Chapter Seven
Mortgage Markets
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Chapter Outline
1.
2.
3.
4.
5.
Overview
Amortization Schedule
Secondary Market
Participants in Mortgage Markets
Collateralized Mortgage Obligations
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1. 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
– home, multifamily dwelling, commercial, and farm
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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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Mortgage Characteristics
• Lien - a public record attached to the title of the
property that gives the FI the right to sell the property if
the mortgage borrower defaults
• Down payment - a portion of the purchase price of the
property a FI requires the mortgage borrower to pay up
front
• Private mortgage insurance - insurance contract
purchased by a mortgage borrower guaranteeing to pay
the FI the difference between the value of the property
and the balance remaining on the mortgage
(continued)
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• Federally insured mortgages - originated by FIs with
repayment guaranteed by either the Federal Housing
Administration (FHA) or the Veterans Administration
(VA)
• Conventional mortgages - issued by FIs that are not
federally insured
• Fixed-rate mortgage - locks in the borrower’s interest
rate and thus the required monthly payment over the life
of the mortgage, regardless of market rate changes
• Adjustable-rate mortgage - where the interest rate is tied
to some market interest rate with potential for change in
required monthly payments over the life of the
mortgage
(continued)
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• Balloon payment mortgages - requires a fixed monthly
interest payment for a three- to five-year period with
full payment of the mortgage principal required at the
end of the period
• Amortized - when the fixed principal and interest
payments fully pay off the mortgage by its maturity
date
• Discount points - interest payments made when the loan
is issued (at closing). One discount point = 1 percent of
the principle value of the mortgage
• Amortization schedule - schedule showing how the
monthly mortgage payments are split between principal
and interest
(continued)
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2. Amortization schedule
• Amortization schedule - schedule showing how
the monthly mortgage payments are split
between principal and interest
(continued)
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Calculation of Monthly Mortgage Payments
PV = PMT(PVIFA i/12, n  12)
Where:
PV =
PMT =
PVIFA =
i =
n=
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Principal amount borrowed through the mortgage
Monthly mortgage payment
Present value interest factor of an annuity
Annual interest rate on the mortgage
Length of the mortgage in years
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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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3. Secondary Mortgage Market
• 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 (mortgage sales)
– issue mortgage-backed securities that are backed by their
newly originated mortgages (securitization)
• Benefits of secondary mortgage market
– Allow FIs to manage credit risk and achieve better asset
diversification, improves their liquidity risk
– FIs are encouraged to sell loans for economic (generate fee
income) and regulatory reasons (reducing reserve req’s)
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Mortgage Sales
• Mortgage sale - sale of a mortgage originated by a bank
with or without recourse to an outside buyer
• Major sellers of mortgage loans are money center
banks, smaller banks, foreign banks, investment banks
• Major buyers of mortgage loans are domestic banks,
foreign banks, insurance companies and pension funds,
and nonfinancial firms
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Securitization of Mortgages
• Pass-through mortgage securities - mortgage-backed
securities that “pass-through” promised payments of
principal and interest on pools of mortgages created by
financial institutions to secondary market participants
holding interests in the pools
• Issued in standard denominations, usually $25,000 with
increments of $5,000 beyond the minimum
• Three government owned or sponsored agencies
involved - Ginnie Mae (GNMA), Fannie Mae (FNMA,
and Freddie Mac (FHLMC)
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History of Secondary Mortgage Markets
• Federal National Mortgage Association (FNMA or
“Fannie Mae”) created during the Great Depression
• FHA (Federal Housing Administration) and VA
(Veterans Administration) insured loans also created
during this time
• Government National Mortgage Association (GNMA or
“Ginnie Mae”) and Federal Home Loan Mortgage
Corp. (FHLMC or “Freddie Mac”) created during
1960’s
• Wide variety of mortgage-backed securities have been
developed and in 1999, approximately 50% of
mortgages are securitized
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Government-Related Mortgage-Backed PassThrough Securities Outstanding ($Bn)
2000
1800
1600
1400
1200
1000
800
600
400
200
0
1995
GNMA
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1998
FNMA
2000
FHLMC
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2004
Private Mortgages
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4. Mortgages Outstanding by Type of Holder(%),
2004
3.37
0.32 4.39
Mortgage Pools
2.62
Depository Institutions
52.42
Life Insurance
Companies
Other Financial
Institutions
Mortgage Companies
36.88
Other
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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
31.10
50.30
Mortgage Companies
Commercial Banks
Thrifts
Other
9.50
9.10
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5. 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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Sequential Pay Tranche CMO
• Several early tranches plus one accrual (zero) tranche
• Each early tranche receives interest payment at a
specified coupon rate
• Extra payment then is used to pay the principle balance
of the first tranche; when the first tranche is paid off,
extra payment is to pay the principle balance of the next
tranche, and so forth
• Zero tranche starts to get payment only until all the
early tranches have been paid off
• Early tranches have more protection against extension
risk; zero tranche has more protection against
contraction risk
PAC Tranche CMO
PAC: Planned Amortization Class
• PAC tranches plus support tranche
• PAC tranches are guaranteed with preset
payment schedule
• Excessive prepayment goes to the support
tranche
• The certainty of PAC tranches payment comes at
the expense of increased prepayment risk of
support tranche