End of Chapter 17 Questions and Answers



End of Chapter 17 Questions and Answers

1. Where does mortgage money come from?

Answer: Mortgage money competes with other capital market investments. While some mortgage money comes from financial institutions through savings and checking account deposits, much comes from the secondary market agencies Freddie Mac and Fannie Mae who buy mortgages made by primary lenders. These secondary market agencies in turn secure money from mortgage bond investors. Primary mortgage lenders include banks, savings institutions as well as mortgage bankers, and credit unions. Commercial mortgage lenders include life insurance companies, Mortgage REITs and pension funds as well as the above.

2. What influences mortgage interest rates? How are mortgages usually priced?

Answer: Mortgage rates go up and down with expected inflation and real risk free rates based on Treasury security yields. The Federal Reserve Bank influences inflation by controlling the money supply relative to the production in the economy. The government also influences rates through the treasury bonds. If the Government pays more or less to borrow all rates go up or down in proportion. Most mortgages will be priced to yield something about the comparable term Treasury Bond, such as 150 basis points over 10 year bonds for fixed rate mortgages. Adjustable mortgages will be priced over shorter term treasuries such as one year bonds.

3. What is the influence of expected inflation on mortgage rates? What is the tilt effect?

Answer: Expected inflation is priced directly into mortgages based on the expected life of a mortgage, which is on average much less than 30 years. Higher inflation will drive rates up and make initial payments more difficult. Yet, over time with inflation actually occurring and incomes rising the mortgage payment will get easier. This “real” inflation adjusted decline in the mortgage payment over time is known as the tilt effect.

4. Who are the primary mortgage originators? Where do they get their money?

Answer:

Savings and Loans – with money coming from depositors.

Commercial Banks – with money coming from depositors.

Mortgage Bankers and Mortgage Brokers – with money coming from borrowing from commercial banks and the resale proceeds on sold loans.

Life Insurance Companies – with money coming from premium reserves on insurance accounts.

Pension Funds – with money coming from active contributors to pension plan reserves.

Individuals – who typically provide loans known as seller financing based on equity in sold property.

5. How does the Federal Reserve influence interest rates?

Answer: Through the discount rate charged member banks. They can raise or lower this rate and directly affect short term lending cost. Also through reserve requirements where they can increase or decrease the money supply. Open market operations where they buy and sell treasury bonds are not as discretionary a method to influence rates.

6. What is the secondary mortgage market?

Answer: The buying and selling of existing mortgages from the primary market. Freddie Mac, Fannie Mae and Ginnie Mae are primary residential players. There is also a commercial secondary market that trades CMBS Commercial Mortgage Backed Securities shares that includes many private investment banks.

7. Look up actual FRM mortgage rates in the Wall Street Journal of from your local newspaper. Then assuming that the real rate of interest is 4.5% what is the expected inflation rate. Hint, use the compounding assumption rather then subtraction.

Answer: In 2002 the FRM rates were under 6%. If the real rate were 4.5% then the inflation rate with a 6.0% mortgage would be 1.06/1.045 – 1 = .01435 or 1.435% over the expected life of the mortgage. This is low compared to historical inflation figures.

8. Why has loan standardization helped influence the cost of mortgage money?

Answer: Loan standardization has resulted in greater mortgage market efficiency. Mortgage processing and servicing has become less expensive lowering the mortgage rates relative to the cost of funds.

9. What is the community reinvestment act? What is it’s purpose?

Answer: The CRA is intended to require that financial institutions, especially banks, put money back into the local community including higher risk lower income areas. The purpose is to try and level out the playing field when it comes to access to borrowed capital.

10. What is the commercial mortgage backed securities market?

Answer: The CMBS market is a market of many mortgages that have been pooled and resold in slices known as tranches. These slices vary by risk and term. It is a way to help standardize a non-standardized product. It provides a way to divvy up risk and return that appeals to different types of investors.

11. Check out some on-line mortgage finding servicers and compare rates for FRMS and ARMs, closing costs and local services.

Answer: Local assignment. We should see ARM rates at 150 to 20 basis points under FRM rates in normal markets.

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