Mortgage Markets

1. 9 Mortgage Markets

2. Mortgage Insurance • Mortgage insurance guarantees repayment in the event of borrower default • Lenders usually require mortgage insurance if you don’t make a 20% downpayment. When loan-to-value ratio (LTV) drops below 80%, mortgage insurance can usually be dropped • Borrower pays insurance premiums, usually on a monthly basis, along with mortgage payment and escrow • Borrowers can obtain mortgage insurance in two broad ways: • Through the government: Federal insurers include Federal Housing Administration (FHA) and Veterans Administration (VA) (about ¼ of the mortgage insurance market) • Through private insurance (called private mortgage insurance or PMI) • FHA/VA insured loans are usually available only to first-time home buyers and require a smaller downpayment; the insurance premiums are lower than PMI; but FHA/VA loans come with miles of red-tape • PMI is a little more expensive but it is cleaner, with less red-tape

3. WWCB Illustration of Interest Rate Risk

4. WWCB Illustration of Interest Rate Risk

5. WWCB Illustration of Interest Rate Risk

6. WWCB Illustration of Interest Rate Risk

7. Types of Residential Mortgages • Fixed-rate mortgages • Adjustable-rate mortgages (ARMs) • Graduated-payment mortgages (GPMs) • Growing-equity mortgages • Second mortgages • Shared-appreciation mortgages • Balloon payment mortgages

8. Fixed-rate Mortgages • Fixed rate loans have a constant rate until maturity (15, 20, 30, 50 or even 100 years) • Interest rate risk hurts lender if interest rates rise • Interest rate risk hurts borrowers if interest rates drop • U.S. is one of few countries in which a rate can be locked for 30 years or more. Very few other countries allow a lock in for > 10 yrs

9. Adjustable-rate Mortgages (ARMs) • Rates vary with some index (prime plus margin, etc.) • e.g. 3/1 means rate won’t change for 3 years after which it can change every year • e.g. Upper and lower boundaries are set (caps) • Less risk for lenders as yields move with cost of funds • Creates uncertainty for borrowers whose mortgage payments can change over time

10. Comparison of Rates on Newly Originated Fixed-Rate and Adjustable-Rate Mortgages

11. Effects of Shorter Maturities • Can save significant interest • Increased popularity of 15-year loans • Lender has lower interest rate risk if the term of the loan is lower • Borrower saves on interest expense over loan’s life but monthly payment is higher • See example. http://www.mortgage-net.com/calculators/mp_cl.html

12. Payments Necessary for 15- and 30-Year Mortgages (Based on an Interest Rate of 8 Percent)

13. Maturity Dates: When is Principal Due? • Balloon payments • Principal not paid until maturity • Forces refinancing at maturity • Amortizing mortgages • Monthly payments consist of interest and principal • During loan’s early years, most of the payment reflects interest

14. Creative Mortgage Financing • Graduated-payment mortgage (GPM) • Small initial payments • Payments increase over time then level off • Assumes income of borrower grows • Growing-equity mortgage • Like GPM, this has low initial payments • Unlike GPM, payments never level off

15. Creative Mortgage Financing • Second mortgage used in conjunction with first or primary mortgage • Shorter maturity typical for 2nd mortgage • 1st mortgage paid first if default occurs so 2nd mortgage has a higher rate/risk • If used by sellers, makes a home with an assumable loan more affordable • Home equity loan is a form of 2nd mortgage • Shared-appreciation mortgage • Below market rate but lender shares in home’s price appreciation (e.g. PUC)

16. Mortgage Refinancing Activity over Time

17. Activities in the Mortgage Markets • Origination (create terms) • Funding, investing or financing • Servicing or maintenance (collecting payments, escrow) • Selling loans • Secondary market exists for loans • Securitization • Pool and repackage loans for resale • Allows resale of loans not easily sold on an individual basis

18. Activities in the Mortgage Markets • Unbundling of mortgage activities provides for specialization in: • Loan origination • Loan servicing • Loan funding • Any combination of the above

19. Institutional Mortgage Holders • Federally related mortgage pools • Commercial banks • Dominate commercial mortgage market • Savings institutions • Primarily residential mortgages • Life insurance companies • Commercial mortgages

20. Institutional Use of Mortgage Markets • Mortgage companies (e.g. Home Loan Ctr.) • Originate and quickly sell loans • Do not maintain large portfolios • Government agencies including Fannie Mae and Freddie Mac • Brokerage firms • Investment banks • Finance companies

21. Risk from Investing in Mortgages • Interest-rate risk (risk of locking in to what becomes an unattractive rate, causing investment value to drop) • Long-term fixed-rate mortgages financed by short-term funds results in high interest-rate risk (e.g. S&L crisis) • To limit exposure to interest rate risk • Sell mortgage shortly after origination • Adjustable rate mortgages • Shorter-term mortgages (e.g. Canada) • Use balloon payments

22. Risk from Investing in Mortgages • Prepayment risk • Borrowers refinance if rates drop by paying off higher rate loan and financing at a new, lower rate • Investor receives payoff but has to invest at the new, lower interest rate (reinvestment risk) • Manage the risk with ARMs or by selling loans

23. Risk from Investing in Mortgages • Credit risk can range from total default to late payments • Factors that affect default risk • Level of borrower equity • Loan-to-value ratio often used • Higher use of debt, more defaults • Borrowers income level • Borrower credit history • FICO (scores 300-850; looks at payment history, credit history, no. & types of accounts, etc.) • Quality of collateral • Require mortgage insurance

24. Unsound & Greedy Lending • Subprime mortgages are given to either: • risky borrowers with poor credit scores (FICO under 620)OR • those who have good credit but provide insufficient documentation or have high DTI (known as Alt-A loans) • Subprimes made up anincreasing portion of totalmortgages, from 5% in 1994to 20% in 2006 .

25. Risk from Investing in Mortgages • Measuring risk • Use sensitivity analysis to review various “what if” scenarios covering everything from default to prepayments (SHOCK treatments, show BMCU) • Asset/Liability Management (ALM)

26. Use of Mortgage-Backed Securities • Securitization is an alternative to the outright sale of a loan • Group of mortgages held by a trustee serves as collateral for the securities • Institution can securitize loans to avoid interest rate risk and credit risk while still earning service fees • Payments passed through to investors can vary over time

27. Securitization • The risk of sub-prime mortgages was spread around the world through securitization. • In a nutshell, this means your home loan is sold by your lender (in a package along with other home loans) to investors all around the world. • Student loans, auto loans, and credit cards markets are also securitized in a similar manner.

28. Simplified Process of Securitization Home Seller Mortgage Broker (Countrywide, Hm Loan Ctr, etc.) Banks(BofA, Wells, etc.) Subprime Borrower $$ Loan Pmts Servicer Loan $$ Pmts MBS Issuer (Investment banks, FNMA, etc.) Rating Agencies (Moody’s, S&P, etc.) MBS Pmts $$ Credit Insurance (CDS) (AIG, etc.) Investors (Hedge Funds, Pension Funds, Endowments, Ins. Co, Intern Fds, etc.) MBS=Mortgage-Backed Securities; CDS=Credit Default Swaps

29. Use of Mortgage-Backed Securities Ginnie Mae (GNMA) mortgage-backed securities • Government National Mortgage Association, created in 1968, with goal of providing liquidity, stability and affordability to the housing market. • Ginnie Mae does not issue mortgage backed securities like its cousins Fannie and Freddie, merely guarantees FHA/VA/RHA mortgages , backed by the full faith and credit of the U.S. • GNMA is not a publically traded company likes its cousins • A U.S. government agency, wholly owned by the Federal government and operated by the Dept. of HUD • Backed by explicit guarantee of Federal government

30. Use of Mortgage-Backed Securities Fannie Mae (FNMA) mortgage-backed securities • Created in 1938 as part of the New Deal; Federally chartered but privately owned with stock traded on NYSE, ticker FNMA. Taken over by the Fed gov’t in Sept/2008 and is now in conservatorship. • No explicit guarantee of bonds by federal government, but gov’t bailed it out in fall/08 – so actions speak louder than words. • Uses funds from mortgage-backed pass-through securities to purchase conventional mortgages (that are not FHA or VA) • Channel funds from investors to institutions that want to sell mortgages • Guarantee timely payments to investors • Some securities strip (securitize) interest and principal payment streams for separate sale • Accounting scandals & CEO Franklin Raines who hadpolitical ambitions; poor kid from Seattle whomade it big at Harvard, Rhoades Scholar; $9 billionacctg fraud = 40% of profits 2001-2004! • Politicians used FNMA to encourage sub-prime borrowing

31. Use of Mortgage-Backed Securities Freddie Mac (Fed. Home Loan. Mort. Assoc.) • Created in 1970, this a financial services company, Federally chartered but privately owned with stock traded on NYSE, ticker FRCC (in conservatorship right now) • Created to compete with FNMA • Mission is to provide liquidity, stability and affordability in the housing market • Sells participation certifications (PCs) to investors and uses these funds purchase conventional mortgages from banks, S&Ls, credit unions, etc. • Guarantees timely payments to investors • No explicit guarantee of bonds by federal government, but gov’t bailed it out in fall/08 – so actions speak louder than words.

32. The Looming Demise of Fannie/Freddie Fannie Mae and Freddie Mac’s reform (January, 2014) There has been talk for years about reforming, or even dismantling Fannie Mae and Freddie Mac but there has been little action to match the talk. That, however, might be changing, as bipartisan momentum for reform seems to be building. President Obama and a number of Democrats have come out in support of reforming Fannie Mae and Freddie Mac and nearly all of the Republican caucus backs the idea. The devil is in the details. Given the giant influence these organizations have on the mortgage market, reform is a thorny issue, and must be addressed systemically to avoid possible negative ramifications the U.S. housing market, including the potential demise of the 30-year mortgage. http://www.valuewalk.com/2014/01/fannie-mae-freddie-mac-and-the-us-housing-market/

33. Use of Mortgage-Backed Securities • Publicly issued pass-through securities (PIPS) • No Federal charter or guarantee • Backed by conventional mortgages instead of FHA or VA mortgages • Private mortgage insurance

34. Use of Mortgage-Backed Securities • Collateralized mortgage obligations (CMOs) • Semi-annual payments differ from other securities’ monthly payments • Segmented into classes • First class has quickest payback • Any repaid principal goes first to investors in this class • Investors choose a class to fit maturity needs • One concern is payback speed when rates drop

35. Use of Mortgage-Backed Securities • CMOs cont. • Can be segmented into interest-only IO or principal-only PO classes • High return for IO reflect risks • Useful investment but be aware of the risks • 1992 failure of Coastal States Life Insurance due to CMO investments • Some CMO mutual funds • Regulators have increased scrutiny

36. Use of Mortgage-Backed Securities • Mortgage-backed securities for small investors • In the past, high minimum denominations • Unit trusts created to allow small investor participation • Mutual funds • Advantages • Can purchase in secondary market without purchasing the need to service loans • Insured and liquid

37. Sub-prime Mortgage Crisis See separate PowerPoint, entitled Econ Crisis and also the following slides.

38. Mortgage Credit Crisis • Interest rates increased in 2006, which made it more difficult for existing homeowners with adjustable-rate mortgages to make their mortgage payments. • Low initial “teaser rates” were expiring and these homeowners also faced higher mortgage payments. • By June 2008, 9 percent of all American homeowners were either behind on their mortgage payments or were in foreclosure.

39. Impact of the Credit Crisis on Fannie Mae and Freddie Mac • The agencies had invested heavily in subprime mortgages that required homeowners to pay higher rates of interest. • By 2008, many subprime mortgages defaulted, so Fannie Mae and Freddie Mac were left with properties (the collateral) that had a market value substantially below the amount owed on the mortgages that they held. • Funding Problems • With poor financial performance, Fannie Mae and Freddie Mac were incapable of raising capital. • FNMA and FHLMC stock values had declined by more than 90 percent from the previous year.

40. Impact of the Credit Crisis on Fannie Mae and Freddie Mac • Rescue of Fannie Mae and Freddie Mac • In September 2008, the U.S. government took over the management of Fannie Mae and Freddie Mac. • The Treasury agreed to provide whatever funding would be necessary to cushion losses from the mortgage defaults. • In return, the Treasury received $1 billion of preferred stock in each of the two companies. • The U.S. government allowed Fannie Mae and Freddie Mac to obtain funds by issuing debt securities so that they could resume purchasing mortgages and thereby ensure a more liquid secondary market for them.

41. Systemic Risk Due to the Credit Crisis • Mortgage insurers that provided insurance to homeowners incurred large expenses. • Some financial institutions with large investments in MBS were no longer able to access sufficient funds to support their operations during the credit crisis. • Individual investors whose investments were pooled (by mutual funds, hedge funds, and pension funds) and then used to purchase MBS experienced losses. • International Systemic Risk - Financial institutions in other countries (e.g., the United Kingdom) had offered subprime loans, and they also experienced high delinquency and default rates.

42. Who Is to Blame? • Mortgage originators - some mortgage originators were aggressively seeking new business without exercising adequate control over quality. • Credit rating agencies - The rating agencies, which are paid by the issuers that want their MBS rated, were criticized for being too lenient in their ratings shortly before the credit crisis. • Financial institutions that packaged MBS - Could have verified the credit ratings assigned by the credit rating agencies by making their own assessment of the risks involved.

43. Who Is to Blame? • Institutional investors that purchased MBS - relied heavily on the ratings assigned to MBS by credit rating agencies without the due diligence of performing their own independent assessment. • Financial institutions that insured MBS - presumed, incorrectly, that the MBS would not default. Conclusion about Blame The question of who is to blame will be argued in courtrooms.

44. Government Programs Implemented in Response to the Crisis • The Housing and Economic Recovery Act of 2008. • Enabled some homeowners to keep their existing homes and therefore reduced the excess supply of homes for sale in the market. • Financial institutions must be willing to create a new mortgage that is no more than 90 percent of the present appraised home value. • Financial institutions that volunteer for the program essentially forgive a portion of the previous mortgage loan when creating a new mortgage. • Other programs promoted “short sale” transactions in which the lender allows homeowners to sell the home for less than what is owed on the existing mortgage.

45. Government Bailout of Financial Institutions • On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act) enabled the Treasury to inject $700 billion into the financial system and improve the liquidity of financial institutions with MBS holdings. • The act also allowed the Treasury to invest in the large commercial banks as a means of providing the banks with capital to cushion their losses.

46. Financial Reform Act • In July 2010 the Financial Reform Act was implemented, and one of its main goals was ensuring stability in the financial system. • The act mandated that financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. • The act also required that financial institutions that sell mortgage-backed securities retain 5 percent of the portfolio unless the portfolio meets specific standards that reflect low risk.