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