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Chapter 9 Mortgage Markets Questions 1. FHA Mortgages. Distinguish between FHA and conventional mortgages. ANSWER: FHA mortgages guarantee loan repayment, thereby covering against the possibility of default by the borrower. The guarantor is the Federal Housing Administration. Conventional mortgages are not federally insured, but they can be privately insured. 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. ANSWER: There is a high positive correlation between mortgage rates and long-term government security rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change. 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. ANSWER: An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk. Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increased cost of funds. 10. Exposure to Interest Rate Movements. Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that such a favorable impact is dampened. By what? ANSWER: When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited. 83 84 Chapter 9/Mortage Markets 12. Selling Mortgages. Explain why some financial institutions prefer to sell the mortgages they originate. ANSWER: Financial institutions may sell their mortgages if they desire to enhance liquidity, or if they expect interest rates to increase. Mortgage companies frequently sell mortgages after they are originated and continue to service them. They do not have sufficient funds to maintain all the mortgages they originate. 16. Mortgage Pass-Through Securities. Describe how mortgage pass-through securities are used. How can the use of pass-through securities reduce a financial institution’s interest rate risk? ANSWER: A financial institution that purchases or originates a portfolio of mortgages can finance those mortgages issuing pass-through securities. The mortgages serve as collateral for the securities. The interest and principal payments on the mortgages are transferred (passed through) to the owners of the securities, after deducting fees for servicing and for guaranteeing payments to the owners.
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