Residential Mortgage Loans

1. Residential Mortgage Loans Chapter 10

2. Mortgage Market • loan secured by collateral of specified real estate property which obliges borrower to make predetermined series of payments • lender has right of foreclosure if borrower defaults • conventional mortgage – lender makes loan based on credit of borrower and on collateral for mortgage • mortgage insurance • FHA • VA • FmHA • private

3. Mortgage Market • participants • mortgage originators – original lender • thrifts • mortgage bankers • commercial banks • sources of profit to originators • origination fee – specified in points (1% of borrowed) • secondary marketing profit – selling loan for more than original cost • mortgage servicers • mortgage insurers

4. Mortgage Market • origination • PTI (payment-to-income) ratio • monthly payments to monthly income – lower ratio, greater likelihood applicant can meet payments • LTV (loan-to-value) ratio • ratio of amount of loan to market value of property – the lower the ratio, the more protection the lender has if default • originators can • hold mortgage in their portfolio • sell mortgage to investor who wants to put in with pool of mortgages • use mortgage themselves as collateral for issuance of security (securitization) • conduit – when federally sponsored or private agency buy mortgages, pool, and sell to investors • conforming mortgage vs. nonconforming mortgage

5. Mortgage Market • sources of revenue from mortgage servicing: • servicing fee • interest earned by servicer from escrow balance • float earned on monthly mortgage payment • ancillary income • late fees • commissions from cross-selling • fees from selling mailing lists • portfolio of borrowers is potential source for other loans

6. Mortgage Market • types of mortgage-related insurance • PMI • credit life • not required by lender • provides for continuation of payments after death of insured person

7. Mortgage Loans • Level-Payment Fixed-Rate Mortgage • borrower pays interest and repays principal in equal installments over agreed-upon period of time – fully amortized over period • example – 30 year $100,000 loan with 8.125% rate • monthly interest rate is 0.0067708 • interest for month 1 is $677.08 and monthly payment is $742.50 - $65.41 to reduce principal

9. where MP = monthly mortgage payment n = # of months MB0 = original balance t = simple monthly note rate Monthly Mortgage Payment

10. ARMs • mortgage where contract rate is reset periodically in accordance with reference rate • reference rate categories • market-determined rates (Treasury based) • calculated rates based on cost of funds for thrifts • (based on monthly weighted average interest costs for thrifts)

11. ARMs • teaser rate usually offered • periodic rate caps • lifetime rate caps and floors • hybrid ARM • rate fixed for period and then floats after • 3/1 ARM means fixed for 3 years and then resets annually • interest-only hybrid ARM • reduce initial monthly payments – pmts first consist of only interest on loan with amortization of principal to start later • balloon mortgage • borrower given long-term financing but at set dates, contract rate is renegotiated • Prepayment Penalty Mortgage • lockout period during which prepayments are not permitted • Reverse Mortgage • for seniors who want to convert home equity into cash

12. Nonconforming Mortgages • loan that does not satisfy one or more of underwriting standards of Fannie, Freddie, and Ginnie (amt of loan, credit worthiness, documentation of loan, purpose of loan) • conventional nonconforming loan does not have any credit guarantee • Jumbo loan – loan larger than conforming limit • subprime – borrowers whose credit has been impaired • Alt-a loan – loans to borrowers who have high credit scores but have variable incomes, are unable or unwilling to document stable income history, or are buying second homes or investment properties • so reduced or alternate forms of documentation are used to qualify loans • borrowers typically have excellent credit ratings • High LTV loans – borrower with good credit quality has option of making a lesser or no down payment

13. Risks Associated with Investing in Mortgages • credit risk • liquidity risk • interest rate risk • prepayment risk

14. Credit Risk • risk that borrower will default • single mortgage credit risk is not as important if investing in pool of mortgages • 10 of pool of 1,000 will default but which ones?? • prime loan – 30 year FRM with 75% to 80% LTV ratio that is fully documented for the purchase of an owner-occupied single family detached home

15. Credit Risk • factors associated with lower default rates • LTV ratio – single most important determinant • current LTV vs. original LTV • mortgage term – credit risk is greater the longer the mortgage term (so 15 year < risk than 30 year) • mortgage type – FRMs considered prime because everyone knows payment and amortization schedule • transaction type – loans for purchases safer than those for cash-out refinancings • documentation – income, employment, and asset verification • occupancy status – less risk if borrower lives in home • property type – single family detached homes least risky • mortgage size/house price • credit worthiness of borrower