Transcript ch11_final.ppt

Chapter Eleven
THE MORTGAGE MARKETS
Chapter Eleven
The Mortgage Markets
In the Beginning . . .
1776 – The Wealth of Nations
• Adam Smith 1723 – 1790
• Wrote “The Wealth of Nations” in 1776
• Developed the Real Bills Doctrine of
banking
“Virtue is more to be feared
than vice, because its
excesses are not subject to the
regulation of conscience.”
—Adam Smith
Slide 11–3
Real Bills Doctrine
• The function of a bank is to supply the working capital needs
of industry
• Banks should only lend against self-liquidating promissory
notes (Account Receivables)
• Banks do not make long term loans
• Banks do not lend against real estate
• Banks do not lend to individuals
Slide 11–4
Characteristics of early Bank Charters
Example: Bank of Montreal
• Voting powers restricted to residents of Montreal & British
subjects (even though most of the founder’s money came from
New York)
• No individual could vote more than 20 shares
• Charter was valid for only ten years
• Prohibition against the bank being involved in any other trade
or business (to prevent conflicts of interest)
• Bank prohibited against taking real property as security
• Double liability for shareholders (Bank of Nova Scotia, 1832)
Slide 11–5
Some Early Bank Acts
• 1871 - The first Bank Act – it was 6 pages long
• 1890 – Bank Circulation Redemption Fund created (an insurance
fund to cover losses in bank notes, due to bank failure)
• 1900 – the Canadian Bankers Association created by an Act of
Parliament
– Banks now allowed to merge without the need for a specific act of
Parliament
• 1913 – Directors of a bank allowed to appoint 1 or more auditors
(but it was not mandatory to do so & the auditors did not have to
be accountants)
• 1923 – Mandatory for a bank to have 2 auditors, each appointed
for three years. However, the concept of government inspection
was rejected
Slide 11–6
Bank Acts: 1954 & 1967
• 1954: The first signs of change
– Banks first allowed to enter the residential real estate
market
– But mortgages had to be insured under NHA
– Mortgage interest rates were capped at 6%
• 1967: Change continues
– Banks allowed to make non-NHA insured mortgages
– Six percent cap on mortgage interest rates lifted
Slide 11–7
Share of the Mortgage Market Held by Major
Mortgage-Lending Institutions
Source: http://www.cmhcschl.gc.ca/mktinfo/store/files/opims/Mortgage%20Market%20Trends%202003%20&%202004/M
MT-03-2004.pdf
Slide 11–8
Mortgage Credit Growth in Canada
Slide 11–9
Canadian Residential Mortgage Market
• Total value of mortgage loans outstanding in Canada as of
December 31, 2005 - $623 Billion
• Canadian banks hold approximately 73% of all mortgage loans
made in Canada
• Mortgages made up approximately 49% of all loans made by
Canadian chartered banks (2003 figures)
• In 1998, 34.3% of dwellings were mortgage free, 30.4%
carried a mortgage and 35.3% were rented (Source: Stats
Canada).
• In 1998, shelter accounted for 20 percent of household
spending -- the largest expense for those with an annual total
income of less than $53,000. For those earning over $53,000,
taxes took the biggest bite out of their pocketbook (Source:
Stats Canada).
Slide 11–10
What Are Mortgages?
mort·gage (môr'gĭj)
n.
1.A temporary, conditional pledge of property to a creditor as
security for performance of an obligation or repayment of a
debt.
2.A contract or deed specifying the terms of a mortgage.
3.The claim of a mortgagee upon mortgaged property.
tr.v., -gaged, -gag·ing, -gag·es.
1.To pledge or convey (property) by means of a mortgage.
[Middle English morgage, from Old French : mort, dead (from Vulgar
Latin *mortus, from Latin mortuus, past participle of morī, to die) +
gage, pledge (of Germanic origin).]
Source: http://www.answers.com/topic/mortgage
Slide 11–11
Characteristics of the Residential Mortgage
• Mortgage Interest Rates
– The posted rate is a nominal rate
– For all conventional mortgages, the nominal rate is compounded semiannually
– For variable rate mortgages, the nominal rate is compounded according
to the payment frequency (typically monthly)
• Term
– The term of the mortgage is the period over which the interest rate is
fixed.
– Usually varies between 6 months to 5 years
• Amortization Period
– This is the period over which the mortgage is repaid
Slide 11–12
Mortgage Rates versus Canada Bonds
Current mortgage interest rates
http://www.canadamortgage.com
Slide 11–13
Loan Terms
• Collateral
– The mortgaged property
• Down Payment
– High ratio mortgages – downpayment is less than 25% of
appraised value (loan to value ratio > 75%)
– Conventional mortgages – downpayment is at least 25% of
appraised value (loan to value ratio < 75%)
• Mortgage Insurance
– Offered by CMHC & Genworth Financial Canada
– Required on all high-ratio mortgages
Slide 11–14
Mortgage Insurance Rates
Genworth Financial Canada: Mortgage Insurance Rates
Slide 11–15
Types of Mortgage Loans
• Insured and Conventional Mortgages
• Fixed- and Variable-Rate Mortgages
• Other Types
–
–
–
–
–
–
–
Open and Closed
Second Mortgages
Reverse Mortgages
Graduated-Payment Mortgages (GPMs)
Growing Equity Mortgages (GEMs)
Shared-Appreciation Mortgages (SAMs)
Equity Participation Mortgages
Slide 11–16
Canadian Residential Mortgages
• Canadian residential mortgages are compounded
twice per year but typically paid monthly
• To solve this type of problem, you must follow a
three step process to first calculate the appropriate
monthly interest rate
• This rate is then used to calculate the monthly
payment
Slide 11–17
Canadian Residential Mortgages
• Step #1: Calculate the effective annual interest rate,
assuming compounding 2 times per year
• Step #2: Calculate a new “notional” nominal rate that
is equivalent to the effective rate from Step #1,
assuming compounding of 12 times per year
• Step #3: Calculate the monthly interest rate by
dividing the answer from Step #2 by 12
Slide 11–18
Example
• Assume you hold a $100,000 Canadian residential
mortgage with a 6% interest rate, amortized over 20
years. What are your monthly payments?
Slide 11–19
Mortgage Problem: Solution
• Step #1: Calculate the effective annual interest rate,
assuming compounding of 2 times per year
m
ieff
inom 

  1+
1

m 

2
0.060 

  1+
1

2 

 0.0609 or 6.09%
Slide 11–20
Mortgage Problem: Solution
• Step #2: Calculate a new “notional” nominal rate that
is equivalent to the effective rate from Step #1,
assuming compounding of 12 times per year
m
ieff 
inom 


inom 

1+

 1
m


1


m 1 m
1

i


Eff




1


12
1.0609

1



 12


0.059263 or 5.9263%
Slide 11–21
Mortgage Problem: Solution
• Step #3: Calculate the monthly interest rate, based on
the solution to Step #2
iMonthly
inom

12
0.059263

12
 0.004939 or 0.4939%
Slide 11–22
Mortgage Problem: Solution
• Final Step: Calculate the monthly payment
n
 1  1  i
Monthly 
PVAnnuity  PMT 

iMonthly

PVAnnuity
PMT 
n
 1  1  i

Monthly 




iMonthly


100, 000

 1  1  .004939  240 




.004939


 $712.24




Slide 11–23
Distribution of Principal and Interest
To find details regarding a single payment on the HP10B calculator:
1. Calculate the payment amount
2. Enter the period, then press INPUT
3. 2nd Function AMORT = (Int), = (Prin), = (Bal O/S)
To find details regarding a series of payments on the HP10B calculator
1. Calculate the payment amount
2. Enter the first period, then press INPUT, then enter the second
period
3. 2nd Function AMORT = (Int), = (Prin), = (Bal O/S)
Slide 11–24
Current Types of Mortgages (BMO)
Source: BMO website - http://www4.bmo.com/personal/0,4344,35649_36757,00.html
Slide 11–25
Solve for Monthly Mortgage Payment
Assumptions:
$100,000 Principal
8% APR, compounded twice a year
25 year amortization
Calculate the Monthly Interest Rate
8 2nd Nom
2 2nd P / Y
2nd Eff 8.16%
12 2nd P / Y
2nd Nom 7.8698%
 12  0.6558%  store as I / Y 
0.6558% is the monthly
interest rate we must
use to calculate the
payment on the
mortgage
Slide 11–26
Solve for Monthly Mortgage Payment
1
2nd
P/Y (One Payment/Year)
100,000
PV
0
FV
25 x 12 =
N
0.6558
I
PMT
$763.21
Note: Please do NOT
enter the interest rate
manually. If you do,
you will incur a
rounding error that can
be significant. Instead,
store the interest rate
as I/Y when you finish
calculating it.
The PMT is the monthly mortgage payment, as shown
on the BMO website.
Slide 11–27
Monthly Mortgage: Total Interest
• Now solve for the total interest paid over the life of
the mortgage
Total Interest  # of Payments x Monthly Payment  Principal
 300 x 763.21  100, 000
 228,963  100, 000
 $128,963
Slide 11–28
Solve for Weekly Payment (BMO Example)
Calculate the Weekly Interest Rate
8 2nd Nom
2 2nd P / Y
2nd Eff 8.16%
52 2nd P / Y
2nd Nom 7.8698%
 52  0.1510%  store as I / Y 
Slide 11–29
Solve for Weekly Payment (BMO Example)
1
2nd
P/Y (One Payment/Year)
100,000
PV
0
FV
25 x 52 =
N
0.1510
I
PMT
$175.68
Slide 11–30
Weekly Mortgage: Total Interest
Now solve for the total interest paid over the life of the mortgage
Total Interest  # of Payments x Monthly Payment  Principal
 1,300 x 175.68  100, 000
 228,388  100, 000
 $128,388
Slide 11–31
Accelerated Weekly Mortgage (BMO)
First, calculate the weekly payment by dividing the monthly
payment by 4: 763.21 ÷ 4 = $190.80
Then solve for the weekly interest rate. Then solve for the
number of weeks required to pay off the mortgage (next page).
Calculate the Weekly Interest Rate
8 2nd Nom
2 2nd P / Y
2nd Eff 8.16%
52 2nd P / Y
2nd Nom 7.8698%
 52  0.1510%  store as I / Y 
Slide 11–32
Accelerated Weekly Mortgage (BMO)
1
2nd
P/Y (One Payment/Year)
100,000
PV
0
FV
190.80 +/-
PMT
0.1510
I
N
1,038.4 weeks
The mortgage will take 19 years, 11.5 months to repay.
To calculate this, simply divide the total number of weeks
by 52.
Slide 11–33
Accelerated Weekly Mortgage: Total Interest
Total Interest  # of Payments x Monthly Payment  Principal
 1, 038.4 x 190.80  100, 000
 198,126.72  100, 000
 $98,126.72
The reason that the total interest payments are so much
smaller in this example is due to the shorter amortization
period (less than 20 years versus 25 years). The
amortization period is shorter because you are making a
larger total payment on the mortgage every year.
Slide 11–34
RBC: Cash Back Mortgage
Available on a Variety of Terms
Cashback is available on fixed rate mortgages with terms of 4, 5 or 7 years.
And the amount of money you receive is based on the size and term of your
mortgage - up to 7% of its value.
Source:
http://www.rbcroyalbank.com/RBC:RCn5mo71A8QAAypuvLU/products/mortgages/
cashback.html
Slide 11–35
RBC: Cash Back Mortgage
Cash back Mortgage
• $100,000
• 5 year term
• 25 year amortization
• 5% cash back on drawdown
date
• 7% APR
Conventional Mortgage
• $100,000
• 5 year term
• 25 year amortization
• 0 cash back on drawdown
date
• 6% APR
Slide 11–36
RBC: Cash Back Mortgage
• To analyze this, we first calculate the correct monthly interest
rate for each type (cash back & no cash back)
Cash back : Monthly Interest Rate
7 2nd Nom
2 2nd P / Y
2nd Eff 7.1225%
Conventional : Monthly Interest Rate
6 2nd Nom
2 2nd P / Y
2nd Eff 6.09%
12 2nd P / Y
2nd Nom 6.90%
12 2nd P / Y
2nd Nom 5.9263%
 12  0.5750%  store as I / Y 
 12  0.4939%  store as I / Y 
Slide 11–37
RBC: Cash Back Mortgage
Now calculate the monthly payments for each alternative:
Cash back Mortgage
1
2nd
P/Y (1 Pay/Year)
Conventional Mortgage
1
2nd
P/Y (1 Pay/Year)
100,000
PV
100,000
PV
0
FV
0
FV
25 x 12 =
N
25 x 12 =
N
0.5750
I
0.4939
I
PMT
$700.42
PMT
$639.81
Slide 11–38
RBC: Cash Back Mortgage
Now calculate the balance outstanding at the end of the
five year fixed rate term for each type of mortgage:
Cash back Mortgage
Conventional Mortgage
First calculate the
payment, then:
First calculate the
payment, then:
60
Input
60
Input
2nd
Amort
2nd
Amort
=
=
=
=
=
$91,044.59
=
$89,836.71
Slide 11–39
RBC: Cash Back Mortgage
We can now calculate the implicit interest rate charged by the bank
for the cash back option.
1. Calculate the difference in monthly payments
2. Calculate the difference in balance outstanding at the end of
the five year fixed term
3. Calculate the implicit interest rate
1
2nd
P/Y (1 Pay/Year)
5,000
PV
1,207.88 +/-
FV
60.61 +/-
PMT
60
N
I
-0.9970%
Based on the assumptions
given, the cost of taking the
$5,000 cash back is negative
0.9970% per month or almost
-12% per year. Since banks
never give anything away for
free, we must assume that they
charge more than a 1%
differential for taking the cash
back option!!
Slide 11–40
Securitization: In the Beginning . . .
•
•
•
•
•
•
THE PAST QUARTER-century has seen a revolution in finance. It's felt every time a homeowner
refinances a mortgage or signs up for a credit card. No one person can claim to have lit the fuse for this
revolution -- but Lewis S. Ranieri was holding the match. Joining Salomon Brothers' new mortgage-trading
desk in the late 1970s, the college dropout became the father of "securitization," a word he coined for
converting home loans into bonds that could be sold anywhere in the world. What Ranieri calls "the
alchemy" lifted financial constraints on the American dream, created a template for cutting costs on
everything from credit cards to Third World debt -- and launched a multibillion-dollar industry.
Salomon and Bank of America Corp. developed the first private mortgage-backed securities (MBS) -bonds that pooled thousands of mortgages and passed homeowners' payments through to investors -- in
1977. Not a moment too soon: Skyrocketing interest rates were turning the business of savings and loans -funding long-term mortgages with short-term deposits -- making it a financial death trap for banks just as
the housing demands of maturing baby boomers began to surge.
Ranieri's job was to sell those bonds -- at a time when only 15 states recognized MBS as legal investments.
With a trader's nerve and a salesman's persuasiveness, he did much more, creating the market to trade MBS
and winning Washington lobbying battles to remove legal and tax barriers.
A less likely financial engineer would be hard to imagine. Ranieri, a Brooklyn native, set out to be an
Italian chef until asthma ruled out work in smoky kitchens. A part-time job in Salomon's mail room set him
on the path to trading. A large, volatile man, Ranieri built the firm's mortgage desk in his own image: "fat
guys," as author Michael Lewis described them in Liar's Poker, promoted from the back office, who
indulged in feeding frenzies and practical jokes while selling strange new bonds to doubtful investors.
But Ranieri also recognized that "mortgages are math." He hired PhDs who developed the "collateralized
mortgage obligation," which turns pools of 30-year mortgages into collections of 2-, 5-, and 10-year bonds
that could appeal to a wide range of investors. The homeowner in Albuquerque could now tap funds from
New York, Chicago, or Tokyo, a change that Ranieri figures cuts mortgage rates by two percentage points.
Soon everything from credit-card balances to auto loans was being repackaged.
As MBS trading exploded in the '80s, Salomon dominated the market. After becoming vice-chairman,
Ranieri was seen as "too big" in the trade by his bosses and was forced out in 1987. Now he is nonexecutive chairman of Computer Associates International Inc. and runs his own investment firm. And the
market he created has funneled trillions into the American dream of homeownership.
Slide 11–41
Source: Business Week Nov 29, 2004.
Securitization: The Creation of a Mortgage
Backed Security
• A typical mortgage consists of three components
– The origination of the loan
– The funding of the loan
– The servicing of the loan
• Traditionally in Canada all three functions have been
done by one institution
• However, it is often more efficient to have each
component done by a separate institution, due to
regulatory and diversification issues
Slide 11–42
Securitized Mortgages
• Benefits
1. Reduces the problems caused by regional lending
institution’s sensitivity to local economic
fluctuations
2. Borrowers have access to a national capital market
3. Investors have low-risk and long-term investments
in mortgages without having to service the loan
Slide 11–43
MBS: Why Growth Occurred in the US
• Unit banking laws in the US prohibited most
branching
• Banks in fast growth areas had more demand for
mortgages than they could satisfy
• Banks in slow growth areas had more deposits than
necessary
• Be securitizing, all banks were better able to achieve
both diversification and business objectives, thereby
increasing return & reducing risk
• Because Canadian banks had an extensive branch
network, they could achieve the same objectives
internally
Slide 11–44
MBS Issues in Canada
Slide 11–45
Mortgage-Backed Securities
Slide 11–46