The Mortgage Market &

Derivatives
Presented by:
Relampago, Jamaika
Baculpo, Iann Chelsea M. Reyes, Jenny Rose
Balase, Rofe Rosila, Gift Jeade
Castillo, Noiza Judea Tapia, Angelica
Conquillo, Vallerie Faith Tutanes, Jeralyn
Villafuerte, Chantal Sheen
 Sub topic
Part A: Mortgage Markets Part B: Derivatives
• Mortgages • Derivatives Financial Instrument
• Characteristics of the Residential • Characteristics of Derivatives
Mortgage • How it works
• Amortization of Mortgage Loan • Typical Example of Derivatives
• Types of Mortgage Loan Future Contracts
• Mortgage Lending Institution Forward Contracts
• Securitization of Mortgages Options
• Impact of Securitized Mortgage on Foreign Currency Futures
the Mortgage Market Interest Rates Swaps
• What Benefits are derived from
Securitized Mortgage
WHAT ARE MORTGAGES?
Mortgages are long-term loan secured by real estate. Both individuals
and businesses obtain mortgages loans to finance real estate
purchases.

A developer may obtain a mortgage loan to finance the construction

of an office building, or a family may obtain a mortgage loan to
finance the purchase of a home. In both cases, the loan is amortized.
The borrower pays it off over time in some combination of principal
and interest payments that result in full payment of the debt by
maturity.
CHARACTERISTICS OF THE
RESIDENTIAL MORTGAGE
A. Mortgage Interest Rates
One of the most important factors in the decision of the borrower of how
much and from whom to borrow is the interest rate on the loan.

There are three important factors that affect the interest rate on the loan.
These are:
1. Current long-term market rates - Long-term market rates are
determined by the supply of and demand for long-term funds, which are
in turn affected by a number of global, natiónal, and regional factors.
Mortgage rates tend to stay above the less risky treasury bonds most of
the time but tend to track along with them.
CHARACTERISTICS OF THE
RESIDENTIAL MORTGAGE
2. Term or Life of the mortgage - Generally, longer-term
mortgages have higher interest rates than short-term mortgages. The
usual mortgage lifetime is 15 or 30 years. Because interest rate risk
falls as the term to maturity decreases, the interest rate on the 15-
year loan will be substantially less than on the 30-year loan.
3. Number of Discount Points Paid - Discount points (or
simply poins) are inferest payments made at the begining of a loan. A
loan with one discount point means that the borrower pays 1% of the
loan amount at closing, the moment when the borrower signs the
loan paper and receives the proceeds of the loan. In exchange for the
points, the lender reduces the interest rate on the loan.
CHARACTERISTICS OF THE
RESIDENTIAL MORTGAGE
B. Loan Terms - Mortgage loan contracts contain many legal and financial
terms, most of which protect the lender from financial loss.

C. Collateral - One characteristic common to mortgage loans is the

requirement that collateral, usually the real estate being financed, be pledged
as security.

D. Down Payment - To obtain a mortgage loan, the lender also requires the
borrower to make a down payment on the property, that is, to pay a portion of
the purchase price. The balance of the purchase price is paid by the loan
proceeds. Down payments (like liens) are intended to make the borrower less
likely to default on the loan.
CHARACTERISTICS OF THE
RESIDENTIAL MORTGAGE
E. Private Mortgage Insurance (PMI) - is an insurance policy
that guarantees to make up any discrepancy between the value of
the property and the loan amount, should a default occur.

F. Borrower Qualification - Before granting a mortgage loan,

the lender will determine whether the borrower qualifies for it.
Qualifying for a mortgage loan is different from qualifying for a
bank loan because most lenders sell their mortgage loans to one of
a few government agencies in the secondary mortgage market.
 AMORTIZATION OF
MORTGAGE LOAN
Figure 10-1: Amortization of a 30-Year, P130,000 loan at 8.5%
TYPES OF MORTGAGE LOANS
Conventional Mortgages- These are originated by banks or other
mortgage lenders but are not guaranteed by government or
government controlled entities. Most lenders though now insure
many conventional loans against default or they require the borrower
to obtain private mortgage insurance on loans.

Insured Mortgages- These mortgages are originated by banks or

other mortgage lenders but are guaranteed by either the
government or government-controlled entities.
TYPES OF MORTGAGE LOANS
Fixed-rate Mortgages- In fixed-rate mortgages, the interest rate
and the monthly payment do not vary over the life of the mortgage.

Adjustable-Rate Mortgages (ARMs) - The interest rate on

adjustable-rate mortgage (ARMs) is tied to some market interest rate,
(e.g., Treasury bill rate) and therefore changes over time. ARMs
usually have limits, called caps, on how high (or low) the interest rate
can move in one year and during the term of the loan.
TYPES OF MORTGAGE LOANS
Graduated-Payment Mortgages (GPMs) - These morgages are
useful for home buyers who expect their incomes to rise.
The GPM has lower payments in the first few years, then the payments
rise. The early payment may not even be sufficient to cover the interest
due, in which case the principal balance increases. As time passes, the
borrower expects income to increase so that higher payment will not be
too much of a burden.

Growing Equity Mortgage (GEMs) - With a GEM, the payments will

initially be the same as on a conventional mortgage. Over time, however,
the payment will increase. This increase will reduce the principal more
quickly than the conventional payment stream would.
TYPES OF MORTGAGE LOANS
Shared Appreciation Mortgages (SAMs) - In a SAM, the lender
lowers the interest rate in the mortgage in exchange for a share of any
appreciation in the real estate (if the property sells for more than a
stated amount, the lender is entitled to a portion of the gain).

Equity Participating Mortgage (EPM) - In EPM, an outside investor

shares in the appreciation of the property. This investor will either
provide a portion of the purchase price of the property or supplement
the monthly payment. In return, the investor receives a portion of any
appreciation of the property. As with the SAM, the borrower benefits by
being able to quality for a larger loan than without such help.
TYPES OF MORTGAGE LOANS
Second Mortgages - These are loans that are secured by the same
real estate that is used to secure the first mortgage. The second
mortgage is junior to the original loan which means that should a default
occur, the second mortgage holder will be paid only after the original
loan has been paid off, if sufficient funds remain.

Reverse Annuity Mortgages (RAMs) - In a RAM, the bank

advances funds to the owner on a monthly schedule to in able him to
eliving expenses he thereby increasing the balance of the loan which in
secured by the real estate. The borrower does not make payments
against the loan and continues to live in his home. When the borrower
dies, the estate sells the property to pay the debt.
MORTGAGE LENDING INSTITUTIONS
The institutions that provide mortgage loans to familiar and business
and their share in the mortgage market are as follows:

Mortgage tools and trusts 49%

Commercial banks 24%
Government agencies and others 15%
Life insurance companies 9%
Savings and loans associates 9%
 SECURITIZATION OF
MORTGAGES
Intermediaries face several problems when trying to sell
mortgages to the secondary market; that is lenders selling the
loans to another investor. These problems are:

a. Mortgages are usually too small to be wholesale instruments

b. Mortgages are not standardized. They have different terms
to maturity, interest rates and contract terms. Thus it is difficult
to bundle a large number of mortgages together and
 SECURITIZATION OF
MORTGAGES
c. Mortgage loans are relatively costly to service. The lenders
must collect monthly payments, often advances payment of
properly taxes and insurance premiums and service reserve
accounts
d) Mortgages have unknown default risk. Investors in
mortgages do not want to spend a lot of time and effort in
evaluating the credit of borrowers.

The above problems inspired the creation of mortgage-backed

security.
 SECURITIZATION OF
MORTGAGES
Mortgage-backed security is a security that is collateralized by
a pool of mortgage loans. this is also known as securitized
mortgage. Securitization is the process of transforming illiquid
financial assets into marketable capital market instruments.

the most common type of mortgage-backed security is the

mortgage pass through.
Impact of securitized Mortgage on
the mortgage market
Mortgage-backed securitie (also called securitized mortgages) have
been in popularity in recent years as institutional investors look for
appreciative investment opportunities that compete for funds with
government notes bonds, corporate bonds and stock.

Securitized mortgage are low risk securities that have higher yield
than comparable government bond and attract funds from around
the world.
what benefits are derived from
securitized Mortgage?
The benefits are:

a. SM has reduced the problems and risks caused by regional lending

institutions sensitivity to local economic fluctuations.
b. Borrowers now have access to national capital market.
c. Investors can enjoying the low risk and long-term nature of
investing mortgages without having to service the loan.
d. Mortgage rates are now more open to national and international
influences. As a consequence, mortgage rates are more volatile than they
were in the past.
PART Ii: DERIVATIVES
In addition to primary instruments such as receivables, payables
and equity instruments, financial instruments also include
derivatives such as financial options. futures and forwards,
interest rate swaps and currency swaps. Derivatives are useful
for managing risks. They can effectively transfer the risks
inherent in an underlying primary instrument between the
contracting parties without any need to transfer the underlying
instruments themselves (either at inception of the contract or
even, where cash settled, or termination).
DERIVATIVE FINANCIAL INSTRUMENTS
Derivatives are financial instruments that "derive"
their value on contractually required cash flows from
some other security or index. For instance, 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:

a. whose value changes in response to the change in a specified interest

rate, security price, commodity price, foreign exchange rate, index of prices
or rates, credit rating or credit index, or similar variable (sometimes called
the "underlying");
b. that requires no initial net investment or little net investment relative to
other types of contracts that have a similar response to changes in market
conditions; and
c. that is settled at a future date. Derivatives are commonly used by investors
to spread risk and / or to speculate.
How it works
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.
Derivatives can enable an investor to gain exposure to a market via a smaller
outlay than if they bought the actual underlying asset. 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.
Derivatives for hedging
Companies use derivatives to protect against cost fluctuations
by fixing a price for a future deal in advance. By settling costs
in this way, buyers gain protection - known as a hedge -
against unexpected rises or falls in, for example, the foreign
exchange market, interest rates, or the value of the
commodity or product they are buying.
For example: A Philippine-based airline company reviews its
fuel stock levels and decides that it will need to buy jet fuel for
its fleet of planes in three months' time.
Derivatives for Speculation
Investors may buy or sell an asset in the hope of
generating a profit from the asset's price fluctuations.
Usually this is done on a short-term basis in assets that are
liquid or easily traded.
For example: An investor notices a company's share price is
going up and buys an option on the share. An option gives
a right to the holder to buy shares at a future date.
Typical Examples of Derivatives
The most frequently used derivatives are futures contracts, forward
contracts, options, foreign currency futures and interest rate swaps.

1.futures contract is an agreement between a seller and a

buyer that requires that seller to deliver a particular
commodity (say com, gold, or soya beans) at a designated
future date, at a predetermined price. These contracts are
actively treated on regulated future exchanges and are
generally referred to as "commodity futures contract.
Typical Examples of Derivatives
2. forward contract is similar to a futures contract but differs in three
ways:
1. A forward contract calls for delivery on a specific date, whereas a
futures contract permits the seller to decide later which specific day within
the specified month will be the delivery date (if it gets as far as actual
delivery before it is closed out).
2. Unlike a futures contract, a forward usually is not traded on a market
exchange.
3. Unlike a futures contract, a forward contract does not call for a daily
cash settlement for price changes in the underlying contract. Gains and
losses on forward contracts are paid only when they are closed out.
Typical Examples of Derivatives
3. 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. Options frequently are purchased to hedge
exposure to the effects of changing interest rates. Options serve
the same purpose as futures in that respect but are fundamentally
different. Importantly, though, the option holder has no obligation
to exercise the option. On the other hand, the holder of a futures
contract must buy or sell within a specified period unless the
contract is closed out before delivery comes due.
Typical Examples of Derivatives
4. Foreign Currency Futures
Foreign loans frequently are denominated in the
currency of the lender (Japanese yen, Swiss franc,
German mark, and so on). When loans must be repaid in
foreign currencies, a new element of risk is introduced.
To hedge against "foreign exchange risk" exposure,
some firms buy or sell foreign currency futures
contracts.
Typical Examples of Derivatives
5. Interest Rate Swaps
There are contracts to exchange cash flows as of a
specified date or a series of specified dates based on a
notional amount and fixed and floating rates.
Over 70% of derivatives are interest rate swaps. These
contracts exchanged fixed interest payments for floating
rate payments, or vice versa, without exchanging the
underlying principal amounts.
Thank
You