Chapter 11 Sources of Funds for Residential Mortgages

1. Chapter 11Sources of Funds for Residential Mortgages REAL ESTATE FINANCE 331

2. the market for home mortgage loans • Mortgage borrowers must compete to borrow funds in the credit markets • Total mortgage debt at the end of 2013Q2 approached $13.003 trillion • There are four major types of mortgage debt (Board of Governors Fed. Res. Sys.) 2013Q2 http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm • Residential (1 to 4 family) $ 9,822 76% • Multifamily apartments $ 885 7% • Commercial $ 2,14116% • Farm $ 167 1% $13,003 100%

3. Mortgage Debt Outstanding

4. Thrifts (S&L, SB)

5. Evolution of Mortgage Finance • Thrifts and Savings and Loans • Dominated mortgage lending: 46% or more y mid 1970s, 3.5% by 2013Q3 • Extremely localized market • Fatal flaw: Funded long-term loans with short-term savings • Cocoon of regulations restricted ability to adapt to changing market conditions • Disintermediation in financial markets led to widespread Thrift/S&L failures • Banking Deregulation and Consolidation • Effects of the Depository Institutions Deregulation and Monetary Control Act • Money center banks begin to enter the mortgage business • Many create mortgage banking subsidiaries

6. Evolution of Mortgage Finance • Mortgage Bankers originate mortgage loans, provide processing services, package mortgages and sell in secondary markets • Servicing is core profit center • Collects monthly payments, remits to investor • Collects and remits payments for property taxes, hazard insurance and mortgage insurance • Manages late payments, defaults, foreclosures • Receives fee of .25% to .44% (25 to 44 basis points: 1 bp = 0.01%) • Typically accept loss at origination of a loan to obtain servicing rights • Three-step process: • Issue mortgage commitment to potential borrower • Close or originate loan (funding loan) • Sell loan • Mortgage Brokers bring borrowers and lenders together but do not own the loans or fund them (charge fees for services)

7. Pipeline Risk: Signature Risk of Mortgage Banking • Pipeline risk: Risk between loan commitment and loan sale • Two components • Fallout risk: Risk that loan applicant backs out • Interest rate/price risk: Risk that closed loans will fall in value before sold • Mortgage bankers highly leveraged • Very sensitive to pipeline risk • Hedging necessary for survival • Management Tools for Pipeline Risk • Good pipeline information • Forward commitment: Sale of loan at a preset price for future delivery • Price set now • Delivery and payment are, 60 to 90 days away • Analogous to futures contract • Standby forward commitment: Optional forward sale • Same as “forward commitment” except that mortgage banker has option to use or not • More costly than forward commitment

8. Secondary Mortgage Market • Mortgage-Backed Securities (MBS) • 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 will be similar: • FHA/VA; conventional • Same vintage (new or recent loans) • Similar interest rates • Nearly two-thirds of all new home loans have been securitized in recent years • Fannie Mae (Federal National Mortgage Association, 1938) • Secondary market for FHA/VA • Funded through both debt issues and mortgage securitization • Has securitized and sold, or owns, about 23% of outstanding home loans • Taken into conservatorship by U.S. in 2008

9. Secondary Mortgage Market • Ginnie Mae (Government National Mortgage Association, 1968) • Created first major pass-through MBS program • Does not buy mortgages • Guarantees timely payment of interest and principal to holders of GNMA securities • Guarantees only securities based on FHA/VA loans • Freddie Mac (Federal Home Loan Mortgage Corporation, 1970) • Chartered by Congress to expand secondary market for mortgages • Deals exclusively in conventional loans • Securitized all loans purchased until recent years • Financially similar to Fannie Mae • Has securitized and sold, or owns, about 15% of outstanding home loans • Taken into conservatorship by U.S. in 2008

10. Secondary Mortgage Market • Importance of Fannie Mae and Freddie Mac • Have brought about standardization in: • Mortgages and mortgage notes • Appraisal forms and practices • Underwriting procedures and standards • Also, influence practices and standards in nonconforming mortgage markets • Have increased liquidity of mortgage markets • No interstate differentials in mortgage interest rates • No home lending disruptions when interest rates rise • New sources of mortgage funds in security investors • Heavily influence what type loans lenders make

11. Secondary Mortgage Market • Major Problems with Fannie and Freddie • Not capitalized to withstand declining home values • Said to wield too much political influence • Said to unsuccessfully mix private enterprise with housing subsidy programs • Said to divert the benefits of their efficiency advantage into the pockets of their management • Said to be unnecessary in a financial world now dominated by a few giant banks • Said to be part of an unnecessary mortgage lending system – for the level-payment fixed rate mortgage

12. Secondary Mortgage Market • Private Mortgage Conduits • Primarily a conduit for jumbo (nonconforming) loans • Briefly active in sub-prime loan market • US Mortgage System basically has 4 Channels • Local depository lending (very limited) • FHA/VA – GNMA securitization process • Conforming conventional – GSE process • Non-conforming conventional – private security process

13. Lenders’ Underwriting Decisions • Underwriting: Process of determining whether the risks of a loan are acceptable • Three “Cs” of traditional underwriting: • Collateral: importance of Uniform Residential Appraisal Report (URAR) • Creditworthiness: Credit report – FICO score • Capacity: Ability to pay (payment ratios)

14. Lenders’ Underwriting Decisions

15. Lenders’ Underwriting Decisions • Computing Payment ratios for Underwriting (manage risk) • Housing Expense Ratio = PITI/GMI (~ Front-end ratio) • PITI is principal, interest, (property) taxes and insurance • GMI is gross monthly income • Recent convention set maximum at: • 28% for conventional loans • 29% for FHA • Total Debt Ratio = (PITI + LTO) ÷ GMI (~Back-end ratio) • LTO is long-term obligation • Recent convention set maximum at: • 36% for conventional loans • 43% for FHA

16. Lenders’ Underwriting Decisions • Recent Underwriting Failures • Problems were due not adhering to procedures and standards described above • Half of sub-prime loans had limited documentation • Most of Alt-A loans had limited or no documentation (Came to be called “liar loans”) • Private securitization firms widely suppressed loan underwriting • Underwriting focuses on comparative risk among borrowers • Recent regulatory proposals by Fed and 5 other Agencies to create QRM (Qualified Residential Mortgage, 2013) • Calls for lenders to keep a 5% stake in the credit risk for certain securitized loans that don’t meet “qualified residential mortgage” standards. • Designed to be particularly safe by making sure that borrowers can afford their mortgages. • Lower retention standards for Fannie (2.44%) and Freddie (2.68%)

17. Emerging Mortgage Classifications • Qualified Mortgage (QM) • Fully amortizing (generally) • No longer than 30 years • Fees of no more that 3 percent (generally) • Debt-to-income ratio no more than 43 percent • Strong verification of borrower income and assets • If ARM, must underwrite to highest possible rate in first five years • Gives lender legal advantage in case of default

18. homework assignment • Key terms: Collateral, Credit Scoring, Disintermediation, Housing Expense ratio, Interest rate Risk, Loan Underwriting, Pipeline Risk, Qualified Mortgage, Total Debt Ratio • Study Questions: 1, 2, 4, 9 (all parts)