Financial Markets and Institutions

Ninth Edition

Chapter 14
The Mortgage Markets

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What are Mortgages?
• A long-term loan secured by real estate
• An amortized loan whereby a fixed payment pays both
principal and interest each month

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Table 14.1 Mortgage Loan Borrowing, 2016

Type of Property Mortgage Loans Proportion of

Issued ($ billions) Total (%)

One- to four-family dwelling 9,986 72.38

Multifamily dwelling 1,099 7.97

Commercial building 2,506 18.16

Farm 205 1.49

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What Are Mortgages? History (1 of 2)
• Mortgages were used in the 1880s, but massive defaults in
the agricultural recession of 1890 made long-term
mortgages difficult to attain.
• Until post-WWII, most mortgage loans were short-term
balloon loans with maturities of five years or less.

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What Are Mortgages? History (2 of 2)
• Balloon 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 (sound familiar?).
• As a part of the depression recovery program, the federal
government assisted in creating the standard 30-year mortgage
we know today.

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Characteristics of the Residential
Mortgage
• Mortgages can be roughly classified along the following
three dimensions:
– Mortgage Interest Rates
– Loan Terms
– Mortgage Loan Amortization

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Characteristics of the Residential
Mortgage: Mortgage Interest Rates
• The stated rate on a mortgage loan is determined by three
rates:
– Market Rates: general rates on Treasury bonds
– Term: longer-term mortgages have higher rates
– Discount Points: a lower rates negotiated for cash up
front

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Figure 14.1 Mortgage Rates and Long-Term Treasury
Interest Rates, 1985–2016

Source: http://www.federalreserve.gov/releases/h15/data.htm.

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Characteristics of the Residential
Mortgage: Loan Terms (1 of 3)
Mortgage loan contracts contain many legal terms that need
to be understood. Most protect the lender from financial loss.
• Collateral: usually the real estate being finance
• Down payment: a portion of the purchase price paid by the
borrower

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Characteristics of the Residential
Mortgage: Loan Terms (2 of 3)
• Mortgage loan contracts contain many legal terms that
need to be understood. Most protect the lender from
financial loss.
• Private Mortgage Insurance: insurance against default by
the borrower
• Qualifications: includes credit history, employment history,
etc., to determine the borrowers ability to repay the
mortgage as specified in the contact

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Characteristics of the Residential
Mortgage: Loan Terms (3 of 3)
Lenders will also order a credit report from one of the credit
reporting agencies.
• The score reported is called the FICO (Our Equifax).
• The range is 300 to 850, with 660 to 720 being average.
• Payment history, debt, and even credit card applications
can affect your credit score.

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Characteristics of the Residential
Mortgage: Loan Amortization
Mortgage loans are amortized loans:
• fixed, level payment
• pays interest due plus some principal
• balance on the mortgage will be zero when the last
payment is made

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Table 14.3 Amortization of a 30-Year, $130,000 Loan at
8.5%

Beginning Amount Amount Ending

Payment Balance of Monthly Applied to Applied to Balance of
Number Loan Payment Interest Principal Loan

1 130,000.00 999.59 920.83 78.76 129,921.24

24 128,040.58 999.59 906.95 92.64 127,947.95

60 124,257.09 999.59 880.15 119.44 124,137.65

120 115,366.01 999.59 817.18 182.41 115,183.60

180 101,786.66 999.59 720.99 278.60 101,508.06

240 81,046.91 999.59 574.08 425.51 80,621.40

360 992.56 999.59 7.03 992.56 0.00

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Types of Mortgage Loans (1 of 2)
• Insured vs. Conventional Mortgages: if the down payment
is less than 20%, insurance is usually required
– Insured loan: less than 20% down payment. Conventional loan: more than 20% down payment.

• Fixed-Rate Mortgages: the interest rate is fixed for the life

of the mortgage
• Adjustable-Rate Mortgages: the interest rate can fluctuate
within certain parameters

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Types of Mortgage Loans (2 of 2)
• Other Types
– Graduated-Payment Mortgages (GPMs)
– Growing Equity Mortgages (GEMs)
– Second Mortgages
– Reverse Annuity Mortgages (RAMs)
– Option ARMs
• The following table lists additional characteristics on all the
loans.

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Table 14.4 Summary of Mortgage Types (1 of 2)

Conventional mortgage Loan is not guaranteed; usually requires

private mortgage insurance; 5% to 20%
down payment
Insured mortgage Loan is guaranteed; low or zero down
payment
Adjustable-rate Interest rate is tied to some other security
mortgage (ARM) and is adjusted periodically; size of
adjustment is subject to annual limits
Graduated-payment Initial low payment increases each year; loan
mortgage (GPM) amortizes in 30 years

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Table 14.4 Summary of Mortgage Types (2 of 2)

Growing-equity Initial payment increases each year; loan

mortgage (GEM) amortizes in less than 30 years
Second mortgage Loan is secured by a second lien against the
real estate; often used for lines of credit
(revolving or non-revolving or home
improvement (equity) loans [1 time amount]
Reverse annuity Lender disburses a monthly payment to the
mortgage borrower on an increasing-balance loan; loan
comes due when the real estate is sold

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Mortgage-Lending Institutions
• Originally, thrift institutions were the primary originator of
mortgages in the U.S. and, therefore, the primary holder of
mortgage loans.
• As the next figure illustrates, this is not the case anymore.

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Figure 14.2 Share of the Mortgage Market Held by Major
Mortgage-Lending Institutions

Source: http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm.

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Loan Servicing (1 of 2)
• Most mortgages are immediately sold - frees cash to
originate another loan.
• Loan servicers collect monthly payments, usually keeping
a portion of the payments received.

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Loan Servicing (2 of 2)
In all, there are three distinct elements in mortgage loans:
• The originator packages the loan for an investor
• The investor holds the loan
• The servicing agent handles the paperwork

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E-Finance: Borrowers Shop the Web for
Mortgages
Mortgages used to originate from a local bank. But the web
is well-suited to handle online mortgage origination:
• This is a financial product—nothing really needs to be
delivered
• Mortgages are fairly standardized. There is no product
differentiation to consider.
• Little bank loyalty for borrowers
• Online lenders have low overhead, and so lower fees.

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Secondary Mortgage Market
• The secondary mortgage market was originally established
by the federal government after WWII when it created
Fannie Mae to buy mortgages from thrifts.
• The market experienced tremendous growth in the early to
mid-1980, and has continued to remain a strong market in
the U.S.

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Securitization of Mortgages (1 of 2)
• The securitization of mortgages developed because of the
risk of default and costs of prepayment / servicing.
• A pool of mortgages reduces this problem through
diversification.

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Securitization of Mortgages (2 of 2)
• The mortgage-backed security (MBS) is created.
• Pools including hundreds of mortgages.
• Rights to the cash flows sold as separate securities.
• At first, simple pass-through securities were designed.

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Securitization of Mortgages: The Mortgage
Pass-Through
• Definition: A security that has the borrower’s mortgage
payments pass through the trustee before being disbursed
to the investors
• This design did eliminate idiosyncratic risk (specific risk),
but investors still faced prepayment risk.

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The Impact of Securitization on the
Mortgage Market
• The value of mortgages held in pools is reaching nearly
$8.0 trillion near the end of 2009.
• Fell dramatically
• The securities compete for funds along with all other bond
market participants.

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Figure 14.3 Value of Mortgage Principal Held in Mortgage
Pools, 1984–2016

Source: http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm.

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Securitization of Mortgages: Types of
Pass-Throughs
There are a variety of different types of pass-through
securities. We will briefly look at three:
• GNMA Pass-Throughs (Government National Mortgage Association)
• “Government agency that guarantees timely payments on mortgage-backed securities”
• AKA- Ginnie Mae – Certain groups of individuals with faulty credit potentially

• FHLMC Pass-Throughs (Federal Home Loan Mortgage Corp.)

• “Stockholder-owned, government-sponsored enterprise (GSE) chartered by Congress in
1970 to keep money flowing to mortgage lenders, which in turn supports
homeownership and rental housing for middle-income Americans.”
• AKA- Freddie Mac– Obtains loans from small banks
• Other Fannie Mae- Obtains mortgage loans from major retail or commercial banks

• Private Pass-Throughs
• “They are called private-label because neither the underlying mortgages nor the
securities themselves are insured or guaranteed by a government agency.”
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Subprime Mortgages and CDOs (1 of 3)
• Subprime loans are loans to borrowers who have poor
credit ratings or other issues with collateral, etc.
• In 2000, only 2% of mortgages were subprime. This
climbed to 17% by 2006.
• The average FICO score was 624 for subprime borrowers.
Prime mortgage borrowers were 742.

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Subprime Mortgages and CDOs (2 of 3)
• However, 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 can’t fall (right?), there is little risk
involved.

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Subprime Mortgages and CDOs (3 of 3)
Several factors lead to this dramatic increase in subprime
lending:
• New mortgage products 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.

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The Real Estate Bubble (1 of 2)
Between 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
housing
• Real estate speculators

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The Real Estate Bubble (2 of 2)
In the aftermath of the financial meltdown, lending policies
have largely returned to selecting capable borrowers:
• CDO issuance peaked in 2006 at $520b, but in 2009 fell to
$4.2b. Up to $58b in 2012.
• New legislation, such a Frank-Dodd, may require mortgage
originators to hold a part of the mortgages they create.

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Copyright

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