“Mortgage markets in the Western World”
Part I: General description of mortgage markets (about 400 words)
a. Tell something about “The Two Golden Rules” of providing mortgage loans
(see lecture sheets)
b. Tell something about the methods to overcome the down-payment barrier.
c. Tell something about specific mortgage products such as endowment,
investment and interest only mortgages. (But not too much.)
d. Funding mechanisms (Deposits, Covered Bonds or Mortgage Backed
e. Is there a relation between house price cycles and mortgage finance?
Mortgage loan is a kind of loan
that is secured by contract associated with a certain property. When a borrower
is unble to pay the loan, lender can minimize loss by repossess the property.
There are two Gold Rules regarding to loan approval. First, the maximum payment
to mortgage should be around 33% of net income. But the percentage is just a
rough number. Normally, people with lower income level will pay lower than 33%
of their net income since they need sufficient budget for daily consumption.
Higher income people typically have higher paying percentage. Second, the maximum of
loan-to-value is 80%. Banks will lend out at most 80% of house value to lower
their risks. It’s unlikely (but possible) that the value of a house will drop
20%. By limiting the LTV to 80%, banks will not suffer as bad as borrowers when
the market is bleak.
There are many ways to overcome
the down payment hurdle. First, borrowers can seek for third party guarantees
on the mortgage payment. They can find support from parents and relatives. In
some countries, government will provde guarantees for qualified borrowers,
though small amount of down-payment is still required. Second, borrowing with
more than 80% LTV but also with much higher interest rates. To compensate the
higher risk of lending more money, banks demand higher interest rates on loans.
Third, borrowers can get a piggy back loan, which is also known as a second and
junior loan, with a higher interest rate. Fourth, borrowers can purchase
private insurance to cover payment risk during bleak market situations.
With an endowment mortgage, borrowers do not need to repay the capital
during the borrowing term. Instead, they will save money on with a certain
scheme to repay the loan at a pre-negotiated time. The biggest difference is
that borrowers will pay a lump-sum amount instead of monthly or annually
payment. Typically, insurance will be needed to guarantee the repayment. With
an investment mortgage, borrowers will invest capital in an investment fund,
which is similarly to endowment mortgage. However, the associated risk is much
higher than other types of mortgages since the equity markets are much riskier
than other markets. Therefore, repayment is not guaranteed. With an
interest-only loan, borrowers only need to make interest payment over the
principal every month or year. However, one need to repay the principal before
There are multiple funding sources
for mortgage loans. First, when people deposit money in their bank accounts,
commercial banks are able to lend out money in the form of loans. Second,
governments will set state housing banks or funds that lend money out to home
borrowers. Third, investors can negotiate covered bond contracts with banks to
invest in mortgage portfolio. Investors will give money to banks and banks will
lend out the money. Fourth, banks can raise money from some other markets and
lend out the money. Then a bank can sell the mortgage portfolio to a SPV. A SPV
will securitize the mortgage portfolio and sell the securities. Banks can raise
new funds through the sales of securitized mortgage portfolio.
There is a relationship between house price cycle and mortgage finance. As
we mention before, there are two golden rules. One is 33% net income to payment
and another is maximum 80% LTV. However, during the increasing housing pricing
situation, the bank will increase the upper limit of LTV. When house price
decrease, the upper limit of LTV also decreases. Similarly, the 33% net income
rule is often violated during housing boom or doom period.