Slide 1

Report
Chapter 9
Mortgage Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
Chapter Outline








Background on mortgages
Residential mortgage characteristics
Creative mortgage financing
Institutional use of mortgage markets
Valuation of mortgages
Risk from investing in mortgages
Mortgage-backed securities
Globalization of mortgage markets
2
Background on Mortgages

A mortgage is a form of debt that finances investment in property

The debt is secured by the property
 The mortgage is the difference between the down payment and the
value to be paid for the property

Financial institutions such as savings institutions and mortgage
companies originate mortgages

They accept mortgage applications and assess the creditworthiness
of the applicants
 The mortgage contract specifies the mortgage rate, the maturity, and
the collateral that is backing the loan
 The originator charges an origination fee
 The originator may earn a profit from the difference between the
mortgage rate and the rate that it paid to obtain funds
3
Background on Mortgages (cont’d)

The level of mortgage debt has risen over time
 Mortgage
debt rises at a slower rate during
recessions

The majority of mortgage debt outstanding is
on one- to four-family properties
4
Residential Mortgage
Characteristics

The mortgage contract should specify:
 Whether
the mortgage is federally insured
 The amount of the loan
 Whether the interest rate is fixed or adjustable
 The interest rate to be charged
 The maturity
 Other special provisions
5
Residential Mortgage
Characteristics (cont’d)

Insured versus conventional mortgages
 Federally
insured mortgages guarantee loan
repayment to the lending financial institution




The insurance fee is 0.5 percent of the loan amount
The guarantor is either the FHA or the VA
The maximum mortgage amount is limited by law
The volume of FHA loans has consistently exceeded that of
VA loans
 Conventional mortgages can be privately insured
 The private insurance premium is typically passed to the
borrowers
6
Residential Mortgage
Characteristics (cont’d)

Fixed-rate versus adjustable-rate mortgages
mortgage locks in the borrower’s
interest rate over the life of the mortgage
 A fixed-rate



The periodic interest payment is constant
Financial institutions that hold fixed-rate mortgages are
exposed to interest rate risk if funds are obtained from
short-term sources
Borrowers with fixed-rate mortgages do not benefit from
declining rates
7
Residential Mortgage
Characteristics (cont’d)

Fixed-rate versus adjustable-rate mortgages (cont’d)

An adjustable-rate mortgage (ARM) allows the mortgage
rate to adjust to market conditions





The formula and frequency of adjustment vary among mortgage
contracts
A common ARM uses a one-year adjustment with the interest rate
tied to the average T-bill rate over the previous year
Some ARMs contain an option that allows mortgage holders to
switch to a fixed rate within a specified period
Most ARMs specify a maximum allowable fluctuation in the
mortgage rate per year and over the mortgage life
Borrowers with ARMs face uncertainty about future interest rates
8
Residential Mortgage
Characteristics (cont’d)

Fixed-rate versus adjustable-rate mortgages
(cont’d)
 Using ARMs,


financial institutions:
Can stabilize their profit margins
Face less interest rate risk than with fixed-rate mortgages
9
Residential Mortgage
Characteristics (cont’d)

Mortgage maturities


Since the 1970s, 15-year mortgages have become more
popular because of savings in interest expenses
Interest rate risk for originators is lower on 15-year mortgages


The mortgage rate on 15-year mortgages is typically lower
A balloon-payment mortgage requires interest payments for
a three- to five-year period when the borrower must pay the full
amount of the principal

No principal payments are made until maturity, so monthly
payments are lower
10
Residential Mortgage
Characteristics (cont’d)

Mortgage maturities (cont’d)

Amortizing mortgages





An amortization schedule shows the monthly payments broken
down into principal and interest
During the early years of a mortgage, most of the payment
reflects interest
Over time, the interest proportion decreases
The lending institution for a fixed-rate mortgage will receive a
fixed amount of equal periodic payments over a specified period
of time
The payment amount depends on the principal, interest rate, and
maturity
11
Writing an Amortization
Schedule
Consider a 15-year (180-month) $200,000
mortgage at an annual interest rate of 9
percent. Develop an amortization schedule for
this mortgage showing all appropriate columns.
Show the first three payments and the last two
payments on the schedule. The monthly
mortgage payment is $2,028.53.
12
Writing an Amortization
Schedule (cont’d)
Payment
Number
Payment
of Interest
Payment
of Principal
Total
Payment
Remaining Loan
Balance
1
$1,500.00
$528.53
$2,028.53
$199,471.47
2
1,496.04
532.50
2,028.53
198,938.97
3
1,492.04
536.49
2,028.53
198,402.48
.
.
.
.
.
179
30.09
1,998.44
2,028.53
2,013.43
180
15.10
2,013.43
2,028.53
0.00
13
Creative Mortgage Financing




Graduated-payment mortgages
Growing-equity mortgages
Second mortgages
Shared-appreciation mortgages
14
Creative Mortgage Financing
(cont’d)

A graduated-payment mortgage:




Allows the borrower to initially make small payments
Results in increased payments over the first 5 to 10 years, at
which time payments level off
Is tailored for families who anticipate higher income
A growing-equity mortgage:



Allows the borrower to initially make small payments
Results in continually increasing payments over time
Results in a relatively short payoff time
15
Creative Mortgage Financing
(cont’d)

A second mortgage:





Can be used in conjunction with the primary or first mortgage
Often has a shorter maturity than the first mortgage
Has a higher interest rate than the first mortgage because of
increased default risk
Is often offered by sellers of homes
A shared-appreciation mortgage:


Allows a home purchaser to obtain a mortgage at a belowmarket interest rate
Allows the lender to share in the price appreciation of the
home
16
Institutional Use of Mortgage
Markets

Development of a secondary mortgage market:




Allows institutions that originate mortgages to sell them
Allows institutional investors to invest in mortgages even if
they have no desire to originate or service them
Allows institutional investors to sell mortgages
Financial institutions that originate mortgages

Mortgage companies:




Originate mortgages and quickly sell the mortgages they originate
Do not maintain large mortgage portfolios
Are not as exposed to interest rate risk as other financial
institutions
Commercial banks and thrift institutions are the primary
originators of mortgages
17
Institutional Use of Mortgage
Markets (cont’d)

Participation in the secondary market
 Financial
institutions sell mortgages they cannot
finance in the secondary market
 Buyers are savings institutions, pension funds, life
insurance companies, and mutual funds
18
Institutional Use of Mortgage
Markets (cont’d)

Roles of Ginnie Mae, Fannie Mae, and Freddie Mac

Fannie Mae:





Issues debt securities and uses the proceeds to purchase
mortgages in the secondary market
Has more than $800 billion of securities outstanding
Is exempt from state income tax and has credit lines from the
Treasury
Is commonly perceived to be backed by the government
Ginnie Mae:



Is a wholly-owned corporation by the federal government
Supplies funds to low- and moderate-income homeowners
indirectly by facilitating the flow of funds into the secondary
mortgage market
Has more than $600 billion of securities outstanding
19
Institutional Use of Mortgage
Markets (cont’d)

Roles of Ginnie Mae, Fannie Mae, and Freddie Mac
(cont’d)

Freddie Mac:
 Ensures that sufficient funds flow into the mortgage market
 Is exempt from state income tax and has lines of credit with
the Treasury
 Has more than $600 billion in debt securities outstanding
 As
a result of these three entities, the secondary
mortgage market:


Is very liquid
Has a lot of funding
20
Institutional Use of Mortgage
Markets (cont’d)

Roles of Ginnie Mae, Fannie Mae, and Freddie
Mac (cont’d)
 The



Freddie Mac accounting scandal
Since 2000, Freddie Mac invested in corporate bonds, strip
malls, and hotels
The company used irregular accounting techniques to
stabilize earnings and hide its increased risk
Freddie Mac was required to restate its 2000-2002
earnings and replaced its CEO and other senior managers
21
Institutional Use of Mortgage
Markets (cont’d)

Securitization is the 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
22
Institutional Use of Mortgage
Markets (cont’d)
Life
Insurance
8%
Savings
Institutions
25%
Commercial
Banks
67%
23
Institutional Use of Mortgage
Markets (cont’d)

Unbundling of mortgage activities

Financial institutions can:







Function as mortgage originators and then sell them in the
secondary market
Sell originated mortgages by maintain the servicing
Focus on servicing mortgages originated by other institutions
Focus on investing in mortgages
Invest in mortgages that it is allowed to service
Brokerage firms participate by matching up sellers and buyers
of mortgages in the secondary market
Investment banking firms participate by helping institutional
investors hedge their mortgage holdings against interest rate
risk
24
Valuation of Mortgages

The market price of mortgages should equal
the present value of their future cash flows:
C  Prin
PM 
t
(
1

k
)
t 1
n


The required rate of return on a mortgage is
influenced by the risk-free rate, credit risk,
and the lack of liquidity:
PM  f ( Rf , RP )
-
25
Valuation of Mortgages (cont’d)

Factors that affect the risk-free interest rate
 The
risk-free rate is driven by inflationary
expectations, economic growth, the money supply,
and the budget deficit:
Rf  f ( INF , ECON, MS, DEF )


 Inflationary expectations

-

Higher expected inflation places upward pressure on
interest rates and on the required return
26
Valuation of Mortgages (cont’d)

Factors that affect the risk-free interest rate (cont’d)

Economic growth


Money supply growth


An increase in economic growth causes an increase in the riskfree rate and in the required rate of return
A high level of money supply growth places downward pressure
on interest rates and on the required rate of return
Budget deficit

An increase in the budget deficit increases government
demand for loanable funds and places upward pressure on the
risk-free rate and the required rate of return
27
Valuation of Mortgages (cont’d)

Factors that affect the risk premium
 The
average risk premium can change in response
to a change in economic growth:
RP  f ( ECON)
 Strong
economic growth improves income or cash
flows and reduces default risk
28
Valuation of Mortgages (cont’d)

Summary of factors affecting mortgage prices
 Price
movements in a mortgage can be modeled
as:
PM  f ( Rf , RP )
-
-
PM  f ( INF , ECON, MS, DEF )
-
?

-
29
Valuation of Mortgages (cont’d)

Summary of factors affecting mortgage prices
(cont’d)
 Impact
of the September 11 attack on mortgage
rates



Short-term rates declined by a full percentage point within
one month
Long-term interest rates declined only slightly
The 30-year conventional mortgage declined by only
about .25 percentage point over the next month
30
Valuation of Mortgages (cont’d)

Indicators of changes in mortgage prices
 Mortgage
market participants monitor indicators
that may signal future changes in the strength of
the economy:



Inflation indicators
Announcements about the budget deficit
Indicators of economic growth in the real estate sector
31
Risk from Investing in Mortgages

Interest rate risk
 Mortgage
prices decline in response to an
increase in interest rates
 Mortgages are commonly financed by
financial institutions with short-term deposits
 Mortgages can generate high returns when
interest rates fall, but gains are limited
because borrowers tend to refinance
32
Risk from Investing in Mortgages
(cont’d)

Interest rate risk (cont’d)
 Limiting

exposure to interest rate risk
Financial institutions can:
Sell mortgages shortly after originating them
 Maintain adjustable-rate residential mortgages
 Invest in fixed-rate mortgages with a short time remaining
to maturity

33
Risk from Investing in Mortgages
(cont’d)

Prepayment risk
 Prepayment
risk is the risk that a borrower may
prepay the mortgage in response to a decline in
interest rates
 The investor receives payment and has to reinvest at
the lower interest rate
 Limiting exposure to prepayment risk

Financial institutions can sell loans shortly after originating
them or invest in adjustable-rate mortgages
34
Risk from Investing in Mortgages
(cont’d)

Credit risk


Credit risk is the possibility that borrowers will make late
payments or even default
The probability of default is influenced by economic conditions
and by:




The level of equity invested by the borrower
The borrower’s income level
The borrower’s credit history
Limiting exposure to credit risk


Financial institutions can purchase insurance
Financial institutions can maintain the mortgages they originate
35
Risk from Investing in Mortgages
(cont’d)

Measuring risk

Financial institutions attempt to estimate the future cash flows to
be generated from mortgage portfolios in various future periods



Prepayment risk and credit risk create uncertainty about future
payments
Sensitivity analysis can be used to forecast cash flows for different
scenarios
Review of financial statements to monitor risk


When interest rates rise, the reported value of mortgage-backed
securities are not revised
A loss in the value of mortgage-backed securities is only recognized
when the financial institution sells them at a loss
36
Mortgage-Backed Securities

Mortgage-backed securities are securities backed by
mortgage loans


Issuing mortgage-backed securities is an alternative to
selling mortgages outright in the secondary market
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
37
Mortgage-Backed Securities
(cont’d)

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
38
Mortgage-Backed Securities
(cont’d)

Prepayment risk on mortgage-backed
securities
 Owners
of pass-through securities are exposed to
prepayment risk because of the borrower’s right
to prepay in part or in full without penalty
 Owners of mortgage-backed securities are also
subject to the possibility that prepayments are
decelerated in response to rising interest rates
39
Mortgage-Backed Securities
(cont’d)

Ginnie Mae mortgage-backed securities

Ginnie Mae guarantees time payment of principal and interest to
investors in FHA or VA mortgages
 All mortgages pooled together must have the same interest rate


The interest rate received by purchasers is about 50 basis points less
Fannie Mae mortgage-backed securities




Fannie Mae issues mortgage-backed securities and uses the
funds to purchase mortgages
Channels funds from investors to financial institutions that desire to
sell their mortgages
Receives a fee for guaranteeing timely payment of principal and
interest to the holders of the mortgage-backed securities
Some mortgage-backed securities are stripped by separating the
principal and interest payments
40
Mortgage-Backed Securities
(cont’d)

Publicly issued pass-through securities (PIPs)


Similar to Ginnie Mae mortgage-backed securities
Backed by conventional rather than FHA or VA mortgages


Insured through private insurance companies
Participation certificates (PCs)

Freddie Mac sells participation certificates (PCs) and
uses the proceeds to finance the origination of conventional
mortgages from financial institutions
41
Mortgage-Backed Securities
(cont’d)

Collateralized mortgage obligations
(CMOs):
 Have
semiannual interest payments
 Are segmented into tranches, with the first tranch
having the quickest payback
 Are attractive because investors can choose a
class that fits their maturity desires
 Are sometimes segmented into interest-only (IO)
and principal-only (PO) classes
42
Mortgage-Backed Securities
(cont’d)

Mortgage-backed securities for small
investors
 Unit
trusts have been created that allow small
investors to participate

e.g., a portfolio of Ginnie Mae pass-through securities is
sold in $1,000 pieces
 Some
mutual funds offer Ginnie Mae funds
43
Globalization of Mortgage Markets



Non-U.S. financial institutions hold mortgages on
U.S. property and vice versa
The use of interest rate swaps to hedge mortgages
in the U.S. often involves a non-U.S. counterpart
Mortgage market participants closely follow
international economic conditions because of the
potential impact on interest rates

A weaker dollar leads to higher inflation and higher interest
rates
44

similar documents