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Econ304 - Business Finance > Capital Markets - Mortgage Markets > Flashcards

Capital Markets - Mortgage Markets Flashcards

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1
Q

Prime vs Subprime Mortgages

A

Prime mortgages = Traditional lending requirements

Subprime borrowers have low income and high debt

Firms increase subprime mortgages in 2000s to expand business

Charge higher fees and interest to compensate for default

Subprime mortgages 1.5-2.5% points above prime mortgages

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2
Q

Fixed Rate Mortgages

A

Locks in borrowers interest over life of mortgage

FI exposed to interest rate risk
- Uses funds from ST customer deposits

If IR increase - FI cost of obtaining funds increase

Borrowers don’t suffer from affects of rising IR

Borrowers don’t benefit from decline in IR

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3
Q

Amortising Fixed Rate Mortgage

A

Amortisation schedule shows monthly payments
- Broken down into principal & interest

During early years of mortgage
- Payments reflect interest

As principal paid off, interest decreases

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4
Q

Adjustable Rate Mortgages

A

Mortgage interest rate adjusts to market conditions

Uses 1 year adjustment with IR tied to average T-Bill rate

ARMs contain option for holders to switch to fixed rate mortgages

If Interest rates are stable or decline
- Borrowers choose ARM

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5
Q

Adjustable Rate Mortgage - FI Perspective

A

IR of ARMS moves with market IR
- FI can stabilise profits

If costs of funds rises, do does return on mortgage

Maximum allowable fluctuation in mortgage rate per year
- 2-5%

Profit margins on ARMS impacted by fluctuating IR

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6
Q

Graduated Payment Mortgages

A

Small payments initially

Payments increase on first 5-10 years

Tailored to families who anticipate higher income in future

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7
Q

Growing Equity Mortgages

A

Low initial monthly payments and increase over time

Payments continue to increase

Entire mortgage paid off in 15 years

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8
Q

Second Mortgages

A

FI offer second mortgage with shorter maturity

IR on secondary mortgage higher

Higher IR = Greater compensation
- Higher Risk incurred

Home sellers offer secondary mortgages

Selling price of home higher than remaining balance on 1st mortgage

Seller makes house more affordable

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9
Q

Shared Appreciation Mortgages

A

Purchaser obtains mortgage at below market IR

Lender has share of price appreciation of house

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10
Q

Balloon Payment Mortgages

A

Interest payments 3-5 years

Borrower pays full principal amount at end

No principal payments made until maturity
- Lower monthly payments

Borrowers unable to pay off mortgage in 3-5 years

Borrowers forced to request new mortgage

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11
Q

Credit Risk

A

The size/likelihood of a loss investors experience if borrower makes late payments

Investor weigh potential return against exposure to risk

Chance a borrower defaults depends on…
- Economic conditions
- Creditworthiness characteristics

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12
Q

Interest Rate Risk

A

Mortgage values decline if IR increase

Mortgage financed with ST deposits
- Exposure to IR Risk

Borrowers refinance with IR decline

FI can limit exposure by selling mortgages shortly after origination

As FI commits to pool of mortgages
- Commits to specific fixed rate

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13
Q

Interest Rate Risk
Part 2

A

Mortgages stored in mortgage pipeline until sufficient mortgages to sell

By the time mortgages originated & sold
- IR have risen

Value of mortgages in pool declined

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14
Q

Ways FI can limit Interest rate risk

A

Offering adjustable rate residential mortgages

Invest in fixed rate mortgages
- Short time until maturity

Can reduce potential gains earned on other strategies

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15
Q

Prepayment Risk

A

Borrower prepays mortgage if IR decline

Investors susceptible to mortgages being paid off

Investor receives payment to retire mortgage

Investor reinvests at lower IR

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16
Q

Prepayment Risk
Part 2

A

FI that invest in Fixed mortgages experience limited benefits when IR decline

FI can insulate against prepayment risk
- Sell loans shortly after originating
- Invest in ARM

17
Q

Criteria to measure creditworthiness- Level of Equity

A
  • Down payment = Equity invested
  • Lower the level of equity, higher probability of default
  • Loan to value ratio - Amount of property value financed by debt
18
Q

Criteria to Measure Creditworthiness - Income Level

A
  • Borrowers with lower income more likely to default
  • Income = amount of funds borrowers have to make monthly payments
  • Income changes over time
19
Q

Criteria to measure creditworthiness - Borrower credit history

A
  • borrower with history of credit problems more likely to default
20
Q

Securitisation Process

A
  • FI combines individual mortgages into packages
  • Package mortgages attracted to large investors - Insurance/savings companies
  • Package rated for exposure to risk of default
  • Investors rely on credit rating assigned
  • After MBS Sold - FI receive interest and principal payment
  • Securitisation popular 2002-2007
21
Q

Ginnie Mae MBS

A
  • Guarantees payment of principal and interest to securities investors
  • mortgages restricted to maximum dollar amount
  • Serve low and moderate income households
  • Can sell mortgages in secondary market as credit risk free
22
Q

Private Label Pass Through Securities

A
  • Similar to Ginnie Mae MBS
  • Backed by conventional mortgages rather than FHA
  • Insured through private insurance companies
23
Q

Fannie Mae MBS

A
  • Develops liquid secondary market
  • Issues long term debt securities to investors
  • Uses funds to purchase mortgages in secondary market
24
Q

Valuations of MBS

A

Reliance of ratings - Rating agencies (Moody’s, S&Ps, Fitch)
- FI pay fee to agency

Fair Value - FI write down value to reflect true market value if they expect a loss on MBS
- Rely on prices of MBS in secondary market

25
Q

Credit Crisis impact on Bear Stearns

A
  • Used high degree of financial leverage to finance operations
  • Incurred large losses due to exposure in 2007
  • Used mortgage securities as collateral for borrowing funds
  • Creditors question quality of mortgages
  • Acquired by US Gov in 2008 via JP Morgan
26
Q

Government Programs in response to crisis

A
  • Housing and Economic Recovery Act 2008
  • homeowners can keep existing homes
  • FI create new mortgages below 90% of home value
  • Short Sale programs - lender sells home for less than what is owed
  • Full amount not recovered
  • minimise losses by avoiding foreclosure
27
Q

Financial Reform Act 2010

A
  • Ensures stability
  • FI verify income, job status, credit history
  • Financial Stability oversight council - 10 members regulating financial system
  • FI selling MBS retain 5% of portfolio
  • Disclosure for quality of underlying assets of MBS
  • Credit rating agencies provide unbiased assessments

Econ304 - Business Finance (5 decks)

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