Chapter Seven
Mortgage Markets
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Mortgages and Mortgage-Backed
Securities
• Mortgages are loans to individuals or
businesses to purchase a home, land, or other
real property
• Many mortgages are securitized
– mortgages are packaged and sold as assets backing a
publicly traded or privately held debt instrument
• Four basic categories of mortgages issued
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Mortgage Loans Outstanding, 2004 ($Bn)
$582
$141
$1,635
$7,771
family
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commercial
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multifamily
farm
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• In 2004 there were over $10 trillion of
mortgages outstanding.
• About 77% of mortgages are single
family (1-4 family) mortgages.
• The rest are divided between commercial
mortgages (16%), multifamily dwelling
mortgages (6%) and a small amount of
farm mortgages (under 1%).
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secondary market for mortgages
• There is a well developed and active
secondary market for mortgages, unlike
most other loan types.
• This is because the government is
heavily involved in the single family
secondary mortgage market to promote
securitization.
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Securitization
• Securitization is the process of
transforming individual loan contracts
into marketable securities. About 60%
of single family mortgages are
securitized
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The saleable contract
• Mortgage contracts by themselves would not be
particularly saleable because they have nonstandard,
fairly small denominations and unique, potentially
substantial credit risk.
• A saleable contract should have a standard, large
denomination to appeal to institutional buyers, a low
cost method of assessment of credit risk, good
collateral, a standard maturity, and a standard interest
rate.
• Standardization improves salability.
• Standard terms improve the ability to market an issue
to buyers because they are more familiar with the
terms and risks of the investment
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• Mortgages have generally good
collateral, standard lengthy maturities
and standard interest rates.
• The small and variable denomination of
individual mortgages implies that
mortgages should be pooled to create a
typical large denomination.
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What about credit risk
• Credit risk analysis of the many
individual borrowers in the pool would
be quite costly and would severely limit
the usefulness of the securitization
process if not alleviated.
• Thus, for most mortgages that are
securitized either the government
provides insurance for mortgages, or an
80% loan to value ratio is required, or the
mortgage must be privately insured.
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Why Securitization
•
•
•
•
•
•
Securitization brings many benefits to FIs.
Securitization allows FIs to
a) become more liquid,
b) reduce interest rate and credit risk,
c) reduce capital and reserve requirements,
d) generate fee income from servicing more
mortgages than they could otherwise.
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Saudi to be soon, so you may wish to consider pursuing
careers in mortgage related areas.
• The mortgage markets are huge (they are
larger than the corporate debt market),
• rapidly growing (from 1992 through 2004 the
amount of home mortgages grew by about
133%)
• becoming increasingly sophisticated.
• Even with the slower economic growth of the
2000s the mortgage markets have continued to
grow, in some areas home prices have
advanced more rapidly than income growth,
generating some concerns that housing prices
could fall precipitously if housing becomes
unaffordable
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Was Greenspan wrong
• Nevertheless, Greenspan has indicated
that he does not foresee problems of this
nature in the housing market.
• However Greenspan did indicate that
rapid growth in two housing related
government sponsored enterprises,
FNMA and FHLMC, was generating
systemic risk to the economy.
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• In other countries and in USA past,
severe collapses in housing prices have
triggered prolonged periods of low
economic growth or even a prolonged
recession.
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The Primary Mortgage Market
• It should be emphasized that the starting
and financing of mortgages are now
largely separate functions.
• One of the primary purposes of the
government’s presence in the mortgage
markets is to ensure the availability of
mortgage credit wherever it is needed.
• Government mortgage insurance and the
securitization process have created a
national market for financing mortgages.
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The separation of creation and financing
of mortgages.
• The financing of mortgages is national, or even
international, in scope.
• The origination (creation) of mortgages is still
primarily a local market, for instance, typically
one does not go to another state to obtain a
mortgage.
• The originators however often sell the
mortgage (individually or in a pool).
• The origination market is itself however
becoming increasingly national because
mortgage companies (a local originating
institution) often obtain mortgage financing
from institutions around the country.
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Electronic mortgage
• Electronic mortgage origination however
has not grown as dramatically as
predicted.
• Applying for a mortgage online remains
a troublesome task, hurting this area of
business.
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Politics or theft or stupid
• Government involvement has done two things.
• One, it has allowed younger, less wealthy
people to own homes by eliminating the large
down payment, thus facilitating a part of the
“American dream” of home ownership.
• Second, it has helped poorer regions of the
country such as West Virginia, Montana, etc
that would not have had enough mortgage
credit available to meet the demand for funds.
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Why home ownership
• For many people, home ownership is one of
the most satisfying assets they obtain.
• It is a person’s major hedge against personal
disasters and inflation.
• Even in low inflation times it is usually (but not
always) an appreciating asset and, unlike
automobiles, should be considered an
investment.
• It is however an illiquid investment and living
in the wrong house for you in the wrong area
can make you miserable for a long time, so
please shop wisely.
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Mortgage Characteristics
• Although mortgages can have unique terms, the
demands of the secondary market increasingly
determine the guidelines for accepting or rejecting a
mortgage application.
•
•
•
•
•
•
•
Lien
Down payment
Private mortgage insurance
Federally insured mortgages
Conventional mortgages
Amortized
Balloon payment mortgages
(continued)
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•
•
•
•
Fixed-rate mortgage
Adjustable-rate mortgage
Discount points
Amortization schedule
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Collateral & lien
• All mortgage loans are backed by collateral
that will have a lien placed against it.
• A lien is a public record attached to the title of
the property that gives the financial institution
the right to sell the property if the mortgage
borrower defaults.
• A lien prevents sale of the property until the
mortgage is paid off and the lien removed.
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Down Payment
• In the absence of government insurance, a
down payment is required to minimize default
risk.
• An 80% loan to value ratio is standard.
• If a borrower cannot pay the required 20%
down payment they may obtain FHA
insurance. (Federal Housing Administration)
• FHA insurance has a maximum borrowing
amount that varies according to regional
housing costs.
• The borrower may instead apply for private
mortgage insurance (PMI).
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PMI
• Most PMI requires a monthly payment
that is added to the principle and interest
payment.
• Although it can vary from lender to
lender, the typical monthly mortgage
insurance payment if the borrower pays
only 10% down can be found by
multiplying the loan amount times a
constant factor equal to 0.0051 and then
dividing the result by 12.
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Example
• For instance, on a $100,000 mortgage
with 10% down, the monthly PMI
premium would be ($100,000*0.0051)/12 =
$42.50.
• If you finance 97% the constant is 0.0090
and the monthly PMI payment would be
$75.
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Tip
• Once the homeowner reduces the
principle amount to 80% or less of the
house value, either through payments
and/or appreciation of the value of the
home, the homeowner may wish to have
the house reappraised and apply for
termination of the mortgage insurance.
The appraisal cost may be as low as
$500-$600.
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Insured vs Conventional Mortgages
• Conventional mortgages are mortgages
not insured by the Federal government.
• The term insured mortgages refers to
mortgages insured by the Federal
government, not privately insured
mortgages.
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Mortgage Maturities
• The two standard maturities are 15 year and 30
year, with 30 year mortgages predominating.
• Some contracts call for balloon payments at
the end of three to five years.
• These contracts may require interest only
payments during the interim period.
• Most borrowers will not be able to pay off the
balloon so the borrower is essentially agreeing
to refinance the mortgage when the balloon is
due.
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Tip
• A balloon payment mortgage is riskier to
the borrower because there is no
guarantee that refinancing will be
granted.
• An injury or illness, a layoff, etc. can
endanger an individual’s primary asset,
their home.
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Interest Rates
•
•
•
•
•
•
•
•
Mortgage rates are a function of:
the fed funds rate,
discount points paid,
whether the loan is FHA or a conventional
mortgage,
maturity,
whether the mortgage is fixed or adjustable
rate,
regional demand for funds and the level of
competition of suppliers of mortgage credit.
Regional credit availability is not an issue due
to the national financing market.
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Fixed versus Adjustable Rate Mortgages
• (FRMs) remain the most popular
mortgage type, although a significant
number of mortgages are adjustable rate.
• With the low rates of the early 2000s,
adjustable rate mortgages (ARMs) have
not been as popular as in prior periods.
• (at one point several years ago 50% of new
originations were adjustable rate).
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prepayment penalties
• The index used cannot be the lender’s cost of
funds and is often an index of lenders’ fund
costs (termed a COFI or cost of funds index).
• The rate change per year and over the life of
the mortgage is capped and prepayment
penalties are not allowed on ARMs.
• (A prepayment penalty is a provision of your contract with the
lender that states that in the event you pay off the loan entirely,
you will pay a penalty. Penalties are usually expressed as a
percent of the outstanding balance at time of prepayment, or a
specified number of months of interest. Usually, prepayment
penalties decline or disappear with the passage of time. Seldom
do they apply after the fifth year. Partial prepayments of up to 20%
of the balance usually are allowed in any one year without a
penalty. A penalty that applies to a home sale as well as a
refinancing, is a "hard" penalty; if it applies only to a refinancing,
it is a "soft" penalty.)
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The cap
• With a fixed rate mortgage the lender
bears the interest rate risk, with an ARM
the borrower bears the interest rate risk.
(implies that even in an ARM the lender still bears
some interest rate risk)
• ARMs result in higher default risk for
lenders in periods of rising interest rates.
• When rates rise, borrowers have more
difficulty making the payments on their
mortgage.
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Discount Points
• A borrower can buy a lower interest rate by
paying points up front.
• A discount point is 1% of the loan amount.
Lenders periodically establish point schedules
that show what interest rate they are willing to
offer if the borrower pays a certain amount of
points.
• A simple breakeven analysis can be used to
determine whether the borrower should pay
the points.
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Other Fees
• A homebuyer will normally face a host of fees (payable
at closing or before) including:
• Application fee
• Title search fee
• Title insurance fee
• Appraisal fee
• Loan origination fee (usually 1% of the loan amount)
• Closing agent/review fee
• Costs to obtain mortgage insurance (FHA, VA or
private) if needed
• Tip: Closing costs average from 3%-5% of the
mortgage amount (excluding points), with 3% the most
common.
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Mortgage Refinancing
• Due to low interest rates in the early 2000s,
mortgage refinancing business has boomed.
• A typical rule of thumb is that the new
mortgage rate should be 200 basis points
below the old rate, but with ARMs and reduced
refinancing costs refinancings can be
worthwhile at smaller rate reductions.
• A breakeven analysis can be used to
determine if refinancing is worthwhile
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Mortgage amortization
• The typical mortgage is fully amortized at
the original maturity so that the principle
is reduced with each payment and no
balloon remains at maturity.
• Amortizing payments are calculated
using the present value of annuity
formula.
• An amortization schedule depicts the
amount of each payment that goes to
principle and to interest.
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Example
• A borrower agrees to a $200,000, thirty year fixed rate
mortgage with a 5.75% quoted interest rate. What is
the payment amount and how much of each payment
goes to principle and interest?
• 30years =360 payment
• Payment = $200,000 / (1-1.004792^-360)/0.004792 =
$1,167.15
• The amortization schedule provides the breakdown of
each payment into principle and interest on a dollar
and a percentage basis.
• Notice that the total interest paid on this mortgage
($220,172.46) is greater than the original balance.
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Calculation of Monthly Mortgage
Payments
PV = PMT(PVIFA r,t )
Where:
PV = Principal amount borrowed through the mortgage
PMT = Monthly mortgage payment
PVIFA = Present value interest factor of an annuity
r = interest rate, i, divided by 12 (months/year)
t = number of months (payments) over life of the mortgage
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Comparison of Monthly Mortgage
Payments
$150,000 home with 30-year mortgage at 8%, 0 points, 20% down
$120,000 = PMT(PVIFA 8%/12, 30  12 )
PMT = $120,000/136.2835 = $880.52
$150,000 home with 15-year mortgage at 8%, 0 points, 20% down
$120,000 = PMT(PVIFA 8%/12, 15  12 )
PMT = $120,000/104.6406 = $1146.78
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Other Types of Mortgages
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•
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Automatic rate-reduction mortgages
Graduated-payment mortgages
Growing-equity mortgages
Second mortgages
Home equity loan
Shared-appreciation mortgage (SAM)
Equity-participation mortgage
Reverse-annuity mortgage
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Automatic Rate-Reduction Mortgages
• When interest rates fall the lender
automatically lowers the existing
mortgage interest rate;
• however the rate is never adjusted
upward.
• This type of mortgage is designed to
discourage refinancing with another
lender if rates fall.
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Graduated Payment Mortgages GPMs
• GPMs allow borrowers to initially make low
monthly payments which rise for the next 5 to
10 years before leveling off.
• GPMs are designed to allow homebuyers to
purchase more house than they can currently
afford under the assumption that their income
will rise to match the growing house payment.
• Relative to a standard fixed rate mortgage, the
borrower will pay more interest overall.
• This type of mortgage is riskier than a
standard fixed rate mortgage with a payment
that the borrower can currently afford.
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Growing Equity Mortgages (GEMs)
• GEMs are mortgages where the
payments increase according to a fixed
schedule over the entire life of the
mortgage.
• GEMs result in faster amortization which
shortens the maturity of the mortgage;
thus they are a way to more quickly pay
down the debt.
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alternative to a GEM.
Without commit it
• A fifteen year mortgage is an alternative to a
GEM.
• Also, a borrower could simply take out a 30
year fixed rate mortgage and make extra
payments each year.
• The latter strategy is probably the least risky
alternative for the borrower if they have the
discipline to stick to the extra payments.
• In any case, GEMs are increasingly being
replaced with 5 year interest only (IO) loans.
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Second Mortgages
• Second mortgages are subordinated claims to
senior mortgages.
• Home equity loans allow customers to borrow
on a line of credit secured with a second
mortgage.
• Interest on home equity loans is normally tax
deductible whereas credit card interest is not.
• Home equity loans have been running about
160 basis points above the 15 year fixed rate,
but this varies.
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Tip
• Be careful advising individuals to use a home
equity loan to pay off credit card debt.
• Theoretically, an expensive vacation or even a
shopping spree could endanger your home
ownership if the buyer cannot manage credit
properly.
• Citigroup and Household International came
under fire in 2002 for their aggressive
marketing tactics used in selling mortgages to
subprime borrowers.
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Shared Appreciation Mortgages
(SAMs)
• SAMs allow home owners to obtain a loan at up to 200
basis points below market rates.
• In exchange, the homeowner must give a portion of the
appreciation in value of the home to the lender upon
sale or refinancing of the home.
• Many SAMs have a refinancing requirement in 5 to 7
years if the home has not already been sold.
• SAMs are another form of mortgage that allows a
homebuyer to buy more house than they can afford at
current interest rates.
• They have not been very popular in recent years; they
were primarily used in the 1980s.
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Equity Participation Mortgages
• An equity participation mortgage is the
same as a SAM except that a third party
(other than the lender) gets a share in the
appreciation of the house.
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Reverse Annuity Mortgages (RAMs)
• RAMs are for homeowners with a substantial amount
of equity in their home who wish to supplement their
income, usually retirees.
• With a RAM the FI makes a monthly payment to the
homeowner.
• The FI is in effect buying out the homeowner’s equity
over time.
• At maturity the house is sold and the proceeds are
used to pay off the FI.
• RAM maturities are usually set up so that the
homeowner will die before maturity.
• As the population ages and health care costs increase
RAMs are likely to grow in popularity.
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New Types of Mortgages
•
•
•
•
•
•
40 year mortgages
Negative Amortization Mortgage
Flex-ARM mortgage
Piggyback Mortgage or Combo loan
103s and 107s
Most of these alternative mortgage types
are riskier for home buyers, they are
generally methods to buy more house
than you could otherwise afford.
McGraw-Hill/Irwin
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40-Year Mortgage
•
These products are similar to 30-year fixed-rate mortgages,
except that borrowers stretch the payments out for an extra 10
years. Lenders, however, charge a slightly higher interest rate, up
to half a percentage point, says Greg McBride of Bankrate.com.
This type of loan is good for first-time buyers who don't plan on
staying in the house for more than a few years, and are looking
for lower monthly payments.
• Pros: A 40-year mortgage offers lower monthly payments than a
30-year loan, while locking in today's attractive rates. On a
$300,000 mortgage at today's prevailing rates -- 6% for a 30-year
and 6.25% for a 40-year -- a home buyer could save nearly $95
each month.
• Cons: By extending the length of the mortgage, the borrower
increases the amount of interest paid over the life of the loan. On
that $300,000 mortgage, it would mean an additional $170,030.42.
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Negative Amortization Mortgage
• This interest-only product allows buyers to pay less
than the full amount of interest necessary to cover the
costs of the mortgage. The difference between the full
amount and the amount paid each month is added to
the balance of the loan. This loan is best for borrowers
with large cash reserves who want the flexibility of
lower payments during certain parts of the year but
plan to pay off loans in large chunks during other
parts.
• Pros: An even smaller monthly payment than an
interest-only mortgage in the first few years.
• Cons: Should housing prices stagnate or fall, buyers
would find themselves in "negative equity," meaning
they would owe money to the lender if they sold their
homes.
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Flex-ARM Mortgage
• Each month the lender sends the borrower a payment
coupon that calculates four payment options: negative
amortization, interest only, 30-year fixed and 20-year
fixed. The homeowner decides how much to pay.
(Some mortgages offer only an interest-only and a 30year-fixed option.) This structure is recommended for
people who like options and have large cash reserves
for when payments increase in the later portion of the
loan.
• Pros: The bank does all the thinking. Each month it
recalculates the balance and tells the borrower how
much he or she would owe under different scenarios.
• Cons: Borrowers could end up owing more on the
mortgage than they can fetch for their homes
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Piggyback Mortgage
• This is really two mortgages, also known as a combo
loan. The first covers 80% of the property's value. The
second, with a slightly higher rate, covers the
remaining balance. Young professionals with high
salaries but little savings would benefit most from this
loan type.
• Pros: In most cases, homeowners save money since
the second loan allows them to avoid paying costly
private-mortgage insurance when buying a home with
less than a 20% down payment.
• Cons: Rates on the second mortgage are higher. And
rates can vary greatly depending on credit scores.
Also, since the borrower has little equity in the home,
should its value fall when it is time to sell, the borrower
would need to pay the difference in cash.
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103s and 107s.
• These loans have no down payment and
allow people to borrow 3% to 7% more
than the house is worth. They are best
for people with large cash reserves who
prefer to invest in, say, the stock market
rather than tying up assets in real estate.
• Pros: Minimal up-front costs.
• Cons: Rates tend to be high. And
borrowers run the risk of negative equity
if the house loses value.
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Secondary Mortgage Market
• Advantages for FI to securitize
– reduces liquidity risk, interest rate risk, and credit risk of
FIs portfolio
– FI retains income from origination fees and service fees
• FI’s remove mortgages from their balance
sheet through one of two mechanisms
– pool recently originated mortgages together and sell
them in the secondary market
– issue mortgage-backed securities that are backed by
their newly originated mortgages
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History And Background Of
Secondary Mortgage Markets
• In 2004 over 60% of all residential mortgages
were securitized.
• Originators often keep the servicing contract.
• Servicing fees range from ¼% to ½% of the
loan amount.
• Securitization also allows FIs to remove the
mortgages from the balance sheet which
improves liquidity, reduces interest rate risk
and reduces capital and other regulatory
costs.
• More details and calculations of savings are
provided in Chapter 24.
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Mortgage Sales outline
• Mortgage sale
• Allow FIs to manage credit risk and achieve better
asset diversification, improves their liquidity risk
• FIs are encouraged to sell loans for economic and
regulatory reasons
• Major buyers of mortgage loans
• Major sellers of mortgage loans are money center
banks, smaller banks, foreign banks, investment
banks
McGraw-Hill/Irwin
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Mortgage Sales1
• Traditionally, mortgage and loan sales were conducted between
correspondent banks.
• Correspondent banks are banks that have ongoing service, loan
and deposit relationships with each other.
• Prototypically, a small bank has a correspondent relationship
with a larger bank.
• The small bank keeps deposits at the larger bank and uses the
larger bank to clear checks, obtain loans and invest extra funds.
• Small banks often also create loans too large for them to finance
and they may sell all or part of the loan to their correspondent
bank.
• The large bank may also sell loan participations to the small
bank if local loan demand is weak at the smaller bank’s locale.
• This practice improves diversification at the smaller bank.
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Mortgage Sales2
• Mortgage (or other loan) sales may be with or without
recourse, most are without recourse and may or may
not lead to securitization.
• If a loan is sold with recourse the loan seller remains
liable to the loan buyer if the borrower defaults.
• The five major buyers of mortgages are banks,
insurance firms, pension funds, closed end bank loan
funds and nonfinancial corporations.
• A major advantage of selling the mortgages is the
reduction in capital required by the selling institution.
• A bank that finances a mortgage must hold 2.8¢ in
equity capital per dollar of mortgage loans.
• Selling the loan reduces the required equity.
• The seller may keep the servicing contract or may not,
preferring to earn origination fees on new mortgages.
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Mortgage-Backed Securities
• Securitization is the process of transforming
individual loan contracts into marketable
securities.
• This is accomplished by depositing a pool of
mortgages with a trustee and then selling
some type of marketable security to investors.
• It is a form of intermediation.
• Mortgage backed bonds and CMOs (REMICs)
are examples of asset transformations.
• As of 2004, there were $4.73 trillion of
mortgage securities outstanding.
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The main types of Securitization of
Mortgages
• Pass-through mortgage securities
• Three government owned or sponsored
agencies involved - Ginnie Mae (GNMA),
Fannie Mae (FNMA, and Freddie Mac
(FHLMC)
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Pass-Through Securities
• On a pass-through security, the pool organizer simply
passes through all mortgage payments made by the
homeowners, including prepayments, to the holders of
the pass-through securities on a pro-rata basis.
• Payments are thus monthly, and are variable based on
how many homeowners pay off their mortgages early.
• The pool organizer or the government usually provides
insurance for the mortgages in the pool.
• Default risk is not generally a worry for a government
backed pass-through security holder (such as a GNMA
pass-through). These securities carry substantial
prepayment risk however.
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Prepayment risk
• Prepayment risk can be illustrated with a
simple example.
• If an investor holds a relatively high interest
rate pass-through it will be priced above par.
• The investor is willing to pay a premium above
par because the claim pays a high level of
interest relative to current rates.
• If the mortgages are prepaid the investor will
receive the par amount but they will have paid
a premium over par that will be lost because
the investor will be cashed out at par.
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GNMA
• The Government National Mortgage Association (GNMA) is a
government agency that was formed in 1968 to provide mortgage
credit to veterans, farmers and lower income individuals.
• Rather than provide direct financing for mortgages, GNMA will
guarantee payment on mortgage pools that are created by private
pool organizers.
• Originators submit a pool of mortgages for GNMA approval.
• All mortgages in the pool must have the same interest rate and
maturity and have FHA, FmHA or VA insurance so GNMA
insurance is really only timing insurance (ensures that the
payments are made in a timely fashion).
The government places caps on the insurable amount of an
individual mortgage. These caps vary according to the cost of
housing in a given area and housing costs through time, but the
maximum was $359,650 in 2004.
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GNMA2
• GNMA does not form mortgage pools but allows pool
organizers to sell securities which use the pool as
collateral and carry GNMA's name.
• These are called GNMA pass-throughs.
• These securities have minimum denominations of
$25,000.
• The pass-through holders receive the amounts paid in
by the homeowners minus a 50 basis point fee.
• GNMA and the mortgage servicers share those basis
points.
• Mortgage companies are the largest issuer of GNMA
pass-throughs.
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Fannie Mae
• FNMA was formed in 1938 as a government agency
and charged with creating a secondary market for FHA
and VA insured mortgages.
• FNMA did so by making and honoring forward
commitments to purchase mortgages from originators.
• FNMA raises money by issuing its own securities to
the public.
• FNMA has an emergency line of credit with the
Treasury if needed although FNMA was privatized in
1968.
• Privatization occurred so that FNMA could expand into
conventional mortgages and because they were
profitable on their own and no longer needed
government support.
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Freddie Mac
• Freddie Mac was created in 1970 as a private
company with the purpose of improving the
liquidity of mortgages originated by thrifts.
• FHLMC buys both FHA, VA and conventional
mortgages, puts the mortgages into pools, and
then sells claims (securities) collateralized by
the mortgage pool.
• Thus FHLMC does not provide the ultimate
financing for the bulk of their mortgages.
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Government Sponsorship of FNMA and
Freddie Mac and recent problems at both
• Both FNMA and FHLMC are implicitly backed by the
U.S. government, indeed both have a credit line with
the Treasury.
• The government backing reduces FNMA’s and
FHLMC’s borrowing costs and both companies have
been consistently profitable.
• Because the government backing lowers these
government sponsored enterprises’ (GSEs) funding
costs, either the GSEs can consistently generate
monopoly profits and/or more funds are channeled
into mortgage investments that otherwise would
have gone elsewhere, probably to corporate bond or
equity investments.
• A second concern is the government’s liability that
would occur if these GSEs experienced financial
difficulties, as both organizations are quite large.
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Problems with derivatives positions
•
•
•
•
•
The Office of Federal Housing Enterprise Oversight
(OFHEO) regulates both corporations.
OFHEO has indicated that both organizations are at
risk from large positions in derivatives, supposedly
designed to hedge their interest rate risk.
If these institutions are hedging appropriately, then the
derivatives positions should not add to bankruptcy
risk to the organizations.
However, hedging reduces both return and risk and
few hedgers can resist the temptation to use
derivatives to try to increase return rather than to
reduce risk.
In 2003, Freddie Mac experienced a 52% drop in
income due to derivatives losses.
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Other problems that have recently arisen
• Both institutions have been accused of
overcharging lenders for mortgage insurance.
• Freddie and Fannie constitute an oligopoly.
Oligopolistic competition should prevent the
firms from earning monopoly rents unless
implicit or explicit price fixing is occurring.
• Because these are GSEs and have subsidized
funds costs, they may not be aggressively
pricing their services.
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Cooking the Books
• In 2003 both institutions restated earnings or
equity.
• Fannie Mae restated equity by $1.1 billion.
• Freddie Mac restated earnings by $4.5 billion.
• Both were claimed to be computational errors.
• Both have since been found to have been
manipulating accounts to smooth earnings
and in one case increase a bonus to an
executive.
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Alan Greenspan
• In February 2004, Alan Greenspan stated that
both institutions pose serious risks to the U.S.
financial system.
• His concern is that their status as GSEs
allows Fannie and Freddie to borrow
excessively.
• The result is that the Treasury department
must now approve new debt issues by both
institutions.
• A new regulator of the industry has also been
proposed.
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Private Mortgage Pass-Throughs
• A limited number of private mortgage passthrough issuers deal with nonconforming
mortgages that do not qualify for government
insurance.
• Prudential Home, Residential Funding
Corporation, GE Capital Mortgages,
Countrywide and a few other companies create
private mortgage pass–throughs.
• The acronym for private mortgage passthroughs is Privately Issued Pass-Throughs or
PIPs.
• PIPs must be registered with the SEC and
normally are rated by one or more of the
ratings agencies.
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Mortgage Backed Pass-Through
Quotes
• Mortgage instruments are priced according to
some assumed level of prepayments. The
Public Securities Association (PSA) has
developed what is known as the “Standard
Prepayment Model:” The PSA model of
prepayments on home mortgages is 0.2%
initially with prepayments rising at 0.2% per
month until month 30, after which
prepayments remain at 6% per year.
•
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prepayment models
• See
www.psa.com/publications/igabs/prepay
ment.htm for various prepayment models
on different loan types.
• If 25% higher prepayments than the
standard are expected (usually due to
falling interest rates) the mortgage
instrument may be priced with expected
prepayments of “125% of PSA.”
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Tip
• It is important to understand that with a passthrough the investor bears all the prepayment
risk and the pool organizer has no prepayment
risk.
• GNMA pass-through securities are often sold
as ‘guaranteed’ because of the government
backing but investors should understand that
the rate of return on the pass-through is not
guaranteed and can vary widely with different
prepayment patterns.
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History of Secondary Mortgage Markets
• Federal National Mortgage Association (FNMA or
“Fannie Mae”) created during the Great Depression
• FHA and VA insured loans also created during this time
• Government National Mortgage Association (GNMA or
“Ginnie Mae”) and Federal Home Loan Mortgage
Corp. (FHLMC or “Freddie Mac”) created during
1960’s
• Wide variety of mortgage-backed securities have been
developed and in 1999, approximately 50% of
mortgages are securitized
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Government-Related Mortgage-Backed
Pass-Through Securities Outstanding ($Bn)
2000
1500
1000
500
0
1995
GNMA
McGraw-Hill/Irwin
FNMA
1998
2000
FHLMC
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2004
Private Mortgages
©2007, The McGraw-Hill Companies, All Rights Reserved
Collateralized Mortgage Obligations
• CMO - a mortgage-backed bond issued in
multiple classes or tranches
– tranches - a bond holder class associated with a CMO
• Created by packaging and securitizing whole
mortgage loans or resecuritizing pass-through
securities
• Attractive to secondary mortgage market
investors because they can choose a particular
CMO class that fits their maturity needs
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Collateralized Mortgage Obligations
(CMOs)
•
•
•
•
•
•
•
•
•
•
•
•
CMOs were created to allow investors to better choose and control the level of
prepayment risk they face.
CMOs are a hybrid between a pass-through and a bond.
CMOs have different payment classes called tranches.
Suppose the CMO has three classes, A, B and C.
The Class A CMO holder would receive all the initial principal payments (on the
entire pool), including all prepayments, whenever they occur, until all the Class A
holders have been paid off.
Buyers of Class A CMOs are interested in short duration investments. ‫مثل األول في‬
‫الجمعية‬
Initially, Class B and C holders would receive no principle, just interest payments
until all of the principle of Class A holders has been paid off.
Likewise, Class C is not affected by any prepayments until Class B holders have
been paid off.
The multiple classes allow investors to better choose the level of prepayment risk
desired.
The REMIC (Real Estate Mortgage Investment Conduit) is essentially a legal form
of CMO that avoids tax complications.
The IRS normally does not allow an intermediary to transform cash flows without
taxing the activity.
In 1986 Congress set up the REMIC as a trust form that is exempt from IRS
taxation.
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Mortgage Backed Bonds (MBBs)
• With MBBs, mortgages are pledged as collateral
backing the bond issue.
• The MBB is in all other respects similar to standard
corporate bonds.
• In this case the bond issuer bears the prepayment risk,
and as a result the bonds normally have to be
significantly overcollateralized to obtain a favorable
bond rating.
• MBBs are not technically a method of securitization in
that the bond issuer does not remove the mortgages
from their balance sheet; thus, issuing MBBs does not
provide some of the aforementioned benefits of
securitization to the FI.
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Participants in the Mortgage Markets
•
•
•
•
•
•
•
•
•
•
•
Who originates single family mortgages? (2004)
Banks
27%
Thrifts
28%
Mortgage Companies 28%
Other
17%
Who finances mortgages?
Depository Institutions
36%
Held in pools
52%
Life Insurers
3%
Mortgage companies <1%
Other
8%
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Mortgages Outstanding by Type of Holder(%),
2004
3.37
Mortgage Pools
0.32 4.39
2.62
52.42
36.88
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Depository
Institutions
Life Insurance
Companies
Other Financial
Institutions
Mortgage
Companies
Other
©2007, The McGraw-Hill Companies, All Rights Reserved
One- to Four-Family Mortgage Originations,
2004
17.50
28.30
Mortgage
Companies
Commercial Banks
Thrifts
Other
27.50
26.70
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Issuers of Ginnie Mae Securities, 2004
Mortgage
Companies
Commercial Banks
31.10
Thrifts
50.30
Other
9.50
9.10
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mortgage companies
• There is a very large difference in the
amount of mortgages originated by
mortgage companies and the amount
financed. Most mortgage companies
quickly sell the mortgages they originate.
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International Trends in Securitization
–
–
•
•
•
•
•
•
Demand by international investors for U.S. mortgage backed
securities
International Mortgage Securitization
Foreign banks hold an insignificant amount of U.S.
mortgages.
Outside the U.S., Europe has engaged in the most
securitization.
The conversion to the Euro has increased the growth
of securitization in Euroland.
Securitization is running at about $200 billion per
year in Europe.
The United Kingdom has more securitization than
any other European country.
France and Germany have not progressed in
securitization to the same degree.
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