Capital Markets - Mortgage Markets Flashcards
Prime vs Subprime Mortgages
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
Fixed Rate Mortgages
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
Amortising Fixed Rate Mortgage
Amortisation schedule shows monthly payments
- Broken down into principal & interest
During early years of mortgage
- Payments reflect interest
As principal paid off, interest decreases
Adjustable Rate Mortgages
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
Adjustable Rate Mortgage - FI Perspective
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
Graduated Payment Mortgages
Small payments initially
Payments increase on first 5-10 years
Tailored to families who anticipate higher income in future
Growing Equity Mortgages
Low initial monthly payments and increase over time
Payments continue to increase
Entire mortgage paid off in 15 years
Second Mortgages
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
Shared Appreciation Mortgages
Purchaser obtains mortgage at below market IR
Lender has share of price appreciation of house
Balloon Payment Mortgages
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
Credit Risk
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
Interest Rate Risk
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
Interest Rate Risk
Part 2
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
Ways FI can limit Interest rate risk
Offering adjustable rate residential mortgages
Invest in fixed rate mortgages
- Short time until maturity
Can reduce potential gains earned on other strategies
Prepayment Risk
Borrower prepays mortgage if IR decline
Investors susceptible to mortgages being paid off
Investor receives payment to retire mortgage
Investor reinvests at lower IR
Prepayment Risk
Part 2
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
Criteria to measure creditworthiness- Level of Equity
- Down payment = Equity invested
- Lower the level of equity, higher probability of default
- Loan to value ratio - Amount of property value financed by debt
Criteria to Measure Creditworthiness - Income Level
- Borrowers with lower income more likely to default
- Income = amount of funds borrowers have to make monthly payments
- Income changes over time
Criteria to measure creditworthiness - Borrower credit history
- borrower with history of credit problems more likely to default
Securitisation Process
- 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
Ginnie Mae MBS
- 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
Private Label Pass Through Securities
- Similar to Ginnie Mae MBS
- Backed by conventional mortgages rather than FHA
- Insured through private insurance companies
Fannie Mae MBS
- Develops liquid secondary market
- Issues long term debt securities to investors
- Uses funds to purchase mortgages in secondary market
Valuations of MBS
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
Credit Crisis impact on Bear Stearns
- 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
Government Programs in response to crisis
- 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
Financial Reform Act 2010
- 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
