2.

Collateral
● Mortgage loans are backed up by a property that
MORTGAGE MARKETS
serves as collateral to the loan.
● The property will be placed with a lien, a public record
MORTGAGE MARKETS attached to the title that give the bank or finance
● The mortgage market is the underlying structure that company the right to sell the property if the borrower
supports home lending through mechanisms that defaults,
help with the free flow of funds so that lending can ● lenders place liens against properties that remain in
continue. place until the loan is fully paid off.
● A mortgage is any loan that pledges a piece a real
estate as collateral 3. Down payment
● The mortgage market is split into two main ● A down payment by the borrower is normally needed
components: a primary mortgage market and a ● A down payment is a portion of the purchase price of
secondary mortgage market. The primary market is the property a financial institution requires the
the one consumers interact with. mortgage borrower to pay up front.
● The lending bank or finance company requires the
MORTGAGE borrower to pay a portion of the purchase price of the
● It is a loan to borrowers (either individuals or property at the closing date, the date of issuance.
businesses) to purchase a real property such as a
house, lot or building. MORTGAGES IN THE PRIMARY MARKET
● These properties act as a collateral to protect the Four basic types of mortgages are issued by financial
financial institution (a bank or finance company) in institutions.
the event of non-payment. ● Home mortgages are used to purchase one- to
● Mortgages differ from stocks and bonds, and the four-family dwellings (called “single-family
following characteristics highlights these differences: mortgages”).
● A type of loan to purchase or maintain a home, land, ● Multifamily dwelling mortgages are used to purchase
or other types of real estate. The borrower agrees to apartment complexes, townhouses, and
pay the lender over time. condominiums.
● Commercial mortgages are used to finance the
Many mortgages are securitized. purchase of real estate for business purposes.
● Securitization occurs when securities are packaged ● Farm mortgages are used to finance the purchase of
and sold as assets backing a publicly traded or farms.
privately held debt instrument.

Mortgages differ from bonds and stocks.

1. Mortgages are backed by a specific piece of real
property.
2. Primary mortgages have no set size or denomination.
3. Primary mortgages generally involve a single investor
(bank or mortgage company).
4. Comparatively little information exists on mortgage
borrowers.
Bank will give the borrower cash, then a loan payable/receivable
CHARACTERISTICS OF MORTGAGES would arise.
1. Customized
● Unlike a bond or stock, which are usually
standardized, mortgages tend to be more customized.
● The terms (such as size, fees, and interest rates) of
each mortgage held by a bank or finance company
can differ.
● A mortgage contract between a financial institution
and a borrower must indicate all of the terms of the
mortgage agreement.
● In other words, they have to agree. They have to make
Cash will be used to buy the house and lot
custom terms as to what the interest is, etc.

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 MORTGAGES IN THE SECONDARY MARKET
FIs 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).
House and lot will then be used as collateral for the loan payable
to the bank. Advantages of securitization.
● FIs can reduce the liquidity risk, interest rate risk, and
Mortgage Refinancing credit risk of their loan portfolios.
Mortgage refinancing. ● FIs generate income from origination and service fees
● When a borrower takes out a new mortgage and uses
the proceeds to pay off an existing mortgage. Secondary Market
● Mortgages are most often refinanced when an ● A secondary market is the market where issued
existing mortgage has a higher interest rate than securities are bought and sold.
current rates. ● In the case of mortgages, after the loan receivable is
● Borrowers must balance the savings of a lower issued, the bank or finance company will sell it to
monthly payment with the costs (fees) of refinancing. another party.
● 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 At the closing of a mortgage, cash is given to the borrower. The
mortgage balance. bank shall have a loan receivable. This is an example of a
primary market transaction.
An amortization schedule shows how the fixed monthly
payments are split between principal and interest.

Mortgage Payments
The present value of a mortgage can be written as:

Banks owe their resources to the depositors. Banks carry a

responsibility to the public, and these depositors would include
every one of us, a lot of low to middle-income individuals.

The role of the central bank is generally to protect these

depositors. Central banks would allegedly protect these
depositors by seeing to it that the banks are liquid, solvent, and
Example: Mortgage Payments have enough capital – we call that CAPITAL ADEQUACY. Now,
A borrower agrees to a P120,000, 30-year fixed-rate mortgage to be safe, there is a maximum limit as to what ratio of loans the
with an 8% quoted interest rate per annum. What is the monthly deposits are.
payment amount and how much of each payment goes to
principal and interest? In loan receivables, there is risk. To reduce the risk, the bank can
sell the loan receivable with or without recourse so the assets of
the bank could be liquid, or transfer the loan receivable to a
special purpose vehicle (entity), or use the loan receivable as
collateral for bonds.

For example, carrying too much mortgage loans receivable in

the balance sheet can be a burden for the bank. This is the
reason why they might decide to transfer this mortgage loan
receivable to another party. In this case, the bank may sell

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some of its mortgage loans receivable. This is a secondary funds, closed-end bank loan mutual funds, and
market transaction. The mortgage is already issued and nonfinancial corporations.
outstanding, now it’s going to be transferred to another lender.
Mortgage Backed Securities
● Instead of selling mortgage loans directly, the bank or
the finance company may decide to issue instruments
representing them.
● An investment security made up of a bundle of
mortgage loans bought from the banks that issued
them.
● Examples:
Secondary market for mortgage may include either: ○ Securitization
Mortgage Sale ■ Pass-through mortgage securities
● This happens when the bank sells the mortgage to ■ Collateralized mortgage obligations
another party. ○ Collateralization
● The sale can occur with recourse or without recourse ■ Mortgage backed bonds
to the issuing bank – similar as to how businesses
factor receivables. Pass-through mortgage securities
● The previous example is a mortgage sale. ● Mortgage-backed securities that “pass through”
promised payments of principal and interest on pools
of mortgages created by banks to secondary market
participants holding interest in the pools.

Here, the select mortgage loans are to be transferred to what we

call a SPECIAL PURPOSE VEHICLE – an entity specifically
created for this transaction. Here, the mortgage loans are pulled
The bank will literally take out the mortgage loan receivable together.
from its balance sheet and sell it to another party in exchange
for cash. It is a pool of fixed-income securities backed by a package of
assets. A servicing intermediary collects the monthly
Mortgage sales occur when an FI originates a mortgage and payments from issuers and, after deducting a fee, remits or
sells it with or without recourse to an outside buyer. passes them through to the holders of the pass-through
● Without recourse means if the borrower was not able security (that is, people or entities who have invested in it).
to pay its mortgage, the buyer of the mortgage cannot
go after the FI The most common type of pass-through is a mortgage-backed
● With recourse, the buyer of the mortgage can go after certificate or a mortgage-backed security (MBS), in which a
the FI should the borrower was not able to pay its homeowner's payment passes from the original bank through a
obligation government agency or investment bank before reaching
investors.
Mortgage sellers.
● Money center banks, smaller banks, foreign banks, These types of pass-throughs derive their value from unpaid
investment banks, hedge funds, and the government. mortgages, in which the owner of the security receives
Mortgage sales allow FIs to manage credit risk, achieve better payments based on a partial claim to the payments being
asset diversification, and improve their liquidity and interest made by the various debtors. Multiple mortgages are packaged
rate risk positions. together, forming a pool, which thus spreads the risk across
multiple loans.
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

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 It is a security consisting of a pool of mortgages organized by
The right side of the balance sheet are securities that represent maturity and level of risk.
an interest in this pool. ● CMO is special purpose entity that owns and
administers the mortgage loans by receiving the
homeowners mortgage payments and passing those
payments on the various investors in the CMO.
● Investors owns bonds issued by the CMO.
● CMOs receive cash flows as borrowers repay the
mortgages that act as collateral on these securities.
In turn, CMOs distribute principal and interest
payments to their investors based on predetermined
Naturally, upon the transfer, the bank will take ownership of rules and agreements.
these securities. Now, this can be sold to investors interested in ● The mortgages are arranged into different pools
owning a pro-rata interest in the mortgage pool. called tranches by maturity and the risk profile of the
homeowners.

Mortgage backed bonds

● Bonds collateralized by a pool of assets.
● Technically speaking, this is not a means of
securitizing the mortgage. But rather, this is just using
the mortgage as a collateral to issue more debt.
● These are bonds collateralized by pool of assets. It is
also called asset-backed bond. It normally remains in
the balance sheet. FIs segregate a group of mortgage
assets on its BS and pledges this group of assets as
Pass-through securities typically have the same risks and
collateral against MBB issue.
rewards for each security. Meaning to say, they are equivalent. If
● In other words, the bank needs additional cash and
a mortgage defaults all securities are to bury the loss. If the
may need to issue bonds to lower interest payments.
mortgage is paid in advance, all securities will lose the future
They can make the bonds less risky by having a
interest income.
collateral on the borrowing and that is the purpose of
the mortgage.
Collateralized mortgage obligations
● A mortgage-backed bond issued in multiple classes
or tranches
○ Tranche: a bond holder class associated with
a Collateralized mortgage obligations

The same mechanism would apply for CMOs, as with

pass-through securities. However, because of the existence of
tranches, investors have a variety of options on what set-up they
prefer. They may take more risks and be exposed to higher
returns or they may take less risk, again depending on what is
suitable to their investment goal.

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