Mortgage Loans
Fixed Income Securities
Outline
What is a mortgage?
Major Originators
Alternative Mortgage Instruments
Prepayments and their impacts on cash
flows
Risks of investing in mortgages
Factors that affect default on mortgage
loans
What is a Mortgage?
A loan that is secured by the collateral of
specified real estate property, which
obliges the borrower to make a
predetermined series of payments.
In the event of default by the borrower, the
lender can sell off the property
General Features of a Mortgage
Loan
 Loan is based on the credit of the borrower and the
collateral for the mortgage—Conventional Mortgage
 Mortgage Insurance
 Usually, amount of loan less than the market value of
the property
 Classified as one to four family homes (residential
property) and income property (office space and
apartment buildings)
 Loan originators include: thrifts, mortgage
companies, and commercial banks for income
property
 Loan originators for income property include
commercial banks, thrifts, and insurance
companies
 Usually, mortgage companies sell most of their
mortgages in the secondary market
 Two primary factors that determine whether loan
should be extended or not:
– The payment to income ratio
– The loan to total value ratio
Alternative Mortgage
Instruments
 Standard Fixed-rate mortgage
– A borrower would take out a mortgage loan for a
principal amount P and repay in equal monthly
installments of M
 Adjustable Rate Mortgage
– A loan in which the contract rate is reset periodically
in accordance with some pre-chosen reference rate,
typically one based on short-term interest rate.
 Graduated Payment Mortgage
 Growing Equity Mortgage
Fixed-Rate Mortgage and
Interest Rate Risk
A rising term-structure can create a gap in
the balance sheet of the lending institution
ARM and Default Risk
If reference rate rises too much, risk of
default rises
Risks in Mortgage Loan Market
Default Risk
– Loan to value ratio
– Second mortgages behind first mortgage
– Seasoning Effect
Liquidity Risk
Interest Rate Risk
Prepayment Risk