Chapter 9 by sofiaie

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									                                          Chapter 9

                               Mortgage Markets
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

   ANSWER: When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the
   benefits to lenders that offer fixed-rate mortgages are limited.

84  Chapter 9/Mortage Markets

12. Selling Mortgages. Explain why some financial institutions prefer to sell the mortgages they

   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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