1 Chapter 9 Mortgage Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on mortgages Residential mortgage characteristics Creative mortgage financing Institutional use of mortgage markets Valuation of mortgages Risk from investing in mortgages Mortgage-backed securities Globalization of mortgage markets 3 Background on Mortgages A mortgage is a form of debt that finances investment in property The debt is secured by the property The mortgage is the difference between the down payment and the value to be paid for the property Financial institutions such as savings institutions and mortgage companies originate mortgages They accept mortgage applications and assess the creditworthiness of the applicants The mortgage contract specifies the mortgage rate, the maturity, and the collateral that is backing the loan The originator charges an origination fee The originator may earn a profit from the difference between the mortgage rate and the rate that it paid to obtain funds 4 Background on Mortgages (cont’d) The level of mortgage debt has risen over time Mortgage debt rises at a slower rate during recessions The majority of mortgage debt outstanding is on one- to four-family properties 5 Residential Mortgage Characteristics The mortgage contract should specify: Whether the mortgage is federally insured The amount of the loan Whether the interest rate is fixed or adjustable The interest rate to be charged The maturity Other special provisions 6 Residential Mortgage Characteristics (cont’d) Insured versus conventional mortgages Federally insured mortgages guarantee loan repayment to the lending financial institution The insurance fee is 0.5 percent of the loan amount The guarantor is either the FHA or the VA The maximum mortgage amount is limited by law The volume of FHA loans has consistently exceeded that of VA loans Conventional mortgages can be privately insured The private insurance premium is typically passed to the borrowers 7 Residential Mortgage Characteristics (cont’d) Fixed-rate versus adjustable-rate mortgages A fixed-rate mortgage locks in the borrower’s interest rate over the life of the mortgage The periodic interest payment is constant Financial institutions that hold fixed-rate mortgages are exposed to interest rate risk if funds are obtained from short- term sources Borrowers with fixed-rate mortgages do not benefit from declining rates 8 Residential 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 conditions The formula and frequency of adjustment vary among mortgage contracts A common ARM uses a one-year adjustment with the interest rate tied to the average T-bill rate over the previous year Some ARMs contain an option that allows mortgage holders to switch to a fixed rate within a specified period Most ARMs specify a maximum allowable fluctuation in the mortgage rate per year and over the mortgage life Borrowers with ARMs face uncertainty about future interest rates 9 Residential Mortgage Characteristics (cont’d) Fixed-rate versus adjustable-rate mortgages (cont’d) Using ARMs, financial institutions: Can stabilize their profit margins Face less interest rate risk than with fixed-rate mortgages 10 Residential Mortgage Characteristics (cont’d) Mortgage maturities Since the 1970s, 15-year mortgages have become more popular because of savings in interest expenses Interest rate risk for originators is lower on 15-year mortgages The mortgage rate on 15-year mortgages is typically lower A balloon-payment mortgage requires interest payments for a three- to five-year period when the borrower must pay the full amount of the principal No principal payments are made until maturity, so monthly payments are lower [...]... to sell mortgages Financial institutions that originate mortgages Mortgage companies: Originate mortgages and quickly sell the mortgages they originate Do not maintain large mortgage portfolios Are not as exposed to interest rate risk as other financial institutions Commercial banks and thrift institutions are the primary originators of mortgages 17 Institutional Use of Mortgage Markets (cont’d)... Banks 67% 23 Institutional Use of Mortgage Markets (cont’d) Unbundling of mortgage activities Financial institutions can: Function as mortgage originators and then sell them in the secondary market Sell originated mortgages by maintain the servicing Focus on servicing mortgages originated by other institutions Focus on investing in mortgages Invest in mortgages that it is allowed to... 2,028.53 198,402.48 179 30.09 1,998.44 2,028.53 2,013.43 180 15.10 2,013.43 2,028.53 0.00 13 Creative Mortgage Financing Graduated-payment mortgages Growing-equity mortgages Second mortgages Shared-appreciation mortgages 14 Creative Mortgage Financing (cont’d) A graduated-payment mortgage: Allows the borrower to initially make small payments Results in increased payments over... homes A shared-appreciation mortgage: Allows a home purchaser to obtain a mortgage at a belowmarket interest rate Allows the lender to share in the price appreciation of the home 16 Institutional Use of Mortgage Markets Development of a secondary mortgage market: Allows institutions that originate mortgages to sell them Allows institutional investors to invest in mortgages even if they have... growing-equity mortgage: Allows the borrower to initially make small payments Results in continually increasing payments over time Results in a relatively short payoff time 15 Creative Mortgage Financing (cont’d) A second mortgage: Can be used in conjunction with the primary or first mortgage Often has a shorter maturity than the first mortgage Has a higher interest rate than the first mortgage. .. Institutional Use of Mortgage Markets (cont’d) Securitization is the pooling and repackaging of loans into securities Investors in these securities become the owners of the represented loans Allows for the sale of smaller mortgage loans that cannot be easily sold individually Can reduce a financial institution’s exposure to default risk or interest rate risk 22 Institutional Use of Mortgage Markets (cont’d)...Residential Mortgage Characteristics (cont’d) Mortgage maturities (cont’d) Amortizing mortgages An amortization schedule shows the monthly payments broken down into principal and interest During the early years of a mortgage, most of the payment reflects interest Over time, the interest proportion decreases The lending institution for a fixed-rate mortgage will receive a fixed... matching up sellers and buyers of mortgages in the secondary market Investment banking firms participate by helping institutional investors hedge their mortgage holdings against interest rate risk 24 Valuation of Mortgages The market price of mortgages should equal the present value of their future cash flows: n C + Prin PM = (1 + k )t t =1 ∑ The required rate of return on a mortgage is influenced by the... - 29 Valuation of Mortgages (cont’d) Summary of factors affecting mortgage prices (cont’d) Impact of the September 11 attack on mortgage rates Short-term rates declined by a full percentage point within one month Long-term interest rates declined only slightly The 30-year conventional mortgage declined by only about 25 percentage point over the next month 30 Valuation of Mortgages (cont’d)... changes in mortgage prices Mortgage market participants monitor indicators that may signal future changes in the strength of the economy: Inflation indicators Announcements about the budget deficit Indicators of economic growth in the real estate sector 31 Risk from Investing in Mortgages Interest rate risk Mortgage prices decline in response to an increase in interest rates Mortgages . Background on mortgages Residential mortgage characteristics Creative mortgage financing Institutional use of mortgage markets Valuation of mortgages. Risk from investing in mortgages Mortgage- backed securities Globalization of mortgage markets 3 Background on Mortgages A mortgage is a form of debt