Transcript Document

9
Mortgage
Markets
Mortgage Insurance
 Mortgage insurance guarantees repayment in the event of borrower
default
 Lenders usually require mortgage insurance if you don’t make a 20%
downpayment. When loan-to-value ratio (LTV) drops below 80%,
mortgage insurance can usually be dropped
 Borrower pays insurance premiums, usually on a monthly basis,
along with mortgage payment and escrow
 Borrowers can obtain mortgage insurance in two broad ways:
 Through the government: Federal insurers include Federal Housing
Administration (FHA) and Veterans Administration (VA) (about ¼ of the
mortgage insurance market)
 Through private insurance (called private mortgage insurance or PMI)
 FHA/VA insured loans are usually available only to first-time home
buyers and require a smaller downpayment; the insurance premiums
are lower than PMI; but FHA/VA loans come with miles of red-tape
 PMI is a little more expensive but it is cleaner, with less red-tape
WWCB Illustration of Interest Rate Risk
WWCB
Balance Sheet
ASSETS
Mortgage Receivable, 30-yr, 7% fixed
LIABILITIES
Deposit Accounts (savings accounts) 3%
EQUITY
Capital of bank owners
TOTAL LIABILITIES & EQUITY
$
100,000
$
90,000
$
$
10,000
100,000
A. Calculate net interest margin in terms of percent
Interest Income Percentage
Interest Expense Percentage
Net Interest Margin
WWCB Illustration of Interest Rate Risk
B. Calculate net income in terms of dollars
Interest Income
Interest Expense
Net Interest Margin
Fixed Oper. Costs (wages, utilities, etc.)
Net Income
C. Calculate net income in dollars assuming
interest rates on deposits increase to 8%
Interest Income
Interest Expense
Net Interest Margin
Fixed Oper. Costs (wages, utilities, etc.)
Net Income
$
2,000
$
2,000
WWCB Illustration of Interest Rate Risk
D. Calculate net income in dollars assuming
interest rates on deposits decrease to 1%
Interest Income
Interest Expense
Net Interest Margin
Fixed Oper. Costs (wages, utilities, etc.)
$
2,000
Net Income
E. What risks does WWCB face? Name each risk below.
- Risk that interest rates will increase and cause net loss:_____________________
- Risk that interest rates will decrease & mortgage will be prepaid early
and then proceeds have to be reinvested at lower rate:_____________________
- Risk that depositors may want to withdraw all their money:_____________________
- Risk that mortgage borrower may default on payments:____________________
WWCB Illustration of Interest Rate Risk
F. What actions can WWCB take to limit interest-rate risk?
G. What actions can WWCB take to limit pre-payment risk?
H. What actions can WWCB take to limit liquidity risk?
I. What actions can WWCB take to limit credit or default risk?
Types of Residential Mortgages
1.
2.
3.
4.
5.
6.
7.
Fixed-rate mortgages
Adjustable-rate mortgages (ARMs)
Graduated-payment mortgages (GPMs)
Growing-equity mortgages
Second mortgages
Shared-appreciation mortgages
Balloon payment mortgages
Fixed-rate Mortgages
 Fixed rate loans have a constant rate until maturity (15,
20, 30, 50 or even 100 years)
 Interest rate risk hurts lender if interest rates rise
 Interest rate risk hurts borrowers if interest rates drop
 U.S. is one of few countries in which a rate can be locked
for 30 years or more. Very few other countries allow a
lock in for > 10 yrs
Exhibit 9.3 Example of Amortization Schedule for Selected Years
(Based on a 30-Year, $100,000 Mortgage at 8 Percent)
Adjustable-rate Mortgages (ARMs)
 Rates vary with some index (prime plus margin, etc.)
 e.g. 3/1 means rate won’t change for 3 years after which it can change
every year
 e.g. Upper and lower boundaries are set (caps)
 Less risk for lenders as yields move with cost of funds
 Creates uncertainty for borrowers whose mortgage
payments can change over time
Comparison of Rates on Newly Originated Fixed-Rate and
Adjustable-Rate Mortgages
Effects of Shorter Maturities
 Can save significant interest
 Increased popularity of 15-year loans
 Lender has lower interest rate risk if the term of the loan is lower
 Borrower saves on interest expense over loan’s life but monthly
payment is higher
 See example. http://www.mortgage-net.com/calculators/mp_cl.html
Payments Necessary for 15- and 30-Year Mortgages
(Based on an Interest Rate of 8 Percent)
Maturity Dates: When is Principal Due?
 Balloon payments
 Principal not paid until maturity
 Forces refinancing at maturity
 Amortizing mortgages
 Monthly payments consist of interest and principal
 During loan’s early years, most of the payment reflects interest
Creative Mortgage Financing
 Graduated-payment mortgage (GPM)
 Small initial payments
 Payments increase over time then level off
 Assumes income of borrower grows
 Growing-equity mortgage
 Like GPM, this has low initial payments
 Unlike GPM, payments never level off
Creative Mortgage Financing
 Second mortgage used in conjunction with first or
primary mortgage
 Shorter maturity typical for 2nd mortgage
 1st mortgage paid first if default occurs so 2nd
mortgage has a higher rate/risk
 If used by sellers, makes a home with an assumable
loan more affordable
 Home equity loan is a form of 2nd mortgage
 Shared-appreciation mortgage
 Below market rate but lender shares in home’s price
appreciation (e.g. PUC)
Mortgage Refinancing Activity over Time
Activities in the Mortgage Markets
 Origination (create terms)
 Funding, investing or financing
 Servicing or maintenance (collecting payments, escrow)
 Selling loans
 Secondary market exists for loans
 Securitization
 Pool and repackage loans for resale
 Allows resale of loans not easily sold on an individual basis
Activities in the Mortgage Markets
 Unbundling of mortgage activities provides for
specialization in:
 Loan origination
 Loan servicing
 Loan funding
 Any combination of the above
Institutional Mortgage Holders
 Federally related mortgage pools
 Commercial banks
 Dominate commercial mortgage market
 Savings institutions
 Primarily residential mortgages
 Life insurance companies
 Commercial mortgages
Institutional Use of Mortgage Markets
 Mortgage companies (e.g. Home Loan Ctr.)
 Originate and quickly sell loans
 Do not maintain large portfolios
 Government agencies including Fannie Mae and Freddie
Mac
 Brokerage firms
 Investment banks
 Finance companies
Risk from Investing in Mortgages
 Interest-rate risk (risk of locking in to what
becomes an unattractive rate, causing investment
value to drop)
 Long-term fixed-rate mortgages financed by
short-term funds results in high interest-rate risk
(e.g. S&L crisis)
 To limit exposure to interest rate risk
 Sell mortgage shortly after origination
 Adjustable rate mortgages
 Shorter-term mortgages (e.g. Canada)
 Use balloon payments
Risk from Investing in Mortgages
 Prepayment risk
 Borrowers refinance if rates drop by paying off higher rate loan and
financing at a new, lower rate
 Investor receives payoff but has to invest at the new, lower interest
rate (reinvestment risk)
 Manage the risk with ARMs or by selling loans
Risk from Investing in Mortgages
 Credit risk can range from total default to late
payments
 Factors that affect default risk
 Level of borrower equity
 Loan-to-value ratio often used
 Higher use of debt, more defaults
 Borrowers income level
 Borrower credit history
 FICO (scores 300-850; looks at payment history, credit
history, no. & types of accounts, etc.)
 Quality of collateral
 Require mortgage insurance
Unsound & Greedy Lending
• Subprime mortgages are
given to either:
• risky borrowers with poor credit
scores (FICO under 620)
OR
• those who have good credit but
provide insufficient
documentation or have high DTI
(known as Alt-A loans)
• Subprimes made up an
increasing portion of total
mortgages, from 5% in 1994
to 20% in 2006 .
Risk from Investing in Mortgages
 Measuring risk
 Use sensitivity analysis to review various “what if” scenarios
covering everything from default to prepayments (SHOCK
treatments, show BMCU)
 Asset/Liability Management (ALM)
Use of Mortgage-Backed Securities
 Securitization is an alternative to the outright sale of a
loan
 Group of mortgages held by a trustee serves as collateral
for the securities
 Institution can securitize loans to avoid interest rate risk
and credit risk while still earning service fees
 Payments passed through to investors can vary over time
Securitization
• The risk of sub-prime mortgages was spread
around the world through securitization.
• In a nutshell, this means your home loan is
sold by your lender (in a package along with
other home loans) to investors all around the
world.
• Student loans, auto loans, and credit cards
markets are also securitized in a similar
manner.
Mortgage Broker
Home
Seller
(Countrywide, Hm
Loan Ctr, etc.)
Simplified Process
of Securitization
$$
Subprime
Borrower
Banks
(BofA, Wells, etc.)
Loan
Pmts
Servicer
$$
Pmts
Rating Agencies
(Moody’s, S&P, etc.)
Loan
MBS Issuer
(Investment banks,
FNMA, etc.)
Pmts
$$
MBS
Credit Insurance (CDS)
(AIG, etc.)
MBS=Mortgage-Backed Securities; CDS=Credit Default Swaps
Investors
(Hedge Funds, Pension
Funds, Endowments, Ins.
Co, Intern Fds, etc.)
Use of Mortgage-Backed Securities
Ginnie Mae (GNMA) mortgage-backed securities
 Government National Mortgage Association, created in 1968, with
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•
•
goal of providing liquidity, stability and affordability to the housing
market.
Ginnie Mae does not issue mortgage backed securities like its
cousins Fannie and Freddie, merely guarantees FHA/VA/RHA
mortgages , backed by the full faith and credit of the U.S.
GNMA is not a publically traded company likes its cousins
A U.S. government agency, wholly owned by the Federal
government and operated by the Dept. of HUD
Backed by explicit guarantee of Federal government
Use of Mortgage-Backed Securities
Fannie Mae (FNMA) mortgage-backed securities
 Created in 1938 as part of the New Deal; Federally chartered but privately
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owned with stock traded on NYSE, ticker FNMA. Taken over by the Fed
gov’t in Sept/2008 and is now in conservatorship.
No explicit guarantee of bonds by federal government, but gov’t bailed it
out in fall/08 – so actions speak louder than words.
Uses funds from mortgage-backed pass-through securities to purchase
conventional mortgages (that are not FHA or VA)
Channel funds from investors to institutions that want to sell mortgages
Guarantee timely payments to investors
Some securities strip (securitize) interest and principal payment streams
for separate sale
Accounting scandals & CEO Franklin Raines who had
political ambitions; poor kid from Seattle who
made it big at Harvard, Rhoades Scholar; $9 billion
acctg fraud = 40% of profits 2001-2004!
Politicians used FNMA to encourage sub-prime borrowing
Use of Mortgage-Backed Securities
Freddie Mac (Fed. Home Loan. Mort. Assoc.)
 Created in 1970, this a financial services company, Federally
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chartered but privately owned with stock traded on NYSE, ticker
FRCC (in conservatorship right now)
Created to compete with FNMA
Mission is to provide liquidity, stability and affordability in the
housing market
Sells participation certifications (PCs) to investors and uses these
funds purchase conventional mortgages from banks, S&Ls, credit
unions, etc.
Guarantees timely payments to investors
No explicit guarantee of bonds by federal government, but gov’t
bailed it out in fall/08 – so actions speak louder than words.
The Looming Demise of Fannie/Freddie
Fannie Mae and Freddie Mac’s reform
There has been talk for years about reforming, or even dismantling Fannie
Mae and Freddie Mac but there has been little action to match the talk.
That, however, might be changing, as bipartisan momentum for reform
seems to be building. President Obama and a number of Democrats have
come out in support of reforming Fannie Mae and Freddie Mac and nearly
all of the Republican caucus backs the idea.
The devil is in the details. Given the giant influence these organizations
have on the mortgage market, reform is a thorny issue, and must be
addressed systemically to avoid possible negative ramifications the U.S.
housing market, including the potential demise of the 30-year mortgage.
Use of Mortgage-Backed Securities
 Publicly issued pass-through securities (PIPS)
 No Federal charter or guarantee
 Backed by conventional mortgages instead of FHA or VA
mortgages
 Private mortgage insurance
Use of Mortgage-Backed Securities
 Collateralized mortgage obligations (CMOs)
 Semi-annual payments differ from other securities’ monthly
payments
 Segmented into classes
 First class has quickest payback
 Any repaid principal goes first to investors in this class
 Investors choose a class to fit maturity needs
 One concern is payback speed when rates drop
Use of Mortgage-Backed Securities
 CMOs cont.
 Can be segmented into interest-only IO or principal-only PO
classes
 High return for IO reflect risks
 Useful investment but be aware of the risks
 1992 failure of Coastal States Life Insurance due to CMO
investments
 Some CMO mutual funds
 Regulators have increased scrutiny
Use of Mortgage-Backed Securities
 Mortgage-backed securities for small investors
 In the past, high minimum denominations
 Unit trusts created to allow small investor participation
 Mutual funds
 Advantages
 Can purchase in secondary market without purchasing the need to
service loans
 Insured and liquid
Sub-prime Mortgage Crisis
See separate PowerPoint, entitled Econ Crisis and also the
following slides.
Mortgage Credit Crisis
Impact of the Credit Crisis on Fannie Mae and Freddie
Mac
 The agencies had invested heavily in subprime
mortgages that required homeowners to pay higher rates
of interest.
 By 2008, many subprime mortgages defaulted, so Fannie
Mae and Freddie Mac were left with properties (the
collateral) that had a market value substantially below the
amount owed on the mortgages that they held.
 Funding Problems
 With poor financial performance, Fannie Mae and Freddie
Mac were incapable of raising capital.
 FNMA and FHLMC stock values had declined by more than
90 percent from the previous year.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Impact of the Credit Crisis on Fannie Mae and Freddie
Mac (cont.)
 Rescue of Fannie Mae and Freddie Mac
 In September 2008, the U.S. government took over the
management of Fannie Mae and Freddie Mac.
 The Treasury agreed to provide whatever funding would be
necessary to cushion losses from the mortgage defaults.
 In return, the Treasury received $1 billion of preferred stock
in each of the two companies.
 The U.S. government allowed Fannie Mae and Freddie Mac
to obtain funds by issuing debt securities so that they could
resume purchasing mortgages and thereby ensure a more
liquid secondary market for them.
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Systemic Risk Due to the Credit Crisis
 Mortgage insurers that provided insurance to
homeowners incurred large expenses.
 Some financial institutions with large investments in MBS
were no longer able to access sufficient funds to support
their operations during the credit crisis.
 Individual investors whose investments were pooled (by
mutual funds, hedge funds, and pension funds) and then
used to purchase MBS experienced losses.
 International Systemic Risk - Financial institutions in
other countries (e.g., the United Kingdom) had offered
subprime loans, and they also experienced high
delinquency and default rates.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Who Is to Blame?
 Mortgage originators - some mortgage originators were
aggressively seeking new business without exercising
adequate control over quality.
 Credit rating agencies - The rating agencies, which are
paid by the issuers that want their MBS rated, were
criticized for being too lenient in their ratings shortly
before the credit crisis.
 Financial institutions that packaged MBS - Could have
verified the credit ratings assigned by the credit rating
agencies by making their own assessment of the risks
involved.
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Who Is to Blame?
 Institutional investors that purchased MBS - relied
heavily on the ratings assigned to MBS by credit rating
agencies without the due diligence of performing their
own independent assessment.
 Financial institutions that insured MBS - presumed,
incorrectly, that the MBS would not default.
 Speculators of Credit Default Swaps - Many buyers of
CDS contracts on MNS were not holding any mortgages
of MBS that they needed to hedge.
 Conclusion about Blame
 The question of who is to blame will be argued in
courtrooms.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Government Programs Implemented in Response to the
Crisis
 The Housing and Economic Recovery Act of 2008.
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Enabled some homeowners to keep their existing homes
and therefore reduced the excess supply of homes for sale
in the market.
Financial institutions must be willing to create a new
mortgage that is no more than 90 percent of the present
appraised home value.
Financial institutions that volunteer for the program
essentially forgive a portion of the previous mortgage loan
when creating a new mortgage.
 Other programs promoted “short sale” transactions in
which the lender allows homeowners to sell the home for
less than what is owed on the existing mortgage.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Government Bailout of Financial Institutions
 On October 3, 2008, the Emergency Economic
Stabilization Act of 2008 (also referred to as the bailout
act) enabled the Treasury to inject $700 billion into the
financial system and improve the liquidity of financial
institutions with MBS holdings.
 The act also allowed the Treasury to invest in the large
commercial banks as a means of providing the banks
with capital to cushion their losses.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Mortgage Credit Crisis
Financial Reform Act
 In July 2010 the Financial Reform Act was
implemented, and one of its main goals was ensuring
stability in the financial system.
 The act mandated that financial institutions granting
mortgages verify the income, job status, and credit history
of mortgage applicants before approving mortgage
applications.
 The act also required that financial institutions that sell
mortgage-backed securities retain 5 percent of the
portfolio unless the portfolio meets specific standards that
reflect low risk.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY

Residential mortgages can be characterized by whether they
are prime or subprime, whether they are federally insured, the
type of interest rate used (fixed or floating), and the maturity.
Quoted interest rates on mortgages vary at a given point in
time, depending on these characteristics.

Various types of residential mortgages are available, including
fixed-rate mortgages, adjustable-rate mortgages, graduatedpayment mortgages, growing equity mortgages, second
mortgages, and shared appreciation mortgages.

The valuation of a mortgage is the present value of its
expected future cash flows, discounted at a discount rate that
reflects the uncertainty surrounding the cash flows. A
mortgage is subject to credit risk, interest rate risk, and
prepayment risk.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY (Cont.)

Mortgage-backed securities (MBS) represent packages
of mortgages; the payments on those mortgages are
passed through to investors. Ginnie Mae provides a
guarantee of payments on mortgages that meet specific
criteria, and these mortgages can be easily packaged
and sold. Fannie Mae and Freddie Mac issue debt
securities and purchase mortgages in the secondary
market.
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY (Cont.)

Mortgages were provided without adequate qualification
standards (including allowing very low down payments)
in the 2003–2006 period. Then a glut in the housing
market caused a drastic decline in home prices, with the
result that the market values of many homes were lower
than the mortgages. Many homeowners defaulted on
their mortgages, which led to a credit crisis in the 2008–
2009 period. The U.S. government use various
strategies to revive the U.S. mortgage market, including
an emergency housing recovery act, the rescue of
Fannie Mae and Freddie Mac, and a bailout of financial
institutions that had heavy investments in mortgages and
mortgage-backed securities.
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.