Mortgage Market & Derivatives PDF

Financial Markets A POWERPOINT PRESENTATION ABOUT The Mortgage Market GROUP 2 INTRODUCTION The introduction states that Chapter 8 addressed money markets, which are concerned with short-term funds, and capital markets, which involve long-term funds such as bonds and equity. This section...

Financial Markets A POWERPOINT PRESENTATION ABOUT The Mortgage Market GROUP 2 INTRODUCTION The introduction states that Chapter 8 addressed money markets, which are concerned with short-term funds, and capital markets, which involve long-term funds such as bonds and equity. This section, however, examines mortgage markets, which provide individuals, businesses, and governments with access to long-term, collateralized loans. As a subset of capital markets, mortgage markets are associated with long-term financing. In contrast to stock and bond markets, mortgage markets primarily serve businesses and government entities as borrowers rather than individuals. Furthermore, mortgage loans are characterized by varying amounts and maturities based on borrowers' specific needs, a feature that poses challenges for the development of a secondary market. WHAT ARE MORTGAGES? Mortgages are long-term loans secured by real estate. Both individuals and businesses obtain mortgage 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 much and from whom to borrow in the interest rate on the loan. MORTGAGE MARKETS 3 Factors Affecting Mortgage Interest Rates 1. Current 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, national, and regional factors. 2. Term or Life of the Mortgage - Generally, longer-term mortgages have higher interest rates than short-term mortgages. 3. Number of Discount Points Paid - Discount Points (or simply points) are interest payments made at the beginning of the loan. A loan with one discount point means that the borrower pays 1% of the loan amount at closing. In exchange for the points, the lender reduces the interest rate on the loan. MORTGAGE MARKETS 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. MORTGAGE MARKETS D. DOWNPAYMENT To obtain a mortgage loan, the lender also requires the borrowe 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. The down payment reduces moral hazard from the borrower. E. Private Mortgage Insurance (PMI) Private Mortgage Insurance (PMI) is an insurance policy that guarantees to make up any discrepancy between the value of the poperty and the loan amount, should a default occur. PMI is usually requires on loans that have less than a 20% down payment. PMI usually costs between P200 and P300 per month for a P10,000 loan. F. Borrower Qualifications Before granting a mortgage loan, the lender will determine whether the borrowerqualifies for it. Qualifying 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 motgage market. These agencies establish very precise guidelines that must be followed before they will accept the loan. Amortization of Mortgage Loan Mortgage loan borrowers generally agree to pay a monthly amount of principal and interest that will be fully amortized by its maturity. 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. 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, and therefore changes over time. Types of Mortgage Loans Graduated-Payment Mortgages (GPMs) These mortgages are useful for home buyers who expect their income to rise. The GPM has lower payments in the first few years, then the payments rise. Growing Equity Mortgage (GEMs) The payments will initially be the same as on a conventional mortgage. Overtime the payment will increase and this increase will reduce the principal more quickly than the conventional payment stream would. Shared Apprecition Mortgages (SAMs) The lender lowers the interest rate in the mortgage in exchange for a share of any appreciation in the real estate  Equity Participating Mortgage (EPM) An outside investor shares in the apprecition 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 apprecition of the property Second Mortgages The second mortgage is junior to the original loan whick 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) The bank advances funds to the owner on a monthly schedule to enable him to meet living 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. Financial Markets Derivatives GROUP 3  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 ageneies 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 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. Mortgage-backed Security Mortgage-backed security is a security that is collateralized by a pool of mortgage loans. This is also known as securitized mortgage. Securitization Securitization is the process of transforming illiquid financial assets into marketable capital market instruments.  BENEFITS DERIVED FROM SECURITIZED MORTGAGE (SM) What benefits are derived from Securitized Mortgage (SM)? The benefits are: 1. SM has reduced the problems and risks caused by regional lending institutions' sensitivity to local economic fluctuations. 2. Borrowers now have access to a national capital market 3. Investors can enjoying the low-risk and long-term nature of investing in mortgages without having to service the loan 4. 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 Derivatives are financial tools that derive value from underlying assets like stocks, interest rates, or currencies. They help manage risks or seek profit by locking in future prices or leveraging price changes.  DERIVATIVES FINANCIAL INSTRUMENTS Derivatives are unique because they "derive" their value from something else, like a stock price, interest rate, or currency value. For example, a contract that allows a company to buy a commodity like coffee beans at a set price in the future is a derivative. Companies use these tools to manage potential price changes in the market, allowing them to operate with greater certainty.  CHARACTERISTICS OF DERIVATIVES Three key characteristics: 1. Their value changes in response to changes in factors like interest rates or commodity prices. 2. They typically require a low initial investment compared to other contracts. 3. Derivatives are settled in the future, meaning the final exchange or payment happens at a later date.  How Derivatives Work : Derivatives are used for two main purposes: hedging, and speculation. 1. Hedging allows companies to protect themselves from unexpected price changes by locking in a price for future purchases or sales. 2. Speculation involves buying and selling with the hope of making a profit from price movements. Both uses rely on the ability of derivatives to provide financial leverage and flexibility.  How Derivatives Work : Derivatives are used for two main purposes: hedging, and speculation. 1. Hedging allows companies to protect themselves from unexpected price changes by locking in a price for future purchases or sales. 2. Speculation involves buying and selling with the hope of making a profit from price movements. Both uses rely on the ability of derivatives to provide financial leverage and flexibility. Typical Examples of Derivatives Future Contracts Forward Contracts Call Options Foreign Currency Futures Interest Rate Swaps Futures Contracts A futures contract is an agreement between a seller and a buyer that requires that seller to deliver a particular commodity (say corn, gold, or soya beans) at a designated future date, at a predetermined price. Forward Contracts 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). Call 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. Options frequently are purchased to hedge exposure to the effects of changing interest rates. Foreign Currency Futures Currency futures are futures contracts for currencies that specify the price of exchanging one currency for another at a future date. The rate for currency futures contracts is derived from spot rates of the currency pair. 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. Examples of Financial Instruments that meet the characteristics of a derivative together with the underlying variable affecting its value are as follows: 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 that time.  Example 2 Call Option A contract or call option allows the holder 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 is 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 a 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 notional 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.  Example 3 Put Option Sampaguita Inc. acquired 1,000 shares of Sunflower Company on January 2, 2014 at a cost of P50 per share. Sampaguita does not plan to sell the shares until mid-2015 at the earliest and therefore classifies this investment as financial asset at fair value/OCI Sampaguita, however, does not want to be exposed to possible declines in the fair value of the investment. Sampaguita therefore acquires a put option to sell the 1,000 shares at a price of P50 per share on June 30, 2015. The cost of the put option contract is zero (or minimal). Sampaguita designates the pur contract as a fair value hedging contract for the investment in Sunflower Company.  Situation 1 Assume that on December 31, 2014, Sunflower Company common stock is trading at P35 per share. Suppose further that the fair value of the put option contract has increased to P15,000. [This change is due to the decline in the fair value of the underlying asset (P50-P35) times 1,000 shares.] Under these circumstances, PAS 39 would require that Sampaguita include the following in its income statement: The unrealized loss on the investment of P15,000 (equal to the decline in fair value per share of P15 times the 1,000 shares). The portion of the unrealized gain on the derivative financial instrument that relates to the hedging activity of P15,000. In this particular case, the hedge is fully effective, and the gain on the hedging instrument exactly offsets the loss on the hedged item.  Situation 2 Suppose instead that the fair value of the put option at December 31, 2014, is only P10,000. (There are number of reasons why this might be the case.) In this case, the hedge is not fully effective, and the ineffective portions of the hedge are included in net income because the unrealized loss of P15,000 is only partially offset by the unrealized gain of P10,000. The net effect would be to report a loss of P5,000 related to this hedge. If this investment were not hedged, the entire unrealized loss of P15,000 would be included only in comprehensive income and reported as a separate component of shareholders' equity as an accumulated unrealized loss from investments in securities available for sale. Financial Markets ank yo h u! T