Mortgage Markets Mortgage •Used for finance real estate purchases •Saving institutions, mortgage companies, commercial banks •Primary market •Secondary market •For needs of long-term funds to purchase real estate •For creditors lending long-term funds for real estate purchase • Background on Mortgage •Debt created to finance investment in real estate •Secured by property •Saving institutions and mortgage companies and commerical banks •Intermediaries •Rating of applicants •Mortgage contract •Martgage rate and maturity and collateral • • Criteria Used to measure Creditworthiness •Reflect the rospective borrower´s to repay loan •Level of equity invested by borrower •Borrower´s income level •Borrower´s credit history • Classifications of Mortgages •Prime versus Subprime Mortgages •Insured versus Conventional Mortgages • Insured vs. Conventional Mortgages •Federal and private insurance guarantees repayment in the event of borrower default •Limits on amounts, borrower requirements •Borrower pays insurance premiums •Federal insurers include Federal Housing Administration and Veterans Administration • Types of Residential Mortgages •Fixed-rate mortgages •Adjustable-rate mortgages •Graduated-payment mortgages •Second martgages •Shared-appreciation mortgages Fixed Rate vs. Adjustable Mortgages •Fixed rate loans have a constant, unchanging rate •Interest rate risk can hurt lender rate of return •If interest rates rise in the market, lender’s cost of funds increases •No matching increase in fixed-rate mortgage return •Borrowers lock in their cost and have to refinance to benefit from lower market rates • Fixed-Rate vs. Adjustable Mortgages •Fixed monthly payment includes •Interest owed first •Balance to principal •Interest on the declining principal balance •Calculating monthly payment •Principal borrowed = PV •Number of months to maturity = years ´ 12 = N •Rate/12 = I • Calculate PMT • Example – geometric sequence •Calculate the monthly payment for a $330,000 home. The new owner has made a $70,000 down payment and plans to finance over 30 years at the current fixed rate of 7%. • • $330,000 – $70,000 = $260,000 PV (original • investment of the financial institution) • 30 x 12 = 360 N; 7/12 = I; Calculate PMT • • $330,000 – $70,000 = $260,000 PV (original • investment of the financial institution) • 30 ´ 12 = 360 N; 7/12 = I; Calculate PMT • PMT = $1,729.79 • • Fixed-Rate vs. Adjustable Mortgages •Adjustable-rate mortgages •Rates and the size of payments can change •Maximum allowable fluctuation over year and life of loan •Upper and lower boundaries for rate changes •Lenders stabilize profits as yields move with cost of funds •Uncertainty for borrowers whose mortgage payments can change over time • Comparison of Rates on Newly Originated Fixed-Rate and Adjustable-Rate Mortgages over Time Mortgage Maturities •Trend shows increased popularity of 15-year loans •Lender has lower interest rate risk if the term or maturity of the loan is lower •Borrower saves on interest expense over loan’s life but monthly payments higher • Types of Mortgage •Graduated-Payment Mortgages (GPMs) •Growing-Equity Mortgages •Second Mortgages •Shared-Appreciation Mortgages •Baloon Payment Mortgages Creative Mortgage Financing •Graduated-payment mortgage (GPM) •Small initial payments •Payments increase over time then level off •Assumes income of borrower grows •Growing-equity mortgage •Like GPM low initial payments •Unlike GPM, payments never level off •Balloon payments •Principal not paid until maturity •Forces refinancing at maturity • • Creative Mortgage Financing •Second mortgage used in conjunction with first or primary mortgage • Shorter maturity typically for 2nd mortgage •1st mortgage paid first if default occurs so 2nd mortgage has a higher rate •Shared-appreciation mortgage •Below market rate but lender shares in home’s price appreciation • Institutional Use of Mortgage Markets •Mortgage companies •Originate and quickly sell loans •Do not maintain large portfolios •Government agencies including Fannie Mae and Freddie Mac •Brokerage firms •Investment banks •Finance companies • Activities in the Mortgage Markets •How the secondary market facilitates mortgage activities •Selling loans •Origination, servicing and funding are separate business activities and may be “unbundled” •Secondary market exists for loans •Securitization •Pool and repackage loans for resale •Allows resale of loans not easily sold on an individual basis • Use of Mortgage-Backed Securities •Securitization is an alternative to the direct sale of a loan •Institution can securitize loans to avoid interest rate risk and credit risk while still earning service fees •Payments passed through to investors can vary over time •Morgage-backed securities (MBS) or pass-through securities • • Types of Mortgage-Backed securities •Ginnie Mae mortgage-backed securities •Fannie Mae mortgage-backed securities •Particiaption certificates •Collateralized mortgage (debt) obligations (CMOs, CDSs) The Federal National Mortgage Association (Fannie Mae) The Federal Home Loan Mortgage Association (Freddie Mac) provide liquidity • Use of Mortgage-Backed Securities •Mortgage-backed securities for small investors •In the past, high minimum denominations •Unit trusts created to allow small investor participation •Mutual funds •Advantages •Can purchase in secondary market without purchasing the need to service loans •Insured •Liquid • Risk of Mortgage-Backed Securities 1.Credit risk: the risk that borrower will make a late payment or will default. 2.Interest rate risk: the risk that value of mortgage will fall when interest rates rise. 3.Prepayment risk: the risk that the borrower will prepay the mortgage when interest rates fall. • Institutional Use of Mortgage Markets •Federally related mortgage pools •37% of all mortgages, mostly residential •Commercial banks •Dominate commercial mortgage market •Hold 23.3% of all mortgages •Savings institutions •Primarily residential mortgages •Hold 10% of all mortgages •Life insurance companies •Commercial mortgages •Hold 3% of all mortgages • Valuation of Mortgages •Market price of mortgages is present value of cash flows • Valuation of Mortgages •Periodic payment commonly includes payment of interest and principal •Required rate of return determined by risk-free rate, credit risk and liquidity •Risk-free interest rate components and relationship •+ inflationary expectations •+ economic growth •– change in the money supply •+ budget deficit • Valuation of Mortgages •Economic growth affects the risk premium •Strong growth improves borrowers’ income and cash flows and reduces default risk •Weak growth has the opposite affect •Potential changes in mortgage prices monitored by reviewing inflation, economic growth, deficits, housing, and other predictor economic statistics • U.S. Fiscal Policy U.S. Monetary Policy U.S. Economic Conditions Prepayment Risk Premium of Issuer Price of Fixed-Rate Mortgage Risk Premium of Issuer Issuer’s Unique Conditions Long-T erm Risk-Free Interest Rate (T -Bond Rate) Issuer’s Industry Commercial Mortgages) Conditions (for on the Fixed-Rate Mortgage Required Return Risk from Investing in Mortgages •Interest rate risk •Present value of cash flows or value of mortgage changes as interest rate changes •Long-term fixed-rate mortgages financed by short-term funds results in risks •To limit exposure to interest rate risk •Sell mortgage shortly after origination (but rate may change in that short period of time) •Make adjustable rate mortgages • Risk from Investing in Mortgages •Prepayment risk •Borrowers refinance if rates drop by paying off higher rate loan and financing at a new, lower rate •Investor receives payoff but has to invest at the new, lower interest rate •Manage the risk with ARMs or by selling loans • Risk from Investing in Mortgages •Credit risk can range from default to late payments •Factors that affect default •Level of borrower equity •Loan-to-value ratio often used •Higher use of debt, more defaults •Borrowers income level •Borrower credit history •Lenders try to limit exposure to credit risk •