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
Fixed-Rate Mortgages
Adjustable-Rate Mortgages
Graduated Payment Mortgages
Growing Equity Mortgages
Second Mortgages Shared Appreciation Mortgages
Balloon Payment Mortgages
Valuation of Mortgages
Credit Risk
Interest Rate Risk
Prepayment Risk
Mortgage Backed Securities
The Securitization Process
Types of Mortgage-Backed Securities
Valuation of Mortgage-Backed Securities
Credit Crisis
Impact of the Crisis on Fannie Mae and Freddie Mac
Impact of Credit Crisis on Exposed Financial Institutions
Systemic Risk Due to the Credit Crisis
Who Is to Blame for the Credit Crisis?
Government Programs in Response to the Crisis
Government Bailout of Financial Institutions
Financial Reform Act of 2010
Chapter 9: Mortgage Markets ❖ 2
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 the mortgage problems led to the credit crisis.
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 the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. FHA Mortgages. Distinguish between FHA and conventional mortgages.
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.
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.
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?
5. Balloon-Payment Mortgage. Explain the use of a balloon-payment mortgage. Why might a financial
institution prefer to offer this type of mortgage?
6. Graduated-Payment Mortgage. Describe the graduated-payment mortgage. What type of
homeowners would prefer this type of mortgage?
7. Growing-Equity Mortgage. Describe the growing-equity mortgage. How does it differ from a
graduated-payment mortgage?
8. Second Mortgages. Why are second mortgages offered by some home sellers?
9. Shared-Appreciation Mortgage. Describe the shared-appreciation mortgage.
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.
12. Selling Mortgages. Explain why some financial institutions prefer to sell 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.
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.
Chapter 9: Mortgage Markets ❖ 5
Advanced Questions
16. Mortgage-Backed Securities. Describe how mortgage-backed securities are used.
17. CMOs. Describe how collateralized mortgage obligations (CMOs) are used and why they have been
popular.
18. Maturities of MBS. Explain how the maturity on mortgage-backed securities can be affected by
interest rate movements.
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
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?
Chapter 9: Mortgage Markets ❖ 6
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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 Mortgages.
How did the repayment of subprime mortgages compare to that of prime mortgages during the credit
crisis?
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.
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?
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?
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.
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.
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.
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?
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?
33. Short Sales. Explain short sales in the mortgage markets. Are short sales fair to homeowners? Are
they fair to mortgage lenders?
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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?
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.
CRITICAL THINKING QUESTION
Regulation in Mortgage Markets. Many critics argue that greed in the mortgage markets caused the
credit crisis. Yet, many market advocates suggest that greed is good, as the thirst for profits by firms that
participate in mortgage markets allows for economic growth. Write a short essay on how regulations can
allow for greed while also ensuring proper transparency in the mortgage markets so that another credit
crisis does not occur.
ANSWER
Many mortgage companies were viewed as greedy by granting mortgages to unqualified home buyers that
Chapter 9: Mortgage Markets ❖ 9
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.”
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.”
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?
b. Given the situation, is there any reason why you might not purchase the class of CMOs that you
selected in the previous question?
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?
Chapter 9: Mortgage Markets ❖ 10
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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.
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?
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?
Chapter 9: Mortgage Markets ❖ 11
Solution to Integrative Problem for Part 3
Asset Allocation
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
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
6. The answer is somewhat subjective. However, there is some rationale for prescribing only the
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
Chapter 9: Mortgage Markets ❖ 12
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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.
normally purchased U.S. Treasury securities. Investment in any type of Japanese securities should
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.