Mortgage Markets & Mortgage Markets & Financial Crisis Financial Crisis

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Mortgage Markets Subprime Market Financial Crisis Economic Recovery

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Fixed-rate versus adjustable-rate◦ A fixed-rate mortgage locks in the borrower’s rate

Financial institutions that hold fixed-rate mortgages are exposed to interest rate risk

Borrowers with fixed-rate mortgages do not benefit from declining rates

◦ An adjustable-rate mortgage (ARM) allows the mortgage rate to adjust to market conditions A common ARM uses a one-year adjustment with the interest

rate tied to the average T-bill rate over the previous year Borrowers with ARMs face uncertainty about future interest

rates Using ARMs, financial institutions: Can stabilize their profit

margins and face less interest rate risk than with fixed-rate mortgages

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Types of mortgages◦ 30-year fixed◦ 15-year fixed◦ ARMs◦ Equity Lines

Creative Mortgages◦ Intro (teaser) rates◦ Stated income & asset◦ Negative amortization loans (pick-a-pay)

Mortgage Lending◦ What are the characteristics in which a loan

should be made?

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Fannie Mae:◦ Issues debt securities and uses the proceeds to purchase

mortgages in the secondary market Freddie Mac:

◦ Ensures that sufficient funds flow into the mortgage market Ginnie Mae:

◦ Is a wholly-owned corporation by the federal government◦ Supplies funds to low- and moderate-income homeowners

indirectly (provides guaranties) by facilitating the flow of funds into the secondary mortgage market

As a result of these three entities, the secondary mortgage market SHOULD BE:◦ very liquid◦ have a lot of funding

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The most common are mortgage pass-through securities◦ A group of mortgages held by trustee serves as

collateral◦ Interest and principal on the mortgages are sent to the

financial institution, which passes them through to the owners of the mortgage-backed securities

◦ Financial institutions earn fees from servicing the mortgages while avoiding exposure to interest rate risk and credit risk

Interest rate risk on mortgage-backed securities◦ Payments received from pass-through securities are

tied to the payments sent to security owners◦ Institutions can insulate their profit margin from

interest rate fluctuations

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Pooling and repackaging of loans into securities◦ Investors in these securities become the

owners of the represented loans◦ Allows for the sale of smaller mortgage loans

that cannot be easily sold individually◦ Can reduce a financial institution’s exposure to

default risk or interest rate risk

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Interest rate riskPrepayment riskCredit risk

What is a subprime loan? A loan made to a person with less than

perfect (prime) credit Other Characteristics of subprime loan

◦ High LTV◦ Poor cash flow to debt◦ Improper documentation

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Bubble in housing marketHousing market dropHow did Financial Institutions get into trouble? Bad Mortgages (Subprime Market) Bets on financial subprime market (derivatives)

Example: CDS

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Homebuyers / Investors◦ Increase use of ARMs and Subprime borrowers finding more◦ Overzealous investors◦ Crazy buyers

Builders◦ Over building the market◦ Too much supply and inventory of homes an now cutting prices

Underwriters / Banks / Mortgage Brokers / Appraisers◦ Lending money with no guidelines◦ Poorly Structured Loans

Stated income, stated assets, poor documentation ARMs Buy downs / Intro-rates Payment Options (Pick-a-payment with Negative Amortization) More subprime loans and lower subprime margins 2.8% to 1.3%

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Securitization – passing the risk along (Credit Agencies)◦ Due to securitization loans with a high risk of default could be

originated, packaged and the risk readily transferred to others. ◦ The securitized share of subprime mortgages (i.e., those passed

to third-party investors) increased from 54% in 2001, to 75% in 2006.

Central Bank (FED)◦ Kept interest rates too low does not try to avoid bubbles◦ Roots of credit crisis laid at Fed's door (2007)

Federal Reserve lowered the federal funds rate target from 6.5% to 1.0% because inflation was thought to be low

Trying to help the economy after Sept. 11th and dot.com bubble

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Economic Recovery? Economic Recovery?

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