Chapter 13:

The Mortgage Market

The mortgage market
Mortgage: A mortgage is a pledge of property to secure payment of a debt. Typically property refers to
real estate, which is often in the form of a house, the debt is the loan given to the buyer of the house by a
lender. Thus, a mortgage might be a pledge of a house to secure payment of a loan. If a homeowner fails
to pay the lender, the lender has the right to foreclose the loan and seize the property in order to ensure
that it is repaid.

Mortgage origination: The original lender is called the mortgage originator. The principal originators
of residential mortgage loans are thrifts, commercial banks and mortgage bankers. Mortgage originator
may generate income from origination fee, secondary market profit and servicing fee.
Risks associated with mortgage origination process:

(i) Price risk: It refers to the adverse effects on the value of the pipeline if mortgage
rates rise. If mortgage rates rise and the mortgage originator has made commitments at a
lower rate, it will either have to sell the mortgages when they close at a value below the
funds lent to homeowners, or retain the mortgages as a portfolio investment earning a
below-market mortgage rate.

(ii) Fallout risk: It is the risk that applicants or those who were issued commitments
letters will not close. It is the result of the mortgage originator giving the potential
borrower the right but not the obligation to close.
Types of mortgage designs:

1. Fixed-rate, level payment, fully amortized mortgage: the

borrower pays interest and repays principal in equal installments
over an agreed upon period of time, called the maturity or term
of the mortgage. Thus at the end of the term, the loan has been
fully amortized. This loan is involved with prepayment risk and
mismatch problem. Example, an individual has borrowed
mortgage loan Tk.200000 @ 12% interest for 5 years period.
Calculated the periodic loan repayment and prepare the
schedule under annual and quarterly loan repayment.

2. Adjustable rate mortgage: mortgage loan where the periodic

payment is changed for changing interest rate for changing
market interest rate and other factors is known as adjustable rate
mortgage.
Types of mortgage designs:
3. Graduated payment mortgage: a graduated payment
mortgage is one whose nominal monthly payment grows at a
constant rate during a portion of the life of the contract,
thereafter leveling off. The mortgage rate is fixed for the life of
the loan, despite the fact that the monthly mortgage payment
gradually increases. The terms of this mortgage include (i) the
mortgage rate (ii) the term of the mortgage (iii) the number of
years over which the monthly mortgage payment will increase
and (iv) the annual percentage increase in the mortgage
payments.

4. Price-level-adjusted mortgage: mortgage loan where interest

rate is adjusted for calculating periodic loan repayment for
existing level of periodic inflation is known as price level
adjusted mortgage. In this mortgage, the terms of the contract
must be specified, namely (i) the real interest rate (ii) the term of
the loan.
Types of mortgage designs:
5. Dual-Rate Mortgage: Also referred to as the inflation proof mortgage, the
dual-rate mortgage (DRM) is similar in spirit and objective to the price level
adjusted mortgage (PLAM) where payments start low- at current mortgage rates
of around 10%, payments would start around 30% to 40% below those required by
the traditional mortgage or by the ARM. They then rise smoothly at the rate of
inflation, if any, achieving, like the PLAM, annual payments approximately level
in terms of purchasing power. Finally, by construction, the debt is fully amortized
by the end of the contract.
6. Prepayment Penalty Mortgages: The majority of the mortgages outstanding do
not penalize the borrower from prepaying any part of all of the outstanding
mortgage balance. However, in recent years mortgage originators have begun
originating prepayment penalty mortgages (PPMs).
7. Growing-Equity Mortgage: A variation of the GPM that does not have negative
amortization is the growing-equity mortgage (GEM), which has a fixed-rate
mortgage whose monthly mortgage payments increase over time. Rather, the
higher monthly mortgage payments serve to pay down the principal faster and
shorten the term of the mortgage.
Types of mortgage designs:
8. Reverse Mortgages: Reverse mortgages are designed for senior homeowners who
want to convert their home equity into cash. Fannie Mae, for instance, offers two
types of reverse mortgages for senior borrowers. The Home Keeper Mortgage is an
adjustable-rate conventional reverse mortgage for borrowers who are of at least 62
years of age, that either own the home outright, or have a very low amount of
unpaid principal balance.
9. High-LTV Loans: Traditionally for a conventional, conforming loan, borrowers
typically were required to make a down payment of 20% when qualifying for a
mortgage. However, today a mortgagor with good credit has the option of making
a lesser down or no down payment, resulting in loans with higher LTVs. Hence,
these mortgage loans are called high-LTV loans.
10. Subprime Loans: Borrowers who apply for subprime loans vary from those who
have or had credit problems due to difficulties in repayment of debt brought on by
an adverse event, such as job loss or medical emergencies, to those that continue
to mismanage their debt and finances. The distinguishing feature of a subprime
mortgage is that the potential universe of subprime mortgagors can be divided
into various risks ranging from A through D. The risk gradation is a function of
past credit history and the magnitude of credit blemishes existing in the history.
 Investment Risks:
1. Credit Risk: Credit risk is the risk that the homeowner/ borrower will
default. For FHA, VA, and FmHA insured mortgages, this risk is
minimal. For privately insured mortgages, the risk can be gauged by
the credit rating of the private insurance company that has insured the
mortgage. For conventional mortgages, the credit risk depends on the
borrower. The LTV provides a useful measure of the risk of loss of
principal in case of default. When LTV is high, default is more likely
because the borrower has little equity in the property.

2. Liquidity Risk: Although there is a secondary market for mortgage

loans, the fact is that bid-ask spreads are large compared to other debt
instruments. That is, mortgage loans tend to be rather illiquid because
they are large and indivisible.
3. Price Risk: The price of a fixed-income instrument will move in an opposite
direction from market interest rates. Thus, a rise in interest rates will decrease
the price of a mortgage loan.

4. Prepayments and Cash Flow Uncertainty: Payments made in excess of the

scheduled principal repayments are called prepayments. Prepayments occur for
one of the several reasons. First, homeowners prepay the entire mortgage when
they sell their house for any number of reasons that require moving. Second,
the borrower has the right to pay off all or part of the mortgage balance at any
time. Effectively, those who invest in mortgages grant the borrower an option
to prepay the mortgage, and the debtor will have an incentive to do so as the
interest rate in the mortgage market falls below the mortgage rate that the
borrower is paying. Third, if homeowners cannot meet their mortgage
obligations, the property is repossessed and sold, with the proceeds from the
sale used to pay the lender in the case of a conventional mortgage. For an
insured mortgage, the insurer will pay off the mortgage balance. Finally, if
property is destroyed by fire, or another insured catastrophe occurs, the
insurance proceeds are used to pay off the mortgage.
Islamic mortgage
According to Islamic economic jurisprudence, Islamic
Shariah law prohibits the payment or receipt of interest,
meaning that Muslims cannot use conventional mortgages.
However, real estate is far too expensive for most people to
buy outright using cash: Islamic mortgages solve this
problem by having the property change hands twice. In one
variation, the bank will buy the house outright and then
act as a landlord. The homebuyer, in addition to paying
rent, will pay a contribution towards the purchase of the
property. When the last payment is made, the property
changes hands. Typically, this may lead to a higher final
price for the buyers.
Islamic mortgage
The contract that is used for Islamic mortgage is the charitable contract
Rahn. Literally, rahn is an Arabic noun derived from the word rahana,
which means either constancy or continuity, or holding and binding.
Technically, rahn, which is also termed as pawning, mortgage,
collateral, change, lien and pledge, refers to taking a property as a
security against a debt, whereby the secured property can be utilised to
repay the debt in the case of nonpayment.
Rahn is a charitable contract as it does not require any financial
obligation in the part of the creditor when the debtor gives him the
pawned object. In this case, rahn is similar to the other charitable
contracts such as gist, simple loan and deposit.
The legality of rahn is based on proof from the Quran, Sunnah and
ijma. In the Quran, Allah (s.w.t.) says,:
If you are on a journey and cannot find a scribe, then use the receipt of
pawn objects (Sura Baqara:Verse 283).
This verse clearly indicates the alternative means of documenting the
debt in the absence of the scribe, i.e. via pawning. Although it was
revealed in the context of travelling, sunnah of Prophet (p.b.u.h.) has
proved its application in all cases of financial transaction without any
restriction.