Chapters 9, 10, & 11: Residential mortgage loans and fund sources

Chapters 9, 10, & 11:
Residential mortgage loans
and fund sources
Real Estate Principles: A Value Approach
Ling and Archer
Outline
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Legal foundations
Mortgage products
Mortgage markets – primary
Mortgage markets – secondary
Mortgage loan
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In a mortgage loan, the borrower always
conveys two documents to the lender: (1) a
note, and (2) a mortgage.
The note details the financial rights and
obligations between borrower and lender,
e.g., whether a loan can be paid off early
and at what cost, what fees can be charged
for late payments, etc.
The mortgage pledges the property as
security for the debt.
The note: interest charges
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Interest rates can be fixed or variable.
The monthly interest rate = the annual stated
contract interest rate / 12.
The actual monthly interest charged = the monthly
interest rate × the beginning-of-month balance.
Example: suppose that the contract rate is 6%. The
balance on the first day of January is $100,000.
The interest for January is: (6% / 12) × $100,000 =
$500.
The $500 interest is payable on the first day of
February.
The note: adjustable rates, I
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This loan type is known as ARM (adjusted rate
mortgage) in the residential loan markets.
The “index rate” is a market determined interest
rate that is the moving part in the adjustable interest
rate.
There is a markup in the adjustable rate, called
“margin.” For standard ARM loans, the average
margin is about 2.75%.
Whenever there is a change in interest rate, home
mortgage lenders usually need to notify borrowers
at least 30 days in advance.
The note: adjustable rates, II
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Periodic cap: the cap that limits change in the
interest rate from one change date to the next.
Overall cap: the cap that limits interest rate change
over the life of the loan.
Teaser rate: many ARM loans are marketed with a
temporarily reduced interest rate.
Payment cap: some lenders offer ARM loans with a
cap on payments rather than on the interest rate.
For example, the payment can be capped at
increases of no more than 5% in a single year.
However, the unpaid interest would usually added
to the original balance, causing the loan balance to
increase (i.e., negative amortization).
The note: payments
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Most standard, fixed loans are level
payment and fully amortizing. That is, zero
balance at the maturity.
Loans can be non-amortizing. That is, only
periodic (monthly) interest payments are
made. The principal payment is required at
the maturity.
A loan can also be partially amortizing or
negatively amortizing.
The mixture of the payments
The note: term
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Most loans have a definite term to maturity, usually
stated in years.
Balloon loan: a partially amortized loan. It has two
terms: (1) term for amortization: determines the
payment, and the schedule of interest and principal
payments, just like a fully amortized loan, (2) term
to maturity: determines when the entire remaining
balance on the loan must be paid in full. (2) is
shorter.
Balloon loans are popular for income-generating
property.
The note: right of prepayment
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Most standard home loans give the borrower the
right to prepay any time, without penalty.
If the note says nothing about the right of
prepayment, the determination of the right will
depend on the law of the state.
Many subprime loans, those made to homeowners
who do not qualify for standard loans, have costly
prepayment penalties.
Commercial loans also often have repayment
penalties that are more costly for the first few years
of the loan.
The note: late fees
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They are usually accessed on
payments received after the 15th of
the month the payment is due.
Late fees are usually about 4-5% of
the late monthly payment.
The note: personal liability
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For home loans, borrowers usually assume
personal liability. That is, if they fail to meet
the terms of the note, they are in the
condition of default, and can be sued.
These loans are called recourse loans
because the lenders have legal recourse.
For commercial loans, borrowers frequently
do not assume personal liability. But the
property is still used as collateral for the
loan.
The mortgage
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The mortgage is a special contract by which
the borrower (mortgagor) conveys to the
lender (mortgagee) a security interest in the
mortgaged property.
In general, the mortgage gives the lender
the right to rely on the property as security
for the debt obligation defined in the note,
but this right only can be exercised in the
event of default on the note.
The mortgage: clauses, I
The major clauses in a standard home loan
mortgage:
 1. Description of the property.
 2. Insurance clause: requires the
maintenance of property casualty insurance
against fire, windstorm, etc.
 3. Escrow clause: requires a borrower to
make monthly deposits into an escrow
account for property taxes, casualty
insurance premiums, etc.
The mortgage: clauses, II
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4. Acceleration clause: enables the lender to
declare the entire loan balance due and payable
when the borrower defaults on the loan.
5. Due-on-sale clause: gives the lender the right to
accelerate the loan, requiring the borrower to pay it
off when the property is sold.
6. Hazardous substances clause and preservation
and maintenance clause: the borrower is prohibited
from using or storing hazardous substances on the
property and is required to maintain the property in
its original condition.
Default
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Default: failure to meet the requirements of
the note (and by reference, the mortgage).
Technique defaults: minor violations of the
note that do not disrupt the payments on the
loan.
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Example: hazard insurance no longer good.
These usually do not trigger legal actions.
Substantive defaults: when payments are
missed, typically for 90 days.
Possible responses to default
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Lenders may help borrowers improve their
household financial management, e.g.,
credit counseling, a temporary reduction of
payments, facilitating the sale of the
property; e.g., short sale.
Foreclosure: a legal process of terminating
all claims of ownership by the borrower, and
all liens inferior to the foreclosing lien.
Foreclosure
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The ultimate recourse of the lender.
Risk of failing to notify a claimant; it is
sometimes difficult to identify and notify all
claimants to the property; legal procedure
need to be perfect.
Presence of superior liens (senior debts).
Costly and time consuming.
Distressed, sub-optimal sale because legal
complexities and lower marketability often
prevent buyers from debt financing.
2 methods of sale in foreclosure
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Judicial foreclosure: courtadministered public auction.
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This method is required in Vermont.
Power of sale: public auction
conducted by trustee or mortgagee
(the lender)
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This method is preferred by lenders.
Cheaper and faster.
Residential mortgage products
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Conventional mortgage loans
 (Fixed-rate) level-payment mortgages (LPMs)
 Adjustable rate mortgage (ARMs)
Government-sponsored mortgage loans
 FHA-insured loans
 VA-guaranteed loans
Other mortgage products
 Home equity loan
 Interest-only mortgage
 Option ARMs
 And more
BoA’s new push in mortgages
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BoA rolled back its residential mortgage business in
2010 and 2011.
Wells Fargo reported record 2012 net income
largely due to historically low interest rate and a
booming mortgage (refinancing and new
purchases) business.
BoA decided to put into resources to grow its
mortgage business.
Source: WSJ, 01/16/2013.
Conventional mortgage loans
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Any standard home loan that is not insured or
guaranteed by an agency of the U.S. government.
Conventional mortgages can be either fixed rate
(LPMs) or adjustable rate (ARMs).
Conventional mortgage loans can be conforming or
nonconforming. A conforming conventional loan is
one that meets the standards (e.g., $ limit) required
for purchase in the secondary market by Fannie
Mae or Freddie Mac.
Nonconforming loans that exceed the dollar limit
($417,000 in 2015 for continental U.S.) are called
jumbo loans.
LPMs
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Fixed monthly payments; no surprises.
Over 75% of outstanding first
mortgage home loans are LPMs.
30-year LPMs are the predominant
form of conventional loan.
LPMs usually require a higher monthly
payment.
ARMs
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Payments are not fixed.
ARMs tend to have a lower monthly
payment; but this may not always the
case.
FHA-insured loans
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The federal housing administration was
established in 1934 to stabilize the housing
industry.
FHA sells mortgage insurance to lowincome households.
FHA mortgage insurance covers any lender
loss after foreclosure and conveyance of
title of the property to the U.S. Department
of Housing and Urban Development (HUD).
VA-guaranteed loans
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The Department of Veterans Affairs
provides VA-guaranteed loans that
help veterans obtain home mortgage
loans with favorable terms.
Home equity loan
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Some home equity loans are closed-end, fixed-term
loans.
Mostly open-end or credit-line loans.
Tax deductible interest (in contrast, the interest
expenses on credit card loans are not tax
deductible).
Strength of the house as security provides
favorable rate and longer term.
Usually limited to total mortgage debt (sum of all
mortgage loans) of 75% to 80% of value.
Increasingly popular.
Interest-only (I-O) mortgage
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I-O with balloon has interest-only payments
for 5 to 7 years, ending with a full repayment
of principal.
I-O amortizing has interest-only payments
for up to 15 years, then converts to a fully
amortizing payment for the remainder of the
term.
Option ARMs
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Typically, borrowers can select among 3 types of
payments: fully amortizing, interest-only, and a
minimum payment.
Borrowers usually choose the minimum payment,
which is initially based on a very low interest rate:
say, 1.5 %.
Minimum payment increases 7.5 percent per year.
Interest rate charged is adjustable, and often is
deeply reduced for the first few months.
Typically, with minimum payment, the loan balance
grows due to “negative amortization.”
At the end of 5 years, or when the balance reaches
125 % of the original loan, the payment is recast to
fully amortize the loan over its remaining term.
Private mortgage insurance (PMI)
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Protect lender against losses due to default.
Generally required for loans over 80% of
value, i.e., loan-to-value (LTV) > 80%.
Protect lender for losses up to 20% of loan.
Premium can be paid in lump sum or in
monthly installments. 2 possible terms:
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2.5 % of loan in single up-front premium.
0.5 % annual premium (0.041% per month).
PMI termination
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Termination may be allowed if loan
falls below 80% of current value and
borrower is in good standing.
Must allow termination when loan falls
to 80% of original value
(Homeowner’s Insurance Act of 1999).
Obligation to terminate when loan falls
to 78% of original value.
An overview of mortgage debt
Mortgage markets
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Primary mortgage market: the loan
origination market.
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For example, you go to a mortgage broker and
get a mortgage loan from a mortgage lender.
Secondary mortgage market: investors and
mortgage originators buy and sell mortgage
loan portfolios in the secondary mortgage
market.
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Fannie Mae and Freddie Mac are the largest
buyer of residential mortgages in the secondary
market.
Economic significance
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When the mortgage finance system works
well, we expect (1) increased finance
availability, and (2) lower finance cost.
These lead to more RE activities, e.g.,
increasing home ownership rate, and a
stronger economy.
This is the reason why governmentsponsored enterprises (GSEs), e.g., Fannie
Mae and Freddie Mac, have been active in
the mortgage finance system.
Primary market: depository lenders
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They are financial intermediaries.
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Pool small amounts of savings.
Channel to large-scale uses (e.g.; mortgage
loans).
Types
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Savings associations (S&Ls, savings banks).
Commercial banks.
Credit unions.
Non-depository lenders:
mortgage companies
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Mortgage banker: not a bank –
accepts no deposits.
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Originates loans to sell.
Often retains right to service the loan for
a fee.
Mortgage broker: brings borrower and
lender together for a fee; never owns
the loan.
Mortgage banker
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Originates and owns loans long
enough to sell the pooled loans (1st
asset).
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Either, Sell loans “whole.”
Or, pool and securitize loans.
Servicing (2nd asset) is core profit
center.
Servicing
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Collects monthly payments, remits to
investor (loan buyer).
Collects and remits payments for
property taxes, hazard insurance and
mortgage insurance.
Manages late payments, defaults,
foreclosures.
Receives fee of .25% to .44%.
Creating 2 assets
Pipeline risk
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Pipeline risk: risk between loan commitment and
loan sale. 2 types:
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Fallout risk: risk that loan applicant backs out because the
market interest rate falls during this window.
Interest rate/price risk: risk that closed loans will fall in
value before sold.
Mortgage bankers are highly leveraged and
sensitive to pipeline risk.
Hedging is often needed (via purchasing a forward
commitment, i.e., sale of loan at a preset price for
future delivery, from GSEs or other issuers).
Secondary market players
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Fannie Mae (1968): spun off from HUD to
become a primary purchaser of FHA and VA
mortgage loans.
Ginnie Mae (1968): empowered to
guarantee “pass-through” mortgage-backed
securities based on FHA and VA loans.
Freddie Mac (1970): formed to purchase
and securitize conventional home loans
from savings associations.
Mortgage-backed securities
(MBSs)
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Multiple mortgage loans in a single pool or fund.
Often “pass-through”: security entitles investor
to pro rata share of all cash flows.
Loans in a given pool are mostly similar:
 Conventional
 Same vintage (new or recent loans)
 Similar interest rates
Nearly two-thirds of all new home loans have
been securitized in recent years.
MBSs can be agency MBSs (e.g., Fannie Mae)
or private-label MBSs (e.g., Goldman Sachs).
Securitization process
The growth
CMOs and CDOs
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A collateralized mortgage obligation (CMO) is a
type of MBS that have trenches, each with a
different level of priority in the debt repayment
stream, giving them different levels of risk and
reward.
The underlying assets of a CMO are often subprime
mortgages.
Tranches—especially the lower-priority, higherinterest tranches—of an MBS are often further
repackaged and resold as collateralized debt
obligations (CDOs), in the name of “diversification”.
Residential underwriting decisions
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Underwriting: process of determining
whether the risks of a loan are
acceptable.
3 “Cs” of traditional residential
underwriting:
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Collateral: Uniform Residential Appraisal
Report required (Fannie and Freddie).
Creditworthiness: credit report and
scoring.
Capacity: ability to pay (payment ratios).
Capacity ratio, I
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Housing expense ratio = PITI / GMI.
PITI is principal, interest, (property)
taxes and insurance.
GMI is gross monthly income.
Traditionally maximum at 28% for
conventional loans.
Capacity ratio, II
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Total debt ratio = (PITI + LTO) ÷ GMI.
LTO is long-term obligation: the sum of
payments for other repeating
obligations, e.g., car leasing payments
and child support.
Traditionally maximum at 36% for
conventional loans.
FICO
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The credit score FICO (maximum 850)
has been widely used for underwriting
in recent years.
A FICO of above 720-730 gives one
the best mortgage rate.
A FICO of above 660 is viewed as high
quality (prime).
Subprime lending
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Many households are unable to qualify for
“affordable” home loans.
Subprime targets three borrower deficiencies:
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Lack of income documentation.
Weak credit.
Seeking financing for 100% LTV or higher.
More expensive than standard home loans.
Polar views of subprime lending:
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Fills compelling, legitimate need (beats credit cards).
Hunting ground of predatory lenders.
Subprime crisis
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Boston Globe (2008): “Subprime loans have
helped boost US homeownership to a
record 69% of households. …In
Massachusetts, subprime loans, fueled by
refinancings, have grown from 1.6% of
mortgages in 2000 to 12.3% today”
In the US, the delinquency rate of subprime
adjustable rate mortgage was 10% in
2004Q4; this delinquency rate became 30%
in 2010Q4.