Chapter 10 THE MORTGAGE MARKETS AND DERIVATIVES

Chapter 8 discusses money markets, short-term funds markets, and capital markets, long-term
funds markets (bonds, equity). The first section focuses on mortgage markets, where borrowers
can obtain long-term collagenized loans. Mortgage markets are a subcategory of capital markets,
but differ from stock and bond markets in several ways.

Capital markets typically involve businesses and government entities as borrowers, while
mortgage markets primarily involve individuals. Mortgage loans vary in amount and maturity,
posing challenges for secondary market development.

What are mortgages?

Mortgages are long-term loans secured by real estate, used by individuals and businesses to
finance real estate purchases. Developers can finance office building construction, while families
can buy homes. Both types of loans are amortized, with the borrower paying off the debt over
time through principal and interest payments, resulting in full repayment by maturity.

CHARACTERISTICS OF THE RESIDENTIAL MORTGAGE

Modern mortgage lenders have refined long-term loans to make them more appealing to
borrowers, with significant changes in lenders and instruments over the past 20 years, including the
development of an active secondary market for mortgage contracts.

The mortgage market has evolved significantly in recent years, with numerous loan production
offices competing in real estate financing. Previously, most mortgage loans were originated by savings
and loan institutions and large banks' mortgage departments. This competition offers borrowers a wide
range of terms and options.

A. Mortgage Interest Rates

One of the most important factors in the decision of the borrower of how much and from whom
to borrow is the interest rate on the loan.

There are three important factors that affect the interest rate on the loan. These are:

1. Current long-term market rates

- Long-term market rates are influenced by the supply and demand of long-term funds, which
are influenced by global, national, and regional factors. Mortgage rates typically stay above
less risky treasury bonds but track with them.
2. Term or Life of the mortgage
- Longer-term mortgages typically have higher interest rates than short-term ones, with the
typical mortgage lifetime being 15 or 30 years. As the term to maturity decreases, the 15-
year loan's interest rate is significantly lower.
3. Number of Discount Points Paid
- Discount points are interest payments made at the beginning of a loan, with one point
requiring the borrower to pay 1% of the loan amount at closing. In exchange, the lender
reduces the interest rate on the loan. Borrowers must decide if the reduced interest rate
fully compensates for the increased upfront expense, considering their loan duration.
Typically, discount points should not be paid if the borrower plans to pay off the loan in five
years or less, as the average home sells every five years.
B. Loan Terms
- Mortgage loan contracts contain many legal and financial terms, most of which protect the
lender from financial loss.
C. Collateral
- One characteristic common to mortgage loans is the requirement that collateral, usually the
real estate being financed, be pledged as security.
D. Down Payment
- A mortgage loan requires a borrower to make a down payment on the property, which is a
portion of the purchase price. The balance is paid by the loan proceeds. Down payments are
designed to reduce the borrower's likelihood of default and protect the borrower from
losing the property and loan. If real estate prices drop, the loan balance may exceed the
collateral's value, reducing moral hazard. The down payment amount depends on the type
of mortgage loan, with many lenders requiring a 5% down payment.
E. Private Mortgage Insurance (PMI)
- Private Mortgage Insurance (PMI) is a policy that compensates for any discrepancy between
the property's value and the loan amount in case of default. It is typically required for loans
with less than a 20% down payment. If the loan-to-value ratio falls due to payments or
property value increases, the borrower can request the PMI requirement be dropped. PMI
typically costs between P200 and P300 per month for a P100,000 loan. The default still
appears on the borrower's credit record.
F. Borrower Qualification
- Before granting a mortgage loan, the lender assesses the borrower's eligibility. This differs
from bank loan qualification as lenders sell their loans to government agencies in the
secondary mortgage market, who set precise guidelines. If a borrower doesn't meet these
guidelines, the lender may be unable to resell the loan, tying up the lender's funds. Banks
can be more flexible with loans kept on their own books.
AMORTIZATION OF MORTGAGE LOAN
- Mortgage loan borrowers are required to pay monthly principal and interest that will be fully
amortized by the loan's maturity, ensuring that the outstanding debt is paid off.
-
Figure 10-1 shows the amortization table of a 30-year, P130,000 loan at annual interest rate 8.5%.

TYPES OF MORTGAGE LOANS

Conventional Mortgages
- Conventional loans, originated by banks or other lenders, are not guaranteed by government
entities. Most lenders now insure these loans against default or require the borrower to
obtain private mortgage insurance.
Insured Mortgages
- These mortgages are originated by banks or other mortgage lenders but are guaranteed by
either the government or government-controlled entities.
Fixed rate Mortgages
- In fixed-rate mortgages, the interest rate and the monthly payment do not vary over the life
of the mortgage.
Adjustable-Rate Mortgages
- Adjustable-rate mortgages (ARMs) have interest rates tied to market interest rates like
Treasury bill rates, which fluctuate over time. ARMs typically have caps to limit the high or
low interest rate changes within a year and loan term.
Graduated-Payment Mortgages (GPMs)
- Mortgages with a variable payment plan (GPM) are beneficial for home buyers expecting
income growth. The early payments may not cover the interest, leading to an increase in the
principal balance. As income increases, the higher payments become less burdensome,
ensuring a smoother loan process.
Growing Equity Mortgage (GEMS).
- With a GEM, the payments will initially be the same as on a conventional mortgage. Over
time, however, the payment will increase. This increase will reduce the principal more
quickly than the conventional payment stream would.
Shared Appreciation Mortgages (SAMs)
- In a SAM, the lender lowers the interest rate in the mortgage in exchange for a share of any
appreciation in the real estate (if the property sells for more than a stated amount, the
lender is entitled to a portion of the gain).
Equity Participating Mortgage (EPM)
- EPM involves an outside investor contributing to the appreciation of a property by either
providing a portion of the purchase price or supplementing the monthly payment. In return,
the investor receives a portion of the property's appreciation, enabling the borrower to
qualify for a larger loan.
Second Mortgages
- Loans secured by the same real estate as the first mortgage are junior to the original loan. If
a default occurs, the second mortgage holder will only be paid after the original loan is paid
off, if sufficient funds remain.
Reverse Annuity Mortgages (RAMs)
- A RAM is a financial arrangement where a bank provides monthly funds to a property owner
to cover living expenses, increasing the loan's balance. The borrower doesn't pay, and the
property is sold to pay the debt when the borrower dies.

The various mortgages types are summarized in

MORTGAGE LENDING INSTITUTIONS

- The institutions that provide mortgage loans to familiar and business and their share in the
mortgage market are as follows:
Mortgage tools and Trusts 49%
Commercial Banks 24%
Government agencies and others 15%
Life insurance companies 9%
Savings and loans associate 9%
Source: Federal Revenue Bulletin, 2018

- Mortgage loan institutions often avoid holding large portfolios of long-term securities,
instead earning revenue through fees for packaging loans for investors. These fees, typically
1% of the loan amount, vary with the market and are typically based on market conditions.
SECURITIZATION OF MORTGAGES

- Intermediaries face several problems when trying to sell mortgages to the secondary
market; that is lenders selling the loans to another investor. These problems are:
a) Mortgages are usually too small to be wholesale instruments
b) Mortgages are not standardized. They have different terms to maturity, interest rates and
contract terms. Thus, it is difficult to bundle a large number of mortgages together and
c) Mortgage loans are relatively costly to service. The lenders must collect monthly
payments, often advances payment of properly taxes and insurance premiums and service
reserve accounts
d) Mortgages have unknown default risk. Investors in mortgages do not want to spend a lot
of time and effort in evaluating the credit of borrowers.