9 mortgage markets. mortgage insurance mortgage insurance guarantees repayment in the event of...

9Mortgage

Markets

Mortgage Insurance Mortgage insurance guarantees repayment in the event of borrower

default Lenders usually require mortgage insurance if you don’t make a 20%

downpayment. When loan-to-value ratio (LTV) drops below 80%, mortgage insurance can usually be dropped

Borrower pays insurance premiums, usually on a monthly basis, along with mortgage payment and escrow

Borrowers can obtain mortgage insurance in two broad ways: Through the government: Federal insurers include Federal Housing

Administration (FHA) and Veterans Administration (VA) (about ¼ of the mortgage insurance market)

Through private insurance (called private mortgage insurance or PMI) FHA/VA insured loans are usually available only to first-time home

buyers and require a smaller downpayment; the insurance premiums are lower than PMI; but FHA/VA loans come with miles of red-tape

PMI is a little more expensive but it is cleaner, with less red-tape

WWCB Illustration of Interest Rate Risk

WWCB

Balance Sheet

ASSETS

Mortgage Receivable, 30-yr, 7% fixed $ 100,000

LIABILITIES

Deposit Accounts (savings accounts) 3% $ 90,000

EQUITY

Capital of bank owners $ 10,000

TOTAL LIABILITIES & EQUITY $ 100,000

A. Calculate net interest margin in terms of percent

Interest Income Percentage

Interest Expense Percentage

Net Interest Margin


B. Calculate net income in terms of dollarsInterest Income Interest Expense Net Interest Margin Fixed Oper. Costs (wages, utilities, etc.) $ 2,000 Net Income

C. Calculate net income in dollars assuminginterest rates on deposits increase to 8%Interest Income Interest Expense Net Interest Margin Fixed Oper. Costs (wages, utilities, etc.) $ 2,000 Net Income

WWCB Illustration of Interest Rate RiskD. Calculate net income in dollars assuming

interest rates on deposits decrease to 1%

Interest Income

Interest Expense Net Interest Margin

Fixed Oper. Costs (wages, utilities, etc.) $ 2,000

Net Income

E. What risks does WWCB face? Name each risk below.

- Risk that interest rates will increase and cause net loss:_____________________

- Risk that interest rates will decrease & mortgage will be prepaid early and then proceeds have to be reinvested at lower rate:_____________________

- Risk that depositors may want to withdraw all their money:_____________________

- Risk that mortgage borrower may default on payments:____________________


F. What actions can WWCB take to limit interest-rate risk?

G. What actions can WWCB take to limit pre-payment risk?

H. What actions can WWCB take to limit liquidity risk?

I. What actions can WWCB take to limit credit or default risk?

Types of Residential Mortgages

1. Fixed-rate mortgages

2. Adjustable-rate mortgages (ARMs)

3. Graduated-payment mortgages (GPMs)

4. Growing-equity mortgages

5. Second mortgages

6. Shared-appreciation mortgages

7. Balloon payment mortgages

Fixed-rate Mortgages Fixed rate loans have a constant rate until maturity (15,

20, 30, 50 or even 100 years) Interest rate risk hurts lender if interest rates rise Interest rate risk hurts borrowers if interest rates drop

U.S. is one of few countries in which a rate can be locked for 30 years or more. Very few other countries allow a lock in for > 10 yrs

Exhibit 9.3 Example of Amortization Schedule for Selected Years (Based on a 30-Year, $100,000 Mortgage at 8 Percent)

Adjustable-rate Mortgages (ARMs) Rates vary with some index (prime plus margin, etc.)

e.g. 3/1 means rate won’t change for 3 years after which it can change every year

e.g. Upper and lower boundaries are set (caps)

Less risk for lenders as yields move with cost of funds Creates uncertainty for borrowers whose mortgage

payments can change over time

Comparison of Rates on Newly Originated Fixed-Rate and Adjustable-Rate Mortgages

Effects of Shorter Maturities Can save significant interest Increased popularity of 15-year loans

Lender has lower interest rate risk if the term of the loan is lower Borrower saves on interest expense over loan’s life but monthly

payment is higher See example. http://www.mortgage-net.com/calculators/mp_cl.html

http://www.mortgage-net.com/calculators/mp_cl.html

Payments Necessary for 15- and 30-Year Mortgages (Based on an Interest Rate of 8 Percent)

Maturity Dates: When is Principal Due? Balloon payments

Principal not paid until maturity Forces refinancing at maturity

Amortizing mortgages Monthly payments consist of interest and principal During loan’s early years, most of the payment reflects interest

Creative Mortgage Financing Graduated-payment mortgage (GPM)

Small initial payments Payments increase over time then level off Assumes income of borrower grows

Growing-equity mortgage Like GPM, this has low initial payments Unlike GPM, payments never level off

Creative Mortgage FinancingSecond mortgage used in conjunction with first or primary mortgage Shorter maturity typical for 2nd mortgage 1st mortgage paid first if default occurs so 2nd

mortgage has a higher rate/risk If used by sellers, makes a home with an assumable

loan more affordable Home equity loan is a form of 2nd mortgage

Shared-appreciation mortgage Below market rate but lender shares in home’s price

appreciation (e.g. PUC)

Mortgage Refinancing Activity over Time

Activities in the Mortgage Markets Origination (create terms) Funding, investing or financing Servicing or maintenance (collecting payments, escrow) Selling loans

Secondary market exists for loans Securitization

Pool and repackage loans for resale Allows resale of loans not easily sold on an individual basis

Activities in the Mortgage Markets Unbundling of mortgage activities provides for

specialization in: Loan origination Loan servicing Loan funding Any combination of the above

Institutional Mortgage HoldersFederally related mortgage poolsCommercial banks

Dominate commercial mortgage marketSavings institutions

Primarily residential mortgagesLife insurance companies

Commercial mortgages

Institutional Use of Mortgage Markets Mortgage companies (e.g. Home Loan Ctr.)

Originate and quickly sell loans Do not maintain large portfolios

Government agencies including Fannie Mae and Freddie Mac

Brokerage firms Investment banks Finance companies

Risk from Investing in Mortgages Interest-rate risk (risk of locking in to what becomes an unattractive rate, causing investment value to drop)

Long-term fixed-rate mortgages financed by short-term funds results in high interest-rate risk (e.g. S&L crisis)

To limit exposure to interest rate risk Sell mortgage shortly after origination Adjustable rate mortgages Shorter-term mortgages (e.g. Canada) Use balloon payments

Risk from Investing in Mortgages Prepayment risk

Borrowers refinance if rates drop by paying off higher rate loan and financing at a new, lower rate

Investor receives payoff but has to invest at the new, lower interest rate (reinvestment risk)

Manage the risk with ARMs or by selling loans

Risk from Investing in MortgagesCredit risk can range from total default to late payments

Factors that affect default risk Level of borrower equity

Loan-to-value ratio often used Higher use of debt, more defaults

Borrowers income level Borrower credit history FICO (scores 300-850; looks at payment history, credit

history, no. & types of accounts, etc.)Quality of collateralRequire mortgage insurance

Unsound & Greedy Lending• Subprime mortgages are

given to either:• risky borrowers with poor credit

scores (FICO under 620)OR

• those who have good credit but provide insufficient documentation or have high DTI (known as Alt-A loans)

• Subprimes made up anincreasing portion of totalmortgages, from 5% in 1994to 20% in 2006 .

Risk from Investing in Mortgages Measuring risk

Use sensitivity analysis to review various “what if” scenarios covering everything from default to prepayments (SHOCK treatments, show BMCU)

Asset/Liability Management (ALM)

Use of Mortgage-Backed Securities Securitization is an alternative to the outright sale of a

loan Group of mortgages held by a trustee serves as collateral

for the securities Institution can securitize loans to avoid interest rate risk

and credit risk while still earning service fees Payments passed through to investors can vary over time

Securitization

• The risk of sub-prime mortgages was spread around the world through securitization.

• In a nutshell, this means your home loan is sold by your lender (in a package along with other home loans) to investors all around the world.

• Student loans, auto loans, and credit cards markets are also securitized in a similar manner.

Subprime Borrower

Banks (BofA, Wells, etc.)

Mortgage Broker (Countrywide, Hm

Loan Ctr, etc.)

Servicer

MBS Issuer(Investment banks,

FNMA, etc.)

Investors(Hedge Funds, Pension

Funds, Endowments, Ins. Co, Intern Fds, etc.)

Pmts

Pmts

$$

HomeSeller

Loan

Loan$$

$$ MBS

Simplified Process of Securitization

Rating Agencies(Moody’s, S&P, etc.)

Credit Insurance (CDS)(AIG, etc.)

Pmts

MBS=Mortgage-Backed Securities; CDS=Credit Default Swaps

Use of Mortgage-Backed Securities

Ginnie Mae (GNMA) mortgage-backed securities Government National Mortgage Association, created in 1968, with

goal of providing liquidity, stability and affordability to the housing market.

Ginnie Mae does not issue mortgage backed securities like its cousins Fannie and Freddie, merely guarantees FHA/VA/RHA mortgages , backed by the full faith and credit of the U.S.

• GNMA is not a publically traded company likes its cousins• A U.S. government agency, wholly owned by the Federal

government and operated by the Dept. of HUD• Backed by explicit guarantee of Federal government

Use of Mortgage-Backed SecuritiesFannie Mae (FNMA) mortgage-backed securities Created in 1938 as part of the New Deal; Federally chartered but privately

owned with stock traded on NYSE, ticker FNMA. Taken over by the Fed gov’t in Sept/2008 and is now in conservatorship.

No explicit guarantee of bonds by federal government, but gov’t bailed it out in fall/08 – so actions speak louder than words.

Uses funds from mortgage-backed pass-through securities to purchase conventional mortgages (that are not FHA or VA)

Channel funds from investors to institutions that want to sell mortgages Guarantee timely payments to investors Some securities strip (securitize) interest and principal payment streams

for separate sale Accounting scandals & CEO Franklin Raines who had

political ambitions; poor kid from Seattle whomade it big at Harvard, Rhoades Scholar; $9 billionacctg fraud = 40% of profits 2001-2004!

Politicians used FNMA to encourage sub-prime borrowing

Use of Mortgage-Backed Securities

Freddie Mac (Fed. Home Loan. Mort. Assoc.) Created in 1970, this a financial services company, Federally

chartered but privately owned with stock traded on NYSE, ticker FRCC (in conservatorship right now)

Created to compete with FNMA Mission is to provide liquidity, stability and affordability in the

housing market Sells participation certifications (PCs) to investors and uses these

funds purchase conventional mortgages from banks, S&Ls, credit unions, etc.

Guarantees timely payments to investors No explicit guarantee of bonds by federal government, but gov’t

bailed it out in fall/08 – so actions speak louder than words.

The Looming Demise of Fannie/Freddie

Fannie Mae and Freddie Mac’s reform

There has been talk for years about reforming, or even dismantling Fannie Mae and Freddie Mac but there has been little action to match the talk.

That, however, might be changing, as bipartisan momentum for reform seems to be building. President Obama and a number of Democrats have come out in support of reforming Fannie Mae and Freddie Mac and nearly all of the Republican caucus backs the idea.

The devil is in the details. Given the giant influence these organizations have on the mortgage market, reform is a thorny issue, and must be addressed systemically to avoid possible negative ramifications the U.S. housing market, including the potential demise of the 30-year mortgage.

Use of Mortgage-Backed Securities Publicly issued pass-through securities (PIPS)

No Federal charter or guarantee Backed by conventional mortgages instead of FHA or VA

mortgages Private mortgage insurance

Use of Mortgage-Backed Securities Collateralized mortgage obligations (CMOs)

Semi-annual payments differ from other securities’ monthly payments

Segmented into classes First class has quickest payback Any repaid principal goes first to investors in this class

Investors choose a class to fit maturity needs One concern is payback speed when rates drop

Use of Mortgage-Backed Securities CMOs cont.

Can be segmented into interest-only IO or principal-only PO classes

High return for IO reflect risks

Useful investment but be aware of the risks 1992 failure of Coastal States Life Insurance due to CMO

investments

Some CMO mutual funds Regulators have increased scrutiny

Use of Mortgage-Backed Securities Mortgage-backed securities for small investors

In the past, high minimum denominations Unit trusts created to allow small investor participation Mutual funds

Advantages Can purchase in secondary market without purchasing the need to

service loans Insured and liquid

Sub-prime Mortgage Crisis

See separate PowerPoint, entitled Econ Crisis and also the following slides.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mortgage Credit Crisis

Impact of the Credit Crisis on Fannie Mae and Freddie MacThe agencies had invested heavily in subprime mortgages that required homeowners to pay higher rates of interest.By 2008, many subprime mortgages defaulted, so Fannie Mae and Freddie Mac were left with properties (the collateral) that had a market value substantially below the amount owed on the mortgages that they held.Funding Problems

With poor financial performance, Fannie Mae and Freddie Mac were incapable of raising capital.

FNMA and FHLMC stock values had declined by more than 90 percent from the previous year.



Impact of the Credit Crisis on Fannie Mae and Freddie Mac (cont.)Rescue of Fannie Mae and Freddie Mac

In September 2008, the U.S. government took over the management of Fannie Mae and Freddie Mac.

The Treasury agreed to provide whatever funding would be necessary to cushion losses from the mortgage defaults.

In return, the Treasury received $1 billion of preferred stock in each of the two companies.

The U.S. government allowed Fannie Mae and Freddie Mac to obtain funds by issuing debt securities so that they could resume purchasing mortgages and thereby ensure a more liquid secondary market for them.



Systemic Risk Due to the Credit CrisisMortgage insurers that provided insurance to homeowners incurred large expenses.Some financial institutions with large investments in MBS were no longer able to access sufficient funds to support their operations during the credit crisis.Individual investors whose investments were pooled (by mutual funds, hedge funds, and pension funds) and then used to purchase MBS experienced losses.International Systemic Risk - Financial institutions in other countries (e.g., the United Kingdom) had offered subprime loans, and they also experienced high delinquency and default rates.



Who Is to Blame?

Mortgage originators - some mortgage originators were aggressively seeking new business without exercising adequate control over quality.

Credit rating agencies - The rating agencies, which are paid by the issuers that want their MBS rated, were criticized for being too lenient in their ratings shortly before the credit crisis.

Financial institutions that packaged MBS - Could have verified the credit ratings assigned by the credit rating agencies by making their own assessment of the risks involved.



Who Is to Blame? Institutional investors that purchased MBS - relied heavily on the ratings assigned to MBS by credit rating agencies without the due diligence of performing their own independent assessment.Financial institutions that insured MBS - presumed, incorrectly, that the MBS would not default.Speculators of Credit Default Swaps - Many buyers of CDS contracts on MNS were not holding any mortgages of MBS that they needed to hedge.Conclusion about Blame

The question of who is to blame will be argued in courtrooms.



Government Programs Implemented in Response to the CrisisThe Housing and Economic Recovery Act of 2008.

Enabled some homeowners to keep their existing homes and therefore reduced the excess supply of homes for sale in the market.

Financial institutions must be willing to create a new mortgage that is no more than 90 percent of the present appraised home value.

Financial institutions that volunteer for the program essentially forgive a portion of the previous mortgage loan when creating a new mortgage.

Other programs promoted “short sale” transactions in which the lender allows homeowners to sell the home for less than what is owed on the existing mortgage.



Government Bailout of Financial Institutions

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act) enabled the Treasury to inject $700 billion into the financial system and improve the liquidity of financial institutions with MBS holdings.

The act also allowed the Treasury to invest in the large commercial banks as a means of providing the banks with capital to cushion their losses.



Financial Reform Act

In July 2010 the Financial Reform Act was implemented, and one of its main goals was ensuring stability in the financial system.

The act mandated that financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications.

The act also required that financial institutions that sell mortgage-backed securities retain 5 percent of the portfolio unless the portfolio meets specific standards that reflect low risk.


SUMMARY

Residential mortgages can be characterized by whether they are prime or subprime, whether they are federally insured, the type of interest rate used (fixed or floating), and the maturity. Quoted interest rates on mortgages vary at a given point in time, depending on these characteristics.

Various types of residential mortgages are available, including fixed-rate mortgages, adjustable-rate mortgages, graduated-payment mortgages, growing equity mortgages, second mortgages, and shared appreciation mortgages.

The valuation of a mortgage is the present value of its expected future cash flows, discounted at a discount rate that reflects the uncertainty surrounding the cash flows. A mortgage is subject to credit risk, interest rate risk, and prepayment risk.


SUMMARY (Cont.)

Mortgage-backed securities (MBS) represent packages of mortgages; the payments on those mortgages are passed through to investors. Ginnie Mae provides a guarantee of payments on mortgages that meet specific criteria, and these mortgages can be easily packaged and sold. Fannie Mae and Freddie Mac issue debt securities and purchase mortgages in the secondary market.


SUMMARY (Cont.)

Mortgages were provided without adequate qualification standards (including allowing very low down payments) in the 2003–2006 period. Then a glut in the housing market caused a drastic decline in home prices, with the result that the market values of many homes were lower than the mortgages. Many homeowners defaulted on their mortgages, which led to a credit crisis in the 2008–2009 period. The U.S. government use various strategies to revive the U.S. mortgage market, including an emergency housing recovery act, the rescue of Fannie Mae and Freddie Mac, and a bailout of financial institutions that had heavy investments in mortgages and mortgage-backed securities.

9 mortgage markets. mortgage insurance mortgage insurance guarantees repayment in the event of...

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