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Week 6 (Chapter 7) Financial Systems

by: Whitney Smith

Week 6 (Chapter 7) Financial Systems FIN 3113

Marketplace > Mississippi State University > Finance > FIN 3113 > Week 6 Chapter 7 Financial Systems
Whitney Smith

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Week 6 Notes on Chapter 7 in Financial Systems
Financial Systems
Wei He
Class Notes
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This 5 page Class Notes was uploaded by Whitney Smith on Monday February 22, 2016. The Class Notes belongs to FIN 3113 at Mississippi State University taught by Wei He in Summer 2015. Since its upload, it has received 35 views. For similar materials see Financial Systems in Finance at Mississippi State University.


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Date Created: 02/22/16
Chapter 7 Mortgage Markets I. Mortgages and Mortgage­Backed Securities  Mortgages are loans to individuals or businesses to purchase homes, land, or other real property  Many mortgages are securitized  Many mortgages are pooled and sold and then the mortgage payments are used to  collateralize mortgage­backed securities (MBSs)   Mortgages differ from bonds and stocks  mortgages are backed by a specific piece of real property  primary mortgages have no set size or denomination  comparatively little information exists on mortgage borrowers II. Primary Mortgage Market  Four basic types of mortgages are issued by financial institutions  home mortgages are used to purchase one­ to four­family dwellings (called “single­ family mortgages”)  multifamily dwellings mortgages are used to purchase apartment complexes, townhouses, and condominiums  commercial mortgages are used to finance the purchase of real estate for business  purposes  farm mortgages are used to finance the purchase of farms 1 Mortgage Characteristics  Collateral: lenders place liens against properties that prevent sale until loans are fully paid off  A down payment is a portion of the purchase price of the property a financial institution requires the borrower to pay up front  private mortgage insurance (PMI) is generally required when the loan­to­value ratio is more  than 80%  Conventional mortgages are mortgages that are not federally insured  Federally insured mortgages ­ repayment is guaranteed by either the Federal Housing  Administration (FHA) or the Veterans Administration (VA)  Amortized mortgages have fixed principal and interest payments that fully pay off the mortgage  by its maturity date   fully amortized mortgage maturities are usually either 15 or 30 years  Each fixed monthly payment consists partly of repayment of the principal and partly of  the interest on the outstanding mortgage balance N’= Number of months I’ = Monthly interest rate PV=Mortgage amount               FV = 0               CPT PMT=? A borrower agrees to a $200,000, 30­year fixed­rate mortgage with a 5.75% quoted interest rate.   What is the payment amount and how much of each payment goes to principle and interest?  Balloon payment mortgages require fixed monthly interest payments for 3 to 5 years whereupon full payment of the mortgage principal is due  Fixed­rate mortgages lock in the borrower’s interest rate  required monthly payments are fixed over the life of the mortgage  lenders assume interest rate risk      Adjustable­rate mortgages (ARMs) tie the borrower’s interest rate to some market interest rate  or interest rate index  Required monthly payments can change over the life of the mortgage, although they may  initially be fixed for a set time period. For example, 5/1 ARMs and 3/1 ARMs are  popular.  Rates or payment changes must be ‘capped.’  For example, the cap on a 5/1  ARM may be stated as ‘5/2/5’  borrowers assume interest rate risk with an ARM  ARMs can increase default risk  Discount points are fees or payments made when a mortgage loan is issued   each point costs the borrower 1 percent of the principal value 2  the lender reduces the interest rate used to determine the payments on the mortgage in  exchange for points paid  Other fees  application fee  title search  title insurance  appraisal fee  loan origination fee  closing agent and review fees  other fees (e.g., VA or FHA loan guarantees and PMI)  Mortgage refinancing  when a borrower takes out a new mortgage and uses the proceeds to pay off an existing  mortgage  mortgages are most often refinanced when an existing mortgage has a higher interest rate  than current rates  borrowers must balance the savings of a lower monthly payment with the costs (fees) of  refinancing  an often­cited rule of thumb is that the new interest rate should be 2 percentage points  less than the refinanced mortgage rate Other Types of Mortgages  Jumbo mortgages  Jumbo mortgages are mortgages for loan amounts that exceed the maximum  ‘conforming’ limits allowed by the mortgage agencies Fannie Mae and Freddie Mac  ($410,000 in 2010, with some exceptions)  Subprime mortgages  Subprime mortgages are mortgages where the borrowers do not qualify for a ‘prime’  credit rating because of a low credit score arising from prior credit problems such as  delinquencies and defaults.  Or they may simply lack sufficient credit history or have  insufficient income.   Second mortgages and home equity loans  Second mortgages are subordinated claims to senior mortgages  Reverse­annuity mortgages (RAMs)  Retirees or homeowners with a substantial amount of equity in their home can sell the  equity back to a bank over time  Various payment options are available  Costs and servicing fees are high III. Secondary Mortgage Markets FIs remove mortgages from their balance sheets through one of two mechanisms   by pooling recently originated mortgages together and selling them in the secondary  market  by securitizing mortgages (i.e., by issuing securities backed by newly originated  mortgages)                     III.1 Mortgage Loan Sales  FIs have sold mortgages among themselves for over 100 years 3  A large part of correspondent banking involves small banks selling parts of large loans to  larger banks  Large banks often sell parts of their loans (i.e., participations) to smaller banks  Mortgage sales occur when an FI originates a mortgage and sells it to an outside buyer  a loan sale is made with recourse if the loan buyer can sell the loan back to the  originator, should it go bad  Mortgage sellers: money center banks, smaller banks, foreign banks, investment  banks  Mortgage buyers: foreign and domestic banks, insurance companies, pension funds,  closed­end bank loan mutual funds, and nonfinancial corporations             Advantages of Mortgage loan sales          – FIs are encouraged to sell loans for economic and regulatory   reasons  reduce credit risk  achieve better asset diversification   improve their liquidity positions  reduce interest rate risk  generate fee income for the bank  reduce the cost of reserve and capital requirements       III.2 Mortgage Loan Securitization              Securitization is the process of creating securities using mortgage loans as the back up assets.       III.2.1  Advantages of securitization   FIs can reduce the liquidity risk, interest rate risk, and credit risk of their loan portfolios   FIs generate income from origination and service fees  The U.S. government established the Federal National Mortgage Association (FNMA or  Fannie Mae) in the 1930s to buy FHA and VA mortgages from thrifts so they could make more  mortgage loans  The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) was formed in  1968 to facilitate financing of conventional mortgages   Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home  Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created in the 1960s   encouraged continued expansion of the housing market, particularly for lower­income  housing  GNMA does not securitize mortgage, rather it provides direct and indirect guarantees that allow private entities to create mortgage­backed securities   Securitization and Congressional goals to increase funding for housing to lower income  individuals led to weakening credit standards and increases in the number of high risk  loans (called subprime mortgages)  Beginning in 2006, problems in the subprime mortgage market led to the financial crisis  of 2007 and 2008  Subprime mortgage holders 60 days or more behind in their payments hit 17.1% in June  2007 and was over 20% in August of the same year 4  Problems in the subprime market spilled over to the broader mortgage markets and  helped fuel nationwide declines in home prices which put many homeowners underwater  and led to the bankruptcies of many major financial institutions  On September 7, 2008, the Federal Housing Finance Agency (FHFA) placed both Fannie  Mae and Freddie Mac in government conservatorship 5


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