Mortgage Markets

Chapter SevenMortgage Markets1McGraw-Hill/IrwinMortgages and Mortgage-Backed SecuritiesMortgages are loans to individuals or businesses to purchase homes, land, or other real propertyMany mortgages are securitizedmortgages are packaged and sold as assets backing publicly traded or privately held debt instruments (i.e., mortgage-backed securities (MBSs))Mortgages differ from bonds and stocksmortgages are backed by a specific piece of real propertyprimary mortgages have no set size or denominationprimary mortgages generally involve only a single investorcomparatively little information exists on mortgage borrowers2McGraw-Hill/IrwinPrimary Mortgage Market Four basic types of mortgages are issued by financial institutionshome mortgages are used to purchase one- to four-family dwellingsmultifamily dwellings mortgages are used to purchase apartment complexes, townhouses, and condominiumscommercial mortgages are used to finance the purchase of real estate for business purposesfarm mortgages are used to finance the purchase of farms3McGraw-Hill/IrwinMortgage Loans Outstanding, 2007 (Trillions of $)4McGraw-Hill/IrwinMortgage Characteristics Collateral: lenders place liens against properties that remain in place until loans are fully paid offA down payment is a portion of the purchase price of the property a financial institution requires the borrower to pay up frontprivate mortgage insurance (PMI) is generally required when the loan-to-value ratio is more than 80%Federally insured mortgagesrepayment is guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA)5McGraw-Hill/IrwinMortgage Characteristics Conventional mortgages are mortgages that are not federally insuredAmortized mortgages have fixed principal and interest payments that fully pay off the mortgage by its maturity datefully amortized mortgage maturities are usually either 15 or 30 yearsBalloon payment mortgages require fixed monthly interest payments for 3 to 5 years whereupon full payment of the mortgage principal is due6McGraw-Hill/IrwinMortgage Characteristics Fixed-rate mortgages lock in the borrower’s interest raterequired monthly payments are fixed over the life of the mortgagelenders assume interest rate riskAdjustable-rate mortgages (ARMs) tie the borrower’s interest rate to some market interest rate or interest rate indexrequired monthly payments can change over the life of the mortgageyearly interest rate changes are often cappedborrowers assume interest rate riskARMs can increase default risk7McGraw-Hill/IrwinMortgage Characteristics Discount points are fees or payments made when a mortgage loan is issuedeach point costs the borrower 1 percent of the principal valuethe lender reduces the interest rate used to determine the payments on the mortgage in exchange for points paidOther feesapplication feetitle searchtitle insuranceappraisal feeloan origination feeclosing agent and review feesother fees (e.g., VA or FHA loan guarantees and PMI)8McGraw-Hill/IrwinMortgage Characteristics Mortgage refinancingwhen a borrower takes out a new mortgage and uses the proceeds to pay off an existing mortgagemortgages are most often refinanced when an existing mortgage has a higher interest rate than prevailing ratesborrowers must balance the savings of a lower monthly payment with the costs (fees) of refinancingan often-cited rule of thumb is that the new interest rate should be 2 percentage points less than the refinanced mortgage rate9McGraw-Hill/IrwinMortgage Amortization Each fixed monthly payment consists partly of repayment of the principal and partly of the interest on the outstanding mortgage balanceAn amortization schedule shows how the fixed monthly payments are split between principal and interest10McGraw-Hill/IrwinMortgage Payments The present value of a mortgage can be written as:PV = principal amount borrowedPMT = monthly mortgage paymentPVIFA = present value interest factor of an annuityr = monthly interest rate on the mortgaget = number of monthly payments over the life of the mortgageRearrange to isolate the payment:11McGraw-Hill/IrwinOther Types of Mortgages Automatic rate-reduction mortgages Graduated-payment mortgages (GPMs)Growing-equity mortgages (GEMs)Second mortgages and home equity loansShared-appreciation mortgages (SAMs)Equity-participation mortgages (EPMs)Reverse-annuity mortgages (RAMs)12McGraw-Hill/IrwinSecondary Mortgage MarketsFIs remove mortgages from their balance sheets through one of two mechanismsby pooling recently originated mortgages together and selling them in the secondary marketby securitizing mortgages (i.e., by issuing securities backed by newly originated mortgages)Advantages of securitizationFIs can reduce the liquidity risk, interest rate risk, and credit risk of their loan portfoliosFIs generate income from origination and service fees13McGraw-Hill/IrwinSecondary Mortgage MarketsThe U.S. government established the Federal National Mortgage Association (FNMA or Fannie Mae) in the 1930s to buy mortgages from thrifts so they could make more mortgage loansFHA and VA insured loans make securitization easier Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created in the 1960s encouraged continued expansion of the housing marketprovided direct and indirect guarantees that allow for the creation of mortgage-backed securities14McGraw-Hill/IrwinMortgage SalesFIs have sold mortgages among themselves for over 100 yearsA large part of correspondent banking involves small banks selling parts of large loans to larger banksLarge banks often sell parts of their loans (i.e., participations) to smaller banksMortgage sales occur when an FI originates a mortgage and sells it to an outside buyera loan sale is made with recourse if the loan buyer can sell the loan back to the originator should it go bad15McGraw-Hill/IrwinMortgage SalesMortgage sellers: money center banks, smaller banks, foreign banks, investment banksMortgage sales allow FIs to manage credit risk, achieve better asset diversification, and improve their liquidity and interest rate risk positionsFIs are encouraged to sell loans for economic and regulatory reasonssold mortgages can still generate fee income for the banksold mortgages reduce the cost of reserve and capital requirementsMortgage buyers: foreign and domestic banks, insurance companies, pension funds, closed-end bank loan mutual funds, and nonfinancial corporations16McGraw-Hill/IrwinMortgage Backed SecuritiesPass-through securities “pass through” promised principal and interest payments to investorsThree agencies are directly involved in the creation of pass-through securitiesGinnie MaeFannie MaeFreddie MacPrivate mortgage pass-through issuers create pass-throughs from nonconforming mortgages17McGraw-Hill/IrwinMortgage Backed SecuritiesCollateralized mortgage obligations (CMOs) are multiclass pass-throughs with multiple bond holder classes or trancheseach bond holder class has a different guaranteed couponmortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protectedMortgage backed bonds (MBBs)MBBs allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheetsa group of mortgage assets is pledged as collateral against a MBB issue, but there is no direct link between the cash flows of the mortgages and the cash flows on the MBB18McGraw-Hill/IrwinMortgages Outstanding by Type of Holder (%)19McGraw-Hill/IrwinInternational Trends in SecuritizationForeign investors participate in U.S. mortgage and MBS markets, but the value held has decreased since 1992Europe is the world’s second largest and most developed securitization marketthe United Kingdom is the biggest MBS issuer in the European market, followed by Germanythe advent of the Euro has accentuated the increased trend in securitization in EuropeMortgage lending has grown in Russia since the early 2000s because of changes in property ownership laws20McGraw-Hill/Irwin