Residential mortgage loans and fund sources

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Residential mortgage loans and fund sources

• Real Estate Principles A Value Approach
• Ling and Archer

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Outline

• Legal foundations
• Mortgage products
• Mortgage markets primary
• Mortgage markets secondary

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Mortgage loan

• 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.

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The note interest charges

• Interest rates can be fixed or variable.
• The monthly interest rate the annual stated
  (quoted) 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.

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The note adjustable rates, I

• 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.

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The note adjustable rates, II

• 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).

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The note payments

• 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.

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The mixture of the payments
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The note term

• 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.

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The note right of prepayment

• 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.

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The note late fees

• 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.

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The note personal liability

• 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.

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The mortgage

• 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.

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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.

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The mortgage clauses, II

• 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.

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Default

• 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.
• Example hazard insurance no longer good.
• These usually do not trigger legal actions.
• Substantive defaults when payments are missed,
  typically for 90 days.

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Possible responses to default

• Lenders may help borrowers improve their
  household financial management, e.g., credit
  counseling, a temporary reduction of payments,
  facilitating the sale of the property.
• Foreclosure a legal process of terminating all
  claims of ownership by the borrower, and all
  liens inferior to the foreclosing lien.

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Foreclosure

• 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.

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Foreclosure for Whitney Houston

• STATE OF GEORGIA COUNTY OF FULTON NOTICE OF SALE
  UNDER POWER Because of a default in the payment
  of the indebtedness secured by that certain
  Security Deed, dated April 28, 2003, executed by
  WHITNEY E. HOUSTON to MORTGAGE ELECTRONIC
  REGISTRATION SYSTEMS, INC., as nominee for
  WACHOVIA MORTGAGE CORPORATION, recorded in Deed
  Book 34852, Page 295, Fulton County, Georgia Deed
  Records, and securing a Note in the original
  principal amount of 1,100,000.00,
• Source http//www.wsbtv.com

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The waves of foreclosures

• In some major markets, including Las Vegas and
  San Diego, foreclosure-related sales have
  accounted for more than 40 of all sales in
  recent months.
• Waves of foreclosures cuts into home prices.
• Source WSJ, Mar. 25, 2008.

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2 methods of sale in foreclosure

• Judicial foreclosure court-administered public
  auction.
• This method is required in Vermont.
• Power of sale public auction conducted by
  trustee or mortgagee (the lender)
• This method is preferred by lenders.
• Cheaper and faster.

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Residential mortgage products

• 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

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Conventional mortgage loans

• 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 level-payment mortgages) 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 2006 for continental U.S.) are
  called jumbo loans.

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LPMs

• 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.

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ARMs

• Payments are not fixed.
• ARMs tend to have a lower monthly payment but
  this may not always the case.

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FHA-insured loans

• The federal housing administration was
  established in 1934 to stabilize the housing
  industry.
• FHA sells mortgage insurance to low-income
  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).

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VA-guaranteed loans

• The Department of Veterans Affairs provides
  VA-guaranteed loans that help veterans obtain
  home mortgage loans with favorable terms.

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Home equity loan

• 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.

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Interest-only (I-O) mortgage

• 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.
• Is I-O amortizing a good product from a home
  buyers perspective?

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Option ARMs

• 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.

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Private mortgage insurance (PMI)

• Protect lender against losses due to default.
• Generally required for loans over 80 of value,
  i.e., loan-to-value (LTV) gt 80.
• Protect lender for losses up to 20 of loan.
• Premium can be paid in lump sum or in monthly
  installments. 2 possible terms
• 2.5 of loan in single up-front premium.
• 0.5 annual premium (0.041 per month).

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PMI termination

• 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 (Homeowners Insurance Act of
  1999).
• Obligation to terminate when loan falls to 78 of
  original value.

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An overview of mortgage debt
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Mortgage markets

• Primary mortgage market the loan origination
  market.
• 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.
• Fannie Mae and Freddie Mac are the largest buyer
  of residential mortgages in the secondary market.

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Economic significance

• 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 government-sponsored
  enterprises (GSEs), e.g., Fannie Mae and Freddie
  Mac, have been active in the mortgage finance
  system.

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Primary market depository lenders

• They are financial intermediaries.
• Pool small amounts of savings.
• Channel to large-scale uses (e.g. mortgage
  loans).
• Types
• Savings associations (SLs, savings banks).
• Commercial banks.
• Credit unions.

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Non-depository lenders mortgage companies

• Mortgage banker not a bank accepts no
  deposits.
• 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.

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Mortgage banker

• Originates and owns loans long enough to sell the
  pooled loans (1st asset).
• Either, Sell loans whole.
• Or, pool and securitize loans.
• Servicing (2nd asset) is core profit center.

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Servicing

• 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.

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Creating 2 assets
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Pipeline risk

• Pipeline risk risk between loan commitment and
  loan sale. 2 types
• 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).

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Secondary market players

• 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.

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Mortgage-backed securities (MBSs)

• Multiple mortgage loans in a single pool or fund.
• Security entitles investor to pro rata share of
  all cash flows.
• Loans in a given pool are 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.

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Securitization process
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The growth
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The bust of Fannie and Freddie

• In September 2008, the government seized their
  operations.
• They recorded a combined 14 billion of losses
  in the 12 months ended June 30, largely because
  they lowered their credit standards and purchased
  or guaranteed dubious home loans.
• These home loans are the so-called Alt-A loans,
  which go to borrowers with good credit records
  who do not fully document their income.
• Source WSJ, Oct. 16, 2008.

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Residential underwriting decisions

• Underwriting process of determining whether the
  risks of a loan are acceptable.
• 3 Cs of traditional residential underwriting
• Collateral URAR appraisal.
• Creditworthiness credit report and scoring.
• Capacity ability to pay (payment ratios).

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Capacity ratio, I

• Housing expense ratio PITI / GMI.
• PITI is principal, interest, (property) taxes and
  insurance.
• GMI is gross monthly income.
• Recent convention set maximum at 28 for
  conventional loans.

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Capacity ratio, II

• 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.
• Recent convention set maximum at 36 for
  conventional loans.

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Subprime lending

• Many households are unable to qualify for
  affordable home loans.
• Subprime targets three borrower deficiencies
• Lack of income documentation.
• Weak credit.
• Seeking financing for 100 LTV or higher.
• More expensive than standard home loans.
• Polar views of subprime lending
• Fills compelling, legitimate need (beats credit
  cards).
• Hunting ground of predatory lenders.

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Subprime crisis

• Loans to homeowners with less-than-sterling
  credit are the fastest-growing segment of the
  mortgage marketSo-called 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 todayAbout 3.5 of
  subprime mortgages and refinancing loans go into
  foreclosure, but a study by the UNC found that
  20 of refinancings in 1998 through 2000 that
  were examined wound up in foreclosure. For
  conventional loans, the rate is 1.1 of mortgages
  and refinancings
• Source Boston Globe

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The scope of high-risk mortgage

• From 2004 to 2006, when conventional lending
  slowed and subprime lending accelerated, more
  than 2,500 financial institutions made a combined
  1.5 trillion in high-interest-rate (high risk)
  mortgage loans. Most subprime loans fall into
  this basket.
• Source WSJ, Oct. 11, 2007.