Mortgage Market and Derivatives

Part l: Mortgage Markets

Mortgage Market
- a market where borrowers-individual business and governments can obtain long-term
collaterized loans.
This market form a subcategory of the capital markets because mortgage involves long-term
funds.

Mortgage Markets and Stock and Bonds Markets

Mortgage Markets differ from stock and bond markets in a number of ways.
First, the usual borrowers in the capital markets are businesses and government entities,
whereas the usual borrowers in the mortgage markets are individual.
Second, mortgage loans are made for varying amounts and maturities depending on the
borrower's needs, features that cause problems for developing secondary markets.

Mortgage
-a long-term loan that is secured by real state
-both individuals and businesses obtain mortgages loans to finance real estate purchases
-developer may obtain a mortgage loan to finance the construction of an office, building, or a
family may obtain a mortgage loan to finance to purchase of a home.

Characteristics of the Residential

Mortgage
There are 6 types of CHARACTERISTICS OF THE RESIDENTIAL MORTGAGE, these are:
• Mortgage Interest Rate
• Loan Terms
• Collateral
• Down Payment
• Private Mortgage Insurance (PMI)
• Borrower Qualifications

A. Mortgage Interest Rates

-the mortgage rate is the interest rate changed on a mortgage. And one of the most
important factors in decision of the borrower is the interest rate on the loan.
Mortgage interest rates compose three important factors that affect the interest rate on the
loan these are:
 1. Current long-term markets rates
-These are ascertained by the supply of and demand for long-term funds, which are
affected by a series of global, national, and regional factors. Mortgage rates has
tendency to stay on the less risky treasury bonds usually, but also has the tendency to
track along with them.
2. Term or life of the mortgage
-In general, long-term mortgages certainly have higher interest rates than of
short-term mortgages. The lifetime of the mortgage is usually 15 or 30 years. The rate of
interest on the 15-year loan will considerably be less than on the 30-year loan, for the
reason that, interest rate falls as the term to maturity decreases.
3. Number of discount points paid
-Discount points are the interest payments made at the beginning of the loan. A loan
with a discount point means that the borrower is ought to pay 1% of the loan amount at
the closing. Usually, the borrower is not obliged to pay the discount points if the
borrower pays the loan in 5 years or less

B. Loan Terms
The terms and conditions involved when borrowing money and it protects the lender from
financial loss
A term loan is a monetary loan that is usually repaid in regular payments over a set period of
time.

C. Collateral
Collateral is an item of value that a lender can seize from a borrower if they fails to repay a
loan according to agreed terms.

D. Down Payment
A Down payment is a percentage of the purchase price that you pay out of the pocket. A
down payment is a sum of money that a buyer pays in the early stages of purchasing an
expensive good or service.

E. Private Mortgage Insurance (PMI)

Private Mortgage Insurance (PMI), is also known as mortgage guaranty insurance guarantees
that in the event of a default, the insurer will pay the mortgage lender for any loss resulting
from a property foreclosure, up to a specific amount.

F. Borrower Qualifications
Before granting a mortgage loan the lender will determine whether the borrower qualifies for
it. A borrower must be income-eligible, demonstrate a credit history that indicates ability and
willingness to repay a loan.

Amortization of Mortgage Loan

Mortgage Loan
-a loan agreed to pay a monthly amount of principal and interest that will be fully amortized by
its maturity.

Fully amortized
-payments will pay off on the maturity date of the loan

Example:

Amortization of a 30-year, P130, 000 loan at 8.5%

Payment Beginning Monthly Amount Amount Ending
Number Balance of Payment Applied to Applied to Balance of
Loan Interest Principal Loan
1 130,000.00 999.59 920.83 78.75 129,921.24
24 128,040.25 999.59 906.95 92.66 127,947.62
60 124,256.74 999.59 880.15 119.43 124,137.31
120 115,365.63 999.59 817.17 182.41 115,183.22
180 101,786.23 999.59 720.99 278.60 101,507.63
240 81,046.41 999.59 547.08 425.51 80,620.90
360 991.77 999.59 7.82 991.77 0
Total P359,852 P229,852 P130,000

TYPES OF MORTGAGE LOANS

a. Conventional Mortgages
-a loan that is not controlled by a government entities
-private loans
-5% to 20% down payment is needed upon borrowing.

b. Insured Mortgage
-default mortgage insurance
-controlled by government or government-controlled entities
-low or zero down payment

c. Fixed-rate Mortgages
-a mortgage where interest rate does not change over the term of the mortgage

d. Adjustable-rate Mortgages (ARMs)

-a mortgage where interest rate is tied to certain market interest rate, thus it changes
gradually
-the size of adjustment is subject to annual limits

e. Graduated-Payment Mortgages
-these mortgages has lesser payments in the first few years, and then its payments rise
each following years.
-loan typically amortizes in 30 years

f. Growing Equity Mortgage

-the payments in Growing Equity Mortgage are initially the same as on the conventional
mortgages
-payment will increase each year
-amortizes in less than 30 years
 g. Shared Appreciation Mortgages
-it is the mortgage where the lender lowers the rate of interest in commutation for a
share of any appreciation in the real estate, or the lender should be entitled to a portion
of the property`s gain if he lowers the interest rate.

h. Equity Participating Mortgage

-it is where an outside investor provides a part of the purchase price of the property
and the investor shares in any appreciation of the property

i. Second Mortgages
-loans that are secured by a property in proliferation to the first mortgage
-the second mortgage holder will only be paid after the primary loan has been paid off,
if the remaining funds are sufficient.

j. Reverse Annuity Mortgages

-it is where the lender pays out a monthly payment to the borrower on an
increasing-balance loan.
-the borrower does not make any payments on the loan and when the borrower dies,
the estate sells the property for the debt to be paid off.\

MORTGAGE LENDING INSTITUTIONS

These are the institution that provide mortgage loans to familiar and business and their
share in the mortgage market are as follows

Mortgage tools and trust 49%

Commercial banks 24%
Government agencies and others 15%
Life insurance companies 9%
Savings and loans associates 9%

Many of the institutions making mortgage loans do not want to hold large portfolios of
long-term securities. Loan organizations make money through the fees that they gain for
packaging loans for other investors to hold. Fees of the loan organization are usually 1% of the
loan amount, through this varies with the market.

SECURITIZATION OF MORTGAGES
Several problems happen when Intermediaries tries to sell mortgages to the secondary
markets. These following problems are
a) Mortgages are usually not enough to be wholesale instruments.
b) Mortgages are not standardized. They do have different terms to maturity, interest rates
and contract terms. Hence, the difficulty to bundle a huge amount of mortgages together.
c) Mortgage loans are costly to service. The lender are ought to collect monthly payments,
often advances payment of properly taxes and insurance premiums and service reserve
accounts.
d) The default risk in mortgages is unknown. Investors in mortgages do not want a lot of time
and effort to be spent in evaluating the credit of the borrowers.

The preceding problems are what inspire the creation of mortgage-backed security.
Mortgage-backed security -is also known as securitized mortgage, it is a security that is
collateralized by a pool of mortgage loans. Moreover, Securitization is the way of changing
illiquid financial assets into marketable financial instrument.
Mortgage pass through- the most common type of mortgage-backed security, refers to a
security that has the borrower’s mortgages through the trustee before being paid to the
investors in the mortgage-pass through.

Impact of Securitized Mortgage on the Mortgage Market

Mortgage-backed securities have been popular in the preceding years as institutional
investors search for appreciative investment opportunities that compete for funds with
government notes bonds, corporate bonds and stock.
Securitized mortgage is securities that are low-risk that have higher yield than comparable
government bond and attract funds globally.

What Benefits are derived from Securitized Mortgage?

a. Has reduced risks and problems because of regional lending institutions’ dependence
towards local economic fluctuations.
b. Borrowers can now have access to a national capital market
c. Investors can enjoy the low-risk and long-term characteristic of investing in mortgages
without having to service the loan
d. Mortgage rates are currently more open towards national and international influences. In
contradictory, mortgage rates are now more volatile than they were in the past.

Derivatives

Part ll: DERIVATIVES

Derivatives
-a security with a price that is dependent upon or derived from one or more underlying assets
-a contract between two or more parties based upon the asset or assets

Derivatives Financial Instruments

-these are financial instruments that “derive” their value on contractually required cash flows
from some other security or index.

EXAMPLE:
 A contract allowing a company to purchase a particular asset (say gold, flour, or
coffee bean) at a designated future date, at a predetermined price is a financial instrument that
derives its value from expected and actual changes in the price of the underlying asset.

Characteristics of Derivatives
A derivative is a financial instrument:
1) Value changes —> the change in a specified interest rate
—> security price
—> commodity price
—> foreign exchange rate
—> index of prices or rates
—> credit rating or credit index
—> similar variable (underlying)

2) No initial net investment or little net investment

3) Settled at a future date

What are derivatives used for?

Investors
- To manage, adjust, and use their underlying investment goals to be managed appropriately
- To spread risk and/or to speculate

Traders
- To access specific markets and trade different assets
- can trade on an exchange or over-the-counter

How Derivatives work:

1. The most common are futures and options-leveraged products in which the
investor puts down a small proportion of the value of the underlying asset
and hopes to gain by a future rise in the value of that asset.
2. Investors may buy derivatives in order to reduce the amount of volatility in
their portfolios, since they can agree on a price for a deal in the present that
 will, in effect happen in the future, or to try to increase their gains through
speculation.
3. Derivatives can enable an investor to gain exposure to a market via a smaller
outlay than if they bought the actual underlying asset.

Derivatives for hedging

● Companies use derivatives to protect against cost fluctuations by fixing a

price for a future deal in advance.

● Buyers gain protection -known as a hedge – against unexpected rises or

falls.

● To protect itself from potential future price increase, it can buy fuel at
today’s prices for delivery and payment at a future date.

Derivative for Speculation

● Investors may buy or sell an asset in the hope off generating a profit from
the asset’s price fluctuations.
● If share prices do rise, investor can profit by buying at a fixed option
price and selling at the current higher price.

Typical Examples of Derivatives

● Future Contracts- A future contract is an agreement between seller and

a buyer that requires that seller to deliver a particular commodity at a
designated future date, at a predetermined price.

● Forward Contracts- A forward contract is similar to a futures contract

but differs in three ways:

1. Calls for delivery on specific date,

2. A forward usually is not traded on market exchange
3. A forward does not call for a daily cash settlement for price changes
in the underlying contract.
- Gains and losses.

● Options- Options give its holder the right either to buy or sell an
instrument, say a Treasury bill, at a specified price and within a given
time period.

● Foreign Currency Features- Foreign loans frequently are denominated

in the currency of the lender.
 ● Interest Rates Swaps- There are contracts to exchange cash flows as
of a specified date or a series of specified dates based on a national
amount and fixed and floating rates.

INTEREST RATE SWAPS

- Future interest payments is exchanged for another based on a specified principal amount
- Can exchange fixed or floating rates in order to reduce or increase exposure to fluctuations
in interest rates.

Types of Interest rate Swaps

1) Fixed-to-floating Swap- a contractual arrangement between two parties in which one
party swaps the interest cash flows of fixed-rate loan(s) with those of floating-rate
loan(s) held by another party.
2) Floating-to-fixed Swap- A company that does not have access to a fixed-rate loan may
borrow at a floating rate and enter a swap to achieve a fixed rate.
3) Float-to-float Swap
-also known as a “basis swap”.
-Two parties agree to exchange variable interest rates.

Examples of financial instruments that meet the characteristics of a derivative together with the
underlying variable affecting its value are as follows:

Underlying variable
Types of contracts (main pricing-settlement variable)
Commodity Swap Commodity price
Commodity futures Commodity price
Commodity forward Commodity price
Credit swap Credit rating, credit index, or credit price
Currency swap (foreign exchange swap) Commodity rates
Currency futures Commodity rates
Currency forward Commodity rates
Equity swap (equity of another firm) Equity prices
Equity forward Equity price (equity of another firm)
Interest rate swap Interest rates
Interest rate future linked to government Interest rates
debt (Treasury futures)
Interest rate forward Interest rates
Purchased or written treasury bond
option(call or put)
Figure 10.1 Financial Instruments That Meet the Characteristics of a Derivative Together with
the Underlying Variable Affecting Its Value

Illustrative cases on Derivatives

Example 1: Forward Contract

Assume that a company like XYZ believes that the price of ABC shares will increase substantially
in the next three months. Unfortunately, it does not 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 the time.
What is the benefit of this derivative contract ?
XYZ can buy ABC shares today and take delivery in three months. If the price goes up, it expects
XYZ profits. If the price goes down, XYZ loses.

Example 2: Call Option

A contract or call option allows 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 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 P50.
Assume that ABC is 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 national 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 in an amount equal to the net gain of
the holder.