FIN 4313 Chapter 9: ch9
Chapter 9: Mortgage markets and mortgage-backed securities
• Mortgages- loans for which the borrower pledges real property as collateral to
guarantee that the debt will be repaid
- if the borrower does not repay the debt as promised, the collateral can be seized
and sold through legal foreclosure; proceeds from the sale help repay the debt
- repaid in monthly installments that include both interest due and repayments of a
portion of the principal due on the loan
• mortgage-backed securities (MBSs)
- reduce the illiquidity risk and payment uncertainties associated with the ownership
of individual mortgages
The unique nature of mortgage markets
• Bring together borrowers and suppliers of long-term funds
1. Always secured by the pledge of real property as collateral
2. Mortgage loans are made for varying amounts and maturities, depending on the
borrower’s needs
3. Issuers (borrowers) of mortgage loans are typically small, relatively unknown financial
entities
4. Secondary capital markets for stocks and bonds are highly developed and work very
efficiently
5. Most segments of the mortgage markets are both highly regulated and strongly
supported by federal government policies
Types of mortgages
• Fixed-rate mortgage (FRM)- the lender takes a lien on real property and the borrower
agrees to make periodic repayments of the principal amount borrowed plus interest on
the unpaid balance of the debt for a predetermined period of time
- Amortized over time to the extent that the periodic payments exceed the interest
due
- Make sense for borrowers who like the certainty of knowing the interest they pay on
their mortgages
• Adjustable-rate mortgage (ARM)- a mortgage with an interest rate that adjusts
periodically in response to changes in market conditions
- Initial interest rate that remains fixed for a period of time ranging from 1 to 10 years
- After the initial period has ended, the interest rate increases or decreases depending
on the reference rate of interest
- Reduce lender’s interest rate risk
- Can be adjusted with varying lags such as monthly, quarterly, or every year or two
- Can increase lenders’ credit risk
- Interest rate cap limits likelihood of default; limits the amount that the interest rate
on a loan can increase during each interest rate period or over the life of the loan
- Payment caps: limit the maximum amount by which the monthly payment can
increase each year or over the life of the loan
• Balloon payment mortgages- relatively low fixed rate of interest for a predetermined
period of time (typically 7 years), the remaining balance of the mortgage comes due at
the end of that period in the form of a balloon payment