Chapter Seven

Mortgage Markets
Mortgages and Mortgage-Backed
Securities
 Mortgages are loans to individuals or businesses to
purchase homes, land, or other real property
 Many mortgages are securitized
 Securitization occurs when securities are packaged and
sold as assets backing a publicly traded or privately held
debt instrument
 Mortgages differ from bonds and stocks
 Mortgages are backed by a specific piece of real property

 Primary mortgages have no set size or denomination

 Primary mortgages generally involve a single investor

 Comparatively little information exists on mortgage

borrowers
Primary Mortgage Market

 Four basic types of mortgages are issued by

financial institutions
 Home mortgages are used to purchase one- to four-family
dwellings (called “single-family mortgages”)
 Multifamily dwelling mortgages are used to purchase
apartment complexes, townhouses, and condominiums
 Commercial mortgages are used to finance the purchase
of real estate for business purposes
 Farm mortgages are used to finance the purchase of farms
Mortgage Loan Outstanding
 National mortgage-in-arrears (i.e. missing payments for 3
months or longer) are low at about 0.24%
 With the price of the average house over $850,750, we
probably need to borrow more
 A “stress test” on all mortgage lending is required since
January 1, 2018
Type of Property Mortgage Loans Proportion of Total
Issued ($ trillions)
1- to 4-family dwelling 10.01 72.3%
Multi-family dwelling 1.11 8.0%
Commercial building 2.52 18.2%
Farm 0.21 1.5%
Features of Mortgage Loans
 Financing options are limited in the Canadian
mortgage markets
 Amortize over a 25-year period but reset the
terms every six months to five years
 A typical mortgage loan is a 5-year fixed-rate
loan amortize over year
 Recently, shorter term, longer amortization
period and variable rate become popular
 20% down payment is normally required, but a
minimum of 5% down payment is introduced in
2008 by CMHC
Mortgage Interest Rates
 Not all mortgages are created equally
 Most critical factor for mortgage borrowing
 (1) Market rates: the supply of and demand for long-
term funds; influenced by global, national and regional
factors; closely tie to the less risky Canada bond rates
but stay above
 (2) Term: interest-rate risk falls as the term to maturity
decreases, e.g. 10-year fixed is 6.10% and 1-year
fixed is 3.59%
 (3) Bonus points: lenders provide incentive offerings
at the beginning of a loan, e.g. free home inspection,
cash back, waiver of closing discharge
 (4) Down payment: a portion of the purchase price
Mortgage : Effective Interest Rate

 Canadian law requires interest on fixed-rate

mortgages to be compounded semiannually
even if payments are made weekly, bi-weekly or
monthly. m
 APR 
EAR  1   1
 In general,  m 
 Given a posted rate = 8% with semi-annual
compounding, the effective annual rate is EAR =
[1+0.08/2]2-1 = 1.0816 – 1 = 8.16%, which is the
true interest cost to a Canada mortgage
borrower
Example
 Mortgage = $100,000. Posted rate = 12%.
 Decision: 1% off vs. 3% cash rebate at closing?
 Paying 1% less makes the stated rate be 11%. EAR
= [1+0.11/2]2-1 = 1.113025–1 = 11.30%
 No discount, EAR = [1+0.12/2]2 -1 = 12.36%; but
$3,000 is received with the proceeds of the loan
 To make this determination, borrower must take into
account how long the loan will be paid off.
 If the mortgage is not paid off early (within 5 years)
borrower may benefit more from the lower interest
rate for a longer length of time
 Using the magic number “5“ is due to the fact that
home sells every five years on average
Other Fees associated with
Mortgages
 Discount points are fees or payments made when a
mortgage loan is issued (at closing)
 Each point costs the borrower 1 percent of the principal value
 The lender reduces the interest rate used to determine the
payments on the mortgage in exchange for points paid

 Other fees
 Application fee
 Title search
 Title insurance
 Appraisal fee
 Loan origination fee
 Closing agent and review fees
 Other fees (e.g. loan guarantees and PMI)
Mortgage Terminologies

 Collateral: lenders place liens against properties that remain

in place until the loan is fully paid off
 A down payment is a portion of the purchase price of the
property a financial institution requires the mortgage borrower
to pay up front
 Private mortgage insurance (PMI) is generally required when
the loan-to-value ratio is more than 80% (i.e., the borrower
makes a down payment of less than 20%)
 Government insured mortgages
 Repayment is guaranteed by Canadian Mortgage and Housing
Corporation (CMHC)
Mortgage Terminologies

 Conventional mortgages are mortgages that are not CMHC

insured
 Amortized mortgages have fixed principal and interest
payments that fully pay off the mortgage by its maturity date
 Fully amortized mortgage maturities are usually 25 years (80%)
 More than 25 years, with 14%>30 yrs, 5%>35 yrs, 1%> 40 yrs
 Fixed-rate mortgages lock in the borrower’s interest rate
 Therefore, required monthly payments are fixed over the life of
the mortgage and lenders assume interest rate risk
Mortgage Terminologies

 Variable-rate mortgages tie the borrower’s interest rate to

some market interest rate or interest rate index
 Required monthly payments can change over the life of the
mortgage, although they may initially be fixed for a set time
period.
 In a 5/1 variable-rate mortgage, the payment is fixed for the first 5
year, and then adjusts annually. Often, payment adjusting begins
immediately.
 Rates or payment changes are usually ‘capped’
 The 5/2/5 cap means that the first rate adjustment can be no more
than 55, after that the maximum annual change is 25 and the
maximum interest rate increase over the life of the mortgage is 5%
 Borrowers assume interest rate risk with an variable-rate
mortgage
 Variable-rate mortgage can increase default risk
Mortgage Rate Trends
 About 65% of Canadian mortgage borrowers choose
fixed-rate mortgage with a 4-5 year term (66%)
 6% < 1 year, 7%: 1-2 years, 7%: 2-3 years, 6%: 3-4
years, 7%: 5-10 years
 Still, variable-rate mortgages have been gain
popularity.
 In the 1st-quarterof 2019, the average share of new
mortgages with a variable-rate was 29%.
 This represents a 12% increase compared to the
same period in 2017.
Mortgage Terminologies
Features
Conventional Loan is not guaranteed; usually requires private
Mortgage mortgage insurance ; 20% or more down payment
Insured Mortgage Loan is guaranteed by CMHC; low down payment
Open Mortgage Allows the borrower to pay off some or all of the loan at
any time at no cost
Closed Mortgage Provides lower rate of interest for a longer term, but
with restrictions on the principal pay down
Amortization Period This is the time period required to retire completely a
debt through scheduled repayments
Term Actual length of time (e.g. 6 months or 5 years) for
which money is loaned at a specific rate of interest
Renewal/Maturity Date on which the term of mortgage expires
Date
Mortgage rate-hold Time before the renewal date to lock in a prevailing
favorable mortgage rate
Prepayment Option Gives the flexibility of increasing monthly payment or
paying down mortgage principal as a whole
Mortgage Insurance Trends
 The share of mortgages that are uninsured has
been increasing. It is the results of adjustments
to regulatory changes, changes in economic
conditions and changes to portfolio insurance
 In 2018, insured mortgage originations account
for less than 1 in 3 new mortgage loans.
 Results: the share of outstanding mortgages that
are insured decreased from 57% in the 1st-
quarter of 2015 to 41% in the 1st-quarter of
2019.
Borrower Qualification
 Qualifying for a mortgage loan (harder) differs from
qualifying for a bank loan (easier) because mortgages must
satisfy the CMHC requirements for securitization
 Qualification depends on: income level, down payment,
credit history, property value and other financial obligation
 GDS (i.e. share of the gross household income needed to
pay home-related expenses, e.g. mortgage payment,
property taxes and heating expenses) and TDS (i.e. share
of the gross household income needed to pay for all debts
including those relating to home ownership) are used when
calculating the ability to pay down debt.
 Rule of thumb: (1) max GDS ≤ 30% of gross household
income; (2) max TDS ≤ 40% of gross household income
Example
 Your gross monthly income is $5,417.
Monthly mortgage payment is $1,650,
property tax is $125, heat is $35, condo fees
are $500. You have a student loan payment
of $550/month.
 GDS = [1,650 + 125 + 35 + (0.5)(500)]/5,417
= 2,060/5,417 = 0.38 = 38%
 TDS = (2,060 + 550)/5,417 = 2,610/5,417 =
0.48 = 48%
 Both ratios are too high according to the
CHMC standards
Example: What to Buy?
 Have a conventional, 25-year, 6% mortgage
 Down payment = $50,000

 Monthly gross household income = $5,000

 Monthly debt payments = $300

 Home insurance + Property taxes = $400/month

Q: How much can you pay for a home and still

meet the normal qualification standards?
A: Use a software “home affordability calculator”
Example
 With 20% down, $50,000 can buy $250,000 as
the maximum
 Given a 28% GDS ratio, (0.28)($5,000)=$1,400 -
$400 = $1,000/month allows you to borrow
$155,207
 Given a 44% TDS ratio, (0.44)($5,000)=$2,200 -
$400 - $300 = $1,500/month qualifies you for a
mortgage of $232,810, which is the most that
you can borrow from a regular mortgage without
paying extra mortgage insurance
 With property of more than $1 million, borrowers
must pay at least 20% down payment
Mortgage Lending Trends
 Decrease in mortgage originations in 2018 resulted
in the slowest growth rate of outstanding mortgages
in over 25 years
 Reasons for this decline include tighter underwriting
criteria and non-underwriting criteria, higher
borrowing costs and modest economic conditions.
All these led to softer housing demand in Canada
 New mortgages for the purchase of property decreases by
19% in 2018
 Refinanced mortgages decreased by 12%
Mortgage Refinancing

 Mortgage refinancing
 When a borrower takes out a new mortgage and uses the
proceeds to pay off an existing mortgage
 Mortgages are most often refinanced when an existing
mortgage has a higher interest rate than current rates
 Borrowers must balance the savings of a lower monthly
payment with the costs (fees) of refinancing
 An often-cited rule of thumb is that the new interest rate
should be 2 percentage points less than the refinanced
mortgage rate
Mortgage Amortization

 Each fixed monthly payment consists partly of

repayment of the principal and partly of the interest
on the outstanding mortgage balance
 An amortization schedule shows how the fixed
monthly payments are split between principal and
interest
 Balloon payment mortgages require fixed monthly
interest payments for 3 to 5 years, at which point full
payment of the mortgage principal is due
Reference: Mortgage Payments

 The present value of a mortgage can be written as:

PV = principal amount borrowed

PMT = monthly mortgage payment
r = monthly interest rate on the mortgage
t = number of months over the life of the mortgage
Example: Mortgage Payments
 A 15-year, $100,000 mortgage loan financed
at 8% (EAR). Monthly payment?
 Use financial calculator: N = 180, PV = -
100,000, I/Y = 8/12 = 0.6667, FV = 0, PMT =
$955.65
 Use formula:
100, 000(0.006667) 666.7
PMT    $955.68
1 0.69762
1
  
180
1 0.006667
Fixed-Rate Mortgages
 $100,000 mortgage loan monthly payments
Rate/Time 25-year 15-year 10-year 5-year
5% $588.14 $793.99 $1,063.67 $1,890.02
8% $782.45 $964.91 $1,221.75 $2,035.31
15% $1,324.75 $1,438.51 $1,648.24 $2,408.85

 Payments are sensitive to the interest rate

and amortization period stipulated in the
mortgage contract.
Mortgage Amortization
 Pay down mortgage principal over the life of the mortgage
 $100,000 mortgage loan amortization schedule for a 15-year
maturity with $955.65 monthly payment
Payment Remaining Principal Interest
Month Principal Reduction Payment
1 $99,711.01 $288.99 $666.67
12 $96,402.15 $310.90 $644.75
60 $78,766.26 $427.69 $527.96
120 $47,131.26 $637.20 $318.46
180 $0 $949.32 $6.33

 Interest payment component gradually declines and

principal payment increases
Mortgage Interest and Principal,
by Age of Mortgage
Other Types of Mortgages
 Subprime mortgages
 Mortgages granted to borrowers do not qualify for a ‘prime’
credit rating because of a low credit score arising from prior
credit problems (e.g. delinquencies, defaults, no credit
history or insufficient income).
 In Canada, there are 3 classes of mortgage lenders:
 A: traditional (prime) lenders include banks (e.g. CIBC,
RBC) and virtual mortgage houses (e.g. Tangerine)
 B: nonconforming or subprime lenders (e.g. Home Capital
Group, Equitable Group)
 C: private lenders (e.g. Sebonic Financial, Home Loans
For All)
Mortgage Lending Trends
 In 2018, federally regulated FIs (e.g. banks) held about
78% of all mortgage debt.
 Provincially regulated FIs (e.g. credit unions) held about
14%.
 The remainder was held by quasi-regulated lenders (e.g.
mortgage finance companies) (6%) and unregulated
lenders (e.g. mortgage investment corporations) (1%)
 Mortgages can either be funded through banking sector
with short-term deposits (89%) or through capital market
with “securitization” (1.5%) by converting pools of
mortgages into fungible bonds sold to investors in small
denominations and with covered bonds (9.5%).
Other Types of Mortgages

 Second mortgages
 Second mortgages are secured by the same property
already used to secure a first mortgage
 Payments are made on the second mortgage just like
the first mortgage payments
 Second mortgages are junior to the first mortgage in
receiving payment of principal in the event of default
 Giving property owners an easy way to get cash from
the equity in their home is a significant advantage of
the second mortgage (i.e. home equity loans)
Other Types of Mortgages
 Reverse-annuity mortgages (RAMs)
 An innovation used by retired people or homeowners to
convert the equity in their home into a liquid asset
 The lending institution makes a monthly payment to the
homeowner
 Various payment options are available
 Each payment increases the lender’s claim against the
house
 Costs and servicing fees are high because the mortgage
loan is increasing with each payment and the accumulation
of interest
 When the person dies, the house is sold and the mortgage
paid off first
Secondary Mortgage Markets
 FIs do not want to lock up their money for a long
period of time and need to remove mortgages from
their balance sheets through one of two
mechanisms
 By pooling recently originated mortgages together and
selling them in the secondary market
 By securitizing mortgages (i.e., by issuing securities
backed by newly originated mortgages)

 Advantages of securitization
 FIs can reduce the liquidity risk, interest rate risk, and
credit risk of their loan portfolios
 FIs generate income from origination and service fees
Mortgage Sales
 FIs have sold mortgages and commercial real estate among
themselves for over 100 years
 A large part of correspondent banking involves small banks
making loans that are too big for them to hold on their balance
sheets and selling parts of these loans to large banks with
whom they have had a long-term deposit and lending
correspondent relationship
 Large banks often sell parts of their loans (i.e. participations)
to smaller banks
 Mortgage sales occur when an FI originates a mortgage and
sells it to an outside buyer
 A loan sale is made with recourse if the loan buyer can sell the
loan back to the originator, should it go bad
Mortgage Sales
 Mortgage sellers
 Domestic banks, foreign banks, investment banks, hedge funds, and the
government
 Mortgage sales allow FIs to manage credit risk, achieve better
asset diversification, and improve their liquidity and interest
rate risk positions
 FIs are encouraged to sell loans for economic and regulatory
reasons
 Sold mortgages can still generate fee income for the bank
 Sold mortgages reduce the cost of reserve and capital
requirements
 Mortgage buyers
 Investment banks, vulture funds, domestic and foreign banks, insurance
companies and pension funds, closed-end mutual funds, and
nonfinancial corporations
Securitization Process
Source Bank
(BMO)

Loan portfolio $ Cash Payment

Credit Rating Special Credit

Agency Rating Purpose Enhancement Enhancement
Agency
(S&P)
Vehicle (CMHC)
$ Fee $ Fee

Securitized instruments $ Cash Proceeds

Capital
Market
(investors)
Securitization Process
 Although home buyers go to local banks for mortgage
financing, few mortgages are actually held by the banks
that originate them
 After writing a mortgage, an originator usually sells the
mortgage to an separate entity, special purpose vehicle
(SPV) who accumulates them into mortgage pools
 To finance the creation of a mortgage pool, the SPV
repackages these loans and issues mortgage-backed
securities (MBS) sold to investors
 Each security claims a pro-rata share of all cash flows
derived from mortgages in the pool in proportion to its
face value
 Each mortgage pool is essentially set up as a trust fund
Securitization Process
 Primary collateral for all mortgage-backed securities is the
underlying pool of mortgages
 A servicing agent for the pool (e.g. the lending bank)
collects all mortgage payments from the home buyers
 The servicing agent then passes these cash flows (less
servicing and guarantee fees) through to security holders.
 For this reason, mortgage-backed securities are often
called mortgage pass-throughs, which is the predominant
type of MBS traded in the secondary market.
 The securities are publicly traded in the conventional
capital markets and compete effectively for investment
funds
 Returns on MBS are based on a pool of mortgages
Cash Flow for MBS
 Mortgage Pass-throughs

MBS
Mortgage
Mortgage Money Investors
Borrowers

Mortgage MBS
Monthly
Lender payments
payments

 When the payments are received on the original loan,

the payments are “passed through” to a trustee who
makes payment to the investors
International Trends in
Securitization
 Europe is the world’s second-largest and most developed
securitization market
 The European mortgage securitization peaked in 2008 before
falling dramatically in 2009 as a result of the financial crisis
 The role of London banks in the mortgage-backed securitization
market is now in question after the U.K.‘s 2016 referendum (aka
“Brexit)

 Parts of Europe and Asian real estate markets were not as

affected by the mortgage crisis because they lacked
substantial subprime lending
International Trends in
Securitization Continued
 The largest banks in the Netherlands, Switzerland, and the
United Kingdom had net losses in 2008
 Banks in Ireland, Spain, and the United Kingdom were especially hard
hit as they had large investments in toxic mortgages and mortgaged-
backed securities, both U.S. and domestic

 Securitization overseas is often structured differently, with

originators retaining title to the mortgages even after
securitization

 Securitization has declined due to the crisis, but will continue

in the future
Mortgage Prepayment Risk
 Borrowers prepay mortgages for many reasons – new job,
death, divorce, refinancing
 When interest rates drop, borrowers are more likely to
refinance
 Sensitive to seasons (people more likely to move in spring
and summer) and economic conditions (fewer prepays in a
bad economy)
 Measured by a prepayment rate (i.e. the probability that a
mortgage will be prepaid in a given year) developed by the
Public Securities Association (PSA)
 Actual prepayment pattern may differ from the PSA model
for various reasons. People quote the prepayment rates as
a percentage (e.g. 60% or 200%) of a PSA benchmark
Mortgage Prepayment Risk
 In the PSA model, the prepayment rates are conditional
(CPR) on the age of the mortgages in the pool.
 For unseasoned mortgages (< 30 months old), prepayment
begins at 0.2% per annum in the first month
 Increases by 0.2% monthly until reaching 6% per annum
after 30 months for seasoned mortgages
 The single monthly mortality (SMM) is calculated from the
100% PSA as:
 SMM = 1 – [1 – CPR](1/12) = 1 – [1 – (100%)(0.2%×t)](1/12) for 1 ≤ t ≤
30
 At 30 months and older, SMM = 0.00514
 The estimated prepayment for a month is the remaining
principal (after that month’s scheduled principal payment)
times the SMM
SMM rate and 100% PSA
Benchmark
Month 100% PSA Prepayment Single Monthly
(per annum, %) Mortality Rate (%)
1 0.2 0.01668
2 0.4 0.03340
3 0.6 0.05014
… … …
12 2.4 0.20223
… … …
28 5.6 0.47909
29 5.8 0.49668
30 6.0 0.51430
Annual Conditional Prepayment
Rates and PSA Benchmark
 Conditional prepayment rate (CPR)

12% 200% PSA

6% 100% PSA
3.6% 60% PSA

0 Mortgage age
3
(month)
0
Example
 The above SMM table is based on 100% PSA. If
the projected prepayment speed is 200% PSA, then
its speed is twice of the benchmark.
 A prepayment rate of 6% per annum can be
converted to an SMM of 0.514%.
 A 0.514% SMM means that approximately 0.514%
of the remaining mortgage balance, less the
scheduled principal payment for the month, will be
repaid this month
 Suppose the opening balance is $200m and the
scheduled principal payment is $5m. The estimated
prepayment for the month will be $1,002,300 =
0.00514 × ($200m - $5m)
Example
 Assume that a $500 million pool of mortgages backs a new
MBS issue. The projected prepayment speed is 160% PSA.
 With a prepayment speed of 160% PSA, an adjustment is
needed. For the first month, set t = 1 into the formula.
 SMM = 1 – [1 – (1.6)(0.0002)(1)]0.08333 = 1 – (1 – 0.00032)0.08333
= 1 – (0.99968)0.08333 = 1 – 0.99973 = 0.00002667 =
0.02667%.
 If the estimated prepayment for the first month will be
$133,460, what is the scheduled principal repayment for this
period?
 (0.00002667)(X) = 0.13346. Solving for X gives X = $499.85
million. Scheduled principal repayment = 500 – 499.85 =
$0.15 million.
CMHC
 Canada Mortgage and Housing Corporation (CMHC) is
Canada’s national housing agency.
 Established as a government-owned corporation in 1946 to
address Canada’s post-war housing shortage, the agency
has grown into a major national institution.
 CMHC is Canada’s premier provider of mortgage loan
insurance, mortgage-backed securities, housing policy and
programs, and housing research.
 CMHC obtained permission to offer MBS for residential
mortgages in 1984.
 With the mission of promoting liquidity in the secondary
market for home mortgages, CMHC has sponsored private
lenders the repackaging of mortgages into MBS pools
CMHC
 Acquiring the mortgages to form a pool, SPV can
issue MBS only after getting approval from CMHC
 CMHC is Canada's national housing agency wholly
owned by the federal government
 Through CMHC, the federal government is committed
to helping house Canadians across the country at an
affordable price.
 CMHC has provided Mortgage Loan Insurance to
protect National Housing Act approved lenders in both
urban and rural communities from borrower default,
and by doing so has helped support a private housing
market
Mortgage Insurance (MI)
 MI plays a big role in setting mortgage lending standard in
Canada
 Loans are originated by banks or mortgage lenders, but are
guaranteed by CMHC.
 Applicants must meet certain criteria e.g. having income
below a given level, and can borrow only up to a certain
amount
 CMHC then guarantees the bank granting the loans against
any losses – CMHC promises to pay off the mortgage loan
if the borrower defaults
 Insurance premium paid by the borrowers
 Advantage: a very low (5%) down payment is required