The document discusses the mortgage markets and the financial crisis. It covers topics like fixed-rate versus adjustable-rate mortgages, the subprime mortgage market, securitization of mortgages, and the housing bubble that contributed to the financial crisis. The crisis occurred as risky mortgages were made, packaged into securities, and spread widely through the financial system. When the housing market declined, it exposed problems and caused instability in financial markets.

1. Mortgage Markets & Financial
Crisis
1

2.  Mortgage Markets
 Subprime Market
 Financial Crisis
 Economic Recovery
2

3.  Fixed-rate versus adjustable-rate
◦ A fixed-rate mortgage locks in the borrower’s rate
 Financial institutions that hold fixed-rate mortgages are exposed to
interest rate risk
 Borrowers with fixed-rate mortgages do not benefit from declining
rates
◦ An adjustable-rate mortgage (ARM) allows the mortgage rate to
adjust to market conditions
 A common ARM uses a one-year adjustment with the interest rate
tied to the average T-bill rate over the previous year
 Borrowers with ARMs face uncertainty about future interest rates
 Using ARMs, financial institutions: Can stabilize their profit margins
and face less interest rate risk than with fixed-rate mortgages
3

4.  Types of mortgages
◦ 30-year fixed
◦ 15-year fixed
◦ ARMs
◦ Equity Lines
 Creative Mortgages
◦ Intro (teaser) rates
◦ Stated income & asset
◦ Negative amortization loans (pick-a-pay)
 Mortgage Lending
◦ What are the characteristics in which a loan should
be made?
4

5.  Fannie Mae:
◦ Issues debt securities and uses the proceeds to purchase mortgages
in the secondary market
 Freddie Mac:
◦ Ensures that sufficient funds flow into the mortgage market
 Ginnie Mae:
◦ Is a wholly-owned corporation by the federal government
◦ Supplies funds to low- and moderate-income homeowners indirectly
(provides guaranties) by facilitating the flow of funds into the secondary
mortgage market
 As a result of these three entities, the secondary mortgage market
SHOULD BE:
◦ very liquid
◦ have a lot of funding
5

6.  The most common are mortgage pass-through
securities
◦ A group of mortgages held by trustee serves as collateral
◦ Interest and principal on the mortgages are sent to the
financial institution, which passes them through to the
owners of the mortgage-backed securities
◦ Financial institutions earn fees from servicing the mortgages
while avoiding exposure to interest rate risk and credit risk
 Interest rate risk on mortgage-backed securities
◦ Payments received from pass-through securities are tied to
the payments sent to security owners
◦ Institutions can insulate their profit margin from interest rate
fluctuations
6

7.  Pooling and repackaging of loans into
securities
◦ Investors in these securities become the owners of
the represented loans
◦ Allows for the sale of smaller mortgage loans that
cannot be easily sold individually
◦ Can reduce a financial institution’s exposure to
default risk or interest rate risk
7

8. 8

9.  Interest rate risk
 Prepayment risk
 Credit risk
9

10.  What is a subprime loan?
 A loan made to a person with less than perfect
(prime) credit
 Other Characteristics of subprime loan
◦ High LTV
◦ Poor cash flow to debt
◦ Improper documentation
10

12.  Bubble in housing market
 Housing market drop
 How did Financial Institutions get into
trouble?
 Bad Mortgages (Subprime Market)
 Bets on financial subprime market
(derivatives)
 Example: CDS

13. 13

14. 14

15.  Homebuyers / Investors
◦ Increase use of ARMs and Subprime borrowers finding more
◦ Overzealous investors
◦ Crazy buyers
 Builders
◦ Over building the market
◦ Too much supply and inventory of homes an now cutting prices
 Underwriters / Banks / Mortgage Brokers / Appraisers
◦ Lending money with no guidelines
◦ Poorly Structured Loans
 Stated income, stated assets, poor documentation
 ARMs
 Buy downs / Intro-rates
 Payment Options (Pick-a-payment with Negative Amortization)
 More subprime loans and lower subprime margins 2.8% to 1.3%
15

16.  Securitization – passing the risk along (Credit Agencies)
◦ Due to securitization loans with a high risk of default could be originated,
packaged and the risk readily transferred to others.
◦ The securitized share of subprime mortgages (i.e., those passed to third-
party investors) increased from 54% in 2001, to 75% in 2006.
 Central Bank (FED)
◦ Kept interest rates too low does not try to avoid bubbles
◦ Roots of credit crisis laid at Fed's door (2007)
 Federal Reserve lowered the federal funds rate target from 6.5% to
1.0% because inflation was thought to be low
 Trying to help the economy after Sept. 11th and dot.com bubble
16

17. Economic Recovery?
17