Business Glossary

debt secured by a real asset. There are two types of mortgage bonds: senior mortgages, which have first claim on assets and earnings and junior mortgages, which have a subordinate lien. A mortgage bond may have a closed-end provision that prevents the firm from issuing additional bonds of the same priority against the same property or may be an open-end mortgage that allows the issuance of additional bonds having equal status with the original issue.

Real estate finance: mortgage that allows the issuance of additional bonds having equal status with the original issue, but that protects the original bondholders with specific restrictions governing subsequent borrowing under the original mortgage. For example, the terms of the original indenture might permit additional mortgage-bond financing up to 75% of the value of the property acquired, but only if total fixed charges on all debt, including the proposed new bonds, have been earned a stated number of times over the previous 5 years. The open-end mortgage is a more practical and acceptable (to the mortgage holder) version of the open mortgage, which allows a corporation to issue unlimited amounts of bonds under the original first mortgage, with no protection to the original bondholders. An even more conservative version is the limited open-end mortgage, which usually contains the same restrictions as the open-end, but places a limit on the amount of first mortgage bonds that can be issued, and typically provides that proceeds from new bond issues be used to retire outstanding bonds with the same or prior security.
Trust banking: corporate trust indenture that permits the trustee to authenticate and deliver bonds from time to time in addition to the original issue. See also authentication.

mortgage agreement between a financial institution and a real estate buyer stipulating predetermined adjustments of the interest rate at specified intervals. Mortgage payments are tied to some index outside the control of the bank or savings and loan institution, such as the interest rates on U.S. Treasury bills or the average national mortgage rate. Adjustments are made regularly, usually at intervals of one, three, or five years. In return for taking some of the risk of a rise in interest rates, borrowers get lower rates at the beginning of the ARM than they would if they took out a fixed rate mortgage covering the same term. A homeowner who is worried about sharply rising interest rates should probably choose a fixed rate mortgage, whereas one who thinks rates will rise modestly, stay stable, or fall should choose an adjustable rate mortgage. Critics of ARMs charge that these mortgages entice young homeowners to undertake potentially onerous commitments.

Also called a Variable Rate Mortgage (VRM), the ARM should not be confused with the Graduated-Payment Mortgage, which is issued at a fixed rate with monthly payments designed to increase as the borrower's income grows.

bond issue that covers several units of property and may refinance separate mortgages on these properties. The consolidated mortgage with a single coupon rate is a traditional form of financing for railroads because it is economical to combine many properties in one agreement.

mortgage-bond issue with an indenture that prohibits repayment before maturity and the repledging of the same collateral without the permission of the bondholders; also called closed mortgage. It is distinguished from an open-end mortgage, which is reduced by amortization and can be increased to its original amount and secured by the original mortgage.

fixed-rate mortgage with loan payments every two weeks, rather than monthly as with most residential mortgages. The loan payment is one-half that of a regular 30-year mortgage, but the accelerated repayment allows the borrower to pay off the mortgage much faster than the mortgage with monthly amortization. The borrower makes 26 half-payments a year or one extra full-month payment. The result is accelerated buildup of equity and lower interest expense over the loan term. A biweekly 30-year mortgage, if held to maturity, is retired in approximately 20 years, yielding a savings of more than $142,000 in interest for every $100,000 borrowed.

residential mortgage loan, usually from a bank or savings and loan association, with a fixed rate and term. It is repayable in fixed monthly payments over a period usually 30 years or less, secured by real property, and not insured by the Federal Housing Administration or guaranteed by the Veterans Administration.

any mortgage other than a fixed-interest-rate, level-payment amortizing loan.

fixed rate mortgage with low payments in the early years, and higher payments later on, designed to meet the financing needs of young home owners with growing incomes. Also known in the trade as a "Jeep" mortgage. The most popular versions of the GPM are 30-year mortgages with payments that rise by a fixed amount each year for the first five to ten years and then level off. Lenders usually charge a slightly higher rate on a GPM than a conventional mortgage, because part of the interest due is deferred until the later years. Even though borrowers ultimately pay more for a GPM, the lower initial payments make this kind of mortgage more affordable to home buyers whose incomes could not support a conventional mortgage loan. A variation is the adjustable rate graduated payment mortgage, which has an interest rate that is adjusted every three to five years.

residential mortgage in which the interest rate floats up or down according to changes in an index rate. Adjustable-rate mortgages usually have lower initial interest rates than fixed-rate mortgages, so there is an opportunity for substantial interest savings over the life of the loan if rates remain steady or decline. Adjustable-rate mortgages first appeared in the 1960s but did not gain wide popularity until the 1980s, when lenders began promoting ARM loans as a low-cost alternative to thirty-year, fixed-rate mortgage loans. ARMs are structured with built-in limits, called interest-rate caps, to cushion the impact of interest-rate fluctuations on loan payments in any year or over the life of the loan. An adjustablerate mortgage with an initial rate of 41/2%, an annual cap of 1%, and a lifetime cap of 4% will have an interest rate no higher than 91/2%. ARM rates are usually adjusted every six months or once a year, depending on the type of loan. Loan payment caps do not limit the amount of interest the lender is earning, which means an ATM loan may cause negative amortization if the accrued loan interest exceeds the interest actually paid.

When computing the loan interest rate, the lender adds a margin to an index rate selected as the benchmark, or base rate. The most common indexes are the Constant Maturity Treasury (CMT) index of Treasury issues with the same final maturity; the Treasury Bill index,based on the current auction yield of 3-month, 6-month or 1-year Treasury bills; the 12-month Moving Treasury Average, computed from the Treasury CMT index for the previous 12 months; the 11th District Cost of Funds Index, the weighted average cost of savings accounts, Federal Home Loan Bank advances, and other sources of funds paid by savings institutions in the 11th Federal Home Loan Bank district; the London Interbank Offered Rate (LIBOR), the rate major London banks charge each other for borrowings; the certificate of deposit (CD) index, the average rate earned by nationally traded certificates of deposit; and the bank prime rate, the rate banks charge their prime business borrowers. The most popular are the Treasury indexes, the 11th District Cost of Funds Index, and the LIBOR index. A popular variation of the adjustable-rate mortgage is the HYBRID ARM, in which the loan has a fixed interest rate for 3 to 10 years and thereafter adjusts according to market conditions.

mortgage that allows the borrower to transfer the outstanding balance of an existing mortgage loan at the same rate when selling one house and buying another. The borrower pays a premium over fixed rate mortgages of comparable maturity, in addition to title insurance and appraisal fees at the time the mortgage deed is transferred. An advantage to the borrower, however, is the absence of closing costs and discount points when buying a new home.

mortgage with a fixed interest rate and growing payments. This technique allows the homeowner to build equity in the underlying home faster than if they made the same mortgage payment for the life of the loan. Borrowers who take on GEM loans should be confident in their ability to make higher payments over time based on their prospects for rising income.

mortgage that does not fully repay principal and interest by the maturity date. A balloon mortgage, also known as a nonamortizing mortgage, has a lower debt repayment than a conventional fixed rate mortgage loan, and thus is attractive to new home buyers whose incomes may be expected to increase, or to people who expect to sell their property and pay off the loan in a much shorter period than if they had borrowed with a conventional, fully-amortized mortgage. The two types of balloon mortgages are the interest-only loan -a mortgage with payments that cover only the interest owed and the partially amortizing mortgage, also known as a rollover mortgage-a short-term mortgage that must be refinanced at the end of a stated term, usually three to five years.

mortgagebacked securities formed by dividing the cash flows from a pool of mortgages into obligations with payment characteristics substantially different from the underlying mortgages. Innovation in the mortgage market has led to numerous derivative mortgage instruments: the Collateralized Mortgage Obligation (CMO) consisting of a series of bonds with different maturity classes; the interest-only (io) strip, receiving only interest payments; theprincipal-only (PO) strip, a security receiving only loan principal payments; and mortgageresidual which are the excess cash flow after debt service payments. Derivative securities often are used as hedging devices to immunize a loan portfolio against interest rate risk.

derivative instrument whose coupon rate is inversely related to some multiple of a specified market rate of interest. Typically a cap and floor are placed on the coupon. As interest rates go down, the amount of interest the inverse floater pays goes up. For example, if the inverse floater rate is 32% and the multiple is four times the London Interbank Offered Rate (LIBOR) of 7%, the coupon is valued at 4%. If the LIBOR goes to 6%, the new coupon is 8%. Many inverse floaters are based on pieces of mortgage-backed securities such as Collateralized Mortgage Obligations which react inversely to movements in interest rates.

mortgage security consisting of the principal portion of stripped mortgage-backed securities. PO strips are created by separating the principal payments from the interest payments collected from a pool of mortgage pass-through securities. The principal payments are combined, regardless of whether principal is paid early or at final maturity.

PO strips are priced and traded at a discount from par value, like zero-coupon issues, rising to par at maturity. PO strips can have high yields if prepayments are accelerated (and interest rates decline), but can have returns much lower than expected if interest rates begin rising. At worst, the return to the investor may never reach the purchase price, resulting in a loss. POs are used mostly to hedge interest rate movements, for example, as a protection against prepayment risk, or the risk of portfolio losses from a sudden increase in mortgage prepayments by mortgagors.

mortgage in which the borrower receives a below-market rate of interest in return for agreeing to share part of the appreciation in the value of the underlying property with the lender in a specified number of years. If the borrower does not want to sell at that time, he or she must pay the lender its share of the appreciation in cash. If the borrower does not have that amount of cash on hand, the lender may force the borrower to sell the property to satisfy their claim.

lien giving a lender a security interest in personal property, as opposed to real estate (land, buildings) pledged as collateral for repayment of a loan. Chattels can be any kind of movable property, such as automobiles, jewelry, and so on. A chattel mortgage is normally used in financing big-ticket consumer goods, such as household appliances; the lien terminates when the obligation is paid.

arrangement whereby a homeowner borrows against home equity and receives regular payments (tax-free) from the lender until the accumulated principal and interest reach the credit limit of equity; at that time, the lender either gets repayment in a lump sum or takes the house. Reverse mortgages are available privately and through the Federal Housing Administration (FHA). They are appropriate for cash-poor but house-rich older borrowers who want to stay in their homes and expect to live long enough to amortize high up-front fees but not so long that the lender winds up with the house. Lower income but greater security is provided by a variation, the Reverse Annuity Mortgage (RAM).

financing arrangement in which monthly payments are less than the true amortized amounts and the loan balance increases over the term of the loan rather than decreases; the interest shortage is added to the unpaid principal. In some cases, the interest shortage is added back to the loan and payable at maturity. For example, amortized payments for the first six months of a 30-year mortgage loan would be based on a 13% rate, but interest would be charged against equity at 18%; this rate charge would fluctuate every six-month period. In some loans, the negative amounts may be made up by applying such deficits against the borrower's down payment equity. Federal law requires mortgage lenders to make sure that borrowers understand the potential impact of negative amortization in several interest rate scenarios through a series of extensive disclosure documents.

security backed by mortgages. Such certificates are issued by the Federal Home Loan Mortgage Corporation, and the Federal National Mortgage Association. Others are guaranteed by the government national mortgage association. Investors receive payments out of the interest and principal on the underlying mortgages. Sometimes banks issue certificates backed by conventional mortgage, selling them to large institutional investors. The growth of mortgage-backed certificates and the secondary mortgage market in which they are traded has helped keep mortgage money available for home financing.

bond collateralized by a pledge of mortgages and payable from the issuer's general funds. Because the market value of the collateral must exceed the outstanding bond principal, additional collateral may be required if the market value of the underlying mortgages declines. Unlike mortgage pass-through securities, which convey an ownership interest in a pool of mortgages, ownership of a mortgage-backed bond, and usually servicing rights, are retained by the issuer, although mortgage servicing can be sold, at a price, to a third party. Also, for tax purposes, mortgage-backed bonds are treated as issuer debt rather than as a sale of assets. Mortgagebacked bonds also have a more predictable maturity than pass-through securities, thus giving the bondholder a kind of call protection against early redemption.

long-term commercial mortgage that defers all payments of principal and interest until maturity. The loan is structured as an accrual note; interest due is rolled into the outstanding principal. At maturity, the borrower must either pay off the note or refinance at current interest rates. The lender arranging financing gets a discounted internal rate of return; the borrower can finance a commercial project with a smaller cash flow, on the expectation that appreciation of the property value over the life of the loan is sufficient to pay off the loan.

form of Graduated Payment Mortgage in which the rate of interest paid remains fixed, but the outstanding balance is adjusted for inflation according to an appropriate price index. Periodically, according to a time schedule approved by both borrower and lender, the outstanding balance owed is revised for appreciation in property values and monthly payments are revised accordingly.

mortgage in which the finance charge periodically is adjusted. A rollover rate mortgage is a short-term loan that must be renewed periodically, say every three to five years, and the interest rate adjusted to reflect market rates at renewal. The best known example is the Canadian Rollover mortgage, where the loan is renegotiated at a new rate every five years. This is the predominant type of residential mortgage in Canada. Also known as a renegotiable rate mortgage.

mutual fund that assesses shareholders for some of its promotion expenses. Adopted by the Securities and Exchange Commission in 1980, Rule 12b-1 provides mutual funds and their shareholders with an asset-based alternative method of covering sales and marketing expenses. At least half of the more than 10,000 mutual funds in existence today have a 12b-1 fee typically ranging from .25%, in the case of "no-load" funds that use it to cover advertising and marketing costs, to as high as 8.5%, the maximum "front-end load" allowed under National Association of Securities Dealers (NASD) rules, in cases where annual 12b-1 "spread loads" replaced traditional front-end loads. The predominant use of 12b-1 fees is in funds sold through brokers, insurance agents, and financial planners.

Changes to 12b-1 that became effective July 7, 1993, aim to limit fees paid by most fund investors to the 8.5% limit on front-end loads. This is achieved by an annual limit and by a rolling cap placed on new sales. The annual limit is .85% of assets, with an additional .25% permitted as a service fee. The rolling cap on the total of all sales charges is 6.25% of new sales, plus interest, for funds that charge the service fee, and 7.25%, plus interest, for funds that do not. The new regulation also prohibits funds with front-end, deferred, and/or 12b-1 fees in excess of .25% from being called "no-load."

investment grade securities backed by a pool of mortgages or trust deeds. Principal and interest payments on the underlying mortgages are used to pay semiannual interest and principal on the securities. Income from the principal and interest payments on the underlying mortgages are used to pay off the bonds.

Most mortgage-backed securities, such as Collateralized Mortgage Obligation and Real Estate Mortgage Income Conduit , consist of multiclass obligations that are divided into different classes of bonds to appeal to different investor needs. Because some mortgage pools will pay off faster than others, mortgaged-backed securities are typically issued as a series of several different bonds, each having a different maturity date.

mortgage-bond issue with an indenture that prohibits repayment before maturity and the repledging of the same collateral without the permission of the bondholders; also called closed mortgage. It is distinguished from an open-end mortgage, which is reduced by amortization and can be increased to its original amount and secured by the original mortgage.

residential mortgage in which the interest rate floats up or down according to changes in an index rate. Adjustable-rate mortgages usually have lower initial interest rates than fixed-rate mortgages, so there is an opportunity for substantial interest savings over the life of the loan if rates remain steady or decline. Adjustable-rate mortgages first appeared in the 1960s but did not gain wide popularity until the 1980s, when lenders began promoting ARM loans as a low-cost alternative to thirty-year, fixed-rate mortgage loans. ARMs are structured with built-in limits, called interest-rate caps, to cushion the impact of interest-rate fluctuations on loan payments in any year or over the life of the loan. An adjustablerate mortgage with an initial rate of 41/2%, an annual cap of 1%, and a lifetime cap of 4% will have an interest rate no higher than 91/2%. ARM rates are usually adjusted every six months or once a year, depending on the type of loan. Loan payment caps do not limit the amount of interest the lender is earning, which means an ATM loan may cause negative amortization if the accrued loan interest exceeds the interest actually paid.

When computing the loan interest rate, the lender adds a margin to an index rate selected as the benchmark, or base rate. The most common indexes are the Constant Maturity Treasury (CMT) index of Treasury issues with the same final maturity; the Treasury Bill index,based on the current auction yield of 3-month, 6-month or 1-year Treasury bills; the 12-month Moving Treasury Average, computed from the Treasury CMT index for the previous 12 months; the 11th District Cost of Funds Index, the weighted average cost of savings accounts, Federal Home Loan Bank advances, and other sources of funds paid by savings institutions in the 11th Federal Home Loan Bank district; the London Interbank Offered Rate (LIBOR), the rate major London banks charge each other for borrowings; the certificate of deposit (CD) index, the average rate earned by nationally traded certificates of deposit; and the bank prime rate, the rate banks charge their prime business borrowers. The most popular are the Treasury indexes, the 11th District Cost of Funds Index, and the LIBOR index. A popular variation of the adjustable-rate mortgage is the HYBRID ARM, in which the loan has a fixed interest rate for 3 to 10 years and thereafter adjusts according to market conditions.

debt secured by a real asset. There are two types of mortgage bonds: senior mortgages, which have first claim on assets and earnings and junior mortgages, which have a subordinate lien. A mortgage bond may have a closed-end provision that prevents the firm from issuing additional bonds of the same priority against the same property or may be an open-end mortgage that allows the issuance of additional bonds having equal status with the original issue.

Real estate finance: mortgage that allows the issuance of additional bonds having equal status with the original issue, but that protects the original bondholders with specific restrictions governing subsequent borrowing under the original mortgage. For example, the terms of the original indenture might permit additional mortgage-bond financing up to 75% of the value of the property acquired, but only if total fixed charges on all debt, including the proposed new bonds, have been earned a stated number of times over the previous 5 years. The open-end mortgage is a more practical and acceptable (to the mortgage holder) version of the open mortgage, which allows a corporation to issue unlimited amounts of bonds under the original first mortgage, with no protection to the original bondholders. An even more conservative version is the limited open-end mortgage, which usually contains the same restrictions as the open-end, but places a limit on the amount of first mortgage bonds that can be issued, and typically provides that proceeds from new bond issues be used to retire outstanding bonds with the same or prior security.
Trust banking: corporate trust indenture that permits the trustee to authenticate and deliver bonds from time to time in addition to the original issue. See also authentication.