Chapter 14 The Mortgage Markets

The mortgage markets differ from the stock and bond markets in important ways:

- First, the usual borrowers in the capital markets are government entities and businesses, whereas
the usual borrowers in the mortgage markets are individuals.
- Second, mortgage loans are made for varying amounts and maturities, depending on the borrowers’
needs, features that cause problems for developing a secondary market.

What Are Mortgages?

A mortgage is a long-term loan secured by real estate. A developer may obtain a mortgage loan to finance
the construction of an office building, or a family may obtain a mortgage loan to finance the purchase of a
home. In either case, the loan is amortized: The borrower pays it off over time in some combination of
principal and interest payments that result in full payment of the debt by maturity.

The mortgage market was devastated by the Great Depression in the 1930s. Millions of borrowers were
without work and were unable to make their loan payments.

One reason that so many borrowers defaulted on their loans was the type of mortgage loan they had. Most
mortgages in this period were balloon loans: The borrower paid only interest for three to five years, at
which time the entire loan amount became due. The lender was usually willing to renew the debt with some
reduction in principal. However, if the borrower were unemployed, the lender would not renew, and the
borrower would default.

As part of the recovery program from the Depression, the federal government stepped in and restructured
the mortgage market. The government took over delinquent balloon loans and allowed borrowers to repay
them over long periods of time.

Characteristics of the Residential Mortgage

1. Mortgage Interest Rates
The interest rate borrowers pay on their mortgages is probably the most important factor in their
decision of how much and from whom to borrow. The interest rate on the loan is determined by three
factors:

- Market rates. Long-term market rates are determined by the supply of and demand for long-term
funds, which are in turn influenced by a number of global, national, and regional factors. Mortgage
rates tend to stay above the less risky Treasury bonds most of the time but tend to track along with
them.

- Term. Longer-term mortgages have higher interest rates than shorter-term mortgages. The usual
mortgage lifetime is either 15 or 30 years. Because interest-rate risk falls as the term to maturity
decreases, the interest rate on the 15-year loan will be substantially less than on the 30-year loan.
 - Discount points. Discount points (or simply points) are interest payments made at the beginning of
a loan. A loan with one discount point means that the borrower pays 1% of the loan amount at
closing, the moment when the borrower signs the loan paper and receives the proceeds of the loan.
In exchange for the points, the lender reduces the interest rate on the loan. In considering whether
to pay points, borrowers must determine whether the reduced interest rate over the life of the loan
fully compensates for the increased up-front expense. To make this determination, borrowers must
take into account how long they will hold on to the loan. Typically, discount points should not be
paid if the borrower will pay off the loan in five years or less.

2. Loan Terms
Mortgage loan contracts contain many legal and financial terms, most of which protect the lender from
financial loss.

- Collateral
One characteristic common to mortgage loans is the requirement that collateral, usually the real
estate being financed, be pledged as security. The lending institution will place a lien against the
property, and this remains in effect until the loan is paid off. A lien is a public record that attaches to
the title of the property, advising that the property is security for a loan, and it gives the lender the
right to sell the property if the underlying loan defaults.

- Down Payments
To obtain a mortgage loan, the lender also requires the borrower to make a down payment on the
property, that is, to pay a portion of the purchase price. The balance of the purchase price is paid by
the loan proceeds. Down payments (like liens) are intended to make the borrower less likely to
default on the loan. The down payment reduces moral hazard for the borrower. The amount of the
down payment depends on the type of mortgage loan.
- Private Mortgage Insurance
Another way that lenders protect themselves against default is by requiring the borrower to
purchase private mortgage insurance (PMI). PMI is an insurance policy that guarantees to make up
any discrepancy between the value of the property and the loan amount, should a default occur.

- Borrower Qualification
Historically, before granting a mortgage loan, the lender would determine whether the borrower
qualified for it. Qualifying for a mortgage loan was different from qualifying for a bank loan because
most lenders sold their mortgage loans to one of a few federal agencies in the secondary mortgage
market. These agencies established very precise guidelines that had to be followed before they
would accept the loan. If the lender gave a mortgage loan to a borrower who did not fit these
guidelines, the lender would not be able to resell the loan. That tied up the lender’s funds.
Includes credit history, outstanding debt, etc., to determine the borrower’s ability to repay the
mortgage as specified in the contact.

3. Mortgage Loan Amortization

Mortgage loan borrowers agree to pay a monthly amount of principal and interest that will fully
amortize the loan by its maturity. “Fully amortize” means that the payments will pay off the
 outstanding indebtedness by the time the loan matures. During the early years of the loan, the lender
applies most of the payment to the interest on the loan and a small amount to the outstanding principal
balance. Many borrowers are surprised to find that after years of making payments, their loan balance
has not dropped appreciably.

Types of Mortgage Loans

1. Insured and Conventional Mortgages

Mortgages are classified as either insured or conventional.

Insured mortgages:

- originated by banks or other mortgage lenders but are guaranteed by either the Federal Housing
Administration (FHA) or the Veterans Administration (VA).
- The FHA or VA guarantees the bank making the loans against any losses—meaning that the agency
guarantees that it will pay off the mortgage loan if the borrower defaults.
- only a very low or zero down payment is required.

Conventional mortgages:

- originated by the same sources as insured loans but are not guaranteed.
- Private mortgage companies now insure many conventional loans against default.
- the down payment is less than 20% .
- mortgage insurance is usually required.

2. Fixed- and Adjustable-Rate Mortgages

The interest rate significantly affects the size of this monthly payment.

In fixed-rate mortgages:

- the interest rate and the monthly payment do not vary over the life of the mortgage.
- fixed-rate borrowers do not benefit if rates fall unless they are willing to refinance their mortgage
(pay it off by obtaining a new mortgage at a lower interest rate).

In adjustable-rate mortgages (ARMs):

- the interest rate is tied to some market interest rate and therefore changes over time.
- ARMs usually have limits, called caps, on how high (or low) the interest rate can move in one year
and during the term of the loan.
- Caps make ARMs more palatable to borrowers.
- interest rates on adjustable-rate mortgages are lower than on fixed-rate mortgages.
Borrowers tend to prefer fixed-rate loans to ARMs because ARMs may cause financial hardship if interest
rates rise.

Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk. Interest-rate risk is the risk that
rising interest rates will cause the value of debt instruments to fall.

Seeing that lenders prefer ARMs and borrowers prefer fixed-rate mortgages, lenders must entice borrowers
by offering lower initial interest rates on ARMs than on fixed-rate loans.

Securitization of Mortgages
Intermediaries still faced several problems when trying to sell mortgages:

1. mortgages are usually too small to be wholesale instruments.

2. The second problem with selling mortgages in the secondary market was that they were not
standardized. They have different times to maturity, interest rates, and contract terms. That
makes it difficult to bundle a large number of mortgages together.
3. mortgage loans are relatively costly to service. The lender must collect monthly payments, often
pay property taxes and insurance premiums, and service reserve accounts.
4. mortgages have unknown default risk. Investors in mortgages do not want to expend energy
evaluating the credit of borrowers. These problems inspired the creation of the mortgage-
backed security, also known as a securitized mortgage.

What Is a Mortgage-Backed Security?

Mortgage-backed security is a security that is collateralized by a pool of mortgages. An alternative to selling
mortgages directly to investors is to create a new security backed by (secured by) a large number of
mortgages assembled into what is called a mortgage pool. A trustee, such as a bank or a government
agency, holds the mortgage pool, which serves as collateral for the new security. This process is called
securitization.

The most common type of mortgage-backed security is the mortgage pass-through, a security that has the
borrower’s mortgage payments pass through the trustee before being disbursed to the investors in the
mortgage pass-through. If borrowers prepay their loans, investors receive more principal than expected. For
example, investors may buy mortgage-backed securities on which the average interest rate is 6%. If interest
rates fall and borrowers refinance at lower rates, the securities will pay off early. The possibility that
mortgages will prepay and force investors to seek alternative investments, usually with lower returns, is
called prepayment risk.

Subprime Mortgages and CDOs

Subprime loans are those made to borrowers who do not qualify for loans at the going market rate of
interest because of a poor credit rating or because the loan is larger than justified by their income.
Before the securitized market made it easy to bundle and sell mortgages, if you did not meet the
qualifications for one of the major mortgage agencies, you were unlikely to be able to buy a house. These
qualifications were strictly enforced, and each element was verified to ensure compliance. Once it became
possible to sell bundles of loans to other investors, different lending rules emerged. These new rules gave
rise to a new class of mortgage loans known as subprime mortgages.

In 2000, only 2% of mortgages were subprime. This climbed to 17% by 2006.

Mortgage products became more complicated, and income requirements for these mortgages became very
lax.

The Real Estate Bubble

The mortgage market was heavily influenced by the real estate boom and bust between the years 2000 and
2008. Between 2000 and 2005 home prices increased an average of 8% per year. They increased 17% in
2005 alone.

The run-up in prices was caused by two factors:

- the increase in subprime loans

With more people now qualifying for loans, there was increased demand

- Real estate speculators

People of all walks of life started noticing that quick and apparently easy money was to be made by
buying real estate for the purpose of resale. The buyers were often speculators with no intention of
occupying the property.
When real estate values were rapidly increasing, borrowers could easily sell their property if they
found themselves unable to make the payments.
As with most speculative bubbles, at some point the process ends. Default rates on the subprime
mortgages increased, and the extent of speculation started to make the news. Those left owning
properties bought at the height of the market suffered losses, including lending institutions and
investors in mortgage-backed securities.
The securitized mortgage was initially hailed as a method for reducing the risk to lenders by
allowing them to sell off a portion of their loan portfolio. The lender could continue making loans
without having to retain the risk. Unfortunately, this led to increased moral hazard. By separating
the lender from the risk, riskier loans were issued than would have been had the securitized
mortgage channel not existed. Individual firm risk may have been reduced, but systemic risk greatly
increased.