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

2. 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 $ trillion

3. 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:

4. Mortgage Debt Outstanding
2015Q2: Trillion

5. Federal Home Loan Mortgage Corp.

6. Federal National Mortgage Assoc.
2015Q2: $3 Trillion

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

8. Thrifts (S&L, SB)

9. 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

10. 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

11. 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

12. 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)

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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)

23. Lenders’ Underwriting Decisions

24. 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

25. 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%)

26. 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

27. 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)