Chapter07

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Chapter07

  1. 1. Chapter Seven Mortgage MarketsMcGraw-Hill/Irwin 7-1 ©2009, The McGraw-Hill Companies, All Rights Reserved
  2. 2. Mortgages and Mortgage-Backed Securities •• Mortgages are loans to individuals or businesses to Mortgages are loans to individuals or businesses to purchase homes, land, or other real property purchase homes, land, or other real property •• Many mortgages are securitized Many mortgages are securitized –– mortgages are packaged and sold as assets backing publicly mortgages are packaged and sold as assets backing publicly traded or privately held debt instruments (i.e., mortgage-backed traded or privately held debt instruments (i.e., mortgage-backed securities (MBSs)) securities (MBSs)) •• Mortgages differ from bonds and stocks Mortgages differ from bonds and stocks –– mortgages are backed by aaspecific piece of real property mortgages are backed by specific piece of real property –– primary mortgages have no set size or denomination primary mortgages have no set size or denomination –– primary mortgages generally involve only aasingle investor primary mortgages generally involve only single investor –– comparatively little information exists on mortgage borrowers comparatively little information exists on mortgage borrowersMcGraw-Hill/Irwin 7-2 ©2009, The McGraw-Hill Companies, All Rights Reserved
  3. 3. Primary Mortgage Market •• Four basic types of mortgages are issued by Four basic types of mortgages are issued by financial institutions financial institutions – home mortgages are used to purchase one- to four- – home mortgages are used to purchase one- to four- family dwellings family dwellings – multifamily dwellings mortgages are used to purchase – multifamily dwellings mortgages are used to purchase apartment complexes, townhouses, and condominiums apartment complexes, townhouses, and condominiums – commercial mortgages are used to finance the purchase – commercial mortgages are used to finance the purchase of real estate for business purposes of real estate for business purposes – farm mortgages are used to finance the purchase of – farm mortgages are used to finance the purchase of farms farmsMcGraw-Hill/Irwin 7-3 ©2009, The McGraw-Hill Companies, All Rights Reserved
  4. 4. Mortgage Loans Outstanding, 2007 (Trillions of $) $0.28 $0.07 $0.74 $3.46 1-4 Family Commercial Multifamily residential FarmMcGraw-Hill/Irwin 7-4 ©2009, The McGraw-Hill Companies, All Rights Reserved
  5. 5. Mortgage Characteristics •• Collateral: lenders place liens against properties that Collateral: lenders place liens against properties that remain in place until loans are fully paid off remain in place until loans are fully paid off •• A down payment is aaportion of the purchase price of the A down payment is portion of the purchase price of the property aafinancial institution requires the borrower to property financial institution requires the borrower to pay up front pay up front –– private mortgage insurance (PMI) is generally required when private mortgage insurance (PMI) is generally required when the loan-to-value ratio is more than 80% the loan-to-value ratio is more than 80% •• Federally insured mortgages Federally insured mortgages –– repayment is guaranteed by either the Federal Housing repayment is guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Administration (FHA) or the Veterans Administration (VA)McGraw-Hill/Irwin 7-5 ©2009, The McGraw-Hill Companies, All Rights Reserved
  6. 6. Mortgage Characteristics •• Conventional mortgages are mortgages that are not Conventional mortgages are mortgages that are not federally insured federally insured •• Amortized mortgages have fixed principal and interest Amortized mortgages have fixed principal and interest payments that fully pay off the mortgage by its maturity payments that fully pay off the mortgage by its maturity date date –– fully amortized mortgage maturities are usually either 15 or 30 fully amortized mortgage maturities are usually either 15 or 30 years years •• Balloon payment mortgages require fixed monthly Balloon payment mortgages require fixed monthly interest payments for 3 to 5 years whereupon full payment interest payments for 3 to 5 years whereupon full payment of the mortgage principal is due of the mortgage principal is dueMcGraw-Hill/Irwin 7-6 ©2009, The McGraw-Hill Companies, All Rights Reserved
  7. 7. Mortgage Characteristics •• Fixed-rate mortgages lock in the borrower’s interest rate Fixed-rate mortgages lock in the borrower’s interest rate –– required monthly payments are fixed over the life of the mortgage required monthly payments are fixed over the life of the mortgage –– lenders assume interest rate risk lenders assume interest rate risk •• Adjustable-rate mortgages (ARMs) tie the borrower’s Adjustable-rate mortgages (ARMs) tie the borrower’s interest rate to some market interest rate or interest rate interest rate to some market interest rate or interest rate index index –– required monthly payments can change over the life of the required monthly payments can change over the life of the mortgage mortgage –– yearly interest rate changes are often capped yearly interest rate changes are often capped –– borrowers assume interest rate risk borrowers assume interest rate risk –– ARMs can increase default risk ARMs can increase default riskMcGraw-Hill/Irwin 7-7 ©2009, The McGraw-Hill Companies, All Rights Reserved
  8. 8. Mortgage Characteristics •• Discount points are fees or payments made when aa Discount points are fees or payments made when mortgage loan is issued mortgage loan is issued –– each point costs the borrower 11percent of the principal value each point costs the borrower percent of the principal value –– the lender reduces the interest rate used to determine the payments the lender reduces the interest rate used to determine the payments on the mortgage in exchange for points paid on the mortgage in exchange for points paid •• Other fees Other fees –– application fee application fee –– title search title search –– title insurance title insurance –– appraisal fee appraisal fee –– loan origination fee loan origination fee –– closing agent and review fees closing agent and review fees –– other fees (e.g., VA or FHA loan guarantees and PMI) other fees (e.g., VA or FHA loan guarantees and PMI)McGraw-Hill/Irwin 7-8 ©2009, The McGraw-Hill Companies, All Rights Reserved
  9. 9. Mortgage Characteristics •• Mortgage refinancing Mortgage refinancing – when aaborrower takes out aanew mortgage and uses the – when borrower takes out new mortgage and uses the proceeds to pay off an existing mortgage proceeds to pay off an existing mortgage – mortgages are most often refinanced when an existing – mortgages are most often refinanced when an existing mortgage has aahigher interest rate than prevailing rates mortgage has higher interest rate than prevailing rates – borrowers must balance the savings of aalower monthly – borrowers must balance the savings of lower monthly payment with the costs (fees) of refinancing payment with the costs (fees) of refinancing – an often-cited rule of thumb is that the new interest rate – an often-cited rule of thumb is that the new interest rate should be 2 percentage points less than the refinanced should be 2 percentage points less than the refinanced mortgage rate mortgage rateMcGraw-Hill/Irwin 7-9 ©2009, The McGraw-Hill Companies, All Rights Reserved
  10. 10. Mortgage Amortization •• Each fixed monthly payment consists partly of Each fixed monthly payment consists partly of repayment of the principal and partly of the repayment of the principal and partly of the interest on the outstanding mortgage balance interest on the outstanding mortgage balance •• An amortization schedule shows how the fixed An amortization schedule shows how the fixed monthly payments are split between principal and monthly payments are split between principal and interest interestMcGraw-Hill/Irwin 7-10 ©2009, The McGraw-Hill Companies, All Rights Reserved
  11. 11. Mortgage Payments •• The present value of a mortgage can be written as: The present value of aj mortgage can be written as: t  1  PV = PMT ∑   = PMT ( PVIFAr ,t ) j =1  1 + r  PV = principal amount borrowed PV = principal amount borrowed PMT = monthly mortgage payment PMT = monthly mortgage payment PVIFA = present value interest factor of an annuity PVIFA = present value interest factor of an annuity rr= monthly interest rate on the mortgage = monthly interest rate on the mortgage tt= number of monthly payments over the life of the mortgage = number of monthly payments over the life of the mortgage •• Rearrange to isolate the payment: PMT = PV Rearrange to isolate the payment: ( PVIFAr ,t )McGraw-Hill/Irwin 7-11 ©2009, The McGraw-Hill Companies, All Rights Reserved
  12. 12. Other Types of Mortgages •• Automatic rate-reduction mortgages Automatic rate-reduction mortgages •• Graduated-payment mortgages (GPMs) Graduated-payment mortgages (GPMs) •• Growing-equity mortgages (GEMs) Growing-equity mortgages (GEMs) •• Second mortgages and home equity loans Second mortgages and home equity loans •• Shared-appreciation mortgages (SAMs) Shared-appreciation mortgages (SAMs) •• Equity-participation mortgages (EPMs) Equity-participation mortgages (EPMs) •• Reverse-annuity mortgages (RAMs) Reverse-annuity mortgages (RAMs)McGraw-Hill/Irwin 7-12 ©2009, The McGraw-Hill Companies, All Rights Reserved
  13. 13. Secondary Mortgage Markets •• FIs remove mortgages from their balance sheets FIs remove mortgages from their balance sheets through one of two mechanisms through one of two mechanisms – by pooling recently originated mortgages together and – by pooling recently originated mortgages together and selling them in the secondary market selling them in the secondary market – by securitizing mortgages (i.e., by issuing securities – by securitizing mortgages (i.e., by issuing securities backed by newly originated mortgages) backed by newly originated mortgages) •• Advantages of securitization Advantages of securitization – FIs can reduce the liquidity risk, interest rate risk, and – FIs can reduce the liquidity risk, interest rate risk, and credit risk of their loan portfolios credit risk of their loan portfolios – FIs generate income from origination and service fees – FIs generate income from origination and service feesMcGraw-Hill/Irwin 7-13 ©2009, The McGraw-Hill Companies, All Rights Reserved
  14. 14. Secondary Mortgage Markets •• The U.S. government established the Federal National The U.S. government established the Federal National Mortgage Association (FNMA or Fannie Mae) in the Mortgage Association (FNMA or Fannie Mae) in the 1930s to buy mortgages from thrifts so they could make 1930s to buy mortgages from thrifts so they could make more mortgage loans more mortgage loans •• FHA and VA insured loans make securitization easier FHA and VA insured loans make securitization easier •• Government National Mortgage Association (GNMA Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created in the 1960s Corp. (FHLMC or “Freddie Mac”) created in the 1960s –– encouraged continued expansion of the housing market encouraged continued expansion of the housing market –– provided direct and indirect guarantees that allow for the creation provided direct and indirect guarantees that allow for the creation of mortgage-backed securities of mortgage-backed securitiesMcGraw-Hill/Irwin 7-14 ©2009, The McGraw-Hill Companies, All Rights Reserved
  15. 15. Mortgage Sales •• FIs have sold mortgages among themselves for over 100 FIs have sold mortgages among themselves for over 100 years years •• A large part of correspondent banking involves small A large part of correspondent banking involves small banks selling parts of large loans to larger banks banks selling parts of large loans to larger banks •• Large banks often sell parts of their loans (i.e., Large banks often sell parts of their loans (i.e., participations) to smaller banks participations) to smaller banks •• Mortgage sales occur when an FI originates aamortgage Mortgage sales occur when an FI originates mortgage and sells it to an outside buyer and sells it to an outside buyer –– aaloan sale is made with recourse if the loan buyer can sell the loan sale is made with recourse if the loan buyer can sell the loan back to the originator should it go bad loan back to the originator should it go badMcGraw-Hill/Irwin 7-15 ©2009, The McGraw-Hill Companies, All Rights Reserved
  16. 16. Mortgage Sales •• Mortgage sellers: money center banks, smaller banks, Mortgage sellers: money center banks, smaller banks, foreign banks, investment banks foreign banks, investment banks •• Mortgage sales allow FIs to manage credit risk, achieve Mortgage sales allow FIs to manage credit risk, achieve better asset diversification, and improve their liquidity and better asset diversification, and improve their liquidity and interest rate risk positions interest rate risk positions •• FIs are encouraged to sell loans for economic and FIs are encouraged to sell loans for economic and regulatory reasons regulatory reasons –– sold mortgages can still generate fee income for the bank sold mortgages can still generate fee income for the bank –– sold mortgages reduce the cost of reserve and capital requirements sold mortgages reduce the cost of reserve and capital requirements •• Mortgage buyers: foreign and domestic banks, insurance Mortgage buyers: foreign and domestic banks, insurance companies, pension funds, closed-end bank loan mutual companies, pension funds, closed-end bank loan mutual funds, and nonfinancial corporations funds, and nonfinancial corporationsMcGraw-Hill/Irwin 7-16 ©2009, The McGraw-Hill Companies, All Rights Reserved
  17. 17. Mortgage Backed Securities •• Pass-through securities “pass through” promised Pass-through securities “pass through” promised principal and interest payments to investors principal and interest payments to investors •• Three agencies are directly involved in the Three agencies are directly involved in the creation of pass-through securities creation of pass-through securities – Ginnie Mae – Ginnie Mae – Fannie Mae – Fannie Mae – Freddie Mac – Freddie Mac •• Private mortgage pass-through issuers create Private mortgage pass-through issuers create pass-throughs from nonconforming mortgages pass-throughs from nonconforming mortgagesMcGraw-Hill/Irwin 7-17 ©2009, The McGraw-Hill Companies, All Rights Reserved
  18. 18. Mortgage Backed Securities •• Collateralized mortgage obligations (CMOs) are Collateralized mortgage obligations (CMOs) are multiclass pass-throughs with multiple bond holder classes multiclass pass-throughs with multiple bond holder classes or tranches or tranches –– each bond holder class has aadifferent guaranteed coupon each bond holder class has different guaranteed coupon –– mortgage prepayments retire only one tranche at aatime, so all mortgage prepayments retire only one tranche at time, so all other trances are sequentially prepayment protected other trances are sequentially prepayment protected •• Mortgage backed bonds (MBBs) Mortgage backed bonds (MBBs) –– MBBs allow FIs to raise long-term low-cost funds without MBBs allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheets removing mortgages from their balance sheets –– aagroup of mortgage assets is pledged as collateral against aaMBB group of mortgage assets is pledged as collateral against MBB issue, but there is no direct link between the cash flows of the issue, but there is no direct link between the cash flows of the mortgages and the cash flows on the MBB mortgages and the cash flows on the MBBMcGraw-Hill/Irwin 7-18 ©2009, The McGraw-Hill Companies, All Rights Reserved
  19. 19. Mortgages Outstanding by Type of Holder (%) 4.03 3.55 Mortgage Pools 1.40 2.23 Depository Institutions Life Insurance Companies Other Financial Institutions 54.00 Mortgage 34.79 Companies OtherMcGraw-Hill/Irwin 7-19 ©2009, The McGraw-Hill Companies, All Rights Reserved
  20. 20. International Trends in Securitization •• Foreign investors participate in U.S. mortgage and MBS Foreign investors participate in U.S. mortgage and MBS markets, but the value held has decreased since 1992 markets, but the value held has decreased since 1992 •• Europe is the world’s second largest and most developed Europe is the world’s second largest and most developed securitization market securitization market –– the United Kingdom is the biggest MBS issuer in the European the United Kingdom is the biggest MBS issuer in the European market, followed by Germany market, followed by Germany –– the advent of the Euro has accentuated the increased trend in the advent of the Euro has accentuated the increased trend in securitization in Europe securitization in Europe •• Mortgage lending has grown in Russia since the early Mortgage lending has grown in Russia since the early 2000s because of changes in property ownership laws 2000s because of changes in property ownership lawsMcGraw-Hill/Irwin 7-20 ©2009, The McGraw-Hill Companies, All Rights Reserved

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