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ARE144_chap_05_bf13ed_v2_KEY_UDPATED - 1 Managerial...

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1 Managerial Economics (ARE) 144 University of California, Davis Instructor: John H. Constantine UPDATED KEY —Handout: Chapter 5, Adjustable Rate and Variable Payment Mortgages PROBLEM 1 ANSWER IS UPDATED . PROBLEM 6 ANSWER IS CORRECTED . NOTES : (1) You should practice using your FINANCIAL CALCULATOR on many of these problems. (2) Many answers have Excel printouts. These are provided to show you how you can use Excel to solve these problems. BUT , you are expected to be able to solve all problems using the given formulas. Detailed answers are provided for many of the questions. In the cases where a full answer is not given, then you can look to a previous answer to get the process to solving. (1) In the previous chapter, significant problems regarding the ability of borrowers to meet mortgage payments and the evolution of fixed interest rate mortgages with various payment patterns were discussed. Why didn’t this evolution address problems faced by lenders? What have lenders done in recent years to overcome these problems? These inadequacies stem from the fact that although payment patterns can be altered to suit borrowers as expectations change, the CAM, CPM, and GPM are all originated in fixed interest rates and all have predetermined payment patterns. Neither the interest rate nor the payment patterns will change, regardless of economic conditions. A variety of mortgages are now made with either adjustable interest rates or with variable payment provisions that change with economic conditions. (2) How do inflationary expectations influence interest rates on mortgage loans? Most savings institutions had been making constant payment mortgage loans with relatively long maturities, and the yields on those mortgages did not keep pace with the cost of deposits. These problems prompted savings institutions (lenders) to change the mortgage instruments to now make more mortgages with adjustable interest rate features that will allow adjustments in both interest rates and payments so that the yields on mortgage assets will change in relation to the cost of deposits. (3) How does the price level adjusted mortgage (PLAM) address the problem of uncertainty in inflationary expectations? What are some of the practical limitations in implementing a PLAM program? One concept that has been discussed as a remedy to the imbalance problems for savings institutions is the price level adjusted mortgage (PLAM). To help reduce interest rate risk, or the uncertainty of inflation and its effect on interest rates, it has been suggested that lenders should originate mortgages at interest rates that reflect expectations of the real interest rate plus a risk premium for the likelihood of loss due to default on a given mortgage loan. Should prices of other goods, represented in the CPI increase faster than housing prices, indexing loan balances to the CPI could result in loan balances increasing faster than property values. If this occurred, borrowers would have an incentive to default.
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