Chapter 12:

The Mortgage Market

The mortgage market
Mortgage: A mortgage is a pledge of property to secure payment of a debt. Typically property refers to
real estate, which is often in the form of a house, the debt is the loan given to the buyer of the house by a
lender. Thus, a mortgage might be a pledge of a house to secure payment of a loan. If a homeowner fails
to pay the lender, the lender has the right to foreclose the loan and seize the property in order to ensure
that it is repaid.

Mortgage origination: The original lender is called the mortgage originator. The principal originators
of residential mortgage loans are thrifts, commercial banks and mortgage bankers. Mortgage originator
may generate income from origination fee, secondary market profit and servicing fee.
Risks associated with mortgage origination process:

(i) Price risk: It refers to the adverse effects on the value of the pipeline if mortgage rates
rise. If mortgage rates rise and the mortgage originator has made commitments at a lower
rate, it will either have to sell the mortgages when they close at a value below the funds
lent to homeowners, or retain the mortgages as a portfolio investment earning a below-
market mortgage rate.

(ii) Fallout risk: It is the risk that applicants or those who were issued commitments
letters will not close. It is the result of the mortgage originator giving the potential
borrower the right but not the obligation to close.
Types of mortgage designs:

1. Fixed-rate, level payment, fully amortized mortgage: the

borrower pays interest and repays principal in equal installments
over an agreed upon period of time, called the maturity or term of
the mortgage. Thus at the end of the term, the loan has been fully
amortized. This loan is involved with prepayment risk and
mismatch problem. Example, an individual has borrowed mortgage
loan Tk.200000 @ 12% interest for 5 years period. Calculated the
periodic loan repayment and prepare the schedule under annual
and quarterly loan repayment.

2. Adjustable rate mortgage: mortgage loan where the periodic

payment is changed for changing interest rate for changing market
interest rate and other factors is known as adjustable rate mortgage.
Types of mortgage designs:
3. Graduated payment mortgage: a graduated payment mortgage
is one whose nominal monthly payment grows at a constant rate
during a portion of the life of the contract, thereafter leveling off.
The mortgage rate is fixed for the life of the loan, despite the fact
that the monthly mortgage payment gradually increases. The terms
of this mortgage include (i) the mortgage rate (ii) the term of the
mortgage (iii) the number of years over which the monthly
mortgage payment will increase and (iv) the annual percentage
increase in the mortgage payments.

4. Price-level-adjusted mortgage: mortgage loan where interest rate

is adjusted for calculating periodic loan repayment for existing level
of periodic inflation is known as price level adjusted mortgage. In
this mortgage, the terms of the contract must be specified, namely
(i) the real interest rate (ii) the term of the loan.
Types of mortgage designs:
5. Dual-Rate Mortgage: Also referred to as the inflation proof mortgage, the
dual-rate mortgage (DRM) is similar in spirit and objective to the price level
adjusted mortgage (PLAM) where payments start low- at current mortgage rates of
around 10%, payments would start around 30% to 40% below those required by
the traditional mortgage or by the ARM. They then rise smoothly at the rate of
inflation, if any, achieving, like the PLAM, annual payments approximately level in
terms of purchasing power. Finally, by construction, the debt is fully amortized by
the end of the contract.
6. Prepayment Penalty Mortgages: The majority of the mortgages outstanding do
not penalize the borrower from prepaying any part of all of the outstanding
mortgage balance. However, in recent years mortgage originators have begun
originating prepayment penalty mortgages (PPMs).
7. Growing-Equity Mortgage: A variation of the GPM that does not have negative
amortization is the growing-equity mortgage (GEM), which has a fixed-rate
mortgage whose monthly mortgage payments increase over time. Rather, the
higher monthly mortgage payments serve to pay down the principal faster and
shorten the term of the mortgage.
Types of mortgage designs:
8. Reverse Mortgages: Reverse mortgages are designed for senior homeowners who
want to convert their home equity into cash. Fannie Mae, for instance, offers two
types of reverse mortgages for senior borrowers. The Home Keeper Mortgage is an
adjustable-rate conventional reverse mortgage for borrowers who are of at least 62
years of age, that either own the home outright, or have a very low amount of
unpaid principal balance.
9. High-LTV Loans: Traditionally for a conventional, conforming loan, borrowers
typically were required to make a down payment of 20% when qualifying for a
mortgage. However, today a mortgagor with good credit has the option of making
a lesser down or no down payment, resulting in loans with higher LTVs. Hence,
these mortgage loans are called high-LTV loans.
10. Subprime Loans: Borrowers who apply for subprime loans vary from those who
have or had credit problems due to difficulties in repayment of debt brought on by
an adverse event, such as job loss or medical emergencies, to those that continue
to mismanage their debt and finances. The distinguishing feature of a subprime
mortgage is that the potential universe of subprime mortgagors can be divided
into various risks ranging from A through D. The risk gradation is a function of
past credit history and the magnitude of credit blemishes existing in the history.
 Investment Risks:
1. Credit Risk: Credit risk is the risk that the homeowner/ borrower will default.
For FHA, VA, and FmHA insured mortgages, this risk is minimal. For privately
insured mortgages, the risk can be gauged by the credit rating of the private
insurance company that has insured the mortgage. For conventional
mortgages, the credit risk depends on the borrower. The LTV provides a useful
measure of the risk of loss of principal in case of default. When LTV is high,
default is more likely because the borrower has little equity in the property.

2. Liquidity Risk: Although there is a secondary market for mortgage loans, the
fact is that bid-ask spreads are large compared to other debt instruments. That
is, mortgage loans tend to be rather illiquid because they are large and
indivisible.
3. Price Risk: The price of a fixed-income instrument will move in an opposite direction from
market interest rates. Thus, a rise in interest rates will decrease the price of a mortgage
loan.

4. Prepayments and Cash Flow Uncertainty: Payments made in excess of the scheduled
principal repayments are called prepayments. Prepayments occur for one of the several
reasons. First, homeowners prepay the entire mortgage when they sell their house for any
number of reasons that require moving. Second, the borrower has the right to pay off all or
part of the mortgage balance at any time. Effectively, those who invest in mortgages grant
the borrower an option to prepay the mortgage, and the debtor will have an incentive to do
so as the interest rate in the mortgage market falls below the mortgage rate that the
borrower is paying. Third, if homeowners cannot meet their mortgage obligations, the
property is repossessed and sold, with the proceeds from the sale used to pay the lender in
the case of a conventional mortgage. For an insured mortgage, the insurer will pay off the
mortgage balance. Finally, if property is destroyed by fire, or another insured catastrophe
occurs, the insurance proceeds are used to pay off the mortgage.
Islamic mortgage
According to Islamic economic jurisprudence, Islamic Shari’ah
law prohibits the payment or receipt of interest, meaning that
Muslims cannot use conventional mortgages. However, real
estate is far too expensive for most people to buy outright using
cash: Islamic mortgages solve this problem by having the
property change hands twice. In one variation, the bank will
buy the house outright and then act as a landlord. The
homebuyer, in addition to paying rent, will pay a contribution
towards the purchase of the property. When the last payment is
made, the property changes hands. Typically, this may lead to a
higher final price for the buyers.
Islamic mortgage
The contract that is used for Islamic mortgage is the charitable contract Rahn.
Literally, rahn is an Arabic noun derived from the word rahana, which means
either constancy or continuity, or holding and binding. Technically, rahn,
which is also termed as pawning, mortgage, collateral, change, lien and
pledge, refers to taking a property as a security against a debt, whereby the
secured property can be utilised to repay the debt in the case of nonpayment.
Rahn is a charitable contract as it does not require any financial obligation in
the part of the creditor when the debtor gives him the pawned object. In this
case, rahn is similar to the other charitable contracts such as gist, simple loan
and deposit.
The legality of rahn is based on proof from the Quran, Sunnah and ijma. In
the Quran, Allah (s.w.t.) says,:
“If you are on a journey and cannot find a scribe, then use the receipt of pawn
objects” (Sura Baqara:Verse 283).
This verse clearly indicates the alternative means of documenting the debt in
the absence of the scribe, i.e. via pawning. Although it was revealed in the
context of travelling, sunnah of Prophet (p.b.u.h.) has proved its application
in all cases of financial transaction without any restriction.