HOFIS Ch21

Question 1

Describe the payment characteristics of a mortgage

Answer 1

Can be amortizing (principal and interest), IO, and/or balloon

Rate can be fixed, adjustable (ARMs), or hybrid ARMs
Ÿ ARMs require payment to be recast when the index-based rate changes

Question 2

Describe the key participants in the mortgage industry

Answer 2

Direct lenders – underwrite and provide loans directly to borrowers

Brokers – work with clients and wholesale lenders

TPOs – when a loan is completely/partially originated/processed by a party other
than seller

Depository institutions – fund loans with bank deposits

Non-depository lenders – fund loans by selling them to investors

Originators – underwrite and fund loans

Servicers – collect monthly payments, handle property tax payments, deal with
delinquencies

MBS providers – public or private companies that buy and securitize mortgages
for investors

Question 3

Describe the loan underwriting process

Answer 3

Underwriter evaluates borrower’s credit and value of property
Criteria used to evaluate credit:
1. Credit (“FICO”) scores: 730+ is strong
2. If LTV ratio ¡ 80%, mortgage insurance required
3. Debt-to-income ratio criteria (lower is better) (e.g. front ratio and back ratio)
Front Ratio
Total Monthly Payments on the Home
Borrower’s Pretax Monthly Income
Back Ratio Front Ratio 􀀀
Other Debt Payments Like Auto Loans
Borrower’s Pretax Monthly Income
Documentation/standards declined until the 2008 crisis, then got stronger

Question 4

Describe the relationship between interest rates, prepayment, and duration

Answer 4

Falling interest rates: prepayments Ò, durations Ó

Rising interest rates: prepayments Ó, durations Ò (“extension”)

Question 5

List 5 items that impact mortgage prepayment risk

Answer 5

Prepayments can be rate-sensitive or rate-insensitive
1. Sale of property
2. Destruction of property (e.g. fire)
3. Borrower default
4. Partial principal prepayments
5. Refinancing

Question 6

Define the following measures of prepayment speeds
1. Single Monthly Mortality (SMM)
2. Conditional Prepayment Rate (CPR)
3. PSA model

Answer 6

1. Single Monthly Mortality (SMM)
   SMM
   Scheduled Balance Actual Balance
   Scheduled Balance
2. Conditional Prepayment Rate (CPR) = annualized SMM
   CPR 1 p1 SMMq
   12
3. PSA Model – reflects that CPRs are not constant over the life of the loan
   Ÿ Assumes CPR increases by 0.2% per month until it hits 6.0% in month 30
   Ÿ Can express in multiples

Question 7

List 5 characteristics used to evaluate mortgage credit risk

Answer 7

1. Credit scores
2. LTVs
3. Number of days delinquent
4. Default (90+ days delinquent)
   Ÿ Some agencies insure (Ginnie Mae)
   Ÿ Non-agency recoveries depend on foreclosure process
5. Default loss severity is higher when:
   Ÿ High LTV
   Ÿ Appraisal values exceed market values
   Ÿ Property values decline after origination
   Ÿ Foreclosure process is expensive