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Chapter Seven

Chapter Seven. Mortgage Markets. 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

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Chapter Seven

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  1. Chapter Seven Mortgage Markets McGraw-Hill/Irwin

  2. 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 McGraw-Hill/Irwin

  3. Mortgage Loans Outstanding, 2004 ($Bn) McGraw-Hill/Irwin

  4. In 2004 there were over $10 trillion of mortgages outstanding. • About 77% of mortgages are single family (1-4 family) mortgages. • The rest are divided between commercial mortgages (16%), multifamily dwelling mortgages (6%) and a small amount of farm mortgages (under 1%). McGraw-Hill/Irwin

  5. secondary market for mortgages • There is a well developed and active secondary market for mortgages, unlike most other loan types. • This is because the government is heavily involved in the single family secondary mortgage market to promote securitization. McGraw-Hill/Irwin

  6. Securitization • Securitization is the process of transforming individual loan contracts into marketable securities. About 60% of single family mortgages are securitized McGraw-Hill/Irwin

  7. The saleable contract • Mortgage contracts by themselves would not be particularly saleable because they have nonstandard, fairly small denominations and unique, potentially substantial credit risk. • A saleable contract should have a standard, large denomination to appeal to institutional buyers, a low cost method of assessment of credit risk, good collateral, a standard maturity, and a standard interest rate. • Standardization improves salability. • Standard terms improve the ability to market an issue to buyers because they are more familiar with the terms and risks of the investment McGraw-Hill/Irwin

  8. Mortgages have generally good collateral, standard lengthy maturities and standard interest rates. • The small and variable denomination of individual mortgages implies that mortgages should be pooled to create a typical large denomination. McGraw-Hill/Irwin

  9. What about credit risk • Credit risk analysis of the many individual borrowers in the pool would be quite costly and would severely limit the usefulness of the securitization process if not alleviated. • Thus, for most mortgages that are securitized either the government provides insurance for mortgages, or an 80% loan to value ratio is required, or the mortgage must be privately insured. McGraw-Hill/Irwin

  10. Why Securitization • Securitization brings many benefits to FIs. • Securitization allows FIs to • a) become more liquid, • b) reduce interest rate and credit risk, • c) reduce capital and reserve requirements, • d) generate fee income from servicing more mortgages than they could otherwise. McGraw-Hill/Irwin

  11. Saudi to be soon, so you may wish to consider pursuing careers in mortgage related areas. • The mortgage markets are huge (they are larger than the corporate debt market), • rapidly growing (from 1992 through 2004 the amount of home mortgages grew by about 133%) • becoming increasingly sophisticated. • Even with the slower economic growth of the 2000s the mortgage markets have continued to grow, in some areas home prices have advanced more rapidly than income growth, generating some concerns that housing prices could fall precipitously if housing becomes unaffordable McGraw-Hill/Irwin

  12. Was Greenspan wrong • Nevertheless, Greenspan has indicated that he does not foresee problems of this nature in the housing market. • However Greenspan did indicate that rapid growth in two housing related government sponsored enterprises, FNMA and FHLMC, was generating systemic risk to the economy. McGraw-Hill/Irwin

  13. In other countries and in USA past, severe collapses in housing prices have triggered prolonged periods of low economic growth or even a prolonged recession. McGraw-Hill/Irwin

  14. The Primary Mortgage Market • It should be emphasized that the starting and financing of mortgages are now largely separate functions. • One of the primary purposes of the government’s presence in the mortgage markets is to ensure the availability of mortgage credit wherever it is needed. • Government mortgage insurance and the securitization process have created a national market for financing mortgages. McGraw-Hill/Irwin

  15. The separation of creation and financing of mortgages. • The financing of mortgages is national, or even international, in scope. • The origination (creation) of mortgages is still primarily a local market, for instance, typically one does not go to another state to obtain a mortgage. • The originators however often sell the mortgage (individually or in a pool). • The origination market is itself however becoming increasingly national because mortgage companies (a local originating institution) often obtain mortgage financing from institutions around the country. McGraw-Hill/Irwin

  16. Electronic mortgage • Electronic mortgage origination however has not grown as dramatically as predicted. • Applying for a mortgage online remains a troublesome task, hurting this area of business. McGraw-Hill/Irwin

  17. Politics or theft or stupid • Government involvement has done two things. • One, it has allowed younger, less wealthy people to own homes by eliminating the large down payment, thus facilitating a part of the “American dream” of home ownership. • Second, it has helped poorer regions of the country such as West Virginia, Montana, etc that would not have had enough mortgage credit available to meet the demand for funds. McGraw-Hill/Irwin

  18. Why home ownership • For many people, home ownership is one of the most satisfying assets they obtain. • It is a person’s major hedge against personal disasters and inflation. • Even in low inflation times it is usually (but not always) an appreciating asset and, unlike automobiles, should be considered an investment. • It is however an illiquid investment and living in the wrong house for you in the wrong area can make you miserable for a long time, so please shop wisely. McGraw-Hill/Irwin

  19. Mortgage Characteristics • Although mortgages can have unique terms, the demands of the secondary market increasingly determine the guidelines for accepting or rejecting a mortgage application. • Lien • Down payment • Private mortgage insurance • Federally insured mortgages • Conventional mortgages • Amortized • Balloon payment mortgages (continued) McGraw-Hill/Irwin

  20. Fixed-rate mortgage • Adjustable-rate mortgage • Discount points • Amortization schedule McGraw-Hill/Irwin

  21. Collateral & lien • All mortgage loans are backed by collateral that will have a lien placed against it. • A lien is a public record attached to the title of the property that gives the financial institution the right to sell the property if the mortgage borrower defaults. • A lien prevents sale of the property until the mortgage is paid off and the lien removed. McGraw-Hill/Irwin

  22. Down Payment • In the absence of government insurance, a down payment is required to minimize default risk. • An 80% loan to value ratio is standard. • If a borrower cannot pay the required 20% down payment they may obtain FHA insurance. (Federal Housing Administration) • FHA insurance has a maximum borrowing amount that varies according to regional housing costs. • The borrower may instead apply for private mortgage insurance (PMI). McGraw-Hill/Irwin

  23. PMI • Most PMI requires a monthly payment that is added to the principle and interest payment. • Although it can vary from lender to lender, the typical monthly mortgage insurance payment if the borrower pays only 10% down can be found by multiplying the loan amount times a constant factor equal to 0.0051 and then dividing the result by 12. McGraw-Hill/Irwin

  24. Example • For instance, on a $100,000 mortgage with 10% down, the monthly PMI premium would be ($100,000*0.0051)/12 = $42.50. • If you finance 97% the constant is 0.0090 and the monthly PMI payment would be $75. McGraw-Hill/Irwin

  25. Tip • Once the homeowner reduces the principle amount to 80% or less of the house value, either through payments and/or appreciation of the value of the home, the homeowner may wish to have the house reappraised and apply for termination of the mortgage insurance. The appraisal cost may be as low as $500-$600. McGraw-Hill/Irwin

  26. Insured vs Conventional Mortgages • Conventional mortgages are mortgages not insured by the Federal government. • The term insured mortgages refers to mortgages insured by the Federal government, not privately insured mortgages. McGraw-Hill/Irwin

  27. Mortgage Maturities • The two standard maturities are 15 year and 30 year, with 30 year mortgages predominating. • Some contracts call for balloon payments at the end of three to five years. • These contracts may require interest only payments during the interim period. • Most borrowers will not be able to pay off the balloon so the borrower is essentially agreeing to refinance the mortgage when the balloon is due. McGraw-Hill/Irwin

  28. Tip • A balloon payment mortgage is riskier to the borrower because there is no guarantee that refinancing will be granted. • An injury or illness, a layoff, etc. can endanger an individual’s primary asset, their home. McGraw-Hill/Irwin

  29. Interest Rates • Mortgage rates are a function of: • the fed funds rate, • discount points paid, • whether the loan is FHA or a conventional mortgage, • maturity, • whether the mortgage is fixed or adjustable rate, • regional demand for funds and the level of competition of suppliers of mortgage credit. • Regional credit availability is not an issue due to the national financing market. McGraw-Hill/Irwin

  30. Fixed versus Adjustable Rate Mortgages • (FRMs) remain the most popular mortgage type, although a significant number of mortgages are adjustable rate. • With the low rates of the early 2000s, adjustable rate mortgages (ARMs) have not been as popular as in prior periods. • (at one point several years ago 50% of new originations were adjustable rate). McGraw-Hill/Irwin

  31. prepayment penalties • The index used cannot be the lender’s cost of funds and is often an index of lenders’ fund costs (termed a COFI or cost of funds index). • The rate change per year and over the life of the mortgage is capped and prepayment penalties are not allowed on ARMs. • (A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest. Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed  in any one year without a penalty. A penalty that applies to a home sale as well as a refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a "soft" penalty.) McGraw-Hill/Irwin

  32. The cap • With a fixed rate mortgage the lender bears the interest rate risk, with an ARM the borrower bears the interest rate risk. (implies that even in an ARM the lender still bears some interest rate risk) • ARMs result in higher default risk for lenders in periods of rising interest rates. • When rates rise, borrowers have more difficulty making the payments on their mortgage. McGraw-Hill/Irwin

  33. Discount Points • A borrower can buy a lower interest rate by paying points up front. • A discount point is 1% of the loan amount. Lenders periodically establish point schedules that show what interest rate they are willing to offer if the borrower pays a certain amount of points. • A simple breakeven analysis can be used to determine whether the borrower should pay the points. McGraw-Hill/Irwin

  34. Other Fees • A homebuyer will normally face a host of fees (payable at closing or before) including: • Application fee • Title search fee • Title insurance fee • Appraisal fee • Loan origination fee (usually 1% of the loan amount) • Closing agent/review fee • Costs to obtain mortgage insurance (FHA, VA or private) if needed • Tip: Closing costs average from 3%-5% of the mortgage amount (excluding points), with 3% the most common. McGraw-Hill/Irwin

  35. Mortgage Refinancing • Due to low interest rates in the early 2000s, mortgage refinancing business has boomed. • A typical rule of thumb is that the new mortgage rate should be 200 basis points below the old rate, but with ARMs and reduced refinancing costs refinancings can be worthwhile at smaller rate reductions. • A breakeven analysis can be used to determine if refinancing is worthwhile McGraw-Hill/Irwin

  36. Mortgage amortization • The typical mortgage is fully amortized at the original maturity so that the principle is reduced with each payment and no balloon remains at maturity. • Amortizing payments are calculated using the present value of annuity formula. • An amortization schedule depicts the amount of each payment that goes to principle and to interest. McGraw-Hill/Irwin

  37. Example • A borrower agrees to a $200,000, thirty year fixed rate mortgage with a 5.75% quoted interest rate. What is the payment amount and how much of each payment goes to principle and interest? • 30years =360 payment • Payment = $200,000 / (1-1.004792^-360)/0.004792 = $1,167.15 • The amortization schedule provides the breakdown of each payment into principle and interest on a dollar and a percentage basis. • Notice that the total interest paid on this mortgage ($220,172.46) is greater than the original balance. McGraw-Hill/Irwin

  38. Calculation of Monthly Mortgage Payments PV = PMT(PVIFAr,t ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity r = interest rate, i, divided by 12 (months/year) t = number of months (payments) over life of the mortgage McGraw-Hill/Irwin

  39. 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 McGraw-Hill/Irwin

  40. Other Types of Mortgages • Automatic rate-reduction mortgages • Graduated-payment mortgages • Growing-equity mortgages • Second mortgages • Home equity loan • Shared-appreciation mortgage (SAM) • Equity-participation mortgage • Reverse-annuity mortgage McGraw-Hill/Irwin

  41. Automatic Rate-Reduction Mortgages • When interest rates fall the lender automatically lowers the existing mortgage interest rate; • however the rate is never adjusted upward. • This type of mortgage is designed to discourage refinancing with another lender if rates fall. McGraw-Hill/Irwin

  42. Graduated Payment Mortgages GPMs • GPMs allow borrowers to initially make low monthly payments which rise for the next 5 to 10 years before leveling off. • GPMs are designed to allow homebuyers to purchase more house than they can currently afford under the assumption that their income will rise to match the growing house payment. • Relative to a standard fixed rate mortgage, the borrower will pay more interest overall. • This type of mortgage is riskier than a standard fixed rate mortgage with a payment that the borrower can currently afford. McGraw-Hill/Irwin

  43. Growing Equity Mortgages (GEMs) • GEMs are mortgages where the payments increase according to a fixed schedule over the entire life of the mortgage. • GEMs result in faster amortization which shortens the maturity of the mortgage; thus they are a way to more quickly pay down the debt. McGraw-Hill/Irwin

  44. alternative to a GEM.Without commit it • A fifteen year mortgage is an alternative to a GEM. • Also, a borrower could simply take out a 30 year fixed rate mortgage and make extra payments each year. • The latter strategy is probably the least risky alternative for the borrower if they have the discipline to stick to the extra payments. • In any case, GEMs are increasingly being replaced with 5 year interest only (IO) loans. McGraw-Hill/Irwin

  45. Second Mortgages • Second mortgages are subordinated claims to senior mortgages. • Home equity loans allow customers to borrow on a line of credit secured with a second mortgage. • Interest on home equity loans is normally tax deductible whereas credit card interest is not. • Home equity loans have been running about 160 basis points above the 15 year fixed rate, but this varies. McGraw-Hill/Irwin

  46. Tip • Be careful advising individuals to use a home equity loan to pay off credit card debt. • Theoretically, an expensive vacation or even a shopping spree could endanger your home ownership if the buyer cannot manage credit properly. • Citigroup and Household International came under fire in 2002 for their aggressive marketing tactics used in selling mortgages to subprime borrowers. McGraw-Hill/Irwin

  47. Shared Appreciation Mortgages (SAMs) • SAMs allow home owners to obtain a loan at up to 200 basis points below market rates. • In exchange, the homeowner must give a portion of the appreciation in value of the home to the lender upon sale or refinancing of the home. • Many SAMs have a refinancing requirement in 5 to 7 years if the home has not already been sold. • SAMs are another form of mortgage that allows a homebuyer to buy more house than they can afford at current interest rates. • They have not been very popular in recent years; they were primarily used in the 1980s. McGraw-Hill/Irwin

  48. Equity Participation Mortgages • An equity participation mortgage is the same as a SAM except that a third party (other than the lender) gets a share in the appreciation of the house. McGraw-Hill/Irwin

  49. Reverse Annuity Mortgages (RAMs) • RAMs are for homeowners with a substantial amount of equity in their home who wish to supplement their income, usually retirees. • With a RAM the FI makes a monthly payment to the homeowner. • The FI is in effect buying out the homeowner’s equity over time. • At maturity the house is sold and the proceeds are used to pay off the FI. • RAM maturities are usually set up so that the homeowner will die before maturity. • As the population ages and health care costs increase RAMs are likely to grow in popularity. McGraw-Hill/Irwin

  50. New Types of Mortgages • 40 year mortgages • Negative Amortization Mortgage • Flex-ARM mortgage • Piggyback Mortgage or Combo loan • 103s and 107s • Most of these alternative mortgage types are riskier for home buyers, they are generally methods to buy more house than you could otherwise afford. McGraw-Hill/Irwin

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