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1.1.1.1.1Chapter Seven
Mortgage Markets
1.1.1.2 I. Chapter Outline
1. Mortgages and Mortgage-Backed Securities: Chapter Overview
2. The Primary Mortgage Market
a. Mortgage Characteristics
b. Mortgage Amortization
c. Other Types of Mortgages
3. The Secondary Mortgage Markets
a. History and Background of Secondary Mortgage Markets
b. Mortgage Sales
c. Mortgage-Backed Securities
4. Participants in the Mortgage Markets
5. International Trends in Securitization
Appendix 7a: Amortization Schedules for 30-year Mortgages in Example 7-1 and in Example
7-4, No Points versus Points, available on Connect or from your McGraw-Hill representative
II. Learning Goals
1. Distinguish between a mortgage and a mortgage-backed security.
2. Describe the main types of mortgages issued by financial institutions.
3. Identify the major characteristics of a mortgage.
4. Examine how a mortgage amortization schedule is determined.
5. Describe some of the new innovations in mortgage financing.
6. Define a mortgage sale.
7. Define a pass-through security.
8. Define a collateralized mortgage obligation.
9. List the major mortgage holders in the United States.
10. Describe the trends in the international securitization of mortgages.
1.1.1.3 III. Chapter in Perspective
This is the third chapter that covers securities markets and it has three major sections. The
primary characteristics of standard fixed and adjustable rate mortgages are covered first. The
second major topic is innovations in mortgage financing methods. Secondary mortgage markets,
government agency involvement in mortgage markets and securitization methods are presented
in the final major section. A brief discussion of international trends in securitization concludes
the chapter. The securitization material is conceptually much more difficult than the prior topics.
The purpose of the chapter is to give the student an understanding of the characteristics of
mortgages and mortgage terminology and alternative means of obtaining mortgage credit. The
reader should also understand the advantages and disadvantages of securitization for financial
intermediaries and the major features of different types of mortgage-backed securities.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Mortgages Second mortgages
Securitization Home equity loan
Lien Reverse annuity mortgage
Down payment Sale with recourse
Private mortgage insurance Pass-through mortgage securities
Insured vs conventional mortgages Timing insurance
Fully amortized vs balloon payment mortgages CMO tranche
Fixed vs adjustable rate mortgages Subprime mortgage
Discount points Option ARMS
Amortization schedule Correspondent banking
Jumbo mortgages Single family mortgages
Alt-A mortgages Privately issued pass-throughs
Mortgage backed bonds (MBBs) Origination versus financing
Subprime mortgages Government agencies
Mortgage companies
1.1.1.5 V. Teaching Notes
1. Mortgages and Mortgage-Backed Securities: Chapter Overview
Mortgages are loans to purchase a home, land or other real property. Late in 2013 there were
$13.244 trillion of mortgages outstanding. About 74.5% of mortgages are single family (1-4
family) mortgages. The rest are divided between commercial mortgages (17.2%), multifamily
dwelling mortgages (6.9%) and a small amount of farm mortgages (under 1%). This chapter
covers the primary and secondary market characteristics of single family mortgages.
There is a well developed and active secondary market for mortgages, unlike many other loan
types. Government involvement in the single family secondary mortgage market through
insurance and promoting securitization has led to the active secondary market for mortgages.
Securitization is the process of transforming individual loan contracts into marketable securities.
About 50%-60% of single family mortgages are typically securitized, with about 60% in
2013. Mortgage contracts by themselves would not be particularly saleable because they have
nonstandard, fairly small denominations and unique, potentially substantial credit risk. A
saleable contract should have a standard, large denomination to appeal to institutional buyers, a
low cost method of assessment of credit risk, good collateral, a standard maturity, and a standard
interest rate.1 Mortgages have generally good collateral, standard lengthy maturities and
standard interest rates. The small and variable denomination of individual mortgages implies
that mortgages should be pooled to create a typical large denomination. Credit risk analysis of
the many individual borrowers in the pool would be quite costly and would severely limit the
usefulness of the securitization process if not alleviated. Thus, for most mortgages that are
securitized either the government provides insurance for mortgages, an 80% loan to value ratio
is required, or the mortgage must be privately insured perhaps by a firm such as CMG
Mortgage Insurance.
Teaching Tip:
FHA insurance cost is two-fold, and some costs vary with down payment & mortgage amount
but there is generally an upfront cost of 1.75% of total loan amount, which can be financed, and
an annual premium that varies with the loan to value (LTV) ratio and mortgage maturity. For a
30 year mortgage with a LTV ratio of 95% or more the annual premium is 1.30% of the loan
amount (paid monthly).
Securitization brings many benefits to FIs. Securitization allows FIs to a) become more liquid,
b) reduce interest rate and credit risk, c) reduce capital and reserve requirements, and d) generate
fee income from servicing more mortgages than they could otherwise.
The mortgage markets are huge (they are larger than the corporate debt market), rapidly growing
(from 2001 through 2013 the amount of single family home mortgages grew by about 73%) and
have become increasingly sophisticated. Even with the downturn in mortgages in the late 2000s,
mortgage markets are likely to generate long term growth. In some areas home prices have
advanced more rapidly than income growth, leading to slowed growth in housing prices and even
declines in some markets such as Florida. In other countries and in our own past, severe
collapses in housing prices have presaged protracted periods of low economic growth or even a
prolonged recession, so over the short to intermediate term, the housing market may remain a
drag on growth.
In 2006, 2007 and 2008 problems in the subprime mortgage market led to the credit crunch of
2007 and 2008. A subprime mortgage is a mortgage made to a borrower with a below normal
credit rating. Credit problems in the sector eventually bankrupted Countrywide Financial, the
largest mortgage issuer, in the summer of 2007. The subprime problems spread to the broader
mortgage markets and resulted in a weakening of stock markets throughout 2007 and on into
2008. According to the Mortgage Bankers Association (MBAA) delinquency rates for
mortgages in the second quarter of 2007 were at 5.12% of all loans, up from prior quarters and
the prior year. The percentage of loans in foreclosures in the same time period was 1.40%, also
up. The rate of loans entering the foreclosure process was 0.65%, also an increase. Interestingly
however, these numbers were driven by mortgage markets in a relatively small number of states.
1 Standardization improves salability. Standard terms improve the ability to market an issue to
buyers because they are more familiar with the terms and risks of the investment.
National foreclosure rates would have fallen if one excluded California, Florida, Nevada and
Arizona. Delinquencies and foreclosures in mortgages and falling home prices were also
problems in Ohio, Michigan, Indiana, Illinois, Kentucky, Tennessee and Pennsylvania.
Delinquencies and foreclosure rates were higher for ARMs than for fixed rate mortgages.2
According to the Office of the Comptroller of the Currency (OCC) as of the end of 2013 about
92% of mortgages in their sample were current and performing. About 3.5% of mortgage
holders were at least 60 days behind on their payments or in the foreclosure process. Census
Bureau housing vacancy rates over time are presented below:
The median asked sales price in the first quarter of 2014 was $139,200 according to the BEA.
The OCC suggests standardized definitions for categories of mortgage creditworthiness based on
the following ranges of borrowers’ credit scores at the time of origination:3
Prime: 660 and above 75% of mortgages
2 “Delinquencies Increase in Latest MBA Delinquency Survey,” by Angela Waugaman,
Mortgage Bankers Association website, 9/6/07 Press releases,
http://www.mbaa.org/NewsandMedia/PressCenter/56555.htm
Alt-A: 620 to 659 10%
Subprime: < 620 6%
Unknown 9%
The percentages are the proportion of the mortgage portfolio held in OTS supervised institutions.
The loans in the data that were not accompanied by credit scores are classified as “other.”
Between May 2005 and February 2007 subprime mortgage default rates increased from 5.37% to
10.09%. Subprime mortgage holders 60 days or more behind in their payments hit 17.1% in
June 2007 and was over 20% in August of the same year. Problems in the subprime market
spilled over to the broader mortgage markets and helped fuel nationwide declines in home prices
which put many homeowners underwater. These mortgage types are also discussed under
mortgage types below.
The Obama administration has employed the Home Affordable Modification Program (HAMP)
to encourage and subsidize lenders to change mortgage terms for homeowners who are
delinquent in their payments.
Source: OCC Mortgage Metrics report
Capitalization is adding missed payments to the loan amount. Note the low number of principal
reduction modifications. Principal reduction is probably the most effective method of ensuring
homeowners do not default given the declines in home prices, but lenders do not like principal
reduction, presumably because they must immediately mark down the value of the loans.
Source: Adapted from OCC Mortgage Metrics report
Not all of these are permanent loan modifications, many are trial period plans and temporary
payment reduction plans. Not all are HAMP plans; some were done independently by private
lenders. Notice that the number of modifications is small relative to the number of seriously
3 Unless noted otherwise all data in this section, including the tables, are from OTS Mortgage
Metrics.
delinquent (60 days or more past due) and foreclosures.
After modification, substantial numbers of home owners continue to have trouble making
payments as data in the following table indicate.
Source: OCC Mortgage Metrics report
Ethics Teaching Tip: The ability to sell and securitize mortgages coupled with a lack of
regulation of mortgage originators, particularly mortgage companies, helped create the subprime
crisis. An extended period of low interest rates in the 2000s helped contribute to rising home
prices, which then gave the appearance of low risk in mortgages. Mortgage originators knew
they would quickly sell the loans and pocket the origination fee. They may or may not retain the
servicing contract which would generate more fee income. Nevertheless, since the mortgages
were sold without recourse to the originator, increasingly lax credit standards were applied. Lax
standards led to poor lending practices such as ‘Low Doc” or “No Doc” loans referring to either
low or no documentation required demonstrating the borrower’s ability to repay the mortgage.
These loans were even given the appellation “Liar’s Loans” because allegedly mortgage lenders
coached applicants to fill out applications to ensure the mortgage would be approved and could
be resold with little regard to the veracity of the statements made. As long as the borrower made
three payments on the mortgage after origination, the originator was free and clear from
recourse. Hence, there was little reason to apply tight credit standards.
What hindsight reveals as excessive risk taking has happened over and over in periods of
booming markets. In these cases participants underestimate risk and reduce risk aversion to the
point where excessive risks are engendered. Whether this results from hubris, its twin,
overconfidence, a lack of economic training and experience, or just poor ethics no one knows for
sure. Undoubtedly it is a result of all these elements combined. The laws of financial gravity,
particularly with respect to long periods of price increases, have not been repealed by financial
innovation and the many risk sharing contracts now being promulgated. For all our
sophistication in finance we should remember two things: 1) It is impossible to eliminate
systemic risk in the aggregate, although you can share it among an increasing number of
participants with the many derivatives we now have; and 2) Policies promoting both solid
ethics and conservative financing principles are always needed. The more ethics failures we
endure, the tighter regulations will have to become, with all the inefficiencies and increase in
regulatory burdens this entails. It is also becoming increasingly obvious to me that
regulations/regulators have not kept up with financial innovation. Whether this is due to inherent
conflicts of interest, lack of funding or training or other reasons cannot be determined. When
you include overseas markets it becomes apparent that we have been moving from one crisis to
another every few years as capital markets have grown at such a rapid pace with extensive
innovation. Perhaps this is nothing new, the capital markets have always operated under the
premise of “caveat emptor.”
2. The Primary Mortgage Market
The origination and financing of mortgages are now largely separate functions. One of the
primary purposes of the government’s presence in the mortgage markets is to ensure the
availability of mortgage credit wherever it is demanded. Government mortgage insurance and
the securitization process have created a national market for financing mortgages. Thus, the
financing of mortgages is national, or even international, in scope. The origination (creation) of
mortgages is still primarily a local market, for instance, typically one does not go to another state
to obtain a mortgage. The originators, however often sell the mortgage (individually or in a
pool).4 Electronic mortgage origination has not grown as dramatically as predicted. Applying
for a mortgage online remains a cumbersome task, hurting this area of business.
Teaching Tip: Government involvement has accomplished at least two socially desirable
outcomes. One, it has allowed younger, less wealthy people to own homes by eliminating the
large down payment, thus facilitating a part of the “American dream” of home ownership.
Second, it has helped poorer regions of the country such as West Virginia, Montana, etc that
would not have had enough mortgage credit available to meet the demand for funds.
Teaching Tip: For many people, home ownership is one of the most satisfying assets they obtain.
It is a person’s major hedge against personal disasters and inflation. Even in low inflation times
it is usually (but not always) an appreciating asset and, unlike automobiles, should be considered
an investment. Homes are an illiquid investment and living in the wrong house for you in the
wrong area can make you miserable for a long time, so please advise students to shop wisely.
4The origination market is itself however becoming increasingly national because mortgage
companies (a local originating institution) often obtain mortgage financing from institutions
around the country.
