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Chapter 7 Mortgage Markets True/False Questions 1. The largest category of mortgages by dollar volume is commercial mortgages. Answer: False Page: 194 Level: Easy 2. A shared appreciation mortgage is one where the borrower must prepay the mortgage in 15 years so that the lender may share in the appreciation by charging a higher interest rate. Answer: False Page: 206 Level: Easy 3. The process of mortgage securitization results in a separation between mortgage origination and mortgage financing. Answer: True Page: 215-216 Level: Easy 4. The secondary market for mortgages influences the accept/reject decision in originally granting a mortgage. Answer: True Page: 194 Level: Easy 5. Federally insured mortgages are called conventional mortgages. Answer: False Page: 196 Level: Easy 6. The duration of a balloon payment mortgage is less than the duration of a fully amortized 30 year fixed rate mortgage. Answer: True Page: 196-197 Level: Medium 7. A borrower using a conventional mortgage will have to put up at least a 20% down payment or purchase private mortgage insurance. Answer: True Page: 196 Level: Easy 8. Discount points are paid to reduce the down payment required. Answer: False Page: 198 Level: Easy

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9. In a growing equity mortgage the borrower pays the real rate of interest and the principle and equity grow with inflation. Answer: False Page: 205 Level: Easy 10. A common rule of thumb is to not refinance your mortgage unless interest rates decline by at least 2 1/2%. Answer: False Page: 199 Level: Easy

Multiple Choice Questions 11. Rank the following types of mortgages by amount outstanding from largest to smallest. I. Home mortgages II. Multifamily mortgages III. Farm mortgages IV. Commercial mortgages A) B) C) D) E)

I, II, III, IV I, II, IV, III II, I IV, III IV, II, III, I I, IV, II, III

Answer: E Page: 194 Level: Medium 12. The process of packaging and/or selling mortgages which are then used to back publicly traded debt securities is called A) Collateralization B) Securitization C) Market capitalization D) Stock diversification E) Mortgage globalization Answer: B Page: 193 Level: Easy

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13. A ___________ placed against mortgaged property ensures that the property cannot be sold (except by the lender) until the mortgage is paid off. A) Collateral B) Lien C) Habeas corpus D) Down payment E) Writ of certiorari Answer: B Page: 194 Level: Medium 14. If a borrower makes a 20% down payment on a conventional mortgage they will be required to obtain A) FHA insurance B) VA insurance C) Private mortgage insurance D) GNMA payment guarantees E) None of the above Answer: E Page: 194 Level: Easy 15. Mortgage payments are _____ on a 15 year fixed rate mortgage than on a 30 year fixed rate mortgage, and _____ is paid on a 15 year mortgage than on a 30 year mortgage, ceteris paribus A) Lower; less interest B) Lower; less principal C) Higher; less interest D) Higher; more principal E) Higher; more interest Answer: C Page: 203 Level: Medium 16. With a fixed rate mortgage the _____ bears the interest rate risk and with an ARM the ______ bears the interest rate risk. A) Borrower; lender B) Borrower; borrower C) Lender; lender D) Lender; borrower E) Federal government; pool organizer Answer: D Page: 197-198 Level: Medium

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17. The schedule showing how monthly mortgage payments are split into principle and interest is called a(an): A) Securitization schedule B) Balloon payment schedule C) Graduated payment schedule D) Amortization schedule E) Growing equity schedule Answer: D Page: 200 Level: Easy 18. You purchase a $200,000 house and you pay 20% down. You obtain a fixed rate mortgage where the annual interest rate is 7% and there are 360 monthly payments. What is the monthly payment? A) $1,330.61 B) $1,074.49 C) $1,064.48 D) $1,327.34 E) $933.33 Answer: C Page: 201-202 Level: Medium Rationale: 0.80*$200,000 = Pmt  PVIFA(0.07/12, 360 months] 19. You obtain a $275,000, 15 year fixed rate mortgage. The annual interest rate is 5.5%. In addition to the principle and interest paid you must pay $225 a month into an escrow account for insurance and taxes. What is the total monthly payment (to the nearest dollar)? A) $2,472 B) $1,561 C) $1,786 D) $2,143 E) $1,967 Answer: A Page: 201-202 Level: Medium Rationale: 275,000 = [Pmt  PVIFA(0.055/12, 180 months)] + 225

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20. You purchase a $300,000 town home and you pay 30% down. You obtain a 30 year fixed rate mortgage with an annual interest rate of 6%. After 5 years you refinance the mortgage for 25 years at a 5% annual interest rate. After you refinance what is the new monthly payment (to the nearest dollar)? A) $1,259 B) $1,142 C) $1,093 D) $1,632 E) $1,176 Answer: B Page: 201-202 Level: Difficult Rationale: 0.70*$300,000 = Pmt  PVIFA(0.06/12, 360 months); Balance after 5 years = 195,414; New Pmt = 195,414 / PVIFA(0.05/12,300) = 1,142.37 21. A borrower took out a 30 year fixed rate mortgage of $130,000 at an 8% annual rate. After five years, he wishes to pay off the remaining balance. Interest rates have by then fallen to 7%. How much must he pay to retire the mortgage (to the nearest dollar)? A) $134,963 B) $118,657 C) $72,766 D) $123,591 E) $114,042 Answer: D Page: 201-202 Level: Medium Rationale: $130,000 = Pmt  PVIFA(0.08/12, 360 months] ; Pmt = $953.89 ; PV = $953.89  PVIFA(0.08/12, 300 months] 22. A homebuyer bought a house for $286,000. The buyer paid 25% down but decided to finance closing costs of 3% of the mortgage amount. If the borrower took out a 30 year fixed rate mortgage at a 6% annual interest rate, how much interest will the borrower pay over the life of the mortgage? A) $255,927 B) $248,473 C) $195,491 D) $266,992 E) $235,453 Answer: A Page: 203 Level: Difficult Rationale: 0.75*286,000*1.03 = Pmt  PVIFA(0.06/12, 360 months] ; Pmt = 1,324.62; Total interest = (360 * 1,324.62) - (0.75*286,000*1.03)

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23. A homeowner could take out a 15 year mortgage at a 6.5% annual rate on a $125,000 mortgage amount, or she could finance the purchase with a 30 year mortgage at a 7.0% annual rate. How much total interest over the entire mortgage periods could she save by financing her home with the 15 year mortgage (to the nearest dollar)? A) $103,387 B) $140,625 C) $92,457 D) $113,786 E) $77,899 Answer: A Page: 203 Level: Difficult Rationale: 125,000 = Pmt  PVIFA(0.065/12, 180 months] ; Pmt of 1,088.88 x 180 = 195,999 ; 125,000 = Pmt  PVIFA(0.07/12, 360 months] ; Pmt of 831.63  360 = 299,386 ; 299,386 - 195,999 = 103,387 Use the following to answer questions 24-26: A homeowner can obtain a $150,000 thirty year fixed rate mortgage at a rate of 7.5% with zero points or at a rate of 7.0% with 2 points. 24. If you will keep the mortgage for 30 years, what is the net present value of paying the points (to the nearest dollar)? A) $18,313 B) $13,667 C) $7,646 D) $5,631 E) $4,646 Answer: E Page: 204 Level: Difficult Rationale: No Points: $1,048.82= $150,000 / PVIFA(0.075/12, 360 months] ; Pay Points: $997.95= $150,000 / PVIFA(0.07/12, 360 months] ; $1,048.82$997.95=$50.87 ; [$50.87 x PVIFA(0.07/12, 360 months)] - (0.02x150,000) = $4,646.15

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25. How long must the owner stay in the house to make it worthwhile to pay the points if the payment saving is invested monthly? A) 5.40 years B) 3.33 years C) 6.04 years D) 4.91 years E) More than 30 years Answer: C Page: 204 Level: Medium Rationale: $3,000 points cost = $50.87 payment savings  PVIFA(0.07/12, N) ; N = 72.49 months / 12 = 6.04 years 26. How long must the owner stay in the house to make it worthwhile to pay the points if the payment saving is not invested? A) 5.40 years B) 3.33 years C) 6.04 years D) 4.91 years E) More than 30 years Answer: D Page: 204 Level: Medium Rationale: $3,000 points cost / $50.87 payment savings = N = 59 months / 12 = 4.91 years 27. A _____ may be used by a borrower who wants to pay off a mortgage more quickly than a standard mortgage. A) Second mortgage B) GPM C) ARM D) Automatic Rate Reduction Mortgage E) GEM Answer: E Page: 205 Level: Medium 28. A _____ is used to purchase a more expensive home than for which the borrower could otherwise qualify. A) Second mortgage B) GPM C) ARM D) Automatic Rate Reduction Mortgage E) GEM Answer: B Page: 205 Level: Medium

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29. A _____ mortgage is primarily used when interest rates are high in order to allow borrowers to obtain mortgages who could not otherwise obtain mortgages to do so. A) SAM B) RAM C) GEM D) ARM E) Automatic Rate Reduction Mortgage Answer: A Page: 206 Level: Medium 30. A _____ is used to help retired people receive monthly income in exchange for the equity in their home. A) SAM B) Equity Participant Mortgage C) RAM D) PLAM E) GEM Answer: C Page: 206-207 Level: Medium 31. Which of the following statements about mortgage markets is/are true? I. Mortgage companies service more mortgages than they originate. II. Servicing fees typically range from 2% to 4%. III. Most mortgage sales are with recourse. IV. The government is involved in the residential mortgage markets. A) B) C) D) E)

I, III and IV only II, III and IV only I, II and IV only II and III only I and IV only

Answer: E Page: 206-208 Level: Medium

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32. Which of the following statements about GNMA is/are true? I. GNMA provides timing insurance. II. GNMA creates pools of mortgages and issues securities. III. GNMA insures only FHA, VA and FmHA loans. IV. GNMA requires that all mortgages in the pool have the same interest rate. A) B) C) D) E)

I, II , III and IV are true I, III and IV only I, II and III only II, III and IV only III and IV only

Answer: B Page: 209 Level: Medium 33. A $25,000 face value GNMA pass-through quote sheet lists a spread to average life of 103, PSA of 220, and a price of 101-09. This means that I. The pass-through yield is 103 basis points above the comparable maturity Treasury bond II. The pass-through is being prepaid more quickly than standard PSA III. The pass-through is priced at $25,272.50 A) B) C) D) E)

I, II and III are correct I and II only I and III only II and III only III only

Answer: B Page: 211 Level: Difficult 34. The advantage of a CMO to an investor over a pass-through is A) The CMO increases the predictability of the period over which cash flows will be received B) The CMO reduces credit risk C) The CMO is not taxable and the pass-through is taxable D) CMO rates of return are guaranteed E) All of the above Answer: A Page: 213-214 Level: Medium

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35. A MBB differs from a CMO or a pass-through in that The MBB does not result in the removal of mortgages from the balance sheet. A MBB holder has no prepayment risk. Cash flows on a MBB are not directly passed through from mortgages. A) B) C) D) E)

I, II and III I and II only II and III only I and III only I only

Answer: A Page: 214 Level: Difficult 36. One fixed rate mortgage pool has a 750 PSA and a second fixed rate pool has 150 PSA. The pool with the higher PSA ________________________ than the pool with the lower PSA. I. probably has a higher coupon II probably has lower default risk III will mature more quickly A) B) C) D) E)

I, II and III I and II only II and III only I and III only I only

Answer: D Page: 211 Level: Difficult 37. As compared to FRMs, ARMs result in which of the following for the lender? higher interest rate risk I. II lower default risk II. III longer mortgage maturity A) B) C) D) E)

I, II and III I and II only II and III only I and III only None of the above

Answer: E Page: 196-197 Level: Medium

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38. An equity participation mortgage is very similar to a A) GEM B) GPM C) SAM D) PLAM E) RAM Answer: C Page: 206 Level: Easy 39. Which one of the following types or mortgages are likely to become more popular as the average age of the U.S. population increases? A) GEM B) GPM C) SAM D) PLA E) RAM Answer: E Page: 206-207 Level: Easy 40. Which one of the following entities is a government agency dealing with mortgages? A) GNMA B) FNMA C) FHLMC D) PIP E) CMO Answer: A Page: 209 Level: Easy

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Short Answer Questions 41. Construct an amortization schedule for the first three months and the final three months of payments for a thirty year, 7% mortgage in the amount of $90,000. What percentage of the 3rd payment is principle? What percentage of the final payment is principle? What do these differences imply? (Hint: The balance after the 357th payment is $1,775.56) Answer:

12.46% of the 3rd payment is principle, 99.42% of the last payment is principle. In a long term amortized loan, the early payments are almost entirely interest, and the borrowers equity position grows only slowly at first, but over time more and more of the payment goes to principle. Page: 202-203 Level: Difficult 42. Why do mortgage lenders prefer ARMs while many borrowers prefer fixed rate mortgages, ceteris paribus. Answer: With an ARM the homeowner bears the interest rate risk (not totally, because the ARM is capped). From the lender's perspective, if deposit rates change, hopefully the ARM rate will change and the lender's net profit will remain about the same. If deposit rates rise, the homeowner's payments are also likely to rise, preserving at least some of the institution's profit margin. With a fixed rate mortgage the homeowner bears no out of pocket interest rate risk, but the lender's profit margin will normally fall if rates rise as their fund's cost will rise but mortgage income stays the same. Page: 196-197 Level: Easy

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Use the following to answer questions 43-44: A homeowner is looking to buy a home in Marvin Gardens. The most he can afford to pay in total is $1,500 per month. Yearly property taxes will probably be about $2,950 (escrowed monthly) and insurance is $65 per month. There are no other costs. 43. If mortgage rates are 6% for a 30 year fixed rate mortgage, how large can his mortgage be? Answer: Max monthly payment = $1,500 - $2,900/12 - $65 = $1,189.17 PV = $1,189.17 * PVIFA(6/12, 360) = $198,343 Page: 201-202 Level: Medium 44. If his parents give him $20,000 for a down payment, what is the most he can pay on a house with a 15 year mortgage if the interest rate is 5.25%? Answer: $1,500 - $2,900/12 - $65 = $1,189.17 PV = $1,189.17 * PVIFA(5.25/12, 180) = $147,929 + $20,000= $167,929 Page: 201-202 Level: Medium 45. What three major ways has the federal government assisted the mortgage markets? Explain. Answer: By providing insurance for homeowners. This assists resale and securitization of mortgages because secondary buyers don't have to engage in credit analysis of homeowners. By sponsoring or creating pools of mortgages for securitization. This provides a national source of funds to all regions of the economy. By directly providing mortgage credit. Page: 206-208 Level: Medium

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46. Why are FNMA and Freddie Mac sometimes considered quasi-government agencies or “government sponsored enterprises (GSEs)? Why have they both been in the news lately? Explain. Answer: FNMA and FHLMC (or Freddie Mac) have lines of credit with the Treasury and most investors believe the government will not allow these large organizations to fail even though both are technically private companies. Because of their low perceived risk, both agencies can borrow at favorable rates, making them more profitable than they would be otherwise and allowing them to grow more than they could otherwise. The agencies have been in the news for excessive interest rate risk caused by large derivatives positions, for overcharging lenders for services provided, for accounting irregularities designed to smooth earnings and/or generate bonuses for employees. Greenspan also stated that these institutions were a source of risk for the economy because of their tie to government and their extensive use of debt to finance growth. Page: 207-208, 219 Level: Medium 47. Who are the major buyers of mortgages after they have been originated? What is the difference between selling with recourse or without recourse? Which is most common? Answer: The five major buyers are: 1. Domestic banks 2. Foreign banks 3. Insurance companies 4. Pension funds 5. Closed end bank loan mutual funds 6. Nonfinancial corporations Selling with recourse means the buyer of the mortgage can require the mortgage seller to repay the mortgage if the homeowner defaults. A sale without recourse means the seller has no legal liability in the event the homeowner defaults. Most sales are without recourse. Page: 206, 208 Level: Medium 48. How does GNMA improve mortgage marketability? Answer: GNMA sponsor pools of FHA or VA insured mortgages and provides timing insurance to investors (ensures the timely receipt of promised cash flows in the event of homeowner default). GNMA allows private pool organizers to issue securities backed by the mortgage pool that bear GNMA's name. The GNMA name tells investors there is no credit risk and that the securities are actively traded. Page: 210 Level: Medium

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49. Explain each term of the following pass-through quote:

Answer: FMAC Gold 7.0%: A pass-through issued by Freddie Mac; maximum payment delay is 55 days. The coupon rate is 7%. 97-31 price on pass-throughs (paid monthly) is 97.9875% of par. 5.9 years average life of security based on prepayment patterns. PSA 150 means that the mortgage holders are prepaying at a rate 50% faster than the benchmark prepayment rate (PSA = 100) Page: 211 Level: Difficult 50. You bought your house 5 years ago and you believe you will be in the house only about 5 more years before it gets too small for your family. Your original home value when you bought it was $250,000, you paid 20% down and you financed closing costs equal to 3% of the mortgage amount. The mortgage was a 30 year fixed rate mortgage with a 6.5% annual interest rate. Rates on 30 year mortgages are now at 5% if you pay 2 points. Your refinancing costs will be 1.5% of the new mortgage amount (excluding points). You won't finance the points and closing costs this time. A new down payment is not required. Should you refinance? Show your work. Answer: Find the original payment and then find what you owe now: 0.80*250,000*1.03 = Pmt * PVIFA(6.5/12,360); Pmt = $1,302.06 Balance now = $1,302.06 * PVIFA(6.5/12,300); Balance now = $192,838.61 New payment if refinance $192,838.61 = Pmt * PVIFA(5/12,360); Pmt = $1,035.2 Pmt savings = $1,302.06 - $1,035.2 = $266.86 per month Refinancing costs = (2%+1.5%)*$192,838.61 = $6,749.35 Find Breakeven time: $6,749.35 = $266.86 * PVIFA(5/12, N); N = 26.78 months = 27 months / 12 = 2.25 years. You plan on being in the house for 5 more years, so it is worthwhile to refinance. Page: 204 Level: Difficult 51. Why were CMOs created? Answer: Some investors desired more protection from prepayment risk than offered by pass-throughs. The creation of different payment tranches in a CMO allows the investor to better tailor their prepayment risk exposure. Page: 213-214 Level: Medium

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