The Mortgage market

1. The Mortgage market www.assignmentPoint.com

2. What is a mortgage market? • While the American dream may be to own a home the major portion of the funds to purchase one must be borrowed. • The market where these funds are borrowed is called the mortgage market or the housing finance market. • This sector of the debt market is by far the largest in the world. www.assignmentPoint.com

3. What are mortgaged back securities? • The mortgage market has undergone significant structural changes since the 1980. Innovations have occurred in terms of the design of new mortgage instruments and the development of products that use pools of mortgages as collateral for the issuance of a security such securities are called mortgaged backed securities. • The mortgage market is a collection of markets which includes a primary market or origination market and a secondary market where mortgages trade. www.assignmentPoint.com

4. What is a mortgage? • A mortgage is a pledge of property to secure payment of debt. • Typically, property refers to real estate, which is often in the form of a house, the debt is the loan given to the buyer of the house by a lender. Thus a mortgage might be a pledge of a house to secure payment of loan. • If a homeowner (The mortgagor) fails to pay the lender (the mortgagee) the lender has the right to foreclose the loan and size the property in order to ensure that it is repaid. www.assignmentPoint.com

5. What is conventional mortgage? • When the lender makes the loan based on the credit of the borrower and on the collateral for the mortgage, the mortgage is said to be a conventional mortgage. • The lender may require the borrower to obtain mortgage insurance to insure against default by the borrower. www.assignmentPoint.com

6. Investors There are four general categories: • Major financial institutions: As for financial institutions the two major investors in mortgages are commercial banks and thrifts (i.e. savings institutions) • Federal and related agencies: Their purpose into provide liquidity to the mortgage market. • Mortgage pools or trusts: Basically, the mortgages held in mortgage pools and trusts are those used as collateral for the issuance of a mortgage-backed security. • Individuals and others: The participation in the mortgage market by other institution investors such as pension funds appears to be small. They invest in mortgages through their ownership of mortgage-backed secretaries. www.assignmentPoint.com

7. Mortgage originators Who is mortgage originator? • The original lender is called the mortgage originator. • Mortgage originators include commercial banks; thrifts mortgage bankers, life insurance companies and pension funds. • The three largest originators for all types of residential mortgages are commercial banks, thrifts and mortgage bankers. • Mortgage bankers or brokers typically do not invest in mortgages they originate but rather sell the mortgages to other entities they will invest in them. www.assignmentPoint.com

8. Sources of revenue for originators: • They typically charge an origination fee which is expressed in terms of points where each point represents 1% of the borrowed funds. For example, an origination fee of two points on a $100000 mortgage represents $2000. • Originators also change application fees and certain processing fees. • Another source of revenue is the profit that might be generated from selling a mortgage at a higher price than it originally cost. This profit is called secondary marketing profit. www.assignmentPoint.com

9. The origination process • The individual who seeks funds completes an application for that provides personal financial information pays an application fee. - Then the mortgage originator performs a credit evaluation of the applicant. - If the lender decides to lend the funds it sends a commitment letter to the applicant. • At the time of commitment letter the lender will require that the applicant pay a commitment fee. • This letter commits the lender to provide funds to the applicant. • The length of time of the commitment varies between 30 and 60 days. • The commitment letter states that for a fee the applicant has right but not the obligation to require the lender to provide funds at a certain interest rate and on certain terms. www.assignmentPoint.com

10. Some terms used in this section are: • Payment to income (PTI) ratio • The loan to value (LTV) ratio • Fixed-rate mortgage • Adjustable mortgage • Securitized • conduits • Conforming mortgages • nonconforming mortgages • Jumbo mortgages www.assignmentPoint.com

11. Payment to income (PTI) ratio: The ratio of monthly payments to monthly income and is a measure of the ability of the applicant to make monthly payments (both mortgage and real estate tax payments) Lower ratio means greater ability to meet the required payments. • The loan to value ratio (LTV): It is the ratio of the amount of the loan to the market (or appraised) value of the property. • Fixed rate mortgage: The lender typically gives the applicant a further choice of when the interest rate on the mortgage will be determined. The three choices are: • At the time the loan application is submitted. • At the time a commitment letter is issued and • At the date when the property is purchased. www.assignmentPoint.com

12. Adjustable mortgage: Adjustable mortgage is a loan in which the contract rate is reset periodically in accordance with some appropriately chosen reference rate. • Securitized: When a mortgage is used as collateral for the issuance of a security; the mortgage is said to be securitized. • Conduits: The government sponsored enterprises and private companies who pool the mortgages and sell them to investors and called conduits. • Conforming mortgages: Conforming mortgages is one that meets the underwriting standard established by the Federal national mortgage association for being in a pool of mortgages underlying a security that they guarantee. • Non conforming mortgages: If an applicant does not satisfy the underwriting standards the mortgage is called a nonconforming mortgage. These do not necessarily have greater credit risk. • Jumbo mortgages: Loans that exceed the maximum loan amount are called jumbo mortgages. www.assignmentPoint.com

13. The risks associated with mortgage origination What is pipeline? • The loan applications being processed and the commitments make by a mortgage originator together are called its pipeline. What is pipeline risk? • It refers to risks associated with originating mortgages. www.assignmentPoint.com

14. This risk has 2 components Price risk: It refers to the adverse effects on the value of the pipeline if mortgage rates rise. Fallout risk: • Fallout risk is the risk that applicants or those who were issued commitment letters will not complete the transaction by purchasing the property with funds borrowed from the mortgage originator. • To protect against price risk, the originator could get a commitment from the agency or the private conduit to which the mortgage originator plans to sell the mortgage. • Mortgage originators can protect themselves against fallout risk by entering into an agreement with an agency or private conduit for optional rather than mandatory delivery of the mortgage. www.assignmentPoint.com

15. Mortgage services • Every mortgage loan must be serviced. • Servicing of a mortgage loan involves: • Collecting monthly payments and forwarding proceeds to owners of the loan. • Sending payment notices to mortgagors; • Reminding mortgagors when payments are overdue; • Maintaining records of principal balances; • Administering an escrow balance for real estate taxes and insurance purposes; • Initiating foreclosure proceedings if necessary and • Furnishing tax information to mortgagers when applicable. • Services include bank-related entities, thrift related entities and mortgage bankers. www.assignmentPoint.com

16. Revenue and costs associated with mortgage services There are five sources of revenue: • Servicing fee • The interest that can be earned by the service • The float earned on the monthly mortgage payment. • Several sources of ancillary income: • A late fee • Commissions from cross-selling their borrowers credit life and other insurance products. • Fees can also be generated from selling mailing lists.   • There are other benefits of servicing rights for services who are also lenders. • The periodic costs of servicing mortgage loans are predominantly the cost of labor and computer systems. www.assignmentPoint.com

17. Mortgage Insurers There are two types of mortgage-related insurance. • The first type is originated by the lender to insure against default by the borrower and is called mortgage insurance. - It is usually required by lenders on loans with loan to value (LTV) ratios greater than 80%. - The amount insured will be some percentage of the loan and may decline as the LTV ratio declines. - While the insurance is required by the lender, the cost of the insurance is borne by the borrower. • The second-type of mortgage related insurance is acquired by the borrower, usually with a life insurance company and is typically called credit life. • The policy provides for a continuation of mortgage payments after the death of the insured person, which allows the survivors to continue living in the house. • Since the insurance coverage decreases as the mortgage balance declines, this type of mortgage insurance is simply a terms policy. www.assignmentPoint.com

18. There are two types of mortgage insurance: • Insurance provided by a government agency and private mortgage insurance. • While both types of insurance have a beneficial effect on the creditworthiness of the borrower, the first type is more important from the lenders perspective. • Mortgage insurance is sought by the lender when the borrower is viewed as being capable of mailing the monthly mortgage payments, but does not have enough funds for a large down payment. www.assignmentPoint.com

19. Default risks associated with mortgage insurance underwriting The various sources of default risk can be classified into the following four broad categories • Normal (or auctorial) risks: Insurers expect that a certain percentage of the borrowers will default due to unique circumstances not directly attributable to any of the other categories of default risk. • Originator underwriting risk: At one time mortgage originators such as banks and thrifts would retain the mortgage loan in their portfolio. As a consequence they kept underwriting standards tight. • National economic risks: Default rates are positively related to national economic conditions. As national unemployment levels increase claims increase. • Local economic risks: While the national economy may be thriving regions within the United States may suffer high levels of unemployment and depressed property values. www.assignmentPoint.com

20. Traditional mortgage • The level payment fixed rate mortgage is also referred to as a traditional mortgage. Characteristics of the fixed rate level payment, fully amortized mortgage • The borrower pays interest and repays principal in equal installments over an agreed upon period of time called the maturity or term of mortgage. • Thus at the end of the terms, the loan has been fully amortized. The frequency of payment is typically monthly and prevailing term of mortgage is 20 to 80 years. Each monthly mortgage payment for a level payment fixed rate mortgage is due on the firms of each month. • When a loan repayment schedule is structured in this way, so that the payments made by the borrower will completely pay off the interest and principal, the loan is said to be fully amortizing. www.assignmentPoint.com

21. Deficiencies of the traditional mortgage • There are problems with the traditional mortgage design. In the presence of high and variable inflation, this mortgage design suffers from two basic and serious shortcomings. These may be labeled as the mismatch problem and tilt problem. • Mortgages a very long term asset have been financed largely by depository institutions that obtain there funds through deposits that are primarily, if not entirely of a short-term nature. These institutions have engages inevitable in a highly speculative activity; borrowing short and lending very long. That is there is a mismatch of the maturity of the assets (i.e. mortgages) and the liabilities raised to fund those assets. This may be resolved the homeowners mortgage obligation places a great burden in real terms in the initial years. In other words, the real burden is tilted to the initial years. www.assignmentPoint.com

22. Balloon Mortgages • A variant of the adjustable rate mortgage is called the balloon / reset mortgage. The primary difference between a balloon / reset mortgage design and the one just described is that the mortgage rate is reset less frequently. • The balloon mortgage has long been used in Canada where it is referred to as a rollover mortgage. • In this mortgage design the borrower is given long-term financing by the lender but at specified future dates the contract rate is renegotiated. www.assignmentPoint.com

23. Hybrid Mortgages What are convertible ARM’s? • ARMs that can be converted into fixed rate mortgages are called convertible ARMs. • There are also fixed rate mortgages whose mortgage rate can fall if interest rates drop by some predetermined level. These are called reducible fixed rate mortgages. • Convertible ARM and reducible FRMs are hybrid mortgages with built in refinancing options. • These hybrid mortgage instruments reduce the converting of refinancing. www.assignmentPoint.com

24. A convertible ARM gives the borrower the choice of converting to a fixed rate mortgage. - The new rate could be either a rage determined by the lender or a market-determined rate. • In the case of a fixed rate mortgage that may be adjusted downward, the borrower can exercise the option to have the mortgage adjusted only if some predetermined index rate falls below a certain level. - Usually this option is not granted for the entire life of the mortgage, but typically only for the first five of six years. www.assignmentPoint.com

25. Graduated Payment Mortgage • A GPM is one in which the nominal monthly payment grows at a contract rate during a portion of the life of the contract, thereafter leveling off. - The mortgage rate is fixed for the life of the loan despite the fact that the monthly mortgage payment gradually increases. • The terms of a GPM plan include: - the mortgage rate - The term of the mortgage - The number of years over which the monthly mortgage payment will increase and when the level payment will being. - The annual percent increase in the mortgage payments. • It does not solve the tilt problem. • It should be apparent that it cannot solve the mismatching problem. www.assignmentPoint.com

26. Price level adjusted mortgage • This mortgage design is similar to the traditional mortgage except that monthly payments are designed to be level in purchasing power terms rather than in nominal terms and that the fixed rate is in the real rather than the nominal rate. • To compute the monthly payment under a price level adjusted mortgage (PLAM) the following terms of the contract must be specified: 1. The real interest rate. 2. The term of the loan and 3. The index to be used to measure the price level usually the consumer price index. • The PLAM is not a new concept it has been used for decades in many countries with high inflation, where the housing industries could not possibly have survived with the traditional mortgage. www.assignmentPoint.com