This document provides an overview of mortgage markets and mortgage-backed securities. It defines different types of mortgages like home mortgages, commercial mortgages, and adjustable-rate mortgages. It describes how mortgages are securitized into mortgage-backed securities and the roles of government agencies like Fannie Mae, Freddie Mac, and Ginnie Mae in the secondary mortgage market. It also discusses trends in subprime lending and the financial crisis.

1. Ch. 1 1
Financial Markets and
Institutions
Course Code 452755
by
Dr. Muath Asmar
An-Najah National University
Faculty of Graduate Studies

2. Chapter Seven
Mortgage Markets
©2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written
consent of McGraw-Hill Education.

3. © 2019 McGraw-Hill Education.
Mortgages and Mortgage-Backed
Securities
Mortgages are loans to individuals or businesses to purchase homes,
land, or other real property.
Many mortgages are securitized.
• Securitization occurs when securities are packaged and sold as
assets backing a publicly traded or privately held debt instrument.
Mortgages differ from bonds and stocks.
• Mortgages are backed by a specific piece of real property.
• Primary mortgages have no set size or denomination.
• Primary mortgages generally involve a single investor.
• Comparatively little information exists on mortgage borrowers.
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Primary Mortgage Market
Four basic types of mortgages are issued by financial
institutions.
• Home mortgages are used to purchase one- to four-family dwellings
(called “single-family mortgages”).
• Multifamily dwelling mortgages are used to purchase apartment
complexes, townhouses, and condominiums.
• Commercial mortgages are used to finance the purchase of real
estate for business purposes.
• Farm mortgages are used to finance the purchase of farms.
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Mortgage Loans Outstanding
Figure 7–1 Mortgage Loans Outstanding
Source: Federal Reserve Board website, “Flow of Fund Accounts,” July 2016. www.federalreserve.gov
Access the long description slide.
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Mortgage Characteristics
Collateral: lenders place liens against properties that remain in place
until the loan is fully paid off.
A down payment is a portion of the purchase price of the property a
financial institution requires the mortgage borrower to pay up front.
• Private mortgage insurance (PMI) is generally required when the loan-to-
value ratio is more than 80% (i.e., the borrower makes a down payment of
less than 20%).
Federally insured mortgages.
• Repayment is guaranteed by either the Federal Housing Administration
(FHA) or the Veterans Administration (VA).
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Mortgage Characteristics
Conventional mortgages are mortgages that are not federally insured.
Amortized mortgages have fixed principal and interest payments that
fully pay off the mortgage by its maturity date.
• Fully amortized mortgage maturities are usually either 15 or 30 years.
Balloon payment mortgages require fixed monthly interest payments
for 3 to 5 years, at which point full payment of the mortgage principal
is due.
Fixed-rate mortgages lock in the borrower’s interest rate.
• Therefore, required monthly payments are fixed over the life of the
mortgage and lenders assume interest rate risk.
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Mortgage Characteristics
Concluded
Adjustable-rate mortgages (ARMs) tie the borrower’s interest rate to
some market interest rate or interest rate index.
• Required monthly payments can change over the life of the mortgage,
although they may initially be fixed for a set time period.
• For example, 5/1 ARMs and 3/1 ARMs are popular.
• Rates or payment changes are usually ‘capped’ .
• For example, the cap on a 5/1 ARM may be stated as ‘5/2/5’.
• Borrowers assume interest rate risk with an ARM.
• ARMs can increase default risk.
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Discount Points and Other Fees
Discount points are fees or payments made when a mortgage loan is
issued (at closing).
• Each point costs the borrower 1 percent of the principal value.
• The lender reduces the interest rate used to determine the payments on
the mortgage in exchange for points paid.
Other fees.
• Application fee.
• Title search.
• Title insurance.
• Appraisal fee.
• Loan origination fee.
• Closing agent and review fees.
• Other fees (e.g., VA or FHA loan guarantees and PMI).
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Mortgage Refinancing
Mortgage refinancing.
• When a borrower takes out a new mortgage and uses the proceeds
to pay off an existing mortgage.
• Mortgages are most often refinanced when an existing mortgage
has a higher interest rate than current rates.
• Borrowers must balance the savings of a lower monthly payment
with the costs (fees) of refinancing.
• An often-cited rule of thumb is that the new interest rate should be
2 percentage points less than the refinanced mortgage rate.
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Mortgage Amortization
Each fixed monthly payment consists partly of repayment
of the principal and partly of the interest on the
outstanding mortgage balance.
An amortization schedule shows how the fixed monthly
payments are split between principal and interest.
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Mortgage Payments
The present value of a mortgage can be written as:
1
1
1
jt
j
PV PMT
r
 
  
 

1
1
(1 )t
r
PMT
r
   
      
 
 
 
 
P V = principal amount borrowed
PMT = monthly mortgage payment
r = monthly interest rate on the mortgage
t = number of months over the life of the mortgage
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Mortgage Payments
A borrower agrees to a $150,000, 30-year fixed-rate mortgage with a
8% quoted interest rate. What is the payment amount and how much
of each payment goes to principle and interest?
 360
1
1
1 0.006667
$120,000
0.006667
PMT
    
    
       
 
 
 
 360
$120,000
1
1
1 0.006667
0.006667
PMT 
    
    
     
 
 
 
 
$120,000
$880.52
136.2835
PMT  
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Other Types of Mortgages 1
Jumbo mortgages.
• Jumbo mortgages are mortgages for loan amounts that exceed the
maximum ‘conforming’ limits allowed by the mortgage agencies Fannie
Mae and Freddie Mac ($417,000 in 2016, with some exceptions).
Subprime mortgages.
• Subprime mortgages are mortgages where the borrowers do not qualify
for a ‘prime’ credit rating because of a low credit score arising from prior
credit problems such as delinquencies and defaults. Or, they may simply
lack sufficient credit history or have insufficient income.
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Other Types of Mortgages 2
Alt-A mortgages.
• “Alternative A-papers” are mortgages that are riskier than prime, but not as risky
as subprime.
• Interest rates on Alt-A loans are usually between prime and subprime rates.
Option ARMs (“Pick-a-Payment”).
• Give homebuyers an initial choice of payment options.
• Minimum payment: 1% interest rate for 12 months, then variable rate,
capitalization of unpaid interest, growing loan balance.
• Interest Only payment: pay interest only at an adjustable rate for first 5 to 10
years of loan, payments will increase substantially when IO term expires.
• 15-year or 30-year fully amortizing payment.
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Other Types of Mortgages 3
Second mortgages and home equity loans.
• Second mortgages are secured by a piece of real estate already
used to secure a first mortgage.
• Home equity loans let customers borrow on a line of credit secured
with a second mortgage on their homes.
Reverse-annuity mortgages (RAMs).
• Retirees or homeowners with a substantial amount of equity in
their home can sell the equity back to a bank over time.
• Various payment options are available.
• Costs and servicing fees are high.
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Secondary Mortgage Markets
FIs remove mortgages from their balance sheets through
one of two mechanisms.
• By pooling recently originated mortgages together and selling them
in the secondary market.
• By securitizing mortgages (i.e., by issuing securities backed by
newly originated mortgages).
Advantages of securitization.
• FIs can reduce the liquidity risk, interest rate risk, and credit risk of
their loan portfolios.
• FIs generate income from origination and service fees.
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Mortgage Sales 1
FIs have sold mortgages and commercial real estate among
themselves for over 100 years.
A large part of correspondent banking involves small banks making
loans that are too big for them to hold on their balance sheets and
selling parts of these loans to large banks with whom they have had a
long-term deposit and lending correspondent relationship.
Large banks often sell parts of their loans (i.e., participations) to
smaller banks.
Mortgage sales occur when an FI originates a mortgage and sells it to
an outside buyer.
• A loan sale is made with recourse if the loan buyer can sell the loan back
to the originator, should it go bad.
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Mortgage Sales 2
Mortgage sellers.
• Money center banks, smaller banks, foreign banks, investment banks, hedge funds,
and the U.S. government.
Mortgage sales allow FIs to manage credit risk, achieve better asset
diversification, and improve their liquidity and interest rate risk
positions.
FIs are encouraged to sell loans for economic and regulatory reasons.
• Sold mortgages can still generate fee income for the bank.
• Sold mortgages reduce the cost of reserve and capital requirements.
Mortgage buyers.
• Investment banks, vulture funds, domestic and foreign banks, insurance companies
and pension funds, closed-end bank loan mutual funds, and nonfinancial
corporations.
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Secondary Mortgage Markets 1
Government-sponsored enterprises (GSEs).
The U.S. government established the Federal National Mortgage
Association (FNMA, or Fannie Mae) in 1938 to buy mortgages from
depository institutions so they could lend to other mortgage
borrowers.
• Mandate was to act as a secondary mortgage market facility that could purchase,
hold, and sell mortgage loans.
The Federal Home Loan Mortgage Corporation (FHLMC, or Freddie
Mac) was formed in the 1960s to facilitate financing of conventional
mortgages.
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Secondary Mortgage Markets 2
Government National Mortgage Association (GNMA, or “Ginnie
Mae”) began operations in 1968 when it split off from Fannie Mae,
and has two major functions.
• Sponsoring mortgage-backed securities programs of financial institutions
such as banks, thrifts, and mortgage bankers.
• Acting as a guarantor to investors in mortgage-backed securities regarding
the timely pass-through of principal and interest payments from the FI or
mortgage servicer to the bond holder.
Only supports those pools of mortgage loans whose default or credit
risk is insured by one of four government agencies, all of which target
groups that might otherwise be disadvantaged in the housing market.
• E.g., Low-income families, young families, and veterans.
• Maximum mortgage under the GNMA securitization program had a cap of
$417,000 for a single-family home in 2016 (with exceptions).
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Secondary Mortgage Markets
Concluded
Between 2005 and 2007, subprime mortgage default rates increased
from 5.37% to 10.09%.
Subprime mortgage holders 60 days or more behind in their payments
hit 17.1% in June 2007 and was over 20% in August of the same year.
Problems in the subprime market spilled over to the broader
mortgage markets and helped fuel nationwide declines in home
prices, which put many homeowners underwater and led to the
bankruptcies of many major financial institutions.
On September 7, 2008, the Federal Housing Finance Agency (FHFA)
placed both Fannie Mae and Freddie Mac in government
conservatorship.
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Mortgage-Backed Securities 1
Mortgage-backed securities allow mortgage issuers to
separate the credit risk exposure from the lending process.
Pass-through securities “pass through” promised principal
and interest payments to investors.
Three agencies are directly involved in the creation of
mortgage-backed pass-through securities.
• Ginnie Mae, Fannie Mae, and Freddie Mac.
Private mortgage pass-through issuers create pass-
throughs from nonconforming mortgages.
• E.g., commercial banks, thrifts, and private conduits.
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Mortgage-Backed Securities 2
Collateralized mortgage obligations (CMOs) are mortgage-backed
bonds with multiple bond holder classes or tranches.
• Each bond holder class has a different guaranteed coupon.
• Mortgage prepayments retire only one tranche at a time, so all
other trances are sequentially prepayment protected.
Mortgage-backed bonds (MBBs).
• MBBs allow FIs to raise long-term low-cost funds without removing
mortgages from their balance sheets.
• 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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Mortgages Outstanding by Type of
Holder
Figure 7–8 Mortgages Outstanding by Type of Holder, 1992, 2007, and 2016
*Includes households, businesses, state and local governments, and the federal government.
†Includes other insurance companies, pension funds, and REITs.
Source: Federal Reserve Board website, “Flow of Fund Accounts,” July 2016. www.federalreserve.gov
Access the long description slide.
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26. © 2019 McGraw-Hill Education.
Mortgage-Backed Pass-Through
Securities Outstanding
Table 7–3 Government-Related Mortgage-Backed Pass-
Through Securities Outstanding (in trillions of dollars)
blank
1995 2000 2005 2008* 2010 2012 2016**
GNMA $ 0.47 $ 0.61 $ 0.40 $ 0.51 $ 1.10 $ 1.37 $ 1.67
FNMA 0.58 1.06 1.83 2.44 3.02 3.00 3.03
FHLMC 0.52 0.82 1.31 1.80 1.90 1.74 1.88
Private
mortgage issuers
0.29 0.74 2.14 2.79 1.92 1.49 0.90
Total $ 1.86 $ 3.23 $ 5.68 $ 7.54 $ 7.94 $ 7.60 $ 7.48
*Second quarter.
**First quarter.
Source: Federal Reserve Board website. www.federalreserve.gov
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International Trends in
Securitization 1
Europe is the world’s second-largest and most developed
securitization market.
• The European mortgage securitization peaked in 2008 before falling
dramatically in 2009 as a result of the financial crisis.
• The role of London banks in the mortgage-backed securitization market is
now in question after the U.K.‘s 2016 referendum (aka “Brexit).
Parts of Europe and Asian real estate markets were not as affected by
the mortgage crisis because they lacked substantial subprime lending.
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International Trends in
Securitization 2
The largest banks in the Netherlands, Switzerland, and the United
Kingdom had net losses in 2008.
• Banks in Ireland, Spain, and the United Kingdom were especially hard hit as they
had large investments in toxic mortgages and mortgaged-backed securities, both
U.S. and domestic.
Securitization overseas is often structured differently, with originators
retaining title to the mortgages even after securitization.
Securitization has declined due to the crisis, but will continue in the
future.
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Global Securitized Asset Issuance 1
Table 7–6 Global Securitized Asset Issuance (in billions of dollars)
Year United States Europe Rest of the
World
Total
2002 $ 2,337.8 $ 90.6 $ 42.4 $ 2,470.8
2003 3,172.6 166.4 57.3 3,396.3
2004 1,916.6 203.1 80.1 2,199.8
2005 2,230.5 301.1 97.6 2,629.2
2006 2,110.3 448.4 121.8 2,680.5
2007 2,204.3 698.4 132.9 3,035.6
2008 1,403.6 970.5 118.9 2,493.0
2009 2,041.1 432.7 96.0 2,569.8
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Global Securitized Asset Issuance 2
Year United States Europe Rest of the
World
Total
2010 1,975.7 421.2 87.1 2,484.0
2011 1,660.2 394.0 94.0 2,148.2
2012 2,157.2 253.4 81.4 2,492.0
2013 2,087.8 180.8 123.2 2,391.8
2014 1,347.7 217.0 110.5 1,675.2
2015 1,690.2 213.8 88.3 1,992.3
2016* 348.4 56.9 15.9 421.2
*Through March.
Source: SIFMA website, July 2016. www.sifma.org
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Mortgage Loans Outstanding Long
Description
In 1995 there was $4.55 trillion outstanding, of which 76.1%
was 1 to 4 family homes, 16.2% was commercial, 6.1% was
multifamily residential, and 1.6% was farm. In 2016, $13.85
trillion was outstanding, of which 72.3% was 1 to 4 family
homes, 18.2% was commercial, 8% was multifamily residential,
and 1.5% was farm.
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Mortgages Outstanding by Type of
Holder Long Description
In 1992 there was $4.07 trillion outstanding, of which 39.04% was
depository institutions, 40.42% were mortgage pools, 10.38% was
other, 5.95% was life insurance companies, 2.72% was other
financial institutions and 1.49% was mortgage companies. In 2007
there was $14.59 trillion outstanding, of which 55.35% mortgage
pools, 34.40 depository institutions, 3.65% mortgage companies,
3.05% other, 2.24% life insurance companies, and 1.31% other
financial institutions. In 2016 there was $13.85 trillion outstanding,
of which 56.40% was mortgage pools, 31.94% was depository
institutions, 5.77% was other, 3.11% was life insurance companies,
1.94% was other financial institutions, and 0.84% was mortgage
companies.
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