Mortgage Default and Underwriting

2. Mortgage Default and Underwriting • Objectives • Causes of Default • House Price or Put Option Theory • Income Theory • Trigger Event Theory • Quantifying Default Risk • Probability of Default– Incidence • Loss in the Event of Default • Managing Default Risk • Before the Loan is Made • Underwriting • After Default Occurs • Loss Mitigation • PMI Insurance • Credit Scoring and loan level pricing

3. 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

4. Quantifying 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” prime residential mortgages; • Incidence is 2%- 4% • Based on a history where house prices rise with inflation • Severity: 15%-25% ignoring interest expenses • 25%-40% including interest expenses • Expected Loss : ~1% • Subprime Experience Looks like it could be 10 times that • For Commercial Mortgage Loans • Incidence is much higher: 10-15% • Severity is about the same: roughly 40% • Expected Loss: 5-6%

11. Managing Default Risk • Mortgage lenders have traditionally used a three-pronged attack on default risk. • Underwriting loan applications to screen out bad risks before loans are made • Insurance for remaining default risk • Mitigating losses after the fact via “workout” efforts • Loan modifications • Quick efficient processes • Mortgage Insurance • Loan level pricing is an approach that has been growing in acceptance and was used to Fannie & Freddie in recent crisis • Fannie and Freddie have “add on” fees based on FICO/LTV grid • MYFICO web page has promoted this concept for several years • FHA has proposed similar pricing • Limit to this approach because adding costs to risky borrowers in turn increases the risk of default

13. Underwriting Loans • The Three “C”s of Underwriting • Capacity • Payment to Income ratios • DSCR ratio for Commercial Loans • Cash to close the loan • reserves • Credit • Track Record and Willingness to Pay • Credit reports • FICO scores • Collateral • LTV ratios

14. 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 (Back end) • Generally, no more than 33% - 40% of borrower’s income can be devoted to fixed obligations (PITI+ car loans, student loans, alimony etc.)

16. Capacity • Mortgage Journal reports each lender’s underwriting ratios • 30 yr FRM • “Tightest” CT Mortgage, Webster and 8 others 28/36 • Common 33/38-45 • Most “lenient” Fairfield Mortgage 40/40 • There have been instances of 50/50 • Traditional ARMs with teasers • Underwriting practices can vary from lender to lender • Some underwrite at teaser rate if teaser <2% from FIAR • Generally somewhat tighter standards but 28/36 is common • Some underwrite at second year payment • Assuming no change in index • Some (few) underwrite at fully indexed rate. • Certain regulations, that apply to “nontraditional” loans require federally chartered lenders and their subsidiaries to “include an evaluation of the their (borrower) ability to repay the debt by final maturity at the fully indexed rate” • Also required to take into account expected negative amortization • Should lenders have responsibility for determining suitability?

17. Trend in Debt to Income Ratios Prime Fixed Rate

18. 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) • My own research supports this as well

20. Traditional Example • Assume a couple with the following attributes • Total joint income: $80,000 /year • Purchasing a property worth $300,000 • Applying for 80% LTV loan of $240,000 • 30 year fixed rate • 6.5% rate • Estimated taxes: $5500/year • Estimated Insurance: $1000/year • Payment on student loans: $400/month • Car payments/leases: $400/month

21. Traditional Example • Front End Ratio: • Monthly income: 80,000/12=6,666.67 per month • Monthly P&I payment: 1516.96 • Monthly Taxes & Insurance (TI): $6500/12=541.67 • Front end ratio=(541.67+1516.96)/6,666.67=30.9% • Back End Ratio: • Denominator is the same: 6,666.67 • Numerator is now PITI + Other Fixed Obligations • (541.67+1516.96+400+400)=2858.63 • Back End Ratio=42.8% • This couple is at the high end of the “common” ratios • Would probably get through with good credit and LTV of 80% in normal times • In today’s market maybe not

22. Capacity • Lenders try to estimate and verify “stable” income • W-2 statements, Form 1040 and written employer verification • “Low Doc/No Doc loans were generally viewed as Alt A or A- loans • Non wage income presents challenges for lenders • Tips, investment profit, self employment income • Low Doc/No Doc Loans were originally designed for these borrowers • Originally required better “other C’s” • Freddie Mac’s Automated Underwriting penalizes self employed, and borrower’s dependent on commissions and or tips. (See Section II) • Lenders may require that you have savings over and above your downpayment to be able to make the first few payments on the loan. • Cash Reserves • For example, the “Gold Measure Worksheet” adds Risk Units if the borrower has less than 2 months payments in the bank and deducts Risk Units if the borrower has reserves in excess of 4 monthly payments

23. Capacity • Freddie’s AUS (Section IV) adds Risk Units for Back End Ratio (Total Fixed Obligations to Income) > 32.6% • Ranges from 2 to 30 Risk Units • 30 Risk Units for back end ratios > 50% • Reject if applicant has more than 18 Risk Units • Adds more Risk Units if the “spread” between the two ratios is more than 10%. • For Example, an applicant with a front end ratio of 28% and a back end ratio of 45% would be assigned 18 Risk Units • Another applicant with a front end ratio of 38% and a back end ratio of 42% would receive 7 Risk Units • A Third Applicant with a front end ratio of 40% and a back end ratio of 40% would receive 4 Risk Units • Freddie’s System clearly emphasizes total debt ratio over the housing payment ratio • In our example with the 32.9/ 42.8 % ratios: • FHLMC risk units: 10 for high total debt to income ratio and 2 for the “spread” between the two ratios • Only has 3 risk units left for everything else.

25. Credit • The second C is credit history • Lender will order a copy of your credit report from one or more of the three major credit bureaus (Experian/Trans Union/Equifax) • 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 judgment. • FICO (or Bureau/Bankruptcy) scores • A FICO score is a numerical summary measure of your credit history. • Low scores--- bad history • High scores --- good history • Freddie Mac assigns Risk Units based on FICO Score • Ranges from -16 RU for 790 and above to 32 RU for 540 or less

26. Credit Scores Fair Isaac has proprietary system for generating scores based on past credit records Based on: Past Credit Payment History ---35% How Much Debt ---30% Length of History ---15% New Credit ---10% Mix of Sources of Credit ---10% Rough Indication of how score is generated is provided on Gold Measure Worksheet (Credit File B)

27. Median FICO Score: ~~ 725

30. Credit History Issues • There is strong evidence from consumer lending and more recently from mortgage lending that bad credit in the past is a good predictor of problems in the future. • The GSEs were leading proponents of using credit scores in mortgage underwriting • Avery, Bostic, Calem and Canner article provides evidence of relevance.

31. Credit Score Issue: Discrimination and Fair Lending • Discrimination Related Issues • Some argue that reducing the amount of human judgement in the lending decision will reduce discrimination. • “Decisions will be made “scientifically” • Others 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 clearly are related to income and wealth • Credit scores seem to vary systematically with geography

32. ACORN –Great Divide Report

35. Facts to Ponder Ratio of Loan Denial Rates to Base of White Denial Rate, Controlling for Income Level

36. 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 • Increasingly, houses are valued using automated valuation models • Apply regression techniques to large amounts of data to predict house price as a function of house characteristics

38. LTV & Default Risk • Avery Bostic Canner & Calem Table 1

41. Bringing It All Together Historically, LTV ratio has been viewed as the primary predictor of default risk

42. Trend in Debt to Income Ratios Prime Fixed Rate

43. Process Depends on State Law • Judicial foreclosure: Lender is required to go to court, show the court that the borrower is in default and request relief • Foreclosure sale • Transfer of property • Deed of Trust : In deed of trust states, the borrower conveys title to a third party trustee at the time the money is borrowed. The trustee is empowered to sell the property in the event of default.

49. 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

50. 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