I.  What is a mortgage?

• It is a type of debt, secured or guaranteed by a pledge of property.
• a conventional mortgage is based solely on the property as collateral and the credit of the borrower

• in the U.S., mortgages can be federally insured by the FHA, VA and RHS or privately insured. PMI (private mortgage insurance) is often required for homebuyers putting less than 20% down.
• mortgages are residential (single and multi-family) and nonresidential (commercial and farm)

• The original lender is called the mortgage originator.

• thrifts and banks used to originate mortgages and hold them in their asset portfolios until maturity. Today many thrifts, banks, and other companies specialize in just originating mortgages and then selling them on the secondary market. This is called mortgage banking
• originater receives an origination fee (percentage of the loan amount 1 to 3 %, or 1 to 3 points)
• servicing fee if continue to collect mortgage payments (50 to 100 bp. of outstanding loan amount)
• secondary market profit from selling the mortgage (or a loss if mortgage rates rise)
• mortgage approval will depend on
• credit history
• credit report from Equifax, Trans Union, or Experian
• mysterious credit score determies approval and rate  (FICO score)
• timely payments AND size of debts, credit line is important
• loan-to-value (LTV)  ratio
• ratio of loan value to appraised value of property
• lower numbers are better--safety cushion for mortgage holder in event of foreclosure
• payment-to-income (PTI) ratio
• ratio of monthly payment to monthly income
• lower numbers are better--applicant less likely to default
• if approved, applicant receives commitment letter giving them the right, but not the obligation to take the loan

• If a fixed rate mortgage is chosen, the rate may be fixed
• at application
• at approval
• at closing

• When a mortgage is granted the originator can

• if choosing (2) or (3) the originator must be concerned about whether or not the mortgage is conforming
• mortgages are conforming if they meet
• a maximum PTI ratio
• a maximum LTV ratio
• a maximum loan amount ($235,000)
• conforming status is important because federally sponsored agencies like Fannie Mae and Freddie Mac will buy ONLY conforming mortgages in the secondary market. Nonconforming mortgages will therefore be less liquid and most often have higher interest rates because of that.
• nonconforming mortgages that exceed loan amount are known as jumbo loans.

• mortgages originators face risk known as pipeline risk due to
• price risk: the inverse relationship between the value of the mortgage and the market interest rate
• fallout risk: the possibility that the mortgage applicant will not close, causing the originator to face some unreimbursed costs.

• Fixed rate, level pmt., fully amortized mortgage--also known as the traditional mortgage
• until the 1970s, this was the only type of mortgage, with the interest rate locked in and equal monthly pmts. for 15, 20, 30 and even 40 years.
• note the cash flow characteristics of this mortgage and the table 23-1, p. 428
• the amount of the monthly pmt. applied to interest declines over the life of the loan, while the amount applied to principal increases because the payments are equal, and as the outstanding loan amount declines, payments get smaller
• there are two problems associated with this mortgage, especially in an environment with high and variable inflation:
• mismatch problem
• originators borrow short and lend long, so they lose money on these mortgages when short-term interest rates rise.
• tilt problem
• the pmts. are fixed over the life of the loan, so their real value declines with inflation. Therefore, the mortgage has its highest burden for the borrower at the beginning--or "tilted" to the initial years
• these two problems have led to the development of other types of mortgages

• Adjustable rate mortgages (ARMs)--designed to deal with the mismatch problem
• mortgage rate is reset periodically according to some index that reflects short-term interest rates
• rate is reset every 6 mos. to 3 years
• the new rate is a benchmark rate + spread--the 6 mo. Tbill rate is often used
• fluctuations in the interest rate are limited by caps and floors
• the borrower bears the interest rate risk with an ARM, instead of the lender.
• there are periodic and lifetime caps and floors that limit
• how much the mortgage rate can change in a given year or period
• how much the mortgage rate can cahnge from the original rate over the life of the loan
• caps and floor mean that the lender still bears some of the interest rate risk

• After mortgages are originated, those who buy them, the investors face 4 types of risk:
• credit risk
• the borrower may default; this is less of a problem for FHA, VA-insured mortgages
• liquidity risk
• mortgages are less liquid than other debt securities, making them more difficult and expensive to buy and sell
• price risk
• like other debt securities, a mortgage’s value is inversely related to the market interest rate
• prepayment risk
• most mortgages allow the borrower to repay early without penalty--for moving, for refinancing, foreclosure, insurance, etc.; the borrower effectively has an unrestricted call provision. For the mortgage investor, this makes the timing and amount of cash flows uncertain.