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Chapter 6: Mortgage Valuation

Chapter 6: Mortgage Valuation. Date: 2/17/2011 Presented by: Josh Pickrell. Loan Types. There are three common loan types: Pure Discount Loan: borrower receives $X today and agrees to pay back $X +$I dollars tomorrow.

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Chapter 6: Mortgage Valuation

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  1. Chapter 6: Mortgage Valuation Date: 2/17/2011 Presented by: Josh Pickrell

  2. Loan Types • There are three common loan types: • Pure Discount Loan: borrower receives $X today and agrees to pay back $X +$I dollars tomorrow. • Interest Only Loan: borrower pays interest periodic interest payments and pays the principal back at the end of the loan. • Amortized Loan: borrowers periodic payments include interest and principal.

  3. Mortgage Loans • A mortgage loan is, typically, an amortized loan that is backed by collateral. • The lender can take control of the collateral if the borrower does not fulfill the contractual obligations. • A lien is placed on the property – the lien prevents the borrower from selling or transferring the property until the loan is paid. • Loans for which the borrower posts collateral are known as secured loans.

  4. Total Mortgage Debt Outstanding • According to the Federal Reserve Release, there is approximately $13.947 trillion worth of mortgage debt outstanding. • http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm • We can observe the breakdown of the four main types of mortgages that the book points out: • Residential • Multifamily • Commercial • Farm

  5. Total Mortgage Debt Outstanding • What does the data tell us? • The $ amount of total mortgage debt has been declining since the middle of 2009. • Most of the outstanding mortgages are one-to-four family residences and most of the mortgage debt is held by major financial institutions and Federal and Related Agencies. • The residential sector represents the majority of mortgage debt outstanding.

  6. Secured Lending and Default • Mortgages that have LTV ratios less than 100% are said to be over collateralized. • There is an direct relation between the LTV ratio and the borrower default rate. • Escrow payments can be added into your monthly payment. Escrow includes insurance costs and property taxes. • Distressed collateral – it is common for homeowners, in foreclosure, to have caused physical damage to the property or they may just neglect the property.

  7. Prepayment Option • Most mortgage include an embedded option – prepayment option – which allows the borrower to pay off the mortgage at any time and without penalty. • A borrower may prepay for liquidity reasons or financial reasons. • A borrower may find it advantageous to refinance the mortgage loan. • Home equity loans • Lower cost of borrowing

  8. Mortgage Origination and Investment • Origination: the loan application process (underwriting) • Servicing: monitoring the mortgage loan, and collecting the payments • Investment: make sure the portfolio of mortgage loans is profitable.

  9. Disintermediation • Disintermediation means that one financial institution does not have to be responsible for all three major aspects of a mortgage loan. • Instead, they can choose to specialize in one or two of the components. • Disintermediation has led to substantial growth in the mortgage market.

  10. Securitization • Securitization has resulted in lower borrowing rates, and it allows funds to flow more efficiently between DSUs and SSUs. • Securitization has also facilitated disintermediation in financial markets.

  11. Mortgage Backed Securities (MBS) • The process of securitization: • Mortgage loans are purchased from lenders and banks. • The mortgage loans are then pooled together • The pool of mortgages is securitized into mortgage backed securities • The two main sub-types of MBS: • A pass-through mortgage-backed security • A collateralized mortgage obligation (CMO)

  12. Residential Mortgages • Fixed-rate mortgages (very common) • Adjustable Rate Mortgages • Balloon Mortgage • Interest-only mortgage

  13. Fixed Rate Mortgages • Three critical components of a fixed rate loan: • Principal balance • Interest rate • Time to maturity • Using equation 6-2 (page 129), we can calculate the principal balance remaining at the end of any month.

  14. The Amortization Schedule • A fixed rate mortgage requires the borrower to pay a fixed dollar amount each month. • This payment includes both an interest payment and a principal payment. • A mortgage loan can be thought of as an annuity; thus, we can use the annuity payment formula to calculate the payment. • SEE EXCEL FILE.

  15. Adjustable Rate Mortgage • Unlike a fixed rate mortgage, the interest rate on an ARM can change over the life of the loan. • This means that the borrowers monthly payment may rise or fall over the life of the loan depending on the related market interest rate. • The ARM contract must specify a specific market interest rate index and margin. • LIBOR, 1-Year Constant Maturity Treasury security, The Cost of Funds Index • The margin may differ from one lender to another, but it is usually constant over the life of the loan.

  16. Adjustable Rate Mortgage • The ARM contract will specify the re-pricing frequency. • Typically, 12 months (annually). • Not uncommon to see semi-annual re-pricing or every two years. • Many ARMs are being originated as fixed-adjustable hybrids. • For example, a 7/1 ARM will have a fixed rate for seven years, and then it will re-price annually for the reminder of the loans life.

  17. Adjustable Rate Mortgage • Most ARMs contain a rate cap and rate floor to protect both the borrower and lender from significant changes in interest rates. • In addition, some ARMs will have a periodic re-pricing limit. • Watch out for the “teaser rate” – the ARM offers an artificially low initial interest rate that is much less than the current index rate plus the spread.

  18. ARM Example *Time Permitting* • Problem 22. What is the scheduled P&I payment for the next two years of a two-year ARM with a remaining principal balance of $220,000, a remaining maturity of 13 years, the two-year constant maturity Treasury yield is 2.4% (index value), and a fixed margin of 300 basis points (or 3%). If two years from now, the index has risen to 3%, what will be the new monthly payment on this loan?

  19. Other Types of Mortgages • A balloon mortgage is one that has a fixed-rate and scheduled payments calculated for 30 years, but requires repayment of the remaining principal in full after a certain period of time. • Interest-only mortgage requires no repayment of principal until the maturity date. • The borrower will build no equity beyond the initial down payment, unless the property value increases.

  20. Mortgage Valuation • Valuation of a mortgage portfolio is complicated by the fact that they have a prepayment option. • In order to value a single mortgage, we would need to know: • Credit quality of the borrower (proper default risk premium) • Time of the anticipated prepayments must be determined

  21. Mortgage Portfolio Valuation • The text uses an adjusted cash flow approach to valuing a mortgage portfolio, which requires you to estimate the expected future cash flows for the portfolio of mortgages. • The PV of the mortgage portfolio is found by discounting these expected future cash flows using the appropriate discount rate.

  22. Mortgage Portfolio Valuation • Prepayments and defaults can significantly effect the E[CF] of the mortgage portfolio. • The discount rate should represent the market return that an investor would earn on an alternative investment with similar characteristics, maturity and risk, to the portfolio being valued. • The textbook argues for the use of the 10-year Treasury Note yield as a reasonable discount rate for the expected cash flows of a fixed-rate mortgage portfolio.

  23. Mortgage Pricing Characteristics • For bonds with no embedded options, fixed income investors analyze the YTM, duration and convexity. • For mortgages, and bonds with embedded options, we have to adjust the calculations. • YTM is not a useful measure of the return that will be earned on a mortgage (portfolio). • There is no established market price for a mortgage (portfolio); thus, we cannot calculate a YTM.

  24. Mortgage Duration • Mortgages are more sensitive to change in interest rates because of the prepayment option. • Bond investors (no embedded options) versus mortgage investors – the effect of rising and falling interest rates… • We must rely on effective duration for mortgage portfolios.

  25. Mortgage Duration • The duration of an ARM portfolio is approximately one-half the average re-pricing frequency of the ARMs in the portfolio. • For example, a portfolio that contains a two-year re-pricing arm, will have duration of approximately 1.

  26. Mortgage Convexity • Convexity improves upon the duration estimate. • Figure 6-8 in the text, shows that the present value of a real mortgage portfolio is concave. • Mortgages exhibit negative convexity, which means that the PV of the mortgage portfolio is always lower than predicted by the duration estimate. • In other words, duration is an optimistic measure for the PV of a mortgage portfolio.

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