1. Chapter Seven
Mortgage Markets
McGraw-Hill/Irwin 7-1 ©2009, The McGraw-Hill Companies, All Rights Reserved

2. Mortgages and Mortgage-Backed
Securities
•• Mortgages are loans to individuals or businesses to
Mortgages are loans to individuals or businesses to
purchase homes, land, or other real property
purchase homes, land, or other real property
•• Many mortgages are securitized
Many mortgages are securitized
–– mortgages are packaged and sold as assets backing publicly
mortgages are packaged and sold as assets backing publicly
traded or privately held debt instruments (i.e., mortgage-backed
traded or privately held debt instruments (i.e., mortgage-backed
securities (MBSs))
securities (MBSs))
•• Mortgages differ from bonds and stocks
Mortgages differ from bonds and stocks
–– mortgages are backed by aaspecific piece of real property
mortgages are backed by specific piece of real property
–– primary mortgages have no set size or denomination
primary mortgages have no set size or denomination
–– primary mortgages generally involve only aasingle investor
primary mortgages generally involve only single investor
–– comparatively little information exists on mortgage borrowers
comparatively little information exists on mortgage borrowers
McGraw-Hill/Irwin 7-2 ©2009, The McGraw-Hill Companies, All Rights Reserved

3. Primary Mortgage Market
•• Four basic types of mortgages are issued by
Four basic types of mortgages are issued by
financial institutions
financial institutions
– home mortgages are used to purchase one- to four-
– home mortgages are used to purchase one- to four-
family dwellings
family dwellings
– multifamily dwellings mortgages are used to purchase
– multifamily dwellings mortgages are used to purchase
apartment complexes, townhouses, and condominiums
apartment complexes, townhouses, and condominiums
– commercial mortgages are used to finance the purchase
– commercial mortgages are used to finance the purchase
of real estate for business purposes
of real estate for business purposes
– farm mortgages are used to finance the purchase of
– farm mortgages are used to finance the purchase of
farms
farms
McGraw-Hill/Irwin 7-3 ©2009, The McGraw-Hill Companies, All Rights Reserved

4. Mortgage Loans Outstanding,
2007 (Trillions of $)
$0.28 $0.07
$0.74
$3.46
1-4 Family Commercial
Multifamily residential Farm
McGraw-Hill/Irwin 7-4 ©2009, The McGraw-Hill Companies, All Rights Reserved

5. Mortgage Characteristics
•• Collateral: lenders place liens against properties that
Collateral: lenders place liens against properties that
remain in place until loans are fully paid off
remain in place until loans are fully paid off
•• A down payment is aaportion of the purchase price of the
A down payment is portion of the purchase price of the
property aafinancial institution requires the borrower to
property financial institution requires the borrower to
pay up front
pay up front
–– private mortgage insurance (PMI) is generally required when
private mortgage insurance (PMI) is generally required when
the loan-to-value ratio is more than 80%
the loan-to-value ratio is more than 80%
•• Federally insured mortgages
Federally insured mortgages
–– repayment is guaranteed by either the Federal Housing
repayment is guaranteed by either the Federal Housing
Administration (FHA) or the Veterans Administration (VA)
Administration (FHA) or the Veterans Administration (VA)
McGraw-Hill/Irwin 7-5 ©2009, The McGraw-Hill Companies, All Rights Reserved

6. Mortgage Characteristics
•• Conventional mortgages are mortgages that are not
Conventional mortgages are mortgages that are not
federally insured
federally insured
•• Amortized mortgages have fixed principal and interest
Amortized mortgages have fixed principal and interest
payments that fully pay off the mortgage by its maturity
payments that fully pay off the mortgage by its maturity
date
date
–– fully amortized mortgage maturities are usually either 15 or 30
fully amortized mortgage maturities are usually either 15 or 30
years
years
•• Balloon payment mortgages require fixed monthly
Balloon payment mortgages require fixed monthly
interest payments for 3 to 5 years whereupon full payment
interest payments for 3 to 5 years whereupon full payment
of the mortgage principal is due
of the mortgage principal is due
McGraw-Hill/Irwin 7-6 ©2009, The McGraw-Hill Companies, All Rights Reserved

7. Mortgage Characteristics
•• Fixed-rate mortgages lock in the borrower’s interest rate
Fixed-rate mortgages lock in the borrower’s interest rate
–– required monthly payments are fixed over the life of the mortgage
required monthly payments are fixed over the life of the mortgage
–– lenders assume interest rate risk
lenders assume interest rate risk
•• Adjustable-rate mortgages (ARMs) tie the borrower’s
Adjustable-rate mortgages (ARMs) tie the borrower’s
interest rate to some market interest rate or interest rate
interest rate to some market interest rate or interest rate
index
index
–– required monthly payments can change over the life of the
required monthly payments can change over the life of the
mortgage
mortgage
–– yearly interest rate changes are often capped
yearly interest rate changes are often capped
–– borrowers assume interest rate risk
borrowers assume interest rate risk
–– ARMs can increase default risk
ARMs can increase default risk
McGraw-Hill/Irwin 7-7 ©2009, The McGraw-Hill Companies, All Rights Reserved

8. Mortgage Characteristics
•• Discount points are fees or payments made when aa
Discount points are fees or payments made when
mortgage loan is issued
mortgage loan is issued
–– each point costs the borrower 11percent of the principal value
each point costs the borrower percent of the principal value
–– the lender reduces the interest rate used to determine the payments
the lender reduces the interest rate used to determine the payments
on the mortgage in exchange for points paid
on the mortgage in exchange for points paid
•• Other fees
Other fees
–– application fee
application fee
–– title search
title search
–– title insurance
title insurance
–– appraisal fee
appraisal fee
–– loan origination fee
loan origination fee
–– closing agent and review fees
closing agent and review fees
–– other fees (e.g., VA or FHA loan guarantees and PMI)
other fees (e.g., VA or FHA loan guarantees and PMI)
McGraw-Hill/Irwin 7-8 ©2009, The McGraw-Hill Companies, All Rights Reserved

9. Mortgage Characteristics
•• Mortgage refinancing
Mortgage refinancing
– when aaborrower takes out aanew mortgage and uses the
– when borrower takes out new mortgage and uses the
proceeds to pay off an existing mortgage
proceeds to pay off an existing mortgage
– mortgages are most often refinanced when an existing
– mortgages are most often refinanced when an existing
mortgage has aahigher interest rate than prevailing rates
mortgage has higher interest rate than prevailing rates
– borrowers must balance the savings of aalower monthly
– borrowers must balance the savings of lower monthly
payment with the costs (fees) of refinancing
payment with the costs (fees) of refinancing
– an often-cited rule of thumb is that the new interest rate
– an often-cited rule of thumb is that the new interest rate
should be 2 percentage points less than the refinanced
should be 2 percentage points less than the refinanced
mortgage rate
mortgage rate
McGraw-Hill/Irwin 7-9 ©2009, The McGraw-Hill Companies, All Rights Reserved

10. Mortgage Amortization
•• Each fixed monthly payment consists partly of
Each fixed monthly payment consists partly of
repayment of the principal and partly of the
repayment of the principal and partly of the
interest on the outstanding mortgage balance
interest on the outstanding mortgage balance
•• An amortization schedule shows how the fixed
An amortization schedule shows how the fixed
monthly payments are split between principal and
monthly payments are split between principal and
interest
interest
McGraw-Hill/Irwin 7-10 ©2009, The McGraw-Hill Companies, All Rights Reserved

11. Mortgage Payments
•• The present value of a mortgage can be written as:
The present value of aj mortgage can be written as:
t
 1 
PV = PMT ∑   = PMT ( PVIFAr ,t )
j =1  1 + r 
PV = principal amount borrowed
PV = principal amount borrowed
PMT = monthly mortgage payment
PMT = monthly mortgage payment
PVIFA = present value interest factor of an annuity
PVIFA = present value interest factor of an annuity
rr= monthly interest rate on the mortgage
= monthly interest rate on the mortgage
tt= number of monthly payments over the life of the mortgage
= number of monthly payments over the life of the mortgage
•• Rearrange to isolate the payment: PMT = PV
Rearrange to isolate the payment:
( PVIFAr ,t )
McGraw-Hill/Irwin 7-11 ©2009, The McGraw-Hill Companies, All Rights Reserved

12. Other Types of Mortgages
•• Automatic rate-reduction mortgages
Automatic rate-reduction mortgages
•• Graduated-payment mortgages (GPMs)
Graduated-payment mortgages (GPMs)
•• Growing-equity mortgages (GEMs)
Growing-equity mortgages (GEMs)
•• Second mortgages and home equity loans
Second mortgages and home equity loans
•• Shared-appreciation mortgages (SAMs)
Shared-appreciation mortgages (SAMs)
•• Equity-participation mortgages (EPMs)
Equity-participation mortgages (EPMs)
•• Reverse-annuity mortgages (RAMs)
Reverse-annuity mortgages (RAMs)
McGraw-Hill/Irwin 7-12 ©2009, The McGraw-Hill Companies, All Rights Reserved

13. Secondary Mortgage Markets
•• FIs remove mortgages from their balance sheets
FIs remove mortgages from their balance sheets
through one of two mechanisms
through one of two mechanisms
– by pooling recently originated mortgages together and
– by pooling recently originated mortgages together and
selling them in the secondary market
selling them in the secondary market
– by securitizing mortgages (i.e., by issuing securities
– by securitizing mortgages (i.e., by issuing securities
backed by newly originated mortgages)
backed by newly originated mortgages)
•• Advantages of securitization
Advantages of securitization
– FIs can reduce the liquidity risk, interest rate risk, and
– FIs can reduce the liquidity risk, interest rate risk, and
credit risk of their loan portfolios
credit risk of their loan portfolios
– FIs generate income from origination and service fees
– FIs generate income from origination and service fees
McGraw-Hill/Irwin 7-13 ©2009, The McGraw-Hill Companies, All Rights Reserved

14. Secondary Mortgage Markets
•• The U.S. government established the Federal National
The U.S. government established the Federal National
Mortgage Association (FNMA or Fannie Mae) in the
Mortgage Association (FNMA or Fannie Mae) in the
1930s to buy mortgages from thrifts so they could make
1930s to buy mortgages from thrifts so they could make
more mortgage loans
more mortgage loans
•• FHA and VA insured loans make securitization easier
FHA and VA insured loans make securitization easier
•• Government National Mortgage Association (GNMA
Government National Mortgage Association (GNMA
or “Ginnie Mae”) and Federal Home Loan Mortgage
or “Ginnie Mae”) and Federal Home Loan Mortgage
Corp. (FHLMC or “Freddie Mac”) created in the 1960s
Corp. (FHLMC or “Freddie Mac”) created in the 1960s
–– encouraged continued expansion of the housing market
encouraged continued expansion of the housing market
–– provided direct and indirect guarantees that allow for the creation
provided direct and indirect guarantees that allow for the creation
of mortgage-backed securities
of mortgage-backed securities
McGraw-Hill/Irwin 7-14 ©2009, The McGraw-Hill Companies, All Rights Reserved

15. Mortgage Sales
•• FIs have sold mortgages among themselves for over 100
FIs have sold mortgages among themselves for over 100
years
years
•• A large part of correspondent banking involves small
A large part of correspondent banking involves small
banks selling parts of large loans to larger banks
banks selling parts of large loans to larger banks
•• Large banks often sell parts of their loans (i.e.,
Large banks often sell parts of their loans (i.e.,
participations) to smaller banks
participations) to smaller banks
•• Mortgage sales occur when an FI originates aamortgage
Mortgage sales occur when an FI originates mortgage
and sells it to an outside buyer
and sells it to an outside buyer
–– aaloan sale is made with recourse if the loan buyer can sell the
loan sale is made with recourse if the loan buyer can sell the
loan back to the originator should it go bad
loan back to the originator should it go bad
McGraw-Hill/Irwin 7-15 ©2009, The McGraw-Hill Companies, All Rights Reserved

16. Mortgage Sales
•• Mortgage sellers: money center banks, smaller banks,
Mortgage sellers: money center banks, smaller banks,
foreign banks, investment banks
foreign banks, investment banks
•• Mortgage sales allow FIs to manage credit risk, achieve
Mortgage sales allow FIs to manage credit risk, achieve
better asset diversification, and improve their liquidity and
better asset diversification, and improve their liquidity and
interest rate risk positions
interest rate risk positions
•• FIs are encouraged to sell loans for economic and
FIs are encouraged to sell loans for economic and
regulatory reasons
regulatory reasons
–– sold mortgages can still generate fee income for the bank
sold mortgages can still generate fee income for the bank
–– sold mortgages reduce the cost of reserve and capital requirements
sold mortgages reduce the cost of reserve and capital requirements
•• Mortgage buyers: foreign and domestic banks, insurance
Mortgage buyers: foreign and domestic banks, insurance
companies, pension funds, closed-end bank loan mutual
companies, pension funds, closed-end bank loan mutual
funds, and nonfinancial corporations
funds, and nonfinancial corporations
McGraw-Hill/Irwin 7-16 ©2009, The McGraw-Hill Companies, All Rights Reserved

17. Mortgage Backed Securities
•• Pass-through securities “pass through” promised
Pass-through securities “pass through” promised
principal and interest payments to investors
principal and interest payments to investors
•• Three agencies are directly involved in the
Three agencies are directly involved in the
creation of pass-through securities
creation of pass-through securities
– Ginnie Mae
– Ginnie Mae
– Fannie Mae
– Fannie Mae
– Freddie Mac
– Freddie Mac
•• Private mortgage pass-through issuers create
Private mortgage pass-through issuers create
pass-throughs from nonconforming mortgages
pass-throughs from nonconforming mortgages
McGraw-Hill/Irwin 7-17 ©2009, The McGraw-Hill Companies, All Rights Reserved

18. Mortgage Backed Securities
•• Collateralized mortgage obligations (CMOs) are
Collateralized mortgage obligations (CMOs) are
multiclass pass-throughs with multiple bond holder classes
multiclass pass-throughs with multiple bond holder classes
or tranches
or tranches
–– each bond holder class has aadifferent guaranteed coupon
each bond holder class has different guaranteed coupon
–– mortgage prepayments retire only one tranche at aatime, so all
mortgage prepayments retire only one tranche at time, so all
other trances are sequentially prepayment protected
other trances are sequentially prepayment protected
•• Mortgage backed bonds (MBBs)
Mortgage backed bonds (MBBs)
–– MBBs allow FIs to raise long-term low-cost funds without
MBBs allow FIs to raise long-term low-cost funds without
removing mortgages from their balance sheets
removing mortgages from their balance sheets
–– aagroup of mortgage assets is pledged as collateral against aaMBB
group of mortgage assets is pledged as collateral against MBB
issue, but there is no direct link between the cash flows of the
issue, but there is no direct link between the cash flows of the
mortgages and the cash flows on the MBB
mortgages and the cash flows on the MBB
McGraw-Hill/Irwin 7-18 ©2009, The McGraw-Hill Companies, All Rights Reserved

19. Mortgages Outstanding by
Type of Holder (%)
4.03 3.55 Mortgage Pools
1.40
2.23
Depository
Institutions
Life Insurance
Companies
Other Financial
Institutions
54.00 Mortgage
34.79
Companies
Other
McGraw-Hill/Irwin 7-19 ©2009, The McGraw-Hill Companies, All Rights Reserved

20. International Trends in Securitization
•• Foreign investors participate in U.S. mortgage and MBS
Foreign investors participate in U.S. mortgage and MBS
markets, but the value held has decreased since 1992
markets, but the value held has decreased since 1992
•• Europe is the world’s second largest and most developed
Europe is the world’s second largest and most developed
securitization market
securitization market
–– the United Kingdom is the biggest MBS issuer in the European
the United Kingdom is the biggest MBS issuer in the European
market, followed by Germany
market, followed by Germany
–– the advent of the Euro has accentuated the increased trend in
the advent of the Euro has accentuated the increased trend in
securitization in Europe
securitization in Europe
•• Mortgage lending has grown in Russia since the early
Mortgage lending has grown in Russia since the early
2000s because of changes in property ownership laws
2000s because of changes in property ownership laws
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