The Mortgage Markets 215
Definition/characteristics/types of mortgages
1 to 4 family dwelling (75% of mortgages) Multifamily dwelling (7% of mortgages) Commercial building (17% of mortgages) Farms (1% of mortgages)
5/1 adjustable rate mortgage
A 5/1 adjustable-rate mortgage, also known as an arm Rate is a bit higher than for the 30-year fixed rate
Jumbo loan
A loan that is for a larger than standard amount If the amount of the mortgage exceeds loan-servicing limits set by Frannie Mae and Freddie Mac Typically this limit is $510,400 for a single family home, except some high cost markets such as Hawaii and Alaska Rates will be higher than for a non-jumbo mortgage
Conventional mortgages
Also originated by banks or other mortgage lenders, but not guaranteed Private mortgage companies now insure many conventional mortgages loans against default Most lenders require borrower to obtain private mortgage insurance on all loans with a loan-to-loan value ratio exceeding 80%
Private Mortgage Insurance
Another way to protect against default is to make borrowers buy PMI Insurance policy that guarantees to make up any discrepancy between the value of the property and the loan amount, should a default occur If the balance on your loan was $120,000 at the time of default and the property was worth only $100,000, PMI would pay the lending institution $20,000. PMI is usually required on loans that have less than a 20% down payment. If the loan-to-value ratio falls because of payments being made or because the value of the property increases, the borrower can request that the PMI requirement be dropped. PMI usually costs between $20 and $30 per month for a $100,000 loan. Private Mortgage Insurance (PMI) Buyer is required to purchase by law unless the appropriate down payment has been made (usually 20% of the cost of the home) Guarantees to make up the differences between the value of the property and the loan amount if default occurs A mortgage on a house worth $350,000 requires what down payment to avoid PMI? .2*350,000 = 70,000
How did the mortgage bank develop
As the secondary market took shape, new intermediary emerged = the mortgage bank Did not accept deposits so could open offices across the country Originated loans, funding initially with its own capital After a group of similar loans were made, they were bundled and sold to one of the fed agencies or to an insurance or pension fund Several advantages: Size = economies of scale in loan origination and servicing Reduced risk = they were able to bundle loans from different regions Lower rates for borrowers = increased competition for loans among intermediaries
Fixed-Rate Mortgages
Borrowers agree to make regular payments on the principal and interest they owe in standard mortgage contracts In fixed-rate mortgages the IR and the monthly payment do not vary over the life of the mortgage
Mortgage Loan Amortization
Borrowers agree to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity Fully amortize = payments will pay off the outstanding indebtedness by the time the loan matures During the early years, the lender applies most of the payment to the interest and a small amount to the outstanding principal balance Ex. Over the life of the $130,000 loan, a total of $229,850 in interest will be paid. If the loan had been financed for 15 years instead of for 30, the payment would have increased by about $280 per month to $1,279.59, but the interest savings over the life of the loan would be nearly $130,000.
Thrift industry during and after 1970s
But in the 70s IRs rose rapidly with inflation and thrifts became victims of IR risk Market IRs rose and the value of their fixed-rate mortgage loan portfolios fell, these losses caused them to stop being the primary source of mortgage loans Another problem in the early market was that thrifts were restricted from nationwide branching by fed and state laws and were not allowed to lend outside their normal lending territory, 100 miles around their offices Even if an institution appeared very diversified with thousands of different loans, all were from the same region and so if a region had economic problems many of the loans would default
Mortgage-backed security
By the late 60s, the secondary market was declining bc fewer veterans were getting guaranteed loans Gov reorganized Fannie Mae and created the Government National Mortgage Association (GNMA or Ginnie Mae) and the Federal Home Loan Mortgage Corporation and the Federal Home Loan Mortgage (FHLMC or Freddie Mac) All three were able to offer new securities backed by both insured and for the first time uninsured mortgages Alternative to selling mortgages directly to investors = create a new security backed by (secured by) a large number of mortgages assembled into what is called a mortgage pool Trustee such as a bank or gov agency, holds the mortgage pool, which serves as collateral for the new security Process = securitization
CDOs
Collateralized Debt Obligation Structured financial product backed by a pool of loans Retail or commercial bank approves loans and then sells them to an investment bank which repackages them into a CDO The principle and interest payments on the loan are redirected to the investors in the pool Collateral gives the loans value If the underlying loans go bad, the bank transfers much of the risk to the investor, which will typically be a large pension fund or a hedge fund As a result banks slice the CDO into risk levels or tranches Senior tranches are the safest because they have the first claim on assets if some of the underlying loans default Junior loans are riskier so have higher IRs During the 1990s and early 2000s most CDOs were backed by a diverse group of loans which limited the risk of default and gave them a reputation of stability But around 2003 the housing boom led a number of banks to use subprime mortgages as their main source of collateral With the popularity of CDOs skyrocketing, home lenders received a steady stream of cash and as a result extended credit to high risk borrowers When the real estate market stalled and mortgage default rose CDO issuers and investors suffered enormous losses While CODs offer the possibility for attractive fixed returns, the fallout from the financial crisis has has led to greater scrutiny regarding the loans that serve as their collateral
Second mortgages during 2008
Contributing factor in the mortgage market collapse was the use of these loans to reduce or eliminate the need for a down payment Borrowers with no real equity in the home were more willing to walk away once its value dropped or their income fell Appropriate use = where a borrower has had a home loan for a number of years and has built up real equity (true market value of the home is much greater than the balance owed on the loan)
The IR on the loan is determined by three factors:
Current long-term market rates, Life (term) of the mortgage, Number of discount points paid
Why did the bubble end
Default rates on subprime mortgages increased and the extent of speculation started to make the news People who owned properties from the height of the bubble suffered losses, including lending institutions and investors in mortgage-backed securities
Types of Mortgage Loans
Different borrowers may qualify for different ones, a skilled mortgage bankers can help find the best type of mortgage loan for each particular situation Mortgages are classified as either insured or conventional
Why people buy mutual funds
Diversification Invest in a diversified portfolio to reduce risk Easy access Trade on major stock exchange, very liquid investments Professional management Low cost way for individuals to participate in mutual funds vs. private funds (clients with >$100000 to invest)
Investopedia FICO Score Video
Fair Isaac Corporation Ranks consumers by how likely they are to pay their credit obligations Lenders use this to assess a loan applicants credit risk Heavily weighed by lenders Also used when determining the interest rate on the loan Weigh the applicants payment history, current indebtedness, types of credit used, duration of credit history, and new credit Range between 300-850, above 650 indicates a good credit history, applicants below 620 usually struggle to obtain loans at a favorable rate
Federal Home Loan Mortgage Corporation (FHLMC) Pass-Throughs
Freddie Mac was created to assist savings and loan associations, which are not eligible to originate Ginnie Mae-guaranteed loans Freddie Mac purchases mortgages for its own account and also issues pass-through securities similar to those issued by Ginnie Mae Pass-through securities issued by Freddie Mac are called participation certificates (PCs) Freddie Mac pools are distinct from Ginnie Mae pools in that they contain conventional (nonguaranteed) mortgages, are not federally insured, contain mortgages with different rates, are larger (ranging up to several hundred million dollars), and have a minimum denomination of $100,000
Government National Mortgage Association (GNMA) Pass-Throughs
Ginnie Mae began guaranteeing pass-through securities in 1968 Since then, the popularity of these instruments increased dramatically Variety of financial intermediaries, including commercial banks and mortgage companies, originate Ginnie Mae mortgages Ginnie Mae aggregates these mortgages into a pool and issues pass-through securities that are collateralized by the interest and principal payments from the mortgages Ginnie Mae also guarantees the pass-through securities against default The usual minimum denomination for pass-throughs is $25,000. The minimum pool size is $1 million. One pool may back up many pass-through securities.
First purpose of second mortgage
Give borrowers a way to use the equity they have in their homes as security for another loan An alternative to the second mortgage would be to refinance the home at higher loan amount than is currently owed but a second mortgage is cheaper usually
Secondary Mortgage Market
Gov founded the secondary market for mortgages To help spur the economy after the great depression the gov est. several agencies to buy mortgages Federal National Mortgage Association (Fannie Mae) Set up to buy mortgages from thrifts so that these institutions could make more mortgage loans Funded these purchases by selling bonds to the public Same time the Fed Housing Admin was est to insure certain mortgage contracts which made it easier to sell mortgages bc the buyer didn't have to be concerned with the borrower's credit history or the value of the collateral Similar program was set up after WW2 through the Veterans Admin to insure loans to veterans One advantage of insured loans = required to be written on a standard loan contract Important factor in growth of the secondary market
Title insurance
Guarantees the buyer that the property is free of encumbrances, any questions about the state of the title to the property, including the existence of liens
Borrower qualification
Historically, qualifying for a mortgage loan = different from bank loan bc most lenders sold their mortgage loans to one of a few federal agencies in the secondary mortgage market These agencies had very precise guidelines that had to be followed before they would accept a loan If the lender gave a mortgage loan to a borrower who didn't fit the guidelines, the lender wouldn't be able to resell the loan and their funds would be tied up Rules were complex and changed but the rule of thumb was that the loan payment, including taxes and insurance should not exceed 25% of gross monthly income Also if the sum of the monthly payments on all loans to the borrower, including car loans and credit cards should not exceed 36% of grossly monthly income Ex. if you earn $60,000 per year ($5,000 per month) and do not have any other debt, your payment should not exceed $5,000 * .25 = $1,250. At a 4% interest rate you would qualify for a loan of about $200,000
Mortgage backed security
Hundreds or thousands of mortgages pooled together into one new product This product is a single security similar to a bond or a stock (process = securitization) This is then sold to an investor The security is called mortgage-backed because the collateral is homes When a bank issues a mortgage it doesn't want to tie up capital and resources by holding the loan It sells the stream of interest and principal payments from loans The bank makes money from originating and servicing the mortgages To sell the loan it bundles a loan with other mortgages and sells it as a single bond to an investment bank The investment bank partitions the pool of loans according to quality and sells the sections to other investors MBS's are a way for banks to free up capital and allow investors to buy into mortgages
Adjustable-Rate Mortgages
In adjustable-rate mortgages (ARMs) the IR is tied to some market IR so it changes over time Usually have limits called caps on how high or low the IR can move in one year and during the term of the loan A typical ARM might tie the IR to the avg t-bill rate plus 2% with caps of 2% per year and 6% over the lifetime of the mortgage over the lifetime of the mortgage Borrowers tend to prefer fixed-rate loans to ARMs bc ARMs may cause financial hardship if the IR rises and individuals are risk-averse But fixed-rate borrowers don't benefit if rates fall unless they refinance their mortgage (pay it off by obtaining a new mortgage at a lower IR) Lenders prefer ARMs because they lessen IR risk Mortgages are usually long-term so their value is very sensitive to IR movements Lenders must entice borrowers by offering lower initial interest rates on ARMs than on fixed-rate loans In May 2016 the reported interest rate for 30-year fixed-rate mortgage loans was 3.79%. The rate at that time for 5-year adjustable- rate mortgages was 2.63%. The rate on the ARM would have to rise 1.16% before the borrower of the ARM would be in a worse position than the fixed-rate borrower.
Loans offered in the 2000s that circumvented the usual lending standards
In the mid-2000s a variety of mortgage loans were offered that circumvented traditional lending practices Ex. No Doc loans (NINJA loans for no income, no job, and no assets) in which income or assets were not required on the loan application bc of a mistaken belief that real estate prices would not decline and so that the collateral was strong enough to justify the loans These practices have been largely abandoned
Characteristics of the Residential Mortgage
In the past 20 years both the nature of the lenders and the instruments have undergone substantial changes Development of an active secondary market for mortgage contracts is one of the biggest changes today 20 years ago savings and loan institutions and the mortgage departments of large banks originated most mortgage loans Some were maintained in-house and some were sold to one of a few firms who tracked delinquency rates and would refuse to continue buying loans from banks where delinquencies were very high Recently many loan production offices arose to compete in real estate financing Some are subsidiaries of banks Some are independently owned Many of these businesses = organized around the originate-to-distribute model where the broker originated the loan and sold (distributed) it to an investor as quickly as possible Reduced the principal-agent problem because the originator didn't really care if the loan was actually paid off
What caused this part 1
Increase in subprime loans With more people qualifying, increased demand Over a short period many new buyers were qualified → home construction increased but could not keep pace with the demand
Current long-term market rates
Influenced by a number of global, national, and regional factors Mortgage rates tend to stay above the less risky treasury bonds but tend to track with them
Reverse Annuity Mortgages (RAMs)
Innovative method for returned people to live on the equity they have in their homes The contract for a RAM has the bank advancing funds on a monthly schedule This increasing-balance loan is secured by the real estate The borrower doesn't make any payments against the loan When the borrower dies, the borrower's estate sells the property to retire the debt Allows retirees to use equity in their homes without the necessity of selling it-for retirees in need of more funds to meet living expenses
Number of discount points paid
Interest payments made at the beginning of a loan One discount point means that the borrower pays 1% of the loan amount at closing Closing = the moment when the borrower signs the loan paper and receives the proceeds of the loan Borrower must determine whether the reduced IR over the life of the loan fully compensates for the increased up-front expense Take into account how long they will hold on to the loan If the borrower will pay off the loan in five years or less then it is not usually a good idea for the borrower to pay discount points Average home sells every five years
Discount points
Interest payments that are made at the beginning of a loan. They are typically paid at closing Closing is a meeting with the seller's real estate agent, a representative with the bank, and an attorney, where you sign papers regarding the mortgage At the end you are making a payment for the mortgage that you are taking on You can prepay some of the interest, this is called a discount point By prepaying some of the interest, the lender would reduce the overall IR that you pay for the life of the loan Can be smart if you are planning to hold the mortgage for a long period of time However, if you are planning to sell it soon, it would not be worth it to you
Securitization of Mortgages
Intermediaries still faced problems trying to sell mortgages 1. Mortgages are usually too small to be wholesale instruments Average new home loan is now about 250,000 far below the 5 million round lot est. for commercial paper Most institutional investors don't want to deal in such small denominations 2. They are not standardized Different times to maturity, IRs, and contract terms so hard to bundle a large number together 3. Mortgages loans = relatively costly to service Lender has to collect monthly payments, often pay property taxes and insurance premiums, and service reserve accounts, none of this is required for a bond 4. Mortgages have unknown default risk Investors in mortgages do not want to expend energy evaluating the credit of borrowers All of these inspired the creation of the mortgage-backed security AKA securitized mortgage
Mutual Funds: Intro
Investment vehicle made up of a pool of money collected from many investors The funds are used to invest in securities such as stocks, bonds, money market instruments, and other assets Mutual funds are operated by professional money managers, who allocate the fund's investments and attempt to produce capital gains and/or income for the fund's investors Mutual fund units, or shares, can typically be purchased or redeemed as needed at the fund's current net asset value (NAV) per share A fund's NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding
Money Market Funds
Investment whose objective is to earn interest for shareholders while maintaining a net asset value (NAV) of $1 per share Comprised of short-term <1 year securities A type of mutual fund Low-risk and low-return
Mortgage Interest Rates
Largely determined by supply and demand for long term loans Mortgage rates are typically higher than long-term treasury rates
Share of the total mortgage market held by major mortgage-lending institutions
Largest investors right now are federal agencies, this is different from several years ago, when Mortgage Pools and Trust had over 50%
Down payments
Lender requires down payment on the property to obtain a mortgage loan Portion of the purchase price The balance of the purchase price is paid by the loan proceeds Intended to make the borrower less likely to default If real estate prices drop even a little the balance due on the loan will exceed the value of the collateral so the down payment reduces moral hazard for the borrower Amount depends on the type of loan Beginning in the mid-2000s the payment was often circumvented with piggyback loans Second mortgage added to the first so 100% financing provided Starting in 2006 many borrowers realized their property was worth less than they owed and default rates skyrocketed Reduces moral hazard (prevents someone from walking away from a home because they are struggling financially) Amount of down payment depends on the type of mortgage Usually about 20%
Credit report
Lenders also order a credit report from one of the major credit-reporting agencies Based on a model that weighs a number of variables found to be predictors of creditworthiness Most common is FICO named after Fair Isaac Company Low is 300 to a maximum of 850, scores above 720 are considered good while bellow 660 is not Determined by your payment history, outstanding debt, length of credit history, number of recent credit applications, and types of credit and loans you have Simply applying for and holding a number of credit cards can significantly affect your FICO score.
Growing-Equity Mortgages (GEMS)
Lenders designed this to help the borrower pay off the loan in a shorter period of time Payments will initially be the same as on a conventional mortgage, but over time the payments will increase which will reduce the principal more quickly Ex. A typical contract may call for level payments for the first two years. The payments may increase by 5% per year for the next five years, then remain the same until maturity. The result is to reduce the life of the loan from 30 years to about 17. Popular among borrowers who expect income to rise in the future bc small payment at the beginning while still retiring the debt early The increase in payments is required in GEMs, but most mortgage loans have no prepayment penalty So borrower with a 30-year loan could create a GEM by simply increasing the monthly payments beyond what is required and designating that the excess be applied entirely to principal Similar to graduated payment mortgage but the goal of the GPM is to help the borrower qualify by reducing the first few years' payments but the loan still pays off in 30 years, the goal of the GEM is to let the borrower pay off early
Aftermath of mortgage-fueled financial meltdown
Lending policies have largely returned to selecting capable borrowers Can be seen in the decline in global CDO issuance Peaked at 520 billion in 2006, by 2009 4.3 billion, and between 2013 and 2015 around 100 billion Securitized mortgage was initially seen as a method for reducing the risk to lenders by allowing them to sell off a portion of their loan portfolio They could keep making loans without having to retain the risk but this led to increased moral hazard Separating the lender from the risk → riskier loans Individual risk was reduced, but systemic risk increased
What did people do to get around PMI
Lending standards led to a competitive mortgage market where lenders found ways to attract customers with questionable practices One was to structure loans to avoid PMI bc it is usually only required on the first mortgage Structured loans so that the first mortgage loan was set at a 80% loan-to-value with a second mortgage covering the remaining 20%
Second Mortgages (piggyback)
Loans that are secured by the same real estate that is used to secure the first mortgage Second mortgage = junior to the original loan If there is a default the second mortgage holder will be paid only after the original loan has been paid of and only if sufficient funds are available from selling the property
What are mortgages?
Long term loan that is secured by real estate Amortized (fixed-payment loan)
Mortgage
Long-term loan secured by real estate Office building, family home (72%) Loan is amortized Borrower pays it off over time in some combo of principal and interest payments ending in full payment of the debt by maturity
Life (term) of the mortgage
Longer-term mortgages have higher IRs than short-term Usual lifetime = 15 or 30 years, 20 years are also offered but they are not as possible IR falls as the term to maturity decreases, so the IR on the 15-year loan will be substantially less than 30-year
Loan Servicing
Many of the institutions making mortgage loans don't want to hold large portfolios of long-term portfolios Ex. commercial banks obtain their funds from short-term sources Commercial banks, thrifts, and most other loan originators do make money through the fees they earn by packaging loans for other investors to hold Loan origination fees are typically 1% of the loan amount but varies with the market Once a loan is made, many lenders immediately sell it to another investor The borrower may not even be aware that the loan was transferred By selling the loan, the originator frees up funds that can be lent elsewhere Some of the originators also provide servicing of the loan The loan-servicing agent collects payments from the borrower, passes the principal and interest on to the investor, keeps required records, and maintains reserve accounts Reserve accounts are est. for most mortgage loans to allow the lender to make tax and insurance payments for the borrower Lenders prefer to make these payments bc they protect the security of the of the loan Loan-servicing agents usually earn 0.5% per year of the total loan amount for their efforts
How did people interpret the increase in subprime loans?
Many saw the increase in mortgage loans to less creditworthy borrowers as progress Relaxed lending standards allowed more families to reach their goal Increased demand for housing fueled economic growth and increased employment in the building industry But the competitive nature of the market led mortgage salespeople to target less financially sophisticated borrowers who were less able to properly evaluate their ability to repay the loans Also relaxed lending standards allowed speculators to obtain loans without investing any equity.
Mortgage pass-through
Most common type of MBS = mortgage pass-through Security that has the borrower's mortgage payments pass through the trustee before being disbursed to the investors in the mortgage pass-through Ex. Investors may buy mortgage-backed securities on which the average interest rate is 6%. If interest rates fall and borrowers refinance at lower rates, the securities will pay off early. The possibility that mortgages will prepay and force investors to seek alternative investments, usually with lower returns, is called prepayment risk.
Mortgages after WW1
National banks were again authorized to make mortgage loans Great Depression Mortgage market was devastated The loans being issued are now referred to as balloon Loans For a predetermined amount of time an individual only has to pay the interest on the loan, and then the entire loan is due If one cannot pay they usually can renew it, but if the debt is called and they cannot repay the loan, they default Government restructured these loans in a way to allow a long term repayment This is largely what we have today
Pros and Cons of Money Market Funds
No loads (fees mutual funds may charge for entering or exiting the fund) Some provide investors with tax advantaged gains by investing in municipal securities that are tax exempt at the federal or state level Con: Not covered by federal deposit insurance
CMOs
One innovation has been the collateralized mortgage obligation (CMO) CMOs are securities classified by when prepayment is likely to occur Differ from traditional MBSs in that they are offered in different maturity groups Help reduce prepayment-risk which is a problem with other types of pass-through securities CMOs backed by a particular mortgage pool are divided into tranches When a principal is repaid, the investors in the first tranche are paid first and so on Investors choose a tranche that matches their maturity requirements There is a distinct risk differential between tranches as well. Those paid off first are less likely to see a default than those paid off last Even when an investor purchases a CMO, there are no guarantees about how long the investment will last. If interest rates fall significantly, many borrowers will pay off their mortgages early by refinancing at lower rates
Insured Mortgages
Originated by banks or other mortgage lenders but are guaranteed by the Federal Housing Administration (FHA) or the Veterans Administration (VA) Applicants must meet certain qualifications, such as having served in the military or having income below a given level and can borrow only up to a certain amount The FHA or VA guarantees the bank making the loans against any losses Only a very low or zero down payment is required
History of Mortgages before WW1
Prior to 1863 states had laws to prevent banks from tying up money in the long term/preventing significant numbers of mortgages from being issued 1863 national banking act added even further restrictions on banks from issuing mortgages As a result people organized them between themselves Agricultural expansion and recession More demand for mortgages Mortgage brokers issued mortgages and sold them back to banks and insurance brokers in the East In the late 1890s a recession led to numerous defaults From this period until after World War 1, it was difficult to get a mortgage
Lien
Public record that attaches to the title of the property advising that the property is security for a loan, and it gives the lender the right to sell the property if the underlying loan defaults No one can buy the property and obtain clear title to it without paying off the lien Explains why a title search is an important part of any mortgage loan transaction Lien - the public record that is attached to the title stating that the property is security for a loan Title - the document stating who owns the property Lien gives the lender the right to sell the property if the mortgage holder defaults The Lien stays with the property until the loan is paid Title search to determine the existence of liens Title insurance guarantees to the buyer that the property is free of encumbrances (no liens against it)
REMICS
Real estate mortgage investment conduits (REMICS) were authorized by the 1986 Tax Reform Act Allows originators to pass through all interest payments tax free Only their legal and tax consequences distinguish REMICs from CMOs Private Pass-Through (PIPs) In addition to the agency pass-throughs, intermediaries in the private sector have offered privately issued pass-through securities The first of these PIPs was offered by BankAmerica in 1977 One mortgage market opportunity available to private institutions is for mortgages larger than the maximum size set by the government Jumbo mortgages = often pooled to back private pass-throughs
What caused this part 2
Real estate speculators People everywhere noticed that easy money could be made by buying real estate for resale Ability to obtain zero down loans allowed them to buy it easily with little committed capital and resell at a higher price Many development projects were sold out before they started Condos esp. Bc they didn't require much upkeep before the next sale At times speculators were selling to other speculators as the demand drove up prices
Collateral
Requirement that collateral (usually the real estate being financed) be pledged as security The lending institution will place a lien against the property, and this remains in effect until the loan is paid off Usually the real estate being financed
Problems in Secondary Market
Size of mortgages Institutional investors are accustomed to investing millions of dollars at a time so mortgages are relatively small Lack of standardization Different interest rates, terms to maturity, types of mortgages Costly to service Servicing agents take care of maintaining the records and ensuring that monthly payments are made on time and spreadsheets are correct = costly Unknown default risk The IR is going to vary partly due to repayment or default risk but it is still unknown if an individual borrower is going to default on a loan This is why mortgage-backed securities were created
Subprime Mortgages
Subprimes loans are made to borrowers who do not qualify for loans at the going market rate of interest bc of poor credit rating or bc loan is larger than justified by their income Car or credit card but subprime are infamous bc high default rates in 2006 Before securitized market made it easy to bundle and sell mortgages if you didn't meet the qualifications for one of the major mortgage agencies you weren't likely to be able to buy a house Once it became possible to sell bundles of loans to other investors new rules emerged → New class of mortgage loans called subprime mortgages In 2000 about 70% of all loans were conventional prime, 20% were FHA, 8% were VA, and only 2% were subprime. In 2006, 70% were still conventional prime, but now fully 17% were subprime, with the balance being FHA and VA.
Loan servicing summary
Summary There are three distinct elements to most mortgage loans: 1. The originator packages the loan for an investor. 2. The investor holds the loan. 3. The servicing agent handles the paperwork. One, two, or three different intermediaries may provide these functions for any particular loan. Mortgage loans are increasingly obtained from the Web.
Second purpose of second mortgage
Take advantage of one of the few tax deductions for the middle class Interest on loans secured by residential real estate is tax-deductible (allows borrowers to deduct the interest on the primary residence and one vacation home) Many banks offer lines of credit secured by second mortgages In many cases, the value of the security is not of great interest to the bank, consumers prefer that the line of credit be secured so that they can deduct the interest on the loan from their taxes
FICO
The FICO score is computed for virtually every borrower. This score is computed by the different credit-rating agencies as an index of credit risk All agencies include payment history, level of current debt, length of credit history, types of credit held, and the number of new credit inquiries made as criteria The average subprime FICO score was 624 versus 742 for prime mortgage loans
The Real Estate Bubble
The mortgage market was heavily influenced by the real estate boom and bust between 2000 and 2008 2000-2005 home prices increased an average of 8% annually 17% in 2005 alone
Interest rate term
The type of interest rate varies depending on the term/maturity Typical for a mortgage to be 30 year fixed-rate Also a 15 year fixed-rate mortgage is common The 30 year rate will likely be higher because it is longer-term so more risky
When did mortgage backed securities get popular?
The volume of outstanding mortgage pools increased steadily from 1984-2009 Mortgage pools became so popular bc they permitted the creation of new securities that made investing in mortgage loans much more efficient Ex. Investor can invest in one large mortgage pass-through instead of many small and dissimilar mortgage contracts Slump in real estate market and losses to mortgage pool investors led to decline after 2009
Mortgage-Lending Institutions Thrifts History
Thrift industry was established bc of Congressional mandate to provide mortgage loans to families Congress have these institutions the ability to attract depositors by allowing S&Ls to pay slightly higher IRs on deposits For many years this did work, thrifts raised short-term funds by attracting depositors and used these funds to make long-term mortgage loans The early growth of the housing industry owes a lot to these institutions Until the 1970s IRs remained stable, the few fluctuations were small and short
Types of pass-through securities
Types of Pass-Through Securities GNMA pass-throughs FHLMC pass-throughs Private pass-throughs
Graduated-Payment Mortgages (GPMs)
Useful for home buyers who expect incomes to rise so that the higher payment will not be a burden Lower payments in the first few year maybe not even enough to cover the interest due in which case the principal balance increases, then the payments rise Advantage = borrowers will qualify for a larger loan than if they requested a conventional mortgage
Mortgages between 2004 and 2008
Various mortgage loan options were offered to allow almost anyone to qualify Argument was that if someone couldn't afford the mortgage anymore they could just sell the home at a profit Since 2008, the mortgage industry has largely stopped offering these high-risk loan options as much
Why purchase money market mutual funds?
Well-suited to small investors Convenient for short time horizon Considered very safe Higher IR than savings account
What led to the increase in subprime loans
What led to this increase? 1. 2/28 ARMs (sometimes called "teaser" loans) These loans freeze the interest rate for 2 years, and then it increases, often substantially, after that Piggyback loans, No Doc, or NINJA (no income no asset loans), and variations on the graduated payment mortgage encouraged borrowers to commit to larger loans than they could realistically handle. In part fueled by the creation of the structured credit products such as the collateralized debt obligation (CDO). These provide a source of funds for high-risk investments Similar to the CMO except that rather than slice the pool of securities by maturity as with the CMO, the CDO usually creates tranches based on risk class. While CDOs can be backed by corporate bonds, real estate investment trust (REIT) debt, or other assets, mortgage-backed securities are common
