Unit 7 Mortgage Market

Mortgage and mortgage backed securities Primary and secondary mortgage markets Participants in mortgage market Mortgage sales International trends in securitization.

Sitaram Dhakal

Mortgage and mortgage backed securities

A mortgage is a form of debt that finances investment in property
The debt is secured by the property The mortgage is the difference between the down payment and the value to be paid for the property

An alternative to selling mortgages directly to investors creating mortgage pool. A trustee, such as a bank or a government agency, holds the mortgage pool, which serves as collateral for the new security. This process is called securitization. The most common type of mortgage-backed security is the mortgage pass-through. It is a security that has the borrowers mortgage payments pass through the trustee before being disbursed to the investors in the mortgage pass-through.

Mortgage and mortgage backed securities

If borrowers prepay their loans, investors receive more principal than expected. For example, investors may buy mortgage-backed securities on which the average interest rate is 6%. If interest rates fall and borrowers refinance at lower rates, the securities will pay off early. The possibility that mortgages will prepay and force investors to seek alternative investments, usually with lower returns, is called prepayment risk. The reason that mortgage pools have become so popular is that they permit the creation of new securities (like mortgage pass-through) that make investing in mortgage loans much more efficient. For example, an institutional investor can invest in one large mortgage passthrough secured by a mortgage pool rather than investing in many small and dissimilar mortgage contracts. There are several types of mortgage pass-through securities:
GNMA pass-through, FHLMC pass-through, and Private pass-through.

GNMA pass-through
Government National Mortgage Association (GNMA) Began guaranteeing pass-through securities in 1968. A variety of financial intermediaries, including commercial banks and mortgage companies, originate Ginnie Mae mortgages. Ginnie Mae aggregates these mortgages into a pool and issues pass-through securities that are collateralized by the interest and principal payments from the mortgages. Ginnie Mae also guarantees the pass-through securities against default. The usual minimum denomination for pass-through is $25,000. The minimum pool size is $1 million. One pool may back up many passthrough securities.

FHLMC pass-through
Federal Home Loan Mortgage Corporation (FHLMC) Created to assist savings and loan associations, which are not eligible to originate Ginnie Maeguaranteed loans. Freddie Mac purchases mortgages for its own account and also issues pass-through securities similar to those issued by Ginnie Mae. Pass-through securities issued by Freddie Mac are called participation certificates (PCs). Freddie Mac pools are distinct from Ginnie Mae pools in that they contain conventional (nonguaranteed) mortgages, are not federally insured, contain mortgages with different rates, are larger (ranging up to several hundred million dollars), and have a minimum denomination of $100,000.

Private pass-through
Private Pass-Through (PIPs) In addition to the agency pass-through, intermediaries in the private sector have offered privately issued pass-through securities. The first of these PIPs was offered by Bank of America in 1977.

Primary and secondary mortgage markets

Primary Mortgage market In the primary market four basic categories of mortgages are issued by financial institutions such as home, multifamily dwelling, commercial and farm. Home mortgages are used one to four family dwellings. Multi-family dwellings mortgages are used to finance the purchase of apartment complexes, townhouses, and condominiums. Commercial mortgages are used to finance the purchase of real estate for business purposes such as office buildings, shopping malls etc. Farm mortgages are used to finance the purchase the farms.

Primary and secondary mortgage markets

Secondary Mortgage market
The federal government founded the secondary market for mortgages. To help the nations economic activity, the government established several agencies to buy mortgages. The Federal National Mortgage Association (Fannie Mae) was set up to buy mortgages from thrifts so that these institutions could make more mortgage loans. This agency would fund these purchases by selling bonds to the public. At about the same time, the Federal Housing Administration was established to insure certain mortgage contracts. This made it easier to sell the mortgages because the buyer did not have to be concerned with the borrowers credit history or the value of the collateral. A similar insurance program was set up through the Veterans Administration to insure loans to veterans after World War II.

Secondary mortgage markets

One advantage of the insured loans was that they were required to be written on a standard loan contract. This standardization was an important factor in the growth of the secondary market for mortgages. As the secondary market for mortgage contracts took shape, a new intermediary, the mortgage bank, emerged. Because this firm did not accept deposits, it was able to open offices across the country. The mortgage bank originated the loans, funding them initially with its own capital. Because of their size, they were able to capture economies of scale in loan origination and servicing. They were also able to bundle loans from different regions together, which helped reduce their risk. The increased competition for loans among these intermediaries led to lower rates for borrowers.

Participants in mortgage market

Mortgage sales
It is a sale of mortgage originated by a bank with or without to an outside buyers. Resource represents the ability of a loan buyer to sell the loan back to the originator should it go bad. In another word, a mortgage sale is a part of correspondent banking which is a relationship between small bank and a large bank in which the large bank provides a number of deposits, lending and other services.

International trends in securitization.

Intermediaries still faced several problems when trying to sell mortgages. The first was that mortgages are usually too small to be wholesale instruments. Many institutional investors do not want to deal in such small denominations. The second problem with selling mortgages in the secondary market was that they were not standardized. They have different times to maturity, interest rates, and contract terms. That makes it difficult to bundle a large number of mortgages together.

International trends in securitization.

Third, mortgage loans are relatively costly to service. Compare the servicing a mortgage loan requires to that of a corporate bond. The lender must collect monthly payments; often pay property taxes and insurance premiums, and service reserve accounts. None of this is required if a bond is purchased. Finally, mortgages have unknown default risk. Investors in mortgages do not want to spend a lot of time evaluating the credit of borrowers. These problems inspired the creation of the mortgage-backed security, also known as a securitized mortgage.

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