Chapter 9
Mortgage Markets
Outline
Background on Mortgages
How Mortgages Facilitate the Flow of Funds
Types of Residential Mortgages
Fixed-Rate Mortgages
Valuation of Mortgages
Credit Risk
Mortgage Backed Securities
The Securitization Process
Credit Crisis
Impact of the Crisis on Fannie Mae and Freddie Mac
Chapter 9: Mortgage Markets ❖ 2
Key Concepts
1. Identify the more popular types of mortgages and elaborate where necessary.
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.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: The question is primarily intended to make students compare mortgages to bonds. There are
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 themselves against interest rate movements.
ANSWER: There is a high positive correlation between mortgage rates and long-term government
security rates.
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.
ANSWER: An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage
to compensate borrowers for incurring the 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 mortgage 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?
ANSWER: A balloon mortgage payment requires interest payments for a three- to five-year period.
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
incomes will rise over time may desire this type of a 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?
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.
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
Chapter 9: Mortgage Markets ❖ 5
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
transferred (passed through) to the owners of the securities, after deducting fees for servicing.
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 of 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 the 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. Describe the characteristics of subprime mortgages.
Why were mortgage companies aggressively offering subprime mortgages before the credit crisis?
ANSWER: Subprime mortgages were provided by mortgage companies to borrowers who would not
Chapter 9: Mortgage Markets ❖ 6
22. Subprime Versus Prime Mortgages.
How did the repayment of subprime mortgages compare to the repayment 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 that arise 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 and institutions beyond homeowners and mortgage companies.
ANSWER: Mortgage insurers incurred expenses from foreclosures of the property they insured.
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 was 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 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).
ANSWER: Credit rating agencies rate the tranches of mortgage-backed securities based on the
Chapter 9: Mortgage Markets ❖ 7
28. Fannie and Freddie Problems. Explain why Fannie Mae and Freddie Mac experienced
mortgage problems during the credit crisis.
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 improved
the ability of mortgage companies to originate mortgages.
ANSWER: Without a strong secondary market for mortgages, financial institutions that originate
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?
details of the mortgages are not disclosed in financial statements.
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 how short sales work 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
Chapter 9: Mortgage Markets ❖ 8
34. Government Intervention in Mortgage Markets. The government intervened 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. Financial Reform Act and Credit Ratings of MBS. Explain how the Financial Reform 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
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.”
The values of principal-only CMOs adjust abruptly to changes in interest rates. Therefore, they
.
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.
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?
Chapter 9: Mortgage Markets ❖ 10
Problem
1. Monthly Mortgage Payment. Use an amortization table (go to www.bankrate.com and click on
“amortization calculator” under “Mortgages” or use another online source) 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 an adjustable 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 the company’s 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, what is the source of 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
1. The supply of available funds in the United States will decline. Given a smaller supply of funds in the
United States, and the same demand for loanable funds, the equilibrium interest rate in the United
States should rise.
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
pressure on the value of the dollar against those currencies.
4. An increase in U.S. interest rates results in an increase in the required rate of return by U.S. investors
on all types of securities. The market value of existing U.S. securities should decrease in response to
the higher required rate of return. Yet, the prices of some securities will be affected more than others.
For example, prices of bonds will be affected more than prices of money market securities.
5. If the U.S. economy weakens (in response to higher U.S. interest rates), the risk premium would
increase, causing an even higher required rate of return on risky securities. This would further reduce
the present value of risky securities. Thus, risky securities would be more adversely affected than
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
by the increased required rate of return than money market securities. Therefore, the remaining 60
percent of funds could be allocated to money market securities.
Chapter 9: Mortgage Markets ❖ 12
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