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CHAPTER 9 MORTGAGE MARKETS 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.

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  2. The Unique Nature ofMortgage 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. • Most people in the United States own their own homes and finance them with mortgage debt. Finance 308

  3. The Unique Nature ofMortgage Markets (concluded) • Weak Secondary Market (in the past) • Little standardization of contracts and terms. • Traditionally issued and held by lender. • Mortgage markets are highly regulated and supported by federal government policies. • However, the securitization of mortgages, the innovative decoupling of principal and interest payments, the alteration of payment timing characteristics via mortgage backed securities have transformed the market. Finance 308

  4. The Mortgage Contract • Borrower Signs a Note and Mortgage, and Title Is Conveyed to Borrower • The note is the borrowing agreement. • Payments amortized over time. • 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. Finance 308

  5. Standard Fixed Rate Mortgages (FRMs) • The lender takes a lien on real property • The borrower agrees to make periodic payments of the money borrowed plus interest on the unpaid balance of the debt for a predetermined period of time. • The interest rate is fixed, and the payments are typically monthly. Finance 308

  6. Current Mortgage Rates • The February 28th, 2005 issue of The Wall Street Journal (Page C 2) reported the following rates: • 30-year fixed rate mortgage – 5.23% • 15-year fixed rate mortgage – 4.80% • Jumbo Mortgage (over $359,650) – 5.51% • One-year ARM – 3.69% • Home-Equity loan – 6.97% Finance 308

  7. Mortgage Balance and Payments Please use your financial calculators to determine the figures. Finance 308

  8. Mortgage Balance and Payments (continued) Finance 308

  9. Mortgage Balance and Payments, cont. Notice the interest difference between the 15-year and 30-year mortgage. Finance 308

  10. Mortgage Balance and Payments Finance 308

  11. 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). • Down payment and rates may be lower. Finance 308

  12. Private Mortgage Insurance • Conventional mortgage borrowers with low down payments must usually buy private mortgage insurance (PMI). • PMI premiums are added to mortgage payments until the value of the mortgage is less than 80% of the value of the house. Finance 308

  13. Private Mortgage Insurance Finance 308

  14. Adjustable Rate Mortgage (ARM) • Fixed-rate mortgages are not acceptable to lenders in high inflation periods. • With adjustable rate contracts, borrowers' costs vary with inflation and interest rate levels. • Caps on ARM interest rates limit interest rate risk to borrowers. • 1 to 2 % cap per year. • 5 % cap over the life of the loan. Finance 308

  15. Methods of Adjustment for ARMs • Rate may vary in a prescribed range (caps) or without limit. • ARMs use various measures for adjusting their rates, including Treasury security rates, the prime rate, LIBOR, and the savings and loan cost-of funds index. • 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. Finance 308

  16. Rate Difference Needed for Borrowers to Take the Risk of an Adjustable-Rate Mortgage Finance 308

  17. Fixed and Adjustable Mortgage Rates Finance 308

  18. Early Payoff Mortgages • Balloon Payment Mortgages -- Traditional loan where interest is paid until a time when the principal was due. • Rollover Mortgage (ROMs) -- refinanced at new rate every few years. • Renegotiated Rate Mortgages (RRMs) -- Loan terms renegotiated periodically at terms prevailing in the market. Finance 308

  19. Other Mortgage Instruments • Reverse Annuity Mortgage (RAM) -- Borrower receives monthly loan proceeds. Interest and principal paid at time of sale of home. • 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. Finance 308

  20. 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. • Prepayment Risk • Extension Risk Finance 308

  21. Mortgage-Backed Securities - continued • Government National Mortgage Association (GNMA) • Ginnie Mae Pass-Throughs pass through all payments of interest and principal received on a pool of federally insured mortgage loans. • Once a pool of mortgages is assembled, pass-through securities are issued that are collateralized by interest and principal payments from the mortgages in the pool. • Guaranteed by GNMA Finance 308

  22. Mortgage-Backed Securities - continued • Federal Home Loan Mortgage Corporation (FHLMC) • Established in 1970 to provide a secondary market for conventional mortgages • Freddie Macs PCs (Participation Certificates) • Contain conventional mortgages • Mortgages are not federally insured • Pools are assembled by the FHLMC • Mortgages in the pool may have more than one interest rate • Minimum denomination is $100,000 Finance 308

  23. Mortgage-Backed Securities - continued • Guaranteed Mortgage Certificates • Issued by the FHLMC • Represent an ownership interest in a particular pool of mortgages • Similar to conventional bonds in that they guarantee repayment of principal and interest on a regular basis • Interest - semiannual • Principal - annually • Guaranteed by FHLMC Finance 308

  24. Types of Pass-Through Securities • Ginnie Mae Pass-Throughs - pools of government insured mortgages. • Freddie Mac Participation Certification - pools of conventional mortgages. • Privately issued pass-through (PIP) • Privately insured • Pools of conventional mortgages Finance 308

  25. Mortgage-Backed Bonds • 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. • Fannie Mae (FNMA) - pools of conventional or insured mortgages. Finance 308

  26. Collateralized Mortgage Obligations (CMOs) • Fixed maturity date and interest payments similar to bonds. • CMOs consist of a series of related debt obligations, called tranches, which divide up the principal and interest payments made on a pool of mortgages and pay principal and interest to various borrowers with different priorities. • The first tranche would receive all payments toward principal, whether scheduled or prepayment. Finance 308

  27. Collateralized Mortgage Obligations (CMOs) - Continued • Each obligation in the debt series except the “residual series” has a fixed maturity priority and interest payments similar to a corporate bond. • The Z tranche is the final tranche and receives all remaining principal payments after every other tranche has been paid off. It receives no other interest payments in the interim. • The major advantage of CMOs is that the size and value of their payments is more certain than on their underlying mortgages unless prepayments vary unexpectedly. Finance 308

  28. Collateralized Mortgage Obligations (CMOs) - Concluded • Recent CMOs feature as many as 30 separate tranches. • Popularity of CMOs are due to: • They allow investors to have mortgage securities tailored to their maturity preferences • They often have high book yields relative to debt instruments of similar quality • They have high credit ratings owing to their backing by mortgage pools issued by GNMA, FHLMC and FNMA. Finance 308

  29. Real Estate Mortgage Investment Conduit (REMIC) • Passes through all interest and principal payments before taxes are levied • Investor pays taxes • Type of CMO but legally different Finance 308

  30. 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. Finance 308

  31. Prepayment Risk • The problem with mortgage-backed securities is that their payment patterns change substantially when interest rates change. • If interest rates fall a great deal, the present value of a pool of high-interest rate mortgages will fall as people refinance their homes at the new lower rates and repay their old mortgages. The owner will not receive the high interest rates promised on the mortgages. Finance 308

  32. Extension Risk • Conversely, if interest rates rise by a large amount, people will be reluctant to move or refinance their homes at the new high mortgage rates. Prepayments of existing mortgages will fall and cash flows from a pool of mortgages will be lower in the short run than they would have been if interest rates had not risen. • PSA (Public Securities Association) repayment rates from past mortgage repayment experiences. Finance 308

  33. Participants in the Mortgage Markets • Thrifts -- dominated and increased share of market until 1970s. • Banks -- Increased share of market and increased powers to make mortgage loans. • Insurance Companies and Pension Funds. • Pools -- Pass-through certificates have become an important source of funds. Pools represented the largest component of mortgage investment in 2001. Finance 308

  34. Participants in the Mortgage Markets (continued) • Government Holdings -- All Levels of Government • FNMA, FHLMC, Federal Land Banks, Farmers Home Administration. • State and local housing authorities issue bonds and buy subsidized, lower-rate mortgages, often for first-time home-buyers. Finance 308

  35. Other Participants • Mortgage Insurers • Developed in 1930s to enhance acceptability of mortgages and to encourage more risky low equity/loan lending. • FHA guaranteed payment to lender in case of default. • VA insurance (1944) for mortgage loans to veterans. • Private mortgage insurance covered low down payment conventional mortgages. • Mortgage insurance has enhanced the development of secondary markets. Finance 308

  36. Other Participants (concluded) • Mortgage bankers originate mortgages, sell them, and often service the mortgage. • Mortgage bankers do not hold mortgage loans in their portfolio for long. • Obtain their income from originating mortgages Finance 308

  37. Underwriting Standards • In order to reduce the chance of default, mortgage lenders must ensure that the property, loan amount, and borrower conform to the lender’s underwriting standards. • FHA and FHLMC underwriting standards determine the maximum credit risk that a mortgage originator can take when making a mortgage loan. • Fannie and Freddie have automated underwriting systems that allow for quick approval of mortgages. Finance 308

  38. Conclusion • Mortgage Markets • Mortgage Calculations • Types of Mortgages • Conventional vs. Insured • FRM vs. ARM • Mortgage Backed Securities • Pass Throughs • CMO, REMIC Finance 308

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