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  • 1. AN-NAJAHNATIONAL UNIVERSITYFaculty of Economics andAdministrative SciencesDepartment of FinanceDr. Muath AsmarChapter 14The Mortgages MarketFinancial MarketsCourse Code 51458
  • 2. © 2012 Pearson Prentice Hall. All rights reserved. 14-2Chapter PreviewPart of the American Dream is to own yourown home. But the average price of a homeis well over $235,000 (and quite a bit higheris some areas, like California). For most ofus, home ownership would be impossiblewithout borrowing most of the cost of ahome.
  • 3. © 2012 Pearson Prentice Hall. All rights reserved. 14-3Chapter PreviewIn this chapter, we identify characteristics of typicalresidential mortgages and the usual term and typesof mortgages available. We then review whoprovides and services the loans, along with thegrowth in the secondary mortgage market. Topicsinclude:─ What Are Mortgages?─ Characteristics of Residential Mortgages─ Types of Mortgage Loans─ Mortgage-Lending Institutions
  • 4. © 2012 Pearson Prentice Hall. All rights reserved. 14-4Chapter Preview (cont.)─ Loan Servicing─ Secondary Mortgage Market─ Securitization of Mortgages
  • 5. © 2012 Pearson Prentice Hall. All rights reserved. 14-5What Are Mortgages? A long-term loan secured by real estate An amortized loan whereby a fixedpayment pays both principal and interesteach month
  • 6. © 2012 Pearson Prentice Hall. All rights reserved. 14-6What Are Mortgages? The next slide shows the total amount ofmortgage debt outstanding in the U.S.during 2009. It further delineates by typeof property. The table shows roughly $13 trillionoutstanding. How does this compare to thevalue of all the companies listed on theNYSE?
  • 7. © 2012 Pearson Prentice Hall. All rights reserved. 14-7What Are Mortgages?Mortgage Loan Borrowers
  • 8. © 2012 Pearson Prentice Hall. All rights reserved. 14-8What Are Mortgages? History Mortgages were used in the 1880s, butmassive defaults in the agriculturalrecession of 1890 made long-termmortgages difficult to attain. Until post-WWII, most mortgage loans wereshort-term balloon loans with maturities offive years or less.
  • 9. © 2012 Pearson Prentice Hall. All rights reserved. 14-9What Are Mortgages? History Balloon loans, however, caused problemsduring the depression. Typically, the lenderrenews the loan. But, with so manyAmericans out of work, lenders could notcontinue to extend credit (sound familiar?). As a part of the depression recoveryprogram, the federal government assisted increating the standard 30-year mortgage weknow today.
  • 10. © 2012 Pearson Prentice Hall. All rights reserved. 14-10Characteristics ofthe Residential Mortgage Mortgages can be roughly classified alongthe following three dimensions:─ Mortgage Interest Rates─ Loan Terms─ Mortgage Loan Amortization
  • 11. © 2012 Pearson Prentice Hall. All rights reserved. 14-11Characteristics of the ResidentialMortgage: Mortgage Interest Rates The stated rate on a mortgage loan isdetermined by three rates:─ Market Rates: general rates onTreasury bonds─ Term: longer-term mortgages havehigher rates─ Discount Points: a lower rates negotiatedfor cash upfrontA variety of fun mortgage calculatorshttp://interest.com/calculators/index.shtml
  • 12. © 2012 Pearson Prentice Hall. All rights reserved. 14-12Characteristics of the ResidentialMortgage: Mortgage Interest Rates The next slide shows the relationshipbetween mortgage rates and long-termtreasury rates. As can be seen, mortgagerates are typically higher than Treasuryrates, but the spread (difference) betweenthe two varies considerably.A variety of fun mortgage calculatorshttp://interest.com/calculators/index.shtml
  • 13. © 2012 Pearson Prentice Hall. All rights reserved. 14-13Characteristics of the ResidentialMortgage: Mortgage Interest RatesCurrent mortgage interest rates http://www.interest.com/
  • 14. © 2012 Pearson Prentice Hall. All rights reserved. 14-14Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points A difficult decision when getting a mortgageis whether to pay points (cash) upfront inexchange for a lower interest rate on themortgage. Suppose you had to choosebetween a 12% 30-year mortgage or an11.5% mortgage with 2 discount points.Which should you choose? Assume youwished to borrow $100,000.A variety of fun mortgage calculatorshttp://interest.com/calculators/index.shtml
  • 15. © 2012 Pearson Prentice Hall. All rights reserved. 14-15Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points First, examine the 12% mortgage.Using a financial calculator, the requiredpayments is: n = 360, i = 12%/12=1%, PV = 100,000, Calculate the PMT. PMT = $1,028.61
  • 16. © 2012 Pearson Prentice Hall. All rights reserved. 14-16Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points Now, examine the 11.5% mortgage. Usinga financial calculator, the requiredpayments is: n = 360, i = 11.5/12, PV = 100,000, Calculate the PMT. PMT = $990.29
  • 17. © 2012 Pearson Prentice Hall. All rights reserved. 14-17Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points So, paying the points will save you $38.32each month. However, you have to pay$2,000 upfront. You can see that the decision depends onhow long you want to live in the house,keeping the same mortgage.
  • 18. © 2012 Pearson Prentice Hall. All rights reserved. 14-18Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points If you only want to live there 12 months,clearly the $2,000 upfront cost is not worththe monthly savings. The next slide shows your effectiveborrowing rate under different repayment(in years) assumptions.
  • 19. © 2012 Pearson Prentice Hall. All rights reserved. 14-19Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points
  • 20. © 2012 Pearson Prentice Hall. All rights reserved. 14-20Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points Many mortgage lenders will point to the30-year effective rate of interest, and arguethat the points are a good deal (and it ishere, compared to the 12.68% effectiverate on a 12% nominal rate mortgage). Although the calculation may be correct,the information may not provide the answeryou need.
  • 21. © 2012 Pearson Prentice Hall. All rights reserved. 14-21Characteristics of the Residential Mortgage:Mortgage Interest Rates & PointsYou need to determine when the presentvalue of the savings ($38.32) equals the$2,000 upfront. Using a financial calculator,this is:i = 1, PV = −2,000, PMT = 38.32Calculate n. n = 74 months, or about6.2 years.
  • 22. © 2012 Pearson Prentice Hall. All rights reserved. 14-22Characteristics of the Residential Mortgage:Mortgage Interest Rates & Points So, if you think you will stay in the houseand not refinance for at least 6.2 years,paying the $2,000 for the lower payment isa sound financial decision. Otherwise, you should accept the 12%loan.
  • 23. © 2012 Pearson Prentice Hall. All rights reserved. 14-23Characteristics of the ResidentialMortgage: Loan TermsMortgage loan contracts contain many legalterms that need to be understood. Mostprotect the lender from financial loss.Collateral: usually the real estate beingfinanceDown payment: a portion of the purchaseprice paid by the borrower
  • 24. © 2012 Pearson Prentice Hall. All rights reserved. 14-24Characteristics of the ResidentialMortgage: Loan Terms PMI: insurance against default by the borrower Qualifications: includes credit history,employment history, etc., to determine theborrowers ability to repay the mortgage asspecified in the contact
  • 25. © 2012 Pearson Prentice Hall. All rights reserved. 14-25Characteristics of the ResidentialMortgage: Loan TermsLenders will also order a credit report fromone of the credit reporting agencies.The score reported is called the FICO.The range is 300 to 850, with 660 to 720being average.Payment history, debt, and even credit cardapplications can affect your credit score.
  • 26. © 2012 Pearson Prentice Hall. All rights reserved. 14-26Characteristics of the ResidentialMortgage: Loan AmortizationMortgage loans are amortized loans. Thismeans that a fixed, level payment will payinterest due plus a portion of the principaleach month. It is designed so that thebalance on the mortgage will be zero whenthe last payment is made.The next table shows a typical amortizationtable for a 30-year mortgage at 8.5%.
  • 27. © 2012 Pearson Prentice Hall. All rights reserved. 14-27Characteristics of the ResidentialMortgage: Loan Amortization Schedule
  • 28. © 2012 Pearson Prentice Hall. All rights reserved. 14-28Types of Mortgage Loans Insured vs. Conventional Mortgages: if thedown payment is less than 20%, insuranceis usually required Fixed-Rate Mortgages: the interest rate isfixed for the life of the mortgage Adjustable-Rate Mortgages: the interestrate can fluctuate within certain parameters
  • 29. © 2012 Pearson Prentice Hall. All rights reserved. 14-29Types of Mortgage Loans Other Types─ Graduated-Payment Mortgages (GPMs)─ Growing Equity Mortgages (GEMs)─ Second Mortgages─ Reverse Annuity Mortgages (RAMs)─ Option ARMs The following table lists additionalcharacteristics on all the loans.
  • 30. © 2012 Pearson Prentice Hall. All rights reserved. 14-30Types of Mortgage Loans
  • 31. © 2012 Pearson Prentice Hall. All rights reserved. 14-31Mortgage-Lending Institutions Originally, thrift institutions were the primaryoriginator of mortgages in the U.S. and,therefore, the primary holder of mortgageloans. As the next figure illustrates, this is not thecase anymore.
  • 32. © 2012 Pearson Prentice Hall. All rights reserved. 14-32Mortgage-Lending Institutions
  • 33. © 2012 Pearson Prentice Hall. All rights reserved. 14-33Loan Servicing Most mortgages are immediately sold toanother investor by the originator. Thisfrees cash to originate another loan andgenerate additional fee income. Still, someone has to collect the monthlypayments and keep records. This is knownas loan servicing, and servicers usuallykeep a portion of the payments received tocover their costs.
  • 34. © 2012 Pearson Prentice Hall. All rights reserved. 14-34Loan ServicingIn all, there are three distinct elements inmortgage loans:The originator packages the loan for aninvestorThe investor holds the loanThe servicing agent handles the paperwork
  • 35. © 2012 Pearson Prentice Hall. All rights reserved. 14-35E-Finance: Shopping for aMortgage Via the WWWMortgages used to originate from a local bank. Butthe web is well-suited to handle online mortgageorigination:This is a financial product—nothing really needs to bedeliveredMortgages are fairly standardized. There is no productdifferentiation to consider.Little bank loyalty for borrowersOnline lenders have low overhead, and so lower fees.
  • 36. © 2012 Pearson Prentice Hall. All rights reserved. 14-36Secondary Mortgage Market The secondary mortgage market wasoriginally established by the federalgovernment after WWII when it createdFannie Mae to buy mortgages from thrifts. The market experienced tremendousgrowth in the early to mid-1980, and hascontinued to remain a strong market inthe U.S.
  • 37. © 2012 Pearson Prentice Hall. All rights reserved. 14-37Securitization of MortgagesThe securitization of mortgages developedbecause of problems dealing with singlemortgages: risk of either default orprepayment and servicing. A pool ofmortgages eliminates part of this problemthrough diversification.
  • 38. © 2012 Pearson Prentice Hall. All rights reserved. 14-38Securitization of MortgagesThe mortgage-backed security (MBS) wascreated. Pools including hundreds ofmortgages were gathered, and the rights tothe cash flows generated by the mortgageswere sold as separate securities.At first, simple pass-through securities weredesigned.
  • 39. © 2012 Pearson Prentice Hall. All rights reserved. 14-39Securitization of Mortgages:The Mortgage Pass-Through Definition: A security that has theborrower’s mortgage payments passthrough the trustee before beingdisbursed to the investors This design did eliminate idiosyncratic risk,but investors still faced prepayment risk.
  • 40. © 2012 Pearson Prentice Hall. All rights reserved. 14-40The Impact of Securitization onthe Mortgage Market As the next figure shows, the value ofmortgages held in pools is reaching nearly$8.0 trillion near the end of 2009. The securities compete for funds along withall other bond market participants.
  • 41. MortgagePools14-41© 2012 Pearson Prentice Hall. All rights reserved.
  • 42. © 2012 Pearson Prentice Hall. All rights reserved. 14-42Securitization of Mortgages:Types of Pass-ThroughsThere are a variety of different types of pass-through securities. We will briefly look atthree:GNMA Pass-ThroughsFHLMC Pass-ThroughsPrivate Pass-Throughs
  • 43. © 2012 Pearson Prentice Hall. All rights reserved. 14-43Securitization of Mortgages:GNMA Pass-ThroughsGinnie Mae began guaranteeingpass-throughs in 1968.GNMA mortgages can be originated by manydifferent financial institutions.GNMA aggregates the mortgages and issuespass-throughs with rights to interest and principle.GNMA also offers default insurance on themortgages in the pools.
  • 44. © 2012 Pearson Prentice Hall. All rights reserved. 14-44Securitization of Mortgages:FHLMC Pass-ThroughsFreddie Mac buys mortgages and packagesthem for resale in MBSs.FHLMC pools contain mortgages that are notguaranteed, and may have different rates, etc.Pass-through securities issued by Freddie arecalled participation certificates.
  • 45. © 2012 Pearson Prentice Hall. All rights reserved. 14-45Securitization of Mortgages:FHLMC Pass-Throughs Definition: A CMO is a structured MBS whereinvestor “tranches” have different rights todifferent sets of cash flows. This design structured the prepayment risk. Sometranches had little prepayment risk, while otherhad a lot. Freddie Mac helped originate these structures,and continues to innovate new tranche designs.
  • 46. © 2012 Pearson Prentice Hall. All rights reserved. 14-46Securitization of Mortgages:Private Pass-Throughs BankAmerica offered the first private pass-through in 1977. Non-agency issuers are free to incorporateany type of mortgages into their MBSs,including jumbo loans, Alt-A loans, andother non-traditional mortgages.
  • 47. © 2012 Pearson Prentice Hall. All rights reserved. 14-47Subprime Mortgages and CDOs Subprime loans are loans to borrowers whohave poor credit ratings or other issues withcollateral, etc. In 2000, only 2% of mortgages weresubprime. This climbed to 17% by 2006. The average FICO score was 624 forsubprime borrowers. Prime mortgageborrowers were 742.
  • 48. © 2012 Pearson Prentice Hall. All rights reserved. 14-48Subprime Mortgages and CDOs However, these mortgages were hailed bypoliticians and bankers alike. They helpedless-then-perfect borrowers secure the“American Dream” of owning a home. Andsince real estate prices can’t fall (right?),there is little risk involved.
  • 49. © 2012 Pearson Prentice Hall. All rights reserved. 14-49Subprime Mortgages and CDOsSeveral factors lead to this dramatic increasein subprime lending:New mortgage products (2/28 ARMS, OptionARMS, NoDoc loans) made expensive houses“affordable” (sort-of).The creation of CDOs helped create deal flow tocontinue lending in subprime markets.When house prices were increasing, subprimeborrowers had an out if problems arose.
  • 50. © 2012 Pearson Prentice Hall. All rights reserved. 14-50The Real Estate BubbleBetween 2000 and 2005 home pricesincreased an average of 8% per year. Therun up in prices was cause by two factors:The increase in subprime loans created newdemand for housingReal estate speculators
  • 51. © 2012 Pearson Prentice Hall. All rights reserved. 14-51The Real Estate BubbleIn the aftermath of the financial meltdown,lending policies have largely returned toselecting capable borrowers:CDO issuance peaked in 2006 at $520b, but in2009 fell to $4.2b.New legislation, such a Frank-Dodd, may requiremortgage originators to hold a part of themortgages they create.
  • 52. © 2012 Pearson Prentice Hall. All rights reserved. 14-52Chapter Summary What Are Mortgages? Loans made for thepurchase on real property, and usuallycollateralized by the purchased property. Characteristics of Residential Mortgages:includes the length of the mortgage, theterms, and the rate charges for the loan
  • 53. © 2012 Pearson Prentice Hall. All rights reserved. 14-53Chapter Summary (cont.) Types of Mortgage Loans: includesconventional, insured, fixed and variablerate, and a variety of other designs. Mortgage-Lending Institutions: the primarilyoriginator and holder of mortgages is nolonger thrift institutions as other attempt togenerate fees
  • 54. © 2012 Pearson Prentice Hall. All rights reserved. 14-54Chapter Summary (cont.) Loan Servicing: the fees generated bycollecting, distributing, and recordingpayments Secondary Mortgage Market: the activemarket for mortgages after the mortgagehas been originated
  • 55. © 2012 Pearson Prentice Hall. All rights reserved. 14-55Chapter Summary (cont.) Securitization of Mortgages: growing inpopularity, causing mortgages to completewith both Treasury and corporate debt. Butalso clearly a part of the problem in theHousing Bubble and Financial Crisis of2007–2009.