I.

MORTGAGE
MARKETS
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EXPECTED LEARNING
•
OUTCOMES:
Explain what mortgage markets are
• Differentiate between stock and bond markets and mortgage market
• Describe what are mortgages
• Enumerate and explain the important factors that affect the interest rate on the loan
• Distinguish between
a. Conventional mortgages and insured mortgages
b. Fixed-rate mortgages and adjustable-rate mortgages
c. Graduated-payment mortgages and growing equity mortgages
• Describe what derivative financial instruments are
• Distinguish between derivatives for hedging and derivatives for speculation
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WHAT ARE MORTGAGES?

• Mortgages are long-term loans secured by real estate. Both
individuals and businesses obtain mortgages to finance real
estate purchases.
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CHRACTERISTICS OF
RESIDENTIAL MORTGAGES
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. Important factors that affect the in the
interest rate of the loan are:

• Current long-term Market Rates

• Term or Life of the Mortgage
• Number of Discount Points Paid
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1 Current long-term Market Rates

• Long-term market rates are determined by the supply of and demand for long-term
funds, which are in turn affected by a number of global, national, and regional factors.
Mortgage rates tend to stay above the less risky treasury bonds most of the time but
tend to track along with them.

2 Term or Life of the mortgage

• Generally, longer-term mortgages have higher interest rates than short-term
mortgages. The usual mortgage lifetime is 15 or 30 years. Because interest rate risk
falls as the term to maturity decreases, the interest rate on the 15-year loan will be
substantially less than on the 30-year loan.
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3 Number of Discount Points Paid

• The number of discount points paid refers to the interest payments made at the
beginning of a loan. Borrowers need to consider whether the reduced interest rate over
the life of the loan fully compensates for the increased up-front expense. Typically, it is
not advisable to pay discount points if the borrower will pay off the loan in five years or
less.
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CHRACTERISTICS OF
RESIDENTIAL MORTGAGES
B. Loan Terms
Mortgage loan contracts contain many legal and financial terms, most of
which protects 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.
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CHRACTERISTICS OF
RESIDENTIAL MORTGAGES
D. Down Payment
• A down payment is a portion of the purchase price of a property that the borrower pays
upfront when obtaining a mortgage loan. The remaining balance of the purchase price is
covered by the loan proceeds.
• The purpose of a down payment is to reduce the likelihood of the borrower defaulting
on the loan and to mitigate moral hazard.
• Typically, lenders require borrowers to pay a certain percentage of the purchase price as
a down payment, with 5% to 20% being common requirements.
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CHRACTERISTICS OF
RESIDENTIAL MORTGAGES
E. Mortgage Markets and Derivatives
• Mortgage markets are where individuals, businesses, and governments obtain long-
term collateralized loans for real estate purchases.
• Mortgages are long-term loans secured by real estate, and borrowers make payments
over time to pay off the debt.
• Derivatives are financial instruments that derive their value from another security or
index, and they are used for managing risks by transferring the risks inherent in an
underlying primary instrument between contracting parties without transferring the
underlying instruments themselves.
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CHRACTERISTICS OF
RESIDENTIAL MORTGAGES
F. Borrower Qualification
• Borrower qualification refers to the process by which a lender determines whether a
borrower is eligible for a mortgage loan. Unlike qualifying for a bank loan, qualifying
for a mortgage loan involves meeting very precise guidelines established by
government agencies in the secondary mortgage market.
• These guidelines must be followed to ensure that the loan can be resold to one of these
agencies.
• If a borrower does not fit these guidelines, the lender may not be able to resell the loan.
Therefore, before granting a mortgage loan, the lender assesses whether the borrower
qualifies for it based on these specific criteria.
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AMORTIZATION OF MORTGAGE
LOAN
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TYPES OF
MORTGAGE LOANS
Conventional Mortgages
These are originated by banks or other mortgage lenders but are not guaranteed
by government or government controlled entities. Most lenders though now
insure many conventional loans against default or they require the borrower to
obtain private mortgage insurance on loans.

Insured Mortgages
These mortgages are originated by banks or other mortgage lenders but are
guaranteed by either the government or government-controlled entities.
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TYPES OF
MORTGAGE LOANS
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 (ARMs)

The interest rate on adjustable-rate mortgage (ARMs) is tied to some market interest
rate, (e.g., Treasury bill rate) and therefore changes over time. ARMs usually have
limits, called caps, on how high (or low) the interest rate can move in one year and
during the term of the loan.
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TYPES OF
MORTGAGE LOANS
Graduated-Payment Mortgages (GPMs)
Initial low payment increases each year; loan usually amortizes in 30 years.

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.
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TYPES OF
MORTGAGE LOANS
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)

In exchange for paying a portion of the down payment or for supplementing the monthly
payments, an outside investor shares in any appreciation in value of the real estate
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TYPES OF
MORTGAGE LOANS
Second Mortgages
Loan is secured by a second lien against the real estate; often used for line of credit or
home improvement loans.

Reverse Annuity Mortgages (RAMs)

Lender disburses a monthly payment to the borrower on an increasing-balance loan; loan
comes due when the real estate is sold
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MORTGAGE
LENDING
• A mortgage loanINSTITUTIONS
institution is an entity that provides mortgage loans to individuals and
businesses.
• These institutions facilitate the process of obtaining long-term collateralized loans
secured by real estate, allowing borrowers to finance real estate purchases.
• Mortgage loan institutions also participate in the secondary mortgage market, where
they may package and sell mortgage loans to other investors.
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SECURITIZATION OF
Intermediaries face several problems when trying to sell mortgages to the secondary market; that is

MORTGAGES
lenders selling the loans to another investor. These problems are:

Mortgages are not standardized. They

Mortgages are usually too small to be
wholesale instruments
Mortgage loans are relatively costly to
service. The lenders must collect monthly
payments, often advances payment of
property taxes and insurance premiums and
service reserve accounts
have different terms to maturity, interest
rates and contract terms. Thus it is
difficult to bundle a large number of
mortgages together.
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.
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MORTGAGE-BACKED
SECURITY
• A Mortgage-backed Security is a type of security that is collateralized by a pool of
mortgage loans. It is also known as securitized mortgage.
• Securitization is the process of transforming illiquid financial assets into marketable
capital market instruments.
• The most common type of mortgage-backed security is the mortgage pass-through,
which is a security that has the borrower's mortgages pass through the trustee before
being disbursed to the investors in the mortgage pass-through. If borrowers pre-pay
their loans, investors receive more principal than expected.
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BENEFITS DERIVED FROM
SECURITIZED MORTGAGE (SM)
SM has reduced the problems and risks Borrowers now have access to a national
caused by regional lending capital market
institutions’ sensitivity to local economic
fluctuations.

Investors can enjoying the low-risk and Mortgage rates are now more open to national
long-term nature of investing in mortgages and international influences. As a
without having to service the loan consequence, mortgage rates are more volatile
than they were in the past.
 II.
DERIVATIVES
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DERIVATIVE
• Derivative financial instruments are financial contracts
whose value is derived from the value of an underlying
asset, such as an interest rate, security price, commodity
price, foreign exchange rate, index of prices or rates,
credit rating, or credit index.
• They are used by investors to spread risk and/or to
speculate, and they allow for the transfer of risks between
contracting parties without the need to transfer the
underlying instruments themselves.
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CHRACTERISTICS OF
DERIVATIVES
value changes in response
to the change in a
Requires no initial net
investment or little net
That is settled
at a future date.
specified interest rate, investment relative to
security price, commodity other types of contracts
price, foreign exchange that have a similar
rate, index of prices or response to changes in
rates, credit rating or market conditions.
credit index, or similar
variable.
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HOW DERIVATIVES
WORK
• Investors may buy derivatives to hedge against risk or to speculate on future price
movements. Derivatives allow investors to lock in prices or gain market exposure
without the need to invest the full amount required to own the actual asset.
• Futures and options are common types of derivatives that are leveraged, meaning they
enable investors to control a large amount of the underlying asset with a relatively small
investment. The hope is to profit from a future rise in the value of that asset.
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HOW DERIVATIVES
For Hedging WORKFor Speculation
Hedging is a strategy used to Investors often use derivatives to
protect against cost fluctuations by speculate, meaning they purchase
setting a fixed price now for a these financial instruments with the
transaction that will take place in hope of making a profit from
the future. By doing this, a fluctuations in the price of an
company can shield itself against underlying asset. This is generally
unexpected price rises or falls in done on a short-term basis with
commodities, foreign exchange assets that are liquid or easily
rates, interest rates, or other traded.
valuable metrics. Selling or purchasing without full
information with risk/guessing
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EXAMPLE OF
Futures contracts DERIVATIVES
• agreements between a seller and a buyer that require the seller to deliver a particular
commodity at a designated future date and at a predetermined price. Hedging
• These contracts are actively traded on regulated futures exchanges and can involve
commodities like gold or financial instruments such as Treasury bills.
• Unlike forward contracts, futures contracts permit the seller to decide later on the
specific day within the specified month for delivery.
• Additionally, futures contracts are traded on market exchanges and do not call for a
daily cash settlement for price changes in the underlying contract. Gains and losses on
futures contracts are realized only when they are closed out. ////Financial/commodity
future contact
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EXAMPLE OF
Forward Contracts DERIVATIVES
A forward contract is similar to a futures contract but differs in three ways
A forward contract calls for Unlike a futures contract, a forward Unlike a futures
delivery on a specific date, contract does not call for a daily contract, a
whereas for futures contract cash settlement for price changes in forward usually is
permits the seller to decide the underlying contract, gains and not traded on a
later which specific day loses on forward contracts are paid market exchange
within the specified month only when they are closed out
will be the delivery date (if it
gets as far as actual delivery
before it is closed out)
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EXAMPLE OF
Options
DERIVATIVES
• are financial instruments that give the holder the right, but not the obligation, to buy
or sell an asset at a specified price within a given time period.
• They are often used for hedging against the effects of changing interest rates and can
be purchased to manage risk associated with price fluctuations of various assets such
as treasury bills, commodities, equities, and foreign currencies.
• Down payment
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EXAMPLE OF
Foreign Currency Futures
DERIVATIVES
• are contracts that allow firms to hedge against foreign exchange risk by buying or selling
specific foreign currencies at a predetermined price on a specified future date.
• These contracts are similar to financial futures, but they specifically involve foreign
currencies rather than specific debt instruments.
• Foreign currency futures work to protect against foreign exchange risk in the same way
that financial futures protect against fair value or cash flow risk.
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EXAMPLE OF
Interest rate swaps
DERIVATIVES
• There are contracts to exchange cash flows as of a specified date or a series of specified
dates based on a notional amount and fixed and floating rates.
• Over 70% of derivatives are interest rate swaps, which involve exchanging fixed
interest payments for floating rate payments, or vice versa, without exchanging the
underlying principal amounts.
• They are used to effectively manage and hedge against interest rate risk by allowing
parties to swap the consequences of rate changes.
• Variable to fixed interest.
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Examples of financial instruments that meet the characteristics of a derivative together with the
underlying variable affecting its value are as follows:

Underlying Variable (Main

TYPE OF Pricing-settlement Variable)
•CONTRACT
Commodity Futures
• Commodity Price
• Currency Forwards
• Commodity Rates
• Equity Swap
• Equity Prices
• Interest Rate Forward
• Interest Rates
• Purchased or Written Currency
• Currency Rates
Options
• Purchased or Written Stock Option
• Equity Price
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EXAMPLE 1: FORWARD
CONTRACTS
Assume that a company like XYZ believes that the price of ABC shares will
increase substantially in the next three months. Unfortunately, it does mot
have the cash resources to purchase the shares today. XYZ therefore enters
into a contract with a broker for delivery of 10,000 ABC shares in three
months at a price of P110 per share

XYZ has entered into a forward contract, a type of derivative As a result of

the contract, XYZ has received the right to receive 10,000 ABC shares in
three months. Further, it has an obligation to pay P110 per share at that time

What is the benefit of this derivative contract?

High price gain - low price loss
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EXAMPLE 2: CALL OPTION

A contract or call option allows the holder to call (purchase) at any time in the next 12 months 10,000 shares of ABC share
at a price of P50 per share. If the call is exercised, it can be settled by payment by the contract issuer to the contract holder
of an amount equal to 10,000 times the difference between the market price of ABC share on the call date and the strike
price of P5O Assume that ABC is a publicly traded company with a current market price of P50. The underlying is the share
price of ABC share, as the price of this contract will depend on this underlying variable, The notional amount is the 10.000
shares that can be called.

The holder can acquire the call contract at a considerably lower cost than that of actually buying the 10,000 shares at P50
per share. Holding the call option contract has the same response to market price changes as does holding the individual
shares themselves.

This contract need not require the actual transfer of shares upon the contract being exercised. The issuer of the contract can
settle with payment of cash mm an amount equal to the net gain of the holder.
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EXAMPLE 3: PUT OPTION

Sampaguita Inc. acquired t,000 shares of Sunflower Company on January 2, 2014 at a cost of P5O
per share, Sampaguita does not plan to sell the shares until mid-2015 at the earliest and therefore
classifies the investment as financial asset at fair value OCI.

Sampaguita, however, does not want to be exposed to possible declines in the fair value of the
investment. Sampaguita therefore acquires a put option to sell the 1000 shares at a price of P50 per
share on June 30, 2015 The cost of the put option contract is zero (or minimal). Sampaguita
designates the put contract as a fair value hedging contract for the investment in Sunflower
Company.
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