1. A mortgage is a form of debt to finance a real estate
2. The mortgage contract specifies:
a. Mortgage rate
3. The originator charges an origination fee when
providing the mortgage
4. Most mortgages have maturities of 30 years, but 15-
year maturities are also available.
The Traditional Game
Fixed rate 30 year FHA/VA insured mortgages
FHA, VA: 3% down, zero down (respectively)
Federal agency is guarantor of last resort
Conventional mortgages (35 – 50% of all mortgages) – fixed or
Minimum cash in from 10% to 20% (w/ 20% typical)
Banker - Brokers do not retain the mortgages
May require Insurance or larger down payments
Large Secondary Market
Fannie Mae and Freddie Mac guarantee or purchase approx. 90% of
all mortgages (2010).
1. Prime versus Subprime Mortgages
a. Prime: borrower meets traditional lending standards
b. Subprime: borrower does not quality for prime loan
i. Relatively lower income
ii. High existing debt
iii. Can make only a small down payment
2. Insured versus Conventional Mortgages
a. Insured: loan is insured by FHA or VA
b. Conventional: loan is not insured by FHA or VA but can be
B. Mortgage Instruments that deal with Interest-rate
Adjustable Rate Mortgage (ARM) Advantage to lender?
Graduated Payment (GPM)
Growing Equity Mortgage (GEM – never a GPM!)
C. Equity-Based Financing
Second Mortgages; fixed loan amounts, rates and terms
Home Equity Loans / Revolving Lines of Credit
D. Desirable Features for a Mortgage (Lender)
Yield flexibility: Responsiveness to changing market rates
Constant real payments; keeping pace with inflation
Payment stability; minimize late payment/default problems
Full security: market value greater than loan amount
Collecting principal and interest when rates are changing
For mortgages allowing negative amortization, tracking changing principal
and interest payments can be difficult
Ability to sell in a secondary market
Sales of mortgage backed securities (MBS) help control total lender risk
Substituting capital market funds for financial institution's funds
■ the pooling and repackaging of loans into securities.
■ Securities are then sold to investors, who become the owners of
the loans represented by those securities.
2. The Securitization Process
a. A financial institution such as a securities firm or commercial
bank combine individual mortgages together into packages.
b. The issuer of the MBS assigns a trustee to hold the mortgages as
collateral for the investors who purchase the securities.
c. 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.
Government Agencies Re-organized as Public
FNMA (1938) (Fannie Mae) organized as government agency. Re-
chartered in 1968 as public company. Provide funds to assist in
GNMA (1968) (Ginnie Mae); insured pass through because GNMA
guarantees investors of mortgage-backed securities will receive timely
payment of P&I. Re-chartered in 1970 as public company.
GNMA backed by full faith and credit of US Government makes it
marketable! Initial pass-through were fixed rate mortgages More
recent ones include variable rate. The latter typically have shorter
3. FHLMA (1970) (Freddie Mac) More funds for mortgage market Public
B. Standard Pass-Through Securities
FNMA, GNMA (FHA, VA), FHLMA Mortgage-backed securities
PIP: (Privately Issued Pass-through): backed by non-conforming
Not insured by any Agency of the US Govt – may be commercially insured
Collateralized Mortgage Obligations (CMO); developed by Freddie Mac
Investors can purchase mortgage assets without having to service loans
Transforms otherwise illiquid mortgages into highly marketable securities
Also allows investors to sell part of the "option risk" to other investors:
Accomplished by rebundling the cash flow pool
C. Mortgage Pools - Sources of Risk
Interest Rate (market value behaves like bonds)
Prepayment (reduces yields)
Credit (sub-prime mortgage problem)
What are the desirable features of a mortgage?
What are the general features of an Adjustable
What are pass-through securities?
What factors contributed to growth of second
Why are CMO such good investments from the
default point of view?
Why do mortgage investors want good loan-to-
market value ratios?