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Chapter Seven

Chapter Seven. Mortgage Markets. Chapter Outline. Overview Amortization Schedule Secondary Market Participants in Mortgage Markets Collateralized Mortgage Obligations. 1. Mortgages and Mortgage-Backed Securities.

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Chapter Seven

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  1. Chapter Seven Mortgage Markets

  2. Chapter Outline • Overview • Amortization Schedule • Secondary Market • Participants in Mortgage Markets • Collateralized Mortgage Obligations

  3. 1. Mortgages and Mortgage-Backed Securities • Mortgages are loans to individuals or businesses to purchase a home, land, or other real property • Many mortgages are securitized • mortgages are packaged and sold as assets backing a publicly traded or privately held debt instrument • Four basic categories of mortgages issued • home, multifamily dwelling, commercial, and farm

  4. Mortgage Loans Outstanding, 2004 ($Bn)

  5. Mortgage Characteristics • Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults • Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front • Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage (continued)

  6. Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) • Conventional mortgages - issued by FIs that are not federally insured • Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes • Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage (continued)

  7. Balloon payment mortgages - requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period • Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date • Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage • Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest (continued)

  8. 2. Amortization schedule • Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest (continued)

  9. Calculation of Monthly Mortgage Payments PV = PMT(PVIFAi/12, n  12) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years

  10. Comparison of Monthly Mortgage Payments $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/136.2835 = $880.52 $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 =PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/104.6406 = $1146.78

  11. 3. Secondary Mortgage Market • FI’s remove mortgages from their balance sheet through one of two mechanisms • pool recently originated mortgages together and sell them in the secondary market (mortgage sales) • issue mortgage-backed securities that are backed by their newly originated mortgages (securitization) • Benefits of secondary mortgage market • Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk • FIs are encouraged to sell loans for economic (generate fee income) and regulatory reasons (reducing reserve req’s)

  12. Mortgage Sales • Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer • Major sellers of mortgage loans are money center banks, smaller banks, foreign banks, investment banks • Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, and nonfinancial firms

  13. Securitization of Mortgages • Pass-through mortgage securities - mortgage-backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools • Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum • Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC)

  14. History of Secondary Mortgage Markets • Federal National Mortgage Association (FNMA or “Fannie Mae”) created during the Great Depression • FHA (Federal Housing Administration) and VA (Veterans Administration) insured loans also created during this time • Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created during 1960’s • Wide variety of mortgage-backed securities have been developed and in 1999, approximately 50% of mortgages are securitized

  15. Government-Related Mortgage-Backed Pass-Through Securities Outstanding ($Bn)

  16. 4. Mortgages Outstanding by Type of Holder(%), 2004

  17. One- to Four-Family Mortgage Originations, 2004

  18. Issuers of Ginnie Mae Securities, 2004

  19. 5. Collateralized Mortgage Obligations • CMO - a mortgage-backed bond issued in multiple classes or tranches • tranches - a bond holder class associated with a CMO • Created by packaging and securitizing whole mortgage loans or resecuritizing pass-through securities • Attractive to secondary mortgage market investors because they can choose a particular CMO class that fits their maturity needs

  20. Sequential Pay Tranche CMO • Several early tranches plus one accrual (zero) tranche • Each early tranche receives interest payment at a specified coupon rate • Extra payment then is used to pay the principle balance of the first tranche; when the first tranche is paid off, extra payment is to pay the principle balance of the next tranche, and so forth • Zero tranche starts to get payment only until all the early tranches have been paid off • Early tranches have more protection against extension risk; zero tranche has more protection against contraction risk

  21. PAC Tranche CMO PAC: Planned Amortization Class • PAC tranches plus support tranche • PAC tranches are guaranteed with preset payment schedule • Excessive prepayment goes to the support tranche • The certainty of PAC tranches payment comes at the expense of increased prepayment risk of support tranche

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