Chapter Seven

Mortgage Markets

7-1

2009, The McGraw-Hill Companies, All Rights

Mortgages and Mortgage-Backed

Securities
Mortgages
Mortgagesare
areloans
loansto
toindividuals
individualsor
orbusinesses
businessesto
to
purchase
purchasehomes,
homes,land,
land,or
orother
otherreal
realproperty
property
Many
Manymortgages
mortgagesare
aresecuritized
securitized

mortgages
mortgagesare
arepackaged
packagedand
andsold
soldas
asassets
assetsbacking
backingpublicly
publicly
traded
tradedor
orprivately
privatelyheld
helddebt
debtinstruments
instruments(i.e.,
(i.e.,mortgage-backed
mortgage-backed
securities
securities(MBSs))
(MBSs))

Mortgages
Mortgagesdiffer
differfrom
frombonds
bondsand
andstocks
stocks

mortgages
mortgagesare
arebacked
backedby
byaaspecific
specificpiece
pieceof
ofreal
realproperty
property
primary
primarymortgages
mortgageshave
haveno
noset
setsize
sizeor
ordenomination
denomination
primary
primarymortgages
mortgagesgenerally
generallyinvolve
involveonly
onlyaasingle
singleinvestor
investor
comparatively
comparativelylittle
littleinformation
informationexists
existson
onmortgage
mortgageborrowers
borrowers

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2009, The McGraw-Hill Companies, All Rights

Primary Mortgage Market

Four
Four basic
basic types
types of
of mortgages
mortgages are
are issued
issued by
by
financial
financial institutions
institutions

home
homemortgages
mortgagesare
areused
usedto
topurchase
purchaseoneone-to
tofourfourfamily
familydwellings
dwellings
multifamily
multifamilydwellings
dwellingsmortgages
mortgagesare
areused
usedto
topurchase
purchase
apartment
apartmentcomplexes,
complexes,townhouses,
townhouses,and
andcondominiums
condominiums
commercial
commercialmortgages
mortgagesare
areused
usedto
tofinance
financethe
thepurchase
purchase
of
ofreal
realestate
estatefor
forbusiness
businesspurposes
purposes
farm
farmmortgages
mortgagesare
areused
usedto
tofinance
financethe
thepurchase
purchaseof
of
farms
farms
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2009, The McGraw-Hill Companies, All Rights

Mortgage Loans Outstanding,

2007 (Trillions of $)

7-4

2009, The McGraw-Hill Companies, All Rights

Mortgage Characteristics
Collateral:
Collateral:lenders
lendersplace
placeliens
liensagainst
againstproperties
propertiesthat
that
remain
remainin
inplace
placeuntil
untilloans
loansare
arefully
fullypaid
paidoff
off
AAdown
downpayment
paymentisisaaportion
portionof
ofthe
thepurchase
purchaseprice
priceof
ofthe
the
property
propertyaafinancial
financialinstitution
institutionrequires
requiresthe
theborrower
borrowerto
topay
pay
up
upfront
front
private
privatemortgage
mortgageinsurance
insurance(PMI)
(PMI)isisgenerally
generallyrequired
requiredwhen
when
the
theloan-to-value
loan-to-valueratio
ratioisismore
morethan
than80%
80%

Federally
Federallyinsured
insuredmortgages
mortgages

repayment
repaymentisisguaranteed
guaranteedby
byeither
eitherthe
theFederal
FederalHousing
Housing
Administration
Administration(FHA)
(FHA)or
orthe
theVeterans
VeteransAdministration
Administration(VA)
(VA)

7-5

2009, The McGraw-Hill Companies, All Rights

Mortgage Characteristics
Conventional
Conventionalmortgages
mortgagesare
aremortgages
mortgagesthat
thatare
arenot
not
federally
federallyinsured
insured
Amortized
Amortizedmortgages
mortgageshave
havefixed
fixedprincipal
principaland
andinterest
interest
payments
paymentsthat
thatfully
fullypay
payoff
offthe
themortgage
mortgageby
byits
itsmaturity
maturity
date
date
fully
fullyamortized
amortizedmortgage
mortgagematurities
maturitiesare
areusually
usuallyeither
either15
15or
or30
30
years
years

Balloon
Balloonpayment
paymentmortgages
mortgagesrequire
requirefixed
fixedmonthly
monthly
interest
interestpayments
paymentsfor
for33to
to55years
yearswhereupon
whereuponfull
fullpayment
payment
of
ofthe
themortgage
mortgageprincipal
principalisisdue
due
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2009, The McGraw-Hill Companies, All Rights

Mortgage Characteristics
Fixed-rate
Fixed-ratemortgages
mortgageslock
lockin
inthe
theborrowers
borrowersinterest
interestrate
rate

required
requiredmonthly
monthlypayments
paymentsare
arefixed
fixedover
overthe
thelife
lifeof
ofthe
themortgage
mortgage
lenders
lendersassume
assumeinterest
interestrate
raterisk
risk

Adjustable-rate
Adjustable-ratemortgages
mortgages(ARMs)
(ARMs)tie
tiethe
theborrowers
borrowers
interest
interestrate
rateto
tosome
somemarket
marketinterest
interestrate
rateor
orinterest
interestrate
rate
index
index
required
requiredmonthly
monthlypayments
paymentscan
canchange
changeover
overthe
thelife
lifeof
ofthe
the
mortgage
mortgage
yearly
yearlyinterest
interestrate
ratechanges
changesare
areoften
oftencapped
capped
borrowers
borrowersassume
assumeinterest
interestrate
raterisk
risk
ARMs
ARMscan
canincrease
increasedefault
defaultrisk
risk

7-7

2009, The McGraw-Hill Companies, All Rights

Mortgage Characteristics
Discount
Discountpoints
pointsare
arefees
feesor
orpayments
paymentsmade
madewhen
whenaa
mortgage
mortgageloan
loanisisissued
issued

each
eachpoint
pointcosts
coststhe
theborrower
borrower11percent
percentof
ofthe
theprincipal
principalvalue
value
the
thelender
lenderreduces
reducesthe
theinterest
interestrate
rateused
usedtotodetermine
determinethe
thepayments
payments
on
the
mortgage
in
exchange
for
points
paid
on the mortgage in exchange for points paid

Other
Otherfees
fees

application
applicationfee
fee
title
titlesearch
search
title
titleinsurance
insurance
appraisal
appraisalfee
fee
loan
loanorigination
originationfee
fee
closing
closingagent
agentand
andreview
reviewfees
fees
other
otherfees
fees(e.g.,
(e.g.,VA
VAor
orFHA
FHAloan
loanguarantees
guaranteesand
andPMI)
PMI)

7-8

2009, The McGraw-Hill Companies, All Rights

Mortgage Characteristics
Mortgage
Mortgage refinancing
refinancing

when
whenaaborrower
borrowertakes
takesout
outaanew
newmortgage
mortgageand
anduses
usesthe
the
proceeds
proceedsto
topay
payoff
offan
anexisting
existingmortgage
mortgage
mortgages
mortgagesare
aremost
mostoften
oftenrefinanced
refinancedwhen
whenan
anexisting
existing
mortgage
mortgagehas
hasaahigher
higherinterest
interestrate
ratethan
thanprevailing
prevailingrates
rates
borrowers
borrowersmust
mustbalance
balancethe
thesavings
savingsof
ofaalower
lowermonthly
monthly
payment
paymentwith
withthe
thecosts
costs(fees)
(fees)of
ofrefinancing
refinancing
an
anoften-cited
often-citedrule
ruleof
ofthumb
thumbisisthat
thatthe
thenew
newinterest
interestrate
rate
should
shouldbe
be22percentage
percentagepoints
pointsless
lessthan
thanthe
therefinanced
refinanced
mortgage
mortgagerate
rate
7-9

2009, The McGraw-Hill Companies, All Rights

Mortgage Amortization
Each
Each fixed
fixed monthly
monthly payment
payment consists
consists partly
partly of
of
repayment
repayment of
of the
the principal
principal and
and partly
partly of
of the
the
interest
interest on
on the
the outstanding
outstanding mortgage
mortgagebalance
balance
An
An amortization
amortization schedule
schedule shows
shows how
how the
the fixed
fixed
monthly
monthly payments
payments are
are split
split between
between principal
principal and
and
interest
interest

7-10

2009, The McGraw-Hill Companies, All Rights

Mortgage Payments
The
Thepresent
presentvalue
valueof
ofaajmortgage
mortgagecan
canbe
bewritten
writtenas:
as:
t
1
PV PMT
PMT ( PVIFAr ,t )
j 1 1 r
PV
PV==principal
principalamount
amountborrowed
borrowed
PMT
PMT==monthly
monthlymortgage
mortgagepayment
payment
PVIFA
PVIFA==present
presentvalue
valueinterest
interestfactor
factorof
ofan
anannuity
annuity
rr==monthly
monthlyinterest
interestrate
rateon
onthe
themortgage
mortgage
tt==number
numberof
ofmonthly
monthlypayments
paymentsover
overthe
thelife
lifeof
ofthe
themortgage
mortgage

Rearrange
Rearrangeto
toisolate
isolatethe
thepayment:
payment: PMT

7-11

PV
( PVIFAr ,t )

2009, The McGraw-Hill Companies, All Rights

Other Types of Mortgages

Automatic
Automatic rate-reduction
rate-reduction mortgages
mortgages
Graduated-payment
Graduated-payment mortgages
mortgages (GPMs)
(GPMs)
Growing-equity
Growing-equity mortgages
mortgages (GEMs)
(GEMs)
Second
Second mortgages
mortgages and
and home
homeequity
equity loans
loans
Shared-appreciation
Shared-appreciation mortgages
mortgages (SAMs)
(SAMs)
Equity-participation
Equity-participation mortgages
mortgages (EPMs)
(EPMs)
Reverse-annuity
Reverse-annuity mortgages
mortgages (RAMs)
(RAMs)

7-12

2009, The McGraw-Hill Companies, All Rights

Secondary Mortgage Markets

FIs
FIs remove
remove mortgages
mortgages from
fromtheir
their balance
balance sheets
sheets
through
through one
one of
of two
two mechanisms
mechanisms

by
bypooling
poolingrecently
recentlyoriginated
originatedmortgages
mortgagestogether
togetherand
and
selling
sellingthem
themin
inthe
thesecondary
secondarymarket
market
by
bysecuritizing
securitizingmortgages
mortgages(i.e.,
(i.e.,by
byissuing
issuingsecurities
securities
backed
backedby
bynewly
newlyoriginated
originatedmortgages)
mortgages)

Advantages
Advantages of
of securitization
securitization

FIs
FIscan
canreduce
reducethe
theliquidity
liquidityrisk,
risk,interest
interestrate
raterisk,
risk,and
and
credit
creditrisk
riskof
oftheir
theirloan
loanportfolios
portfolios
FIs
FIsgenerate
generateincome
incomefrom
fromorigination
originationand
andservice
servicefees
fees
7-13

2009, The McGraw-Hill Companies, All Rights

Secondary Mortgage Markets

The
TheU.S.
U.S.government
governmentestablished
establishedthe
theFederal
FederalNational
National
Mortgage
MortgageAssociation
Association(FNMA
(FNMAor
orFannie
FannieMae)
Mae)in
inthe
the
1930s
1930sto
tobuy
buymortgages
mortgagesfrom
fromthrifts
thriftsso
sothey
theycould
couldmake
make
more
moremortgage
mortgageloans
loans
FHA
FHAand
andVA
VAinsured
insuredloans
loansmake
makesecuritization
securitizationeasier
easier
Government
GovernmentNational
NationalMortgage
MortgageAssociation
Association(GNMA
(GNMAor
or
Ginnie
GinnieMae)
Mae)and
andFederal
FederalHome
HomeLoan
LoanMortgage
Mortgage
Corp.
Corp.(FHLMC
(FHLMCor
orFreddie
FreddieMac)
Mac)created
createdin
inthe
the1960s
1960s

encouraged
encouragedcontinued
continuedexpansion
expansionof
ofthe
thehousing
housingmarket
market
provided
provideddirect
directand
andindirect
indirectguarantees
guaranteesthat
thatallow
allowfor
forthe
thecreation
creation
of
ofmortgage-backed
mortgage-backedsecurities
securities

7-14

2009, The McGraw-Hill Companies, All Rights

Mortgage Sales
FIs
FIshave
havesold
soldmortgages
mortgagesamong
amongthemselves
themselvesfor
forover
over100
100
years
years
AAlarge
largepart
partof
ofcorrespondent
correspondentbanking
bankinginvolves
involvessmall
small
banks
banksselling
sellingparts
partsof
oflarge
largeloans
loansto
tolarger
largerbanks
banks
Large
Largebanks
banksoften
oftensell
sellparts
partsof
oftheir
theirloans
loans(i.e.,
(i.e.,
participations)
participations)to
tosmaller
smallerbanks
banks
Mortgage
Mortgagesales
salesoccur
occurwhen
whenan
anFI
FIoriginates
originatesaamortgage
mortgage
and
andsells
sellsititto
toan
anoutside
outsidebuyer
buyer
aaloan
loansale
saleisismade
madewith
withrecourse
recourseififthe
theloan
loanbuyer
buyercan
cansell
sellthe
the
loan
loanback
backtotothe
theoriginator
originatorshould
shouldititgo
gobad
bad

7-15

2009, The McGraw-Hill Companies, All Rights

Mortgage Sales
Mortgage
Mortgagesellers:
sellers:money
moneycenter
centerbanks,
banks,smaller
smallerbanks,
banks,
foreign
foreignbanks,
banks,investment
investmentbanks
banks
Mortgage
Mortgagesales
salesallow
allowFIs
FIsto
tomanage
managecredit
creditrisk,
risk,achieve
achieve
better
betterasset
assetdiversification,
diversification,and
andimprove
improvetheir
theirliquidity
liquidityand
and
interest
interestrate
raterisk
riskpositions
positions
FIs
FIsare
areencouraged
encouragedto
tosell
sellloans
loansfor
foreconomic
economicand
and
regulatory
regulatoryreasons
reasons

sold
soldmortgages
mortgagescan
canstill
stillgenerate
generatefee
feeincome
incomefor
forthe
thebank
bank
sold
soldmortgages
mortgagesreduce
reducethe
thecost
costof
ofreserve
reserveand
andcapital
capitalrequirements
requirements

Mortgage
Mortgagebuyers:
buyers:foreign
foreignand
anddomestic
domesticbanks,
banks,insurance
insurance
companies,
companies,pension
pensionfunds,
funds,closed-end
closed-endbank
bankloan
loanmutual
mutual
funds,
funds,and
andnonfinancial
nonfinancialcorporations
corporations
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2009, The McGraw-Hill Companies, All Rights

Mortgage Backed Securities

Pass-through
Pass-through securities
securities pass
pass through
through promised
promised
principal
principal and
and interest
interest payments
payments to
to investors
investors
Three
Three agencies
agencies are
are directly
directly involved
involved in
in the
the
creation
creation of
of pass-through
pass-through securities
securities
Ginnie
GinnieMae
Mae
Fannie
FannieMae
Mae
Freddie
FreddieMac
Mac

Private
Private mortgage
mortgagepass-through
pass-through issuers
issuers create
create
pass-throughs
pass-throughs from
fromnonconforming
nonconforming mortgages
mortgages
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2009, The McGraw-Hill Companies, All Rights

Mortgage Backed Securities

Collateralized
Collateralizedmortgage
mortgageobligations
obligations(CMOs)
(CMOs)are
are
multiclass
multiclasspass-throughs
pass-throughswith
withmultiple
multiplebond
bondholder
holderclasses
classes
or
ortranches
tranches

each
eachbond
bondholder
holderclass
classhas
hasaadifferent
differentguaranteed
guaranteedcoupon
coupon
mortgage
mortgageprepayments
prepaymentsretire
retireonly
onlyone
onetranche
trancheatataatime,
time,so
soall
all
other
trances
are
sequentially
prepayment
protected
other trances are sequentially prepayment protected

Mortgage
Mortgagebacked
backedbonds
bonds(MBBs)
(MBBs)

MBBs
MBBsallow
allowFIs
FIstotoraise
raiselong-term
long-termlow-cost
low-costfunds
fundswithout
without
removing
removingmortgages
mortgagesfrom
fromtheir
theirbalance
balancesheets
sheets
aagroup
groupof
ofmortgage
mortgageassets
assetsisispledged
pledgedas
ascollateral
collateralagainst
againstaaMBB
MBB
issue,
issue,but
butthere
thereisisno
nodirect
directlink
linkbetween
betweenthe
thecash
cashflows
flowsof
ofthe
the
mortgages
mortgagesand
andthe
thecash
cashflows
flowson
onthe
theMBB
MBB

7-18

2009, The McGraw-Hill Companies, All Rights

Mortgages Outstanding by
Type of Holder (%)

7-19

2009, The McGraw-Hill Companies, All Rights

International Trends in Securitization

Foreign
Foreigninvestors
investorsparticipate
participatein
inU.S.
U.S.mortgage
mortgageand
andMBS
MBS
markets,
markets,but
butthe
thevalue
valueheld
heldhas
hasdecreased
decreasedsince
since1992
1992
Europe
Europeisisthe
theworlds
worldssecond
secondlargest
largestand
andmost
mostdeveloped
developed
securitization
securitizationmarket
market
the
theUnited
UnitedKingdom
Kingdomisisthe
thebiggest
biggestMBS
MBSissuer
issuerininthe
theEuropean
European
market,
market,followed
followedby
byGermany
Germany
the
theadvent
adventof
ofthe
theEuro
Eurohas
hasaccentuated
accentuatedthe
theincreased
increasedtrend
trendinin
securitization
securitizationininEurope
Europe

Mortgage
Mortgagelending
lendinghas
hasgrown
grownin
inRussia
Russiasince
sincethe
theearly
early
2000s
2000sbecause
becauseof
ofchanges
changesin
inproperty
propertyownership
ownershiplaws
laws
7-20

2009, The McGraw-Hill Companies, All Rights