LEARNING OBJECTIVES

After studying this unit, you should be able to:

• define the organization of the mortgage markets;

• outline the basic components and structure of the mortgage markets;

• enumerate the main participants of the mortgage markets;

• define terminology related to the mortgage markets;

• state the role of the mortgage markets in the financial system.

Starting-up

Exercise 1.Comment on the following quotations. Which of them do you agree with? Which do you disagree with? Why?

1. “There is no class of people in the world, who have such good memories as creditors.”P.T. Barnum

2. “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain."Mark Twain

3. “Those who understand interest earn it; those who don’t, pay it.”Henry Ford

Reading

TheAspects of the Mortgage Markets Industry

The mortgage markets form a subcategory of the capital markets because mortgages involve long-term funds. But the usual borrowers in the capital markets are government entities and businesses, whereas the usual borrowers in the mortgage markets are individuals. Also mortgage loans¹are made for varying amounts and maturities, depending on the borrowers' needs, features that cause problems for developing a secondary market.

A mortgage is a long-term loan secured by real estate². A developer³ may obtain a mortgage loan to finance the construction of an office building, or a family may obtain a mortgage loan to finance the purchase of a home. The loan is amortized⁴: the borrower pays it off over time in some combination of principal and interest payments that result in full payment of the debt by maturity.

The mortgage markets can be divided into primary and secondary mortgage markets.

The primary mortgage market is the market where borrowers and mortgage originators come together to negotiate terms and effectuate mortgage transaction. Mortgage brokers, mortgage bankers, credit unions⁵ and banks are all part of the primary mortgage market.

After being originated in the primary mortgage market, most mortgages are sold into the secondary mortgage market. Unknown to many borrowers is that their mortgages usually end up as part of a package of mortgages⁶ that comprise a mortgage-backed security⁷ (MBS), asset-backed security⁸ (ABS) or collateralized debt obligation⁹ (CDO).

The secondary mortgage market is the market where mortgage loans and servicing rights¹⁰ are bought and sold between mortgage originators, mortgage aggregators (securitizers) and investors. The secondary mortgage market is extremely large and liquid.

A large percentage of newly originated mortgages are sold by their originators into the secondary market, where they are packaged into¹¹ mortgage-backed securities and sold to investors such as pension funds, insurance companies and hedge funds¹². The secondary mortgage market helps to make credit equally available to all borrowers across geographical locations.

The mortgage market has become very competitive in recent years. Thirty years ago, savings and loan institutions and the mortgage departments¹³ of large banks originated most mortgage loans. Currently, there are many loan production offices¹⁴ that compete in real estate financing. Some of these offices are subsidiaries¹⁵ of banks, and others are independently owned. As a result of the competition for mortgage loans, borrowers can choose from a variety of terms and options¹⁶ such as mortgage interest rates, loan terms (influenced by collateral¹⁷, down payments¹⁸, private mortgage insurance, borrower qualification¹⁹) and mortgage loan amortization.

* The mortgage interest rate borrowers pay is probably the most important factor in their decision of how much and from whom to borrow.

* Mortgage loan contracts contain many legal and financial terms, most of which protect the lender from financial loss. Options that influence a loan term²⁰ are the following:

• Collateral is one of the characteristics common to mortgage loans. It is the requirement that collateral, usually the real estate being financed, be pledged as security. The lending institution²¹ will place a lien against the property²², and this remains in effect until the loan is paid off. A lien is a public record that attaches to the title of the property²³, advising²⁴ that the property is security for a loan, and it gives the lender the right to sell the property if the underlying loan²⁵ defaults.

No one can buy the property and obtain clear title²⁶ to it without paying off this lien. For example, if you purchased a piece of property with a loan secured by a lien²⁷, the lender would file notice of this lien²⁸ at the public recorder’s office²⁹. The lien gives notice to the world that if there is a default on the loan, the lender has the right to seize the property³⁰. If you try to sell the property without paying off the loan, the lien would remain attached to the title³¹ or deed ³²to the property. Since the lender can take the property away from whoever owns it, no one would buy it unless you paid off the loan. The existence of liens against real estate explains why a title search³³ is an important part of any mortgage loan transaction. During the title search, a lawyer or title company³⁴ searches the public record for any liens. Title insurance³⁵ is then sold that guarantees the buyer that the property is free of encumbrance³⁶, any questions about the state of the title to the property, including the existence of liens.

• A down payment on the property is also required by the lender from the borrower to obtain a mortgage loan, it means that the borrower is to pay a portion of the purchase price. The balance of the purchase price is paid by the loan proceeds³⁷. Down payments (like liens) are intended to make the borrower less likely to default on the loan. A borrower who does not make a down payment could walk away from the house and the loan and lose nothing. Furthermore, if real estate prices drop even a small amount, the balance due on the loan³⁸ will exceed the value of the collateral. The down payment reduces moral hazard³⁹for the borrower. The amount of the down payment depends on the type of mortgage loan.

• Purchasing private mortgage insurance (PMI) is another way that lenders protect themselves against default of borrowers. PMI is an insurance policy that guarantees to make up any discrepancy⁴⁰ between the value of the property and the loan amount, should a default occur.

• Borrower qualification is very important. Before granting a mortgage loan⁴¹, the lender will determine whether the borrower qualifies for⁴² it. Qualifying a borrower is rather complex and constantly changing procedure. Factors that influence it are loan payment, taxes, insurance other debt obligations and gross monthly income⁴³.

Mortgage loan amortization⁴⁴is one of the main characteristics of a mortgage. Mortgage loan borrowers agree to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity. “Fully amortize” means that the payments will pay off the outstanding indebtedness⁴⁵ by the time the loan matures. During the early years of the loan, the lender applies most of the payment to the interest on the loan and a small amount to the outstanding principal balance⁴⁶. Many borrowers are surprised to find that after years of making payments, their loan balance has not dropped appreciably.