Questions
1. FHA Mortgages. Distinguish between FHA and conventional mortgages.
ANSWER: FHA mortgages guarantee loan repayment, thereby covering against the possibility of
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
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.
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
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
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
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Chapter 9: Mortgage Markets 2
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
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
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
9. Shared-Appreciation Mortgage. Describe the shared-appreciation mortgage.
ANSWER: A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an
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?
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
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
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.
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Chapter 9: Mortgage Markets 3
ANSWER: The secondary market for stocks and bonds is facilitated by an organized exchange such
as the New York Stock Exchange. The prices of these securities sold in the secondary market are
14. Financing Mortgages. What types of financial institutions finance residential mortgages? What type
of financial institution finances the majority of 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,
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 sell
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
18. Maturities of MBS. Explain how the maturity on mortgage-backed securities can be affected by
interest rate movements.
ANSWER: When interest rates decline, prepayments on mortgages occur because some homeowners
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
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Chapter 9: Mortgage Markets 4
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
20. CDOs. Explain collateralized debt obligations (CDOs).
ANSWER: A CDO represents a package of debt securities backed by collateral that is sold to
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
22. Subprime Versus Prime Mortgages.
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
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
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
25. Blame for Credit Crisis. Many investors that purchased the mortgage-backed securities just
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Chapter 9: Mortgage Markets 5
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
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
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).
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 made poor
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.
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
improve the situation for mortgage-backed securities.
ANSWER: The secondary market for mortgage-backed securities was inactive during the credit
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?
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Chapter 9: Mortgage Markets 6
32. Mortgage Information During the Credit Crisis. Explain why mortgage originators have been
criticized for their behavior during the credit crisis. Should other participants in the mortgage
securitization process have recognized that lack of complete disclosure in mortgages?
ANSWER: This question that is intended to make students consider the process from the point
mortgages are originated to the point at which investors purchase mortgage-backed securities. In
33. Short Sales. Explain short sales in the mortgage markets. Are short sales fair to homeowners? Are
they fair to mortgage lenders?
ANSWER: In a short sale transaction, the lender allows homeowners to sell the home for less than
what is owed on the existing mortgage. The lender appraises the home and informs the homeowner of
34. Government Intervention in Mortgage Markets. The government intervened in order to resolve
problems in the mortgage markets during the credit crisis. Summarize the advantages and
disadvantages of the government intervention during the credit crisis. Should the government
intervene when mortgage market conditions are very weak?
ANSWER Some government programs stabilized the market for mortgage-backed securities, and
therefore helped the financial institutions that invested in them. To the extent that the government’s
35. Dodd-Frank Act and Credit Ratings of MBS. Explain how the Dodd-Frank Act of 2010 attempted
to prevent biased ratings of mortgage-backed securities by credit rating agencies.
ANSWER: The Dodd-Frank Act requires that credit rating agencies publicly disclose data on
assumptions used to derive each credit rating. The agencies are also required to provide an annual
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Chapter 9: Mortgage Markets 7
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
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
c. “When purchasing principal-only (PO) CMOs, be ready for a bumpy ride.”
.
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
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
c. Your boss suggests that the value of CMOs at any point in time should be the present value of
their future payments. He says that since a CMO represents mortgages, its valuation should be
simple. Why is your boss wrong?
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Chapter 9: Mortgage Markets 8
CMOs are segmented into classes, and each class has a specific payback priority. Yet, the timing
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.
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?
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
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?
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Chapter 9: Mortgage Markets 9
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
2. If U.S. interest rates rise, the quantity of loanable funds demanded will decline. Consequently, the
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
Currencies other than the Japanese yen may also be affected. Once U.S. interest rates rise, investors
4. An increase in U.S. interest rates results in an increase in the required rate of return by U.S. investors
5. If the U.S. economy weakens (in response to higher U.S. interest rates), the risk premium would
A weaker economy also affects the expected cash flows to be received by a firm. The value of a stock
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
7. Investment in low-risk bonds and money market securities is more appropriate, since the risk
8. Based on expectations that the dollar will weaken against the yen and strengthen against other
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Chapter 9: Mortgage Markets 10
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
The bond prices would still be expected to decline because of the expectation of higher interest rates.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.