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Residential mortgage loans and fund sources

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Title: Residential mortgage loans and fund sources


1
Residential mortgage loans and fund sources
  • Real Estate Principles A Value Approach
  • Ling and Archer

2
Outline
  • Legal foundations
  • Mortgage products
  • Mortgage markets primary
  • Mortgage markets secondary

3
Mortgage loan
  • In a mortgage loan, the borrower always conveys
    two documents to the lender (1) a note, and (2)
    a mortgage.
  • The note details the financial rights and
    obligations between borrower and lender, e.g.,
    whether a loan can be paid off early and at what
    cost, what fees can be charged for late payments,
    etc.
  • The mortgage pledges the property as security for
    the debt.

4
The note interest charges
  • Interest rates can be fixed or variable.
  • The monthly interest rate the annual stated
    (quoted) contract interest rate / 12.
  • The actual monthly interest charged the monthly
    interest rate the beginning-of-month balance.
  • Example suppose that the contract rate is 6.
    The balance on the first day of January is
    100,000.
  • The interest for January is (6 / 12) 100,000
    500.
  • The 500 interest is payable on the first day of
    February.

5
The note adjustable rates, I
  • This loan type is known as ARM (adjusted rate
    mortgage) in the residential loan markets.
  • The index rate is a market determined interest
    rate that is the moving part in the adjustable
    interest rate.
  • There is a markup in the adjustable rate, called
    margin. For standard ARM loans, the average
    margin is about 2.75.
  • Whenever there is a change in interest rate, home
    mortgage lenders usually need to notify borrowers
    at least 30 days in advance.

6
The note adjustable rates, II
  • Periodic cap the cap that limits change in the
    interest rate from one change date to the next.
  • Overall cap the cap that limits interest rate
    change over the life of the loan.
  • Teaser rate many ARM loans are marketed with a
    temporarily reduced interest rate.
  • Payment cap some lenders offer ARM loans with a
    cap on payments rather than on the interest rate.
    For example, the payment can be capped at
    increases of no more than 5 in a single year.
    However, the unpaid interest would usually added
    to the original balance, causing the loan balance
    to increase (i.e., negative amortization).

7
The note payments
  • Most standard, fixed loans are level payment and
    fully amortizing. That is, zero balance at the
    maturity.
  • Loans can be non-amortizing. That is, only
    periodic (monthly) interest payments are made.
    The principal payment is required at the
    maturity.
  • A loan can also be partially amortizing or
    negatively amortizing.

8
The mixture of the payments
9
The note term
  • Most loans have a definite term to maturity,
    usually stated in years.
  • Balloon loan a partially amortized loan. It has
    two terms (1) term for amortization determines
    the payment, and the schedule of interest and
    principal payments, just like a fully amortized
    loan, (2) term to maturity determines when the
    entire remaining balance on the loan must be paid
    in full. (2) is shorter.
  • Balloon loans are popular for income-generating
    property.

10
The note right of prepayment
  • Most standard home loans give the borrower the
    right to prepay any time, without penalty.
  • If the note says nothing about the right of
    prepayment, the determination of the right will
    depend on the law of the state.
  • Many subprime loans, those made to homeowners who
    do not qualify for standard loans, have costly
    prepayment penalties.
  • Commercial loans also often have repayment
    penalties that are more costly for the first few
    years of the loan.

11
The note late fees
  • They are usually accessed on payments received
    after the 15th of the month the payment is due.
  • Late fees are usually about 4-5 of the late
    monthly payment.

12
The note personal liability
  • For home loans, borrowers usually assume personal
    liability. That is, if they fail to meet the
    terms of the note, they are in the condition of
    default, and can be sued.
  • These loans are called recourse loans because the
    lenders have legal recourse.
  • For commercial loans, borrowers frequently do not
    assume personal liability. But the property is
    still used as collateral for the loan.

13
The mortgage
  • The mortgage is a special contract by which the
    borrower (mortgagor) conveys to the lender
    (mortgagee) a security interest in the mortgaged
    property.
  • In general, the mortgage gives the lender the
    right to rely on the property as security for the
    debt obligation defined in the note, but this
    right only can be exercised in the event of
    default on the note.

14
The mortgage clauses, I
  • The major clauses in a standard home loan
    mortgage
  • 1. Description of the property.
  • 2. Insurance clause requires the maintenance of
    property casualty insurance against fire,
    windstorm, etc.
  • 3. Escrow clause requires a borrower to make
    monthly deposits into an escrow account for
    property taxes, casualty insurance premiums, etc.

15
The mortgage clauses, II
  • 4. Acceleration clause enables the lender to
    declare the entire loan balance due and payable
    when the borrower defaults on the loan.
  • 5. Due-on-sale clause gives the lender the right
    to accelerate the loan, requiring the borrower to
    pay it off when the property is sold.
  • 6. Hazardous substances clause and preservation
    and maintenance clause the borrower is
    prohibited from using or storing hazardous
    substances on the property and is required to
    maintain the property in its original condition.

16
Default
  • Default failure to meet the requirements of the
    note (and by reference, the mortgage).
  • Technique defaults minor violations of the note
    that do not disrupt the payments on the loan.
  • Example hazard insurance no longer good.
  • These usually do not trigger legal actions.
  • Substantive defaults when payments are missed,
    typically for 90 days.

17
Possible responses to default
  • Lenders may help borrowers improve their
    household financial management, e.g., credit
    counseling, a temporary reduction of payments,
    facilitating the sale of the property.
  • Foreclosure a legal process of terminating all
    claims of ownership by the borrower, and all
    liens inferior to the foreclosing lien.

18
Foreclosure
  • The ultimate recourse of the lender.
  • Risk of failing to notify a claimant it is
    sometimes difficult to identify and notify all
    claimants to the property legal procedure need
    to be perfect.
  • Presence of superior liens (senior debts).
  • Costly and time consuming.
  • Distressed, sub-optimal sale because legal
    complexities and lower marketability often
    prevent buyers from debt financing.

19
Foreclosure for Whitney Houston
  • STATE OF GEORGIA COUNTY OF FULTON NOTICE OF SALE
    UNDER POWER Because of a default in the payment
    of the indebtedness secured by that certain
    Security Deed, dated April 28, 2003, executed by
    WHITNEY E. HOUSTON to MORTGAGE ELECTRONIC
    REGISTRATION SYSTEMS, INC., as nominee for
    WACHOVIA MORTGAGE CORPORATION, recorded in Deed
    Book 34852, Page 295, Fulton County, Georgia Deed
    Records, and securing a Note in the original
    principal amount of 1,100,000.00,
  • Source http//www.wsbtv.com

20
The waves of foreclosures
  • In some major markets, including Las Vegas and
    San Diego, foreclosure-related sales have
    accounted for more than 40 of all sales in
    recent months.
  • Waves of foreclosures cuts into home prices.
  • Source WSJ, Mar. 25, 2008.

21
2 methods of sale in foreclosure
  • Judicial foreclosure court-administered public
    auction.
  • This method is required in Vermont.
  • Power of sale public auction conducted by
    trustee or mortgagee (the lender)
  • This method is preferred by lenders.
  • Cheaper and faster.

22
Residential mortgage products
  • Conventional mortgage loans
  • (Fixed-rate) level-payment mortgages (LPMs)
  • Adjustable rate mortgage (ARMs)
  • Government-sponsored mortgage loans
  • FHA-insured loans
  • VA-guaranteed loans
  • Other mortgage products
  • Home equity loan
  • Interest-only mortgage
  • Option ARMs
  • And more

23
Conventional mortgage loans
  • Any standard home loan that is not insured or
    guaranteed by an agency of the U.S. government.
  • Conventional mortgages can be either fixed rate
    (LPMs level-payment mortgages) or adjustable
    rate (ARMs).
  • Conventional mortgage loans can be conforming or
    nonconforming. A conforming conventional loan is
    one that meets the standards (e.g., limit)
    required for purchase in the secondary market by
    Fannie Mae or Freddie Mac.
  • Nonconforming loans that exceed the dollar limit
    (417,000 in 2006 for continental U.S.) are
    called jumbo loans.

24
LPMs
  • Fixed monthly payments no surprises.
  • Over 75 of outstanding first mortgage home loans
    are LPMs.
  • 30-year LPMs are the predominant form of
    conventional loan.
  • LPMs usually require a higher monthly payment.

25
ARMs
  • Payments are not fixed.
  • ARMs tend to have a lower monthly payment but
    this may not always the case.

26
FHA-insured loans
  • The federal housing administration was
    established in 1934 to stabilize the housing
    industry.
  • FHA sells mortgage insurance to low-income
    households.
  • FHA mortgage insurance covers any lender loss
    after foreclosure and conveyance of title of the
    property to the U.S. Department of Housing and
    Urban Development (HUD).

27
VA-guaranteed loans
  • The Department of Veterans Affairs provides
    VA-guaranteed loans that help veterans obtain
    home mortgage loans with favorable terms.

28
Home equity loan
  • Some home equity loans are closed-end, fixed-term
    loans.
  • Mostly open-end or credit-line loans.
  • Tax deductible interest (in contrast, the
    interest expenses on credit card loans are not
    tax deductible).
  • Strength of the house as security provides
    favorable rate and longer term.
  • Usually limited to total mortgage debt (sum of
    all mortgage loans) of 75 to 80 of value.
  • Increasingly popular.

29
Interest-only (I-O) mortgage
  • I-O with balloon has interest-only payments for 5
    to 7 years, ending with a full repayment of
    principal.
  • I-O amortizing has interest-only payments for up
    to 15 years, then converts to a fully amortizing
    payment for the remainder of the term.
  • Is I-O amortizing a good product from a home
    buyers perspective?

30
Option ARMs
  • Typically, borrowers can select among 3 types of
    payments fully amortizing, interest-only, and a
    minimum payment.
  • Borrowers usually choose the minimum payment,
    which is initially based on a very low interest
    rate say, 1.5 .
  • Minimum payment increases 7.5 percent per year.
  • Interest rate charged is adjustable, and often is
    deeply reduced for the first few months.
  • Typically, with minimum payment, the loan balance
    grows due to negative amortization.
  • At the end of 5 years, or when the balance
    reaches 125 of the original loan, the payment
    is recast to fully amortize the loan over its
    remaining term.

31
Private mortgage insurance (PMI)
  • Protect lender against losses due to default.
  • Generally required for loans over 80 of value,
    i.e., loan-to-value (LTV) gt 80.
  • Protect lender for losses up to 20 of loan.
  • Premium can be paid in lump sum or in monthly
    installments. 2 possible terms
  • 2.5 of loan in single up-front premium.
  • 0.5 annual premium (0.041 per month).

32
PMI termination
  • Termination may be allowed if loan falls below
    80 of current value and borrower is in good
    standing.
  • Must allow termination when loan falls to 80 of
    original value (Homeowners Insurance Act of
    1999).
  • Obligation to terminate when loan falls to 78 of
    original value.

33
An overview of mortgage debt
34
Mortgage markets
  • Primary mortgage market the loan origination
    market.
  • For example, you go to a mortgage broker and get
    a mortgage loan from a mortgage lender.
  • Secondary mortgage market investors and mortgage
    originators buy and sell mortgage loan portfolios
    in the secondary mortgage market.
  • Fannie Mae and Freddie Mac are the largest buyer
    of residential mortgages in the secondary market.

35
Economic significance
  • When the mortgage finance system works well, we
    expect (1) increased finance availability, and
    (2) lower finance cost.
  • These lead to more RE activities, e.g.,
    increasing home ownership rate, and a stronger
    economy.
  • This is the reason why government-sponsored
    enterprises (GSEs), e.g., Fannie Mae and Freddie
    Mac, have been active in the mortgage finance
    system.

36
Primary market depository lenders
  • They are financial intermediaries.
  • Pool small amounts of savings.
  • Channel to large-scale uses (e.g. mortgage
    loans).
  • Types
  • Savings associations (SLs, savings banks).
  • Commercial banks.
  • Credit unions.

37
Non-depository lenders mortgage companies
  • Mortgage banker not a bank accepts no
    deposits.
  • Originates loans to sell.
  • Often retains right to service the loan for a
    fee.
  • Mortgage broker brings borrower and lender
    together for a fee never owns the loan.

38
Mortgage banker
  • Originates and owns loans long enough to sell the
    pooled loans (1st asset).
  • Either, Sell loans whole.
  • Or, pool and securitize loans.
  • Servicing (2nd asset) is core profit center.

39
Servicing
  • Collects monthly payments, remits to investor
    (loan buyer).
  • Collects and remits payments for property taxes,
    hazard insurance and mortgage insurance.
  • Manages late payments, defaults, foreclosures.
  • Receives fee of .25 to .44.

40
Creating 2 assets
41
Pipeline risk
  • Pipeline risk risk between loan commitment and
    loan sale. 2 types
  • Fallout risk risk that loan applicant backs out
    because the market interest rate falls during
    this window.
  • Interest rate/price risk risk that closed loans
    will fall in value before sold.
  • Mortgage bankers are highly leveraged and
    sensitive to pipeline risk.
  • Hedging is often needed (via purchasing a forward
    commitment, i.e., sale of loan at a preset price
    for future delivery, from GSEs or other issuers).

42
Secondary market players
  • Fannie Mae (1968) spun off from HUD to become a
    primary purchaser of FHA and VA mortgage loans.
  • Ginnie Mae (1968) empowered to guarantee
    pass-through mortgage-backed securities based
    on FHA and VA loans.
  • Freddie Mac (1970) formed to purchase and
    securitize conventional home loans from savings
    associations.

43
Mortgage-backed securities (MBSs)
  • Multiple mortgage loans in a single pool or fund.
  • Security entitles investor to pro rata share of
    all cash flows.
  • Loans in a given pool are similar
  • Conventional
  • Same vintage (new or recent loans)
  • Similar interest rates
  • Nearly two-thirds of all new home loans have been
    securitized in recent years.

44
Securitization process
45
The growth
46
The bust of Fannie and Freddie
  • In September 2008, the government seized their
    operations.
  • They recorded a combined 14 billion of losses
    in the 12 months ended June 30, largely because
    they lowered their credit standards and purchased
    or guaranteed dubious home loans.
  • These home loans are the so-called Alt-A loans,
    which go to borrowers with good credit records
    who do not fully document their income.
  • Source WSJ, Oct. 16, 2008.

47
Residential underwriting decisions
  • Underwriting process of determining whether the
    risks of a loan are acceptable.
  • 3 Cs of traditional residential underwriting
  • Collateral URAR appraisal.
  • Creditworthiness credit report and scoring.
  • Capacity ability to pay (payment ratios).

48
Capacity ratio, I
  • Housing expense ratio PITI / GMI.
  • PITI is principal, interest, (property) taxes and
    insurance.
  • GMI is gross monthly income.
  • Recent convention set maximum at 28 for
    conventional loans.

49
Capacity ratio, II
  • Total debt ratio (PITI LTO) GMI.
  • LTO is long-term obligation the sum of payments
    for other repeating obligations, e.g., car
    leasing payments and child support.
  • Recent convention set maximum at 36 for
    conventional loans.

50
Subprime lending
  • Many households are unable to qualify for
    affordable home loans.
  • Subprime targets three borrower deficiencies
  • Lack of income documentation.
  • Weak credit.
  • Seeking financing for 100 LTV or higher.
  • More expensive than standard home loans.
  • Polar views of subprime lending
  • Fills compelling, legitimate need (beats credit
    cards).
  • Hunting ground of predatory lenders.

51
Subprime crisis
  • Loans to homeowners with less-than-sterling
    credit are the fastest-growing segment of the
    mortgage marketSo-called subprime loans have
    helped boost US homeownership to a record 69 of
    households. In Massachusetts, subprime loans,
    fueled by refinancings, have grown from 1.6 of
    mortgages in 2000 to 12.3 todayAbout 3.5 of
    subprime mortgages and refinancing loans go into
    foreclosure, but a study by the UNC found that
    20 of refinancings in 1998 through 2000 that
    were examined wound up in foreclosure. For
    conventional loans, the rate is 1.1 of mortgages
    and refinancings
  • Source Boston Globe

52
The scope of high-risk mortgage
  • From 2004 to 2006, when conventional lending
    slowed and subprime lending accelerated, more
    than 2,500 financial institutions made a combined
    1.5 trillion in high-interest-rate (high risk)
    mortgage loans. Most subprime loans fall into
    this basket.
  • Source WSJ, Oct. 11, 2007.
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