Mortgage Default and Underwriting

1. Mortgage Default and Underwriting • Objectives • Default viewed as a “Put” option • Impact of default • On lender’s yield • On borrower • Underwriting rules • Credit Scoring

2. Default Option • A put option is a security that gives the holder the rightbut not the obligation to sell an asset at a specified price. • Call and put options on common stocks • Call option gives the holder the right to buy a share of Fannie Mae stock at $60 • Valuable to the holder if and only if stock price rises above the strike price ($60) before the expiration of the option. • Put option gives the holder the right to sell Fannie Mae stock at $40. • Valuable to the holder if and only if the price of the stock falls below $40 before the expiration of the option.

3. Default Option • A mortgage borrower has the right to default on his note. • Eliminates the obligation to make the remaining payments on the mortgage. (In many states.) • We can calculate the present value of those remaining payments. Eliminating that obligation is like receiving a payment equal to the present value of the remaining payments. • Transfers ownership of the house that was pledged as security of the loan.

4. Default Option • Default can be thought of as a way of selling your house for the value of the remaining payments. • However, there are other considerations: • Loss of credit standing -- problem getting future loans/leases • Deficiency judgements • Tax obligations

5. Implications of Default • Lender expected to receive an annuity of 360 level monthly payments • When there is a default, the lender receives regular monthly payments until default. • Period of no payments and significant expenses while lender attempts to gain control of the property. • Net sales proceeds from the property.

6. Example • Lender A makes an 83.33% LTV mortgage loan with a coupon of 10% to C. U. Around. • The original home value was $120,000 • C.U. pays the lender 1 point and a $500 origination fee. • The monthly payments are $877.57 • The APR on the loan is 10.18%

7. Example • C.U. makes his regular payments for 3.5 years and then defaults. • The lender works for three months to get C.U. to resume payments • It takes 9 months to get the court to transfer ownership to the lender • It takes six months to sell the home

8. Example • Assume the lender sells the home for a price of $95,000. • Net cash received will be about $88,000 • Cost incurred over the 18 months of foreclosure: • Property taxes: @1.5% /year: $2,700 • Property Insurance: $ 500 • Winterizing & Utilities $ 1,000

10. Realized Yield

11. Example • Solve for i; • Using cash flow keys of your calculator: • IRR of the specified cash flows: • 5.04% /year • Accounting for loan default: • Stop accruing interest on loan after 90 days • Keep paying interest on the funds you borrowed to make the original loan. • Incur expenses over the eighteen month default period • Record loss on sale of 9,786 (88,000-97,786)

12. Default Costs • Lenders analyze default costs using two factors: • The probability of default : incidence • The loss in the event of default: severity • For “plain vanilla” residential mortgages; • Incidence is 2%- 4% • Severity: 15%-25% ignoring interest expenses • 25%-40% including interest expenses

13. Default • Causes of Default : • House Price Theory (Strict Put Option View) • Borrowers default when house prices decline enough below market value of loan payments to outweigh “other” costs • Income Theory • Borrowers default when they lose jobs, become ill, divorce etc. and can no longer make payments • Trigger Event Theory • Borrowers default when some “trigger event” like job loss, divorce or a job move AND upon analysis of their situation they find their house price is less than the loan amount

14. Managing Default Risk • Mortgage lenders have traditionally used a two-pronged attack on default risk. • Underwriting loan applications to screen out bad risks before loans are made • Mitigating losses after the fact via “workout” efforts • Loan modifications • Quick efficient processes • Loan level pricing is an alternative approach that is gaining favor • Read the Kling article in SMM

15. Underwriting Loans • Remember the Three “C”s • Capacity • Payment to Income ratios • Cash to close the loan • reserves • Credit • Credit reports • FICO scores • Collateral • LTV ratios

16. Capacity • Residential lenders calculate two standard ratios to help them determine a borrower’s capacity to make the required payments • Housing payment to income ratio (Front end ) • Generally, no more than 28% - 38% of borrower’s pretax income can be devoted to making housing payment (“PITI”) • Total obligations to income • Generally, no more than 33% - 40% of borrower’s income can be devoted to fixed obligations (PITI+ car loans, student loans, alimony etc.)

17. Capacity • There is not much empirical evidence supporting the view that income matters a whole lot in default. • Standard lending practices make this difficult to test. • Lenders screen the population to those with proven capacity to pay. • See Avery, Bostic, Calem and Canner Federal Reserve article (page 633 and table 6)

18. Example • Assume you make $30,000/year or $2,500/month. • You also have a car lease payment of $150/month • How large a loan will you qualify for if loan rates are 7.5% and your lender strictly adheres to 25%/33% underwriting?

19. Example • Front end ratio: • 25% of your income is $625/month • You estimate taxes and insurance (TI) are $150/month leaving a max of $475 for PI • N=360 • I=7.5/12 • PMT=475 • PV=???(67,933).

20. Example • Back end ratio • 33% of your income is $825 • Estimated TI is $150/month • Car loan is $150/month • Leaves $525/month for TI • Based on the total obligations to income ratio, you qualify for a loan of $75,084 • You will be limited to the smaller of the two numbers or $68,000

21. Capacity • Lenders need to estimate and verify “stable” income • W-2 statements, Form 1040 and written employer verification • Non wage income presents challenges for lenders • Tips, investment profit, self employment income • Lenders may require that you have savings over and above your downpayment to be able to make the first few payments on the loan. • Reserves

22. Credit • The second C is credit history • Lender will order a copy of your credit report from one of the three major credit bureaus • Creditors rate your past borrowing from 1 (“Paid as agreed”) to 9 (“written off”). • Traditionally mortgage lenders had a human underwriter review credit reports and make a judgement. • FICO (or Bureau) scores • A FICO score is a numerical summary measure of your credit history. • Low scores--- bad history • High scores --- good history

23. Credit History Issues • There is strong evidence from consumer lending and growing evidence from mortgage lending that bad credit in the past is a good predictor of problems in the future. • Freddie Mac has been a leading proponent of using credit scores in mortgage underwriting • Avery, Bostic, Calem and Canner article: See tables

24. Credit History Issues • Current debate • Some argue that using credit scores perpetuates discrimination in lending • If you can’t get credit because of discrimination, you can’t build up a good FICO score. • Credit scores seem to vary systematically with geography • Others argue that reducing the amount of human judgement in the lending decision will reduce discrimination. • “Decisions will be made “scientifically”

25. Collateral • The third C refers to the collateral that is pledged as security for the loan. • Verify the value • Limit initial loan to value ratio. • Lenders will normally require an appraisal of the home you intend to buy. • Value= Lower of purchase price or appraised value

26. Bringing It All Together

27. Mortgage Insurance • Mortgage Insurance has been used to mitigate default risk since early this century • 1904: New York authorized formal mortgage insurance • Until the Depression, rising house prices offset chronic industry problems • low capitalization • questionable business practices • Little or no regulation

28. Mortgage Insurance • Government efforts to revive the housing industry led to the establishment by the Federal Housing Administration of the Mutual Mortgage Insurance Fund to provide insurance on FHA loans. • FHA limits the size of the mortgage it will insure • VA guarantees only a portion of the loan and is available only to veterans

29. Private Mortgage Insurance • Private Mortgage Insurance re-emerged in 1957 with the creation of Mortgage Guarantee Insurance Corporation (MGIC) • Private mortgage insurance guarantees only a fraction of the loan • Generally up to 30-35% of the loan amount • On a $100,000 loan, the PMI’s obligation to pay claims is capped at the stated percentage--e.g. $30,000

31. Mortgage Insurance • PMI and VA Provide Insurance that is “Capped” at an upper limit • FHA Provides “100%” Insurance • FHA limits the size of the loan that can be insured • “Standard Limit”: $121,296 • Exceptions for “High Cost” areas • In Hartford area: $197,621 • In Fairfield area: $219,849 • Down Payment • VA: None required • FHA: 3%-5% minimum • PMI: 3%-20%

32. Mortgage Insurance • Underwriting Differences -- Measuring Capacity • FHA establishes strict limits for front and back ratios • 29%/41% • PMIs can set their own limits and generally conform to “secondary market standards” • VA uses “residual income” approach • Starts with gross income, deducts taxes, debts and PITI • Sets standards for residual

33. Mortgage Programs • One Big Difference: FHA & VA loans are fully assumable • “Conventional” loans are generally subject to Due-on-Sale clause

34. Decisions • VA Program pretty good deal for those who qualify, have limited funds for down payment and need a loan of about $150,000 or less • FHA loans are good for borrowers who have very limited funds for down payment and need “aggressive” ratios • Special programs for recovering neighborhoods, GPMs, etc • Conventional loans are used by about 85% of the population