The Mortgage Markets
Chapter 14
Dr. Lakshmi Kalyanaraman
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What are mortgages?
• Long-term loan secured by real estate.
• Loan to finance construction of an office
building or purchase of a home
Dr. Lakshmi Kalyanaraman
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Amortized mortgage
• Borrower pays off the loan over time in some
combination of principal and interest
payments that result in full payment of the
debt by maturity.
Dr. Lakshmi Kalyanaraman
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Balloon mortgage
• Only interest is paid over the life of the
mortgage
• Principal is paid at maturity
• High default risk
Dr. Lakshmi Kalyanaraman
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CHARACTERISTICS OF RESIDENTIAL
MORTGAGES
Dr. Lakshmi Kalyanaraman
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Mortgage interest rates
•
•
•
•
Determined by three factors:
1. current long-term market rates
2. life of the mortgage
3. number of discount points paid
Dr. Lakshmi Kalyanaraman
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Market rates
• Determined by the supply of and demand for
long-term funds
• Determined by a number of global, national
and regional factors
Dr. Lakshmi Kalyanaraman
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Term
 Usually
the lifetime is 15 or 30 years
 Lenders
also offer 20 years
 Longer-term
interest
mortgages
mortgages
rate
than
have higher
shorter-term
 Interest
rate risk falls as the term to
maturity decreases
Dr. Lakshmi Kalyanaraman
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Discount points
• Interest payments made at the beginning of a
loan
• A loan with one discount point means that the
borrower pays 1% of the loan amount at
closing
• Closing is when the borrower signs the loan
paper and receives the proceeds of the loan
Dr. Lakshmi Kalyanaraman
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Discount points
 Lender
reduces the interest rate on the
loan
Dr. Lakshmi Kalyanaraman
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Discount points
• Borrower evaluates
• Reduced interest rate over the life of the loan
• Versus
• Increased up-front expense
Dr. Lakshmi Kalyanaraman
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Discount points
 Depends
on how long the borrower will
hold on to the loan
 May
not be feasible if borrower repays in
5 years or less
Dr. Lakshmi Kalyanaraman
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LOAN TERMS
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Collateral
• Real estate bought with the mortgage loan is
pledged as collateral
• Lending institution will place a lien against the
property till the loan is repaid
• Lien is a public record that attaches to the title
of the property
Dr. Lakshmi Kalyanaraman
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Collateral
• Lender gets the right to sell the property if the
underlying loan defaults
• No one can buy the property and obtain clear
title to it without paying off this lien
• Existence of liens against real estate explains
why title search is important part of mortgage
loan
Dr. Lakshmi Kalyanaraman
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Down payment
• Borrower pays a portion of purchase price
• Balance of purchase price is paid by the loan
proceeds
• Down payment reduces default risk
Dr. Lakshmi Kalyanaraman
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Private mortgage insurance
• Insurance contract purchased by FI paid by the
borrower
• guaranteeing to pay the FI
• Difference between the value of the property
and the balance remaining in the mortgage, in
case of default
Dr. Lakshmi Kalyanaraman
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Mortgage loan amortization
• Borrower agrees to pay a monthly amount of
principal and interest that will fully amortize
the loan by its maturity
• ‘Fully amortize’ means that the payments will
pay off the outstanding indebtedness by the
time the loan matures
• During early years of the loan, the lender
applies most of payment to interest and small
amount to outstanding principal balance
Dr. Lakshmi Kalyanaraman
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TYPES OF MORTGAGE LOANS
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Insured and conventional mortgages
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Insured mortgages
• Originated by banks or other mortgage
lenders but are guaranteed by government
agencies
• Applicants either served in the military or
having income below a given level
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Insured mortgages
• Can borrow only up to a certain amount
• Very low or zero down payment
• Agency guarantees the payment of mortgage
loan if the borrower defaults
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Conventional mortgages
• Not guaranteed
• Most lenders require that borrowers to obtain
private mortgage insurance on all loans with
loan-to-value exceeding 80%
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FIXED AND ADJUSTABLE-RATE
MORTGAGES
Dr. Lakshmi Kalyanaraman
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Fixed rate mortgages
• Interest rate and the monthly payment do not
vary over the life of the mortgage
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Adjusted-rate mortgages
• Tied to some market interest rate
•
• Changes over time
• ARMs usually have limits
• Caps, how high the interest rate can move in one year
and during the term of the loan
• For example 2% in one year and 6% over the life of the
loan
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Fixed versus ARM
• Borrowers prefer fixed as ARMs may cause
financial hardship if interest rate rises
• However, fixed rate borrowers lose if interest
rate falls
• Borrowers are risk-averse means that fear of
hardship most often overwhelms anticipation
of savings
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Fixed versus ARM
• Lenders, by contrast, prefer ARMs because
ARMs lessen interest-rate risk
• Interest-rate risk is the risk that rising interest
rates will cause the value of debt instruments
to fall.
•
• The effect on the value of the debt is greatest
when the debt has a long term to maturity.
Dr. Lakshmi Kalyanaraman
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Fixed versus ARM
• Since mortgages are usually long-term, their
value is very sensitive to interest-rate
movements
• Lending institutions can reduce the sensitivity
of their portfolios by making ARMs instead of
standard fixed-rate loans.
Dr. Lakshmi Kalyanaraman
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Fixed versus ARM
• Seeing that lenders prefer ARMs and
borrowers prefer fixed-rate mortgages
• Lenders must entice borrowers by offering
lower initial interest rates on ARMs than on
fixed-rate loans
Dr. Lakshmi Kalyanaraman
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OTHER TYPES OF MORTGAGES
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Graduated payment mortgages
• Useful for home buyers who expect their incomes
to rise
• Has lower payments in the first few years, may
not even cover interest
• Then payments rise
• Advantage is borrowers qualify a higher loan than
conventional mortgage
• Buyers can buy adequate house now
• Payments escalate later when income does or not
Dr. Lakshmi Kalyanaraman
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Growing equity mortgages
• Growing equity mortgage helps to pay off loan in
short period
• Initial payments like conventional mortgage
• Over time payment increases to reduce principal
quickly
• No prepayment penalty
Dr. Lakshmi Kalyanaraman
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Graduated versus growing
• Difference between graduated payment and
growing equity mortgages is that the
graduated is to qualify for a higher loan by
reducing the initial payments and loan paid in
30 years. But growing is to help prepayment
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Second mortgages (piggyback)
• On same real estate like first mortgage
• Second mortgage junior to the original loan
• In case of default, the original loan will be paid
off first and the second mortgage holder from
the left over funds
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Second mortgages (piggyback)
• Borrowers use the equity they have in their
homes as security for another loan
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Second mortgages (piggyback)
• An alternative to the second mortgage would
be to refinance the home at a higher loan
amount than is currently owed.
• The cost of obtaining a second mortgage is
often much lower than refinancing.
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Reverse annuity mortgages
• Innovative method for retired people to live on
the equity they have in their homes
• The contract for a RAM has the bank advancing
funds on a monthly schedule.
• This increasing-balance loan is secured by the real
estate
• borrower does not make any payments against
the loan.
• When the borrower dies, the borrower’s estate
sells the property to retire the debt.
Dr. Lakshmi Kalyanaraman
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Reverse annuity mortgages
• The advantage of the RAM is that it allows
retired people to use the equity in their
homes without the necessity of selling it.
• For retirees in need of supplemental funds to
meet living expenses, the RAM can be a
desirable option.
Dr. Lakshmi Kalyanaraman
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Mortgage institutions
• Many institutions making mortgage loans do not
want to hold long-term
• Short-term sources used for long-term loans
• Many lenders sell the loans immediately to another
investor
• Borrower may not be aware
• Originator frees the funds and gets loan origination
fees normally 1%
Loan servicing
• Some originators provide loan servicing
• Collect payments from borrowers, passes principal
and interest to the investor, keeps record and reserve
account for payment of insurance and taxes
• Earn a fee of around 0.5% of loan amount every year
for servicing
Loan servicing
• 1. Originator packages the loan for an investor.
• 2. Investor holds the loan.
• 3. Servicing agent handles the paperwork.
Dr. Lakshmi Kalyanaraman
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Secondary mortgage market
• Problems in selling mortgages:
• 1. Mortgages are too small to be wholesale
instruments.
• Mortgages value around $250,000 while
commercial paper is around $5 million
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Secondary mortgage market
• Second problem with selling mortgages in the
secondary market was that they were not
standardized.
• They have different times to maturity, interest
rates, and contract terms.
• That makes it difficult to bundle a large
number of mortgages together
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Secondary mortgage market
• Third, mortgage loans are relatively costly to
service
• The lender must collect monthly payments,
often pay property taxes and insurance
premiums, and service reserve accounts.
• Finally, mortgages have unknown default risk
• These problems inspired the creation of the
mortgage-backed security, also known as a
securitized mortgage
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Securitization
• Process of taking an illiquid asset, or group of
assets and through financial engineering
transforming them into a security
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Mortgage backed security
• Large number of mortgages are pooled into
mortgage pool
• A trustee, a bank or government agency, holds
mortgage pool as collateral for new security
• This process is called securitization
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Major types of MBS
• Pass-through security
• Collateralized Mortgage Obligations (CMO)
• Mortgage Backed Bond
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Pass-through Mortgage Securities
• FIs pool mortgages and offer interest in the pool in
the form of pass-through certificates
• Each pass through security represents fractional
ownership in mortgage pool
• Pass through promised payments of principal and
interest on pools of mortgages to secondary market
investors
• No guaranteed annual coupon
• Originating FI or third party servicer takes a fee
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Collateralized Mortgage Obligations
(CMO)
• Multiclass pass-through with multiple bond holder
classes or tranches
• Pass through a pro-rata of mortgage pool but CMO
multi-class pass-through with a number of different
bond holder classes or tranches
• Pass-through no guaranteed coupon, but CMO, each
class has a different guaranteed coupon
• Mortgage prepayments retire only one tranche at a
time, so all other trances are sequentially
prepayment protected
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Mortgage Backed Bonds (MBBs)
– MBBs allow FIs to raise long-term low-cost funds
without removing mortgages from their balance
sheets
– Group of mortgage is pledged as collateral against
MBB
– MBB issues have excess collateral
– Pass-through and CMO are securitization, while
MBB is collateralization
– Pass-through and CMO remove mortgage from
Balance sheet, MBB does not
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Mortgage Backed Bonds (MBBs)
– A 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 MBB
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