CHAPTER 10: THE MORTGAGE MARKET AND DERIVATIVES

PART I.

WHAT IS MORTGAGE?

 Mortgages are long-term loan secured by real estate. Both individuals and
businesses obtain mortgages loans to finance real estate purchases.

 The loan is amortized. The borrower pays it off over time in some combination of
principal and interest payments that result to full payment of the debt by maturity.

MORTGAGE MARKET

 It is where borrowers, businesses and governments can obtain long-term collaterized

loans.

PRIMARY MORTGAGE MARKET

 The primary mortgage market is where borrowers and lenders directly iteract
to make a new mortgage loan.

Ex.: Pag-IBIG Fund, Commercial Banks (BDO, Landbank, Security Bank), Rural
Banks

SECONDARY MORTGAGE MARKET

 The secondary mortgage market is where existing mortgage loans are bought
and sold between financial institutions and investors.

TYPES OF REAL ESTATE MORTGAGE

 RESIDENTIAL MORTGAGE

A residential mortgage is a loan used to buy a property meant for living purposes,
such as a house, apartment, or condominium.

 NON-RESIDENTIAL MORTGAGE

A non-residential mortgage (a.k.a., commercial mortgage) is a loan used to purchase

or develop properties tot meant for living.m,

CATEFGORIES (Investoperdia, 2025): Commercial, Industrial, Raw Land, and Special

Use
CHARACTERISTICS OF RESIDENTIAL MORTGAGE

A. MORTGAGE INTEREST RATES

Factors that affect interest rates:

1. CURRENT LONG-TERM MARKETS

 Long-term market rates are determined by the supply and demand for long-
term funds, which are in turn affected by a number of global, national, 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.

2. TERM OF 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 on the 15-year
loan will be substantially less than on the 30-year loan.

3. NUMBER OF DISCOUNT POINTS PERIOD PAID

 Discount points are upfront interest payments, equal to 1% of the loan
amount per point, paid at closing in exchange for a lower loan interest rate.
Borrowers should weigh the upfront cost against long-term savings and
consider how long they’ll keep the loan. Paying points is usually not
worthwhile if the loan will be repaid within five years, which aligns with the
average home sale timeline.

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
 A down payment is the portion of the property price a borrower pays upfront,
while the rest is covered by the loan. It reduces the risk of default and is usually 5%
to 20% of the purchase price.
E. PRIVATE MORTGAGE INSURANCE (PMI)
 PMI protects lenders by covering the difference between the loan balance and the
property’s value if the borrower defaults. It is usually required when the down
payment is less than 20%, costs about P200–P300 per month per P100,000 loan,
and can be removed once the loan-to-value ratio improves.
F. BORROWER QUALIFICATIONS
 Mortgage loan borrowers generally agree to pay a monthly amount of principal and
interest that will be fully amortized by its maturity. “Fully Amortized” means that
the payments will pay off the outstanding indebtedness by the time the loan
matures.

AMORTIZATION OF THE LOAN

Mortgage loan borrowers generally agree to pay a monthly amount of principal and interest
that will be fully amortized by its maturity. “Fully Amortized” means that the payments will
pay off the outstanding indebtedness by the time the loan matures.
TYPES OF MORTGAGE LOANS
A. CONVENTIONAL MORTGAGES
 Originated by banks but loan is not government guaranteed; usually requires
private mortgage insurance; 5% to 20% down payment.
B. INSURED MORTGAGES
 Mortgages are originated by banks or other mortgage lenders but are guaranteed
by either the government or government-controlled entities.
C. FIXED RATE MORTGAGES
 The interest rate and the monthly payment do not vary over the life of the mortgage.
D. ADJUSTABLE-RATE MORTGAGES (ARMs)
 Interest rate is tied to some other security and is adjusted periodically; size of
adjustment is subject to annual limits.
E. GRADUATED-PAYMENT MORTGAGES (GPMs)
 Initial low payment increases each year, loan usually amortizes in 30 years.
F. GROWING EQUITY MORTGAGES (GEMs)
 Initial payment increases each year, loan amortizes in less than 30 years.
G. SHARED APPRECIATION MORTGAGES (SAMs)
 In exchange for providing a low interest rate, the lender shares in any appreciation
in value of the real estate.
H. EQUITY PARTICIPATING MORTGAGES (EPMs)
 In exchange for paying a portion of the down payment or for supplementing the
monthly payments, an outside investor shares in any appreciation in value of the
real estate.
I. SECOND MORTGAGES
 Loan is secured by a second lien against the real estate; often used for line of credit
or home improvement loans
J. REVERSE ANNUITY MORTGAGES (RAMs)
 Lender disburses a monthly payment to the borrower on an increasing-balance
loan; loan comes due when the real estate is sold.
MORTGAGE LENDING INSTITUTION
The institutions that provide mortgage loans to familiar and business and their share in the
mortgage markets are as follows:
MORTAGAGE TOOLS AND TRUST 49%
COMMERCIALS BANKS 24%
GOVERNMENT AGENCIES AND OTHERS 15%
LIFE INSURANCE COMPANIES 9%
SAVINGS AND LOANS ASSOCIATES 9%

Source: Federal Revenue Bulletin, 2018

SECURIZATION OF MORTGAGES
Problems faced by several intermediaries when trying to sell mortgages to the secondary
market:
a. Mortgages are usually too small to be wholesale instruments
b. Mortgages are not standardized.
c. Mortgage loans are relatively costly to service.
d. Mortgages have unknown default risk.
The above problems inspired the creation of mortgage-backed security.

WHAT IS 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 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, a
security that has the borrower's mortgages pass through the trustee before being
disbursed to the investors in the mortgage-pass through. If borrowers pre-pay their
loans, investors receive more principal than expected.
 IMPACT OF SECURIZED MORTGAGE ON THE MORTGAGE MARKET
 Mortgage-backed securities (also called securitized mortgages) have been growing
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 ARE THE BENEFITS DERIVED FROM SECURITIZED MORTGAGE (SM)?

A. SM has reduced the problems and risks caused by regional lending institutions'
sensitivity to local economic fluctuations.
B. Borrowers now have access to a national capital market
C. Investors can enjoy the low-risk and long-term nature of investing in 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.
WHAT IS DERIVATIVE?
 are financial instruments that derive their value on contractually required cash flow
from some other security index.

CHARACTERISTICS OF DERIVATIVES
 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
 that requires no initial net investment or little net investment relative to the other
types of contracts that is similar response to changes in market condition; and
 that is settled at a future date Derivatives are commonly used by investor to spread
risk and/or to speculate.
DERIVATIVES FOR HEDGING
 Companies use derivatives to protect against cost fluctuation by fixing a price for a
future deal in advance. By settling cost in this way, buyers gain protection-known as
hedge-against unexpected rises or falls in.

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 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.

For example: An investor notices a company’s share price is going up and buys an
option the share. An option gives a right to the holder to buy shares at a future date.

TYPES OF DERIVATIVES
 Future Contract - an agreement between a seller or buyer that requires that seller to
deliver a particular commodity at a designated future date, at a predetermine price.
These contracts are actively treated on regulated future exchanges and are generally
referred to as “commodity future contracts”, when the “commodity” is financial
instrument, the agreement is referred to as “financial future contract”. Future
contracts are purchased either as an investment or as hedge against the risk of
future price changes.

 Forward Contracts - similar to future contracts but differs in three ways;

1. calls for delivery on a specific date

2. not traded on market exchange
3. does not call for daily cash settlement for price changes in the
underlying contract. Gains and losses on forward contracts are paid
only when they are closed out.

 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 - Foreign loans frequently are dominated in the currency
of the lender. When loans must be repaid in foreign currencies, a new element of
risk is introduced. This is because if exchange rates change, the peso equivalent of
the foreign currency that must be repaid differs from the peso equivalent of the
foreign currency borrowed.
 Interest Rate Swaps - there are contracts to exchange cash flows as of a specified
date or series of a specified dates based on a notional amount and fixed and floating
rates. These contracts exchanged fixed interest payments for floating rate payments,
or vice versa, without exchanging the underlying principal amounts.

 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.
What is the benefit of this derivative contract?

XYZ can buy ABC shares today and take delivery in three months. If the price
goes up, it expects XYZ profits. If the price goes down, XYZ loses.