Financial Transaction

9 Mortgage Markets

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ provide a background on mortgages,

· ▪ describe the common types of residential mortgages,

· ▪ explain the valuation and risk of mortgages,

· ▪ explain mortgage-backend securities, and

· ▪ explain how mortgage problems led to the 2008- 2009 credit crisis.

9-1 BACKGROUND ON MORTGAGES

A mortgage is a form of debt created to finance investment in real estate. The debt is secured by the property, so if the property owner does not meet the payment obligations, the creditor can seize the property. Financial institutions such as savings institutions and mortgage companies serve as intermediaries by originating mortgages. They consider mortgage applications and assess the creditworthiness of the applicants.

   The mortgage represents the difference between the down payment and the value to be paid for the property. The mortgage contract specifies the mortgage rate, the maturity, and the collateral that is backing the loan. The originator charges an origination fee when providing a mortgage. In addition, if it uses its own funds to finance the property, it will earn profit from the difference between the mortgage rate that it charges and the rate that it paid to obtain the funds. Most mortgages have a maturity of 30 years, but 15-year maturities are also available.

9-1a How Mortgage Markets Facilitate the Flow of Funds

WEB

www.mbaa.org

News regarding the mortgage markets.

The means by which mortgage markets facilitate the flow of funds are illustrated in  Exhibit 9.1 . Financial intermediaries originate mortgages and finance purchases of homes. The financial intermediaries that originate mortgages obtain their funding from household deposits. They also obtain funds by selling some of the mortgages that they originate directly to institutional investors in the secondary market. These funds are then used to finance more purchases of homes, condominiums, and commercial property. Overall, mortgage markets allow households and corporations to increase their purchases of homes, condominiums, and commercial property and thereby finance economic growth.

Institutional Use of Mortgage Markets  Mortgage companies, savings institutions, and commercial banks originate mortgages. Mortgage companies tend to sell their mortgages in the secondary market, although they may continue to process payments for the mortgages that they originated. Thus their income is generated from origination and processing fees, and not from financing the mortgages over a long-term period. Savings institutions and commercial banks commonly originate residential mortgages. Commercial banks also originate mortgages for corporations that purchase commercial property. Savings institutions and commercial banks typically use funds received from household deposits to provide mortgage financing. However, they also sell some of their mortgages in the secondary market.

Exhibit 9.1 How Mortgage Markets Facilitate the Flow of Funds

   The common purchasers of mortgages in the secondary market are savings institutions, commercial banks, insurance companies, pension funds, and some types of mutual funds. The participation by financial institutions in the mortgage market is summarized in  Exhibit 9.2 .

Exhibit 9.2 Institutional Use of Mortgage Markets

TYPE OF FINANCIAL INSTITUTION	INSTITUTION PARTICIPATION IN MORTGAGE MARKETS
Commercial banks and savings institutions	· • Originate and service commercial and residential mortgages and maintain mortgages within their investment portfolios. · • Bundle packages of mortgages and sell mortgage-backed securities representing the packages of mortgages. · • Purchase mortgage-based securities.
Credit unions and finance companies	· • Originate mortgages and maintain mortgages within their investment portfolios.
Mortgage companies	· • Originate mortgages and sell them in the secondary market.
Mutual funds	· • May sell shares and use the proceeds to construct portfolios of mortgage-backed securities.
Securities firms	· • Bundle packages of mortgages and sell mortgage-backed securities representing the packages of mortgages. · • Offer instruments to help institutional investors in mortgages hedge against interest rate risk.
Insurance companies	· • Commonly purchase mortgages or mortgage-backed securities in the secondary market.

9-1b Criteria Used to Measure Creditworthiness

When financial institutions consider mortgage applications, they review information that reflects the prospective borrower's ability to repay the loan. The following are three important criteria that are used to measure a borrower's repayment ability:

· ▪ Level of equity invested by the borrower. The down payment represents the equity invested by the borrower. The lower the level of equity invested, the higher the probability that the borrower will default. One proxy for this factor is the loan-to-value ratio, which indicates the proportion of the property's value that is financed with debt. When borrowers make relatively small down payments, the loan-to-value ratio is higher and borrowers have less to lose in the event that they stop making their mortgage payments.

· ▪ Borrower's income level. Borrowers who have a lower level of income relative to the periodic loan payments are more likely to default on their mortgages. Income determines the amount of funds that borrowers have available per month to make mortgage payments. Income levels change over time, however, so it is difficult for mortgage lenders to anticipate whether prospective borrowers will continue to earn their monthly income over the life of the mortgage, especially given the high frequency of layoffs.

· ▪ Borrower's credit history. Other conditions being similar, borrowers with a history of credit problems are more likely to default on their loans than those without credit problems.

9-1c Classifications of Mortgages

Mortgages can be classified in various ways, but two important classifications are prime versus subprime mortgages and insured versus conventional mortgages.

Prime versus Subprime Mortgages  Mortgages can be classified according to whether the borrower meets the traditional lending standards. Borrowers who obtain “prime” mortgages satisfy the traditional lending standards. “Subprime” mortgages are offered to borrowers who do not qualify for prime loans because they have relatively lower income or high existing debt, or can make only a small down payment. In recent years, especially between 2003 and 2005, many financial institutions such as mortgage companies increased their offerings of subprime loans as a way of expanding their business. In addition, they could charge higher fees (such as appraisal fees) and higher interest rates on the mortgages to compensate for the risk of default. Subprime mortgage rates were commonly 1.5 to 2.5 percentage points above the rates of prime mortgages. Although subprime mortgages enabled some people to purchase homes who otherwise could not have, these mortgages were very susceptible to default. The large number of defaults of subprime mortgages led to the credit crisis that began in 2008, as explained later in this chapter.

   Mortgages referred to as Alt-A typically satisfy some but not all of the criteria for prime mortgages. Thus Alt-A mortgages are generally perceived to have more risk of default than prime loans but less risk of default than subprime loans.

Insured versus Conventional Mortgages  Mortgages are also often classified as federally insured or conventional. Federally insured mortgages guarantee loan repayment to the lending financial institution, thereby protecting it against the possibility of default by the borrower. An insurance fee of 0.5 percent of the loan amount is applied to cover the cost of insuring the mortgage. The guarantor can be either the Federal Housing Administration (FHA) or the Veterans Administration (VA). To qualify for FHA and VA mortgage loans from a financial institution, borrowers must meet various requirements specified by those government agencies. In addition, the maximum mortgage amount is limited by law (although the limit varies among states to account for differences in the cost of housing). The volume of FHA loans has consistently exceeded that of VA loans since 1960. Both types of mortgages have become increasingly popular over the past 30 years.

   Financial institutions also provide conventional mortgages. Although not federally insured, they can be privately insured so that the lending financial institutions can still avoid exposure to credit risk. The insurance premium paid for such private insurance will likely be passed on to the borrowers. Lenders can choose to incur the credit risk themselves and avoid the insurance fee. Some participants in the secondary mortgage market purchase only those conventional mortgages that are privately insured (unless the mortgage's loan-to-value ratio is less than 80 percent).

9-2 TYPES OF RESIDENTIAL MORTGAGES

WEB

www.bloomberg.com/markets/rates/keyrates.html

Provides quotes on mortgage rates.

Various types of residential mortgages are available to homeowners, including the following:

· ▪ Fixed-rate mortgages

· ▪ Adjustable-rate mortgages

· ▪ Graduated-payment mortgages

· ▪ Growing-equity mortgages

· ▪ Second mortgages

· ▪ Shared-appreciation mortgages

· ▪ Balloon-payment mortgages

9-2a Fixed-Rate Mortgages

WEB

www.bloomberg.com/invest/calculators/index.html

Calculates monthly mortgage payments based on the type of mortgage, the Loan amount, the maturity, and the interest rate.

One of the most important provisions in the mortgage contract is the interest rate. It can be specified as a fixed rate or can allow for periodic rate adjustments over time. A fixed-rate mortgage locks in the borrower's interest rate over the life of the mortgage. Thus the periodic interest payment received by the lending financial institution is constant, regardless of how market interest rates change over time. A financial institution that holds fixed-rate mortgages in its asset portfolio is exposed to interest rate risk because it commonly uses funds obtained from short-term customer deposits to make long-term mortgage loans. If interest rates increase over time, the financial institution's cost of obtaining funds (from deposits) will increase. The return on its fixed-rate mortgage loans will be unaffected, however, causing its profit margin to decrease.

   Borrowers with fixed-rate mortgages do not suffer from the effects of rising interest rates, but they also fail to benefit from declining rates. Although they can attempt to refinance (obtain a new mortgage to replace the existing mortgage) at the lower prevailing market interest rate, they will incur transaction costs such as closing costs and an origination fee.

Amortizing Fixed-Rate Mortgages  Given the maturity and interest rate on a fixed-rate mortgage, an  amortization schedule  can be developed to show the monthly payments broken down into principal and interest. During the early years of a mortgage, most of the payment reflects interest. Over time, as some of the principal is paid off, the interest proportion decreases.

Exhibit 9.3 Example of Amortization Schedule for Selected Years (Based on a 30-Year, $100,000 Mortgage at 8 Percent)

PAYMENT NUMBER	PAYMENT OF INTEREST	PAYMENT OF PRINCIPAL	TOTAL PAYMENT	REMAINING LOAN BALANCE
1	$666.66	$ 67.10	$733.76	$99,932.90
2	666.21	67.55	33.76	99,865.35
100	604.22	129.54	733.76	90,504.68
101	603.36	130.40	733.76	90,374.28
200	482.01	251.75	733.76	72,051.18
201	480.34	253.42	733.76	71,797.76
300	244.52	489.24	733.76	36,188.12
301	241.25	492.51	733.76	35,695.61
359	9.68	724.08	733.76	728.91
360	4.85	728.91	733.76	0

   The lending institution that holds a fixed-rate mortgage will receive equal periodic payments over a specified period of time. The amount depends on the principal amount of the mortgage, the interest rate, and the maturity. If insurance and taxes are included in the mortgage payment then they, too, influence the amount.

   Consider a 30-year (360-month) $100,000 mortgage at an annual interest rate of 8 percent. To focus on the mortgage principal and interest payments, insurance and taxes are not included in this example. A breakdown of the monthly payments into principal versus interest is shown in Exhibit 9.3. In the first month, the interest payment is $666.66 while the principal payment is only $67.10. Observe that a larger proportion of interest is paid in the earlier years and a larger portion of principal in the later years. Website calculators are widely available to determine the amortization schedule for any type of mortgage.

   An amortization schedule can also be used to compare monthly payments required on a 30-year mortgage versus a 15-year mortgage.

EXAMPLE

A 30-year, $100,000 mortgage at 8 percent requires monthly payments (excluding taxes and insurance) of approximately $734. The same mortgage for 15 years would require monthly payments of $956. Total payments for the 30-year loan would be $264,155, versus $172,017 for the 15-year mortgage. Total payments are lower on mortgages with shorter lives because of the more rapid amortization and lower cumulative interest.

   For the financial institutions that provide mortgages, 15-year mortgages are subject to less interest rate risk than 30-year mortgages because of the shorter term to maturity.

9-2b Adjustable-Rate Mortgages

An  adjustable-rate mortgage (ARM)  allows the mortgage interest rate to adjust to market conditions. Its contract will specify a precise formula for this adjustment. The formula and the frequency of adjustment can vary among mortgage contracts. A common ARM uses a one-year adjustment with the interest rate tied to the average Treasury bill rate over the previous year (for example, the average T-bill rate plus 2 percent may be specified).

   Some ARMs now contain an option clause that allows mortgage holders to switch to a fixed rate within a specified period, such as one to five years after the mortgage is originated (the specific provisions vary).

    Exhibit 9.4  shows the rate charged on newly originated fixed-rate and adjustable-rate mortgages over time. Notice that the fixed rate is typically higher than the adjustable rate at any given time when a mortgage is originated. Home buyers attempt to assess future interest rate movements at the time a mortgage is originated. If they expect that interest rates will remain somewhat stable or decline during the period they will own the property, they will choose an ARM. Conversely, if they expect that interest rates will increase substantially over time, they will prefer a fixed-rate mortgage.

ARMs from the Financial Institution's Perspective  Because the interest rate of an ARM moves with prevailing interest rates, financial institutions can stabilize their profit margin. If their cost of funds rises, so does their return on mortgage loans. For this reason, ARMs have become very popular over time.

   Most ARMs specify a maximum allowable fluctuation in the mortgage rate per year and over the mortgage life, regardless of what happens to market interest rates. These caps are commonly 2 percent per year and 5 percent for the mortgage's lifetime. To the extent that market interest rates move outside these boundaries, the financial institution's profit margin on ARMs could be affected by interest rate fluctuations. Nevertheless, this interest rate risk is significantly less than that of fixed-rate mortgages.

Exhibit 9.4 Comparison of Rates on Newly Originated Fixed-Rate and Adjustable-Rate Mortgages over Time

9-2c Graduated-Payment Mortgages

A  graduated-payment mortgage (GPM)  allows the borrower to make small payments initially on the mortgage; the payments increase on a graduated basis over the first 5 to 10 years and then level off. This type of mortgage is tailored for families who anticipate higher income (and thus the ability to make larger monthly mortgage payments) as time passes. In a sense, they are delaying part of their mortgage payment.

9-2d Growing-Equity Mortgages

A  growing-equity mortgage  is similar to a GPM in that the monthly payments are initially low and increase over time. Unlike the GPM, however, the payments never level off but continue to increase (typically by about 4 percent per year) throughout the life of the loan. With such an accelerated payment schedule, the entire mortgage may be paid off in 15 years or less.

9-2e Second Mortgages

WEB

www.hsh.com

Detailed information about mortgage financing.

A  second mortgage  can be used in conjunction with the primary or first mortgage. Some financial institutions may limit the amount of the first mortgage based on the borrower's income. Other financial institutions may then offer a second mortgage with a maturity shorter than that of the first mortgage. In addition, the interest rate on the second mortgage is higher because its priority claim against the property (in the event of default) is behind that of the first mortgage. The higher interest rate reflects greater compensation as a result of the higher risk incurred by the provider of the second mortgage.

   Sellers of homes sometimes offer buyers a second mortgage. This practice is especially common when the old mortgage is assumable and the selling price of the home is much higher than the remaining balance on the first mortgage. By offering a second mortgage, the seller can make the house more affordable and therefore more marketable. The seller and the buyer negotiate specific interest rate and maturity terms.

9-2f Shared-Appreciation Mortgages

A  shared-appreciation mortgage  allows a home purchaser to obtain a mortgage at a below-market interest rate. In return, the lender providing the attractive loan rate will share in the price appreciation of the home. The precise percentage of appreciation allocated to the lender is negotiated at the origination of the mortgage.

9-2g Balloon-Payment Mortgages

A  balloon-payment mortgage  requires only interest payments for a three-to five-year period. At the end of this period, the borrower must pay the full amount of the principal (the balloon payment). Because no principal payments are made until maturity, the monthly payments are lower. Realistically, though, most borrowers have not saved enough funds to pay off the mortgage in three to five years, so the balloon payment in effect forces them to request a new mortgage. Therefore, they are subject to the risk that mortgage rates will be higher at the time they refinance the mortgage.

9-3 VALUATION AND RISK OF MORTGAGES

Since mortgages are commonly sold in the secondary market, they are continually valued by institutional investors. The market price (PM) of a mortgage should equal the present value of its future cash flows:

where C denotes the interest payment (similar to a coupon payment on bonds), Prin the principal payment made each period, and k the required rate of return by investors. As with bonds, the market value of a mortgage is the present value of the future cash flows to be received by the investor. Unlike bonds, however, the periodic cash flows commonly include a payment of principal along with an interest payment.

   The required rate of return on a mortgage is primarily determined by the existing risk-free rate for the same maturity. However, other factors such as credit risk and lack of liquidity will cause the required return on many mortgages to exceed the risk-free rate. The difference between the 30-year mortgage rate and the 30-year Treasury bond rate, for example, is due mainly to credit risk and therefore tends to increase during periods when the economy is weak (e.g., during the credit crisis in 2008).

Since the required rate of return on a fixed-rate mortgage is primarily driven by the prevailing risk-free rate (Rf) and the risk premium (RP), the change in the value (and hence in the market price PM) of a mortgage can be modeled as

An increase in either the risk-free rate or the risk premium on a fixed-rate mortgage results in a higher required rate of return when investing in the mortgage, which causes the mortgage price to decrease.

9-3a Risk from Investing in Mortgages

WEB

finance.yahoo.com/personal-finance/home-values

Information about home values, mortgage rates home equity loans, and credit reports.

Given the uncertainty of the factors that influence mortgage prices, future mortgage prices (and therefore returns) are uncertain. The uncertainty that financial institutions face when investing in mortgages is due to credit risk, interest rate risk, and prepayment risk, as explained next.

Credit Risk  Credit (default) risk represents the size and likelihood of a loss that investors will experience if borrowers make late payments or even default. Whether investors sell their mortgages prior to maturity or hold them until maturity, they are subject to credit risk. Consequently, investors must weigh the higher potential return from investing in mortgages against the exposure to risk (that the actual return could be lower than the expected return). The probability that a borrower will default is influenced both by economic conditions and by the borrower characteristics that lenders consider when assessing a borrower's creditworthiness (level of equity invested by the borrower, the borrower's income level, and the borrower's credit history).

Interest Rate Risk  Financial institutions that hold mortgages are subject to interest rate risk because the values of mortgages tend to decline in response to an increase in interest rates. Mortgages are long term but are commonly financed by some financial institutions with short-term deposits, so the investment in mortgages may create high exposure to interest rate risk. Such mortgages can also generate high returns when interest rates fall, but the potential gains are limited because borrowers tend to refinance (obtain new mortgages at the lower interest rate and prepay their mortgages) when interest rates decline.

   When investors hold fixed-rate mortgages until maturity, they do not experience a loss due to a change in interest rates. However, holding fixed-rate mortgages to maturity can create a so-called opportunity cost of what the investors might have earned if they had invested in other securities. For example, if interest rates rise consistently from the time fixed-rate mortgages are purchased until they mature, investors who hold the mortgages to maturity gave up the potential higher return that they would have earned if they had simply invested in money market securities over the same period.

   Financial institutions can limit their exposure to interest rate risk by selling mortgages shortly after originating them. However, even institutions that use this strategy are partially exposed to interest rate risk. As a financial institution originates a pool of mortgages, it may commit to a specific fixed rate on some of the mortgages. The mortgages are stored in what is referred to as a mortgage pipeline until there is a sufficient pool of mortgages to sell. By the time the complete pool of mortgages is originated and sold, interest rates may have risen. In this case, the value of the mortgages in the pool may have declined by the time the pool is sold.

   Another way financial institutions can limit interest rate risk is by offering adjustable rate residential mortgages. Alternatively, they could invest in fixed-rate mortgages that have a short time remaining until maturity. However, this conservative strategy may reduce the potential gains that could have been earned.

Prepayment Risk  Prepayment risk is the risk that a borrower may prepay the mortgage in response to a decline in interest rates. This type of risk is distinguished from interest rate risk to emphasize that even if investors in mortgages do not need to liquidate the mortgages, they are still susceptible to the risk that the mortgages they hold will be paid off. In this case, the investor receives a payment to retire the mortgage and must then reinvest at the prevailing (lower) interest rates. Thus the interest rate on the new investment will be lower than the rate that would have been received on the retired mortgages.

   Because of prepayments, financial institutions that invest in fixed-rate mortgages may experience only limited benefits in periods when interest rates decline. Although these mortgages offer attractive yields compared to the prevailing low interest rates, they are commonly retired as a result of refinancing. Financial institutions can insulate against prepayment risk in the same manner that they limit exposure to interest rate risk: they can sell loans shortly after originating them or invest in adjustable-rate mortgages.

9-4 MORTGAGE-BACKED SECURITIES

As an alternative to selling their mortgages outright, financial institutions can engage in  securitization , or the pooling and repackaging of loans into securities called  mortgagebacked securities (MBS)  or  pass-through securities . These securities are then sold to investors, who become the owners of the loans represented by those securities.

9-4a The Securitization Process

When mortgages are securitized, a financial institution such as a securities firm or commercial bank combine individual mortgages together into packages. Securitization allows the institution to sell mortgage loans in large batches. When several small mortgage loans are packaged together, they become more attractive to the large institutional investors (such as commercial banks, savings institutions, and insurance companies) that focus on large transactions. The issuer of the MBS assigns a trustee to hold the mortgages as collateral for the investors who purchase the securities. After the securities are sold, the financial institution that issued the MBS receives interest and principal payments on the mortgages and then transfers (passes through) the payments to investors that purchased the securities. The financial institution deducts a fee for servicing these mortgages.

9-4b Types of Mortgage-Backed Securities

Five of the more common types of mortgage-backed securities are the following:

· ▪ GNMA (Ginnie Mae) mortgage-backed securities

· ▪ Private-label pass-through securities

· ▪ FNMA (Fannie Mae) mortgage-backed securities

· ▪ FHLMC participation certificates

· ▪ Collateralized mortgage obligations (CMOs)

Each type is described in turn.

GNMA Mortgage-Backed Securities  The Government National Mortgage Association (called GNMA, or Ginnie Mae) was created in 1968 as a corporation that is wholly owned by the federal government. When mortgages are backed by FHA and VA mortgages, Ginnie Mae guarantees timely payment of principal and interest to investors who purchase these securities. The mortgages must satisfy specific guidelines. They are restricted to a maximum dollar amount (that changes over time), since they are intended to serve low- and moderate-income homeowners. The financial institutions that originate mortgages with the Ginnie Mae guarantee can more easily sell the mortgages in the secondary market, because the institutional investors do not have to worry about credit risk. Thus institutional investors are more willing to invest in MBS that incorporate Ginnie Mae's guarantee, which results in a more active secondary market for mortgages.

Private Label Pass-Through Securities  Private label pass-through securities are similar to Ginnie Mae mortgage-backed securities except that they are backed by conventional rather than FHA or VA mortgages. The mortgages backing the securities are insured through private insurance companies.

WEB

http://mtgprofessor.com/secondary_markets.htm

Detailed information on the secondary mortgage markets.

FNMA Mortgage-Backed Securities  The Federal National Mortgage Association (called FNMA, or Fannie Mae) was created by the government in 1938 to develop a more liquid secondary market for mortgages. It issues long-term debt securities to institutional investors and uses the funds to purchase mortgages in the secondary market. In essence, Fannie Mae channels funds from institutional investors to financial institutions that desire to sell their mortgages. These financial institutions may continue to service the mortgages and earn a fee for this service. The mortgage payments on mortgages backing these securities are sent to the financial institutions that service the mortgages. The payments are channeled through to the purchasers of MBS, which may be collateralized by conventional or federally insured mortgages.

FHLMA Participation Certificates  The Federal Home Loan Mortgage Association (called FHLMA or Freddie Mac) was chartered as a corporation by the federal government in 1970 to ensure that sufficient funds flow into the mortgage market. It went public in 1989. It sells  participation certificates (PCs)  and uses the proceeds to finance the origination of conventional mortgages from financial institutions. This provides another outlet for financial institutions that desire to sell their conventional mortgages in the secondary market.

   Fannie Mae and Freddie Mac enhance liquidity in the mortgage market, as illustrated in  Exhibit 9.5 . The proceeds received from selling securities are channeled to purchase mortgages in the secondary market from mortgage originators. As a result of Fannie Mae and Freddie Mac, the secondary mortgage market is more liquid than it otherwise would be. In addition, originators of the mortgages can originate more mortgages because they are not forced to finance the mortgages on their own. Because the mortgage market is more liquid, mortgage rates are more competitive and housing is more affordable for some homeowners.

Collateralized Mortgage Obligations   Collateralized mortgage obligations (CMOs)  represent a type of MBS in which the underlying mortgages are segmented into tranches (classes), according to their maturity, and the cash flows provided by each tranche are typically structured in a sequential manner. In this way, the timing of the cash flows generated by a particular tranche are more predictable. The first tranche has the quickest payback. Any repaid principal is initially sent to owners of the first-tranche CMOs until the total principal amount representing that tranche is fully repaid. Then any further principal payments are sent to owners of the second-tranche CMOs until the total principal amount representing that tranche is fully repaid. This process continues until principal payments are made to owners of the last-tranche CMOs. Issues of CMOs typically have from three to ten tranches.

Exhibit 9.5 How Fannie Mae and Freddie Mac Enhance Liquidity in the Mortgage Market

   The CMOs are sometimes segmented into interest-only (IO) and principal-only (PO) tranches. Investors in interest-only CMOs receive only interest payments that are paid on the underlying mortgages. When mortgages are prepaid, the interest payments on the underlying mortgages are terminated, and so are payments to investors in interest-only CMOs. For example, mortgage prepayments may cut off the interest rate payments on the CMO after a few years, even though these payments were initially expected to last five years or more. Consequently, investors in these CMOs could lose 50 percent or more of their initial investment. The relatively high yields offered on interest-only CMOs are attributable to their high degree of risk.

   Because investors in the principal-only CMO receive principal payments only, they generally receive payments further into the future. Even though the payments to these investors represent principal, the maturity is uncertain owing to possible prepayment of the underlying mortgages.

   Some mortgages are also sold through a  collateralized debt obligation (CDO) , which is a package of debt securities backed by collateral that is sold to investors. A CDO differs from a CMO in that it also contains some other, nonmortgage types of debt securities (e.g., automobile loans and credit card loans). Collateralized debt obligations became popular in the late 1990s and, by 2007, the value of CDOs issued was about $500 billion.

   Like CMOs, CDOs can be separated into tranches based on risk. On average, MBS represent about 45 percent of a CDO, but the percentage may be as low as zero or as high as about 90 percent. The mortgages that are included in CDOs are commonly subprime mortgages. When economic conditions weaken, there are more mortgage defaults and so the riskiest tranches of a CDO may suffer major losses. Even highly rated tranches are subject to losses in such periods. Tranches assigned a AAA rating by rating agencies had a risk premium (above the risk-free Treasury bond rate) of close to zero in 2005 as compared with a risk premium of 5 percent in 2008. This significant increase in the premium reflected the additional compensation that investors required when the housing market collapsed in 2008.

   When CMO and CDO values deteriorate, financial institutions have more difficulty selling mortgages that they originate. Thus the activity in the CMO and CDO market influences the volume of funds available to finance new mortgages.

9-4c Valuation of Mortgage-Backed Securities

The valuation of MBS is difficult because of the limited transparency. Although there is a secondary market for mortgage-backed securities, it is not very active in some periods. There is no centralized reporting system that reports the trading of MBS in the secondary market, as there is for other securities such as stocks and Treasury bonds. The only participants who know the price of the securities that were traded are the buyer and the seller. Given the lack of a centralized reporting system, it is quite possible that a financial institution may overpay when buying MBS.

Reliance on Ratings to Assess Value  When deciding whether to purchase MBS, institutional investors may rely on rating agencies (Moody's, Standard & Poor's, or Fitch) rather than attempt to conduct their own valuation. An agency is hired by the issuer of the securities to assign ratings to the MBS that it plans to sell. The financial institutions that create MBS pay a fee to rating agencies to assign a rating to their MBS. Many institutional investors will not purchase MBS unless they are rated high. However, many of the MBS that were highly rated still suffered major losses during the credit crisis.

Fair Value of Mortgage-Backed Securities  When financial institutions believe that they will incur a loss on MBS (or any other long-term assets), they are expected to “write down” the value to reflect its true market value (also called its “fair value”). In doing so, they may attempt to rely on prices of MBS that are traded in the secondary market in order to determine the market value of the MBS they are holding. However, MBS can vary substantially in terms of risk, so that mortgage-backed securities at a particular financial institution may warrant a much higher (or lower) valuation than those recently traded in the secondary market. Furthermore, when the secondary market for MBS is not active (such as during the credit crisis, when investors were no longer willing to buy them), there is insufficient market information to derive a market value.

9-5 MORTGAGE CREDIT CRISIS

In the 2003–2006 period, low interest rates and favorable economic conditions stimulated the demand for new homes. The market values of homes increased substantially, and many institutional investors used funds to invest in mortgages or mortgage-backed securities. Home builders responded to the favorable housing conditions by building more homes. Furthermore, many lenders were so confident that home prices would continue to rise that they reduced the down payment (equity investment) that they required from home buyers. The lenders assumed that, even if the home buyers defaulted on the loan, the home's value would serve as sufficient collateral.

   In 2006, however, some prospective buyers were less willing to purchase homes because of the abrupt increase in home prices during 2005. Suddenly, the demand for new homes was less than the supply of new and existing homes for sale, and housing prices declined. Along with these conditions, interest rates increased in 2006, which made it more difficult for existing homeowners with adjustable-rate mortgages to make their mortgage payments. In addition, mortgage companies had previously offered mortgages with low initial rates for the first few years. Now these “teaser rates” were expiring on homes that were recently purchased, and these homeowners also faced higher mortgage payments. Consequently, mortgage defaults increased. Because the market values of homes had declined substantially in some areas, in many cases the collateral backing the mortgage was not sufficient to recapture the entire mortgage amount. Even some mortgages that were insured against default by private insurers defaulted because some insurance companies that insured mortgages did not have adequate funds to cover their obligations.

   As economic conditions weakened further, mortgage defaults continued to increase. By June 2008, 9 percent of all American homeowners were either behind on their mortgage payments or were in foreclosure. The defaults were much higher on subprime mortgages than on prime mortgages. In 2008, about 25 percent of all outstanding subprime mortgages had late payments of at least 30 days, versus fewer than 5 percent for prime mortgages. In addition, about 10 percent of outstanding subprime mortgages were subject to foreclosure in 2008, versus fewer than 3 percent for prime mortgages. Some mortgages that were supposed to be backed by insurance were not. Furthermore, while many mortgages were backed by insurance, some private insurers went bankrupt—exposing the institutional investors holding the mortgages to major losses.

9-5a Impact of the Credit Crisis on Fannie Mae and Freddie Mac

As of 2007, Fannie Mae held about $47 billion in subprime mortgages and/or securities backed by these mortgages, while Freddie Mac held about $124 billion in such securities. Although these companies were chartered by the federal government to provide liquidity to the mortgage market, the compensation of their executives was tied to the companies' performance, which led to risk taking. They had reduced their standards in order to attempt to maintain their market share when investing in mortgages. This is an example of a moral hazard problem, which occurs when a person or institution does not have to bear the full consequences of its behavior and therefore assumes more risk than it otherwise would. In this case, the executives could take risks knowing that they would benefit if their gambles paid off and that the government would likely bail them out if the gambles failed.

   Fannie Mae and Freddie Mac invested heavily in subprime mortgages that required homeowners to pay higher rates of interest. By 2008, many subprime mortgages defaulted, so Fannie Mae and Freddie Mac were left with properties (the collateral) that had a market value substantially below the amount owed on the mortgages that they held. Fannie Mae and Freddie Mac attempted “workouts” in some cases, whereby they renegotiated the terms of mortgage contracts or arranged additional financing for homeowners in order to help them avoid foreclosures. Some of the mortgages that Fannie Mae and Freddie Mac purchased from commercial banks and other mortgage originators misrepresented the qualifications of the homeowners.

   By the summer of 2008, Fannie Mae and Freddie Mac owned or guaranteed more than $5 trillion of U.S. home mortgages, or about half the value of all outstanding mortgages in the United States. In August 2008, Fannie Mae and Freddie Mac reported losses of more than $14 billion over the previous year. At that time, they held about $84 billion in capital, which represented less than 2 percent of all the mortgages that they held. This was a very small cushion to cover possible losses on their mortgages.

Funding Problems  Because of their poor financial performance, Fannie Mae and Freddie Mac were incapable of raising capital to improve their financial position or to continue their role of supporting the housing market. Their stock values had declined by more than 90 percent from the previous year, so issuing new equity to obtain funds was not a feasible solution. The yield offered on Fannie Mae and Freddie Mac debt securities was 2.5 percent higher than that of Treasury securities with a similar maturity, which reflected the large risk premium that investors were requiring in order to invest in these securities. Thus the cost of debt to Fannie Mae and Freddie Mac was extremely high because investors feared that these agencies might not be able to repay their debt. Their cost of debt would have been even higher if investors had not presumed that the government would bail out the two companies if necessary.

Rescue of Fannie Mae and Freddie Mac  In September 2008, the U.S. government took over the management of Fannie Mae and Freddie Mac. Their regulator, the Federal Housing Finance Agency, became responsible for managing them until they are determined to be financially healthy. The CEOs of both companies were removed from their positions, but they left with compensation packages that many critics would say were very forgiving. In the previous year, Fannie Mae's CEO received income of $11.6 million and Freddie Mac's CEO received $19.8 million.

   The Treasury agreed to provide whatever funding would be necessary to cushion losses from the mortgage defaults. In return, the Treasury received $1 billion of preferred stock in each of the two companies. This arrangement gave Congress time to determine whether and how these companies should be structured in the future. Congress could also establish guidelines that would restrict them from investing in risky mortgages that do not meet specific standards.

   The U.S. government rescue of Fannie Mae and Freddie Mac removed the risk of their debt securities defaulting and therefore increased the values of these debt securities. It allowed Fannie Mae and Freddie Mac to obtain funds by issuing debt securities so that they could resume purchasing mortgages and thereby ensure a more liquid secondary market for them.

9-5b Systemic Risk Due to the Credit Crisis

The impact of the credit crisis extends far beyond the homeowners who lost their homes and the financial institutions that lost money on their mortgage investments. Mortgage insurers that provided insurance to homeowners incurred large expenses from many foreclosures because the property collateral was worth less than the amount owed on the mortgage. In this way, the problems of the mortgage sector affected the insurance industry. In addition, some insurance companies that sold credit default swaps on mortgages suffered heavy losses.

   As mortgages defaulted, the valuations of mortgage-backed securities (MBS) weakened. Consequently, financial institutions were no longer able to use MBS as collateral when borrowing funds from lenders. The lenders could not trust that the MBS would constitute adequate collateral if the financial institutions that borrowed funds were unable to repay their loans. As a result, some financial institutions (such as Bear Stearns) with large investments in MBS were no longer able to access sufficient funds to support their operations during the credit crisis. Moreover, they could not sell their MBS in the secondary market to obtain cash because by this time there were few investors willing to purchase MBS in the secondary market.

   Individual investors whose investments were pooled (by mutual funds, hedge funds, and pension funds) and then used to purchase MBS experienced losses, as did investors who purchased stocks of financial institutions. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. Home builders also went bankrupt, and many employees in the home building industry lost their jobs, too. The losses on investments and layoffs contributed to a weaker economy, which made the crisis worse.

   The concerns about MBS also spread to other types of debt securities, including corporate bonds. When investors fully recognized the risk associated with MBS during 2008, they no longer considered MBS as adequate collateral to back commercial paper. Consequently, some financial institutions were no longer able to issue commercial paper unless they had better forms of collateral. This paralyzed the commercial paper market, and forced financial institutions to seek alternative markets to obtain short-term funding.

International Systemic Risk  Although much of the credit crisis was focused on the United States, the problems were contagious to international financial markets as well. Financial institutions in other countries (e.g., the United Kingdom) had offered subprime loans, and they also experienced high delinquency and default rates. In addition, some financial institutions based in foreign countries were common purchasers of subprime mortgages that originated in the United States. Many institutional investors in Asia and Europe had purchased MBS and CDOs that contained subprime mortgages originated in the United States. For example, UBS (a large Swiss bank) incurred a loss of $35 billion from its positions in MBS. Such problems contributed to weaker economies around the world.

9-5c Who Is to Blame?

The credit crisis illustrated some important problems in the mortgage markets. Various participants in the process of mortgage financing were subjected to criticism, as explained next.

Mortgage Originators  The mortgage companies and other financial institutions that originate mortgages are supposed to assess the creditworthiness of prospective homeowners. During the housing boom in the 2003–2005 period, however, some mortgage originators were aggressively seeking new business without exercising adequate control over quality. In some cases, they approved loans without even verifying the prospective buyer's income. As described earlier, they also reduced the required down payment because they incorrectly presumed that home prices would not decrease and that the property would therefore be sufficient collateral in the event of default.

Credit Rating Agencies  As described earlier, the mortgage-backed securities that are issued by securities firms and financial institutions are assigned credit ratings by credit rating agencies. The rating agencies, which are paid by the issuers that want their MBS rated, were criticized for being too lenient in their ratings shortly before the credit crisis. Mortgage-backed securities were commonly rated AAA even though they represented risky mortgages. Some mortgage-backed securities were rated based on an assessment of the mean (average) of the underlying mortgages, which ignores information about the distribution of mortgages. Thus an MBS could be rated high as long as some of its constituent mortgages were rated high enough to offset those that were rated low. A large proportion of the mortgage-backed securities that were issued in 2006 and backed by subprime mortgages were either in default or rated at the lowest level by 2010.

   According to the Securities and Exchange Commission, many MBS and CDO tranches were overrated for the following reasons. First, credit rating agencies were understaffed and did not perform thorough analyses. Second, credit rating agencies did not monitor the performance of the tranches over time and so did not detect deterioration in existing tranches. Third, some analysts at rating agencies were motivated to assign a high rating because the issuing firms could more easily sell highly rated tranches and would therefore be more likely to hire the same agencies to rate future tranches. A credit rating agency typically receives a fee of between $300,000 and $500,000 from the issuer for rating a package of mortgages. By assigning high ratings to mortgage-backed securities, a credit rating agency attracts future business from financial institutions that want to issue MBS and need to have the securities certified with a high rating.

   Publicized results of investigations of credit rating agencies documented that some analysts at credit rating agencies apparently understood that there were problems with their ratings. For example, a manager at one agency sent an e-mail to his co-workers saying that assigning high ratings to tranches of MBS was like building a house of cards that would inevitably fall. As another example, an e-mail message from a rating agency's analyst stated that the rating model used by the agency to assess risk did not capture even half of the risk involved.

The credit ratings come with a disclaimer in small print that says investors should not rely on the credit rating to make investment decisions. Nevertheless, investors who suffered major losses on their MBS investments might well ask why credit rating agencies are hired to assign ratings if it is not to determine the risk of the MBS.

Financial Institutions That Packaged the MBS  Securities firms, commercial banks, and other financial institutions that packaged the mortgage-backed securities could have verified the credit ratings assigned by the credit rating agencies by making their own assessment of the risks involved. After all, such financial institutions have considerable experience in assessing credit quality. Yet they relied on the high ratings assigned by the rating agencies, or presumed that households would continue to make their mortgage payments, or simply assumed that the real estate would serve as adequate collateral if households could not make payments.

Institutional Investors That Purchased MBS  Many financial institutions pooled money that they received from individual investors and used the proceeds to invest in MBS. These institutions could have conducted their own assessment of the credit quality of the MBS, since they also have experience in assessing credit quality. Once again, however, it appears that they relied heavily on the ratings assigned to MBS by credit rating agencies without the due diligence of performing their own independent assessment.

Financial Institutions That Insured MBS  Insurance companies also insured mortgages that backed securities sold in securitizations. MBS that contained insured mortgages provided a slightly lower return to investors (to reflect the fee paid to insurers) but would be viewed as safe and would be easier to sell to investors. Yet, as many MBS defaults occurred, some insurance companies found that the mortgages they insured were fraudulent because of inaccurate information that hid the potential default risk. Thus the financial institution that originated the mortgage was at fault because the mortgage contracts were fraudulent.

Speculators of Credit Default Swaps  A credit default swap (CDS) is a privately negotiated contract that protects investors against the risk of default on particular debt securities such as MBS. The buyer of the CDS provides periodic (usually quarterly) payments to the other party, and the seller of the CDS is obligated to provide a payment in the case of default of the securities specified in the swap agreement.

   Although the CDS contracts could be purchased by financial institutions to protect (or hedge) against a possible decline in valuations of mortgages held, they were commonly purchased in 2006 by institutions that were betting on the potential demise of specific mortgages. For example, some financial institutions believed that the MBS containing subprime mortgages were much riskier than perceived by credit rating agencies and other institutional investors. They were able to purchase CDS contracts from other financial institutions (sellers of CDS contracts) at a low price because those sellers presumed, incorrectly, that the MBS would not default. Thus, many of the buyers of CDS contracts on MBS were not holding any mortgages of MBS that they needed to hedge and instead were simply betting that subprime mortgages within the MBS would default. By purchasing CDS contracts, they were “insured” against the defaults on specific pools of mortgages even though they did hold the mortgages that defaulted.

   Speculators of credit default swaps were criticized for capitalizing on the collapse of the mortgage market. Yet those speculators may counter that if the sellers of CDS contracts were not so greedy to do business in this market and more properly assessed the risk that they assumed when selling the contracts, the speculators would not have been so willing to take the other side of the CDS contracts.

Conclusion about Blame  The question of who is to blame is still being argued in courtrooms. Participants in the MBS market have filed hundreds of lawsuits claiming that there was a lack of disclosure about the risk of the MBS. Some mortgage companies that originated the mortgages are being sued by securities firms that packaged the mortgages because the mortgages did not fully disclose information to reflect the risk of the home buyers. Mortgage insurers sued mortgage originators for the same reason. In particular, there was a large court battle between MBIA (a large mortgage insurance company) and Countrywide Financial (a large mortgage company) in 2012. The securities firms that sold MBS are being sued by the financial institutions that purchased the MBS. Finally, the individuals whose money was used to purchase the MBS are suing the financial institutions that made investments in the MBS because the investments were not suitable because of their excessive risk.

9-5d Government Programs Implemented in Response to the Crisis

In an effort to stimulate the market for homes and mortgages and reduce the number of foreclosures, the U.S. government implemented various programs. The Housing and Economic Recovery Act of 2008 was passed in July 2008. The act enabled some homeowners to keep their existing homes and therefore reduced the excess supply of homes for sale in the market. The financial institutions must be willing to create a new mortgage that is no more than 90 percent of the present appraised home value. Since the mortgage value exceeds the home value for many of the qualified homeowners, financial institutions that volunteer for the program essentially forgive a portion of the previous mortgage loan when creating a new mortgage.

   Other programs promoted “short sale” transactions in which the lender allows homeowners to sell the home for less than what is owed on the existing mortgage. The lender appraises the home and informs the homeowner of the price it is willing to accept on the home. Lenders involved in this program do not recover the full amount owed on the mortgage. However, they may minimize their losses because they do not have to go through the foreclosure process, and the homeowners reduce the potential damage to their credit report.

9-5e Government Bailout of Financial Institutions

As the credit crisis intensified, many investors were unwilling to invest in mortgagebacked securities because of the risk of continued defaults. Thus financial institutions that had large holdings of MBS could not easily sell them in the secondary market. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act) enabled the Treasury to inject $700 billion into the financial system and improve the liquidity of these financial institutions. A key part of the act was the Troubled Asset Relief Program (TARP), which allows the Treasury to purchase MBS from financial institutions and thereby provide them with more cash. A key challenge of this activity has been to determine the proper price at which the securities should be purchased, since the secondary market for the securities is not sufficiently active to determine appropriate market prices. The act also allowed the Treasury to invest in the large commercial banks as a means of providing the banks with capital to cushion their losses.

   The original proposal for the act was contained in three pages, but by the time the act was passed, it was 451 pages long. Although the initial intent was to resolve the credit crisis, the final act contained many other provisions unrelated to the crisis: tax breaks for producers of rum in the Virgin Islands, racetrack owners, film producers, and alternative energy producers. These additional provisions were included to satisfy special interests of various House and Senate members and win their approval for the act.

9-5f Financial Reform Act

In July 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (also called Financial Reform Act) was implemented; one of its main goals was to ensure stability in the financial system. This act mandated that financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. The goal was to prevent the looser standards that were instrumental in the credit crisis of 2008.

   The Financial Reform Act called for the creation of the Financial Stability Oversight Council to identify risks of the financial system and to make regulatory recommendations that could reduce those risks. The council consists of 10 members representing the heads of agencies that regulate key components of the financial system, including the housing industry, securities trading, depository institutions, mutual funds, and insurance companies.

   The act also required that financial institutions that sell mortgage-backed securities retain 5 percent of the portfolio unless the portfolio meets specific standards that reflect low risk. This provision forces financial institutions to maintain a stake in the mortgage portfolios that they sell. The act requires more disclosure regarding the quality of the underlying assets when mortgage-backed securities are sold.

   It also requires new rules intended to ensure that credit rating agencies provide unbiased assessments when rating mortgage-backed securities. Specifically, the credit rating agencies are required to publicly disclose data on assumptions used to derive each credit rating. The agencies are also required to provide an annual report about their internal controls used to ensure an unbiased process of rating securities. The act also prevents the SEC from relying on ratings within its regulations, so that it has to use its own assessment of risk.

SUMMARY

· ▪ Residential mortgages can be characterized by whether they are prime or subprime, whether they are federally insured, the type of interest rate used (fixed or floating), and the maturity. Quoted interest rates on mortgages vary at a given point in time, depending on these characteristics.

· ▪ Various types of residential mortgages are available, including fixed-rate mortgages, adjustable-rate mortgages, graduated-payment mortgages, growing-equity mortgages, second mortgages, and shared-appreciation mortgages.

· ▪ The valuation of a mortgage is the present value of its expected future cash flows, discounted at a discount rate that reflects the uncertainty surrounding the cash flows. A mortgage is subject to credit risk, interest rate risk, and prepayment risk.

· ▪ Mortgage-backed securities (MBS) represent packages of mortgages; the payments on those mortgages are passed through to investors. Ginnie Mae provides a guarantee of payments on mortgages that meet specific criteria, and these mortgages can be easily packaged and sold. Fannie Mae and Freddie Mac issue debt securities and purchase mortgages in the secondary market.

· ▪ Mortgages were provided without adequate qualification standards (including allowing very low down payments) in the 2003–2006 period. Then a glut in the housing market caused a drastic decline in home prices, with the result that the market values of many homes were lower than the mortgages. Many homeowners defaulted on their mortgages, which led to a credit crisis in the 2008–2009 period. The U.S. government used various strategies to revive the U.S. mortgage market, including an emergency housing recovery act, the rescue of Fannie Mae and Freddie Mac, and a bailout of financial institutions that had heavy investments in mortgages and mortgage-backed securities.

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 the financial statements of the firms that issued the bonds. The assessment of mortgages requires an understanding of the structure of the mortgage market (MBS, CMOs, etc.).

Who Is Correct  Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 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 institution 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 that of other financial institutions.

Advanced Questions

· 16. Mortgage-Backed Securities Describe how mortgage-backed securities (MBS) 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 current conditions that could affect interest rates, including inflation (including oil prices), the economy, the budget deficit, and the Fed's monetary policy. 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?

· 20. CDOs Explain collateralized debt obligations (CDOs).

· 21. Motives for Offering Subprime Mortgages Explain subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages?

· 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 mortgage-backed securities.

· 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 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 another 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 to 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 MBS.

· 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?

· 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 of MBS Explain how the Dodd-Frank Act of 2010 attempted to prevent biased ratings of mortgage-backed securities by credit rating agencies.

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 CMOs, be ready for a bumpy ride.”

Managing in Financial Markets

CMO Investment Dilemma 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?

PROBLEM

Amortization Use an amortization table (such as  www.bloomberg.com/invest/calculators/index.html ) 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 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 pay 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 make 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?

INTERNET/EXCEL EXERCISE

Assess a mortgage payment schedule such as  http://realestate.yahoo.com/calculators/amortization.html . Assume a loan amount of $120,000, an interest rate of 7.4 percent, and a 30-year maturity. Given this information, what is the monthly payment? In the first month, how much of the monthly payment is interest and how much is principal? What is the outstanding balance after the first year? In the last month of payment, how much of the monthly payment is interest and how much is principal? Why is there such a difference in the composition of the principal versus interest payment over time?

WSJ EXERCISE

Explaining Mortgage Rate Premiums

Review the “Corporate Borrowing Rates and Yields” table in a recent issue of the Wall Street Journal to determine the Treasury bond yield. How do these rates compare to the Fannie Mae yield quoted in the Journal's “Borrowing Benchmarks” section? Why do you think there is a difference between the Fannie Mae rate and Treasury bond yields?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. subprime mortgages AND risk

· 2. adjustable-rate mortgage AND risk

· 3. balloon-payment mortgage AND risk

· 4. mortgage AND credit risk

· 5. mortgage AND prepayment risk

· 6. [name of a specific financial institution] AND mortgage

· 7. credit crisis AND mortgage

· 8. mortgage-backed securities AND default

· 9. credit crisis AND Fannie Mae

· 10. credit crisis AND Freddie Mac

PART 3 INTEGRATIVE PROBLEM: Asset Allocation

This problem requires an understanding of how economic conditions influence interest rates and security prices ( Chapters 6 ,  7 ,  8 , and  9 ).

As a personal financial planner, one of your tasks is to prescribe the allocation of available funds across money market securities, bonds, and mortgages. Your philosophy is to take positions in securities that will benefit most from your forecasted changes in economic conditions. As a result of a recent event in Singapore, you expect that in the next month investors in Singapore will reduce their investment in U.S. Treasury securities and shift most of their funds into Singapore securities. You expect that this shift in funds will persist for at least a few years. You believe this single event will have a major effect on economic factors in the United States, such as interest rates, exchange rates, and economic growth in the next month. Because the prices of securities in the United States are affected by these economic factors, you must determine how to revise your prescribed allocation of funds across securities.

Questions

· 1. How will U.S. interest rates be directly affected by the event (holding other factors equal)?

· 2. How will economic growth in the United States be affected by the event? How might this influence the values of securities?

· 3. Assume that day-to-day exchange rate movements are dictated primarily by the flow of funds between countries, especially international bond and money market transactions. How will exchange rates be affected by possible changes in the international flow of funds that are caused by the event?

· 4. Using your answer to (1) only, explain how prices of U.S. money market securities, bonds, and mortgages will be affected.

· 5. Now use your answer to (2) along with your answer to (1) to assess the impact on security prices. Would prices of risky securities be affected more or less than those of risk-free securities with a similar maturity? Why?

· 6. Assume that, for diversification purposes, you prescribe that at least 20 percent of an investor's funds should be allocated to money market securities, to bonds, and to mortgages. This allows you to allocate freely the remaining 40 percent across those same securities. Based on all the information you have about the event, prescribe the proper allocation of funds across the three types of U.S. securities. (Assume that the entire investment will be concentrated in U.S. securities.) Defend your prescription.

· 7. Would you recommend high-risk or low-risk money market securities? Would you recommend high-risk or low-risk bonds? Why?

· 8. Assume that you would consider recommending that as much as 20 percent of the funds be invested in foreign debt securities. Revise your prescription to include foreign securities if you desire (identify the type of security and the country).

· 9. Suppose that, instead of reducing the supply of loanable funds in the United States, the event increased demand for them. Would the assessment of future interest rates be different? What about the general assessment of economic conditions? What about the general assessment of bond prices?