Understanding Mortgages and Capital Market Instruments
Mortgages play a crucial role in lending for real estate properties, classified into categories such as home, commercial, and farm mortgages. They can be backed by specific property, offering security to lenders in case of defaults. On the other hand, capital market instruments involve contracts between financial institutions and borrowers, specifying mortgage agreement details and assessing loan eligibility. Understanding these concepts is essential for navigating the world of borrowing and investments in real estate and financial markets.
Download Presentation
Please find below an Image/Link to download the presentation.
The content on the website is provided AS IS for your information and personal use only. It may not be sold, licensed, or shared on other websites without obtaining consent from the author. Download presentation by click this link. If you encounter any issues during the download, it is possible that the publisher has removed the file from their server.
E N D
Presentation Transcript
Loans to individuals or businesses to purchase a home, land or other real property. Categories of mortgages Home mortgages Multifamily dwelling mortgages Commercial mortgages Farm mortgages
Mortgages Backed by specific piece of real property. If borrower defaults, FI can take ownership of property Mortgages Stocks and bonds Give a general claim on borrowers assets Only mortgage bonds are backed by a specific piece of property that allows the lender to take ownership in the event of a default. Stocks and bonds
Mortgages Primary mortgages have no set size or denomination. Size of each mortgage depends on the borrower s needs and ability to repay Mortgages Stocks and bonds Bonds denomination $1,000 or multiple of $1,000 per bonds Shares of stock $1 per share Stocks and bonds
Mortgages Primary mortgages generally involve only a single investor Mortgages Stocks and bonds Bonds and stock issues by many investors Stocks and bonds
Mortgages Comparatively little information exists on mortgage borrowers, since borrowers are individuals Mortgages Stocks and bonds Bonds and stocks are issued by publicly traded corporations, hence subject to extensive rules and regulations Hence information is available Stocks and bonds
Capital market instruments Contract between a financial institution and a borrower Contract specifies characteristics of the mortgage agreement When a FI receives mortgage application, it must determine whether the applicant qualifies for a loan
Backed by a specific property serves as a collateral FI will place lien fully paid off Nobody can buy the property and obtain a clear title Lien is a public record attached to the title of the property with public recorder s office that gives the FI the right to sell the property if the borrower defaults or falls into arrears lien against property until loan is
Mortgage borrower pays a portion of purchase price of the property on the day mortgage is closed. Balance of the purchase price is the face value of mortgage (Loan proceeds) Decreases default risk for the FI How?
A mortgage borrower who makes a large down payment invests more personal wealth into the home Less likely to default if the property value falls Value of the property is more than the mortgage loan
Size of down payment depends on the financial position of the borrower Generally 20% is down payment Loan to Value ratio may not be more than 80% Borrowers who pay less than 20% purchase private mortgage insurance
Purchased by the lender (FI) and paid by the borrower as part of monthly payment In the event of default, PMI issuer guarantees to pay the FI the difference between value of the property and the balance remaining on the mortgage. If the property value increases or mortgage is paid PMI may be removed by the FI
Originated by FI Repayment guaranteed (fee 0.5% of loan amount) by Federal Housing Administration (FHA) or Veterans Administration (VA) Loan applicants to meet specific requirements set by these govt. agencies Available only to individuals from military services Maximum size of the mortgage is limited depending on location and cost of living Require either a very low (3%) or zero down payment
Not federally insured If down payment less than 20%, privately insured Secondary market mortgage buyers will not buy conventional mortgages if Loan-to-value ratio more than 80% Not privately insured
Generally 15 or 30 years 15-year more popular 15-year mortgage offers potential savings in interest paid However, monthly payments are higher
Fixed principal and interest payments fully pay off mortgage by its maturity date. During the early years of mortgage, most of the fixed monthly payment represents interest on the outstanding principal and a small amount represents payoff of the outstanding principal As mortgage reaches maturity, most of the payment represents payoff of the outstanding principal and a small amount represents interest Reduces default risk
Shows how the monthly mortgage payments are split into principal and interest
Interest payment for 3 to 5 years Full payment of mortgage principal at the end of the period Default risk is high
Most important characteristics Mortgage borrowers choose how much to borrow and from whom based on interest rates
FIs base their quoted mortgage rates on several factors 1. Market rates at which FIs borrow (rate on certificate of deposit or Federal funds rate) 2. Rate on specific mortgage loan depends on whether it is a fixed or variable rate of interest or loan specifies discount points
Locks in interest rate, regardless of market rate changes
Interest rate tied to some market rate Required monthly payments can change over the life of mortgage
Payment made when mortgage loan is issued One discount point paid up front is equal to 1% of the principal FI reduces interest rate in exchange of discount point Borrower weighs reduced interest payment over the life of loan versus upfront payment Decision depends on the period of time the borrower expects to hold the mortgage
Borrower takes a new mortgage and uses the proceeds to pay off the current mortgage Done when interest rate falls Decision involves balancing the savings of a lower monthly payment against the costs (fees) of refinancing Thumb rule interest rate should fall by 2 percentage points of more
When prevailing rates fall, rate on an existing mortgage lowers automatically Unlike variable rate mortgages, in this mortgage type interest rate only falls and does not increase This is to keep off from refinancing when interest rates fall
Small payments early in the life of mortgage Payments increase over first 5 to 10 years Final payments level off at the end of the mortgage Used by borrowers who expect their income to rise Or quickly refinance Default risk high
Initial payments same as conventional Increase over a portion or entire life of the mortgage Increase in monthly payments reduces the principal quickly and reduces the actual life of mortgage In contrast to Graduated payment mortgages, which do not mortgage is paid off, in GEM incremental increase in monthly payments reduces the actual life of the mortgage affect the time until the Dr. Lakshmi Kalyanaraman 28
Already a security in first mortgage Loan is secured again Should a default occur, the second mortgage holder is paid only after the first mortgage is paid off Interest rates on second mortgages are generally higher than the first mortgages
Second mortgage only from home equity built Home equity loan line of credit secured with a second mortgage by customers Home equity = current market value of the home-outstanding mortgage balance
Mortgage interest at a rate less than the current market rate in exchange for share in property value appreciation If property sold for more than the original purchase price, FI shares the gain FI shares the gain Dr. Lakshmi Kalyanaraman 31
Similar to Share appreciation mortgage Instead of FI, an outside investor share appreciation The investor either provides a portion of the down payment on the property or Provides monthly payments an outside investor share the Dr. Lakshmi Kalyanaraman 32
Borrower receives regular monthly payments from a FI When RAM matures or borrower dies, property is sold and debt retired Dr. Lakshmi Kalyanaraman 33
After FIs originate mortgages, they sell or securitize them in secondary mortgage market. Reduces liquidity risk, interest rate risk and credit risk of their portfolios Dr. Lakshmi Kalyanaraman 34
Liquidity Risk: Depository institutions obtain majority of their funds from short-term deposits. Mortgage maturities are of 15 or 30 years Liquidity Risk: Dr. Lakshmi Kalyanaraman 35
Interest Rate Risk: Holding long-term fixed rate mortgages subject them to interest rate risk, if interest rates are expected to rise Interest Rate Risk: Dr. Lakshmi Kalyanaraman 36
Credit Risk Since mortgage maturities are of 15 or 30 years, FIs face the risk that promised cash flows from loans may not be paid in full Credit Risk: (Default Risk)
FIs prefer servicing mortgages rather than long-term financing Long-term financing mortgages are in Balance sheet Loan originator acts as Servicer Servicer collect payments from mortgage borrowers and pass the required interest and principal payments through to the secondary market investor Dr. Lakshmi Kalyanaraman 38
Servicer keeps formal records of mortgage transaction For the service, FI collects a monthly fee Fee ranges from to percent of the mortgage balance Dr. Lakshmi Kalyanaraman 39
FIs remove mortgages by 1. pooling all recently originated mortgages together and sell them in the secondary mortgage market 2. issuing mortgage backed securities i.e. securitization of mortgages Dr. Lakshmi Kalyanaraman 40
The U.S. government established the Federal National Mortgage Association (FNMA or Fannie Mae) they could make more mortgage loans FHA and VA insured loans make securitization easier Government National Mortgage Association (GNMA or Corp. (FHLMC or Freddie Mac ) 1960s encouraged continued expansion of the housing market provided direct and indirect guarantees that allow for the creation of mortgage-backed securities Federal National Mortgage Association (FNMA or Fannie Mae) in the 1930s to buy mortgages from thrifts so Government National Mortgage Association (GNMA or Ginnie Corp. (FHLMC or Freddie Mac ) created in the Ginnie Mae ) Mae ) and Federal Home Loan Mortgage Federal Home Loan Mortgage Dr. Lakshmi Kalyanaraman 41
FI originates a mortgage and sells to an outside buyer With recourse loan buyer sells back the loan back to the originator if it goes bad contingent credit risk liability for the originator Without recourse buyer bears credit risk Dr. Lakshmi Kalyanaraman 42
FI sells loans to manage their credit risk better Removes assets (and credit risk) from the balance sheet Allows FI to achieve better asset diversification Allows FI to better manage interest rate risk and liquidity risk Generates fee income Reduces the cost of reserve requirement Reduces the cost of holding capital requirements against mortgages
Domestic banks Foreign banks Insurance companies Pension funds Closed-end bank loan mutual funds Nonfinancial corporations Dr. Lakshmi Kalyanaraman 44
Money center banks Small regional or community banks Foreign banks Investment banks Dr. Lakshmi Kalyanaraman 45
1. Pass-through security 2. Collateralized Mortgage Obligations (CMO) 3. Mortgage Backed Bonds Dr. Lakshmi Kalyanaraman 46
Pass through securities and Collateralized Mortgage Obligations (CMO) are securitized mortgages. Securitization of mortgages involves pooling of a group of mortgages Removal Subsequent sale pool to secondary market investors Securitization results in the creation of mortgage backed securities, traded in the secondary markets pooling of a group of mortgages with similar characteristics Removal of these mortgages from Balance sheet Subsequent sale of interests in the mortgage from Balance sheet traded in the secondary markets
FIs asset portfolios more liquid Reduces interest rate risk and credit risk Source of fee income Reduces the effect of regulatory constraints such as capital requirement Dr. Lakshmi Kalyanaraman 48
FIs pool mortgages and offer interest in the pool in the form of pass-through certificates Each pass through security represents fractional ownership in mortgage pool Dr. Lakshmi Kalyanaraman 49
1% share of a pass-through mortgage security issue is entitled to a 1% share of the principal and interest payments made over the life of the mortgages underlying the pool of securities Pass through promised payments of principal and interest on pools of mortgages to secondary market investors No guaranteed annual coupon Dr. Lakshmi Kalyanaraman 50
