Chapter 7

Mortgage Markets
&
Chapter 24 Managing
Risk off the Balance
Sheet with loan Sales
and Securitization 1
 Learning Outcomes

• Why Study Mortgage Markets

• Primary Mortgage Market
– Categories of Mortgages
– Mortgage Characteristics
– Mortgage Amortization
– Other Types of Mortgages
• Secondary Mortgage Market (Risk Management off the Balance Sheet)
– Mortgage Loan Sales
– Mortgage Loan Securitization

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 Why Study Mortgage Markets?
• Mortgages are loans to individuals or businesses to purchase a home,
land, or other real property.

 Corporate bonds give the holder a general claim to the

company’s assets.1
Bonds  Bonds generally have a denomination of multiple of $1000.
 Bonds issues are held by many investors.
 Corporations are subject to extensive rules and regulations
regarding information availability and reliability.

 Property backing the loan allows the lender to take

Mortgage Loan possession in the case of a default.
 There is no set size or denomination for primary mortgages.2
 Primary mortgages generally involve a single investor (e.g. a
bank or mortgage company).
 Information on borrowers is less extensive and unaudited. 3
 Mortgage markets are something of great effect on bond and
stock markets as well as the overall economy. 4 3
 Primary Mortgage Market

Home
mortgages1

Categories
Farm Multi- family
of dwelling
mortgages4 Mortgages mortgages2

Commercial
mortgages3

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Primary Mortgage Market (Cont.)

Mortgage Characteristics

Down Mortgage
Collateral Interest Rates
Payment Maturities

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 Primary Mortgage Market (Cont.)

Collateral
The financial institution will place a lien against a property that remains
in place until the loan is fully paid off.

A lien is a public record attached to the title of the property that gives the
financial institution the right to sell the property if the mortgage
borrower defaults in payment.

The mortgage is secured by the lien- that is until the loan is paid off, no
one can buy the property and obtain clear title of it.

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Primary Mortgage Market (Cont.)

Down payments decrease

Down Payment the probability that the
borrower will default on the
A financial institution requires the mortgage. (Why? )*
mortgage borrower to pay a portion of the
purchase price of the property (a down
payment) at the closing (the day the
mortgage is issued). The balance of the
purchase price is the face value of the Borrowers who pay less
mortgage (or the loan proceeds). than 20% down payment
are required to purchase
The size of the down payment depends on private mortgage
the financial situation of the borrower. insurance (PMI).
Generally a 20% down payment is (Why? )**
required.

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 Primary Mortgage Market (Cont.)
Mortgage Maturities
• A mortgage generally has an original maturity of either 15 or 30 years.

Financial institutions and borrowers

find the 15-year mortgage more
attractive. (Why? ) *

Borrowers find that monthly To attract borrowers, financial

mortgage payments are higher institutions generally charge a
on a 15-year than on a 30-year lower interest rate on a 15-year
mortgage as the mortgage is paid maturity than a 30-year
off in half the time. mortgage.

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 Primary Mortgage Market (Cont.)
Interest Rates
• Mortgage borrowers often decide how much to borrow and from whom solely
by looking at the quoted mortgage rates of several financial institutions.

• In turn, financial institutions base their quoted mortgage rates on several

factors.
First, they use the market rate at which they obtain funds
(e.g., the fed funds rate or the rate on certificates of
deposit) as the base rate used to determine mortgage rates

Second, the rate on specific mortgage is then adjusted for

other factors (e.g., whether the mortgage specifies a fixed
or variable rate of interest, discount points and other fees)

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 Primary Mortgage Market (Cont.)
Interest Rates (Cont.)

Fixed-rate mortgage Adjustable-rate mortgage (ARM)

Locks in the borrowers interest rate and The interest rate is tied to some market
thus required monthly payments over the interest rate or interest rate index. Thus
life of the mortgage regardless of how the required monthly payments can
market rates change. change over the life of the mortgage.

When interest rates in the economy

are low, mortgage borrowers prefer
the fixed-rate loans while mortgage
lenders prefer ARMs. (Why? )*

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 Primary Mortgage Market (Cont.)
Interest Rates (Cont.)

These are fees or

payments made when a
mortgage loan is
Discount Points
issued. One discount
point paid up front is
equal to 1% of the
principal value of the
mortgage.
For example, if the
borrowers pay 2 points
‫حخهىفس‬
up front on a $100,000
‫يهسؤخعىف‬
mortgage, he or she
must pay $2000 at the
closing of the mortgage
(2% of $100,000).

In exchange for points paid up front,

the financial institution reduces the
interest rate used to determine the
monthly payments on the mortgage. 11
 Primary Mortgage Market (Cont.)
Interest Rates (Cont.)
In addition to interest, mortgage contracts generally require the borrower to pay a
collection of fees to cover the mortgage issuer’s cost of processing the mortgage.
These include:
Application
fee

Other Title
costs Search

Other
Fees

Loan Title
origination Insurance
fee
Appraisal
fee
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Primary Mortgage Market (Cont.)

Mortgage Amortization

The fixed monthly payment made by a mortgage borrower

generally consists partly of repayment of the principal borrowed
and partly of the interest on the outstanding (remaining) balance of
the mortgage. These fixed mortgage payments are fully amortized
(paid off) by its maturity date.

 
Monthly Mortgage Payments

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 Primary Mortgage Market (Cont.)
Example (1)
• 
You plan to purchase a house for $150,000 using a 30-year mortgage obtained
from your local bank. The mortgage rate offered to you is 8% with zero points. In
order to forgo the purchase of private mortgage insurance, you will make a down
payment of 20% of the purchase price at closing and borrow $120,000 through the
mortgage.
A. Calculate the monthly mortgage payment?
B. Assume that you used a 15-year mortgage instead and that the mortgage rate
is 7.25%, calculate the monthly mortgage payment?

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 Primary Mortgage Market (Cont.)
Example (2)
• 
You plan to purchase a house for $150,000 using a 30-year mortgage obtained
from your local bank. You will make a down payment of 20% of the purchase
price, in this case, equal to $30,000. Thus, the mortgage loan amount will be
$120,000. Your bank offers you the following two options for payment:
Option 1: Mortgage rate of 8% and zero points
Option 2: Mortgage rate of 7.75% and 2 points
Determine the best option?
We first calculate the monthly payment for both options:

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 Primary Mortgage Market (Cont.)
Example (2) – Cont.
• 
Option 2 reduces your monthly mortgage payment by $20.83 in exchange for 2
discount points paid up front ($120,000 * 0.02 = $2,400).

The present value of these savings (evaluated at 7.75%) over the 30 years is:

Option 2 is the better choice. The present value of the monthly savings, $2,906.54,
is greater than the points paid up front, $2,400.

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Primary Mortgage Market (Cont.)

Other Types of Mortgages

Subprime Second
Jumbo Mortgages*
Mortgages** Mortgages***

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 Secondary Mortgage Market
• After financial institutions originate mortgages, they often sell or
securitize them in the secondary mortgage market.

• The sale/securitization of mortgages in the secondary markets

provides the financial institutions with many advantages:

Reduce Liquidity risk

Reduce Interest Rate Risk*

Reduce Credit Risk

Asset Diversification

Creates Fee Income

Reduce Regulatory
Constraints**
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Secondary Mortgage Market (Cont.)
First Dimension

Mortgage
Assignments 2
loan Sales Participations1

Second Dimension

With Mortgage Without

Recourse4 loan Sales Recourse3

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Secondary Mortgage Market (Cont.)

Sale of selected loans

Or sale of a share in
selected loans

Institutional
Commercial Bank
investors in the
Assets include loans
money and capital
to be sold)*
market**
Proceeds of loan sale
($)

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Secondary Mortgage Market (Cont.)
The Risks in Loan Sales
1 2
The best quality loans are
most likely to find a ready
resale market leaving the
lender’s portfolio heavily
stocked with poorer-quality
loans
A sold loan my turn as bad
loan as the seller may have
done a poor job of
evaluating the borrower’s
financial condition. This
obliges the purchaser to
review both the seller and
the borrower
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Secondary Mortgage Market
(Cont.)

• https://youtu.be/Bzc8ZO5XYyo

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Secondary Mortgage Market (Cont.)
Loan Securitization
Pass-Through Mortgage Securities:
Securitization of mortgages involves the pooling of a group of mortgages with
similar characteristics, the removal of these mortgages from the balance sheet,
and the subsequent sale of interests (mortgage-backed securities or pass-through
mortgage securities) in the mortgage pool to secondary market investors.
Pass-Through
Financial
Households Security
Institution
Holders
1 2 Pools
Receive 3 Buy Pass-
Mortgages
Funds for Through
sells interest
Mortgages Securities
in Pool
4 5 Passes Cash Flows (net of 6 Receive Cash
Pay Principal
and Interest servicing fee) through from Flo
Mortgage Holder to Pass- 23
Through Holder
Secondary Mortgage Market (Cont.)

Loan Securitization (Cont.)

Collateralized Mortgage Obligation:
The CMO is a device for making mortgage-backed securities more attractive to
investors. It is a pass-through security which gives each investor a pro rata share
of any promised coupon and principal cash flows on a mortgage pool.
Pass-Through
Security
Holders
(Class A)
Financial Pass-Through
Households Security
Institution
Holders
(Class B)
Pass-Through
Security
Holders
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(Class C)
Secondary Mortgage Market (Cont.)
Loan Securitization (Cont.)
• 
Collateralized Mortgage Obligation (Cont.):
Example (3)
Suppose that an FI pooled mortgages of $150 million in total and issued CMOs
behind these mortgages with the following three classes:
Class A: annual fixed coupon 7 percent, class size $50 million
Class B: Annual fixed coupon 8 percent, class size $50 million
Class C: Annual fixed coupon 9 percent, class size $50 million
Suppose that in month 1, the promised monthly mortgage repayment of $2.5
million was received comprised of (interest of $1 million and principal of $1.5
million). How will the cash flows be distributed among the three classes?
The promised interest will be distributed as follows:
Class A:
Class B:
Class C:
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Secondary Mortgage Market (Cont.)

Example (3) - Cont.

Thus, the total promised interest payments to the three classes is equal to $1
million.

The remaining $1.5 million principal repayment will be paid to class A holder. At
the end of month 1, only $48.5 million ($50 million – $1.5 million of class A
principal remains outstanding, compared to $50 million of class B and $50 million
of class C.

This continues until the full amount of the principal of class A is paid off. Once
this happens, any subsequent repayments of principal go to retire the principal
outstanding to class B holders and after they are paid off, to class C holders.

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Secondary Mortgage Market (Cont.)

Loan Securitization (Cont.)

Mortgage-Backed Bond:
It is a bond issue backed by a group of mortgages on an FIs balance sheet. MBB
differ from pass-throughs and CMOs in two key dimensions:

Pass-throughs and CMOs MBB

 Mortgages backing MBBs

 FIs remove mortgages
from their balance sheet.
 There is a direct link
between the cash flows on
the underlying mortgages
and the securities issues.
normally remain on the
balance sheet.
 The cash flows on the
mortgages backing the bond
are not necessarily directly
connected to interest and
principal payments on the
MBB 27
 Learning Outcomes

• Why Study Mortgage Markets

• Primary Mortgage Market
– Categories of Mortgages
– Mortgage Characteristics
– Mortgage Amortization
– Other Types of Mortgages
• Secondary Mortgage Market (Risk Management off the Balance Sheet)
– Mortgage Loan Sales
– Mortgage Loan Securitization

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