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IIM RanchiPGP-II

June-August-2014

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Part-07

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In most developed countries the right to own ahome is virtually a fundamental right

But few people can pay the full purchase pricefrom their own funds

So most of the required funds are borrowed A mortgage loan is a loan collateralized by real

estate

The lender is the mortgagee

The borrower is the mortgagor In the event of default the lender can seize the

property and sell it to recover his dues

This is called the Right of Foreclosure

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There are three categories of players Mortgage originators

Mortgage servicers

Mortgage insurers

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Who is an originator? The original lender or the party who first extends a

loan to the acquirer of the property

Originators include: Thrifts or S&Ls

Commercial Banks

Mortgage Bankers

Life Insurance Companies

Pension Funds

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The originator gets income from varioussources

When a loan is granted he will levy anOrigination Fee

This is expressed in terms of points

Each point is 1% of the borrowed amount

So a fee of 1.5 points on a loan of $200,000 willamount to $3,000

Most originators will also levy an applicationfee and certain processing fee

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The second source is the profit that can beearned if and when the loan is sold to anotherparty

A mortgage loan is a type of debt

It is therefore vulnerable to interest ratefluctuations

If rates were to decline the sale of a loan will

result in a gain for the seller

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This is called a Secondary Marketing Profit However if rates were to rise after the loan is

disbursed there will be a loss

If the originator decides to hold the loan asan asset he will earn periodic income in theform of interest

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Every loan has to be serviced This includes the following activities

Collection of monthly payments and forwarding theproceeds to the owner of the loan

Sending payment notices to mortgagors

Reminding mortgagors whose payments areoverdue

Maintaining records of principal balances

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Administering escrow balances for real estate taxesand insurance purposes

Initiating foreclosure proceedings if necessary

Furnishing tax information to mortgagors when

applicable Servicers include

Bank related entities

Thrift related entities

Mortgage bankers

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An escrowaccount is a trust account held inthe name of the mortgagor to pay statutorylevies such as Property taxes

Insurance premiums

The maintenance of such accounts helpsensure that payments are made when due Because it becomes the lenders responsibility to do

so

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In most cases the borrower makes monthlydeposits Along with the loan payment

The payments accrue at the lender

The monthly deposit required is a function of The cost of insurance

And the tax assessment of the property

Consequently it fluctuates from year to year

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The primary income is the Servicing Fee This is fixed percentage of the outstanding

mortgage balance

Since the loan is amortized the outstanding

principal will steadily decline So the revenue from servicing in dollar terms will

steadily decline

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The second source of income is the interestthat is earned from the escrow accountsmaintained by the borrowers

The third source is the float on the monthlymortgage payment This is because a delay is permitted from the time

the servicer receives the monthly payment and thetime that it has to be forwarded to the lender

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Once the loan is granted the originator canhold it as an asset or sell it to an investor

An investor may wish to hold it as aninvestment

Or seek pool individual loans and use them ascollateral for the issuance of securities This is called SECURITIZATION

Of course this may be done by the originatorhimself

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These agencies buy CONFORMINGMORTGAGES

What is a conforming mortgage? It is one that meets the underwriting criteria set by

them from the standpoint of being eligible to beincluded in a pool for subsequent securitization

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A conforming mortgage must satisfy threecriteria

They must have a maximum Payment toIncome (PTI) ratio

The PTI ratio is the ratio of monthly payments loan payment + tax payment to theborrowers monthly income

Obviously the lower the ratio the lower is thechance of default

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A maximum LTV ratio A maximum loan amount

Mortgages which are non-conformingbecause they are for amounts in excess of thepurchasing limit set by the agencies arecalled JUMBO Mortgages

Those which are non-conforming because of

credit quality or LTV ratio are termed as SUB-PRIME mortgages

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Investors who invest in mortgage loans areexposed to 4 main risks Default risk

Liquidity risk

Interest rate risk Pre-payment risk

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This is the risk that the borrower may default For government insured mortgages the risk is

minimal because the insurance agencies aregovernment sponsored

For privately insured mortgages the riskdepends on the credit rating of the insurancecompany

For uninsured mortgages it would depend onthe credit quality of the borrower

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Mortgage loans are LARGEand INDIVISIBLE So while an active secondary market exists

for such loans Bid-Ask spreads are highrelative to other debt securities

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The price of a mortgage loan moves inverselywith interest rates just like other Debtsecurities

Since these loan are for long time periods theprice impact of an interest rate change can besignificant

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Most homeowners pay all or a part of theirmortgage balance prior to the maturity date

Payments in excess of scheduled principalrepayments are called PREPAYMENTS

Such premature payments can occur forseveral reasons

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Borrowers tend to prepay the entire mortgagewhen they sell their home

The sale may be due to: A change of employment that necessitates moving

The purchase of a more expensive home

A divorce in which the settlement requires sale ofthe marital residence

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Second if market rates decline below the loanrate the borrower may prepay since he canrefinance at a lower rate

Third in the case of homeowners who cannotmeet their obligations, the property will berepossessed and sold The proceeds from the sale will be used to pay off

the mortgage in the case of uninsured mortgages

For an insured mortgage the insurance companywill pay off the balance

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Finally if a property is destroyed by an Act ofGodthe insurance proceeds will be used topayoff the mortgage

The effect of prepayments, whatever may be

the reason, is that the cash flows from the

mortgage becomes unpredictable.

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Cindy has taken a loan of $800,000 It is 10 year mortgage with a rate of 12% per

annum

Installments are due every six months

Interest is compounded semi-annually

At the end of the first year, just after payingthe second installment the interest on home

loans drops to 10.8%

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The refinancing fee is 1.75% of the amountbeing refinanced.

Cindys opportunity cost of funds is 9.8% perannum

Is refinancing attractive?

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The quantum of the semi-annual interest payment is given by :

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The amount outstanding after the second installment is

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Thus the cost of re-financing is

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In an ARM the interest rate is resetperiodically

The rate is linked to a benchmark such asLIBOR

If the benchmark were to rise so will themortgage rate

Else if the benchmark were to decline the

mortgage rate will fall

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The monthly installment for the first year is:

The outstanding balance at the end of the first year is:

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=$217676.16

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In the case of certain ARMs the borrower maybe given the option to keep the monthlyinstallment at the initial level and have thematurity altered every time the rate is reset

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The outstanding balance after one year is$616,722.81. If we keep the equated monthlypayment at $18,678.19, the life of the loan ifthe rate is reset at 9% is given by:

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The starting mortgage rate is 5.70% which isless than the lifetime cap of 9%

The rate at the end of the first year should be7.50% in the absence of a periodic cap However there is a periodic cap of 1.5%

The rate cannot increase or decrease by more than1.5%

Thus the rate for the second year is 7.2%

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The uncapped rate for the third year is 8.50% This is the same as the capped rate

For it is only 1.3% more than the rate for theprevious year

The rate for the fourth year in the absence ofa cap should be 9.5% This does not violate the periodic cap requirement

The change is only 1% with respect to the previous

year But since there is a lifetime cap of 9% the rate for the

year will be 9%

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Young home buyers may not have thedisposable income required to avail aconventional fixed rate mortgage But they have the potential to earn substantially

more in the coming years GPMs were designed to encourage them to take

loans

A GPM starts with a level of payment that

increases steadily up to a point and then

remains steady

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All the mortgages being securitized will nothave the same mortgage rate or time tomaturity

So it is a common practice to calculate the

weighted average coupon rate WAC) and the

weighted average time to maturity WAM)

The weight for each coupon or term tomaturity Is the outstanding amount of that mortgage by

the cumulative outstanding amount of allmortgages in the pool

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