving regions

within the United States may suffer high levels of unemployment and depressed property values.

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Default risks associated with mortgage insurance underwriting