1. OVERVIEW:  Mortgages are loans to individuals or businesses to buy real estate, using the property as collateral.  See Figure 7-1 on p. 188, 75% of mortgages are home mortgages (1-4 family), 17% are commercial (offices, warehouse, retail), 6% for multifamily (apartments, townhouses and condominiums) and 1.5% for farms.

60% of home mortgages are securitized, a process that transforms an illiquid asset (single mortgage) into a liquid and marketable security, by combining and packaging dozens or hundreds of mortgages to create a "mortgage portfolio" that can be traded.  Advantages of securitization to FIs: 1) Asset portfolio is more liquid, 2) Reduces interest rate risk, 3) reduces credit risk, and 4) provides a source of fee income (servicing the loans). 

Mortgages are treated separately from Bonds and Stocks because:

1) Mortgages are backed and secured by a specific asset (real property), compared to stocks and bonds, which are backed by only a general claim to the firm's assets (unsecured). 

2) Mortgages have no uniform or standard amount, they vary by the individual size of the loan (and value of the property, down payment, etc.). 

3) Individual mortgages are usually held by only one bank or mortgage company, versus bonds or stocks which are held by thousands of investors.   

4) Mortgage borrowers are typically individuals (or couples), and information about these borrowers may be less extensive compared to a publicly traded company with audited financial statements.  Individuals have credit history, but don't have audited financial statements. 

Point: Mortgages are unique capital market instruments. 

MORTGAGE CHARACTERISTICS

If securitized, a mortgage must meet standardized requirements and guidelines (e.g., creditworthiness of borrower) because the mortgage will become part of a mortgage portfolio.  If the bank or FI keeps the mortgage, there is more flexibility. 

Collateral.  All mortgages are secured by real estate, and the FI will record a lien against the property, which protects the FI's financial interest in the property, prevents transfer of title, and gives the FI the right to start foreclosure, and eventually evict the homeowner and reclaim the property if payments are in default.  REO (real-estate owned), bank property from foreclosure.  

Down Payment.  Most mortgages require down payment (10-20% for conventional, 3-5% for FHA, and 0% for VA).  The larger the down payment, the more protection for the bank, the less likely the homeowner will default.  See 7-1 on p. 190 about foreclosures and S&L troubles.  With less than 20% down payment, the borrower is required to purchase PMI (private mortgage insurance) for the lender, to cover the FI for the difference between the value of the property and the balance remaining on the mortgage.  Suppose a $100,000 home is purchased with 10% down, $90,000 mortgage, and the value of the home falls to $85,000 and goes into default/foreclosure.  PMI would cover the $5,000 difference for the lender (might be slightly less if the mortgage had been paid down below $90,000).  As the value of the principal decreases, and as the property value increases, the borrower can eventually ask that the PMI be removed. 

FHA/VA vs. Conventional Mortgages.  Federally insured mortgages are offered by banks and mortgage companies, but repayment is guaranteed by either the FHA or VA (for a .5% fee, 1/2 point).  VA mortgages are for veterans only, 0% down payment.  FHA mortgages are for middle class homeowners, 3% down payment, with maximum loans of $144,00 to $280,000 depending on location and cost of living.  For Genesee County, FHA limit is $160,000 (Oct 2004), $226,00 for Oakland and Lapeer Counties, $290,000 in many parts of CA. 
(Web site for FHA: https://entp.hud.gov/idapp/html/hicostlook.cfm ). 

Conventional mortgages are not federally insured, but use PMI for default protection.  Secondary mortgage market generally requires either: a) 20% down payment or b) PMI. 

Mortgage Maturities.  Usually 30 years (360 months) or 15 years (180 months).  Borrowers like 15 year mortgages, because they can be paid off in 1/2 the time, if they can afford a higher payment.  And the interest rates are lower, e.g., 5.50% now (10/2003) for 30 year, and 4.75% for 15 year.  

30 YR, $100,000 @ 5.50%    

   360      5.5/12       $100,000    ______            0

15 YR, $100,000 @ 4.75%       

   180     4.75/12      $100,000    ________        0

FIs like 15-year mortgages because they have less interest rate risk than a 30-year (lower duration). 

Balloon payment mortgages have an early payoff at the end of 5 or 7 years, when principal becomes due.  Could be interest only, or payments based on 30-year amortization at a fixed rate, but with a 5-7 year balloon, often with the option to refinance/convert to a new fixed rate for the remaining 23-25 years. 

Mortgage Interest Rates.  Mortgage rates (30-year) are tied closely to the 10-year treasury bond/note rate, see Figure 7-3 on p. 192.  Why 10-year T-Bonds and not 30-year? 

Fixed vs. Adjustable Rates.  Borrowers choose between fixed-rate mortgage (fixed monthly payments), and ARM adjustable-rate mortgage (adjustable payments).  See Figure 7-4, p. 193, ARM share of market, 1987-2001.  Current programs, October 2003 from http://www.bankrate.com :

30 year fixed      5.50%

15 year fixed      4.75%

1/1 yr ARM        3.25% (Fixed for 1 years, then adjustable every year)

3/1 yr ARM        3.65% (Fixed for 3 years, then adjustable every year)

5/1 yr ARM        4.25% (Fixed for 5 years, then adjustable every year)

ARMs are usually adjusted to some index, like 1, 3, 5 or 10 year T-note rates, + some margin (1-2%), along with some lifetime cap above the starting rate (5-6%). 

Borrowers generally prefer fixed rates when interest rates are _______ and ARMs when interest rates are ___________.   See p. 193, in 1987 fixed rates were more than 11%, more than 9% in 1994, and more than 8% in 2000, all periods where the share of ARMs was high. 

Discount Points.  Prepaid interest at closing to buy the rate down, and lower monthly payments.  1 point = 1% of the mortgage amount, e.g. 2 points on $100,000 mortgage is $2,000. 

Examples:      5.50%, 0 points

                      5.38%, 1.25 points

                      5.25%, 2 points

Other Fees. Application fee, Title Search, Title Insurance, Appraisal Fee, Loan Origination Fee, Closing Costs, Recording fees, etc. 

Mortgage Refinancing.   Mortgages generally give the borrower a "call option" to refinance anytime during the life of the mortgage.  Note that the option is asymmetric, the lender/FI does not have a "put option" to refinance on the borrower.  For example, mortgage interest rates are 8%.  If mortgage rates fall to 4%, borrowers exercise their call option and refinance down to 4%.  If mortgage rates rise to 12%, the lenders/FIs cannot refinance up to 12%.  

Mortgage refinancing typically goes up when interest rates fall, see Figure 7-5 on p. 195.  In periods of historically low interest rates (1993, 1998, 2001) mortgage refinancing goes up, to 50% or more of all new mortgages.  Refinancing decision involves a cost-benefit analysis, comparing the costs of refinancing ($1000 or more) to the benefits of lower mortgage payments over some expected period.  General rule of thumb: You need to save 2% and expect to stay in your house for 2 years for refinancing to make sense. 

MORTGAGE AMORTIZATION

Monthly mortgage payments include principal and interest (PI) and usually taxes and insurance, PITI.  Why are insurance and taxes included?  Each payment includes principal and interest, and those amounts change monthly. 

Example: $150,000 house, 30-year, 8% fixed-rate mortgage, with 20% down ($30,000).  Mortgage = $120,000.  Calculate monthly payments:

   360       8/12       $120,000      ______             0

Amortization Schedule:

Yellow Key, AMORT (FV)

= (displays Principal of PMT 1)

= (displays Interest of PMT 1)

= (displays balance of PMT 1)

Yellow Key, AMORT (for second payment)

=, =, =

Yellow Key, AMORT (for next payment)

=, =, =

For payments 1-12:

1, Input, 12, Yellow Key, AMORT

=, =, =

For payments 13-24:

13, Input, 24, Yellow Key, AMORT

=, =, =

For payment 180:

180, Input, 180

Yellow Key, AMORT

=, =, =

Total PMTS = 360 x $880.52 = $316,987

15-year, 8% fixed-rate $120,000 mortgage.  Calculate monthly payments:

   180       8/12       $120,000      ______             0

Yellow Key, AMORT

=, =, =

Total PMTS = 180 x $1146.78 = $206,421

Discount Points.  Prepaid interest to reduce payments and the interest rate.  Example 7-4, p. 199.

Two ways to compare: Cost/Benefit analysis or APR:

APR

   360      7.75/12      $120,000   ______             0

   360    ______       $117,600      ______          0

APR = ______ vs. 8%

Calculate PV of the difference in payments:

   360       7.75/12     _______          20.83            0

PV of Benefits: ___________  vs. $2,400 (Cost)

Breakeven Point (Number of months to breakeven):

 _____       7.75/12       (2400)        20.83            0

You have to plan on paying the mortgage for _____ months to save enough money to pay for the points.  If you are planning on moving or paying off the mortgage before the ______  month, you are better off without paying the points. 

Second Mortgages and Home Equity Loans.  In addition to a first mortgage, about 15% of mortgage holders have second mortgages, which are also secured by the real estate, but are secondary in priority in the event of default or foreclosure.  Home equity loans are a line of credit arrangement similar to a second mortgage.  Both allow homeowners to tap into the equity in their home without having to sell the house, e.g., to raise money to start a business, pay for college, buy a vacation home, buy a car, etc.  Because of the higher risk, second mortgages and home equity loans charge a higher interest than first mortgages, about 1.5%-2% risk premium.  Note: Interest on all mortgage loans (first, second, home equity) is tax-deductible. 

SECONDARY MORTGAGE MARKETS

After banks or mortgage companies originate mortgages, 60% are sold or securitized in the secondary mortgage market.  Reasons: 1) Reduces interest rate risk for S&Ls and banks, due to the maturity/duration mismatch of assets (long-term loans) and liabilities (short-term deposits), especially if interest rates ________ .  2) Generates income/revenue from servicing the mortgages for a fee, i.e., the bank sells the mortgage but continues to service it for a fee of 1/4%-1/2% (collects monthly payments of PITI from borrower, passes on to mortgage investor, maintains escrow account and all records).  Some mortgage companies specialize in loan servicing rather than investing in mortgages.

How do FIs sell individual mortgages from their loan portfolio?  1) Package a group of new mortgages into a "mortgage portfolio" and sell as a pool on the secondary market, or 2) Issue mortgage-backed securities backed by a portfolio of recently issued mortgages. 

History and Background of Secondary Mortgage Markets.  Secondary mortgage markets were created during the 1930s as part of major banking (and stock market) reform, with the establishment of Federal National Mortgage Association (FNMA or Fannie Mae), Federal Housing Administration (FHA) and the Veterans Administration (VA).  FNMA would buy mortgages from thrifts (S&Ls), allowing the S&Ls to make more loans.  FHA and VA would guarantee mortgages.  The backing of the federal government through FNMA, FHA, and VA facilitated the creation of the secondary mortgage market, since mortgage investors were protected from default risk.

In the 1960s, VA loans decreased, and the government created additional agencies to expand the secondary mortgage markets, GNMA (Ginnie Mae), FHLMC (Freddie Mac). 

MORTGAGE SALES

Banks and S&Ls have sold residential and commercial mortgages to each other for 100 years. Example: Small rural bank originates a large commercial loan from a local farm/business, and wants to remove all or part of the loan from its balance sheet.  Reasons: 1) Has too many farm loans and is exposed to lending concentration risk, or 2) Mortgages generally have the highest default risk and highest interest rate risk among the bank's assets.  Or a small bank may want part to participate/invest in a large loan that they can't handle themselves, and will buy part of a large loan from a larger bank.

Mortgage sale occurs when an FI originates the loan and sells it to another party, either immediately after the origination or at some subsequent date, without recourse usually (72%) or sometimes with recourse.  No new security is created.  If sold without recourse, the asset/loan is taken off the balance sheet of the seller. 

Who buys mortgages?  Banks (domestic and foreign), insurance companies, pension funds, mortgage security/bond mutual funds. 

Why sell mortgages?  Risk management for banks, helps reduce credit risk and interest rate risk.  Helps match duration of assets and liabilities.  Example: Banks sells a $100,000 30-year fixed rate 8% mortgage and buys a 2-year $100,000 5% T-note when short-term deposits are paying 2%.   

MORTGAGE SECURITIZATION

Total of about $4T mortgage-backed securities (MBSs) in 2001.  3 Types: 1) Pass-through securities, 2) CMOs and 3) mortgage-backed bonds.  General process:

1) Pooling a group of mortgages together with similar characteristics (30-year fixed rates) to create a mortgage portfolio.

2) Removing these mortgages from the balance sheet of the originating FI.

3) Selling interests in the portfolio as mortgage securities to investors.     

Result: More efficient risk management for FIs, greater volume of mortgage credit, lower costs to borrowers, increased investment opportunities for investors.  Example of significantly increased efficiencies of indirect finance.    

1. Pass Through Securities.  Primary mechanism for securitization. Mortgage portfolios are created, say $2.5m pool, and pass-through mortgage securities (certificates) are created and sold to investors in standard denominations, minimum $25,000 investment, $5,000 increments.  Each $25,000 investment would represent a 1% ownership interest in the mortgage pool.  Principal and interest payments from the homeowners are paid to the FI and then passed through to the investors, minus a servicing fee.  See Figure 7-7, p. 203. 

Pass-through securities are created by federally-insured GNMA, FNMA, and FHLMC; and also by private mortgage issuers, each with roughly 25% of the market, see Figure 7-3, p. 204. 

GNMA (16% market) Government-owned agency.  Deals only with pass-through securities created from federally-insured mortgages by FHA, VA and FHMA.   Minimum pool $1m, minimum investment $25,000, all mortgages in pool have the same interest rate, e.g. 6% fixed rate.  Investors receive about .50% less than the underlying mortgage rate, e.g. 5.50%, and the .50% is split between the servicing FI and GNMA ($10,000 per year for every $1m pool).  GNMA provides timing insurance, guarantees full and timely payments to investors.     

FNMA (35% market) Created in 1938 as a government mortgage agency, now a private corporation owned by shareholders, stock traded on NYSE.  FNMA has a secured line of credit from Treasury, so it has implicit govt. backing and is considered very safe, AAA-rated bonds.  FNMA securitizes FHA, VA and conventional loans (with 20% min. down payment, or PMI).  FNMA creates MBSs by purchasing packages of mortgages from banks, S&Ls, and mortgage companies, sells to pension funds and life insurance companies.  Guarantees timing of payments. 

FHLMC (26% market) Private, stockholder owned corporation with a line of credit from Treasury (AAA rating).  Historically specialized in mortgages issued by S&Ls.  Guarantees timely payments.  VA, FHA and conventional loans.  

Private Mortgage Pass-Through Issuers (24% market). Citigroup/Citibank, Chase Mortgage Finance, GE Capital Mortgages, etc.  Must register securities with SEC.  MBSs from nonconforming mortgages (jumbos, low down payments, low/no documentation). 

MBS Quotes, see Table 7-4 p. 206. GNMA, FNMA and FHLMC quotes.  30 year and 15 year quotes.  Mortgage coupon rates (6.5%, 7%, 7.5%), prices are quoted like bonds, e.g. 101-12 is 101 12/32, or 101.375% or $1013.75 per $1000 face value.  Average life is estimated (2.5 to 7.5 years) based on pre-payment projections.  The MBS-Treasury spread is quoted, based on matching average life maturity, e.g. 162 basis points or 1.62% spread, 200 bp or 2% spread, etc.  Prepayment speed is quoted, e.g., 249 which means that prepayment is currently taking place 2.49x faster than normal, due to _______________.  YTM is quoted based on the price, coupon rate, and prepayment projections. 

2. Collateralized Mortgage Obligations (CMOs).  Second mechanism for creating MBSs.  Pass-throughs give investors a fixed pro-rata share of CFs (e.g., 1%), with no guaranteed CF amount, and no protection against prepayment (all investors are equally exposed to prepayment risk).  CMO is a multi-class MBS with different investor classes or tranches, each with a different guaranteed semi-annual coupon payment, like a bond.  Also, excess CFs from increased prepayments go only to one class of bondholders, leaving other classes unaffected and protected.  Compared to pass-throughs, CMOs give investors greater control over maturity/duration by selling different tranches, with different maturities. 

Creation of CMOs.   Double securitization process: GNMA pass-through is created and issued.  Investment bank (e.g., Goldman Sachs) would purchase a pass-through MBS issue and then re-package the CFs to appeal to different types of investors with different time horizons.  (Note: similar to an investment bank creating zero-coupon bonds from coupon bonds).  Goldman Sachs places the pass-through MBS in escrow/trust, and then issues 3-17 new classes/tranches of bonds backed by the original pass-through securities, i.e., repackage the original CFs.  See Figure 7-8, p. 208, creation of three classes/tranches: A-1 ($215m) at 7% coupon, A-2 ($350m) at 8% coupon, and A-3 ($435m) at 9% coupon.

The creator of the CMO makes a profit by repackaging the CFs from single-class, pass-through GNMA, into different CFs more attractive to different groups of investors.  The sum of the prices at which different classes of CMO CFs can be sold normally exceeds that of the original pass-through, creating profits/gains from repackaging CFs. 

Class A-1: Least pre-payment protection.  Any excess CFs, from prepayment, automatically go to class A-1 bondholders.  Shortest maturity/duration, with least prepayment protection, and attractive to investors seeking short-duration MBS (< 5 years) to reduce duration of asset portfolios.  Biggest purchaser of A-1 class MBSs?  Depository institutions like commercial banks and S&Ls.  Why? 

Class A-2: After A-1 investors have been paid off completely, excess CFs from prepayment now go to A-2 investors.  Duration of 5-7 years, buyers include pension funds and life insurance companies, some banks/S&Ls. 

Class A-3: Greatest prepayment protection, and longest duration. More attractive to life insurance companies and pension funds who want to match long-term duration assets with long-term duration liabilities more effectively than regular pass-through MBSs (no prepayment protection).   

CMOs can have up to 17 classes, not just 3.  CMOs are attractive because investors have greater control over duration/maturity compared to pass-throughs, although there is still some uncertainty about the exact duration since prepayment activity is still somewhat unpredictable.  Depends on?

3. Mortgage-Back Bonds (MBBs) are the third type of MBS.  Features: 1) MBBs stay on a bank's balance sheet, pass-throughs and CMOs remove mortgages from a bank's balance sheet.  2) CFs (payments) to investors are not directly tied to the underlying mortgage payments for a MBB, unlike pass-throughs and CMOs.  MBBs is a process of collateralizing a portion of a bank's mortgage portfolio into a specific pool, and issuing low-cost long-term bonds to the public to raise funds to support the mortgage pool.  A third-party trustee is appointed to monitor the MBB issue, and a credit rating is assigned (usually investment grade of BBB or higher). 

Example: Bank issues $100m of mortgage-back bonds at 6% to finance a $110m pool of new 8% mortgages, pledges those specific mortgages as collateral to back the bonds (with a $10m excess collateral cushion to protect against defaults).  Advantages: Bank matches long-term assets (mortgages) with long-term liabilities (MBBs), reduces interest rate risk.   

Disadvantages: 1) MBBs tie up a bank's assets and balance sheet for a long time (ten years) and reduces liquidity, 2) excess collateral to achieve a higher credit rating also reduces liquidity and profits (bank pays interest expense on a liability ($110m) of greater value than the asset amount ($100m) that generates interest income), and 3) mortgages on the balance sheet require certain capital adequacy standards (capital-asset ratio and risk-adjusted capital-asset ratio, net worth requirements).  Capital requirements are higher for riskier assets (mortgages).  Because of these costs, MBBs are the least common form of MBS. 

PARTICIPANTS IN THE MORTGAGE MARKETS

See Figure 7-12 on p. 213, for a breakdown of mortgage holders.  Note the increase in MBS (mortgage pools) from 40% in 1992 to 52% in 2001, and the decrease in Depository Institutions (banks) from 39% to 35%. 

Note the small holdings of mortgages by mortgage companies (only .48% in 2001).  Mortgage companies typically make money from the origination of the mortgages (loan origination fee, usually 1%), and servicing the mortgages, but don't hold them as investments.  25% of residential mortgages are originated by mortgage companies, see Figure 7-13 on p. 214, vs. about 50% from banks and S&Ls.  In terms of issuing GNMA MBSs, mortgage companies represent 70% of the market, vs. 24% for banks/thrifts.  Point: Mortgage companies specialize in originating and then selling and securitizing mortgages in the secondary market, continuing to service them.  Issue: Mortgage companies are not depository institutions. 

International Trends.  Securitization of mortgages is now common in Europe (UK, Germany, France, Netherlands), especially because of ________________.  

Securitization of Other Assets.  See p. 664.  The same process used to securitize mortgages can also be applied to car loans, student loans, mobile home loans, ARMs, SBA loans, credit card loans/receivables, commercial loans, etc. 

Two-step process to fixed-income securitization: 1) Create a portfolio/pool of loans, and 2) Sell shares like a mutual fund.  Financial Engineering, creating new fixed-income securities through indirect finance. 

Benefits of Securitization: 1) More liquid credit market, 2) Greater volume of credit available, 3) More competitive credit market for borrowers and investors, 4) Increased efficiency of credit markets, 5) Greater flexibility for borrowers and investors, more loan options for borrowers, greater control over maturity/duration for investors, 6) Enhances Risk Management and 7) Ultimately a higher standard of living, more wealth and prosperity.