Chapter 9: Mortgage markets

Chapter 9Mortgage MarketsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBackground on mortgagesResidential mortgage characteristicsCreative mortgage financingInstitutional use of mortgage marketsValuation of mortgagesRisk from investing in mortgagesMortgage-backed securitiesGlobalization of mortgage markets2Background on MortgagesA mortgage is a form of debt that finances investment in propertyThe debt is secured by the propertyThe mortgage is the difference between the down payment and the value to be paid for the propertyFinancial institutions such as savings institutions and mortgage companies originate mortgagesThey accept mortgage applications and assess the creditworthiness of the applicantsThe mortgage contract specifies the mortgage rate, the maturity, and the collateral that is backing the loanThe originator charges an origination feeThe originator may earn a profit from the difference between the mortgage rate and the rate that it paid to obtain funds3Background on Mortgages (cont’d)The level of mortgage debt has risen over timeMortgage debt rises at a slower rate during recessionsThe majority of mortgage debt outstanding is on one- to four-family properties4Residential Mortgage CharacteristicsThe mortgage contract should specify:Whether the mortgage is federally insuredThe amount of the loanWhether the interest rate is fixed or adjustableThe interest rate to be chargedThe maturityOther special provisions5Residential Mortgage Characteristics (cont’d)Insured versus conventional mortgagesFederally insured mortgages guarantee loan repayment to the lending financial institutionThe insurance fee is 0.5 percent of the loan amountThe guarantor is either the FHA or the VAThe maximum mortgage amount is limited by lawThe volume of FHA loans has consistently exceeded that of VA loansConventional mortgages can be privately insuredThe private insurance premium is typically passed to the borrowers6Residential Mortgage Characteristics (cont’d)Fixed-rate versus adjustable-rate mortgagesA fixed-rate mortgage locks in the borrower’s interest rate over the life of the mortgageThe periodic interest payment is constantFinancial institutions that hold fixed-rate mortgages are exposed to interest rate risk if funds are obtained from short-term sourcesBorrowers with fixed-rate mortgages do not benefit from declining rates7Residential Mortgage Characteristics (cont’d)Fixed-rate versus adjustable-rate mortgages (cont’d)An adjustable-rate mortgage (ARM) allows the mortgage rate to adjust to market conditionsThe formula and frequency of adjustment vary among mortgage contractsA common ARM uses a one-year adjustment with the interest rate tied to the average T-bill rate over the previous yearSome ARMs contain an option that allows mortgage holders to switch to a fixed rate within a specified periodMost ARMs specify a maximum allowable fluctuation in the mortgage rate per year and over the mortgage lifeBorrowers with ARMs face uncertainty about future interest rates8Residential Mortgage Characteristics (cont’d)Fixed-rate versus adjustable-rate mortgages (cont’d)Using ARMs, financial institutions:Can stabilize their profit marginsFace less interest rate risk than with fixed-rate mortgages9Residential Mortgage Characteristics (cont’d)Mortgage maturitiesSince the 1970s, 15-year mortgages have become more popular because of savings in interest expensesInterest rate risk for originators is lower on 15-year mortgagesThe mortgage rate on 15-year mortgages is typically lowerA balloon-payment mortgage requires interest payments for a three- to five-year period when the borrower must pay the full amount of the principalNo principal payments are made until maturity, so monthly payments are lower10Residential Mortgage Characteristics (cont’d)Mortgage maturities (cont’d)Amortizing mortgagesAn amortization schedule shows the monthly payments broken down into principal and interestDuring the early years of a mortgage, most of the payment reflects interestOver time, the interest proportion decreasesThe lending institution for a fixed-rate mortgage will receive a fixed amount of equal periodic payments over a specified period of timeThe payment amount depends on the principal, interest rate, and maturity11Writing an Amortization ScheduleConsider a 15-year (180-month) $200,000 mortgage at an annual interest rate of 9 percent. Develop an amortization schedule for this mortgage showing all appropriate columns. Show the first three payments and the last two payments on the schedule. The monthly mortgage payment is $2,028.53.12Writing an Amortization Schedule (cont’d)Payment NumberPayment of InterestPayment of PrincipalTotal PaymentRemaining Loan Balance1$1,500.00$528.53$2,028.53$199,471.4721,496.04532.502,028.53198,938.9731,492.04536.492,028.53198,402.48.....17930.091,998.442,028.532,013.4318015.102,013.432,028.530.0013Creative Mortgage FinancingGraduated-payment mortgagesGrowing-equity mortgagesSecond mortgagesShared-appreciation mortgages14Creative Mortgage Financing (cont’d)A graduated-payment mortgage:Allows the borrower to initially make small paymentsResults in increased payments over the first 5 to 10 years, at which time payments level offIs tailored for families who anticipate higher incomeA growing-equity mortgage:Allows the borrower to initially make small paymentsResults in continually increasing payments over timeResults in a relatively short payoff time15Creative Mortgage Financing (cont’d)A second mortgage:Can be used in conjunction with the primary or first mortgageOften has a shorter maturity than the first mortgageHas a higher interest rate than the first mortgage because of increased default riskIs often offered by sellers of homesA shared-appreciation mortgage:Allows a home purchaser to obtain a mortgage at a below-market interest rateAllows the lender to share in the price appreciation of the home16Institutional Use of Mortgage MarketsDevelopment of a secondary mortgage market:Allows institutions that originate mortgages to sell themAllows institutional investors to invest in mortgages even if they have no desire to originate or service themAllows institutional investors to sell mortgagesFinancial institutions that originate mortgagesMortgage companies:Originate mortgages and quickly sell the mortgages they originateDo not maintain large mortgage portfoliosAre not as exposed to interest rate risk as other financial institutionsCommercial banks and thrift institutions are the primary originators of mortgages17Institutional Use of Mortgage Markets (cont’d)Participation in the secondary marketFinancial institutions sell mortgages they cannot finance in the secondary marketBuyers are savings institutions, pension funds, life insurance companies, and mutual funds18Institutional Use of Mortgage Markets (cont’d)Roles of Ginnie Mae, Fannie Mae, and Freddie MacFannie Mae:Issues debt securities and uses the proceeds to purchase mortgages in the secondary market Has more than $800 billion of securities outstandingIs exempt from state income tax and has credit lines from the TreasuryIs commonly perceived to be backed by the governmentGinnie Mae:Is a wholly-owned corporation by the federal governmentSupplies funds to low- and moderate-income homeowners indirectly by facilitating the flow of funds into the secondary mortgage marketHas more than $600 billion of securities outstanding19Institutional Use of Mortgage Markets (cont’d)Roles of Ginnie Mae, Fannie Mae, and Freddie Mac (cont’d)Freddie Mac:Ensures that sufficient funds flow into the mortgage marketIs exempt from state income tax and has lines of credit with the TreasuryHas more than $600 billion in debt securities outstandingAs a result of these three entities, the secondary mortgage market:Is very liquidHas a lot of funding20Institutional Use of Mortgage Markets (cont’d)Roles of Ginnie Mae, Fannie Mae, and Freddie Mac (cont’d)The Freddie Mac accounting scandalSince 2000, Freddie Mac invested in corporate bonds, strip malls, and hotelsThe company used irregular accounting techniques to stabilize earnings and hide its increased riskFreddie Mac was required to restate its 2000-2002 earnings and replaced its CEO and other senior managers21Institutional Use of Mortgage Markets (cont’d)Securitization is the pooling and repackaging of loans into securitiesInvestors in these securities become the owners of the represented loansAllows for the sale of smaller mortgage loans that cannot be easily sold individuallyCan reduce a financial institution’s exposure to default risk or interest rate risk22Institutional Use of Mortgage Markets (cont’d)23Institutional Use of Mortgage Markets (cont’d)Unbundling of mortgage activitiesFinancial institutions can:Function as mortgage originators and then sell them in the secondary marketSell originated mortgages by maintain the servicingFocus on servicing mortgages originated by other institutionsFocus on investing in mortgagesInvest in mortgages that it is allowed to serviceBrokerage firms participate by matching up sellers and buyers of mortgages in the secondary marketInvestment banking firms participate by helping institutional investors hedge their mortgage holdings against interest rate risk24Valuation of MortgagesThe market price of mortgages should equal the present value of their future cash flows:The required rate of return on a mortgage is influenced by the risk-free rate, credit risk, and the lack of liquidity:25Valuation of Mortgages (cont’d)Factors that affect the risk-free interest rateThe risk-free rate is driven by inflationary expectations, economic growth, the money supply, and the budget deficit:Inflationary expectationsHigher expected inflation places upward pressure on interest rates and on the required return26Valuation of Mortgages (cont’d)Factors that affect the risk-free interest rate (cont’d)Economic growthAn increase in economic growth causes an increase in the risk-free rate and in the required rate of returnMoney supply growthA high level of money supply growth places downward pressure on interest rates and on the required rate of returnBudget deficitAn increase in the budget deficit increases government demand for loanable funds and places upward pressure on the risk-free rate and the required rate of return27Valuation of Mortgages (cont’d)Factors that affect the risk premiumThe average risk premium can change in response to a change in economic growth:Strong economic growth improves income or cash flows and reduces default risk28Valuation of Mortgages (cont’d)Summary of factors affecting mortgage pricesPrice movements in a mortgage can be modeled as:29Valuation of Mortgages (cont’d)Summary of factors affecting mortgage prices (cont’d)Impact of the September 11 attack on mortgage ratesShort-term rates declined by a full percentage point within one monthLong-term interest rates declined only slightlyThe 30-year conventional mortgage declined by only about .25 percentage point over the next month30Valuation of Mortgages (cont’d)Indicators of changes in mortgage pricesMortgage market participants monitor indicators that may signal future changes in the strength of the economy:Inflation indicatorsAnnouncements about the budget deficitIndicators of economic growth in the real estate sector31Risk from Investing in MortgagesInterest rate riskMortgage prices decline in response to an increase in interest ratesMortgages are commonly financed by financial institutions with short-term depositsMortgages can generate high returns when interest rates fall, but gains are limited because borrowers tend to refinance32Risk from Investing in Mortgages (cont’d)Interest rate risk (cont’d)Limiting exposure to interest rate riskFinancial institutions can:Sell mortgages shortly after originating themMaintain adjustable-rate residential mortgagesInvest in fixed-rate mortgages with a short time remaining to maturity33Risk from Investing in Mortgages (cont’d)Prepayment riskPrepayment risk is the risk that a borrower may prepay the mortgage in response to a decline in interest ratesThe investor receives payment and has to reinvest at the lower interest rateLimiting exposure to prepayment riskFinancial institutions can sell loans shortly after originating them or invest in adjustable-rate mortgages34Risk from Investing in Mortgages (cont’d)Credit riskCredit risk is the possibility that borrowers will make late payments or even defaultThe probability of default is influenced by economic conditions and by:The level of equity invested by the borrowerThe borrower’s income levelThe borrower’s credit historyLimiting exposure to credit riskFinancial institutions can purchase insuranceFinancial institutions can maintain the mortgages they originate35Risk from Investing in Mortgages (cont’d)Measuring riskFinancial institutions attempt to estimate the future cash flows to be generated from mortgage portfolios in various future periodsPrepayment risk and credit risk create uncertainty about future paymentsSensitivity analysis can be used to forecast cash flows for different scenariosReview of financial statements to monitor riskWhen interest rates rise, the reported value of mortgage-backed securities are not revisedA loss in the value of mortgage-backed securities is only recognized when the financial institution sells them at a loss36Mortgage-Backed SecuritiesMortgage-backed securities are securities backed by mortgage loansIssuing mortgage-backed securities is an alternative to selling mortgages outright in the secondary marketThe most common are mortgage pass-through securitiesA group of mortgages held by trustee serves as collateralInterest and principal on the mortgages are sent to the financial institution, which passes them through to the owners of the mortgage-backed securitiesFinancial institutions earn fees from servicing the mortgages while avoiding exposure to interest rate risk and credit risk37Mortgage-Backed Securities (cont’d)Interest rate risk on mortgage-backed securitiesPayments received from pass-through securities are tied to the payments sent to security ownersInstitutions can insulate their profit margin from interest rate fluctuations38Mortgage-Backed Securities (cont’d)Prepayment risk on mortgage-backed securitiesOwners of pass-through securities are exposed to prepayment risk because of the borrower’s right to prepay in part or in full without penaltyOwners of mortgage-backed securities are also subject to the possibility that prepayments are decelerated in response to rising interest rates39Mortgage-Backed Securities (cont’d)Ginnie Mae mortgage-backed securitiesGinnie Mae guarantees time payment of principal and interest to investors in FHA or VA mortgagesAll mortgages pooled together must have the same interest rateThe interest rate received by purchasers is about 50 basis points lessFannie Mae mortgage-backed securitiesFannie Mae issues mortgage-backed securities and uses the funds to purchase mortgagesChannels funds from investors to financial institutions that desire to sell their mortgagesReceives a fee for guaranteeing timely payment of principal and interest to the holders of the mortgage-backed securitiesSome mortgage-backed securities are stripped by separating the principal and interest payments40Mortgage-Backed Securities (cont’d)Publicly issued pass-through securities (PIPs)Similar to Ginnie Mae mortgage-backed securitiesBacked by conventional rather than FHA or VA mortgagesInsured through private insurance companiesParticipation certificates (PCs)Freddie Mac sells participation certificates (PCs) and uses the proceeds to finance the origination of conventional mortgages from financial institutions41Mortgage-Backed Securities (cont’d)Collateralized mortgage obligations (CMOs):Have semiannual interest paymentsAre segmented into tranches, with the first tranch having the quickest paybackAre attractive because investors can choose a class that fits their maturity desiresAre sometimes segmented into interest-only (IO) and principal-only (PO) classes42Mortgage-Backed Securities (cont’d)Mortgage-backed securities for small investorsUnit trusts have been created that allow small investors to participatee.g., a portfolio of Ginnie Mae pass-through securities is sold in $1,000 piecesSome mutual funds offer Ginnie Mae funds43Globalization of Mortgage MarketsNon-U.S. financial institutions hold mortgages on U.S. property and vice versaThe use of interest rate swaps to hedge mortgages in the U.S. often involves a non-U.S. counterpartMortgage market participants closely follow international economic conditions because of the potential impact on interest ratesA weaker dollar leads to higher inflation and higher interest rates44