CHAPTER 11

Overview of Mortgage Contracts

Home ownership in many countries is achieved through a
mortgage, which is, in essence, a secured loan.
Two basic players in mortgage markets:
Lenders
Borrowers

In addition, there are other important players, such as :

mortgage insurers,
mortgage servicers,
government agencies that have been set up to promote access
to housing credit, and regulators.

More than 95% of the loans to the residential market are

originated by thrifts, commercial banks, and mortgage
bankers
they collects fee from their service its called
origination fee

Total Outstanding Mortgages

Lenderss Risk
Default Risk
Lenders face the risk that the borrower could default on the loan. To
minimize the probability of default, lenders will take a number of actions
at the time the borrower makes the loan application.
Collect information from the borrower about credit history and about other
loans and liabilities by using FICO score
(a)
(b)
(c)
(d)
(e)

the borrowers payment history,

the borrowers level of existing debt,
the borrowers years of transactions with credit accounts,
his or her record of delinquencies and defaults, and
the nature of the borrowers credit history (such as student loans, credit cards, etc.)

The lender will assess the value of the property and set certain policy limits
on loan-to-value (LTV) ratio and the down payments that are expected from
borrowers.

Typically, lenders also may face delinquencies in their loan portfolios. The
proportion of the loans that are delinquent may depend on the general
economic conditions and the level of mortgage interest rates.

Prepayments
Lenders also face the prospect that borrowers may choose to
refinance their previously taken loans.
Rational borrowers who are financially able will then prepay
their loans if their loan rates are higher than the rates at which
they can get a mortgage in the current market conditions.
Lenders might deal with such a risk in many ways:
They will charge a higher mortgage rate to compensate them for
the fact that borrowers have the option to call back the highinterest rate mortgage and refinance them with a low interest rate
mortgage when mortgage rates drop.
They may hedge their interest rate exposure, or
They can sell their mortgage loan portfolios to buyers (such as
federal agencies, described later in the chapter) or
Issue mortgage loans (such as adjustablerate mortgages) that are
less susceptible to prepayments.

Interest Rate Risk

In addition to default risk and prepayments
risks, general interest rate fluctuations may also
expose the lender to risks.
When the interest rates go up, the key risk is not
the risk of prepayments but the fact that the loan
portfolio is sensitive to changes in interest rates.
For example, a fixed-rate loan portfolio will lose
value when interest rates go up.

Types of Mortgages

Fixed-rate mortgages (FRMs)

Adjustable-rate mortgages (ARMs)
Agency mortgages
Jumbo mortgages
Alt-A mortgages
Subprime mortgages

Fixed-rate Mortgages (FRMs)

FRMs are offered in two different maturities: 15
years and 30 years.
FRMs result in constant monthly payments for
the borrower. This is helpful in planning for
funds.
So that the borrower has no uncertainty about
his or her mortgage obligations, the interest rate
specified in an FRM does not change during the
life of the contract.

Adjustable-rate mortgages (ARMs)

The interest rate on an ARM changes over the
life of the contract.
The rates are linked to certain indexes of
borrowing rates.
(1) the Eleventh Federal Home Loan Bank Board
District Cost of Funds Index (COFI) and
(2) The National Cost of Funds Index, also
(3) LIBOR

Table 11.3 , which contains the key provisions of an ARM

loan known as a 2/28.

 ARMs have a lower

prepayment risk, since the
rates are indexed to market
conditions.
This allows the lenders to
worry less about prepayment
risk and focus on managing
credit risk.

Agency mortgages
Agency mortgages are mortgage loans that must
conform to the standards set forth by federal
agencies. These standards pertain to the loan
size, the borrowers credit score, documentation,
and the LTV.

Jumbo mortgages & Alt-A mortgages

Jumbo mortgages cannot be sold by lenders to
federal agencies. These are relatively large loans,
and the average credit quality of the borrowers
tends to be high.
Alt-A mortgages are mortgages that generally
conform with agency standards in terms of loan
size and borrower credit score. On the other
hand, these mortgages can have other
unattractive features, such as low documentation.

Subprime mortgages
Subprime mortgages tend to have much lower
FICO scores relative to agency standards.
They also attract borrowers who are relatively
more heavily levered as measured by income-tomortgage-debt ratio, for example.
In addition, the documentation on subprime
mortgages tends to be much lower than agency
standards.

MORTGAGE CASH FLOWS AND YIELDS

Bond yields are therefore quoted in nominal
annualized terms, assuming semiannual
compounding
bond-equivalent yield
(BEY).

Mortgages differ from bonds in several respects.

Hence mortgage yields are quoted in annualized
terms, assuming monthly compounding. This is
called mortgage-equivalent yield , or MEY.

The present value of the sum of all the payments must be

the value of the loan

We can compute the monthly cash fl ows of an FRM by

first assuming that there will be no prepayments or
default, as follows:
In a level-pay mortgage, each monthly payment is the same.
Part of it goes toward principal and the rest toward interest.
Let x be the level payments for N 360 months.

Click icon to add picture

We sketch out the

pattern of interest and
principal payments in a
30-year fixed rate
mortgage in Figure 11.5 .

In the absence of any prepayments, it takes

nearly 265 months before half
the original borrowed amount is repaid.
This can be seen by looking at the manner
in which the original borrowed amount is
amortized, as shown in Figure 11.6

FEDERAL AGENCIES
The mortgage market has two segments.
Primary mortgage market, where borrowers get
their loans from lenders.
Secondary mortgage markets, Mortgages that
were previously originated are bought and sold.

Both these segments have been significantly

changed by the presence of federal agencies.

Government National Mortgage Association

The Government National Mortgage Association
(GNMA), or Ginnie Mae, is a government agency
charged with the mission of promoting liquidity in
the secondary market for home mortgages.
GNMA mortgage pools are based on mortgages
issued under programs administered by
The Federal Housing Administration (FHA)
The Veterans Administration (VA), and
The Farmers Home Administration (FmHA).

Government National Mortgage Association

Mortgages in GNMA pools are said to be fully
modified because GNMA guarantees
bondholders full and timely payment of both
principal and interest.
Although investors in GNMA pass-throughs do not
face default risk, they still face prepayment risk.
Prepayments are passed through to bondholders.
If a default occurs, GNMA fully prepays the
bondholders.

GNMA Clones
Besides GNMA, there are two other significant
mortgage repackaging sponsors.
Federal Home Loan Mortgage Corporation
(FHLMC), or Freddie Mac, and
Federal National Mortgage Association (FNMA),
or Fannie Mae.

Both are government-sponsored enterprises

(GSEs) and trade on the New York Stock
Exchange.

GNMA Clones, Cont.

Like GNMA, both FHLMC and FNMA operate with
qualified underwriters who accumulate mortgages into
pools financed by an issue of bonds.
However, because FHLMC and FNMA are only GSEs,
their fully modified pass-throughs do not carry the
same default protection as GNMA fully modified
pass-throughs.
That is, Congress may or may not be willing to rescue a
financially strapped GSE.

FEDERAL AGENCY DEBT SECURITIES

There are other agencies that do not directly issue securities
but do so via the Federal Financing Bank, such as the
Tennessee Valley Authority (TVA) and Ginnie Mae.
Many players in the market, including the U.S. Treasury, have
some concerns about the growth of the agency debt market.
One concern is that the spurt in the growth of the agency debt
market is threatening to crowd out comparable corporate
securities.
This might in turn require that corporate debt securities offer
higher spreads.
The U.S. Treasury is concerned with the growth of the agency
market from a public policy perspective.