CHAPTER 9

MORTGAGE MARKETS

Copyright© 2012 John Wiley & Sons, Inc.

 The Unique Nature of Mortgage Markets
Mortgage loans are secured by the pledge of real
property.
Mortgage loans are made for varied amounts - no
standard denomination.
Issuers of mortgages are usually small family or
business entities.
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.
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 Fixed Rate Mortgages (FRMs)

The note is the borrowing agreement.

Payments amortized over time. (See Exhibit 9.1
for example)
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
Copyright© 2012 John Wiley & Sons, Inc. 3
 Adjustable Rate Mortgage (ARM)
Fixed-rate mortgages are not acceptable to lenders in high
inflation periods.
With ARMs, borrowers' costs vary with inflation and
interest rate levels.
Lenders shift interest rate risk to the borrower.
Caps on ARM 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 Adjustments 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.
Markets price the extent of interest rate risk
assumed by borrower and lender.
ARMs have lower starting rates than going FRM rates.
Common rate indices include Treasury rates,
fixed-rate mortgage indices, prime rate, and
LIBOR.

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Which is the better choice – FRM or ARM?

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Fixed and Adjustable Mortgage Rates

7
Copyright© 2012 John Wiley & Sons, Inc.
 Other Mortgage Instruments
Balloon Payment Mortgages
Traditional loan where interest is paid until a time when
the principal is due.
Terms can be 3, 5 or 7 years.
Interest is based on15- or 30-year period so payments
are no different than in an 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.

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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.
Copyright© 2012 John Wiley & Sons, Inc. 9
 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.
Copyright© 2012 John Wiley & Sons, Inc. 10
 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.

Copyright© 2012 John Wiley & Sons, Inc. 11

 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.
Allow home owners to borrow against the
equity built up in their homes.

Copyright© 2012 John Wiley & Sons, Inc. 12

 What Does it Take to Buy a Home?

Several factors influence a home

buyer’s ability to secure a mortgage
loan.
Borrower’s 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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 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 payments 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 balance of the mortgage
is less than 75% of the property’s value.

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 Private Mortgage Insurance
Uninsured conventional Privately Insured
mortgage conventional mortgage
$12,500 down
$25,000 down Equity payment
Equity payment
Insured Risk $12,500 mortgage
insurance

Uninsured $100,000 Uninsured $112,500

Mortgage mortgage at Mortgage mortgage at
10% APR. 10% plus
insurance
premium = 10¼
to 10½% APR
on $112,500
balance

Copyright© 2012 John Wiley & Sons, Inc. 16

 Mortgage-Backed Securities (MBS)

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 holders of MBS.
Other MBS use pools of mortgages as
collateral for debt securities.

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 Development of a Secondary Market
U. S. Congress initiated the development of a secondary
market for mortgages in 1934 by creating the Federal
Housing Administration (FHA).
In 1938, the Federal National Mortgage Association
(FNMA) was created; it was authorized to buy FHA
insured loans.
In 1968, FNMA was split up into two entities – FNMA
and GNMA (Government National Mortgage
Association).
GNMA was authorized by Congress to guarantee mortgage
pools insured by FHA, VA, and other federal agencies.
In 1970, the Federal Home Loan Mortgage Corporation
(FHLMC) was created to help develop a secondary market
for conventional mortgages.

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 Advantages of MBS 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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 Types of MBS - GNMA

Ginnie Mae Pass-Throughs - pools of

government insured mortgages.
GNMA guarantees the timely payment of principal and
interest on MBS backed by federally insured or
guaranteed loans.
GNMA charges issuers of pass-throughs a fee ranging
from 0.25 % to 0.75 % to offer its guarantee.
Investors in Ginnie Mae securities will earn a lower
yield reflecting a lower default risk because of the dual
guarantee by GNMA on the MBS and the FHA/VA
guaranty on the original loans.

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 GNMA (continued)

Ginnie Mae I are pass-throughs secured by a mortgage

pool consisting of the same type of mortgage loans.
Have the same interest rate.
Are originated by the same lender.
The minimum pool size is $1 million.
Ginnie Mae II are also pass-throughs secured by a
mortgage pool consisting of the same type of mortgage
loans, but are different in other aspects.
They may be issued by multiple lenders.
Interest rates may vary over the portfolio of loans by as
much as 75 basis points (or 0.75%).
The minimum pool size is $250,000 for multi-lender pools
and $1 million for single-lender pools.
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 Types of MBS - Freddie Macs PCs

Freddie Mac Participation Certification - pools

of conventional mortgages.
Issued by the Federal Home Loan Mortgage
Corporation (FHLMC).
• Participation certificates (PCs) are issued by the FHLMC and
conventional loans are purchased from S&Ls.
• PCs are different from GNMA securities.
• Include conventional mortgages as collateral.
• Mortgages are not federally insured.
• Mortgages are pooled by FHLMC, not by private-sector
originators.
• Interest rates among pooled mortgages vary.
• Larger individual mortgages.
• Mortgage originators service the mortgages (collect payments)
for a fee.
Copyright© 2012 John Wiley & Sons, Inc. 22
 Types of MBS (Continued)

Fannie Mae pass-throughs - pools of

conventional or insured mortgages. Issued by
FNMA.
Securities similar to FHLMC’s PC.
Can issue pass-throughs for either conventional or federally
insured mortgage loans.
Privately Issued Pass-Throughs (PIPs)
First issued in 1977 by Bank of America.
PIPs are issued by private institutions or mortgage bankers.
They are similar to “Ginnie Maes” except that they are
backed by conventional mortgages.
Typically used to securitize large, non-conforming mortgage
loans called jumbo loans.

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 Types of MBS (Continued)
Collateralized Mortgage Obligations (CMOs) - fixed
maturity date and interest payments similar to bonds .
CMOs are like serial bonds.
CMO issues have between 3 and 10 classes.
Investors can choose the class that matches their
maturity preference.
CMOs are sometimes split into “interest only” (IO)
and “principal only” (PO) classes.
CMOs have a major disadvantage because they can
create tax problems for the originators.

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 Types of Pass-Through Securities

Real Estate Mortgage Investment Conduit

(REMIC)
Investor pays taxes.
Type of CMO.
Differs from CMOs only in how they are set up
legally.

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 Stripped Mortgage Backed Securities (SMBSs)

Similar to pass-throughs, SMBSs pass on all

payments of principal and interest to investors.
Two kinds – Interest Only (IO) and Principal
only (PO).
Investors in IOs receive cash flows only from the
interest payments on the mortgage pool. Cash
flows decline as mortgage loans in the pool are
paid down.
Holders of POs receive all cash flows from the
principal payments on the mortgage pool.

Copyright© 2012 John Wiley & Sons, Inc. 26

 Mortgage-Backed Bonds
Federal agencies like FNMA and FHLMC issue bonds to
raise funds using the mortgage loans they own as
collateral. These are referred to as “Fannie Mae” bonds
and “Freddie Mac” bonds, respectively.
Private institutions and investor groups also issue
mortgage-backed bonds using the pool of mortgage loans
they own.
Typically use higher than 100% of mortgage pool as
collateral.
Maturities range from 5 to 10 years.
Often rated AAA, thus lowering the required yield.
State and local government housing agencies also can issue
similar securities to fund low income housing
developments.
Exempt from federal income tax because they are
munis.
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 Mortgage Prepayment Risk

Mortgages guaranteed by agencies have yields

above U.S. Treasury Bonds, indicating some risk
besides default risk.
Prepayment risk - the risk that the borrower will
repay (call) the debt before maturity causing the
realized yield to be different from expected.
When interest rates decline, homeowners
(borrowers) refinance, paying off their old
mortgage and creating a new one. The mortgage
investor then receives the principal back when
interest rates are lower.
Copyright© 2012 John Wiley & Sons, Inc. 28
 Mortgage Prepayment Risk (continued)
When rates are high and rising,
homeowners will be slow to refinance or
trade homes, thus extending the length of
their mortgage financing, keeping the rates
to the mortgage lender below market rates.
This extension risk keeps the lender's return
below current market yields.
Prepayment and extension risk causes the
actual return of mortgage investors to vary
from the expected return.

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Refinancing Activity

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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 represent the
largest component of mortgage investment.

Copyright© 2012 John Wiley & Sons, Inc. 31

 Participants in the Mortgage Markets

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.

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Mortgages Outstanding

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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.
Copyright© 2012 John Wiley & Sons, Inc. 34
 Other Participants (continued)
Mortgage Bankers
Originate mortgages, collect fees for origination.
Do not fund mortgages but sell them (e.g., to
GNMA).
Often retain servicing rights to the mortgages,
collecting payments, taxes, and collecting
delinquent payments.
Mortgage banking and loan servicing are very
competitive with technology applications
decreasing expenses with time.

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Mortgage Markets vs. Capital Markets

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