Residential Mortgage Characteristics

Residential Mortgage Characteristics

l      Federal insurance guarantees repayment in the event of borrower default

l      Limits on amounts, borrower requirements

l      Borrower pays insurance premiums

l      Conventional mortgages can also be privately insured

Residential Mortgage Characteristics

n     Fixed rate loans have a constant rate

l      Interest rate risk can hurt lender rate of return

u   If interest rates rise in the market, lender’s cost of funds increases with no matching increase in return

l      Borrowers lock in their cost and have to refinance to benefit from lower market rates

u   The benefit must outweigh the transaction costs of refinancing

Residential Mortgage Characteristics

n     Adjustable-rate mortgages

l      Rates and the size of payments can change

u   Maximum allowable fluctuation over year and life of loan

u   Upper and lower boundaries for rate changes

l      Lenders stabilize profits as yields move with cost of funds

l      Uncertainty for borrowers whose mortgage payments can change over time

l      Yields generally lower than fixed-rate mortgages (why?)

Residential Mortgage Characteristics

n     Balloon payments

l      Principal not paid until maturity (after 3-5 years)

l      Forces refinancing at maturity

n     Amortizing mortgages

l      Monthly payments consist of interest and principal

l      During loan’s early years, most of the payment reflects interest

Creative Mortgage Financing

n     Graduated-payment mortgage (GPM)

l      Small initial payments

l      Payments increase over 5-10 years, then level off

l      Assumes income of borrower grows

n     Growing-equity mortgage

l      Like GPM low initial payments

l      Unlike GPM, payments never level off

Creative Mortgage Financing

n     Second mortgage used in conjunction with first or primary mortgage

l       Shorter maturity typically for 2nd mortgage

l      1st mortgage paid first if default occurs so 2nd mortgage has a higher rate

l      Sellers use second mortgages to make a home more affordable

n     Shared-appreciation mortgage

l      Below market rate but lender shares in home’s price appreciation

Activities in the Mortgage Markets

n     The secondary market facilitates mortgage activities

l      Origination and funding are separate business activities and may be “unbundled”

n     Securitization

l      Pool and repackage loans for resale

l      Allows resale of loans not easily sold on an individual basis

Institutional Use of Mortgage Markets

n     Finance and Mortgage companies

l      Originate and quickly sell loans

l      Do not maintain large portfolios

n     Government agencies including Fannie Mae, Ginnie Mae and Freddie Mac

n     Other financial institutions act as mortgage investors and/or offer instruments to hedge interest rate risk of other mortgage investors

Valuation of Mortgages

n     Market price of mortgages is PV of cash flows

n     Periodic payment commonly includes payment of interest and principal

n     Required rate of return determined by risk-free rate, credit risk and liquidity

Risk from Investing in Mortgages

n     Interest rate risk: Value of mortgage decreases as market interest rate (i.e. discount rate) increases

n     Prepayment risk:

l      Borrowers refinance if market interest rates drop by paying off higher rate loan

l      Investor receives payoff but has to invest at the new, lower interest rate

Risk from Investing in Mortgages

n     To limit exposure to interest rate risk and prepayment risk

l      Sell mortgage shortly after origination

l      Originate or invest in ARMs

Risk from Investing in Mortgages

n     Credit risk: risk of default or late payments

n     Factors that affect default

l      Level of borrower equity

l      Borrowers income level and volatility

l      Borrower credit history

l      “Subprime” mortgages

n     Lenders limit exposure to credit risk through:

l      Insurance

l      Maintaining mortgages originated by itself

Use of Mortgage-Backed Securities

n     Securitization is an alternative to the outright sale of a loan

n     Group of mortgages held by a trustee serves as collateral for the securities

n     Institution can securitize loans to avoid interest rate risk and credit risk while still earning service fees

n     However, prepayment risk is the same