Chapter 09 (Financial Institute and Market)

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CHAPTER

9MortgageMarkets

© 2003 South-Western/Thomson Learning



Chapter Objectives

n Describe characteristics of residential

mortgages

n

Describe the common types of creativemortgage financing

n Explain the role of the federal government in

supporting the development of the secondary

mortgage market

n Relate the development and use of mortgage-

backed securities





Residential Mortgage Characteristics

n Fixed rate loans have a constant, unchangingrate

l Interest rate risk can hurt lender rate of return

u If interest rates rise in the market, lender’s cost of fundsincreases

u No matching increase in fixed-rate mortgage return

l Borrowers lock in their cost and have to refinance

to benefit from lower market rates

Fixed Rate vs. Adjustable Mortgages




n Fixed monthly payment includes

l Interest owed first

l Balance to principal

n Interest on the declining principal balance

n Calculating monthly payment

l

Principal borrowed = PVl Number of months to maturity = years 12 = N

l Rate/12 = I

l Calculate PMT




Calculate the monthly payment for a $330,000

home. The new owner has made a $70,000

down payment and plans to finance over 30

years at the current fixed rate of 7%.




Calculate the monthly payment for a

$330,000 home. The new owner has made a

$70,000 down payment and plans to financeover 30 years at the current fixed rate of 7%.

$330,000 – $70,000 = $260,000 PV (originalinvestment of the financial institution)

30 x 12 = 360 N; 7/12 = I; Calculate PMT




Calculate the monthly payment for a $330,000

new home. The new owner has made a

$70,000 down payment and plans to finance

for 30 years at the current fixed rate of 7%.

$330,000 – $70,000 = $260,000 PV (original

investment of the financial institution)

30 12 = 360 N; 7/12 = I; Calculate PMT

PMT = $1,729.79




n Adjustable-rate mortgages

l Rates and the size of payments can change

u Maximum allowable fluctuation over year and life of loan

u Upper and lower boundaries for rate changes

l Lenders stabilize profits as yields move with cost of funds

l Uncertainty for borrowers whose mortgage payments can

change over time

Fixed-Rate vs. Adjustable Mortgages




n Trend shows increased popularity of 15-year

loans

l

Lender has lower interest rate risk if the term ormaturity of the loan is lower

l Borrower saves on interest expense over loan’s

life but monthly payments higher

Mortgage Maturities




n Balloon payments

l Principal not paid until maturity

l Forces refinancing at maturity

n Amortizing mortgagesl Monthly payments consist of interest and principal

l During loan’s early years, most of the payment

reflects interest

Mortgage Maturities



Creative Mortgage Financing

n Graduated-payment mortgage (GPM)

l Small initial payments

l Payments increase over time then level off

l Assumes income of borrower grows

n Growing-equity mortgage

l Like GPM low initial payments

l Unlike GPM, payments never level off



Creative Mortgage Financing

n Second mortgage used in conjunction with

first or primary mortgage

l Shorter maturity typically for 2nd mortgage

l 1st mortgage paid first if default occurs so 2nd

mortgage has a higher rate

l If used by sellers, makes a home with an

assumable loan more affordable

n Shared-appreciation mortgage

l Below market rate but lender shares in home’s

price appreciation



Activities in the Mortgage Markets

n How the secondary market facilitatesmortgage activities

n Selling loans

l Origination, servicing and funding are separate business activities and may be “unbundled”

l Secondary market exists for loans

n Securitizationl Pool and repackage loans for resale

l Allows resale of loans not easily sold on anindividual basis



Activities in the Mortgage Markets

n Unbundling of mortgage activities provides

for specialization in:

l Loan origination

l Loan servicing

l Loan funding

l Any combination of the above



Institutional Use of Mortgage Markets,

December, 2002

n Federally related mortgage poolsl 37% of all mortgages, mostly residential

n Commercial banks

l Dominate commercial mortgage marketl Hold 23.3% of all mortgages

n Savings institutions

l Primarily residential mortgages

l Hold 10% of all mortgages n Life insurance companies

l Commercial mortgages

l Hold 3% of all mortgages





Valuation of Mortgages

n Market price of mortgages is present value of cashflows

P M

= Market price of a mortgage

C = Interest payment and PRIN is principal

k = Investor’s required rate of return

t = maturity

Where:

n

t t M k

C P

1 1 )(

PRIN




n Periodic payment commonly includes payment of interest and principal

n Required rate of return determined by risk-free

rate, credit risk and liquidity n Risk-free interest rate components and

relationship

l + inflationary expectationsl + economic growth

l – change in the money supply

l + budget deficit




n Economic growth affects the risk premium

l Strong growth improves borrowers’ income and

cash flows and reduces default risk

l Weak growth has the opposite affect

n Potential changes in mortgage prices

monitored by reviewing inflation, economic

growth, deficits, housing, and other predictoreconomic statistics



Exhibit 9.8

U.S.

Fiscal Policy

U.S.

Monetary Policy

U.S.

Economic Conditions

Prepayment Risk

Premium of Issuer

Price of Fixed-Rate

Mortgage

Risk Premium of Issuer

Issuer’s Unique

Conditions

Long-T erm Risk-Free

Interest Rate (T -Bond Rate)

Issuer’s Industry

Commercial Mortgages)

Conditions (for

on the Fixed-Rate Mortgage

Required Return



Risk from Investing in Mortgages

n Interest rate risk

n Present value of cash flows or value of

mortgage changes as interest rate changes

n Long-term fixed-rate mortgages financed by

short-term funds results in risks

n

To limit exposure to interest rate riskl Sell mortgage shortly after origination (but rate

may change in that short period of time)

l Make adjustable rate mortgages




n Prepayment risk

l Borrowers refinance if rates drop by paying off

higher rate loan and financing at a new, lower rate

l Investor receives payoff but has to invest at the

new, lower interest rate

l Manage the risk with ARMs or by selling loans




n Credit risk can range from default to late

payments

n Factors that affect default

l Level of borrower equity

u Loan-to-value ratio often used

u Higher use of debt, more defaults

l Borrowers income level

l Borrower credit history

n Lenders try to limit exposure to credit risk




n Measuring risk

l Use sensitivity analysis to review various “what

if” scenarios covering everything from default to

prepayments

l Incorporate likelihood of various events

l Review effect on cash flows

l Institution tries to measure risks and useinformation to restructure or manage risk



Use of Mortgage-Backed Securities

n Securitization is an alternative to the outright

sale of a loan

n Group of mortgages held by a trustee serves as

collateral for the securities

n Institution can securitize loans to avoid

interest rate risk and credit risk while still

earning service fees

n Payments passed through to investors can vary

over time




Ginnie Mae mortgage-backed securities

l Government National Mortgage Association

l Guarantees timely interest and principal payments

to investors

l Pool of loans with the same interest rate

l Purchasers receive slightly lower rate than that on

the loans to cover service and guarantee




n Fannie Mae mortgage-backed securities

l Uses funds from mortgage-backed pass-through

securities to purchase mortgages

l Channel funds from investors to institutions that

want to sell mortgages

l Guarantee timely payments to investors

l Some securities strip (securitize) interest and principal payment streams for separate sale




n Publicly issued pass-through securities (PIPS)

l Backed by conventional mortgages instead of

FHA or VA mortgages

l Private mortgage insurance

n Participation certificates (PCs)

l Freddie Mac sells and uses funds to finance

origination of conventional mortgages fromfinancial institutions




n Collateralized mortgage obligations (CMOs)

l Semi-annual payments differ from other

securities’ monthly payments

l Segmented into classes

u First class has quickest payback

u Any repaid principal goes first to investors in this class

l Investors choose a class to fit maturity needsl One concern is payback speed when rates drop




n CMOs (cont.)

l Can be segmented into interest-only IO or

principal-only PO classes

l High return for IO reflect risks

n Useful investment but be aware of the risks

l 1992 failure of Coastal States Life Insurance due

to CMO investments

l Some CMO mutual funds

l Regulators have increased scrutiny




n Mortgage-backed securities for small investors

l In the past, high minimum denominations

l Unit trusts created to allow small investor

participationl Mutual funds

n Advantages

l

Can purchase in secondary market without purchasing the need to service loans

l Insured

l Liquid



Globalization of Mortgage Markets

n Mortgage market activity not confined to just

one country

n Market participants follow global economic

conditions

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Chapter 09 (Financial Institute and Market)

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