Ch. 9: Mortgage Markets

Explain collateralized debt obligations (CDOs).

A CDO represents a package of debt securities backed by collateral that is sold to investors. A CDO commonly combines a variety of debt securities, including subprime mortgages, prime mortgages, automobile loans, and other credit card loans. It was a popular means by which a creditor would originate a loan and even service it without lending its own funds.

Explain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer this type of mortgage?

A balloon payment mortgage requires interest payments for a 3-5 year period. At the end of the period, full payment is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages.

Describe how mortgage-backed securities are used.

A financial institution that purchases or originates a portfolio of mortgages can sell mortgages by packaging them and issuing MBS. The mortgages serve as collateral for the debt securities issued. The interest and principal payments on the mortgages are transferred to the owners of the securities after deducting service fees.

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

A growing equity mortgage requires continual increasing mortgages payments throughout the life of the mortgage. The mortgage lifetime is reduced because of the accelerated payment schedule, whereas a GPM's life is not reduced.

Why are second mortgages offered by some home sellers?

A second mortgage is often used when financial institutions provide a first mortgage that does not fully cover the amount of funds the borrower needs. A second mortgage complements the first mortgage. It falls behind the first mortgage in priority claim against the property in the event of default.

Describe the shared-appreciation mortgage.

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

How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? Explain how caps on ARMs can affect a financial institution's exposure to interest rate risk.

An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk. Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charge can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increase cost of funds.

What types of financial institutions finance residential mortgages? What type of financial institution finances the majority of commercial mortgages?

Commercial banks and savings and loans associations dominate the one-to-four family mortgages. Commercial banks dominate the commercial mortgages.

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

Credit rating agencies rate the trenches of MBS based on the mortgages they represent.

Distinguish between FHA and conventional mortgages.

FHA mortgages guarantee loan repayment, thereby covering against the possibility of default by the borrower. The guarantor is the Federal Housing Administration. Conventional mortgages are not federally insured, but they can be privately insured.

Explain why some financial institutions prefer to sell the mortgages they originate.

Financial institutions may sell their mortgages if they desire to enhance liquidity, or if they expect interest rates to increase. Mortgage companies frequently sell mortgages after they are originated and continue to service them. They do not have sufficient funds to maintain all the mortgages they originate.

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

Mortgage companies concentrate on servicing mortgages rather than investing in mortgages. Thus, they are not as concerned about hedging mortgages over the long run. However, they are exposed to interest rate risk during the period from when they originate mortgages until they sell them. If interest rates change over this period, the price at which they can sell the mortgages will change.

Describe the factors that affect mortgage prices.

Mortgage prices are affected by changed in interest rates and risk premiums. Factors such as economic growth, money supply, and inflation affect interest rates and therefore affect mortgage prices. A change in economic growth may also affect the risk premium.

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

Subprime mortgages were provided by mortgage companies to borrowers who would not have qualified for prime loans. These mortgages enabled more people with relatively lower income, high existing debt, or a small down payment to purchase homes. Many financial institutions such as mortgage companies were willing to provide subprime loans because it allowed them a way to expand their business. They could also charge higher fees and higher interest rates on the mortgage in order to compensate for the risk of default.

Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial institution higher for a 15-year or a 30-year mortgage? Why?

The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is higher for a 30 year mortgage because the 15-year one exists for only half the period.

Describe the graduated-payment mortgage. What type of homeowners would prefer this type of mortgage?

The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5-10 years. They level off after the 5-10 year period. Homeowners whose incomes will rise over time may desire this mortgage.

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 risk of MBS is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements.

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.

The secondary market for stocks and bonds is facilitated by an organized exchange such as the New York Stock Exchange. The prices of these securities sold in the secondary market are more transparent. The prices of mortgages sold in the secondary market are not transparent. However, the secondary market for mortgages has been enhanced because of securitization. This allows for the sale of smaller loans that could not be as easily sold if they were not packaged.

What is the general relationship between mortgage rates and long-term government security rates? Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements.

There is a high positive correlation between mortgage rates and long-term gov't security rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates because their cost of financing the mortgages would increase while the interest revenue received would be unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenue received from mortgages could change in the same direction as the cost of financing as interest rates change.

Explain the problems in valuing MBS.

There is no centralized reporting system that reports the trading of MBS in the secondary market, as there is for other securities such as stocks and Treasury bonds. The only participants who know the price of the MBS that was traded is the buyers and the seller.

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

When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to the lenders that offer fixed-rate mortgages are limited.