2. The Unique Nature of Mortgage
Markets
Mortgage loans are secured by the pledge of real property
as collateral.
Mortgage loans are made for varied amounts - no
standard denomination.
Issuers of mortgages are usually small family or business
entities.
Weak Secondary Market for Original Mortgages
– Little standardization of contracts and terms.
– Traditionally issued and held by lender.
Relatively strong secondary for mortgage-backed
securities
Mortgage markets are highly regulated and supported by
federal government policies.
Mortgage Markets-2
3. Standard Fixed-Rate Mortgage
(FRM)
Amortized loan with periodic payments that exceed the
interest due. Payment in excess of interest is credited
toward repayment of the principal.
Interest is usually computed on the declining balance.
The mortgage is a lien on the property used as collateral
for the loan.
If the contract is broken, the lender may use the property
to pay the loan.
When mortgage is fully paid, the lien is removed and the
borrower obtains a clear title to the property.
Mortgage Markets-3
4. FRM Balance and Payments
Principal and interest Payments on a 9%, 15-
year, $100,000 mortgage with payments of
$1,015 per month
$1,200
$1,000
$800
Payment
Interest Payment
$600
Principal Payment
$400
$200
$0
0 12 24 36 48 60 72 84 96 108 120 132 144 156 168
Month
Mortgage Markets-4
5. FRM Balance and Payments
(concluded)
Principal and interest Payments on a 9%, 30-
year, $100,000 mortgage with payments of
$805 per month
$900.00
$800.00
$700.00
$600.00
Payment
$500.00 Interest Payment
$400.00 Principal Payment
$300.00
$200.00
$100.00
$0.00
0 36 72 108 144 180 216 252 288 324
Month
Mortgage Markets-5
6. Conventional and Insured
Mortgages
Conventional mortgages represent
lending/borrowing in the private markets.
Insured and/or guaranteed mortgages are
supported by federal and state agencies.
– Federal Housing Administration (FHA).
– Veterans Administration (VA).
– Downpayment and rates may be lower.
Mortgage Markets-6
7. Private Mortgage Insurance
Conventional mortgage borrowers with low
downpayments must usually buy private
mortgage insurance (PMI).
PMI premiums are added to mortgage payments
until the value of the mortgage is less than 75%
of the value of the house.
Mortgage Markets-7
8. Private Mortgage Insurance
Uninsured conventional Privately Insured
mortgage conventional mortgage
$12,500 down
$25,000 down Equity payment
Equity payment
Insured Risk $12,500 mortgage
insurance
Uninsured $100,000 Uninsured $112,500
Mortgage mortgage at Mortgage mortgage at
10% APR. 10% plus
insurance
premium = 10¼
to 10½% APR
on $112,500
balance
Mortgage Markets-8
9. Adjustable Rate Mortgage
(ARM)
Fixed-rate mortgages are not attractive to lenders in high
inflation periods.
With adjustable rate contracts, borrowers' costs vary with
inflation and interest rate levels.
Lenders shift interest rate risk to the borrower.
Caps on ARM interest rates limit interest rate risk to borrowers.
– Capped ARMs may have a “payment cap”, “rate cap”, or
both.
– Payment caps limit the maximum amount the payment can
go up by in any year and over the life of the loan.
– Interest rate caps or rate caps limit the size of the increase
in the loan rate in any year and over the loan’s life. Typically,
the annual cap is 1-2%, and the lifetime cap is 5%.
Mortgage Markets-9
10. Methods of Adjustment for
ARMs
Rate may vary in a prescribed range (caps) or without
limit.
Payments, maturity, or principal may vary.
Rates may vary based on a previously determined interest
rate index or the cost of the funds of the lender.
The market prices (difference between fixed and variable
rates) the extent of interest rate risk (impact of varying
interest rates) assumed by borrower and lender.
Common rate indices include Treasury rates, fixed rate
mortgage indices, prime rate, and the LIBOR rate.
Mortgage Markets-10
12. Other Mortgage Instruments
Balloon Payment Mortgages
– Traditional loan where interest is paid until a time when the
principal was due.
– Terms can be 3, 5 or 7 years.
– Loan is amortized over 15 or 30 year period so that monthly
payments are no different than a FRM of equal maturity.
– Rate is fixed over the contract term.
– Popular with borrowers who may either sell or refinance prior
to maturity.
Rollover Mortgage (ROMs)
– Refinanced at new rate every few years.
– Adjustment period is longer than traditional ARMs.
– Payment is fixed
Mortgage Markets-12
13. Other Mortgage Instruments
(continued)
Renegotiated Rate Mortgages (RRMs)
– Loan terms renegotiated periodically at terms prevailing in
the market.
– Adjustment period is longer than traditional ARMs.
– Payment is fixed.
Interest Only Mortgages
– Low payments in initial years (10 to 15 years) – only
includes interest on borrowed amount.
– After initial period, payments increase such that entire loan
amount is amortized by the end of 30 years.
– Borrower pays interest for a considerable period on the
entire loan balance, but avoids having to pay down balance
in initial years.
Mortgage Markets-13
14. Other Mortgage Instruments
(continued)
Construction-to Permanent Mortgages
– Bridge financing is provided by lender over the
time frame required by the borrower to purchase
land and construct the house.
– Only interest payment is made until construction is
completed.
– Loan is financed in increments as construction
payments have to be made.
– On completion of the construction, loan balance is
rolled over into the type of mortgage contract
desired by borrower.
Mortgage Markets-14
15. Other Mortgage Instruments
(continued)
Reverse Annuity Mortgages (RAMs)
– RAMs allow homeowners to borrow against the
equity on their homes at low rates.
– Typically obtained by older people whose home
loans have been paid off, but can use income of
the real estate investment they own.
– Typical term is no more than 20 years and could
be for borrower’s lifetime as an annuity.
– Homeowners’ equity declines by amount
borrowed.
Mortgage Markets-15
16. Other Mortgage Instruments
(continued)
Second Mortgage - extended at time of
purchase or later as equity is borrowed from
property.
Home equity lines of credit became popular
after the 1986 federal tax law.
Home equity loans and lines of credit allow home
owners to borrow against the equity built up in
their homes because of paying down the loan
and/or because of the appreciation of the
property.
Mortgage Markets-16
17. What Does it Take to Buy a
Home?
Several factors influence a home buyer’s
ability to secure a mortgage loans.
– Borrower Income from all sources gives the
lender an idea of the ability of the borrower to
meet the monthly mortgage commitment.
– Down Payment refers to the amount of cash the
borrower can contribute towards the cost of the
house as their equity.
– Mortgage Insurance is necessary for borrowers
who are unable to come up with a 20 percent
down payment.
Mortgage Markets-17
18. Payment to Income Ratio
Examples
30-year Fixed
Rate (5%)
Annual Gross 28% of Mortgage 36% of
income monthly Qualification monthly
$20,000 $467 $59,985 $600
$30,000 $700 $89,913 $900
$40,000 $933 $119,841 $1,200
$50,000 $1,167 $149,897 $1,500
$60,000 $1,400 $179,826 $1,800
$80,000 $1,867 $239,810 $2,400
$100,000 $2,333 $299,667 $3,000
$150,000 $3,500 $449,564 $4,500
Mortgage Markets-18
19. Mortgage Origination
The original lender in a mortgage is called the
mortgage originator. They generate income in
one or more of the following ways:
– They charge an origination fee
– They may sell the mortgage
– They may service the loan for the eventual owners
of the loan in exchange for a servicing fee
– They may sell the servicing of the mortgage to
another party.
– They may hold the mortgage in their investment
portfolio.
Mortgage Markets-19
20. The Mortgage Origination
Process
A potential homeowner applies for a loan from a
mortgage originator. He/she specifies:
– type of mortgage (FRM,ARM,etc.)
– when the interest rate is set
The mortgage originator then performs a credit
evaluation of the applicant
Mortgage Markets-20
21. The Mortgage Origination
Process (continued)
If the lender decides to lend the funds, it sends a
commitment letter to the applicant, and the
applicant pays a commitment fee.
If the mortgage originator intends to sell the
mortgage, it may obtain a commitment from the
potential buyer.
At the closing date, if the borrower does not back
out, the loan is made. If the borrower backs out,
he loses the commitment fee.
Mortgage Markets-21
22. Pipeline Risk
is the risk associated with mortgage origination
– Price risk
– Fallout risk
Mortgage Markets-22
23. Hedging Pipeline Risk
Obtain a commitment from a conduit to buy the
mortgage
Obtain an agreement for the optional delivery of
the mortgage
Mortgage Markets-23
30. Mortgage-Backed Securities --
One way to develop a secondary market
for mortgages.
Mortgage pass-through securities pass through
payments of principal and interest on pools of
mortgages to holder of the securities.
Other Mortgage backed securities use pools of
mortgages as collateral for debt securities.
Mortgage Markets-30
31. Types of Pass-Through
Securities
Ginnie Mae Pass-Throughs - pools of
government insured mortgages.
Freddie Mac Participation Certification - pools of
conventional mortgages.
Freddie Mac Guaranteed Mortgage Certificates -
promises regular repayment of principal and
interest.
Mortgage Markets-31
32. Types of Pass-Through
Securities (concluded)
Fannie Mae pass-throughs - pools of
conventional or insured mortgages.
Privately issued pass-throughs (PIP).
Mortgage Markets-32
33. Other Mortgage-backed Securities
Unit investment trusts -- Mortgage pools
assembled by investment bankers in unit "trusts."
Claims on trust is sold to investor.
Mortgage-backed mutual funds -- offer GNMA
insurance but at yields higher than treasuries.
FHLMC, FNMA, and private mortgage-backed
debt.
State/local government revenues bonds -- type of
muni, tax-free bond.
Mortgage Markets-33
34. Derivative Mortgage Securities
Collateralized mortgage obligations (CMOs) --
fixed maturity date and interest payments similar
to bonds.
REMICS -- real estate mortgage investment
conduit; Investor pays taxes. Type of CMO.
Mortgage Markets-34
37. Advantages of Mortgage-backed
Securities over Individual
Mortgages
Issued in standardized denominations and are
negotiable.
Issued or backed by quality borrowers.
Usually insured and highly collateralized.
Repayment schedules vary, but many are similar
to other bonds.
Mortgage Markets-37
