THE MORTGAGE MARKET Instructor: Mahwish Khokhar

THE MORTGAGE MARKET

Instructor: Mahwish KhokharCHAPTER 23THE MORTGAGE MARKETThe mortgage market is a collection of markets, which includes a primary (or origination) market and a secondary market where mortgages trade.

WHAT IS A MORTGAGE?

By definition, a mortgage is a pledge of property to secure payment of a debt. Typically, property refers to real estate, which is often in the form of a house; the debt is the loan given to the buyer of the house by the lender.Thus, a mortgage might be a pledge of a house to secure payment of a loan. If a homeowner (the mortgagor) fails to pay the lender (the mortgagee), the lender has the right to foreclose the loan and seize the property in order to ensure that it is repaid.

Contd..When the loan is solely based on the credit of the borrower and on the collateral for the mortgage, the mortgage is said to be a conventional mortgage. The lender also may take out mortgage insurance to provide a guarantee for the fulfilment of the borrowers obligations. There are three forms of mortgage insurance guaranteed by the US government if the borrower can qualify: Federal Housing Administration FHA, Veterans Administration VA, and Rural Housing Service Insurance RHS.

Contd..There are also private mortgage insurers such as Mortgage Guaranty Insurance Company (owned by Sears, Roebuck). The cost of the mortgage is paid to the guarantor by mortgage originator but passed along to the borrower in the form of higher mortgage payments. The types of real estate properties that can be mortgaged are divided into two broad categories:Single-family (one-to-four-family) residential and commercial properties. It includes houses, condominiums, cooperatives, and apartments.Multifamily properties(apartments, office buildings, industrial properties, shopping centres, hotels and health care properties).

MORTGAGE ORIGINATION

The original lender is called the mortgage originator. The principal originators of residential mortgage loans are thrifts, commercial banks, and mortgage bankers. Other private mortgage originators are life insurance companies and to a much lesser extent, pension funds. The mortgage originators may generate income from mortgage activity in one or more ways. First, they typically charge an origination fee. This fee is expressed in terms of points, where each point represents 1% of the borrowed funds.

Contd..For example, an origination fee of two points on a $100,000 mortgage loan is $2000. Originators also may charge application fees and certain processing fees. The second source of revenue is the profit that might be generated from selling a mortgage at a higher price than it originally cost. This profit is called secondary market profit. If the mortgage rates rise, the originator will realize loss when the mortgage is sold in the secondary market.The originators may also service the mortgage they originate, for which they obtain a servicing fee. It involves collecting monthly payments from mortgagors and forwarding proceeds to the original owner of the loan.

MORTGAGE ORIGINATION PROCESSSomeone who wants to borrow funds to purchase home will apply for a loan from a mortgage originator. The potential homeowner will complete the application form, which provides financial information about the applicant, and pays an application fees; then the mortgage originator performs a credit evaluation of the applicant. The two primary factors in determining whether or not the funds will be lent are the:Payment to income PTI ratioLoan to value LTV ratio

Contd..The first is the ratio of monthly payments to monthly income, which measures the ability of the applicant to make monthly payments. The lower this ratio, greater the likelihood of the applicant to meet the required payments.The LTV is the ratio of the amount of the loan to the market value of the property. The lower this ratio, greater the protection for the lender if the applicant defaults on the payments and the lender must repossess and sell the property.

THE RISKS ASSOCIATED WITH MORTGAGE ORIGINATION

The loan applications being processed and the commitments made by a mortgage originator together are called its pipeline. Pipeline risk refers to the risks associated with originating mortgages. This risk has two components:Price RiskFallout Risk

Contd..Price risk refers to the adverse effects on the value of the pipeline if mortgage rates rise. If mortgage rates rise, the mortgage originator has made commitments at lower mortgage rate, it will either have to sell the mortgages when they close at a value below the funds lent to homeowners, or retain the mortgages as a portfolio investment earning a below market mortgage rate. The mortgagor faces the same risk when the borrower fix the rate at the time of application is submitted.

Contd..Fallout risk is a risk that the applicant or those who were issued commitments letters will not close the transaction. The chief reason that the potential borrowers will cancel the commitments or withdraw their mortgage application is that mortgage rates have declined sufficiently so that it is viable to find other sources of the funds.

Contd..The fallout risk results from the fact that the mortgage originator gives the right not the obligation to the borrower to close the transaction. There are other factors too like unfavourable property inspection report or purchase could have been predicted on a change in the employment but it did not happen. The mortgage originators protect themselves from the pipeline risks discussed above by signing the commitment from the borrower.

TYPES OF MORTGAGE DESIGNSBetween the 1930s and early 1970s, only one type of mortgage loan was available in the US: Fixed-Rate, Level-Payment, Fully Amortized Mortgages. The deficiencies of this mortgage design commonly referred to as the traditional mortgage, led to the introduction of new mortgage designs.

Contd..Fixed-Rate, Level-Payment, Fully Amortized MortgagesThe basic idea behind the design of traditional mortgage is that the borrower pays interest and repays principal in equal instalments over an agreed-upon period of time called the maturity or the term of the mortgage.Thus, at the end the loan has to be fully amortized-means there is no mortgage balance remaining. The interest rate is usually above the risk free rate because of the servicing costs.

Contd..Characteristics of Traditional Mortgage:Each monthly mortgage payment for a level-payment, fixed-rate mortgage is due on first of each month and consists of: Interest of 1/12th of the fixed annual interest rate times the amount of the outstanding mortgage, andA repayment of a portion of the outstanding mortgage balance (Principal)

Contd..There are two significant problems associated with the traditional mortgage design. In the presence of high and variable inflation this mortgage design suffers from two problems:Mismatch problemTilt problemThe mismatch problem occurred in post-World War-II period when depository institutions borrowed short and lent very long. With the rise in inflation rate the mismatch problem occurred.

Contd..Another mismatch problem is caused by the Balance sheet and income statement. The difference between the lending and borrowing rates will cause the lending institutions to become technically insolvent, in the sense that the market value of its assets will be insufficient to cover its liabilities.The tilt problem refers to what happens to the real burden of the mortgage payments over the life of the mortgage as a result of inflation. If the general price level rises, the real value of the mortgage payments will decline over time.

Contd..

Adjustable-Rate MortgagesOne way to resolve the mismatch problem is to redesign the traditional mortgage so as to produce an asset, whose return would match the short-term market rates, thus better matching the cost of the liabilities. One instrument that satisfies these requirements and has won considerable popularity is called the Adjustable-Rate Mortgage.

Contd..Characteristics of the Adjustable-Rate Mortgage:ARM calls for resetting the interest rate periodically, in accordance with some appropriately chosen index reflecting short term market rates.The ARM contracts currently popular in the US call for resetting the interest rate every month, six months, years, two years or three years.

Contd..Balloon/Reset Mortgages:Another type of ARM is the balloon/reset mortgage. The main difference between a balloon/reset mortgage design and the traditional mortgage is that the mortgage rate is reset less frequently.It is long been used in Canada with the name of rollover mortgage. In this type of mortgage the borrower is given long-term financing by the lender but at specified future dates the contract rate is renegotiated.

Contd..Graduated-Payment MortgageGPM is one whose nominal monthly payments grow at a constant rate during the life of the contract, thereafter levelling off. The mortgage rate is fixed for the life of the mortgage loan, despite the fact that the monthly payments increase gradually. (Read page 434)

Contd..Price-Level-Adjusted MortgageThis mortgage design is similar to the traditional mortgage except that monthly payments are designed to be the level of purchasing power terms rather than in nominal terms, and that the fixed rate is the real rate rather than the nominal rate. To compute the monthly payments under PLAM the terms of the contract must be specified as:The real interest rateThe term of the loanThe index to be used (the CPI index)

Contd..Dual-Rate MortgageAlso known as inflation-proof mortgage, the dual-rate mortgage DRM is similar in spirit and objective of PLAM: payments start low at current mortgage rates of around 10%, payments would start around 30% to 40% below those required by the traditional mortgage or by ARM. They then rise smoothly to the inflation rate.