Madura_FMI9e_IM_Ch09
Chapter 9
Mortgage Markets
Outline
Background on Mortgages
How Mortgages Facilitate the Flow of Funds
Criteria Used to Measure Creditworthiness
Classifications of Mortgages
Types of Residential Mortgages
Mortgage-Backed Securities
The Securitization Process
CDOs
Within
MBS
Types of Mortgage-Backed Securities
Mortgage Credit Crisis
Who is to Blame?
Contagion Effects of the Credit Crisis
Government Programs Implemented in Response to the Crisis Impact of the Crisis on Fannie Mae and Freddie Mac
Government Bailout of Financial Institutions
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Key Concepts
1.Identify the more popular types of mortgages, and elaborate where necessary.
2.Describe how financial institutions participate in mortgage markets.
3.Explain how some types of mortgages can help reduce a financial institution’s exposure to risk. POINT/COUNTER-POINT:
Is the Trading of Mortgages Similar to the Trading of Corporate Bonds? POINT: Yes. In both cases, the issuer’s ability to repay the debt is based on income. Both types of debt securities are highly influenced by interest rate movements.
COUNTER-POINT: No. The assessment of corporate bonds requires an analysis of financial statements of the firms that issued the bonds. The assessment of mortgages requires an understanding of the structure of the mortgage market (CMOs, etc.).
WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue. Offer your own opinion on this issue.
ANSWER: The question is primarily intended to make students compare mortgages to bonds. There are some similarities, but an institutional investor who manages a corporate bond portfolio would not be able manage a mortgage portfolio without adequate training, and vice versa.
Questions
1.FHA Mortgages. Distinguish between FHA and conventional mortgages.
ANSWER: 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.
2. Mortgage Rates and Risk. 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.
ANSWER: There is a high positive correlation between mortgage rates and long-term government 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 revenues
received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change.
Chapter 9: Mortgage Markets 3 3. ARMs. 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.
ANSWER: 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 charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, 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 increased cost of funds.
4.Mortgage Maturities. 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?
ANSWER: 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 than for a 15-year mortgage, because the 15-year mortgage exists for only half the period.
5. Balloon-Payment Mortgage. Explain the use of a balloon-payment mortgage. Why might a financial
institution prefer to offer this type of mortgage?
ANSWER: A balloon mortgage payment requires interest payments for a three- to five-year period.
At the end of the period, full payment (a balloon payment) is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate
mortgages.
6. Graduated-Payment Mortgage. Describe the graduated-payment mortgage. What type of
homeowners would prefer this type of mortgage?
ANSWER: The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years. They level off after a 5- or 10-year period. Homeowners whose incomes will rise over time may desire this type of a mortgage.
7. Growing-Equity Mortgage. Describe the growing-equity mortgage. How does it differ from a
graduated-payment mortgage?
ANSWER: A growing-equity mortgage requires continual increasing mortgage 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.
8. Second Mortgages. Why are second mortgages offered by some home sellers?
ANSWER: 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.
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9. Shared-Appreciation Mortgage. Describe the shared-appreciation mortgage.
ANSWER: 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.
10.Exposure to Interest Rate Movements. Mortgage lenders with fixed-rate mortgages should benefit
when interest rates decline, yet research has shown that this favorable impact is dampened. By what?
ANSWER: When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited.
11.Mortgage Valuation. Describe the factors that affect mortgage prices.
ANSWER: Mortgage prices are affected by changes 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.
12. Selling Mortgages. Explain why some financial institutions prefer to sell the mortgages they
originate.
ANSWER: 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.
13.Secondary Market. 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.
ANSWER: 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.
14. Financing Mortgages. What types of financial institutions finance residential mortgages? What type
of financial institution finances the majority of commercial mortgages?
ANSWER: Commercial banks and savings and loan associations dominate the one- to four-family mortgages. Commercial banks dominate the commercial mortgages.
15. Mortgage Companies. Explain how a mortgage company’s degree of exposure to interest rate risk
differs from other financial institutions.
ANSWER: 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.
Chapter 9: Mortgage Markets 5 Advanced Questions
16.Mortgage-Backed Securities. Describe how mortgage-backed securities are used.
ANSWER: A financial institution that purchases or originates a portfolio of mortgages can finance those mortgages issue mortgage-backed securities. The mortgages serve as collateral for the
securities. The interest and principal payments on the mortgages are transferred (passed through) to the owners of the securities, after deducting fees for servicing.
17.CMOs. Describe how collateralized mortgage obligations (CMOs) are used and why they have been
popular.
ANSWER: Collateralized mortgage obligations (CMOs) are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences.
18. Maturities of Pass-Through Securities. Explain how the maturity on pass-through securities can be
affected by interest rate movements.
ANSWER: When interest rates rise, prepayments on mortgages occur. If these mortgages were
financed with pass-through securities, the payments will be channeled to the investors that purchased the pass-through securities.
19.How Secondary Mortgage Prices May Respond to Prevailing Conditions. Consider the prevailing
conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on prevailing conditions, do you think the values of mortgages that are sold in the secondary market will increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on the values of existing mortgages?
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants.
20. CDOs. Explain collateralized debt obligations (CDOs).
ANSWER: 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 other credit card loans. It was a popular means by which a
creditor could originate a loan and even service it without lending its own funds.
21. Motives for Offering Subprime Mortgages. Explain subprime mortgages. Why were mortgage
companies aggressively offering subprime mortgages?
ANSWER: Subprime mortgages were provided by mortgage companies to borrowers who would not have qualified for prime loans. Thus, these mortgages enabled more people with relatively lower income, or 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
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them a way to expand their business. In addition, they could charge higher fees (such as appraisal fees) and higher interest rates on the mortgage in order to compensate for the risk of default.
22. Subprime Versus Prime Mortgage Problems. How Subprime Mortgages Caused the Crisis.
How did the repayment of subprime mortgages compare to that of prime mortgages during the credit crisis?
ANSWER: In 2008, about 25 percent of all outstanding subprime mortgages had late payments of at least 30 days, versus less than 5 percent for prime mortgages. In addition, about 10 percent of
outstanding subprime mortgages were subject to foreclosure in 2008, versus less than 3 percent for prime mortgages.
23. MBS Transparency. Explain the problems in valuing MBS.
ANSWER: 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 MBS that was traded is the buyer and the seller.
24. Contagion Effects of Credit Crisis. Explain how the credit crisis adversely affected many other
people beyond homeowners and mortgage companies.
ANSWER: Mortgage insurers incurred expenses from foreclosures of the property they insured.
Individual investors whose investments were pooled by mutual funds, hedge funds, and pension funds and used to purchase MBS experienced losses. Investors who invested in stocks of financial
institutions experienced losses. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. Home builders went bankrupt and many employees in the home building industry lost their jobs.
25. Blame for Credit Crisis. Many investors that purchased the mortgage-backed securities just before
the credit crisis believed that they were misled, because these securities were riskier than they
thought. Who is at fault?
ANSWER: Answers might include the households that applied for mortgages but could not afford them, the originators of mortgages, the financial institutions that packaged mortgages into tranches, the rating agencies, and the financial institutions that invested in mortgage-backed securities. Each party could be partially accountable for not recognizing the high potential for default risk.
26. Avoiding Another Credit Crisis. Do you think that the U.S. financial system will be able to avoid a
credit crisis like this in the future?
ANSWER: A credit crisis is triggered by fear of investors that purchase debt securities. A credit crisis could occur again in the future in response to a weak economy or to various events that cause
concerns that issuers of debt will not repay their debt.
27. Role of Credit Ratings in Mortgage Market. Explain the role of credit rating agencies in facilitating
the flow of funds from investors into the mortgage market (through mortgage-backed securities).
ANSWER: Credit rating agencies rate the tranches of mortgage-backed securities based on the
mortgages they represent.
Chapter 9: Mortgage Markets 7 28. Fannie and Freddie Problems. Explain why Fannie Mae and Freddie Mac experienced
mortgage problems.
ANSWER: Fannie Mae and Freddie Mac are major investors in mortgages. However, they make poor investment decisions by using funds to invest in many mortgages that involved high risk.
29. Rescue of Fannie and Freddie. Explain why the rescue of Fannie Mae and Freddie Mac improves
the ability of mortgage companies to originate mortgages.
ANSWER: Without a strong secondary market for mortgages, financial institutions that originate mortgages would not be able to sell mortgages, and therefore may have to finance them on their own.
This would severely limit the amount of funding for new mortgages. Thus, while the government rescue is primarily focused on ensuring a more liquid secondary market, this action indirectly
encourages more originations of new mortgages.
30. U.S. Treasury Bailout Plan. The U.S. Treasury attempted to resolve the credit crisis by establishing
a plan to buy mortgage-backed securities held by financial institutions. Explain how the plan could
possibly improve the situation for mortgage-backed securities.
ANSWER: The secondary market for mortgage-backed securities was inactive during the credit crisis, because of the high level of mortgage defaults. Investors were afraid to purchase these
securities because of the risk involved. The Treasury’s purchase of the mortgage-backed securities corrected the imbalance (excessive supply) in the secondary market.
31. Assessing the Risk of MBS. 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?
ANSWER: The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements.
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
a. “If interest rates continue to decline, the interest-only CMOs will take a hit.”
When interest rates decline, mortgages are commonly prepaid, and the interest payments on
those mortgages are terminated. Therefore, payments to investors holding the interest-only
CMOs are terminated as well.
b. “Estimating the proper value of CMOs is like estimating the proper value of a baseball player; the
proper value is much easier to assess five years later.”
The future value of a CMO is dependent on the future interest rate movements. Since interest rate movements are difficult to forecast, it is difficult to properly value a CMO. It would be easier to look back in time after recognizing how interest rates moved to determine what the value of the
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CMO should have been.
c. “When purchasing principal-only (PO) CMOs, be ready for a bumpy ride.”
The values of principal-only CMOs adjust abruptly to changes in interest rates. Therefore, they exhibit a high degree of volatility (risk)
.
Managing in Financial Markets
As a manager of a savings institution, you must decide whether to invest in collateralized mortgage obligations (CMOs). You can purchase interest-only (IO) or principal-only (PO) classes. You anticipate that economic conditions will weaken in the future and that government spending (and therefore government demand for funds) will decrease.
a. Given your expectations, would IOs or POs be a better investment?
POs would be a better investment. Given your expectations, interest rates are likely to decrease.
This would result in mortgage prepayments, which causes interest payments on those mortgages to be terminated. Therefore, payments on the IOs are terminated as well. An investment in POs would result in accelerated payment of the principal during a period in which interest rates are declining, as mortgages are prepaid.
b. Given the situation, is there any reason why you might not purchase the class of CMOs that you
selected in the previous question?
If you are not confident about the future interest rate movements, you may prefer to avoid any
investment in CMO classes, because the returns on CMO classes are subject to a high degree of interest rate risk.
c. Your boss suggests that since CMOs typically have semiannual interest payments, their value at
any point in time should be the present value of their future payments, and that the valuation of CMOs should be simple. Why is your boss wrong?
CMOs are segmented into classes, and each class has a specific payback priority. Yet, the timing of the payback on any particular CMO class is uncertain, which makes it difficult to properly
discount the future payments.
Chapter 9: Mortgage Markets 9 Problem
1.Monthly Mortgage Payment. Use an amortization table that determines the monthly mortgage
payment based on a specific interest rate and principal with a 15-year maturity, and then for a 30-year maturity. Is the monthly payment for the 15-year maturity twice the amount as for the 30-year
maturity, or less than twice the amount? Explain.
ANSWER: The monthly mortgage payment on a 15-year mortgage is less than twice the payment on
a 30-year mortgage, because the principal is paid off at a faster rate.
Flow of Funds Exercise
Mortgage Financing
Carson Company currently has a mortgage on its office building through a savings institution. It is attempting to determine whether it should convert its mortgage from a floating rate to a fixed rate. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. The fixed rate that it would pays if it refinances is higher than the prevailing short-term rate, but lower than the rate it would pay from issuing bonds.
a.What macroeconomic factors could affect interest rates and therefore affect the mortgage
refinancing decision?
Any indicators of economic growth, the budget deficit, and inflation would affect interest rates
and therefore could influence the refinancing decision.
b.If Carson refinances its mortgage, it also must decide on the size of a down payment. If it uses
more funds for a larger down payment, it will need to borrow more funds to finance its
expansion. Should Carson use a minimum down payment or a larger down payment if it
refinances the mortgage? Why?
It should use a minimum down payment, because it can obtain long-term funds through the
mortgage at a lower rate than if it issued bonds. Thus, it should obtain as much funding as
possible from the mortgage so that it does not have to obtain as much funding from other sources in which the cost of funds is higher.
c.Who is indirectly providing the money that is used by companies such as Carson to purchase
office buildings? That is, where does the money that the savings institutions channel into
mortgages come from?
The money comes from individual depositors and is pooled by savings institutions to provide
mortgage loans.
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Solution to Integrative Problem for Part III
Asset Allocation
1. The supply of available funds in the United States will decline. Given a smaller supply of funds in the
United States, and the same demand for loanable funds, the equilibrium interest rate in the United States should rise.
2. If U.S. interest rates rise, the quantity of loanable funds demanded will decline. Consequently, the
amount of spending by businesses and households will decline. If interest rates rise, the values of existing securities may decline because the required return by investors would have increased.
3. If the event causes a net decrease in the Japanese investment in U.S. Treasury securities, the Japanese
demand for U.S. dollars is reduced, which should place downward pressure on the value of the dollar with respect to the Japanese yen. One may try to argue that once U.S. interest rates are higher,
Japanese investment will flow back to the U.S. However, the case assumes that a flow of funds back to the U.S. will not occur for at least a few years.
Currencies other than the Japanese yen may also be affected. Once U.S. interest rates rise, investors from other countries could attempt to capitalize on the high interest rates, which would place upward pressure on the value of the dollar against those currencies.
4. An increase in U.S. interest rates results in an increase in the required rate of return by U.S. investors
on all types of securities. The market value of existing U.S. securities should decrease in response to the higher required rate of return. Yet, the prices of some securities will be affected more than others.
For example, prices of bonds will be affected more than prices of money market securities.
5. If the U.S. economy weakens (in response to higher U.S. interest rates), the risk premium would
increase, causing an even higher required rate of return on risky securities. This would further reduce the present value of risky securities. Thus, risky securities would be more adversely affected than risk-free securities with a similar maturity.
A weaker economy also affects the expected cash flows to be received by a firm. The value of a stock
is the discounted value of future cash flows. The value would not only be affected by a higher
required rate of return (resulting from the higher interest rate and possibly a higher risk premium), but also by lower expected cash flows.
6. The answer is somewhat subjective. However, there is some rationale for prescribing only the
minimum 20 percent to bonds and to stocks. Both types of securities will be more adversely affected by the increased required rate of return than money market securities. Therefore, the remaining 60 percent of funds could be allocated to money market securities.
7. Investment in low-risk bonds and money market securities is more appropriate, since the risk
premium is expected to increase, which will have a greater adverse impact on prices of riskier
securities.
8. Based on expectations that the dollar will weaken against the yen and strengthen against other
currencies, it may be feasible to invest in Japanese securities. In particular, it would be wise to invest in the type of Japanese securities that will be purchased by Japanese investors who would have
normally purchased U.S. Treasury securities. Investment in any type of Japanese securities should
Chapter 9: Mortgage Markets 11
benefit from the expected appreciation of the yen (from a U.S. investor’s perspective). Japanese bonds would probably be a good investment because the expected increase in the supply of funds in Japan (resulting from the expected decrease in investment in U.S. Treasury securities) will place downward pressure in Japanese interest rates in the future.
9. An increase in the demand for loanable funds in the United States would also have placed upward
pressure on U.S. interest rates.
However, the impact on economic conditions could have been different, because the interest rates would have been driven by a strong demand, which reflects a high level of borrowing and spending.
The equilibrium quantity of loanable funds would have been larger in this case.
The bond prices would still be expected to decline because of the expectation of higher interest rates.
However, there would not be an increase in the risk premium since economic conditions are still favorable.