Chapter 5

Mortgage Markets

 Background on Mortgages
A mortgage is a form of debt created to finance investment in real estate. The debt is
secured by the property, so if the property owner does not meet the payment obligations,
the creditor can seize the property. Financial institutions such as savings institutions and
mortgage companies serve as intermediaries by originating mortgages. They consider
mortgage applications and assess the creditworthiness of the applicants.
The mortgage represents the difference between the down payment and the
value to be paid for the property. The mortgage contract specifies the mortgage rate, the
maturity, and the collateral that is backing the loan. The originator charges an origination
fee when providing a mortgage. In addition, if it uses its own funds to finance the
property, it will earn profit from the difference between the mortgage rate that it charges
and the rate that it paid to obtain the funds. Most mortgages have a maturity of 30 years,
but 15-year maturities are also available.

 How Mortgage Markets Facilitate the Flow of Funds

The means by which mortgage markets facilitate the flow of funds are illustrated in Figure
1. Financial intermediaries originate mortgages and finance purchases of homes. The
financial intermediaries that originate mortgages obtain their funding from household
deposits. They also obtain funds by selling some of the mortgages that they originate
directly to institutional investors in the secondary market. These funds are then used to
finance more purchases of homes, condominiums, and commercial property. Overall,
mortgage markets allow households and corporations to increase their purchases of
homes, condominiums, and commercial property and thereby finance economic growth.

Figure 1 How Mortgage Markets Facilitate the Flow of Funds

 Institutional Use of Mortgage Markets

Mortgage companies, savings institutions, and commercial banks originate mortgages.
Mortgage companies tend to sell their mortgages in the secondary market, although they
may continue to process payments for the mortgages that they originated. Thus their
income is generated from origination and processing fees, and not from financing the
mortgages over a long-term period. Savings institutions and commercial banks
commonly originate residential mortgages. Commercial banks also originate mortgages
for corporations that purchase commercial property. Savings institutions and commercial
banks typically use funds received from household deposits to provide mortgage
financing. However, they also sell some of their mortgages in the secondary market. The

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 common purchasers of mortgages in the secondary market are savings institutions,
commercial banks, insurance companies, pension funds, and some types of mutual
funds. The participation by financial institutions in the mortgage market is summarized
in Table 1.
Table 1 How Mortgage Markets Facilitate the Flow of Funds

 Housing Loan Options Based on Financing Scheme

There are three housing loan options you can choose from, based on financing schemes.
These are:
1. Bank financing
Most banks in the country offer housing loans. However, the application can be
rigorous, with the amount of money you can borrow and loan terms varying from
bank to bank.

2. Pag-IBIG housing loan

If you are a Pag-IBIG member, you can get a housing loan from this government
agency. This is open for salaried, self-employed, and OFWs up to the age of 65
years old. It also lets you borrow up to ₱6 million for a residential lot, house, or
condominium.

3. In-house financing
You can get a housing loan directly from real estate developers. However, this
loan option has a shorter tenure of only up to five years.

 The Two Mortgage Markets

1. Primary Mortgage Market
It is where loans are originated. Loan origination is a fancy word for the process
of creating a new loan. Many different parties participate in the primary mortgage
market. Borrowers obviously are in the market looking for money, but there are
also several types of loan originators who will work with the borrower to create a
real estate loan.
Originators include mortgage brokers, mortgage bankers, commercial
banks and credit unions. A mortgage banker is a person or institution that
specializes in providing mortgage loans and usually sells them soon after. Your
typical commercial banks, like your typical hometown bank, and credit unions also
originate mortgage loans.

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 2. Secondary Mortgage Market
Secondary mortgage market, which is where lenders can sell their loans to
interested parties. The bank is making its money off the loan origination fees
rather than from holding the loan for the interest. An origination fee is generally
a percentage of the loan value paid to the originator, somewhat like a sales
commission.
The loans are sold on the secondary mortgage market, where the
mortgage originators, like bank, can sell their loans to investors or mortgage
aggregators. A mortgage aggregator is someone who buys a bunch of
mortgages and securitizes them, or turns them into a security. The mortgage
aggregator securitizes them into mortgage backed securities (MBS), which are
sold to investors much the same way an investor may buy a corporate bond. While
a corporate bond involves investing in a corporate debt, a mortgage backed
security is about investing in mortgage debt. In a sense, the investor becomes the
lender, and her investment does well or poorly depending upon whether
borrowers of the mortgage loans underlying the MBS, pay on their loans or
default.

o National Home Mortgage Finance Corporation (NHMFC)

Unlike Pag-IBIG Fund, the NHMFC is catered to the secondary market that
operates or finances for home mortgages. There is actually only one loan
program that NHMFC offers which is the Housing Loan Receivables Program
(HLRPP). This is directed to financial institutions, developers, LGUs,
cooperatives and other private sectors. They’ve created a program to help
these organizations have more to lend to potential homeowners by liquidating
their qualified housing receivables.
Aside from this, the HLRPP also looks into helping these organizations
better manage their investment risk profiles and create more affordable
housing loans with lower interest rates to eventually extend repayment
methods for borrowers such as yourself.

 Mortgage-Backed Securities
As an alternative to selling their mortgages outright, financial institutions can engage in
securitization, or the pooling and repackaging of loans into securities called mortgage-
backed securities (MBS) or pass-through securities. These securities are then sold
to investors, who become the owners of the loans represented by those securities.

 Securitization
Securitization is the process of turning assets into securities. More specifically, specific
assets are pooled together and repackaged as interest-bearing securities. Securities are
financial or investment vehicles that are bought and sold in financial markets similar to
how stocks and bonds are traded.
The purchasers of the new, repackaged interest-bearing securities receive
interest and principal payments. Let's also define assets. Assets can be converted into
cash, some easier and quicker than others. An asset that can be converted into cash
quickly is called a liquid asset. An asset that takes longer to convert to cash and will
likely sell for a price lower than market value is called an illiquid asset.
For example, a money market account is an account at a bank used to store cash.
It usually pays a small rate of interest based on the amount of money on deposit in the
account. If the owner of the account wants to withdraw all or a portion of the money, he

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 can simply use a withdrawal form at the bank to take money out immediately. A money
market account is an example of a liquid asset.
However, if a person who owns a home decides to sell the house, it could take
days or months before the house sells. The owner needs to put the house up for sale,
advertise or use a real estate agent, and find a buyer for the house. Once the owner
finds a buyer willing to purchase the home, it's not guaranteed that the owner will receive
the full value of the home, and it can take days or even months to complete the
transaction. A house is an example of an illiquid asset.
From the bank's perspective, a mortgage loan is considered an asset because
the bank receives interest and principal payments from the borrower each month for a
specific length of time. However, the mortgage asset carried on the bank's statement of
financial position is considered an illiquid asset because the mortgage is tied to the
borrower's home, which is also an illiquid asset.

 How Securitization Works

Securitization turns illiquid assets, like mortgages, into liquid assets. First, a bank or
financial institution compiles hundreds or thousands of mortgages into a pool. Think of
a 'pool' of mortgages as a large grouping of mortgages. The bank divides the pool into
pieces called shares and sells the shares to investors and other companies in the form
of what are called securities. Remember, the securities are made up of hundreds or
thousands of mortgages.
For example, John purchases a piece or share of the pool. John has purchased
the right to receive a portion of the mortgage payments made by all the hundreds of
thousands of homeowners whose mortgages were pooled together to form the
securities. The securities that are made of mortgages are called mortgage-backed
securities.

 Parties involved in Asset Securitization

o Originator
The originator is the original lender and the seller of the loans. Typical originators:
Mortgage brokers, Mortgage bankers, Commercial banks, and Credit unions.

o Obligator/Borrower
The borrower is the counterparty to whom the originator makes the loan.

o Investors
Investors are the persons who subscribe the securities. Banks, Financial
Institution, and Mutual Fund are the main investors in a securitized paper.

o Trustee
Trustees are normally reputed banks, financial institutions or independent trust
companies set up for the purpose of settling trusts. Trustees oversee the
performance of the transaction till maturity and are vested with necessary powers to
protect investor’s interests.

o Credit Rating Agencies

Independent rating agencies analyze the risks associated with an asset securitization
transaction and assign a credit rating to the instrument issued. These rating agencies
perform a vital role in Structured Finance. They are evaluating the credit quality of
the transactions. They are experts in evaluating various underlying asset type.
Ratings are important because investors generally accept ratings by the major public
rating agencies like Moody, standard and poor.

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 o Special Purpose Vehicle (SPV)
SPVs are companies or trusts formed for th specific purpose of issuing securities in
asset securitization transactions whose ownership and management are
independent of the Originator. SPV is mainly formed to raise funds by collateralizing
future receivables.

Figure 2 Parties involved in Asset Securitization

 Typical Asset Securitization structure

o As you know John wants to buy a house and he approached the Loan
originator i.e. Metro Bank.
o There are thousands of Johns who are getting a loan from the bank by
keeping different type of mortgages.
o Bank issues a loan to them and creates a pool of mortgages.
o Bank then sale these pool of mortgage to the SPV (Special Purpose Vehicle)
with the intention to convert these pool of mortgages into marketable
securities.
o Then credit rating agencies and investment banks (Ancillary service
providers) come into the picture. Credit rating agencies give a rating to the
securities and investment bank provide liquidity support to the security.
o When such structured securities are issued in the market, many Investors
subscribe to them.

Figure 3 Typical Asset Securitization structure

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 Benefits of Securitization
The process of securitization creates liquidity by letting retail investors purchase shares
in instruments that would normally be unavailable to them. For example, with an MBS
an investor can buy portions of mortgages and receive regular returns as interest and
principal payments. Without the securitization of mortgages, small investors may not be
able to afford to buy into a large pool of mortgages.
Unlike some other investment vehicles, many loan-based securities are backed
by tangible goods. Should a debtor cease the loan repayments on, say, his car or his
house, it can be seized and liquidated to compensate those holding an interest in the
debt.
Also, as the originator moves debt into the securitized portfolio it reduces the
amount of liability held on their statement of financial position. With reduced liability, they
are then able to underwrite additional loans.

 Drawbacks to Consider
Even though the securities are back by tangible assets, there is no guarantee that the
assets will maintain their value should a debtor cease payment. Securitization provides
creditors with a mechanism to lower their associated risk through the division of
ownership of the debt obligations. But that doesn't help much if the loan holders' default
and little can be realized through the sale of their assets.
Different securities—and the tranches of these securities—can carry different
levels of risk and offer the investor various yields. Investors must take care to understand
the debt underlying the product they are buying.
Even so, there can be a lack of transparency about the underlying assets. MBS
played a toxic and precipitating role in the financial crisis of 2007 to 2009. Leading up to
the crisis the quality of the loans underlying the products sold was misrepresented. Also,
there was misleading packaging—in many cases repackaging—of debt into further
securitized products. Tighter regulations regarding these securities have since been
implemented. Still—caveat emptor—or beware buyer.
A further risk for the investor is that the borrower may pay off the debt early. In
the case of home mortgages, if interest rates fall, they may refinance the debt. Early
repayment will reduce the returns the investor receives from interest on the underlying
notes.

Table 2 Summary of the Pros and Cons of Securitization

Pros Cons
 Turns illiquid assets into liquid  Investor assumes creditor role
ones  Risk of default on underlying loans
 Frees up capital for the originator  Lack of transparency regarding
 Provides income for investors assets
 It lets small investor play  Early repayment damages
investor's returns

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