HOFIS 24 - Mortgages & the Mortgage Market Flashcards
Mortgage definition
Loan secured by the underlying real estate
Lien status
- Dictates the loan’s seniority in liquidation
- First-lien status: grant the lender first call on proceeds of liquidation of property
- Second-lien status: used for purposes such as home improvements or other large purchases
Balloon Mortgages
Require the borrower to repay all unamortized principal at a specified date (e.g., 5 or 7 years)
Adjustable-rate Mortgages (ARMs)
Have an interest rate that varies during the term
- Set based on underlying index plus spread a (margin)
- Rates usually reset annually
- Teaser (artificially low) rate in the first year
Interest-only (IO) ARM Mortgages
- Have lower monthly payments initially since no principal is included; at the end of the IO period, the loan is recast
- Recast a loan means the payments are recalculated so that the new payments (principal and interest) will pay off the loan over the remaining perdiod
Payment-Option and Negative-Amortization Mortgages
Allow for payments less than the monthly interest accrual
- Less common and illegal in some states
Role and Sources of Mortgage Credit Support
- Enhance mortgage loans liquidity
- Come from the goverment, GSEs, or private entities
Jumbo Loans
- Loans larger than the conforming limits
- Securitized by private-label transactions (private sector - not agencies or GSEs)
Morgage Loan Conforming vs Nonconforming Balances
- Conforming balances are loans within limits set by statue for GSEs
- Freddie Mac and Fannie Mae
- Ginnie Mae limits are lower and differentiated b/w high and low costs states
Alternative- A (Alt-A) Mortgages
Fall b/w prime and subprime mortgages
Direct vs. Third-Party Originations in the Mortgage Industry
- Direct lender - underwrite and provide loans direclty to borrowers
- Brokers - represents clients and works with various lenders
- Wholesale channels - lender operations that work with brokers
- Retail channels - ones that work directly with borrowers
Depository vs. Nondepository in the Mortgage Industry
- Depository institutions - (e.g., banks) can use deposits to fund loan activities
- Nondepository lender - (e.g., mortgage bankers) sell most of their loan production to investors
Originators vs. Servicers in the Mortgage Industry
- Originators - underwrite and fund loans
- Servicers - collect monthly payments, handle property taxes, and deal with delinquencies
Fully Amortized Mortgage Monthly Payment Formula
- B is the original loan balance;
- i is the monthly interest rate;
- n is the loan term in months
Committed vs Uncommitted Mortgage Loans
- Uncommitted loans - borrower has not yet locked in an interest rate
- Committed loans - borrower has locked in the interest rate
Components of Mortgage Underwriting Process
- Evaluating of borrower’s creditworthiness
- Ensuring the integrity of the property value
Indications of Loan-to-Value (LTV) Ratios
- Indicator of the borrower’s leverage
- Indicates how much can be recovered in a default situation
- Impacts expected payment performance of the borrower
- Combined LTV (CLTV) takes into account any second liens (better indicator)
Debt-to-Income Ratios
- Front Ratio: (should be below 28%)
- Total monthly mortgage payments divided by borrower’s gross monthly income
- Back Ratio: (should be less than 36%)
- Includes other debt payments such as auto loans in front ratio numerator
Stated Income (Mortagage Loan Documentation)
- Mortgage loans that require no documentation
- Called NINA (no income/no asset)
Influencers of Mortgage Rates
MBS market (GSEs and agencies) has a lot of influence on mortgage rates
Creation of MBS
- MBS providers aggregate loans with similar characteristics into pools
- Called “pass-throughs” since principal and interest are passed to investors
- MBS provider sells shares to the pool of investors
MBS Weighted Average Coupon (WAC)
Average loan rate in the MBS pool
Components of Spread b/w MBS investor’s coupon and WAC
- Servicing fee paid to servicer of the loan
- Guaranty fees paid to agencies that insure the loans
- Excess servicing fee - additional spread that reduces investor’s spread to a desired level
Mortgage Discount Points
Upfront fee that lenders charge borrower at closing
- the higher discount points, the lower the loan rate
Mortgage Risk-based Pricing
- Riskier borrowers require higher guaranty costs (a.k.a credit enhancements)
- To offset, lenders charge more discount points (add-ons) which increases the borrowers closing costs
Non-Agency (private) MBS Credit Enhancement
Accomplished through subordination
- Junior (subordinate) bonds will suffer losses before senior bonds
- Junior bonds trade at larger discounts to senior bonds (riskier for investors)
Mortgage Prepayment Risk
- Similar to call risk
- Borrowers tend to refinance as market rates fall
- Investors lose a high-yielding asset and have to reinvest principal in lower-yielding assets
Events that Cause Mortgage Prepayments
- Refinancing
- Partial principal prepayements
- Sale of property
- Default of borrower
- Destruction of property (e.g., fire)
MBS Convexity
MBS have negative convexity and tend to under-perform non-callable bonds
- if rates fall, prepayments increase -> MBS duration fall (mutes increase in prices)
- if rates rise, prepayments slow -> MBS duration lenghten (mutes decrease in price)
Measures of Mortgage Prepayment Speeds - SMM
- Single Monthly Mortality (SMM)
- (scheduled balance - actual balance) / scheduled balance
Measures of Mortgage Prepayment Speeds - CPR
- Conditional Prepayment Rate (CPR) = annualized SMM
- CPR = 1 - (1-SMM)^12
Measures of Mortgage Prepayment Speed - PSA Model
- Reflects that CPRs are not constant over the life of the loan
- assumes CPR increases by .2% per month until it hits 6.0% in month 30
- can express in multiples (e.g., 200% PSA doubles the speed at each time step)
Aspects of MBS credit risk modeling that are different from bonds
- Quantifying and stratifying characteristics of 1000s of underlying loans
- Translating characteristics into best-, worst-, and likely-case scenarios
- Calculating returns based on above scenarios
Characteristics used to evaluate mortgage credit risk before and after mortgage is originated
- Before mortgage is originated:
- Credit scores
- LTVs
- After mortgage pool is created:
- Number of days delinquent
- Default (90+ days delinquent)
- Agency insured vs. non-agency
- Default loss severity
Morgage Default Severity Factors
Severity is higher when:
- High LTV
- Appraisal values exceed market values
- Property values decline after origination
- Foreclosure process is expensive
Mortgage Agency Pool vs Private-Label Defaults Recoveries
- Agency pool defaults – covered by the agency, so effectively just another prepayment to the investor
- Private-label (non-agency) defaults – recoveries depend on the foreclosure process
- Reported separately and measured by condition default rates (CDRs)
Explain the impacts of prepayment risk on cash flow patterns of
mortgages
Changes in prepayment rates lead to negative convexity of price performance.
Prepayment risk leads to extension, causing the price of mortgage or MBS to
decline more than comparable fixed-maturity instruments at the prevailing level
of yields increases.
when market yields increase, prepayments tend to slow, causing the average life and duration of mortgages or MBS to increase;
while when market yields decline and bond prices increase, prepayment increase, mortgage shorten in average life and duration.
As a result, the price performance tends to lag that of bonds without prepayment exposure when interests decline.
