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Widman RHSITH MBA Lecture


Countrywide Financial Corporation. Slide 1 , BUFN700, Spring 2008, Professor Doron Avramov ... About Countrywide Financial, NYSE Ticker = CFC. Key Facts: ... – PowerPoint PPT presentation

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Title: Widman RHSITH MBA Lecture

Residential Mortgage Finance Products, Markets,
Risk Assessment, Pricing, and Securitization
Andrew Widman SVP, Enterprise Risk
Management Countrywide Financial Corporation
A foreword on the significance of housing finance
  • Housing is a basic human necessity and a critical
    component of every economy in all parts of the
  • Home ownership builds social stability, serves as
    a store of value, and provides a source of income
  • Along with governmental, monetary, and property
    rights stability, a reliable system of housing
    finance is argued by some as a major aid to
    sustainable economic development
  • The US model with long-term financing and broad
    accessibility is a luxury not available in many
  • This document and todays discussion reflect my
    views alone and not those of Countrywide Financial

About Countrywide Financial, NYSE Ticker CFC
  • Key Facts
  • Mortgage-centered, diversified financial services
    company with rapid business growth during the
    2000s, especially in non-traditional loans
  • Growth in PayOption and Sub Prime mortgages
    more on these later
  • Servicer of nearly 1.5 Trillion in mortgage
  • Payment processing for 1 in 8 loans 2 industry
  • Set to be acquired by Bank of America following
    precipitous 80 decline in market value during
  • http//finance.yahoo.com/q/bc?sCFCt2ylonzm
  • January announcement with July consummation
  • 100 stock transaction priced at 0.1822 shares of
    BAC per share of CFC
  • Whats the implication of CFCs current stock
    price compared to the deal-implied price?

Whats your favorite angle on the real estate
  • Toxicity?
  • http//www.google.com/search?hlenqtoxicmortgag
  • Victims and predators?
  • http//www.google.com/search?hlenqmortgagepred
  • Industry doomsayers?
  • http//ml-implode.com/
  • Cash infusions?
  • http//www.google.com/search?hlenqmortgagecash

Humor? (warning explicit!)
  • US residential real estate finance market
  • Real estate as an investment asset
  • Home financing basics and loan instruments
  • Primary and secondary markets, loan origination
    and disposition
  • Risk assessment and loan pricing
  • Default, loss severity, and prepayment risks
  • Option-embedded fixed income valuation
  • Mortgage securitization
  • Rationale, relation to other assets
  • GSEs, other credit enhancement, rating agencies,
  • Structures and issuer/investor considerations

Residential real estate from an in investment
  • Home ownership is encouraged by our government
  • Tax advantages on interest costs and capital
  • Post-depression agencies were created to bear
  • Provides diversification benefits as an asset
  • Imperfect correlation improves risk-adjusted
    portfolio returns
  • But for many, real estate concentration is
    arguably too high
  • Mean/variance optimization would allocate a lower
  • Highly leveraged financing is now the norm
  • 10 house price change on 10 down 100 return
  • Actual return depends on treatment of borrowing
  • Like buying stock on margin without the margin
  • Liquidity can be poor and markets inefficient
  • Thin markets, few transactions, no natural short
  • Limited availability of hedges note recent rise
    of CME futures

House prices and the early 2000s experience
  • In the early 2000s, house prices offset losses in
    equities as cheap credit, investor interest, and
    loose underwriting standards prevailed
  • For most homeowners, their gains were unrealized

House prices and the late 90s experience
  • In the mid-late 90s, housing stagnated as
    equities tripled
  • Assuming you were omniscient and bought at the
    bottoms and sold at the end, where did you make
    your best returns SP during the 1990s or on a
    house in DC in the 2000s?

House prices and future prognostications
  • Economists across the board are bearish on
    housing activity and prices in the near-to-mid
  • Few are as negative as Mark Zandi of Moodys

Residential mortgage basics in the US
  • A residential mortgage is a long-term loan used
    to finance a home which serves as collateral
  • Traditionally, repayment is made through level
    monthly installments comprising both interest and
  • Until the recent housing boom, the most common
    loan was a fixed rate, 30-year, level-pay, fully
    amortizing mortgage
  • Useful Excel function for monthly, level,
    amortizing payment
  • pmt(rate/12, months, loan amount)
  • pmt(6/12, 360, 250,000) 1,499
  • In this example, a 250k loan at a fixed rate of
    6 has a monthly payment of 1,499 and will be
    paid off after 30 years

Time profile of a 250k, fixed rate 30-year
mortgage at 6
  • Interest due dominates the early payments as it
    takes more than 20 years to cut the balance in
  • Most borrowers will have long since pre-paid by
  • Average holding period for a fixed rate 30-year
    mortgage lt 7yrs

Non-traditional features grew during the boom in
home prices
  • Down payment
  • Traditionally 20 covered by borrower funds
    and/or mortgage insurance
  • Increasingly secondary financing (aka piggyback
    lending) up to 100
  • Income and asset documentation
  • Traditionally full verification of employment and
    financial assets
  • Increasingly no-income-no-asset (NINA)
  • Amortization features
  • Traditionally fully amortizing until maturity
  • Increasingly initial interest-only or negative
    amortization periods
  • Term to maturity
  • Traditionally 15 or 30 years increasingly up to
    40 years
  • Interest rate variability
  • Traditionally fixed increasingly adjustable
    with teasers and resets
  • Prepayment option
  • Traditionally permissible to prepay the remaining
    balance any time
  • Increasingly penalized for early payment in
    exchange for better terms

Adjustable rate mortgages (ARMs) allow lower
initial payments
  • Common products 1-yr, 3/1-yr, 5/1-yr, 7/1-yr,
  • Loans with fixed periods gt1yr commonly called
    hybrid ARMs
  • Rate typically offered at a discount to the
    30-year fixed rate
  • Discount amount depends on shape of the yield
  • With a flat yield curve, the rate benefit is
  • Interest rate and payment are fixed for the
    initial period
  • Rate reset is based on a reference rate plus a
    margin constrained by maximum periodic adjustment
    and ceiling
  • For example, a borrower with good credit and 20
    down could get a 5/1-yr ARM with following terms
    as of April 2008
  • Initial rate 5.75
  • Margin over 1-yr constant maturity
    treasury 2.75
  • Maximum lifetime adjustment 5.00
  • The same lender offers a 30-year fixed rate loan
    at 5.875
  • Are the borrowers savings worth the added risk?

Other popular loans with lower initial payments
  • Interest-only (IO) mortgages
  • Easy to think of as an add-on feature to ARMs
  • Increasingly popular feature now attached to gt50
    of new ARMs
  • The initial period specifies a fixed payment with
    no principal
  • At reset, the rate adjusts and an amortizing
    payment is required
  • If held to reset the new payment may rise by 30
    or more
  • Negatively amortizing mortgages
  • Marketed as PayOptions, OptionARMs, and
  • A low payment is permitted which causes the loan
    balance to rise
  • Lets review the glossy literature
  • http//www.countrywide.com/pdf/050850_POA_brochure
  • In this instrument the actual accrual rate
    adjusts monthly
  • This feature makes it a popular bank investment
  • Payment shock after the fifth year can be
    devastatingly large
  • Bank of America plans to discontinue after the
    CFC acquisition

Even more ways loan payments were reduced
  • 3-2-1 buydowns, often offered by home builders
  • The builder effectively subsidizes the mortgage
    for 3 years
  • A 3 rate discount in year 1, followed by 2,
    then 1
  • Maybe a good deal for the borrower but more
    likely a signal that the borrower paid too much
    for the house
  • 40-year or greater terms-to-maturity
  • Longer terms require lower payments of principal
  • Not very common yet due to limited investor
  • All of the above products grew in popularity
    during the boom and almost certainly contributed
    to escalating prices
  • In many cases, interest rate risks more capably
    managed by financial institutions are now borne
    by private citizens

The Primary Mortgage Market
  • Institutions/individuals who market, originate
    loans to borrowers comprise the primary mortgage
  • Loan providers include
  • Traditional depositories
  • Banks, Savings Loans, Credit Unions
  • Have the capacity to fund and portfolio loans
    (but may not)
  • May also perform loan servicing
  • Mortgage bankers
  • Generally mono-line companies that make, fund,
    and sell loans
  • May also perform loan servicing
  • Mortgage brokers
  • Independent agents who generally act as
  • Generally dont underwrite or put capital at risk
  • For the typical borrower, there is no universal,
    material advantage to any one type of loan

The Secondary Mortgage Market
  • The secondary mortgage market is comprised of
    funding, buying, selling, servicing, and
    securitizing closed loans
  • This activity replenishes funds for making new
  • Secondary market mortgage participants include
  • Primary market participants
  • When they sell their loans and/or servicing
  • Fannie Mae and Freddie Mac (the GSEs)
  • When they guarantee and securitize loans
    (discussed later)
  • Investment banks
  • When they buy, structure, and securitize loans
  • Prior to the 1930s depression, loan sales were
  • Fannie Mae was the first institution created to
    ensure lenders funds for loans other than their
    own locally-based deposits

Drawbacks and benefits of the Secondary Mortgage
  • The growth and robustness of the secondary market
    has improved the pricing and availability of
    mortgage credit
  • Risks can be allocated more optimally
  • Borrowers arent hindered by local economic
  • Uniform performance data can be collected and
  • Models can be improved so the right borrowers are
  • International funds can flow more readily to
  • Increased supply of funds reduces borrowing costs
  • Innovation in mortgages and securitization is
  • Structures can be developed for borrowers and
  • The secondary market and structured
    securitization in particular have been criticized
    as primary to the housing bust
  • Critics say originators were too far removed from

Interaction of primary and secondary markets
  • Participants are engaged in a relatively
    efficient market
  • Borrowers enjoy certain regulatory protections
    and transparency
  • RESPA, good faith estimates, HUD-1
  • The internet is a good source for finding the
    best loan terms
  • http//www.amerisave.com/index.cfm,
  • Originators have multiple choices for loan
  • Hold for portfolio investment to profit from net
    interest margin (NIM)
  • Sell to a GSE or to an aggregator/issuer a
    bigger institution
  • Sell the future stream of payments for their
    present value
  • Best execution is the process for determining
    where to place different loans to achieve optimal
    value on a pool of loans
  • The aggregator may re-sell to a GSE or issue its
    own security
  • Parties typically engage in forward agreements to
    originate and fund/sell loans with specified
    terms/pricing at future dates
  • A borrowers rate lock-in is a type of forward

Mortgages are grouped into several categories for
secondary marketing
  • Conventional/Conforming (C/C)
  • Meets standards for loan features, credit
    quality, approval guidelines and size limits
    specified by the GSEs
  • C/C loans can be both fixed rate or ARMs
  • Interest-only loans were approved as C/C in the
    early 2000s
  • Many lenders have 12-month term agreements with
    GSEs to sell a representative mix of their C/C
    production for the coming year
  • Agreements are often dimensioned by relative
    share and loan/pool credit quality stipulations
    or loan/credit price adjustments
  • Lenders retain the ability to conduct best
    execution subject to the constraints of the GSE
    sales agreements
  • The GSEs closely monitor lenders selling
    behavior to watch for population skewness, a.k.a.
    adverse selection

Other major mortgage categories
  • Conventional/Jumbo
  • Consistent in most respects with GSE guidelines
    with the major exception of loan size (currently
    gt 417k)
  • Typically sold to an institution with security
    issuance capabilities (for later discussion)
    interest rates are usually 0.25 higher
  • Cannot be sold to GSEs
  • Alt-A (the label is hotly debated and often
  • Generally represents loans made to prime quality
    A borrowers (typically defined by FICO score)
    but outside standard guidelines
  • e.g., 90 financing with cash out, investor
    occupancy, no-income-no-asset documentation
    (NINA), or other layered risk
  • Separate from the forward agreements GSEs may be
    willing to buy Alt-A loans on a pool-by-pool
    basis after close consideration
  • Otherwise Alt-A is portfolio-ed or sold to an

Even more major categories of mortgage loans
  • Government guaranteed
  • Federal Housing Administration (FHA), Veterans
    Administration (VA), Rural Housing Service (RHS)
  • Primarily designated to finance modest housing
    for certain borrower segments, e.g., first time
    buyers, lower income, veterans, etc.
  • Manufactured housing (MH) loans
  • MH residing on leased land is not considered real
  • More like personal property lending, e.g. car
    loans, than housing
  • Sub prime mortgages
  • Typically outside guidelines due to ineligible
    borrower quality
  • Low FICO, recent bankruptcy, unpaid collection
    accounts, etc.
  • Formerly primarily home equity lending, i.e.,
    poor credit quality but with reasonable equity in
    the property
  • More recently evolved into first time buyers and
    high LTV lending
  • Typically sold to an issuer of mortgage-backed

Risk assessment and loan pricing e.g.,
corporate debt
  • In the world of corporate lending, unsecured debt
    is commonly graded and priced according to risk
  • source Vanguard
  • Lower grade corporate borrowers pay higher
    interest rates to account for a higher perceived
    probability of default and loss

Risk assessment and loan pricing in mortgage
  • Mortgages are also priced according to risk,
    though rate responsiveness is fairly minor among
    prime FICO borrowers
  • Like secured corporate debt, the mortgage
    collateral, i.e., house has a stabilizing effect
    on the interest rates offered
  • Credit quality below certain thresholds triggers
    sub prime rates
  • source myfico.com

Risk assessment and pricing models have evolved
in the last decade
  • The practice of charging higher rates to
    compensate for higher risk has existed since the
    dawn of lending
  • Statistical performance models to determine
    mortgage pricing have become increasingly
    prominent in the last decade
  • Growth of the secondary market, creation of FICO
    scores, and increased data collection have
    enabled statistical sophistication
  • The modern-day application of the risk assessment
    entails supplying application data into models
    that predict
  • Probability of borrower default, a.k.a. default
  • Loss given default, a.k.a. severity rates
  • Expected loan life, a.k.a. prepayment rates

Its helpful to think about loan performance
  • Why do borrowers default?
  • A borrower is likely to default on a mortgage if
  • Can no longer afford the payments and
  • Cannot sell the property without a loss
  • Why do borrowers prepay?
  • Early payoff may be made for the following
  • Rate incentive a better rate becomes available
  • Mobility the owner sells the home and moves
  • Cash out the owner extracts home equity as cash
  • What losses are sustained in the event of
  • Severity rates are generally a function of
  • Property value deficiency relative to loan amount
  • Lost interest prior to property liquidation

Significant origination predictors of default and
severity in credit models
  • FICO measure of borrower credit line performance
  • Most significant indicator of default rate along
    with LTV
  • Loan-to-value ratio of loan amount to property
  • Important to both default and severity rates
  • Loan purpose purchase, refinance, or cash-out
  • Cash-out usually considered riskier for default
    and severity
  • Occupancy owner, investment, or second/vacation
  • Investment considered a higher risk for default
    and severity
  • Documentation full income/asset verification, or
  • Reduced documentation may signal increased
    default risk
  • Payment-to-income ratio of loan payment to
    income level
  • High ratio suggests increased default risk

Significant origination predictors of mortgage
  • Among prime mortgages, in general, origination
    loan attributes that suggest higher credit risk
    also suggest slower prepayment or longer average
  • Alternately stated, a borrower with a good credit
    profile and low-risk origination attributes may
    more readily relocate to another home or
    refinance when financially advantageous
  • Within the sub prime space, borrowers with weak
    loan attributes and commensurately high note
    rates generally prepay faster with a shorter
    average life
  • The phenomenon is referred to as credit curing
    whereby a borrower can lower her monthly payment
    by refinancing when her credit score improves

Major macroeconomic predictors of mortgage
  • By and large, the most important factors that
    affect mortgage performance are house prices and
    interest rates
  • Favorable house prices
  • Reduce default and severity rates
  • Increase prepayment rates by increasing housing
  • Stagnant or declining house prices
  • Increase default and severity rates
  • Reduce prepayment rates by lowering mobility
  • Low or declining interest rates
  • Create the incentive for borrowers to refinance
  • Increase housing mobility by improving
  • High or increasing interest rates
  • Reduce prepayment rates
  • Increase pay shock default risk with ARM
  • Inferences from origination loan attributes are
    excellent for determining ordinal pool
    performance poor for cardinal

House price and interest rate models
  • Monte Carlo simulation employs a multi-scenario
  • Single scenario assumptions fail to capture risk
  • Variations in prices are dimensioned by
    volatility and random shocks
  • Interest rate models typically employ
    mean-reversion features
  • Volatility exists but invisible forces pull rates
    toward their long run averages
  • Each path produces a different level of
    defaults and losses

Considering mortgages in a valuation framework
  • Mortgage cash flows can be valued similar to
    other assets
  • The value of a risk-free vanilla bond or annuity
    is equivalent to its PV of future cash flows in
    this way a mortgage is no different
  • The key differentiating feature of mortgage
    valuation is uncertainty due to embedded options
  • The right to prepay is equivalent to a call
  • The right to default is equivalent to a put
  • In simple terms, a mortgage rate (or IRR) should
    be the sum of
  • The underlying rate of a risk free annuity of the
    same maturity
  • The value of the embedded call option
  • The value of the embedded put option
  • Valuing these options is difficult in reality due
    to inefficient exercise

The price-yield relationship and negative
  • A plain vanilla bond possesses
  • An inverse relationship between price and yield
  • Convexity properties that
  • accelerate increases in value in response to
    declining rates
  • Decelerate declines in value when rates increase
  • A mortgage loan possesses
  • Negative convexity which
  • Constrains value increases in response to
    declining rates
  • As rates decline, prepayment incentives increase
    the value of the call option for the borrower

Plain Vanilla Bond
Mortgage Loan
Asset securitization
  • Securitization is the packaging of designated
    pools of loans or receivables with an appropriate
    level of credit enhancement and the
    redistribution of these packages to investors.
  • Mark Fisher Zoe Shaw, eds., Euromoney Books,
    London 2003
  • Securitization was first developed for US
    mortgages, but the basic principles are now
    applied worldwide to various assets such as
  • Credit card receivables
  • Car loans
  • Student loans
  • Tax liens
  • Gambling revenues
  • Royalties

Mortgage securitization practices
  • US mortgage loans are securitized in two primary
  • GSE guarantor execution
  • Conventional/conforming loans sold to the GSEs
    are typically pooled together and issued as
    mortgage-backed securities (MBS)
  • MBS are guaranteed against credit losses and
    rated AAA based on the perception of US
    Government backing of the GSEs
  • This form of credit enhancement, i.e., provided
    by corporate guarantee, is referred to as
    external enhancement
  • Private label execution
  • In private label MBS, enhancement is typically
    achieved internally
  • Subordination assigns sequential payment priority
    to senior classes
  • Overcollateralization describes the practice of
    absorbing losses by issuing securities with total
    value smaller than the underlying loans
  • Excess spread describes the reliance on excess
    interest payments to form a reserve to provide
    for coverage for pool losses
  • Credit rating agencies assign ratings based on
    the level of support
  • Enhancement structures are engineered to achieve
    desired ratings

MBS cash flows GSE execution example
MBS Investors
  • Make monthly payments to servicers of Principal,
    Interest, Taxes, Insurance (PITI)
  • Retain servicing fees to cover costs
  • Escrow and pay property taxes and insurance to
    third parties
  • Remit principal and remaining interest portion to
    next party
  • Earn ancillary income interest on escrows,
    product cross-sales, late fees
  • Keep guarantee fees (g-fees) in exchange for
    protecting investors against default
  • Remit to MBS investor at pass-through rate
  • Receive guaranteed principal and interest at
    pass-through rate
  • Seller-Servicers and GSE portfolios are major MBS

MBS cash flows numeric GSE example
MBS Investors
  • Pay PITI to servicer at 6 note rate
  • Retain 0.25 as servicing revenue
  • Remit PI at 5.75 to Fannie or Freddie
  • Keep 0.25 as g-fee revenue
  • Remit to MBS investor at 5.5 pass-through rate
  • Receive guaranteed principal and interest at 5.5

To illustrate, assume... - 6 note rate - ¼
guaranty fee - ¼ servicing fee - 5½
pass-through rate
Internal credit enhancement mechanics further
  • In the most basic form, internal enhancement is
    achieved through sequential pay,
    senior/subordinate structures
  • The subordinates take on losses until their
    balances dry up
  • Because the subordinates are riskier, they pay
    higher yields
  • The bigger the subordinates, the more protected
    the seniors
  • The smaller the subordinates, the more profitable
    to the issuer
  • Credit rating agencies
  • Standard Poors (SP) and Moodys exist to rate
  • they specify the required subordinate security
    sizings for the issuer to achieve certain ratings
    on the senior securities
  • In the process of preparing for securitization,
    an issuer will send to the rating agencies the
    underlying loan details for sizing
  • The riskier the loans the bigger the subordinate
    class required

Internal credit enhancement mechanics
simplified example
  • Assume 100M pool of risky mortgages with an
    average rate of 6 (post servicing)
  • The rating agency specifies that 10 of potential
    losses must be covered to achieve the desired
    senior rating
  • Issue 90M senior security and 10M risky
  • Investors require 5 yield on the senior, 15 on
    the sub
  • The weighted average rate stays the same but the
    losses are redistributed
  • 905 1015 6

Other practices in mortgage securitization
  • The three types of cash flows within mortgage
    pools, interest, scheduled principal, and
    prepayments can be assigned to different classes
    or tranches and subjected to different rules and
    triggers through time
  • In practice, collateralized mortgage obligations
    (CMOs) can strip-out and structure many types of
    instruments from highly predictable to highly
    unpredictable and risky
  • Some examples
  • Interest only (IO) bonds
  • On a separate note, loan servicing fees are a
    natural form of IO
  • Servicing can be retained or released (sold) upon
    loan disposition
  • Market standards regulate a minimum servicing fee
  • Excess servicing beyond the minimum can be
  • Principal only (PO) bonds
  • Planned Amortization Class (PAC) bonds
  • Non-Accelerating Senior (NAS) bonds

Major advantages securitizing mortgages issuer
  • Liquidity
  • Uniform, well-understood securities are easier to
    value and trade than individual loans
  • Risk management
  • Credit risks and balance sheet issues, such as
    asset-liability matching can be more readily
    optimized per tolerance levels
  • Pricing
  • Cash flows can be restructured to suit investor
    demand and yield better all-in pricing though
    arbitrage arguments disagree
  • Profit taking
  • Profits can be realized upon the sale of the
    assets rather than incrementally over the life of
    the mortgages

Major advantages to securitization investor
  • Improve diversification and risk-adjusted returns
  • Securitization can make ordinarily un-traded,
    weakly correlated assets available for investment
    managers as rated securities
  • Many managers are restricted to investment grade
    assets only
  • Risk management or speculation
  • Some instruments can serve as effective hedges
    for other investment or business activities
    (negatively correlated asset)
  • The same instruments, absent an offsetting
    position, can allow investors to make highly
    leveraged bets on prepayment rates, interest
    rates, or loss levels
  • Investment repackaging
  • Collateralized debt obligations (CDOs) can pool
    and re-securitize securities to provide yet
    another form of investment
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