Mortgage Markets

A key feature of fixed-rate mortgages is that they embed a valuable option for the borrower.

• If rates fall: The borrower can refinance—take out a new mortgage at the lower prevailing rate and use the proceeds to pay off the existing mortgage. The borrower effectively has a call option to retire the debt at par whenever it is advantageous to do so.
• If rates rise: The borrower is locked in at the original lower rate, which is now below the market rate. The borrower benefits relative to someone who would have to borrow at the new higher rate.

This asymmetry—gain if rates fall, protection if rates rise—means the fixed-rate mortgage borrower is always in a favorable position relative to the market. From the lender's perspective, this embedded option is a cost: they face prepayment risk when rates fall and hold low-yielding assets when rates rise. This contributes to the negative convexity of mortgage-backed securities discussed below.

A common ARM structure is the 5/1 ARM:

• The rate is fixed for the first 5 years
• After year 5, the rate resets annually based on the index + margin
• ARMs typically include rate caps to limit changes:
  • Periodic cap: limits the change at each reset (e.g., ±2% per year)
  • Lifetime cap: limits the total change over the life of the loan (e.g., ±5% from the initial rate)

ARMs typically offer a lower initial rate than fixed-rate mortgages, called the teaser rate. Borrowers benefit from ARMs when:

1. They plan to sell or refinance before the initial fixed period ends
2. They expect interest rates to fall
3. They need a lower initial payment to qualify for a larger loan

Lenders benefit because the interest rate risk is shifted to the borrower. However, this can increase default risk—borrowers who stretched to afford the teaser payment may default when the rate resets upward. This dynamic was a central cause of the 2007-2008 financial crisis.

• Loan-to-Value (LTV) Ratio: The loan amount divided by the appraised property value. A lower LTV means the borrower has more equity and the lender has more collateral cushion. LTV > 80% typically requires the borrower to purchase Private Mortgage Insurance (PMI), which protects the lender (not the borrower) against default losses.
• Credit Score (FICO): Scores range from 300-850. Most conventional mortgages require a score of at least 620; prime borrowers typically have scores above 740. Subprime mortgages are made to borrowers with scores below roughly 620 and carry higher interest rates to compensate for the elevated default risk.
• Debt-to-Income (DTI) Ratio: Total monthly debt payments divided by gross monthly income. Conventional loans typically require a DTI below 43%. A high DTI signals the borrower may struggle to service the debt.
• Documentation: Full-documentation loans verify income and assets through tax returns, pay stubs, and bank statements. "Stated income" or "no-doc" loans (where borrowers self-reported income without verification) were common pre-2008 and contributed to the financial crisis by allowing fraudulent applications.

To be sold to Fannie Mae or Freddie Mac, a loan must be conforming—it must meet limits on loan size (the conforming loan limit, which adjusts annually; $766,550 for most areas in 2024), LTV, DTI, documentation, and borrower credit quality. Non-conforming loans (including jumbo loans) must be held on the originating bank's balance sheet or sold to private investors at a discount.

The Government National Mortgage Association is a true government agency (part of HUD). Ginnie Mae guarantees MBS backed by FHA- and VA-insured loans. Its guarantee is backed by the full faith and credit of the U.S. government, making Ginnie Mae MBS essentially free of credit risk.

The Federal National Mortgage Association is a Government-Sponsored Enterprise (GSE)—a shareholder-owned corporation created by Congress with an implicit government guarantee. Fannie Mae purchases conforming conventional mortgages from lenders, pools them, and issues MBS. It was placed into government conservatorship in September 2008 during the financial crisis after suffering catastrophic losses on subprime mortgage exposure.

The Federal Home Loan Mortgage Corporation is also a GSE with a similar mandate to Fannie Mae. Congress created it in 1970 to provide competition to Fannie Mae and expand the secondary mortgage market. Freddie Mac was likewise placed into conservatorship in 2008.

Agency MBS (issued or guaranteed by Ginnie, Fannie, or Freddie) are among the most liquid fixed-income securities in the world, second only to U.S. Treasury securities. They carry an implicit (Fannie/Freddie) or explicit (Ginnie) government guarantee against default, so investors focus primarily on prepayment risk rather than default risk when pricing them.

Extra Credit: Does credit card delinquency precede mortgage delinquency? Pull data from FRED and test.

Like any fixed-income instrument, mortgages lose value when interest rates rise and gain value when rates fall. This price sensitivity is measured by duration.

A 30-year fixed-rate mortgage has a stated maturity of 30 years, but because borrowers make monthly principal payments (amortization) and can prepay at any time, its effective duration is much shorter—typically 5-10 years under normal rate conditions.

More importantly, mortgages exhibit negative convexity, which makes them unusual among fixed-income instruments:

• When rates fall, borrowers refinance (prepay early), shortening the mortgage's effective duration just when the lender would prefer longer duration to benefit from rising prices. The lender receives their principal back and must reinvest at the now-lower market rates.
• When rates rise, borrowers hold on to their below-market fixed-rate mortgages longer, extending the effective duration just when the lender would prefer shorter duration.

This "worst of both worlds" behavior for the lender means the price appreciation a mortgage investor earns when rates fall is less than a comparable straight bond, while the price decline when rates rise is similar. The chart below illustrates the concept:

Price
  |        Standard bond (positive convexity)
  |       /
  |      /
  |     /  Mortgage (negative convexity)
  |    / /
  |   //
  |  /
  | /
  +--------------------------> Yield (falls to the right)

Banks and thrift institutions holding large portfolios of fixed-rate mortgages are significantly exposed to this risk. The failure of many savings and loan (S&L) institutions in the 1980s was largely due to this mismatch: they had funded long-duration fixed-rate mortgages with short-term deposits during a period of sharply rising rates.

Default risk is the risk that a borrower stops making mortgage payments. If the borrower defaults, the lender initiates foreclosure and takes possession of the property. The lender's ultimate loss (the loss given default) depends on:

1. Equity at default: If the property value has fallen below the loan balance (the borrower is "underwater," i.e., LTV > 100%), the lender will not recover the full outstanding principal even after foreclosure.
2. Time in foreclosure: The process can take months to years depending on the state. During this time the lender receives no payments and the property may deteriorate.
3. Distressed sale price: Foreclosed properties typically sell at a discount to market value.

Key predictors of default risk:

• High LTV ratio (especially > 100%)
• Low FICO credit score
• High DTI ratio
• ARM loans resetting to higher payments
• Weak local labor market conditions

The 2007-2008 financial crisis was triggered by widespread defaults on subprime mortgages—loans made to borrowers with poor credit, high LTV ratios, limited documentation, and often teaser-rate ARMs scheduled to reset sharply upward. When U.S. home prices declined nationally for the first time since the Great Depression, millions of borrowers found themselves with negative equity and defaulted, causing losses that rippled through the entire global financial system.

Prepayment risk is the risk that the borrower repays principal earlier than the scheduled amortization requires. Common causes include:

• Refinancing: The most important driver. When market rates fall significantly below the borrower's note rate (typically by 1.5–2 percentage points), refinancing becomes financially attractive. This creates a strong negative relationship between interest rates and prepayment speeds.
• Home sale: Most mortgages contain a due-on-sale clause requiring full repayment when the property is sold.
• Curtailments: Voluntary extra principal payments above the scheduled amount.
• Default and foreclosure: Results in full or partial principal recovery ahead of schedule.

Consider a pool of 1,000 mortgages, each with:

• Principal balance: $300,000
• Interest rate: 7%
• Term: 30 years

The total pool balance is $300 million. An MBS is issued where investors purchase certificates representing a pro-rata share of all cash flows from the 1,000 underlying mortgages. If you own 1% of the MBS, you receive 1% of every principal and interest dollar paid by the borrowers.

Borrowers ──────────────────────────────────────────────► MBS Investors
 (monthly P+I payments)   [Mortgage Servicer collects,     (pass-through P+I,
                            remits net of fees]              net of fees)

The pass-through rate (the rate paid to MBS investors) is slightly below the mortgage coupon rate:

Say we have a MBS with an expected overall 10% default rate. Roughly, for every $10 in principal invested in the security, you expect to lost $1 due to default. This default rate is fairly high.

However, what if we split this MBS into tranches. The first tranche (tranche A) receives all principal payments until they are repaid their full principal. Let's say each tranche is 20% of the CMO. Then for A to not receive its principal in full, more than 80% of the mortgages underlying the CMO must default. So A is very safe.

Once tranche A is paid, all principal payments will flow to tranche B. Once B is paid payments flow to tranche C, D, and finally Z (the last tranche is known as the Z-tranche). In terms of default risk, tranche B is also very safe, C a bit more risky, down to tranche Z which is very risky. In fact, we expect 50% of Z-tranche to default.

Taking a step back, what the CMO has allowed us to do is take a pool of mortgages with moderate risk, and transform this into a set of securities, some of which are very safe, and some very risky. We do this because investors have different risk preferences—some may want very safe securities and some may want risky (high return) securities. Thus, we can target investor preferences.

CMOs can also be stripped into interest-only (IO) or principal-only (PO) securities. IO securities only receive interest payments, and POs only principal. Remember standard fixed-rate mortgage payments are part interest and part principal.

IO/PO CMOs are an important tool for banks to manage prepayment risk. Let's say you are exposed to prepayment risk, which means if interest rates decline you will receive the funds you lent back in a lower interest rate environment. So you want to buy a security that increases in value if prepayments increase. You can then buy a PO security—if prepayments increase the PO receives its money earlier which increases its value.