Financial Markets and InstitutionLECTURE 8THE MORTGAGE MARKET

Learning Outcome At the end of this chapter, students will be able to Discuss the characteristics of residential mortgage.Compute the loan amortization. Discuss risks from investing in mortgage.Distinguish the types of mortgage loans. Discuss on the securitization of mortgage.

What Are Mortgages?A long-term loan secured by real estateAn amortized loan whereby a fixed payment pays both principal and interest each month

Total Amount of Mortgage Debt Outstanding in U.S.Source: http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm

What Are Mortgages? HistoryMortgages were used in the 1880s, but massive defaults in the agricultural recession of 1890 made long-term mortgages difficult to attain until WWI.During WWI, property market boom and mortgage lending expanded rapidly until Great Depression. Until post-WWII, most mortgage loans were short-term balloon loans with maturities of five years or less.Balloon loan borrowers paid interest only for three to five years, then the loan due. If good customer renew the loan. If bad customer not renew, borrower will default.

What Are Mortgages? HistoryBalloon loans, however, caused problems during the depression. Typically, the lender renews the loan. But, with so many Americans out of work, lenders could not continue to extend credit. As a part of the depression recovery program, the federal government assisted in creating the standard 30-year mortgage that we know today.

Characteristics of the Residential MortgageMortgages can be roughly classified along the following three dimensions:Mortgage Interest RatesLoan TermsMortgage Loan Amortization

Characteristics of the Residential Mortgage: Mortgage Interest RatesThe stated rate on a mortgage loan is determined by three rates:Market Rates: general rates on Treasury bonds (relationship Positive)Term: longer-term mortgages have higher rates (relationship Positive)Discount Points: a lower rates negotiated for cash upfront. Determine if the reduced interest rate compensate the increase up-front expenses. (relationship negative)

Characteristics of the Residential Mortgage: Mortgage Interest RatesCurrent mortgage interest rates http://www.interest.com/

Characteristics of the Residential Mortgage: Mortgage Interest Rates & PointsA difficult decision when getting a mortgage is whether to pay points (cash) upfront in exchange for a lower interest rate on the mortgage. Suppose you had to choose between a 12% 30-year mortgage or an 11.5% mortgage with 2 discount points. Which should you choose? Assume you wished to borrow $100,000.A variety of fun mortgage calculatorshttp://interest.com/calculators/index.shtml

Characteristics of the Residential Mortgage: Mortgage Interest Rates & PointsExamine the 12% mortgage. n = 360, i = 0.12/12=0.01, PV = 100,000, Calculate the monthly repayment (PMT)

PMT = $1,028.61

Characteristics of the Residential Mortgage: Mortgage Interest Rates & PointsExamine the 11.5% mortgage.

n = 360, i = 0.115/12 = 0.0096, PV = 100,000 PMT = $990.29

Characteristics of the Residential Mortgage: Mortgage Interest Rates & PointsSo, paying the points will save you $38.32 each month. However, you have to pay $2,000 upfront.You can see that the decision depends on how long you want to live in the house, keeping the same mortgage.If you only want to live there 12 months, clearly the $2,000 upfront cost is not worth the monthly savings.

Characteristics of the Residential Mortgage: Loan TermsMortgage loan contracts contain many legal terms that need to be understood. Most protect the lender from financial loss.Collateral: usually the real estate being financeDown payment: a portion of the purchase price paid by the borrower

Characteristics of the Residential Mortgage: Loan TermsPrivate Mortgage Insurance (PMI): insurance against default by the borrower. Guarantee to make up any discrepancies between the value of the property and the loan amount to the bank. Qualifications: includes credit history, employment history, etc., to determine the borrowers ability to repay the mortgage as specified in the contact

Characteristics of the Residential Mortgage: Loan AmortizationMortgage loans are amortized loans. This means that a fixed, level payment will pay interest due plus a portion of the principal each month. It is designed so that the balance on the mortgage will be zero when the last payment is made.

Characteristics of the Residential Mortgage: Loan Amortization Schedule Interest paid = Beginning balance x (I /12)

Principal paid = PMT - I

Discuss risks from investing in mortgage.

Credit risk: The risk that borrower will make a late payment or default.Interest rate risk: The risk that the value of mortgage will fall when interest rates rise.Prepayment risk: The risk that the borrower will repay the mortgage when interest rates fall.

Major Types of Mortgage LoansInsured vs. Conventional MortgagesInsured mortgage guaranteed by Fed Housing Administration (FHA) or Veterans Administration (VA)Must meet certain qualifications: having served in military, having low income, can only borrow up to certain amount. Qualified borrowers required to pay a very low or zero down payment.

Major Types of Mortgage LoansInsured vs. Conventional MortgagesConventional mortgages are not guaranteed by those agencies. PMI insured many conventional mortgages if loan-to-value ratio exceeding 80%.

Major Types of Mortgage LoansFixed-Rate Mortgages: the interest rate is fixed for the life of the mortgage.Adjustable-Rate Mortgages: the interest rate can fluctuate within certain parameters. In Malaysia, it tie the interest rate to the Base Lending Rate (BLR) 6.85%.

Other Types of Mortgage LoansGraduated-Payment Mortgages (GPMs)Used by borrowers who expect their incomes to rise.Lower payments in the early periods. It may not even sufficient to cover the interest expenses, resulted in increased principal balance. Longer loan term as compared to conventional loans.

Other Types of Mortgage LoansGrowing Equity Mortgages (GEMs)Help borrowers to pay off loan in a shorter period of time. Initial payment same as that of the conventional loan. Payment will increase over time Reduce principal more quickly.No prepayment penalty.Second MortgagesLoan that are secured by the same real estate that is used to secured the 1st mortgage.Junior to the original loan.

Other Types of Mortgage LoansReverse Annuity Mortgages (RAMs)Benefit to those retiree.No monthly payment is required. Borrowers estate will sells the property to retire the debt when borrower pass away.

Types of Mortgage Loans

Loan ServicingMost mortgages are immediately sold to another investor by the originator. This frees cash to originate another loan and generate additional fee income.Still, someone has to collect the monthly payments and keep records. This is known as loan servicing, and servicers usually keep a portion of the payments received to cover their costs.

Loan ServicingIn all, there are three distinct elements in mortgage loans:The originator packages the loan for an investorThe investor holds the loanThe servicing agent handles the paperwork

Secondary Mortgage MarketThe secondary mortgage market was originally established by the federal government after WWII when it created Fannie Mae to buy mortgages from thrifts.Fannie Mae fund these purchase by selling bonds. The market experienced tremendous growth in the early to mid-1980, and has continued to remain a strong market in the U.S. The emerged of mortgage bank.

Securitization of MortgagesThe securitization of mortgages developed because of problems dealing with single mortgages: Risk of default.A pool of mortgages eliminates part of this problem through diversification.

Securitization of MortgagesThe mortgage-backed security (MBS) was created. Pools including hundreds of mortgages were gathered, and the rights to the cash flows generated by the mortgages were sold as separate securities.At first, simple pass-through securities were designed.

Securitization of Mortgages: The Mortgage Pass-ThroughDefinition: A security that has the borrowers mortgage payments pass through the trustee before being disbursed to the investorsInvestors face the prepayment risk.Borrowers will prepay whenever the interest rate fall. When they prepare, investors who holding asset-backed securities have to look for alternative investments that provide lower return (due to lower interest rate now).

Securitization of Mortgages: Types of Pass-ThroughsThere are three types of popular pass-through securities. GNMA Pass-ThroughsFHLMC Pass-ThroughsPrivate Pass-Throughs

Subprime Mortgages and CDOsSubprime loans are loans to borrowers who have poor credit ratings or loan is larger than their income. In 2000, only 2% of mortgages were subprime. This climbed to 17% by 2006.This was due to the development of securitized market. The average FICO score was 624 for subprime borrowers. Prime mortgage borrowers were 742.

Subprime Mortgages and CDOsHowever, these mortgages were hailed by politicians and bankers alike. They helped less-then-perfect borrowers secure the American Dream of owning a home. And since real estate prices cant fall (right?), there is little risk involved.

Subprime Mortgages and CDOsSeveral factors lead to this dramatic increase in subprime lending:New mortgage products (2/28 ARMS, Option ARMS, NoDoc loans) made expensive houses affordable (sort-of).The creation of CDOs helped create deal flow to continue lending in subprime markets.When house prices were increasing, subprime borrowers had an out if problems arose.

The Real Estate BubbleBetween 2000 and 2005 home prices increased an average of 8% per year. The run up in prices was cause by two factors:The increase in subprime loans created new demand for housingReal estate speculatorsReal estate market cooled in 2006/07 cause many speculators hard to sell off properties and were forced into default.

ReferencesMishkin & Eakins. 2012. Financial Markets and Institutions, 7th ed. Pearson.Tutorial 8 pg. 381 i) Questions 1,2,6,9,14ii) Quantitative problems 1,2,3,4

The table shows roughly $13 trillion outstanding. How does this compare to the value of all the companies listed on the NYSE?

*Balloon loan borrowers paid interest only for three to five years, then the loan due. If good customer renew the loan. If bad customer not renew, borrower will default. **Mortgage rate stay above the Treasury bonds rate but track along with them. *Use PVA method to find PMT *PMI is required for loan with down payment less than 20%. PMI make up any discrepancy between the value of property and loan balance (Loan balance = 100k, property value = 20k, PMI pay only 20k when borrower default.

2. In Malaysia, we have MRTA settle your housing loan in the event anything to you. Cover unpaid portion your loan.

3. Lender will sell their mortgage loan to fed agencies in secondary mortgage market. So must make sure it follows all requirement. *PVA = 130k, PMT = 999.59Ending balance for 1st mth = 130k 78.75 =129921.24

Interest payment for 1st mth = 130k x (0.085/12) = 920.83Interest payment for 24th mth =128040.25 x (0.085/12) = 906.95*

2. Conventional mortgage:Not guaranteed.

*Malaysia banks are not allowed to offer fixed-rate mortgages. Now, only insurance companies like AIA is allowed to offer this. **Borrowers will prepay whenever the interest rate fall. When they prepare, investors who holding asset-backed securities have to look for alternative investments that provide lower return (due to lower interest rate now). *