FIN 433 — Chapter 9
Exam Study Guide: Questions & Answers
Mortgage Markets, Types, Risks, Securitization, and MBS
MORTGAGE BASICS
Q1 | Concept
What is a mortgage and what makes it a secured form of debt?
A mortgage is a form of debt created to finance investment in real estate. It is secured because
the property itself serves as collateral — if the borrower defaults, the lender can seize and sell the
property to recover the loan.
Example
You borrow $200,000 to buy a house. The bank holds a lien on the house. If you stop making payments,
the bank can foreclose and sell the house to recover what you owe.
Q2 | Insured vs conventional
What is the difference between insured and conventional mortgages?
Insured mortgages: federal insurance (e.g., FHA) guarantees repayment to the lender in the event
of borrower default, reducing credit risk. However, there are limits on loan amounts and borrower
requirements. Conventional mortgages: no federal insurance; lender bears the full credit risk.
Example
An FHA-insured mortgage allows a borrower with a lower credit score or small down payment to qualify.
If they default, the government repays the lender. A conventional mortgage requires stronger
creditworthiness.
MORTGAGE TYPES
Q3 | Fixed rate — lender
What is a fixed-rate mortgage and what interest rate risk does it create for the lender?
A fixed-rate mortgage has a constant interest rate for the life of the loan. The risk for the lender: if
market interest rates rise, the lender's cost of funds increases but they receive no matching
increase in return from the fixed-rate borrower, compressing profit margins.
Example
A bank lends at 6% fixed for 30 years. Three years later, market rates rise to 9%. The bank now pays
8% to attract deposits but still earns only 6% on that mortgage — losing money on every dollar lent.
Q4 | Fixed rate — borrower
What is the risk of a fixed-rate mortgage from the borrower's perspective?
Borrowers lock in their cost, which is good if rates rise. But if market rates fall, the borrower is
stuck paying a higher rate unless they refinance. The benefit of refinancing must outweigh the
transaction costs (fees, closing costs).
Example
You have a 7% fixed mortgage. Rates drop to 4%. Refinancing costs $5,000. You calculate monthly
savings to find the break-even point — only worth it if you stay in the home long enough.
Q5 | ARM
What is an adjustable-rate mortgage (ARM) and how does it shift risk between lender and
borrower?
An ARM has an interest rate that changes based on market conditions, with upper and lower caps
on yearly and lifetime rate changes. Lender benefit: yields move with cost of funds, stabilizing
profits. Borrower risk: monthly payments become uncertain. ARMs generally offer lower initial
rates than fixed-rate mortgages.
Example
A 5/1 ARM at 4%: fixed for 5 years, then adjusts annually. If rates rise to 7% after year 5, your payment
jumps. But you saved money in the first 5 years vs. a 6% fixed-rate mortgage.
Q6 | Balloon vs amortizing
What is the difference between a balloon payment mortgage and an amortizing mortgage?
Balloon mortgage: only interest is paid during the term (3-5 years); the entire principal comes due
at maturity in one large payment, forcing refinancing. Amortizing mortgage: monthly payments
include both interest AND principal. In early years most of the payment is interest; over time the
principal share grows.
Example
Balloon: Pay $800/month (interest only) for 5 years, then owe the full $150,000 at once. Amortizing:
Month 1 payment of $1,000 = $900 interest + $100 principal. By year 25, the split reverses.
Q7 | GPM
What is a graduated-payment mortgage (GPM) and who is it designed for?
A GPM starts with small initial payments that increase over 5-10 years, then level off permanently.
Designed for borrowers whose income is expected to grow over time — they can afford low initial
payments and can handle higher payments later.
Example
A new medical school graduate takes a GPM. Payments start at $800/month for 5 years, rising to
$1,400/month over the next 5 years, then staying flat — matching their income trajectory from resident to
attending physician.
Q8 | GEM
How does a growing-equity mortgage (GEM) differ from a GPM?
Both start with low initial payments. Key difference: in a GPM, payments increase then level off. In
a GEM, payments never level off — they keep increasing throughout the loan's life, paying off the
mortgage much faster and saving significant interest.
Example
A GEM borrower starts at $900/month and increases payments continuously every year. They might pay
off a 30-year mortgage in 15-18 years.
Q9 | Second mortgage
What is a second mortgage and why does it carry a higher interest rate?
A second mortgage is an additional loan against a property that already has a first mortgage.
Higher interest rate reflects higher risk: if the borrower defaults, the first mortgage is paid first from
property sale proceeds. The second mortgage lender gets whatever remains — possibly nothing.
Sellers sometimes offer second mortgages to make homes more affordable.
Example
Home sells for $300,000. First mortgage: $240,000 at 6%. Seller offers second mortgage of $30,000 at
9%. If the buyer defaults and the house sells for $250,000 at foreclosure, the first lender gets $240,000,
the second lender gets $10,000 (a $20,000 loss).
Q10 | Shared-appreciation
What is a shared-appreciation mortgage and what does the borrower give up?
A shared-appreciation mortgage offers a below-market interest rate. In exchange, the lender
receives a share of the property's price appreciation when the home is eventually sold. The
borrower gets lower monthly payments; the lender gets future upside in the property value.
Example
You get a mortgage at 4% instead of 6%. When you sell in 10 years, the lender gets 30% of the price
gain. If the home appreciates from $200,000 to $350,000, the lender gets 30% of $150,000 = $45,000.
SECONDARY MARKET & SECURITIZATION
Q11 | Secondary market
What role does the secondary market play in mortgage markets, and what does 'unbundling'
mean?
The secondary market allows mortgages to be bought and sold after origination, providing liquidity
to lenders. Origination (creating the loan) and funding (holding the loan) are separate activities
that can be 'unbundled' — a bank can originate a mortgage and immediately sell it, separating the
two functions.
Example
A local bank originates a $200,000 mortgage, collects its origination fee, then sells the mortgage to
Fannie Mae. The bank gets cash to make new loans; Fannie Mae holds the mortgage and collects future
payments.
Q12 | Securitization
What is securitization and why is it useful?
Securitization is the process of pooling multiple mortgages and repackaging them as securities
sold to investors. It allows resale of loans not easily sold individually. A group of mortgages held
by a trustee serves as collateral for the securities issued.
Example
A bank pools 1,000 mortgages worth $200M. It creates securities backed by this pool and sells them to
pension funds. The bank gets $200M immediately; investors receive monthly payments from the
mortgage pool.
Q13 | Institutions
What are the key institutional players in the mortgage market and what role does each play?
Finance and mortgage companies: originate loans and quickly sell them — do not maintain large
portfolios. Government agencies (Fannie Mae, Ginnie Mae, Freddie Mac): buy mortgages on the
secondary market, providing liquidity. Other financial institutions: act as mortgage investors and/or
offer instruments to hedge interest rate risk.
Example
A mortgage broker originates your loan, sells it to Fannie Mae within days. Fannie Mae pools it with
thousands of others, issues mortgage-backed securities, and sells them to a pension fund that receives
your monthly payments.
VALUATION & RISK
Q14 | Valuation
How is the market price of a mortgage determined, and what factors set the required rate of
return?
The market price of a mortgage is the present value (PV) of its future cash flows. The required
rate of return is determined by: (1) the risk-free rate; (2) credit risk premium (risk of default); (3)
liquidity premium (how easily the mortgage can be sold).
Example
A mortgage paying $1,000/month for 20 years. If the required return is 6%, its PV is higher than if the
required return is 8%. Rising market rates increase the discount rate and decrease the mortgage's
market price.
Q15 | Interest rate risk
What is interest rate risk in the context of mortgages?
The value of a mortgage decreases as market interest rates rise. The mortgage's fixed cash flows
are discounted at a higher rate, reducing their present value. Lenders holding fixed-rate
mortgages are most exposed — their asset loses value while their cost of funds rises.
Example
A bank holds a $100,000 fixed-rate mortgage at 5%. Market rates rise to 8%. The market value of that
mortgage drops below $100,000 — nobody pays face value for a 5% mortgage when new mortgages
pay 8%.
Q16 | Prepayment risk
What is prepayment risk and why is it a problem for mortgage investors?
When market interest rates drop, borrowers refinance by paying off higher-rate mortgages early.
The investor receives their principal back but must reinvest it at the new, lower interest rates —
earning less. They lose the high-rate income stream they were counting on.
Example
You invested in a pool of 8% mortgages. Rates drop to 4%. Borrowers rush to refinance and pay you
back early. Now you have cash but can only reinvest at 4% — half your original return.
Q17 | Credit risk
What is credit risk in mortgage markets and what factors affect default probability?
Credit risk is the risk of borrower default or late payments. Key factors: (1) level of borrower equity
— more equity means less incentive to default; (2) borrower income level and volatility; (3)
borrower credit history. Subprime mortgages are loans to borrowers with poor credit history,
carrying higher credit risk.
Example
A borrower with 20% down, stable income, and excellent credit = low credit risk. A subprime borrower
with 3% down, variable income, and past defaults = high credit risk. The 2008 financial crisis was
triggered largely by mass defaults on subprime mortgages.
Q18 | Limiting risk
What strategies do lenders use to limit interest rate risk, prepayment risk, and credit risk?
To limit interest rate and prepayment risk: (1) sell the mortgage shortly after origination — transfer
risk to buyer; (2) originate or invest in ARMs — rate adjusts with market. To limit credit risk: (1)
require mortgage insurance; (2) only maintain mortgages originated by itself (better borrower
knowledge).
Example
A bank originates a fixed-rate mortgage and sells it to Fannie Mae within 30 days — earns origination
fees with no interest rate risk. Alternatively, it offers ARMs that reprice annually, keeping yield aligned
with cost of funds.
MORTGAGE-BACKED SECURITIES
Q19 | MBS
What are mortgage-backed securities (MBS) and how do they differ from outright loan sales?
MBS are created through securitization — an alternative to outright loan sales. A group of
mortgages held by a trustee serves as collateral for securities sold to investors. The securitizing
institution avoids interest rate risk and credit risk while still earning service fees. However,
prepayment risk is NOT eliminated — it is passed on to MBS investors.
Example
A bank pools 500 mortgages, creates MBS, and sells them. The bank collects a 0.5% annual servicing
fee for managing payments — steady income with no credit or interest rate risk. But if rates drop and
borrowers prepay, MBS investors receive principal back early and must reinvest at lower rates.