lecture notes - residential mortgage finance - nov 11

8/10/2019 Lecture Notes - Residential Mortgage Finance - Nov 11

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International Capital Markets

Lecture Notes

Residential Mortgage Finance

November 11, 2014

The U.S. mortgage market and its role in the financial crisis is not a simple matter. If we want to

understand it in a serious way, we will need to become friendly with the details. Apart from the

crisis, residential mortgage finance plays an important role in capital markets and deserves to be

studied for its own sake. First to remind ourselves about what the world was like before the

crisis:

Pre-Crisis Issuance

Intro to Asset Backed Securities Terminology

Please try to learn the meaning of the words in bold.

The following steps capture the main idea of most ABS:

(i) A bank or finance company originatesassets.

(ii) The assets are transferred to a special purpose vehicle (SPV)which is bankruptcy

remote.

Federal Agency issuers are, in order of importance, Federal Home Loan Banks,Freddie Mac, Fannie Mae, Farm Credit System and Tennessee Valley Authority.These are not mortgage-backed securities but bonds that Freddie Mac and Fannie Maeissue to fund mortgages that they hold in their retained portfolios, as discussed below.

Agency andnon-agency


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(iii) The SPV issues debt securities called asset backed securities (ABS). It uses the

proceeds from issuing securities to pay the originator for the assets.

(iv) The servicercollects the cash (e.g., from the homeowners in the case of mortgage-

backed security) and pays it to the SPV. Often, the servicer is the originator. The

servicer receives a fee often called mortgage servicing rights (MSRs).

(v) The cash flow from the assets is used to pay interest and principal on the SPVs debt.

The trusteehandles the payments and looks out for the interests of the bondholders.

(vi) If the servicer is no longer fulfilling its duties, the trustee can appoint a new servicer.

An ABS is designed to be remote from the bankruptcy of the originator. The assets that back an

ABS are often called the collateral or the collateral pool.

Some pools are revolving. That means, the originator can add new assets to the collateral pool as

old assets mature. Deals backed by credit card receivables, for example, are revolving. Deals

backed by mortgages on homes are usually staticas we will see.

ABS are carved up into tranches. The SPV issues several classes of securities. The junioror

subordinatedtranches absorb the first losses.

Summary of a Straight Pass-Through Securitization

Seller

SPV (Issuer)

Homeowners

transfer of themortgages

Monthlyprincipal and

interest

Servicer

Monthly

principal and

interest

Investors

SeniorTriple-A

Mezzanine

Single-A

Subord-inatedTriple-B

Purchase price +

monthly excess

spread

Monthly

principal and

interest


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Much of the non-conforming (i.e., sub-prime or low documentation mortgages) were financed inthis way until the new issue market collapsed in 2009. Note that investors must accept uncertaincash flows in these structures. Since the bonds are floating rate and investors dont incur a directeconomic loss due to interest rates if they prepay more quickly or slowly.

How can a bond backed by risky assets attain a triple-A rating? Usually, the senior tranches areovercollateralized. The collateral pool can suffer a certain amount of credit loss and the seniortranche will be okay. The amount of overcollateralization required to obtain a triple-A rating willdepend on the expected defaults of the collateral pool and the amount of diversification. TVcommentators often say things like it is absurd to create triple-A rated securities out of riskyloans, like subprime mortgages. But it is not absurd, it is entirely plausible if the amount ofovercollateralization is set to the right level. In fact, most triple-A tranches of U.S. subprime willend up receiving all the promised interest and principle, with the exception of some 2006-2008vintages.

According to S&P, 0.10% of the !756 billion in rated residential mortgage-backed securities

(RMBS) in Europe outstanding in mid-2007 defaulted by September 2013. That is not an annualfigure, but cumulative over five years. This includes all rated tranches, from single-B to triple-A.It includes RMBS in distressed real estate markets from Iceland and Ireland to Spain and Greece.Triple-A European RMBS defaults were confined to two technical events: (i) For the US dollartranches of Eurosail, a U.K. nonprime RMBS, USD payments were stuck with the swapcounterparty, Lehman, over the weekend when Lehman filed for bankruptcy. This led to adelayed payment which was eventually paid in full. (ii) Several tranches in Celtic Irish RMBStransactions were restructured, but ultimately paid the triple-A tranches in full.

Some ABS, such as Start VIII, are synthetic: they do not actually transfer the assets to an SPV,

but rather transfer the risk of a pool of assets using a credit default swap.

Common ABS in the U.S. and Europe are residential and commercial mortgages, auto loans,

credit card receivables, student loans and lease receivables.

Economic function of ABS:

ABS solve a principal/agent problem associated with corporate debt. The investor does

not need to worry that the SPV will act against its interests. However, the investor does

need to address the possibility that the servicer wont exercise diligence in servicing the

loans after they are sold.

ABS reduce the asymmetric information problem inherent in corporate debt: management

invariably knows more about the company than investors. In theory, ABS give a

relatively transparent view of the underlying obligations.

Tranching allows investors to specialize. Investors in triple-A tranches shouldnt need to

devote as much effort to analyzing the risk. Investors in junior tranches have incentives to

work harder.


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As in the case of Start VIII, securitization can be used to package generalized business

risk that banks would prefer to shed.

On the negative side, detractors have observed:

Credit analysis relies on historical performance. But over time, behavior adapts. Finance

companies and banks can develop a culture of originate to sell and standards

deteriorate.

Third party servicers interests are not as well aligned as servicers that own the assets.

The massive revenues that ratings agencies derived from structured finance led to

corruption. Moodys, S&P and Fitch all relaxed their traditional discipline.

Moodys Ratings Revenues by Category ($ millions)

2006 (mm) 1999 (mm) % change

Structured Finance $886.70 $172.40 514

Corporate Bond $396.20 $165.50 239

Financial Institution and Sovereign $266.80 $104.80 255

Municipal Bond $85.90 $59.50 144

Total $1,635.60 $502.20 228Source: Moodys Annual Reports

Residential Mortgage Loans

Most consumer debt consists of mortgage loans to finance homes. These loans are secured by the

propertythe lender has the legal right to foreclose on the property if the homeowner fails to

pay. We use the term home loans or residential mortgages to distinguish from commercial

mortgages which are loans secured by office buildings, hotels, shopping malls and other

commercial properties. In the U.S. as of June 2014, home mortgage debt made up 70% of

consumer debt. About 11% of consumer debt is revolving credit (credit card or home equity lines

of credit); 10% is student loans (up from 4.4% in 2007 Q4!); 7% is auto loans; and the remaining

2% is mainly for mobile homes, boats and trailers.

U.S. One- to Four- Family Non-Farm Mortgage Debt Outstanding to GDP ($ trillions)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Res. Mtg Debt 5.65 6.32 7.12 8.27 9.38 10.45 11.17 11.07 10.86 10.55 10.17 9.92 9.86 9.86

Nominal GDP 10.7 11.0 11.5 12.3 13.1 13.8 14.5 14.7 14.4 15.0 15.5 16.2 16.8 17.2

Ratio 53% 57% 62% 67% 72% 76% 77% 75% 75% 70% 66% 61% 59% 57%

Source: U.S. Federal Reserve, Bureau of Economic Analysis; data for 2014 is through Q2

The amount of residential mortgage debt varies a great deal across countries. The chart below

shows mortgage debt to GDP for European countries. The Netherlands is an outlier due to a tax


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law that gives incentives to individuals to borrow on their homes and invest in insurance

products; the insurance contract secures the mortgage loan in addition to the property.

Source: European Mortgage Federation

In 1980, mortgage debt as a percent of GDP in the U.S. was 35%, vs. 57% in at the end of June

2014. The EU-27 is now 52%. In the U.S., Denmark, Australia, Belgium, UK, Sweden and

Japan, homeowners can typically borrow about 80% of the cost of the home. Spain averages

61% post-crisis, down from around 65% pre-crisis.

Developing countries lag behind in terms of mortgage availability:

Sources: European Mortgage Federation, Central Banks, UN Habitat, and Regional Industry Reports

Mortgage Debt to GDP for Selected Developing Countries by Region

November 2010 - most recent available data

22

19

15

10

87

4 43 3 3

1

25

16

32

1

42

20

53

0.4

0

5

10

15

20

25

30

35

40

45

Panama

Chile

CostaRica

ElSalvador

Mexico

Guatemala

Columbia

DomRep

Peru

Ecuador

Brazil

Argentina

Malaysia

Thailand

Indonesia

Philippines

India

SouthAfrica

Namibia

Ghana

Botswana

Nigeria

PerCent


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Latin American mortgage finance grew steadily, even during the crisis:

Sources: European Mortgage Federation, Central Banks, UN Habitat, and Regional Industry Reports.

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What determines the efficiency of a countrys mortgage market?

Mortgage Enforcement Procedures

CountryMonths requiredfor payment to

creditors

Administrative Costsas percentage of loan

Netherlands 6 3

Denmark 6 0.5

Germany 12-24 4.2

France 15-25 7

Italy 60-84 14-18

United States 8.4* 11.5

Source: BIS; LoanPerformance

*Pre-crisis. Its now taking much, much longer. Mid-year, New York foreclosures took an

average of 930 days to complete according to RealtyTrac. These are clearly the easy cases wherehomeowners are not demanding production of the mortgage and deed. In some New York

localities, judges are refusing to hear foreclosure cases altogether.

But there are other costs to transferring property that can impede the efficiency of a mortgage

market:

Registering Property in Germany Cost

1The notary obtains an extract from the Land Registry and

notarizes the transfer agreement

EUR 10-20 (extract) + EUR 4194

to 7573.4 + 19% VAT (notarys

fees)

2 Obtain waiver of preemption rights with the municipality EUR 100 (consent of negativeattest of city council)

3

Fulfillment of the pre-conditions for the validity of the purchase

price: Registration of the priority notice in the land register;

negative attest of the public authorities; consents to the

cancellations

EUR 1388

4Payment of the transfer tax and obtaining the confirmation

(statement of innocuousness)6% of purchase price

5Application for the registration of the new owner and deletion of

the priority notice to the land register

EUR 2,775 (Registration Fee) +

EUR 694 (!fee for cancellation)


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Compare this to the U.S.:

Registering Property in the United States Cost

1 Obtain a title report $1200

2 Buyer obtains and fills the forms needed for the transfer$55 + 0.4% of property value

(state forms + transfer tax)

3 The title is recorded with the County Clerk

$28 + $ 3 per page (assuming that

the title consists of about 12

pages)

But the U.S. ranks poorly in terms of making defaulting homeowners pay.

Source: Moodys

Credit Bureaus

Privately-owned profit-maximizing: U.S., UK, Spain, Netherlands, Portugal, Australia,

Finland,

Private, owned by financial institutions: Denmark, Germany, Greece, Ireland, Italy,

Sweden

Consortium of credit providers: Austria, Belgium, Italy

State-owned: Belgium, France, Portugal, Spain

Belgium, Spain and Portugal have private and state-owned credit bureaus that co-exist.


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Consumer lenders in the U.S. rely on FICO scores. The FICO model was developed by Fair,

Isaac Company in the early 1980s. Three main credit bureausExperian, Equifax and

TransUnioneach apply this model based on data they collect from merchants, financial

institutions and public records. FICO measures a persons conduct with consumer credit and

does not depend on factors like income, profession, education, employment history, cash in the

bank or assets.

The table below comes from data assembled by the IFC:

Summary of Institutional Characteristics for Selected Countries 2014

Credit Bureau Effectiveness Creditors

Legal

Rights

Private %

Covered

Public %

Covered

Retailer

Info

Data >

2 yrs

old

Positive

&

Negative

0 4

Australia 100 0 Yes Yes No 4Austria 53 2 Yes Yes Yes 4

Belgium 0 89 Yes No No 3

Canada 100 0 Yes Yes Yes 1

Denmark 7 0 Yes No Yes 3

Finland 19 0 No Yes Yes 2

France 0 42 No No No 1

Germany 100 1 Yes Yes Yes 3

Greece 84 0 No Yes Yes 0

Ireland 100 0 No Yes Yes 2

Italy 100 24 No Yes Yes 0

Japan 100 0 Yes Yes Yes 3

Netherlands 82 0 Yes Yes Yes 3

Portugal 23 90 No Yes Yes 1

Spain 13 50 Yes No No 2

Sweden 100 0 No No Yes 1

UK 100 0 Yes Yes Yes 3

U.S. 100 0 Yes Yes Yes 3

Key:

Private % Covered: The share of households covered by private credit bureaus.

Retailer Info: Does the registry distribute credit information from retailers, trade creditors or

utility companies as well as financial institutions?

Data > 2 yrs old: Are more than 2 years of historical credit information distributed?Positive & Negative: Does regulation prohibit sharing positive information such as balances,

credit limits, details on credit card spending, recent changes to borrowing limits?

Creditors Legal Rights Index (1 point for each yes)

1. Do secured creditors have absolute priority to their collateral outside bankruptcy procedures?


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Source: IFC

Source: Eurostat, U.S. Census Bureau

What determines a countrys homeownership rates? Its not a simple question. Availability of

mortgage finance seems a poor answerthe data suggest that countries get the mortgage

finance that they want, although the factors are to some extent jointly determined. A regression

of homeownership rates on urbanization shows a relationship that is significant at the 2.4% level:

a 1% increase in urbanization is associated with a 0.37% decrease in homeownership rates.


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Urban populations are more likely to rent. However, the r-square is only 17%. Richer

populations are more urban these days, and richer people are more likely to own their homes.

This could cause the regression to understate the impact of urbanization.

Is homeownership a desirable social goal? This was not controversial in the United States before

the crisis, but now its not so clear. Mortgage debt does not necessarily improve the lives of the

borrowers. Homeowners may be more tied to their communities, but they cant move as easily to

take advantage of economic opportunity. Higher homeownership may go together with a higher

natural rate of unemployment. The countries on the left-hand part of the scale of the chart above

are not obviously better countries to live in than the ones on the right.

Background: Home Prices

The U.S. led the way up and down:

The S&P Case-Shiller index is set to 100 in January 2000. Price declines are highly regionalized.

Change is the change from the April 2007 peak. Except for San Francisco, the biggest busts were

preceded by the biggest booms. New York boomed but never really busted. Home price

appreciation has slowed lately, but notice how much the market recovered in 2013:


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Case-Shiller Index for Selected Areas

City Aug 2014 Dec 2013 Dec 2012 Dec 2011 Dec 2010 Dec 2009 Apr 2007 Change*

Las Vegas, NV 136.65 129.93 102.19 90.49 99.2 104.1 228.67 -60%

Phoenix, AZ 147.58 144.18 125.33 101.91 103.1 111.96 215.04 -53%

Miami, FL 188.24 177.57 152.36 137.7 143.11 148.66 273.53 -50%

Tampa, FL 162.4 155.79 134.63 125.55 130.94 138.88 226.76 -45%

Detroit, MI 99.05 94.6 80.26 70 67.56 71.94 116.69 -40%

San Francisco, CA 194.53 181.52 147.89 129.25 136.49 136.8 213.65 -40%

San Diego, CA 203.7 194.94 164.87 150.94 159.56 156.89 234.64 -36%

Composite 173.66 166.62 146.37 136.94 142.66 146.06 202.9 -33%

Washington, DC 210.68 204.75 189.74 179.27 183.76 179.55 238.62 -25%

New York, NY 177.55 172.05 161.84 162.75 168.11 171.86 213.73 -24%

Charlotte, NC 128.24 124.07 114.86 109.97 112.41 117.79 131.98 -17%

Cleveland, OH 107.5 104.33 100.69 97.75 100.21 103.86 117.57 -17%

Boston, MA 176.73 168.65 154.76 149.42 153.4 154.64 171.76 -13%

Denver, CO 156.17 146.26 135.15 124.52 124.95 127.99 136.58 -9%

*Change from April 2007 peak to December 2011 bottom.

U.S. house prices had not had a meaningful decline until the crisis:

Source: U.S. Census Bureau


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Residential Mortgage-Backed Securities (RMBS)

A mortgage market begins with laws that enable homeowners to pledge their home and lenders

to foreclose on the property if the homeowner fails to pay. The market needs firms that originate

and service mortgages as well as credit bureaus to provide common information. Mortgage

lenders require money to finance their loans. The main methods are bank deposits and RMBS all

over the world and covered bonds in Europe. RMBS rely on a legal infrastructure for transferring

the loans to a special purpose vehicle or a trust where they will be remote from bankruptcy of the

issuer.

We will focus our discussion with the U.S. However, RMBS are not only a U.S. phenomenon.

They are an important source of mortgage finance in Canada, Australia, Belgium, Ireland, Italy,

Netherlands, Portugal, Spain and UK. The table below shows the share of mortgages funded by

RMBS and covered bonds (well discuss them shortly). Most of the rest are funded by bank,

specialized financial institutions such as Building Societies or Bausparkassen.

Source of Mortgage Finance in SelectedCountries (2008)

RMBS (%)Covered

Bonds (%)

Australia 17

Austria 3 7

Belgium 30

Canada 31 1

Denmark 100

France 2 22

Germany 2 19

Ireland 30 16

Italy 31 2

Japan 4

Netherlands 31 4

Portugal 27 15

Spain 24 46

Sweden 54

U.K. 31 14

U.S. 64

Source: IMF


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The U.S. housing market, mortgage market, and the market for RMBS have changed radically

over the last 6 years. We will look at what happened, try to make sense of it and assess where we

stand today.

There are about 75 million owner-occupied homes in the U.S. of which 52 million have a

mortgage (70%). Here is what happened to mortgages that were securitized in 2005-2008

through the end of 2010.

Source: Moodys

Real estate owned (REO) = already foreclosed and owned by the lender. Once the lender

disposes of the property, it is no longer counted as delinquent. We will discuss in detail shortly

but heres a taste of how bad it is.

Foreclosures are a local phenomenon. In 2009, the five states with the highest foreclosure rates

were: Nevada (1 in 10 homes, 112,000 homes), Arizona (1 in 16, 163,000 homes), Florida (1 in

17, 516,000 homes), 1 in 21 in California (632,000), and Utah (1 in 34, 27,000 homes). This

compares to 1 in 2178 in Vermont (143 homes), 1 in 796 in North Dakota (390 homes), 1 in 597

in West Virginia (1,479 homes), and 1 in 45 nationally (2,825,000 homes).

As of September 2014, the foreclosure rate had dropped, but its still high. In Florida, 1 in every434 homes was foreclosed (1 in 36 annual rate); 1 in every 511 homes in New Jersey (1 in 42); 1

in every 673 in Maryland (1 in 56); 1 in every 789 in Illinois (1 in 65), and 1 in every 797 in

Nevada (1 in 66). The national rate dropped to 1 in every 1,232 (1 in 102). Here is the

distribution when foreclosures were at their worst:


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In the U.S. in 2008, over 75% of funding for new mortgages came from RMBS compared to25% in Europe. RMBS became even more important for the U.S. since 2008: while the private

sector has dropped out, Freddie Mac and Fannie Mae have increased their market share despite

the fact that they are operating under government conservatorship.

Summary of the U.S. RMBS Market

About 70% of U.S. homeowners have a mortgage. The majority of these mortgages are

securitized by either U.S. federal agencies or by investment banks. The approximate composition

is as follows:

Residential Mortgage Debt Outstanding: $9.86tn(as per cent of total, approx. June 2014)

Agency MBS: 53%

Fannie Mae 20%

Freddie Mac 16%

Ginnie Mae 17%

Non-Agency MBS: 9% (pre-crisis origination)

Prime Jumbo 2% (too big for agencies)Alt-A 4% (borderline subprime)

Subprime 3%

Non-Securitized: 38%

Freddie Mac 4% (retained)

Fannie Mae 4% (retained)

Non-agency 30%


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The Government National Mortgage Association (GNMA or Ginnie Mae) guarantees

securitized mortgages for low-income families and veterans. It is backed by the full faith and

credit of the U.S. government. Ginnie Mae is a wholly-owned government corporation within

the U.S. Department of Housing and Urban Development (HUD).

The Federal Home Loan Mortgage Corporation (or Freddie Mac) and Federal National

Mortgage Association (or Fannie Mae) are publicly owned companies. They are chartered by

Congress and benefit from implied government support. They have their own regulator, Federal

Housing Finance Agency (FHFA), which is part of HUD. Fannie Mae shares fell from $67 in

September 2007 to $0.74 in October 2008 when it was taken into conservatorship (see below).

Freddie Mac shares have followed a similar trajectory.

All three are referred to as government agencies although Fannie and Freddie technically are

not government agencies. The proper name for them is government sponsored enterprises

(GSE). FHFA permits Fannie Mae and Freddie Mac to underwrite loans that conform to certainstandards. The maximum allowable loan was, until recently, $417,000 for a single-family home.

Back in February 2008when the GSEs were crowing about their superior performance

Congress passed the Recovery Rebates and Economic Stimulus for the American People Act of

2008 allowing agencies to securitize or purchase larger loans that exceed the limit in a high

cost area, Alaska or Hawaii. In 2010, the limit for a conforming mortgage in a high cost area

was raised to $729,750 in the contiguous U.S. (New York City, Nassau County and Westchester

County all qualify); as a result of political pressures, it was lowered to $625,000 in September

2011. In Alaska and Hawaii the general limit is $625,500 and the limit in high cost areas is

$938,250. The higher limit for the high cost areas is expected to be eliminated at some point.

Since the FHFA placed Fannie Mae and Freddie Mac in conservatorship in September 2008, the

U.S. government has effectively backed the GSEs debt, although the guarantee is not explicit.

To describe the agency origination process in the simplest terms, an initial mortgage lender,

usually a bank or a mortgage bank, advances money to the homeowner at closing. The mortgage

lender exchanges individual mortgages that it has originated for a Participation Certificate in a

pool of many mortgages with similar characteristics. The agencies deduct a guarantee fee of

approximately 50 basis points and pass through the remaining principal and interest. The

lender may continue to service the mortgages in exchange for a servicing fee. Payments to

investors are made on a monthly basis, tracking the payments homeowners make to the servicer.

The guarantee fee will probably rise at some point.

Non-agency securities or whole loans are not guaranteed or underwritten by the three

agencies but are packaged, tranched and sold by investment banks. In 2005, non-agency RMBS

surpassed agencies.


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But lately, business for private issuers has not been good:

Source: Federal Home Loan Mortgage Corporation

Through the third quarter of 2014 private label RMBS issuance is $18.0 billion, accounting for

about 3% of the $702.4 billion in new issuance.

Lately, the Federal Housing Administration (FHA), part of the Department of Housing and

Urban Development's (HUD), has stepped in to fill the void for subprime. In 2006, the FHA

insured 5% of U.S. mortgages. In 2010, this rose to 33% and in 2011 to 35%. In the last three

years, FHA has had to pay out $37 billion in insurance claims against defaulting homeowners


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and is almost out of cash. FHA requires as little as 3.5% down. Expect a controversial bailout in

the next year or two. These loans go into Ginnie Maes.

At the moment, 90% of mortgages are securitized by Freddie, Fannie and Ginnie Mae. The

remaining 10% of mortgages do not conform to agency standards. These stay in banks

portfolios. Mainly, they are jumbo mortgages for regular customers.

Until this month, the Fed had been buying up every mortgage in sight, as discussed in our first

lecture. Here are Ginnie Maes for example:

Ginnie Mae Holdings

In addition to MBS, Freddie and Fannie issued debentures (ordinary bonds like we studied in the

second and third lectures). They used the money to buy home mortgages, which they retained intheir portfolios.

ARMS = adjustable rate mortgages. ARMS adjust based on libor, a one-year U.S. Treasury

index, or a cost of funds index that equals the weighted average interest rate that banks in

Nevada, Arizona and California pay on checking and savings accounts. The 11thDistrict of the

Federal Home Loan Bank in San Francisco publishes this rate each month. Hybrid ARMS

became popular during the boom. These are fixed, usually for 3, 5, 7 or 10 years and float

annually thereafter. The amortization schedule is usually fixed according to a 15 or 30 year

schedule.

About 70% of U.S. RMBS are backed by fixed rate mortgages and the proportion of fixed rate in

new origination has been much higher since the crisis. The RMBS investor bears the prepayment

risk. Prepayments are caused by six factors: death, divorce, destruction, default, relocation and

refinance. The first three are a predictable function of the loans age. Default and relocation are a


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function of the economy (when the economy is bad, homeowners default more often; when the

economy is good, prepayments due to relocation pick up).1

Refinancing depends mainly on interest rates. Understanding this relationship is the key to

investing in fixed rate MBS. When mortgage interest rates decline, prepayments rise. The

duration shortens, and MBS investors earn a lower profit than they would have earned with an

equivalent duration fixed rate bond. As interest rates rise, prepayments slow down and duration

increases. MBS investors lose more than they would have lost with an equivalent duration fixed

rate bond. This is called the negative convexity of MBS. Why would anyone buy an MBS?

They have a higher coupon than equivalent fixed rate bonds to compensate investors for

prepayment (i.e., refinancing risk).

Source: Mortgage Bankers Association

Alt-A basically describes mortgage loans that dont qualify for prime GSE standards but are not

subprime. The following characteristics can make a loan Alt-A:

- LTV > 80% (average = 88%)

- borrower is a temporary resident alien

- buy-to-let or vacation home (22%)

- Interest-only or option ARM (62% in 2006)- low documentation of income or assets (81% in 2006, up from 64% in 2004)

Subprime means FICO < 620; or a borrower with FICO > 620 but who has been delinquent in

the last 12 months or bankrupt in the last 24 months. The average Alt-A FICO score is 717.

1Prepayment fees are normally charged in most countries other than the U.S., Denmark, Netherlands, Japan and

Sweden.


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Alt-A grew steadily as a per cent of new origination. Since 2009, origination has been zero:

Option ARMs allow the homeowner to pay less than the interest due for a period of time. The

principal increases during these months. In mortgage lingo, it is subject to negative

amortization or is neg-amming. When the loan balance hits a cap, say 125% of the original,

negative amortization drops, and the homeowner must begin repaying principal. The required

monthly payment can rise sharply at that point.

All of this is probably gone forever. But it deserves our attention due to the central role of the

U.S. mortgage market in the crisis and the importance of the crisis in reformulating capitalmarkets.

Source: U.S. Census Bureau


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Closer Look at U.S. Subprime

The subprime market exploded in 2003-2006. You can see this in the graph on p. 17. Subprime

origination was $138 billion in 2000. In 1995 it was $65 billion and in 1994 it was $35 bn.

Average FICO: 646

Average loan to value: 94%

Low/no documentation: 50%

Share of 2/28 ARMs: 78%

Share of buyers taking out simultaneous second mortgages: 40%

Top Subprime Lenders in 2006

Rank Lender Share Where are they now?

1 Wells Fargo 13.0% Out of subprime, Sep 2007

2 HSBC 8.3 Ceased subprime operations Nov 20083 New Century 8.1 Bankrupt

4 Countrywide 6.3 Bailed out by BofA, @ about $1 per share

5 CitiMortgage 5.9 34% owned by the U.S. government

6 WMC Mortgage 5.2 GE sub; no longer making loans; website down

7 Fremont Investment 5.0 Bankrupt

8 Ameriquest 4.6 Bankrupt

9 Option One 4.5 Sold to W. Ross and now part of Ocwen. Does not lend, only services.

10 First Franklin 4.3 Acquired by ML for $1.3 bn before crisis.

Source: Mortgage Lender Implode-O-Meter (www.ml-implode.com); (see for list of 388 mor tgages lenders that have imploded in the

last eight years)

Lets take a closer look at one deal. SAIL 2006-4 was originated by sold by Lehman on June 30,

2006. The underlying mortgages were originated around March 2006. By February 2008in less

than two years1.73% had already been written off (Cumulative Losses), 9.87% was REO (real

estate owned = already foreclosed), 16.7% was in foreclosure, 4.82% was 90+ days delinquent

and not yet in foreclosure, and 2.25% was delinquent between 60 and 90 days. The performance

was terrible long before it experienced reset shock. In 2/28 arms, a below-market teaser rate

applies for the first two years. Then the rate jumps up to a spread over libor, such as L+6%.

Periodic caps may keep the rate from rising to its fully indexed level all at once.


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Things keep getting worse:


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The five triple-A tranches made up about ($747,827,000 + $391,109,000 + $602,379,000 +

$190,163,000 + $90,492,000)/$2,446,422 = 83% of the pool. Although, the performance of this

pool is stunningly bad, the triple-A investors will not lose as much as you might expect.

Altogether, the triple-A tranches have received $1.53 billion (76%) and are still owed $589

million. Only $441 million of outstanding balance is remaining and 35% of that is 90+ days

delinquent, in foreclosure, or already foreclosed, so there is no way the triple-A will get back all

its money. But it is reasonable to expect that as a whole the triple-As will eventually receive 80-

85% of the original principal. This might surprise people considering that SAIL 2006-4 is a

notoriously bad deal. The $311 million of mezzanine bonds, originally rated triple-B, will get

nothing.

Many subprime borrowers intended to refinance their mortgage within two years. At that point,

they expected the home value to have risen, enabling them to qualify for a prime mortgage.

Source: Moodys

0%

4%

8%

12%

16%

20%

24%

28%

32%

3 9 15 21 27 33 39 45 51 57 63 69 75 81 87 93

%o

fOriginalBalance

Months After Issuance

U.S. First Lien Subprime RMBS 60+ Day Delinquencies

1999 2000 2001 2002 2003

2004 2005 2006 2007


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Source: Moodys

How did this happen? Average FICOs were rising:

and loan-to-value (LTV) was steady:

0%

5%

10%

15%

20%

25%

30%

35%

3 9 15 21 27 33 39 45 51 57 63 69 75 81 87 93

%o

fOriginalBalance


U.S. First Lien Subprime RMBS Cumulative Losses

1999 2000 2001 2002 2003

2004 2005 2006 2007


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Fitch conducted a study of 45 randomly selected loans that were early payment defaulters in

2006. Although the sample is small, the review of each loan was intensive.

Characteristics of the 45 files reviewed (loans may appear in more than one finding):

66% Occupancy fraud (stated owner occupied never occupied), based on information provided by

borrower or field inspector51% Property value or condition issues Materially different from original appraisal, or original

appraisal contained conflicting information or items outside of typically accepted parameters

48% First Time Homebuyer Some applications indicated no other property, but credit report showed

mortgage information

44% Payment Shock (greater than 100% increase) Some greater than 200% increase

44% Questionable stated income or employment Often in conflict with information on credit report

and indicated to be outside reasonableness test

22% Hawk Alert Fraud alert noted on credit report

18% Credit Report Questionable ownership of accounts (name or SS #s do not match)

17% Seller Concessions (outside allowed parameters)

16% Credit Report Based on authorized user accounts

16% Strawbuyer/Flip scheme indicated based on evidence in servicing file

16% Identity theft indicated

10% Signature fraud indicated

6% Non-arms length transaction indicated

The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance. November 28,

2007. FitchRatings.


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Bob Simpson, president of Investors Mortgage Asset Recovery Company LLC (Simpson, whose firm ishired by lenders and mortgage insurers to audit files on delinquent loans, spoke by telephone toBloomberg News from Irvine, California, November 2008):

On mortgage losses:

One of the reasons we continue to be surprised by these losses is somehow it's infected theconversation that we have to work these loans out with everybody. No, we don't, and we can't. Unlessthere's a real stark realization about the number of rental properties owned by a part-time loanofficer/parking valet in Las Vegas, unless you realize that all six of those loans that guy got are going togo bad, you're going to continue to hold out hope. You're going to continue to value that portfolio atmaybe 80 cents on the dollar. It's not worth that. You can identify which of these loans are going to gobad, and it's time to stop being a Pollyanna about these loans.''

Everybody is continuing to labor under the assumption that people are `almost qualified' for theseloans -- and it's but for an interest rate we can reduce, or maybe we give them a better term or a periodof interest-only payments ... people continue to labor under the assumption that that's what in this bookof business. That is not what's in these loans. Not from what we've seen from the thousands that we'veaudited. Whats in these loans is people who park cars and bought three investment properties, who

wait tables and bought a $400,000 condo. Unless Treasury gets real informed, real fast about how littlehope there is for a substantial portion of this book of business, they're going to continue tounderestimate how much this is going to cost.''

Let me give you an example I've seen: A guy who works as a card dealer at a southern Californiacasino. We've spoken to him. He makes about $2,100 a month. He bought at the height of the marketand paid $700,000 for a house. He makes about $25,000 a year. This is not that uncommon: ... Loansthat terrible are not uncommon. Now that that $700,000 house is worth $500,000, there is zero to bedone for that card dealer. He doesn't want the house. He doesn't want the burden of it. He can't evenafford the taxes, much less the debt coverage. That loan will default, there's nothing to be done. Peopleare walking away because their gamble on real-estate values didn't pay off. This is pretty much thedefinition of Henderson, Nevada. An entire town purchased by people who work in the hotel industry inLas Vegas and were buying half-million-dollar homes. They have to default. These people are tapped

out at $150,000. I've got a parking valet here with mortgage bills of $9,000 a month, who works for tips.That person is going to default, must default. That person has no business owing more than $100,000.And they borrowed $625,000.

As I review servicing records, I see person after person after person who doesn't want help. They'redone. They don't want relief. About 20 percent of the loans we audit here for mortgage fraud are peoplewho own more than one property. Nobody's doing the math, saying `Tell me about those properties, tellme the addresses, what do you owe?' Those properties, those three rentals owned by a hairdresser,they have to be booked as `will be foreclosed upon.'


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Alt-A did not workout so well either:

Source: Moodys

Source: Moodys

0%

4%

8%

12%

16%

20%

24%

3 9 15 21 27 33 39 45 51 57 63 69 75 81 87 93

%o

fOriginalBalance


U.S. Alt-A RMBS 60+ Day Delinquencies

2001 2002 2003 2004

2005 2006 2007

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

3 9 15 21 27 33 39 45 51 57 63 69 75 81 87 93

%o

fOriginalBalance


U.S. Alt-A RMBS Cumulative Losses

2001 2002 2003 2004

2005 2006 2007


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But neither did Prime Jumbo. Defaults are much lower for Prime Jumbo, but it is just as bad as

subprime and Alt-A relative to expectations. 2006 and 2007 vintages have been disasters:

Source: Moodys

Moodys estimated that 2005-2008 vintage subprime as a whole will ultimately lose 32%. It

estimates that for the same vintages, Alt-A will ultimately lose 25% while the 2007 vintage will

lose 31.6%. Prime Jumbo 2006 vintage will lose a shocking 7.4% and 2007 vintage an even

more shocking 9.8%.

U.S. Policy Response

A homeowner who is delinquent for 90 days receives a Notice of Default. If the default is not

cured within an additional 90 days, the servicer makes a notice of foreclosure sale that serves

as a public notice of an upcoming auction. If the home sells successfully, then the foreclosure is

removed from the pool. Otherwise, it is classified as REO, or real estate owned. Title is

passed to the trust and the servicer becomes responsible for selling the home. The servicer cuts

prices sharply and the home is usually sold within a few months. Details differ among states.

Background:

Deficiency Judgment: The process for foreclosing on a seriously delinquent loan varies

from state to state. Most significantly, in deficiency states the lender can foreclose on

the home, sell it and pursue the homeowner personally for any losses. In single-action

states such as California, the lender can foreclose or pursue the borrower, but not both.

0.0%

0.8%

1.6%

2.4%

3.2%

4.0%

4.8%

5.6%

3 9 15 21 27 33 39 45 51 57 63 69 75 81 87 93

%o

fOriginalBalance


U.S. Jumbo RMBS Cumulative Losses

2001 2002 2003 2004

2005 2006 2007


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Single-Action States

Alaska

Arizona

California

Iowa

Minnesota

Montana

North Carolina (purchase mortgages)

North Dakota

Oregon

Washington

Wisconsin

Percent of borrowers who go into foreclosure without returning a single phone call from a

collector: 50%. Judicial Foreclosure: Florida requires a court to order a foreclosure. This leads to all sorts

of anti-social practices whereby homeowners and their lawyers can drag the foreclosure

out for a long time while the homeowner lives in the house rent free. The other main

judicial states are New York and New Jersey. In New York it takes over two and a half

years (if ever) to foreclose.


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Recoveries in judicial states are terrible:

Advances in the graph above are money that lenders pay to keep up the house, including real

estate taxes and insurance. Non-judicial states are bad, too, but lenders are at least getting back

some recoveries:

The five states with high foreclosure rates in 2009 are characterized by tough consumer

protection laws, such as those that prohibit deficiency judgments on foreclosed homeowners or

limit lenders to a single lawsuit to pursue either the property or the homeowner (fourteen anti-

deficiency or one action states including Arizona, California, Florida, Nevada and Utah) or

requiring a court order for a foreclosure (judicial mortgage states such as Florida). However the

states ranked 6, 7 and 8 in terms of the highest 2009 foreclosure ratesGeorgia, Colorado and


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Michiganallow the lender to pursue both the homeowner and the property and do not require

judicial approval, so consumer protection laws are not the whole story.

Bankruptcy: Mortgage debt on the primary residence is not dischargeable in a

bankruptcy. If the homeowner becomes delinquent, after the bankruptcy is discharged

(i.e., it is over), the servicer can foreclose.

Loan Modification: Loan modification is a voluntary offer by the lender to reduce the

interest rate or principal to avoid default; in theory, this could be more efficient than

foreclosure. An important study by the Federal Reserve Bank of Boston sheds a great

deal of light on this problem: Why Dont Lenders Renegotiate More Home Mortgages?

Redefaults, Self-Cures, and Securitization

http://www.bos.frb.org/economic/ppdp/2009/ppdp0904.pdf (July 2009). We document

the fact that servicers have been reluctant to renegotiate mortgages since the foreclosure

crisis started in 2007, having performed payment-reducing modifications on only about 3

percent of seriously delinquent loans. We show that this reluctance does not result fromsecuritization: servicers renegotiate similarly small fractions of loans that they hold in

their portfolios. We use a theoretical model to show that redefault risk, the possibility that

a borrower will still default despite costly renegotiation, andself-cure risk, the possibility

that a seriously delinquent borrower will become current without renegotiation, make

renegotiation unattractive to investors. More than 30% of seriously delinquent

mortgages self-cure the borrower repays without any help. A lender that offers a

modification will lose the amount of any concessions for a borrower that would have self-

cured in the absence of a modification. Additionally, the probability of re-default of a

modified mortgage within a year is about 50%. Between the time of the modification and

the redefault, the homes value may have deteriorated.

There are two main government programs to keep people in their homes. They have been a

mess.

Home Affordable Modification Program (HAMP) was designed to let homeowners avoid

foreclosure by subsidizing mortgage lenders' modifications to borrowers' home loans. To qualify

a borrower must:

Have a housing payment including principal, interest, property taxes, HOA dues, and

insurance that exceeds 31% of the borrowers gross monthly income.

Have a documentable hardship -- either a significant reduction in income or increase in

expenses that was beyond the borrowers control.

Have a stable source of income sufficient to make a modified payment.

Borrower does not have to be current.


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Home Affordable Refinance Program(HARP) was created to let creditworthy homeowners who

are underwater (mortgage is greater than home's value) on their mortgages refinance to the

lowest available mortgage rates. Borrowers don't have to be cash-strapped or at risk of

foreclosure. To qualify for HARP, a borrower must:

Have a mortgage that is owned or guaranteed by Freddie Mac or Fannie Mae.

The mortgage must have been sold to Fannie Mae or Freddie Mac on or before May 31,

2009.

The mortgage cannot have been refinanced under HARP previously unless it is a Fannie

Mae loan that was refinanced under HARP from March-May, 2009.

The mortgages current loan-to-value (LTV) ratio must be greater than 80%.

The borrower must be current on the mortgage at the time of the refinance, with a good payment

history in the past 12 months. Under the newly revised HARP program, the GSEs are waiving

the Representations and Warranties related to loan-to-value (LTV) and the borrowers income;lenders that move existing borrowers into newly originated HARP loans can essentially get off

the hook on their existing Reps and Warranties while originating a loan where they dont have

to make them. This is a huge win for originators who were subject to put-back risk for not

underwriting mortgages to minimal standards.

In addition, originators receive large fees for modifying mortgages into these programs.

Source: Comptroller of the Currency/OCC Mortgage Metrics


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Source: Office of the Comptroller of the Currency (OCC)

Synthetic Risk-Sharing Transaction from Freddie Mac (Like START)

Congress mandated risk sharing transactions. This is the first from Freddie Mac. Fannie Mae also

issued one in July 2013. This had no SPVthe notes are obligations of Freddie Mac:


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Source: Moodys

Notes Rating Coupon Subordination

A-H NR 3%

M-1 Baa1 L+1.70% 1.95%M-2 NR L+5% 0.30%

B-H NR First loss

Amortization: Pro-rata along with the mortgages

Maturity: 10 year bullet

Freddie Mac is raising amount equal to the combined tranche thickness (2.7%) " the issued

amount (80%, 20% of each tranche is retained) " the size of the reference portfolio ($35.3

billion): $762 million.

In the START transactions, as you will recall, SCB determined the amount of loss based on

actual workouts of the loans. Freddie Mac is simplifying the investors analysis by fixing

recovery rates at the beginning:

When the first mortgage defaults (180 day delinquency) the transaction assumes 85% recoveries.

Once losses reach 1% of the deals size or $353 million, 75% recoveries are assumed until losses


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reach 2%. At that point, 60% recoveries are assumed. If a loan in a judicial state takes 10 years to

work out, investors dont have to wait to find out the outcome.

Bank Liability

Banks are now being sued for various failures.

MERS is the Mortgage Electronic Registry System. It was devised by the GSEs and the large

banks to streamline the assignment of title. This was needed as title passes from the originator to

the sponsor to the trust in an ABS transaction. Instead, MERS was the assignee and remained so

acting as agent for all involved parties. Unfortunately, it has now become clear that while this

reduced costs (no transfer tax) and sped up the process it did not comply with state laws in many

cases. In addition, this electronic process frequently did not take care to preserve the legal

documents. Frequently the mortgage was lost and only the title retained. But in all cases,

employees of banks acting as MERS Vice Presidents would execute documents.

This process of agents not acting in good faith is mirrored in Robo-signing where an employee

or agent would attest to knowledge of the borrower and the details of the eviction, but in fact

have the job of merely signing and processing without the familiarity or oversight and

compliance checks which were legally required.

In 2012, banks reached a settlement with attorneys general of 49 states and the federal

government. $19.1 billion goes to financial relief for borrowers. The banks have to pay $3.5

billion to state and federal governments and $1.5 billion to borrowers who lost their homes as a

result of wrongful conduct.

Many other streams of litigation are ongoing.


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Recent Changes in Regulation

After the financial crisis, lawmakers identified loose mortgage credit as one of the necessaryconditions to the subprime meltdown and set about making it harder for banks to lend tosubprime borrowers. Section 941 of the Dodd-Frank Act called for implementing rules thatwould require sponsors of RMBS securitization transactions to retain a piece (5%) of the creditrisk of their deals. After an initial proposal of the rule in 2011, six regulatory agencies (The Fed,

SEC, HUD, FHFA, OCC and the FDIC) jointly adopted a re-proposed version in October.RMBS backed by pools of qualified residential mortgages (QRMs) such as agencysecuritizations are exempt from the 5% risk retention requirement.

Features of a QRM: Regular periodic payments that are substantially equal; No negative amortization, interest only or balloon features; A maximum loan term of 30 years; Total points and fees that do not exceed 3 percent of the total loan amount; Payments underwritten using the maximum interest rate that may apply during the first

five years after the date on which the first regular periodic payment is due;

Consideration and verification of the consumer's income and assets, includingemployment status if relied upon, and current debt obligations, mortgage-relatedobligations, alimony and child support; and

Total debt-to-income (DTI) ratio that does not exceed 43 percent.

Now regulators think that mortgage credit is too tight. The final definition of a QRM did awaywith a minimum 20% down payment requirement that was included in the original proposal.


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The German Mortgage Banks Act of 1900 created the legal framework for Pfandbriefe. The

market is supervised by the German Financial Supervisory Authority (BAFin). Until recently, the

only regulated mortgage banks or public sector banks were allowed to issue Pfandbriefe. In

2005, the regulation was relaxed to permit Pfandbriefe to be issued by any entity with a banking

license. In addition, starting in 2005, Pfandbriefe could be secured by mortgage collateral in the

EU, Switzerland, Canada, the U.S. and Japan. .

There are two types of Pfandbriefe - public Pfandbriefe where the collateral consists of loans

to public sector entities and mortgage Pfandbriefe collateralized by residential and commercial

mortgages. By law, the loan-to-value ratio of each mortgage must not exceed 60%. The

mortgages must be first lien mortgages. Lenders typically provide packages of first and second

lien loans. For owner-occupied housing for prime borrowers, 90% LTV is ordinarily possible. A

typical German mortgage is fixed for ten years and then resets. Annual issuance of Pfandbriefe is

about !175 million and !1 trillion are outstanding. About 75% are public sector.

The German RMBS market was restrained by a provision of the German Banking Act that

required the land charge to be re-entered into the land register in order to transfer legal

ownership of a mortgage. This law made transfer of mortgages to an SPV so costly that only one

true RMBS has ever been issued in Germany. We have seen synthetic transactions (like Start V)

that use CDS to transfer the risk of first lien and second lien mortgages to investors. The German

Banking Act was amended in 2006 to permit transfer of mortgages without re-entering them in

the land register, but so far it hasnt made any difference.

Information on consumer credit relies mainly on the Schutzgemeinschaft fr allgemeine

Kreditsicherung called Schufa. Founded in 1927, Schufa is a non-profit company owned bybanks and retailers. Schufa collects data both positive and negative on German 55 million

individuals payment history and shares it with participating firms. In addition to Schufa, the

public registry has operated since 1934; however, it is less useful, since it has data on fewer than

500,000 people.

Besides Germany, France, Spain, Portugal and Ireland have significant covered bond markets.


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Japan

The mortgage market is shrinking in Japan along with the population and housing starts:

Source: S&P


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while banks are gaining market share:

In 2013, RMBS issuance fell 10.3% vs. 2012 to 1,816 bn. About 88% were issued by Japan

Housing Finance Agency which is similar to U.S. GSEs.

Development of Mexican Securitization Market

The rise and fall of Mexican RMBS broadly resembles the U.S. Through June 2014, 1.2 million

Mexican mortgages were securitized in 110 transactions. So while this market cannot be called a

failure, neither has it lived up to its early promise. It is now dominated by federal agencies

Fovissste (for government workers) and Infonavit (for non-government workers).

Step 1: Creation of legal framework to privatize pension fund system (1996) resulting in an

increasing local investor base.

Step 2: Changes in the legal framework to promote securitization

! Enactment of New Commercial Insolvency Law in 2000.

! Revision of Securitization Law (2000) facilitating the legal transfer of assets to trusts (a

true sale of assets).

! Creation of Transparency Law by the CNBV (National Securities Exchange

Commission).


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! Most states have modified their civil codes to allow for the assignment of mortgages to

trusts without the need for obligor notification and registration

Step 3: Sociedad Hipotecaria Federal (SHF) provides mortgage insurance for first 25% of loss.

Sofoles were authorized to extend mortgage loans to low income individuals.

As a result, securitization in Mexico flourished, representing the most dynamic RMBS market in

emerging economies and the model for developing countries with low mortgage credit

penetration.

Initially Mexican RMBS were dominated by issuances by Non-Bank Financial Institutions

(SOFOLES or NBFIs) with the initial RMBS in 2003 and followed by government-sponsored

institutions (GSI) such as Infonavit and Fovissste. While banks gained momentum in 2007-2008,

in 2009 only a single private RMBS was issued by the Mexican subsidiary of Spanish bank

BBVA.

However, in 2009 Mexico took a double hit by the global financial crisis and the swine flu

epidemic, which resulted in Mexicos deepest economic contraction since the great depression.

Since then, only GSIs have been able to issue RMBS.


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Typical MBS Transaction Structure

MortgageBorrowers

Trust

(Issuer)

$ Issuance Proceeds

NotesClass A

Subordinated

Credit

Enhancement

Mortgage

Insurance

Servicer

Mortgage Loan

Originators

Class B

$ Loan

Mortgage

$ Principal +

$ Interest

Loan

Titles

$ Principal + Interest

$ Issuance

Proceeds

Notes

While in the typical RMBS transaction servicers collect mortgage payments directly from the

borrowers, under a GSI issued RMBS employers make direct payroll deductions and transfer

servicing payments directly to the servicer. This has resulted in a significant lower delinquency

rates in GSI RMBS compared to NBFIS issuances. Fluctuations in Fovissste delinquency rates

reflect difficulties faced by the issuer in its systems for collecting transfers rather than non-

payment by the homeowner.


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NBFIs focused on unbanked populations and low income housing. Until 2009 banks served the

medium to high income population and the prime residential sector. Once the securitization

market closed down, NBFIs experienced a liquidity crisis which weakened their servicing

capacity.

Mexican Social Housing

Houses are built on a slab

to reduce costs.

Approximately 2000 houses

per development.

Photos: Christofferson, Robb & Co.


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Mexican Social Housing (cont)

Walls are poured concrete. Downstairs: kitchen, !bath,

front room, dining room.

Upstairs: 2 small bedrooms,full bath. Approx. 700 sq. ft.

lecture notes - residential mortgage finance - nov 11

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