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

Real Estate Principles: A Value ApproachLing and Archer

Outline

Legal foundations Mortgage products Mortgage markets – primary Mortgage markets – secondary

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.

The note: interest charges

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

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

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

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

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

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

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

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

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

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

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.

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; 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

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

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.

Foreclosure and value (a commercial case)

A Pennsylvania mall that was foreclosed on after its owners failed to repay $143 million has been auctioned off for $100.

Wells Fargo Bank was owed the money from a 2006 loan and submitted the winning bid for the 1.1 million-square-foot Galleria at Pittsburgh Mills on Wednesday.

Wells Fargo foreclosed last year on the mall, which opened in 2005. The mall once was worth $190 million but recently was appraised at just $11 million and is slightly more than half occupied.

Source: AP, 2017

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

BoA’s new push in mortgages

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

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

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

Payments are not fixed. ARMs tend to have a lower monthly

payment; but this may not always the case.

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).

VA-guaranteed loans

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

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.

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.

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.

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) > 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).

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 (Homeowner’s Insurance Act of 1999).

Obligation to terminate when loan falls to 78% of original value.

An overview of mortgage debt

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.

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.

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 (S&Ls, savings banks). Commercial banks. Credit unions.

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.

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.

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%.

Creating 2 assets

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).

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.

Mortgage-backed securities (MBSs)

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).

Agency MBSs

Agency (Fannie, Freddie, Ginnie) MBSs guarantee home mortgage default risk. So the investors of agency MBSs do not bear default risk.

The investors of agency MBSs do bear prepayment risk and interest rate risk.

Prepayment risk: the risk of early unscheduled return of the remaining loan balance (principal).

Securitization process

The growth

CMOs and CDOs

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, higher-interest tranches—of an CMO/MBS are often further repackaged and resold as collateralized debt obligations (CDOs), in the name of “diversification”.

Residential underwriting decisions

Underwriting: process of determining whether the risks of a loan are acceptable.

3 “Cs” of traditional residential underwriting: Collateral: Uniform Residential Appraisal

Report required (Fannie and Freddie). Creditworthiness: credit report and

scoring. Capacity: ability to pay (payment ratios).

Capacity ratio, I

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

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

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

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.

Subprime crisis

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.