guest lecture on residential mortgage finance

, BUFN700, Spring 2008, Professor Doron Avramov

Residential Mortgage Finance

Residential Mortgage Finance: Products, Markets, Risk Assessment, Pricing, and Securitization

Andrew WidmanSVP, Enterprise Risk ManagementCountrywide Financial Corporation



A foreword on the significance of housing finance

Housing is a basic human necessity and a critical component of every economy in all parts of the world

Home ownership builds social stability, serves as a store of value, and provides a source of income

Along with governmental, monetary, and property rights stability, a reliable system of housing finance is argued by some as a major aid to sustainable economic development

The US model with long-term financing and broad accessibility is a luxury not available in many countries

This document and today’s discussion reflect my views alone and not those of Countrywide Financial



About Countrywide Financial, NYSE Ticker = CFC

Key Facts:

Mortgage-centered, diversified financial services company with rapid business growth during the 2000s, especially in non-traditional loans

Growth in PayOption and Sub Prime mortgages – more on these later

Servicer of nearly $1.5 Trillion in mortgage assetsPayment processing for 1 in 8 loans – #2 industry wide

Set to be acquired by Bank of America following precipitous 80+% decline in market value during 2007

http://finance.yahoo.com/q/bc?s=CFC&t=2y&l=on&z=m&q=l&c=

January announcement with July consummation target- 100% stock transaction priced at 0.1822 shares of BAC per share of CFC

What’s the implication of CFC’s current stock price compared to the deal-implied price?



What’s your favorite angle on the real estate debacle?

Toxicity?http://www.google.com/search?hl=en&q=toxic+mortgage

Victims and predators?http://www.google.com/search?hl=en&q=mortgage+predators+and+victims

Industry doomsayers?http://ml-implode.com/

Cash infusions?http://www.google.com/search?hl=en&q=mortgage+cash+infusion

Humor? (warning: explicit!)



Agenda

US residential real estate finance market Real estate as an investment asset

Home financing basics and loan instruments

Primary and secondary markets, loan origination and disposition

Risk assessment and loan pricingDefault, loss severity, and prepayment risks

Option-embedded fixed income valuation

Mortgage securitizationRationale, relation to other assets

GSEs, other credit enhancement, rating agencies,

Structures and issuer/investor considerations



Residential real estate from an in investment perspective

Home ownership is encouraged by our governmentTax advantages on interest costs and capital gainsPost-depression “agencies” were created to bear risk

Provides diversification benefits as an asset classImperfect correlation improves risk-adjusted portfolio returnsBut for many, real estate concentration is arguably too high

- Mean/variance optimization would allocate a lower amount

Highly leveraged financing is now the norm10% house price change on 10% down = 100% return

- Actual return depends on treatment of borrowing costs/expenses- Like buying stock on margin – without the margin call

Liquidity can be poor and markets inefficientThin markets, few transactions, no natural short positionLimited availability of hedges – note recent rise of CME futures



House prices and the early 2000s experience

In the early 2000s, house prices offset losses in equities as cheap credit, investor interest, and loose underwriting standards prevailed

For most homeowners, their gains were unrealized

Local House Prices vs. Equities, The Aught Years

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House prices and the late 90s experience

In the mid-late 90s, housing stagnated as equities tripled

Assuming you were omniscient and bought at the bottoms and sold at the end, where did you make your best returns – S&P during the 1990s or on a house in DC in the 2000s?

Local House Prices vs. Equities, 1993 - 1999

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Sources: Yahoo Finance, Office of Federal Housing Enterprise Oversight

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House prices and future prognostications

Economists across the board are bearish on housing activity and prices in the near-to-mid term

Few are as negative as Mark Zandi of Moody’s Economy.com

House Price Forecasts - Economy.com Mild Recession Series

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Residential mortgage basics in the US

A residential mortgage is a long-term loan used to finance a home which serves as collateral

Traditionally, repayment is made through level monthly installments comprising both interest and principal

Until the recent housing boom, the most common loan was a fixed rate, 30-year, level-pay, fully amortizing mortgage

Useful Excel function for monthly, level, amortizing payment:= pmt(rate/12, #months, loan amount)

= pmt(6%/12, 360, $250,000) = $1,499

In this example, a $250k loan at a fixed rate of 6% has a monthly payment of $1,499 and will be paid off after 30 years



Time profile of a $250k, fixed rate 30-year mortgage at 6%

Interest due dominates the early payments as it takes more than 20 years to cut the balance in half

Most borrowers will have long since pre-paid by then

Average holding period for a fixed rate 30-year mortgage < 7yrs

Mortgage Payment Time Profile

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Total payment = $1,499

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Interest Principal Balance



Non-traditional features grew during the boom in home prices

Down paymentTraditionally 20% covered by borrower funds and/or mortgage insuranceIncreasingly secondary financing (aka piggyback lending) up to 100%

Income and asset documentationTraditionally full verification of employment and financial assetsIncreasingly no-income-no-asset (NINA)

Amortization featuresTraditionally fully amortizing until maturityIncreasingly initial interest-only or negative amortization periods

Term to maturityTraditionally 15 or 30 years – increasingly up to 40 years

Interest rate variabilityTraditionally fixed – increasingly adjustable with teasers and resets

Prepayment optionTraditionally permissible to prepay the remaining balance any timeIncreasingly penalized for early payment in exchange for “better” terms



Adjustable rate mortgages (ARMs) allow lower initial payments

Common products: 1-yr, 3/1-yr, 5/1-yr, 7/1-yr, 10/1-yrLoans with fixed periods >1yr commonly called “hybrid” ARMsRate typically offered at a discount to the 30-year fixed rate

- Discount amount depends on shape of the yield curve- With a flat yield curve, the rate benefit is minimal

Interest rate and payment are fixed for the initial periodRate reset is based on a reference rate plus a margin constrained by maximum periodic adjustment and ceilingFor example, a borrower with good credit and 20% down could get a 5/1-yr ARM with following terms as of April 2008

- Initial rate: 5.75%- Margin over 1-yr constant maturity treasury: 2.75%- Maximum lifetime adjustment: 5.00%

The same lender offers a 30-year fixed rate loan at 5.875%- Are the borrower’s savings worth the added risk?



Other popular loans with lower initial payments

Interest-only (IO) mortgagesEasy to think of as an add-on feature to ARMs

- Increasingly popular feature now attached to >50% of new ARMs- The initial period specifies a fixed payment with no principal- At reset, the rate adjusts and an amortizing payment is required- If held to reset the new payment may rise by 30% or more

Negatively amortizing mortgagesMarketed as PayOptions, OptionARMs, and Pick-a-Payments

- A low payment is permitted which causes the loan balance to rise- Let’s review the glossy literature

http://www.countrywide.com/pdf/050850_POA_brochure_70.06.pdf

- In this instrument the actual accrual rate adjusts monthlyThis feature makes it a popular bank investment product

- Payment shock after the fifth year can be devastatingly large

Bank of America plans to discontinue after the CFC acquisition

Payment Profiles



Even more ways loan payments were reduced

3-2-1 buydowns, often offered by home buildersThe builder effectively subsidizes the mortgage for 3 years

- A 3% rate discount in year 1, followed by 2%, then 1%

Maybe a good deal for the borrower but more likely a signal that the borrower paid too much for the house

40-year or greater terms-to-maturityLonger terms require lower payments of principal

Not very common yet due to limited investor interest

All of the above products grew in popularity during the boom and almost certainly contributed to escalating prices

In many cases, interest rate risks more capably managed by financial institutions are now borne by private citizens



The Primary Mortgage Market

Institutions/individuals who market, originate loans to borrowers comprise the primary mortgage marketLoan providers include

Traditional depositories- Banks, Savings & Loans, Credit Unions- Have the capacity to fund and portfolio loans (but may not)- May also perform loan servicing

Mortgage bankers- Generally mono-line companies that make, fund, and sell loans- May also perform loan servicing

Mortgage brokers- Independent agents who generally act as intermediaries- Generally don’t underwrite or put capital at risk

For the typical borrower, there is no universal, material advantage to any one type of loan provider



The Secondary Mortgage Market

The secondary mortgage market is comprised of funding, buying, selling, servicing, and securitizing closed loans

This activity replenishes funds for making new loans

Secondary market mortgage participants include Primary market participants

- When they sell their loans and/or servicing rights

Fannie Mae and Freddie Mac (the GSEs)- When they guarantee and securitize loans (discussed later)

Investment banks- When they buy, structure, and securitize loans

Prior to the 1930s depression, loan sales were uncommon

Fannie Mae was the first institution created to ensure lenders funds for loans other than their own locally-based deposits



Drawbacks and benefits of the Secondary Mortgage Market

The growth and robustness of the secondary market has improved the pricing and availability of mortgage credit

Risks can be allocated more optimally- Borrowers aren’t hindered by local economic weakness

Uniform performance data can be collected and analyzed- Models can be improved so the right borrowers are approved

International funds can flow more readily to mortgages- Increased supply of funds reduces borrowing costs

Innovation in mortgages and securitization is encouraged- Structures can be developed for borrowers and investors

The secondary market and structured securitization in particular have been criticized as primary to the housing bust

Critics say originators were too far removed from risks



Interaction of primary and secondary markets

Participants are engaged in a relatively efficient marketBorrowers enjoy certain regulatory protections and transparency

- RESPA, good faith estimates, HUD-1 - The internet is a good source for finding the best loan terms- http://www.amerisave.com/index.cfm, http://www.borrow123.com

Originators have multiple choices for loan placement- Hold for portfolio investment to profit from net interest margin (NIM)- Sell to a GSE or to an aggregator/issuer – a bigger institution

Sell the future stream of payments for their present value

“Best execution” is the process for determining where to place different loans to achieve optimal value on a pool of loans

The aggregator may re-sell to a GSE or issue its own security

Parties typically engage in forward agreements to originate and fund/sell loans with specified terms/pricing at future dates

- A borrower’s rate lock-in is a type of forward agreement



Mortgages are grouped into several categories for secondary marketing

Conventional/Conforming (C/C)Meets standards for loan features, credit quality, approval guidelines and size limits specified by the GSEs

- C/C loans can be both fixed rate or ARMs- Interest-only loans were approved as C/C in the early 2000s

Many lenders have 12-month term agreements with GSEs to sell a representative mix of their C/C production for the coming year

- Agreements are often dimensioned by relative share and loan/pool credit quality stipulations or loan/credit price adjustments

- Lenders retain the ability to conduct best execution subject to the constraints of the GSE sales agreements

- The GSEs closely monitor lenders’ selling behavior to watch for population skewness, a.k.a. adverse selection



Other major mortgage categories

Conventional/JumboConsistent in most respects with GSE guidelines with the major exception of loan size (currently > $417k)

- Typically sold to an institution with security issuance capabilities (for later discussion); interest rates are usually 0.25% higher

- Cannot be sold to GSEs

Alt-A (the label is hotly debated and often changing)Generally represents loans made to prime quality “A” borrowers (typically defined by FICO score) but outside standard guidelines

- e.g., 90% financing with cash out, investor occupancy, no-income-no-asset documentation (NINA), or other layered risk

- Separate from the forward agreements GSEs may be willing to buy Alt-A loans on a pool-by-pool basis after close consideration

- Otherwise Alt-A is portfolio-ed or sold to an aggregator/issuer



Even more major categories of mortgage loans

Government guaranteedFederal Housing Administration (FHA), Veterans Administration (VA), Rural Housing Service (RHS)

- Primarily designated to finance modest housing for certain borrower segments, e.g., first time buyers, lower income, veterans, etc.

Manufactured housing (MH) loansMH residing on leased land is not considered real estate

- More like personal property lending, e.g. car loans, than housing

Sub prime mortgages Typically outside guidelines due to ineligible borrower quality

- Low FICO, recent bankruptcy, unpaid collection accounts, etc.- Formerly primarily home equity lending, i.e., poor credit quality but

with reasonable equity in the property- More recently evolved into first time buyers and high LTV lending- Typically sold to an issuer of mortgage-backed securities



Risk assessment and loan pricing – e.g., corporate debt

In the world of corporate lending, unsecured debt is commonly graded and priced according to risk

source: Vanguard

Lower grade corporate borrowers pay higher interest rates to account for a higher perceived probability of default and loss

Rat

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Risk assessment and loan pricing in mortgage lending

Mortgages are also priced according to risk, though rate responsiveness is fairly minor among prime FICO borrowers

Like secured corporate debt, the mortgage collateral, i.e., house has a stabilizing effect on the interest rates offered

Credit quality below certain thresholds triggers sub prime rates

source: myfico.com



Risk assessment and pricing models have evolved in the last decade

The practice of charging higher rates to compensate for higher risk has existed since the dawn of lending

Statistical performance models to determine mortgage pricing have become increasingly prominent in the last decade

Growth of the secondary market, creation of FICO scores, and increased data collection have enabled statistical sophistication

The modern-day application of the risk assessment entails supplying application data into models that predict:

Probability of borrower default, a.k.a. default rates

Loss given default, a.k.a. severity rates

Expected loan life, a.k.a. prepayment rates



It’s helpful to think about loan performance intuitively

Why do borrowers default? A borrower is likely to default on a mortgage if s/he

- Can no longer afford the payments and - Cannot sell the property without a loss

Why do borrowers prepay?Early payoff may be made for the following reasons

- Rate incentive: a better rate becomes available- Mobility: the owner sells the home and moves- Cash out: the owner extracts home equity as cash

What losses are sustained in the event of default?Severity rates are generally a function of

- Property value deficiency relative to loan amount- Lost interest prior to property liquidation



Significant origination predictors of default and severity in credit models

FICO: measure of borrower credit line performanceMost significant indicator of default rate along with LTV

Loan-to-value: ratio of loan amount to property valueImportant to both default and severity rates

Loan purpose: purchase, refinance, or cash-out refinanceCash-out usually considered riskier for default and severity

Occupancy: owner, investment, or second/vacation homeInvestment considered a higher risk for default and severity

Documentation: full income/asset verification, or reducedReduced documentation may signal increased default risk

Payment-to-income: ratio of loan payment to income levelHigh ratio suggests increased default risk



Significant origination predictors of mortgage prepayments

Among prime mortgages, in general, origination loan attributes that suggest higher credit risk also suggest slower prepayment or longer average life

Alternately stated, a borrower with a good credit profile and low-risk origination attributes may more readily relocate to another home or refinance when financially advantageous

Within the sub prime space, borrowers with weak loan attributes and commensurately high note rates generally prepay faster with a shorter average life

The phenomenon is referred to as “credit curing” whereby a borrower can lower her monthly payment by refinancing when her credit score improves



Major macroeconomic predictors of mortgage performance

By and large, the most important factors that affect mortgage performance are house prices and interest rates

Favorable house prices - Reduce default and severity rates- Increase prepayment rates by increasing housing mobility

Stagnant or declining house prices - Increase default and severity rates - Reduce prepayment rates by lowering mobility

Low or declining interest rates - Create the incentive for borrowers to refinance (prepay)- Increase housing mobility by improving affordability

High or increasing interest rates - Reduce prepayment rates- Increase pay shock default risk with ARM borrowers

Inferences from origination loan attributes are excellent for determining ordinal pool performance; poor for cardinal



House price and interest rate models

Monte Carlo simulation employs a multi-scenario approach Single scenario assumptions fail to capture risk asymmetries

Variations in prices are dimensioned by volatility and random shocks

Interest rate models typically employ mean-reversion features- Volatility exists but invisible forces pull rates toward their long run averages

Each “path” produces a different level of defaults and losses

Monte Carlo Simulation Example - Sample House Price Paths

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Considering mortgages in a valuation framework

Mortgage cash flows can be valued similar to other assetsThe value of a risk-free vanilla bond or annuity is equivalent to its PV of future cash flows; in this way a mortgage is no different

The key differentiating feature of mortgage valuation is uncertainty due to embedded options

The right to prepay is equivalent to a call option

The right to default is equivalent to a put option

In simple terms, a mortgage rate (or IRR) should be the sum of:The underlying rate of a risk free annuity of the same maturity

The value of the embedded call option

The value of the embedded put option

Valuing these options is difficult in reality due to inefficient exercise



The price-yield relationship and negative convexity

A plain vanilla bond possesses:

An inverse relationship between price and yield

Convexity properties thataccelerate increases in value in response to declining rates

Decelerate declines in value when rates increase

A mortgage loan possesses:

Negative convexity whichConstrains value increases in response to declining rates

As rates decline, prepayment incentives increase the value of the call option for the borrower

Plain Vanilla Bond

Mortgage Loan



Asset securitization

“Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors.”

Mark Fisher & Zoe Shaw, eds., Euromoney Books, London 2003

Securitization was first developed for US mortgages, but the basic principles are now applied worldwide to various assets such as

Credit card receivables

Car loans

Student loans

Tax liens

Gambling revenues

Royalties



Mortgage securitization practices

US mortgage loans are securitized in two primary waysGSE guarantor execution

- Conventional/conforming loans sold to the GSEs are typically pooled together and issued as mortgage-backed securities (MBS)

- MBS are guaranteed against credit losses and rated ‘AAA’ based on the perception of US Government backing of the GSEs

- This form of credit enhancement, i.e., provided by corporate guarantee, is referred to as external enhancement

Private label execution- In private label MBS, enhancement is typically achieved internally

Subordination assigns sequential payment priority to senior classesOvercollateralization describes the practice of absorbing losses by issuing securities with total value smaller than the underlying loansExcess spread describes the reliance on excess interest payments to form a reserve to provide for coverage for pool losses

- Credit rating agencies assign ratings based on the level of supportEnhancement structures are engineered to achieve desired ratings



MBS cash flows – GSE execution example

• Make monthly payments to servicers of Principal, Interest, Taxes, Insurance (PITI)

• Retain servicing fees to cover costs

• Escrow and pay property taxes and insurance to third parties

• Remit principal and remaining interest portion to next party

• Earn ancillary income – interest on escrows, product cross-sales, late fees

• Keep guarantee fees (g-fees) in exchange for protecting investors against default

• Remit to MBS investor at pass-through rate

• Receive guaranteed principal and interest at pass-through rate

• Seller-Servicers and GSE portfolios are major MBS investors

Borrowers Servicers Fannie/Freddie MBS Investors



MBS cash flows – numeric GSE example

• Pay PITI to servicer at 6% note rate

• Retain 0.25% as servicing revenue

• Remit P&I at 5.75% to Fannie or Freddie

• Keep 0.25% as g-fee revenue

• Remit to MBS investor at 5.5% pass-through rate

• Receive guaranteed principal and interest at 5.5%

Borrowers Servicers Fannie/Freddie MBS Investors

To illustrate, assume... - 6% note rate - ¼% guaranty fee - ¼% servicing fee - 5½% pass-through rate



Internal credit enhancement mechanics – further detail

In the most basic form, internal enhancement is achieved through sequential pay, senior/subordinate structures

The subordinates take on losses until their balances dry up

Because the subordinates are riskier, they pay higher yields

The bigger the subordinates, the more protected the seniors

The smaller the subordinates, the more profitable to the issuer

Credit rating agenciesStandard & Poors (S&P) and Moody’s exist to rate securities

- they specify the required subordinate security sizings for the issuer to achieve certain ratings on the senior securities

In the process of preparing for securitization, an issuer will send to the rating agencies the underlying loan details for “sizing”

- The riskier the loans the bigger the subordinate class required



Basic Senior/Subordinate Two-Tranche Structure

Subordinate10%

Senior90%

Internal credit enhancement mechanics – simplified example

Assume $100M pool of risky mortgages with an average rate of 6% (post servicing)

The rating agency specifies that 10% of potential losses must be covered to achieve the desired senior rating

Issue $90M senior security and $10M risky subordinate

Investors require 5% yield on the senior, 15% on the sub

The weighted average rate stays the same but the losses are redistributed

90%*5% + 10%*15% = 6%



Other practices in mortgage securitization

The three types of cash flows within mortgage pools, interest, scheduled principal, and prepayments can be assigned to different classes or tranches and subjected to different rules and triggers through timeIn practice, collateralized mortgage obligations (CMOs) can strip-out and structure many types of instruments from highly predictable to highly unpredictable and riskySome examples

Interest only (IO) bonds- On a separate note, loan servicing fees are a natural form of IO

Servicing can be retained or released (sold) upon loan dispositionMarket standards regulate a minimum servicing fee“Excess” servicing beyond the minimum can be securitized

Principal only (PO) bondsPlanned Amortization Class (PAC) bondsNon-Accelerating Senior (NAS) bonds



Major advantages securitizing mortgages – issuer perspective

LiquidityUniform, well-understood securities are easier to value and trade than individual loans

Risk managementCredit risks and balance sheet issues, such as asset-liability matching can be more readily optimized per tolerance levels

PricingCash flows can be restructured to suit investor demand and yield better all-in pricing – though arbitrage arguments disagree

Profit takingProfits can be realized upon the sale of the assets rather than incrementally over the life of the mortgages



Major advantages to securitization – investor perspectives

Improve diversification and risk-adjusted returnsSecuritization can make ordinarily un-traded, weakly correlated assets available for investment managers as rated securities

- Many managers are restricted to investment grade assets only

Risk management or speculationSome instruments can serve as effective hedges for other investment or business activities (negatively correlated asset)

The same instruments, absent an offsetting position, can allow investors to make highly leveraged bets on prepayment rates, interest rates, or loss levels

Investment repackagingCollateralized debt obligations (CDOs) can pool and re-securitize securities to provide yet another form of investment

guest lecture on residential mortgage finance

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