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    CHAPTER 10

    RESIDENTIAL MORTGAGE LOANS

    CHAPTER SUMMARY

    Although the American dream may be to own a home, the major portion of the funds to purchase one must be borrowed. The market where these funds are borrowed is called the mortgage market. A mortgage is a pledge of property to secure payment of a debt. Typically, property refers to real estate. If the property owner (the mortgagor) fails to pay the lender (the mortgagee), the lender has the right to foreclose the loan and seize the property in order to ensure that it is repaid. The types of real estate properties that can be mortgaged are divided into two broad categories: single-family (one- to four-family) residential and commercial properties. This chapter describes residential mortgage loans, and the three chapters to follow describe securities created by using residential mortgage loans as collateral. In Chapter 14, we cover commercial loans and securities backed by commercial loans.

ORIGINATION OF RESIDENTIAL MORTGAGE LOANS

The original lender is called the mortgage originator. The principal originators of residential

    mortgage loans are thrifts, commercial banks, and mortgage bankers. Mortgage originators may service the mortgages they originate, for which they obtain a servicing fee.

    When a mortgage originator intends to sell the mortgage, it will obtain a commitment from the potential investor (buyer). Two government-sponsored enterprises (GSEs) and several private companies buy mortgages. Because these entities pool these mortgages and sell them to investors, they are called conduits. When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized.

Underwriting Standards

    Originators may generate income for themselves in one or more ways. First, they typically charge an origination fee. The second source of revenue is the profit that might be generated from selling a mortgage at a higher price than it originally cost. This profit is called secondary

    marketing profit. Third, the mortgage originator may hold the mortgage in its investment portfolio.

    Mortgage originators can either (i) hold the mortgage in their portfolio, (ii) sell the mortgage to an investor who wishes to hold the mortgage or who will place the mortgage in a pool of mortgages to be used as collateral for the issuance of a security, or (iii) use the mortgage themselves as collateral for the issuance of a security. When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized.

    A conforming mortgage is one that meets the underwriting standards established by these agencies for being in a pool of mortgages underlying a security that they guarantee. If an applicant does not satisfy the underwriting standards, the mortgage is called a nonconforming

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    mortgage. Mortgages acquired by the agency may be held as investments in their portfolio or securitized.

Payment-to-Income Ratio

The payment-to-income ratio (PTI) is the ratio of monthly payments to monthly income, which

    measures the ability of the applicant to make monthly payments (both mortgage and real estate tax payments). The lower the PTI, the greater the likelihood that the applicant will be able to meet the required monthly mortgage payments.

Loan-to-Value Ratio

    The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property. The lower this ratio is, the greater the protection for the lender if the applicant defaults on the payments and the lender must repossess and sell the property.

    The LTV has been found in numerous studies to be the single most important determinant of the likelihood of default. The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default.

TYPES OF RESIDENTIAL MORTGAGE LOANS

    There are different types of residential mortgage loans. They can be classified according to the following attributes: lien status; credit classification; interest rate type; amortization type; credit guarantees; loan balances; and, prepayments and prepayment penalties.

Lien Status

    The lien status of a mortgage loan indicates the loan’s seniority in the event of the forced liquidation of the property due to default by the obligor.

Credit Classification

    A loan that is originated where the borrower is viewed to have a high credit quality is classified as a prime loan. A loan that is originated where the borrower is of lower credit quality or where the loan is not a first lien on the property is classified as a subprime loan.

    While the credit scores have different underlying methodologies, the scores generically are referred to as “FICO scores.” FICO scores range from 350 to 850. The higher the FICO score is, the lower the credit risk.

    The LTV has proven to be a good predictor of default: a higher LTV implies a greater likelihood of default. When the loan amount requested exceeds the original loan amount, the transaction is referred to as a cash-out-refinancing. If instead, there is financing where the loan balance

    remains unchanged, the transaction is said to be a rate-and-term refinancing or no-cash

    refinancing.

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    The front ratio is computed by dividing the total monthly payments (which include interest and principal on the loan plus property taxes and homeowner insurance) by the applicant’s pre-tax

    monthly income. The back ratio is computed in a similar manner. The modification is that it

    adds other debt payments such as auto loan and credit card payments to the total payments.

    The credit score is the primary attribute used to characterize loans as either prime or subprime. Prime (or A-grade) loans generally have FICO scores of 660 or higher, front and back ratios with the above-noted maximum of 28% and 36%, and LTVs less than 95%.

Interest Rate Type

The interest rate that the borrower agrees to pay, referred to as the note rate, can be fixed or

    change over the life of the loan. For a fixed-rate mortgage (FRM), the interest rate is set at the

    closing of the loan and remains unchanged over the life of the loan.

For an adjustable-rate mortgage (ARM), as the name implies, the note rate changes over the

    life of the loan. The note rate is based on both the movement of an underlying rate, called the index or reference rate, and a spread over the index called the margin. Two categories of

    reference rates have been used in ARMs: (1) market-determined rates, and (2) calculated rates based on the cost of funds for thrifts.

    The basic ARM is one that resets periodically and has no other terms that affect the monthly mortgage payment. Typically, the mortgage rate is affected by other terms. These include (1) periodic rate caps, and (2) lifetime rate cap and floor.

Amortization Type

    The amount of the monthly loan payment that represents the repayment of the principal borrowed is called the amortization. Traditionally, both FRMs and ARMs are fully amortizing

    loans.

    Fully amortizing fixed-rate loans have a payment that is constant over the life of the loan. For example, suppose a loan has an original balance of $200,000, a note rate of 7.5%, and a term of 30 years. Then the monthly mortgage payment would be $1,398.43. The formula for calculating the monthly mortgage payment is

    n?!ii(1 + ). MP = MB0?,n(1 + 1i),(

where MP = monthly mortgage payment ($), MB = original mortgage balance ($), i = note rate 0

    divided by 12 (in decimal), and n = number of months of the mortgage loan.

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    To calculate the remaining mortgage balance at the end of any month, the following formula is used:

    nt?!(1(1 + ;;ii)) = MB. MBt0?,n(1 + 1i),(

where MB = mortgage balance after t months. t

    To calculate the portion of the monthly mortgage payment that is the scheduled principal payment for a month, the following formula is used:

    t1?!ii(1 + )SP = MB. t0?,n(1 + 1i)?,,(

where SP= scheduled principal repayment for month t. t

    For an ARM, the monthly mortgage payment adjusts periodically. Thus, the monthly mortgage payments must be recalculated at each reset date. This process of resetting the mortgage loan payment is referred to as recasting the loan.

    In recent years, several types of nontraditional amortization schemes have become popular in the mortgage market. The most popular is the interest-only product (or IO product). With this type

    of loan, only interest is paid for a predetermined period of time called the lockout period.

Credit Guarantees

    Mortgage loans can be classified based on whether a credit guarantee associated with the loan is provided by the federal government, a government-sponsored enterprise, or a private entity. Loans that are backed by agencies of the federal government are referred to under the generic term of government loans and are guaranteed by the full faith and credit of the U.S. government.

    The Department of Housing and Urban Development (HUD) oversees two agencies that guarantee government loans. The first is the Federal Housing Administration (FHA. The second is the Veterans Administration (VA).

In contrast to government loans, there are loans that have no explicit guarantee from the federal

    government. Such loans are said to be obtained from “conventional financing” and therefore are

    referred to in the market as conventional loans. A conventional loan can be insured by a private

    mortgage insurer.

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Loan Balances

    For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The loan limits, referred to as conforming limits, for Freddie Mac and

    Fannie Mae are identical because they are specified by the same statute. Loans larger than the conforming limit for a given property type are referred to as jumbo loans.

Prepayments and Prepayment Penalties

    Homeowners often repay all or part of their mortgage balance prior to the scheduled maturity date. The amount of the payment made in excess of the monthly mortgage payment is called a prepayment.

This type of prepayment in which the entire mortgage balance is not paid off is called a partial

    payment or curtailment. When a curtailment is made, the loan is not recast. Instead, the borrower continues to make the same monthly mortgage payment.

    The more common type of prepayment is one where the entire mortgage balance is paid off. All mortgage loans have a “due on sale” clause, which means that the remaining balance of the loan must be paid when the house is sold.

    Effectively, the borrower’s right to prepay a loan in whole or in part without a penalty is a called an option. A mortgage design that mitigates the borrower’s right to prepay is the prepayment

    penalty mortgage.

CONFORMING LOANS

    Freddie Mac and Fannie Mae are government-sponsored enterprises (GSEs) whose mission is to provide liquidity and support to the mortgage market. While Fannie Mae and Freddie Mac can buy or sell any type of residential mortgage, the mortgages that are packaged into securities are restricted to government loans and those that satisfy their underwriting guidelines. The conventional loans that qualify are referred to as conforming loans. A conforming loan is

    simply a conventional loan that meets the underwriting standard of Fannie Mae and Freddie Mac. Thus, conventional loans in the market are referred to as conforming conventional loans and

    nonconforming conventional loans.

    Qualifying for a conforming loan is important for both the borrower and the mortgage originator. This is because the two GSEs are the largest buyers of mortgages in the United States. Hence, loans that qualify as conforming loans have a greater probability of being purchased by Fannie Mae and Freddie Mac to be packaged into an MBS. As a result, they have lower interest rates than nonconforming conventional loans.

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HOME EQUITY LOANS

    A popular mortgage product backed by residential property that is classified as a subprime mortgage loan is the home equity loan (HEL). Typically the borrower has either an impaired

    credit history and/or the payment-to-income ratio is too high for the loan to qualify as a conforming loan for securitization by Ginnie Mae, Fannie Mae, or Freddie Mac.

    There are both fixed-rate and variable-rate closed-end HELs. Typically, variable-rate loans have a reference rate that is LIBOR and have periodic caps and lifetime caps.

RISKS ASSOCIATED WITH INVESTING IN MORTGAGE LOANS

    The principal investors in mortgage loans include thrifts and commercial banks. Pension funds and life insurance companies also invest in these loans, but their ownership is small compared to that of the banks and thrifts. Investors face four main risks by investing in residential mortgage loans: (1) credit risk, (2) liquidity risk, (3) price risk, and (4) prepayment risk.

Credit Risk

    Credit risk is the risk that the homeowner/borrower will default. For FHA- and VA-insured mortgages, this risk is minimal. The LTV ratio provides a useful measure of the risk of loss of principal in case of default.

At one time, investors considered the LTV only at the time of origination (called the original

    LTV) in their analysis of credit risk. For periods in which there are a decline in housing prices, the current LTV becomes the focus of attention.

Liquidity Risk

    Although there is a secondary market for mortgage loans, the fact is that bid-ask spreads are large compared to other debt instruments. That is, mortgage loans tend to be rather illiquid because they are large and indivisible. The degree of liquidity determines the liquidity risk.

Price Risk

    The price of a fixed-income instrument will move in an opposite direction from market interest rates. Thus, a rise in interest rates will decrease the price of a mortgage loan.

Prepayments and Cash Flow Uncertainty

    The three components of the cash flow are: interest; principal repayment (scheduled principal repayment or amortization); and, prepayment.

    Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate.

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    ANSWERS TO QUESTIONS FOR CHAPTER 10

    (Questions are in bold print followed by answers.)

1. What type of property is security for a residential mortgage loan?

    Typically, property refers to real estate. If the property owner (the mortgagor) fails to pay the lender (the mortgagee), the lender has the right to foreclose the loan and seize the property in order to ensure that it is repaid. The types of real estate properties that can be mortgaged are divided into two broad categories: single-family (one- to four-family) residential and commercial properties. The latter (residential mortgage loan) category includes houses, condominiums,

    cooperatives, and apartments. Commercial properties are income-producing properties: multifamily properties (i.e., apartment buildings), office buildings, industrial properties (including warehouses),

    2. What are the two primary factors in determining whether or not funds will be lent to an applicant for a residential mortgage loan?

    2. What are the two primary factors in determining whether funds will be lent to an applicant for a mortgage loan?

    A potential homeowner who wants to borrow funds to purchase a home will apply for a loan from a mortgage originator and supply financial information used to perform a credit evaluation. The two primary factors in determining whether the funds will be lent are the payment-to-

    income (PTI) ratio and the loan-to-value (LTV) ratio. The PTI, the ratio of monthly payments

    (both mortgage and real estate tax payments) to monthly income, is a measure of the ability of the applicant to make monthly payments. A lower ratio indicates a greater likelihood that the applicant will be able to meet the required payments. The difference between the purchase price of the property and the amount borrowed is the borrower’s down payment. The LTV is the ratio of the amount of the loan to the market (or appraised) value of the property. The lower this ratio, the more protection the lender has if the applicant defaults and the property must be repossessed and sold.

    3. Explain why the higher the loan-to-value ratio is, the greater the credit risk is to which the lender is exposed.

    The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property. The higher this ratio is, the less the protection (and the greater the credit risk) for the lender if the applicant defaults on the payments and the lender must repossess and sell the property. Below are more details.

    If an applicant wants to borrow $225,000 on property with an appraised value of $300,000, the LTV is 75%. Suppose the applicant subsequently defaults on the mortgage. The lender can then repossess the property and sell it to recover the amount owed. But the amount that will be received by the lender depends on the market value of the property. In our example, even if conditions in the housing market are weak, the lender will still be able to recover the proceeds Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall. 220

    lent if the value of the property declines by $75,000. Suppose, instead, that the applicant wanted to borrow $270,000 for the same property. The LTV would then be 90%. If the lender had to foreclose on the property and then sell it because the applicant defaults, there is less protection for the lender. The LTV has been found in numerous studies to be the single most important determinant of the likelihood of default. The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default. They will either try to protect this equity by remaining current or, if they fail, sell the house or refinance it to unlock the equity. In any case, the lender is protected by the buyer’s self-interest. On the other hand, if the borrower

    has little or no equity in the property, the value of the default option is much greater.

    4. What is the difference between a cash-out refinancing and a rate-and-term refinancing?

    When a lender is evaluating an application from a borrower who is refinancing, the loan-to-value ratio (LTV) is dependent upon the requested amount of the new loan and the market value of the property as determined by an appraisal. When the loan amount requested exceeds the original loan amount, the transaction is referred to as a cash-out-refinancing. If instead, there is

    financing where the loan balance remains unchanged, the transaction is said to be a rate-and-

    term refinancing or no-cash refinancing. That is, the purpose of refinancing the loan is to

    either obtain a better note rate or change the term of the loan.

5. What are the front ratio and back ratio, and how do they differ?

Lenders calculate income ratios such as the payment-to-income ratio (PTI) to assess the

    applicant’s ability to pay. These ratios compare the monthly payment that the applicant would

    have to pay if the loan is granted to the applicant’s monthly income. The most common measures are the front ratio and the back ratio. The front ratio is computed by dividing the total monthly

    payments (which include interest and principal on the loan plus property taxes and homeowner insurance) by the applicant’s pre-tax monthly income. The back ratio is computed in a similar

    manner. The modification is that it adds other debt payments such as auto loan and credit card payments to the total payments. In order for a loan to be classified as “prime,” the front and back ratios should be no more than 28% and 36%, respectively.

6. What is the difference between a prime loan and a subprime loan?

    A loan that is originated where the borrower is viewed to have a high credit quality (i.e., where the borrower has strong employment and credit histories, income sufficient to pay the loan obligation without compromising the borrower’s creditworthiness, and substantial equity in the underlying property) is classified as a prime loan. A loan that is originated where the borrower

    is of lower credit quality or where the loan is not a first lien on the property is classified as a subprime loan.

7. How are FICO scores used in classifying loans?

    In assessing the credit quality of a mortgage applicant, lenders look at a FICO score in order to a classify loan. A FICO score refers to how financial institutions rank the credit worthiness of a borrower. FICO scores range from 350 to 850. There is an inverse relation between a FICO score Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall. 221

    and a firm’s credit risk. Thus, if a firm receives a high FICO score this means it has low credit risk. More details are given below.

    In assessing the credit quality of a mortgage applicant, lenders look at various measures. The starting point is the applicant’s credit score. There are several firms that collect data on the payment histories of individuals from lending institutions and, using statistical models, evaluate and quantify individual credit worthiness in terms of a credit score. Basically, a credit score is a numerical grade of the credit history of the borrower. The three most popular credit reporting companies that compute credit scores are Experian, Transunion, and Equifax. While the credit scores have different underlying methodologies, the scores generically are referred to as “FICO

    scores.” Typically, a lender will obtain more than one score in order to minimize the impact of variations in credit scores across providers. FICO scores range from 350 to 850. The higher the FICO score is, the lower the credit risk.

    The credit score is the primary attribute used to characterize loans as either prime or subprime. Prime (or A-grade) loans generally have FICO scores of 660 or higher, front and back ratios with the above-noted maximum of 28% and 36%, and LTVs less than 95%. Alt-A loans may vary in a number of important ways. While subprime loans typically have FICO scores below 660, the loan programs and grades are highly lender-specific. One lender might consider a loan with a 620 FICO score to be a “B-rated loan,” while another lender would grade the same loan higher or lower, especially if the other attributes of the loan (such as the LTV) are higher or lower than average levels.

8. What is an alternative-A loan?

    Between the prime and subprime sector is a somewhat nebulous category referred to as an alternative-A loan or, more commonly, alt-A-loan. These loans are considered to be prime

    loans (the “A” refers to the A grade assigned by underwriting systems), but they have some attributes that either increase their perceived credit riskiness or cause them to be difficult to categorize and evaluate.

9. What is an FHA-insured loan?

    An FHA-insured loan is a government loan by virtue of being backed by an agency of the federal government. As such it is guaranteed by the U.S. government. More details are given below.

    Mortgage loans can be classified based on whether a credit guarantee associated with the loan is provided by the federal government, a government-sponsored enterprise, or a private entity. Loans that are backed by agencies of the federal government are referred to under the generic term of government loans and are guaranteed by the full faith and credit of the U.S. government.

    The Department of Housing and Urban Development (HUD) oversees two agencies that guarantee government loans. The first is the Federal Housing Administration (FHA), a governmental entity created by Congress in 1934 that become part of HUD in 1965. FHA provides loan guarantees for those borrowers who can afford only a low down payment and generally also have relatively low levels of income.

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10. What is a conventional loan?

In contrast to government loans, there are loans that have no explicit guarantee from the federal

    government. Such loans are obtained from “conventional financing” and therefore are referred to in the market as conventional loans. Although a conventional loan may not be insured when it is

    originated, a loan may qualify to be insured when it is included in a pool of mortgage loans that backs a mortgage-backed security (MBS).

11. Answer the below questions.

(a) What is meant by conforming limits?

    For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The maximum loan size for one- to four-family homes changes every year. The change is based on the percentage change in the average home price published by the Federal Housing Finance Board. The loan limits, referred to as conforming limits, for Freddie

    Mac and Fannie Mae are identical because they are specified by the same statute.

    It can also be noted that one of the underwriting standards is the loan balance at the time of origination. Conventional loans that meet the underwriting standards of the two government-sponsored enterprises (GSEs) are called conforming limits. But there are other important

    underwriting standards that must be satisfied such as the type of property, loan type, transaction type, loan-to-value ratio by loan type, loan-to-value ratio by loan type and transaction type, borrower credit history, and documentation.

(b) What is a jumbo loan?

    For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The loan limits, referred to as conforming limits, for Freddie Mac and

    Fannie Mae are identical because they are specified by the same statute. Loans larger than the conforming limit for a given property type are referred to as jumbo loans.

12. Answer the below questions.

    (a) When a prepayment is made that is less than the full amount to completely pay off the loan, what happens to future monthly mortgage payments for a fixed-rate mortgage loan?

    Homeowners often repay all or part of their mortgage balance prior to the scheduled maturity date. The amount of the payment made in excess of the monthly mortgage payment is called a prepayment. This type of prepayment in which the entire mortgage balance is not paid off is called a partial payment or curtailment. When a curtailment is made, the loan is not recast.

    Instead, the borrower continues to make the same monthly mortgage payment. The effect of the prepayment is that more of the subsequent monthly mortgage payment is applied to the principal. The net effect of the prepayment is that the loan is paid off faster than the scheduled maturity Copyright ? 2010 Pearson Education, Inc. Publishing as Prentice Hall. 223

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