Dr Lakshmi Kalyanaraman 1 What are mortgages Longterm loan secured by real estate Loan to finance construction of an office building or purchase of a home Dr Lakshmi Kalyanaraman 2 Amortized mortgage ID: 1028612
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1. The Mortgage MarketsChapter 14Dr. Lakshmi Kalyanaraman1
2. What are mortgages?Long-term loan secured by real estate.Loan to finance construction of an office building or purchase of a homeDr. Lakshmi Kalyanaraman2
3. Amortized mortgageBorrower pays off the loan over time in some combination of principal and interest payments that result in full payment of the debt by maturity. Dr. Lakshmi Kalyanaraman3
4. Balloon mortgageOnly interest is paid over the life of the mortgage Principal is paid at maturityHigh default riskDr. Lakshmi Kalyanaraman4
5. Characteristics of residential mortgagesDr. Lakshmi Kalyanaraman5
6. Mortgage interest ratesDetermined by three factors:1. current long-term market rates2. life of the mortgage3. number of discount points paidDr. Lakshmi Kalyanaraman6
7. Market ratesDetermined by the supply of and demand for long-term fundsDetermined by a number of global, national and regional factorsDr. Lakshmi Kalyanaraman7
8. TermUsually the lifetime is 15 or 30 yearsLenders also offer 20 yearsLonger-term mortgages have higher interest rate than shorter-term mortgagesInterest rate risk falls as the term to maturity decreasesDr. Lakshmi Kalyanaraman8
9. Discount pointsInterest payments made at the beginning of a loanA loan with one discount point means that the borrower pays 1% of the loan amount at closingClosing is when the borrower signs the loan paper and receives the proceeds of the loanDr. Lakshmi Kalyanaraman9
10. Discount pointsLender reduces the interest rate on the loanDr. Lakshmi Kalyanaraman10
11. Discount pointsBorrower evaluatesReduced interest rate over the life of the loanVersusIncreased up-front expenseDr. Lakshmi Kalyanaraman11
12. Discount pointsDepends on how long the borrower will hold on to the loanMay not be feasible if borrower repays in 5 years or lessDr. Lakshmi Kalyanaraman12
13. Loan termsDr. Lakshmi Kalyanaraman13
14. CollateralReal estate bought with the mortgage loan is pledged as collateral Lending institution will place a lien against the property till the loan is repaidLien is a public record that attaches to the title of the propertyDr. Lakshmi Kalyanaraman14
15. CollateralLender gets the right to sell the property if the underlying loan defaultsNo one can buy the property and obtain clear title to it without paying off this lienExistence of liens against real estate explains why title search is important part of mortgage loanDr. Lakshmi Kalyanaraman15
16. Down paymentBorrower pays a portion of purchase priceBalance of purchase price is paid by the loan proceedsDown payment reduces default riskDr. Lakshmi Kalyanaraman16
17. Private mortgage insuranceInsurance contract purchased by FI paid by the borrower guaranteeing to pay the FI Difference between the value of the property and the balance remaining in the mortgage, in case of defaultDr. Lakshmi Kalyanaraman17
18. Mortgage loan amortizationBorrower agrees to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity‘Fully amortize’ means that the payments will pay off the outstanding indebtedness by the time the loan maturesDuring early years of the loan, the lender applies most of payment to interest and small amount to outstanding principal balanceDr. Lakshmi Kalyanaraman18
19. Types of mortgage loansDr. Lakshmi Kalyanaraman19
20. Insured and conventional mortgagesDr. Lakshmi Kalyanaraman20
21. Insured mortgagesOriginated by banks or other mortgage lenders but are guaranteed by government agenciesApplicants either served in the military or having income below a given levelDr. Lakshmi Kalyanaraman21
22. Insured mortgagesCan borrow only up to a certain amountVery low or zero down paymentAgency guarantees the payment of mortgage loan if the borrower defaultsDr. Lakshmi Kalyanaraman22
23. Conventional mortgagesNot guaranteedMost lenders require that borrowers to obtain private mortgage insurance on all loans with loan-to-value exceeding 80%Dr. Lakshmi Kalyanaraman23
24. Fixed and adjustable-rate mortgagesDr. Lakshmi Kalyanaraman24
25. Fixed rate mortgagesInterest rate and the monthly payment do not vary over the life of the mortgageDr. Lakshmi Kalyanaraman25
26. Adjusted-rate mortgagesTied to some market interest rate Changes over timeARMs usually have limitsCaps, how high the interest rate can move in one year and during the term of the loanFor example 2% in one year and 6% over the life of the loanDr. Lakshmi Kalyanaraman26
27. Fixed versus ARMBorrowers prefer fixed as ARMs may cause financial hardship if interest rate risesHowever, fixed rate borrowers lose if interest rate fallsBorrowers are risk-averse means that fear of hardship most often overwhelms anticipation of savingsDr. Lakshmi Kalyanaraman27
28. Fixed versus ARMLenders, by contrast, prefer ARMs because ARMs lessen interest-rate riskInterest-rate risk is the risk that rising interest rates will cause the value of debt instruments to fall. The effect on the value of the debt is greatest when the debt has a long term to maturity. Dr. Lakshmi Kalyanaraman28
29. Fixed versus ARMSince mortgages are usually long-term, their value is very sensitive to interest-rate movementsLending institutions can reduce the sensitivity of their portfolios by making ARMs instead of standard fixed-rate loans.Dr. Lakshmi Kalyanaraman29
30. Fixed versus ARMSeeing that lenders prefer ARMs and borrowers prefer fixed-rate mortgagesLenders must entice borrowers by offering lower initial interest rates on ARMs than on fixed-rate loansDr. Lakshmi Kalyanaraman30
31. Other types of mortgagesDr. Lakshmi Kalyanaraman31
32. Graduated payment mortgagesUseful for home buyers who expect their incomes to riseHas lower payments in the first few years, may not even cover interestThen payments riseAdvantage is borrowers qualify a higher loan than conventional mortgageBuyers can buy adequate house nowPayments escalate later when income does or notDr. Lakshmi Kalyanaraman32
33. Growing equity mortgagesGrowing equity mortgage helps to pay off loan in short periodInitial payments like conventional mortgageOver time payment increases to reduce principal quicklyNo prepayment penaltyDr. Lakshmi Kalyanaraman33
34. Graduated versus growingDifference between graduated payment and growing equity mortgages is that the graduated is to qualify for a higher loan by reducing the initial payments and loan paid in 30 years. But growing is to help prepaymentDr. Lakshmi Kalyanaraman34
35. Second mortgages (piggyback)On same real estate like first mortgageSecond mortgage junior to the original loanIn case of default, the original loan will be paid off first and the second mortgage holder from the left over fundsDr. Lakshmi Kalyanaraman35
36. Second mortgages (piggyback)Borrowers use the equity they have in their homes as security for another loanDr. Lakshmi Kalyanaraman36
37. Second mortgages (piggyback)An alternative to the second mortgage would be to refinance the home at a higher loan amount than is currently owed.The cost of obtaining a second mortgage is often much lower than refinancing.Dr. Lakshmi Kalyanaraman37
38. Reverse annuity mortgagesInnovative method for retired people to live on the equity they have in their homesThe contract for a RAM has the bank advancing funds on a monthly schedule.This increasing-balance loan is secured by the real estateborrower does not make any payments against the loan.When the borrower dies, the borrower’s estate sells the property to retire the debt.Dr. Lakshmi Kalyanaraman38
39. Reverse annuity mortgagesThe advantage of the RAM is that it allows retired people to use the equity in their homes without the necessity of selling it. For retirees in need of supplemental funds to meet living expenses, the RAM can be a desirable option.Dr. Lakshmi Kalyanaraman39
40. Mortgage institutionsMany institutions making mortgage loans do not want to hold long-termShort-term sources used for long-term loansMany lenders sell the loans immediately to another investorBorrower may not be awareOriginator frees the funds and gets loan origination fees normally 1%
41. Loan servicingSome originators provide loan servicingCollect payments from borrowers, passes principal and interest to the investor, keeps record and reserve account for payment of insurance and taxesEarn a fee of around 0.5% of loan amount every year for servicing
42. Loan servicing1. Originator packages the loan for an investor.2. Investor holds the loan.3. Servicing agent handles the paperwork.Dr. Lakshmi Kalyanaraman42
43. Secondary mortgage marketProblems in selling mortgages:1. Mortgages are too small to be wholesale instruments. Mortgages value around $250,000 while commercial paper is around $5 millionDr. Lakshmi Kalyanaraman43
44. Secondary mortgage marketSecond problem with selling mortgages in the secondary market was that they were not standardized.They have different times to maturity, interest rates, and contract terms. That makes it difficult to bundle a large number of mortgages togetherDr. Lakshmi Kalyanaraman44
45. Secondary mortgage marketThird, mortgage loans are relatively costly to serviceThe lender must collect monthly payments, often pay property taxes and insurance premiums, and service reserve accounts.Finally, mortgages have unknown default riskThese problems inspired the creation of the mortgage-backed security, also known as a securitized mortgageDr. Lakshmi Kalyanaraman45
46. SecuritizationProcess of taking an illiquid asset, or group of assets and through financial engineering transforming them into a securityDr. Lakshmi Kalyanaraman46
47. Mortgage backed securityLarge number of mortgages are pooled into mortgage poolA trustee, a bank or government agency, holds mortgage pool as collateral for new securityThis process is called securitization47
48. Major types of MBSPass-through securityCollateralized Mortgage Obligations (CMO)Mortgage Backed Bond48
49. Pass-through Mortgage SecuritiesFIs pool mortgages and offer interest in the pool in the form of pass-through certificatesEach pass through security represents fractional ownership in mortgage poolPass through promised payments of principal and interest on pools of mortgages to secondary market investorsNo guaranteed annual couponOriginating FI or third party servicer takes a fee 49
50. Collateralized Mortgage Obligations (CMO)Multiclass pass-through with multiple bond holder classes or tranchesPass through a pro-rata of mortgage pool but CMO multi-class pass-through with a number of different bond holder classes or tranchesPass-through no guaranteed coupon, but CMO, each class has a different guaranteed couponMortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protected50
51. Mortgage Backed Bonds (MBBs)MBBs allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheetsGroup of mortgage is pledged as collateral against MBBMBB issues have excess collateralPass-through and CMO are securitization, while MBB is collateralizationPass-through and CMO remove mortgage from Balance sheet, MBB does not51
52. Mortgage Backed Bonds (MBBs)A group of mortgage assets is pledged as collateral against a MBB issue, but there is no direct link between the cash flows of the mortgages and the cash flows on the MBB52