FINC 3345 Chapter 9

graduated-payment mortgage

A __________ allows the borrower to initially make small payments on the mortgage. The payments then increase over the first 5 to 10 years and then level off.

Collateralized debt obligation (CDO)

A package of securities that are backed by collateral and are sold to investors.

Credit default swap (CDS)

A privately negotiated contract that protects investors against the risk of default on particular debt securities.

Selling credit default swaps

American International Group (AIG) experienced financial problems during the credit crisis because it focused heavily on

increasing; decreasing

An institution that originates and holds a fixed-rate mortgage is adversely affected by ____ interest rates; the borrower who was provided the mortgage is adversely affected by ____ interest rates.

Positively; positively

At a given point in time, the price of a credit default swap contract should be ________ related to the default risk of the securities covered by the contract. For a given set of securities that are covered by a credit default swap, the price of the contract should be _______ related to the default risk as it changes over time.

Mortgages

Bear Stearns commonly used __________ as collateral when borrowing short-term funds, but its funding was cut off because prospective creditors questioned the quality of the collateral.

Participation certificates (PCs)

Certificates sold by the Federal Home Loan Mortgage Association; the proceeds are used to purchase conventional mortgages from financial institutions.

A high degree of prepayment risk

Collateralized mortgage obligations (CMOs) are generally perceived to have

The prices of stocks and bonds sold on the secondary market are more transparent, while the prices of mortgages aren't. However, the secondary market for mortgages has been enhanced because of securitization.

Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Provide a general explanation for the difference in the activity level.

Collateralized mortgage obligations are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences

Describe how collateralized mortgage obligations (CMOs) are used and why they have been popular.

The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years and then they level off after this period.

Describe the graduated-payment mortgage

A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage.

Describe the growing-equity mortgage

A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates, while in return the lender will share in the price appreciation of the home.

Describe the shared-appreciation mortgage.

The Federal Housing Administration protects FHA mortgages against the possibility of default by the borrower, while conventional mortgages doesn't.

Distinguish between FHA and conventional mortgages.

A CDO represents a package of debt securities backed by collateral that is sold to investors

Explain collateralized debt obligations (CDOs).

Mortgage companies concentrate on servicing mortgages, thus, they are not mortgages over the long run. Mortgage companies' exposure to interest rate risk exists before the mortgage is sold

Explain how a mortgage company's degree of exposure to interest rate risk differs from other financial institutions.

If interest rates move beyond the boundaries implied by the caps, the exposure to interest rate risk will be adversely affected as the mortgage rates may not fully offset the increased cost of funds.

Explain how caps on ARMs can affect a financial institution's exposure to interest rate risk.

Lenders of fixed-rate mortgages can be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages would remain unchanged . They could reduce their exposure to interest rate risk by offering adjustable-rate

Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements.

The Dodd-Frank Act requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating. The Dodd-Frank Act requires the credit rating agencies to provide an annual report about their internal controls used to ensure an unbiased process of rating securities.

Explain how the Dodd-Frank Act of 2010 attempted to prevent biased ratings of mortgage-backed securities by credit rating agencies.

Mortgage insurers incurred expenses from foreclosures of the property they insured. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs.

Explain how the credit crisis adversely affected many other people beyond homeowners and mortgage companies

When interest rates rise, prepayments on mortgages don't occur because none of homeowners refinance with a new mortgage with a higher interest rate.

Explain how the maturity on mortgage-backed securities can be affected by interest rate movements.

In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage.

Explain short sales in the mortgage markets.

Subprime mortgages are a type of mortgage that are offered to borrowers who do not qualify for prime loans. Many financial institutions were aggressively offering subprime mortgages to expand their business.

Explain subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages?

The only participants who know the price of MBS that was traded is the buyer and the seller.

Explain the problems in valuing MBS

Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent.

Explain the role of credit rating agencies in facilitating the flow of funds from investors into the mortgage market (through mortgage-backed securities).

A balloon mortgage payment requires interest payments for a three- to five-year period and full payment at the end of the period.

Explain the use of a balloon-payment mortgage.

the loan repayment to lending institution

Federally insured mortgages are intended to protect

GNMA (Ginnie Mae) mortgage-backed securities Private-label pass-through securities FNMA (Fannie Mae) mortgage-backed securities FHLMA (Freddie Mac) participation certificates Collateralized mortgage obligations (CMOs)

Five of the more common types of mortgage-backed securities are the following:

In 2008, the number of all outstanding subprime mortgages with late payments of at least 30 days was higher than the number of prime mortgages with the same characteristics. The number of prime mortgages that were subject to foreclosure was lower than the number of such subprime mortgages.

How did the repayment of subprime mortgages compare to that of prime mortgages during the credit crisis?

The growing-equity mortgage lifetime is reduced, whereas a GPM's life isn't reduced.

How does the growing-equity mortgage differ from a graduated-payment mortgage?

An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk.

How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why?

Growing-equity mortgage

Mortgage in which the initial monthly payments are low and increase over time.

When interest rates decline, a large proportion of mortgages are refinanced and the benefits are limited.

Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what?

Shared-appreciation mortgage

Mortgage that allows a home purchaser to pay a below-market interest rate; in return, the lender shares in the appreciation of the home's value.

Graduated-payment mortgage (GPM)

Mortgage that allows borrowers to initially make small payments on the mortgage; the payments are increased on a graduated basis.

Fixed-rate mortgage

Mortgage that locks in the interest rate paid by the borrower over the life of the loan.

Balloon-payment mortgage

Mortgage that requires payments for a three- to five-year period; at the end of the period, full payment of the principal is required.

Adjustable-rate mortgage (ARM)

Mortgage that requires payments that adjust periodically according to market interest rates.

Second mortgage

Mortgage used in conjunction with the primary or first mortgage.

Securitization

Pooling and repackaging of loans into securities, which are sold to investors.

Amortization schedule

Schedule developed from the maturity and interest rate on a mortgage to determine monthly payments broken down into principal and interest.

Pass-through securities

Securities issued by a financial institution and backed by a group of mortgages. The mortgage interest and principal are sent to the financial institution, which then transfers the payments to the owners of the pass-through securities after deducting a service fee. Also called mortgage-backed securities.

Mortgage-backed securities (MBS)

Securities issued by a financial institution that are backed by a pool of mortgages; also called pass-through securities.

Collateralized mortgage obligations (CMOs)

Securities that are backed by mortgages; segmented into classes (or tranches) that dictate the timing of the payments.

Primary

The ____ market for mortgages is where mortgages are originated.

More than

The credit risk to a financial institution from investing in mortgage-backed securities representing subprime mortgages is ____ that of mortgage-backed securities representing prime mortgages.

The government intervention stabilized the market for mortgage-backed securities, and therefore helped the financial institutions and homeowners. However, the government budget deficit increased due to the intervention.

The government intervened in order to resolve problems in the mortgage markets during the credit crisis. Summarize the advantages and disadvantages of the government intervention during the credit crisis.

Prepayment risk

The possibility that the assets to be hedged may be prepaid earlier than their designated maturity; also applies to mortgages.

There is a high positive correlation between mortgage rates and long-term government security rates.

What is the general relationship between mortgage rates and long-term government security rates?

Commercial banks

What type of financial institution finances the majority of commercial mortgages?

Homeowners whose incomes will rise over time may desire this type of a mortgage.

What type of homeowners would prefer this type of mortgage?

Commercial banks and savings and loan associations

What types of financial institutions finance residential mortgages?

A second mortgage is often used when a first mortgage does not fully cover the amount of funds the borrower needs and complements the first mortgage.

Why are second mortgages offered by some home sellers?

The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements.

Why do you think it is difficult for investors to assess the financial condition of a financial institution that has purchased a large amount of mortgage-backed securities?

The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. Is the interest rate risk to the financial institution higher for a 15-year or a 30-year mortgage? Why? The interest rate risk is lower for a 15-year mortgage because it has shorter mortgage period.

Why is the 15-year mortgage attractive to homeowners?

Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages.

Why might a financial institution prefer to offer this type of mortgage?

Financial institutions may sell their mortgages if they do not have sufficient funds to maintain all the mortgages they originate

Why some financial institutions prefer to sell the mortgages they originate?

Financial institutions may sell their mortgages if they desire to enhance liquidity.

Why some financial institutions prefer to sell the mortgages they originate? 2

Private-label pass-through securities

____ are backed by conventional mortgages.