Mortgage Markets

Mortgage Markets

What are Mortgages?

  • Definition: Loans provided to individuals or firms for the purpose of acquiring homes, land, or other forms of real estate.

Differences Between Mortgages and Other Securities

  • Backing: Mortgages are secured by real property, whereas stocks and bonds are often backed by intangibles.

  • Standardization: Mortgages frequently lack a standardized size or denomination.

  • Investor Involvement: Mortgages typically involve a single investor.

  • Information Disclosure: There is limited information available on mortgage borrowers compared to stock and bond issuers, which must share financial statements, earnings, debt, credit ratings, etc.

  • Quote: "Companies tell the world their #’s, us regular people don’t."

Mortgage Acquisition

  • Mortgages can be acquired from various sources, not just banks. These include:

    • Credit unions

    • Government programs

    • Online lenders

  • Primary Mortgage Market: This is the main market where borrowers initially connect with lenders for home loans.

    • Example: You approach Chase Bank for a loan of $300,000, which you pay back monthly.

  • Types of Mortgages in the Primary Market:

    • Home Mortgages: For 1-4 person dwellings (total outstanding: $10.87 trillion).

    • Multifamily Mortgages: For apartment complexes, townhouses, and condos (total outstanding: $1.47 trillion).

    • Commercial Mortgages: For business real estate (total outstanding: $2.84 trillion).

    • Farm Mortgages: For rural properties (total outstanding: $0.25 trillion).

Key Characteristics of Mortgages

  • Down Payments: The initial payment a borrower must make, typically a percentage of the property's purchase price.

  • Private Mortgage Insurance (PMI): This insurance is mandatory when the loan-to-value ratio exceeds 80% (i.e., when down payment is less than 20%).

  • Federally Insured Mortgages: Loans backed by the Federal Housing Administration (FHA) or Veterans Administration (VA), which are not considered conventional mortgages.

Mortgage Payment Mechanics

  • Amortization: Payments are structured so that principal and interest are paid off gradually over time.

    • Balloon Payment Mortgages: Feature fixed monthly interest payments for a term of 3-5 years, after which the full principal is due.

    • Adjustable-rate Mortgages (ARMs): Interest rates fluctuating based on the market; as rates change, monthly payments may increase or decrease.

Borrower Protections

  • Discount Points: Upfront fees paid at closing that lower the interest rate.

    • 1 point = 1% of the loan amount. (Example: For a $200,000 loan, 1 point = $2,000)

  • Refinancing: Obtaining a new loan to replace the existing one, usually to benefit from lower current interest rates, thereby reducing monthly payments.

Mortgage Structuring

  • Amortization Schedule: A table that depicts how each monthly payment divides between interest and principal.

    • Initially, a larger proportion of payments goes towards interest. Over time, a greater portion is paid towards principal, culminating in full amortization by the end of the loan term.

Mathematical Concepts in Mortgages

  • Amortization Calculation:

    • Difference between the bond’s market rate and coupon rate is needed.

    • Multiply by the carrying value to establish interest expense.

    • Deduct actual coupon payments to calculate amortization:

    • Example: For a semi-annual bond with a par value of $1,000, a 10% coupon rate, and a market rate of 12%:

      • Coupon Payment = rac{1000 imes 10 ext{%}}{2} = 50 every 6 months

      • Interest Expense = rac{1000 imes 12 ext{%}}{2} = 60 on interest

      • Final amortization for the period = 60−50=1060 - 50 = 10 of bond discount amortization.

Mortgage Payment Calculation

  • Formula: PV = PMT imes extstyle{igg( rac{(1 - [1/(1 + r)^{t}])}{r}igg)} where:

    • PVPV = Principal amount borrowed through the mortgage

    • PMTPMT = Monthly mortgage payment

    • rr = Monthly interest rate (annual nominal interest rate divided by 12).

    • tt = Total number of months over the mortgage's life.

Bond Pricing Formula

  • Formula for the initial bond pricing: extBondPriceInitial=Cimesrac1−[1/(1+r)n]r+extCallPriceimesrac1(1+r)next{Bond Price Initial} = C imes rac{1 - [1/(1 + r)^{n}]}{r} + ext{Call Price} imes rac{1}{(1 + r)^{n}} where:

    • CC = Coupon payment

    • nn = Number of periods until the call date

    • rr = Yield to call (YTC).

Comparison of Interest Paid on Mortgages

  • Example Analysis: For a $120,000 loan at 7.25% with a term of 15 years (180 months):

    • Monthly payment calculation using mortgage formula leads to:

    • PMT = rac{120,000}{igg( rac{(1 - [1/(1+0.00604167)^{180}])}{0.00604167}igg)}

  • Monthly Payment = 1,095.441,095.44

  • Total payments over 15 years = 197,179.20197,179.20

  • Total interest = 77,179.2077,179.20 compared to a 30-year mortgage interest of 196,987.20196,987.20.

  • Monthly payment for a 30-year mortgage is 880.52880.52, leading to a monthly difference of 214.92214.92, affecting affordability for borrowers with lower income levels.

Market Regulators and Mortgage Types

  • Fannie Mae & Freddie Mac: Government-sponsored entities established to ensure ample money availability for home purchases by buying mortgages and creating mortgage-backed securities (MBS).

  • Jumbo Mortgages: Loans that exceed conventional limits set by Fannie Mae and Freddie Mac, > 484,000484,000 as of 2019.

  • Subprime Mortgages: Loans given to borrowers with poor credit, often resulting in higher interest rates, contributing to the 2008 financial crisis due to their high default rates.

Alternative Mortgage Types

  • Alt-A Mortgages: Risk profile between prime and subprime.

  • Option ARMs: Offer several monthly payment choices including minimum payments with the highest risks and full amortizing payments over various terms (15 years vs. 30 years).

  • Second Mortgages: Additional loans on top of the original mortgage using the same house as collateral, often with higher interest rates.

  • Home Equity Loans: Allow borrowing against home equity, similar to a credit card, enabling withdrawals as needed.

  • Reverse Mortgages: Banks make monthly payments to homeowners (often seniors), securing the loan interest against home equity to be paid back upon sale or death.

Secondary Mortgage Markets

  • Firms move mortgages via pooling or securitization:

    • Pooling: Selling recently originated mortgages in the secondary market.

    • Securitization: Issuing securities backed by these mortgages to reduce liquidity, interest rate, and credit risks.

Historical Context of Secondary Mortgage Markets

  • Formation of agencies like Fannie Mae in 1938 to facilitate mortgage availability.

  • Establishment of Ginnie Mae and Freddie Mac for mortgage investment security.

Mortgage Sales Dynamics

  • Banks have engaged in buying/selling mortgages for over 100 years. Large loans may be shared between smaller and larger banks through correspondent banking.

    • Sale with Recourse: Original bank retains some liability for defaults.

    • Sale without Recourse: New buyer assumes all associated risks.

Mortgage-Backed Securities (MBS)

  • Bundling loans creates MBS, allowing banks to quickly recover cash and allocate risk to investors.

  • Types of MBS:

    • Pass-Through Securities: Direct payments from mortgage payments to investors.

    • Collateralized Mortgage Obligations (CMO): Risk layers based on different tranches.

    • Mortgage-Backed Bonds: Bonds collateralized by mortgages.

Government-Related MBS Outstanding

  • Tracking the outstanding MBS for agencies from 1995 to 2019:

    • GNMA, FNMA, FHLMC, and private issuers with figures representing billions.

Ginnie Mae, Fannie Mae, and Freddie Mac Overview

  • Roles and responsibilities outlined; Ginnie Mae guarantees timely MBS payments while Fannie Mae and Freddie Mac facilitate the flow of loans from banks to MBS, with significant market shares.

Criticism of Fannie Mae and Freddie Mac

  • Held 44% of the U.S. single-family mortgages, faced scrutiny for risky lending during the housing boom, leading to government intervention post-2008.

Mortgages Outstanding by Holder Type

  • Distribution of mortgage ownership among individuals and financial institutions across selected years, indicating trends toward increasing financial institution holdings.

International Trends in Securitization

  • Global participation in U.S. MBS markets outlined, with Europe notably developing its own securitization frameworks.

    • Synthetic Securitization: A technique that allows banks to transfer risk of loans without selling them through derivatives like credit default swaps (CDS).

Real-World Example of Synthetic Securitization

  • Example of a bank managing $100 million in risky loans through a CDS agreement, illustrating how risk management can preserve assets while mitigating exposure to losses.

Questions?

  • Open forum for inquiries regarding previous topics.