Mortgages represent a major portion of the debt market. Mortgages are used to finance real estate purchases. An active secondary market has developed for mortgages. This chapter looks at the various types of mortgages and also looks at some of the new innovation in mortgage financing.

Mortgages are generally used to finance real estate purchases. The most common type of purchase is the single family (or more specifically the 1 to 4 family) home.

In a typical mortgage, the lender lends money to the borrower who in turn agrees to make payments over the life of the loan. If the borrower fails to make the payments, the lender has the right to take back the property. (that is the lender has a lien on the property.)

There are many different types of mortgages. For example the mortgae can vary based on time to maturity, on whether it is insured or not, on the terms of the interest rates (fixed or floating), or on other parts of the mortgage. The reason for the many types of mortgage is that each borrower has slightly different needs.

1. Insured vs. Conventional Mortgages

In a conventional mortgage the borrower is required to have a 20% equity stake in the property. (Paying 20% of the purchase price generally does this). However, 20% is a burden to many would-be home purchasers. As a result, the Federal government has developed programs to subsidize home ownership. The two most widely known plans are through the VA and the FHA.

Mortgages can be insured by the Veterans Administration (VA) or by the Federal Home Administration (FHA). If the borrower can qualify, then the provider will guarantee the borrower will be repaid in the event of a default.

Additionally there are many private mortgage insurance companies that lend for a price. This price is usually quite high as the risk to the insurer is high. However, mortgage insurance, (while at first glance a "bad deal" may be worthwhile if there are no other ways to raise the down payment. PMI can be paid on an annual basis or up front. Generally, it is no longer needed when the equity crosses the 20% barrier.

http://www.approved.com/pmi.html

http://www.mgic.com/home/article/mi101.html

As the names suggest a fixed rate mortgage is one whose interest rate is constant over the life of the loan. An adjustable rate mortgage (ARM) is one whose interest rate changes on a regular basis. The ARM rate is generally tied to a floating rate index such as the T-Bill rate or the Prime rate.

Ceteris paribus, Banks would rather make ARM loans as there is less interest rate exposure. However, many customers (borrowers) are not willing to accept the added risk associated with ARMs. Thus, the rate on ARMs is slightly lower. Due to their size, banks have a competitive advantage in dealing with the risk (for example by using swaps or by selling the loan, the bank need not be exposed to the interest rate risk). Therefore ARMs have not been as successful as banks hoped and the majority of mortgages (especially personal mortgages) are still fixed rate loans.

ARMs generally are more complex with caps and floors which limit the amount that interest rates can move in a year and over the life of the loan. Further many newer ARMS have a lock-in feature that allows the borrower to lock in a rate at some point over the life of the contract.

http://www.bankrate.com/brm/green/mtg/mort1d.asp

http://www.bankrate.com/brm/green/mtg/mort1c.asp

The traditional loan is for 30 years. In recent years 15-year mortgages have grown in popularity. However, the 30-year loan is still the most common.

There are also mortgages with balloon payments. These payments (generally after 5 years) require the complete payment at that point, (although the payments had been based on a longer-term mortgage). This provision has commonly forces the borrower to "re-borrow," which shortens the duration and hence lowers the risk to the lender.

http://www.calcbuilder.com/cgi-bin/HOM6.cgi/FinanCenter

• Graduated-payment mortgage—payments increase over first portion, then payments level off
• Growing-Equity Mortgage -- —payments increase over first portion, payments do not level off
• Secondary Mortgages — a mortgage that is subordinate to a primary mortgage. Often shorter and for a lesser amount. As would be expected these usually have a higher interest rate. –often held by the seller but need not be. Home equity loans are in effect merely secondary mortgages.
• Shared Appreciation Mortgages—borrower gets a lower rate, but lender gets a portion of appreciation.

Interest rate risk is especially pronounced for mortgages as the loan is for a long-time period. There is also default risk.

There is an active secondary market for securitized mortgages. Mortgages are pooled together and then sold to investors. The securitization process allows smaller loans to be sold since they are repackaged into larger loans.

Often the mortgage is sold but the loan originator continues to serve the loan.

http://www.cityresearch.com/pres/secondary.htm

The valuation of mortgages is similar to the valuation of any fixed income asset. The market value is based on the present value of the cash-flows.

Predicting the timing is not as easy as it would appear. Borrowers have a prepayment option. This is exercised if rates fall or if the borrower sells property. Predicting these exercises is important as it determines the cash flow timing (indeed even their existence!)

The mortgages are sold while the serving of the loan stays with the originator.

Mortgage-Backed Securities are the typical way in which mortgages are sold. A trustee holds the mortgages but the loans are serviced by the lender. The payments are then transferred (passed through) to the owners. Interest payments are generally made on a monthly basis. The common types are

• Ginnie-Mae
• Fannie Mae
• Publicly issued
• Participation certificates
• Collateralized mortgage Obligations (CMOs)

http://www.ginniemae.gov/mbs/mbs.htm

CMOs were developed in 1983. CMOs are a good example of financial engineering. The overall cash flows are diced up in many ways. The various slices are called tranches.

One way to slice up payments is on time. For example first tranch, second tranch. Any principal that is paid down goes first to the first tranch. After they are paid off, the payments go to the second tranch etc. (There are generally from 3- 10 levels.)

This type of investment is attractive to investors since it can match their horizon. However, as mentioned above, the mortgagee has a prepayment option that makes it difficult to determine what the maturity will be.

An alternative way of cutting the cash flows is on whether the cash is for interest or is a principal payment. Investors who would like to own the interest payments buy IOs. These Interest-Only payments are risky as the amount of payments is contingent on the balance outstanding. Thus, if the loan is paid off early, the size of the payments is reduced. In the absence of prepayments, a higher proportion of early payments is for interest.

Owners of POs, Principal Only, get the principal payments. If the borrower makes only the minimum payments then the PO holders get little in the early years and more in the later years (the opposite of IO holders).

CMOs are quite risky and many large institutions have lost millions of dollars with CMOs. The main reason that CMOs are so risky is that the timing, indeed the mere existence, of the cash flows is not known. (for example, suppose you invest in IOs and interest rates drop. Suddenly people refinance and there go your interest payments.)

Institutions have been the biggest player in this market, but like in most markets, as the market develops, financial intermediaries develop ways to market these securities to individual investors. In this case, Ginnie Mae pass-through securities have minimum investments of $25,000 and unit-trusts that invest in the Ginnie Mae pass throughs have minimums of $1,000. Additionally many mutual funds have Ginnie Maes in their portfolio.

That said, institutions remain the most active participants. Commercial banks still hold approximately 50% of mortgages.

Borrower’s equity

Borrower’s income

Borrower’s Credit History

Banks typically use Credit-Scoring and Credit checks to gauge default risk.

Suggested Questions

2,3,7,8,15.16.17

Managing in Financial Markets:

Understand the case and be able to answer the questions

Monitoring Wall Street

1,2,3