Chapter 11 Sources of Funds for Residential Mortgages REAL ESTATE FINANCE 331

the market for home mortgage loans Mortgage borrowers must compete to borrow funds in the credit markets Total mortgage debt at the end of 2014Q2 approached $13.584 trillion

the market for home mortgage loans C. There are four major types of mortgage debt (Board of Governors Fed. Res. Sys.) Data as of 2015Q2:

Mortgage Debt Outstanding 2015Q2: 13.584Trillion

Federal Home Loan Mortgage Corp.

Federal National Mortgage Assoc. 2015Q2: $3 Trillion

Gov’t National Mortgage Assoc. 2015Q2: $90.88 Billion

Thrifts (S&L, SB)

Evolution of Mortgage Finance Thrifts and Savings and Loans Dominated mortgage lending: 46% or more y mid 1970s, 3.5% by 2013Q3 Extremely localized market Fatal flaw: Funded long-term loans with short-term savings Cocoon of regulations restricted ability to adapt to changing market conditions Disintermediation in financial markets led to widespread Thrift/S&L failures

Evolution of Mortgage Finance C. Banking Deregulation and Consolidation Effects of the Depository Institutions Deregulation and Monetary Control Act Money center banks begin to enter the mortgage business Many create mortgage banking subsidiaries

Evolution of Mortgage Finance Mortgage Bankers originate mortgage loans, provide processing services, package mortgages and sell in secondary markets Servicing is core profit center Collects monthly payments, remits to investor Collects and remits payments for property taxes, hazard insurance and mortgage insurance Manages late payments, defaults, foreclosures Receives fee of .25% to .44% (25 to 44 basis points: 1 bp = 0.01%) Typically accept loss at origination of a loan to obtain servicing rights

Evolution of Mortgage Finance b. Three-step process: Issue mortgage commitment to potential borrower Close or originate loan (funding loan) Sell loan 3. Mortgage Brokers bring borrowers and lenders together but do not own the loans or fund them (charge fees for services)

Pipeline Risk: Signature Risk of Mortgage Banking Pipeline risk: Risk between loan commitment and loan sale Two components Fallout risk: Risk that loan applicant backs out Interest rate/price risk: Risk that closed loans will fall in value before sold Mortgage bankers highly leveraged Very sensitive to pipeline risk Hedging necessary for survival

Pipeline Risk: Signature Risk of Mortgage Banking Management Tools for Pipeline Risk Good pipeline information Forward commitment: Sale of loan at a preset price for future delivery Price set now Delivery and payment are, 60 to 90 days away Analogous to futures contract Standby forward commitment: Optional forward sale Same as “forward commitment” except that mortgage banker has option to use or not More costly than forward commitment

Secondary Mortgage Market Mortgage-Backed Securities (MBS) Multiple mortgage loans in a single pool or fund Security entitles investor to pro rata share of all cash flows Loans in a given pool will be similar: FHA/VA; conventional Same vintage (new or recent loans) Similar interest rates Nearly two-thirds of all new home loans have been securitized in recent years

Secondary Mortgage Market Fannie Mae (Federal National Mortgage Association, 1938) Secondary market for FHA/VA Funded through both debt issues and mortgage securitization Has securitized and sold, or owns, about 23% of outstanding home loans Taken into conservatorship by U.S. in 2008

Secondary Mortgage Market Ginnie Mae (Government National Mortgage Association, 1968) Created first major pass-through MBS program Does not buy mortgages Guarantees timely payment of interest and principal to holders of GNMA securities Guarantees only securities based on FHA/VA loans

Secondary Mortgage Market D. Freddie Mac (Federal Home Loan Mortgage Corporation, 1970) Chartered by Congress to expand secondary market for mortgages Deals exclusively in conventional loans Securitized all loans purchased until recent years Financially similar to Fannie Mae Has securitized and sold, or owns, about 15% of outstanding home loans Taken into conservatorship by U.S. in 2008

Secondary Mortgage Market Importance of Fannie Mae and Freddie Mac Have brought about standardization in: Mortgages and mortgage notes Appraisal forms and practices Underwriting procedures and standards Also, influence practices and standards in nonconforming mortgage markets Have increased liquidity of mortgage markets No interstate differentials in mortgage interest rates No home lending disruptions when interest rates rise New sources of mortgage funds in security investors Heavily influence what type loans lenders make

Secondary Mortgage Market Major Problems with Fannie and Freddie Not capitalized to withstand declining home values Said to wield too much political influence Said to unsuccessfully mix private enterprise with housing subsidy programs Said to divert the benefits of their efficiency advantage into the pockets of their management Said to be unnecessary in a financial world now dominated by a few giant banks Said to be part of an unnecessary mortgage lending system – for the level-payment fixed rate mortgage

Secondary Mortgage Market Private Mortgage Conduits Primarily a conduit for jumbo (nonconforming) loans Briefly active in sub-prime loan market US Mortgage System basically has 4 Channels Local depository lending (very limited) FHA/VA – GNMA securitization process Conforming conventional – GSE process Non-conforming conventional – private security process

Lenders’ Underwriting Decisions Underwriting: Process of determining whether the risks of a loan are acceptable Three “Cs” of traditional underwriting: Collateral: importance of Uniform Residential Appraisal Report (URAR) Creditworthiness: Credit report – FICO score Capacity: Ability to pay (payment ratios)

Lenders’ Underwriting Decisions

Lenders’ Underwriting Decisions Computing Payment ratios for Underwriting (manage risk) Housing Expense Ratio = PITI/GMI (~ Front-end ratio) PITI is principal, interest, (property) taxes and insurance GMI is gross monthly income Recent convention set maximum at: 28% for conventional loans 29% for FHA Total Debt Ratio = (PITI + LTO) ÷ GMI (~Back-end ratio) LTO is long-term obligation 36% for conventional loans 43% for FHA

Lenders’ Underwriting Decisions Recent Underwriting Failures Problems were due not adhering to procedures and standards described above Half of sub-prime loans had limited documentation Most of Alt-A loans had limited or no documentation (Came to be called “liar loans”) Private securitization firms widely suppressed loan underwriting Underwriting focuses on comparative risk among borrowers Recent regulatory proposals by Fed and 5 other Agencies to create QRM (Qualified Residential Mortgage, 2013) Calls for lenders to keep a 5% stake in the credit risk for certain securitized loans that don’t meet “qualified residential mortgage” standards. Designed to be particularly safe by making sure that borrowers can afford their mortgages. Lower retention standards for Fannie (2.44%) and Freddie (2.68%)

Emerging Mortgage Classifications Qualified Mortgage (QM) Fully amortizing (generally) No longer than 30 years Fees of no more that 3 percent (generally) Debt-to-income ratio no more than 43 percent Strong verification of borrower income and assets If ARM, must underwrite to highest possible rate in first five years Gives lender legal advantage in case of default

homework assignment Key terms: Collateral, Credit Scoring, Disintermediation, Housing Expense ratio, Interest rate Risk, Loan Underwriting, Pipeline Risk, Qualified Mortgage, Total Debt Ratio Study Questions: 1, 2, 4, 9 (all parts)