Mortgage Markets

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Chapter 9
Mortgage Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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 amount of equal periodic payments over a specified period
of time

The payment amount depends on the principal, interest rate, and
maturity
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Writing an Amortization
Schedule
Consider 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.
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Writing an Amortization
Schedule (cont’d)
Payment
Number
Payment
of Interest
Payment
of Principal
Total
Payment
Remaining Loan
Balance

1 $1,500.00 $528.53 $2,028.53 $199,471.47
2 1,496.04 532.50 2,028.53 198,938.97
3 1,492.04 536.49 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
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Creative Mortgage Financing

Graduated-payment mortgages

Growing-equity mortgages

Second mortgages

Shared-appreciation mortgages
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Creative Mortgage Financing
(cont’d)

A graduated-payment mortgage:

Allows the borrower to initially make small payments

Results in increased payments over the first 5 to 10 years, at
which time payments level off

Is tailored for families who anticipate higher income

A 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
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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 because of
increased default risk

Is often offered by sellers of homes

A shared-appreciation mortgage:

Allows a home purchaser to obtain a mortgage at a below-
market interest rate

Allows the lender to share in the price appreciation of the home
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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 no desire to originate or service them

Allows institutional investors 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