1. Learning Objectives  Types of mortgages  Credit Guarantees  Mortgage Amortization  Mortgage Origination and Underwriting Standards  Mortgage refinancing and Prepayment  Factors affecting mortgage rates  Home equity loan  Mortgage price and Shiller index  Risk associated with investing in mortgage loans

2. Interest rate type  Fixed  Adjustable rate mortgage (ARM)  Hybrid ARM

3. Amortization type  Fully amortized loans  Interest only loan  Graduated mortgage  Reverse Annuity Mortgage

4. Loan balances  Conforming loans  Jumbo loans

5. Credit classification  Prime loan  Sub-prime loan  Alt-A-Loan

6. Lien status  First lien  Second or junior lien

7. 5.95 percent 30 year mortgage and 4.875 percent 15 year mortgage Legend

8. Types of index Constant Maturity Treasury (CMT) Treasury Bill (T-Bill) 12-Month Treasury Average (MTA or MAT) 11th District Cost of Funds Index (COFI) Cost of Savings Index (COSI) London Inter Bank Offering Rates (LIBOR) Constant Maturity Treasury (CMT) Treasury Bill (T-Bill) 12-Month Treasury Average (MTA or MAT) 11th District Cost of Funds Index (COFI) Cost of Savings Index (COSI) London Inter Bank Offering Rates (LIBOR) Certificates of Deposit (CD) Index Bank Prime Loan (Prime Rate) Fannie Mae's Required Net Yield (RNY) National Average Contract Mortgage Rate Bank Prime Loan (Prime Rate) Fannie Mae's Required Net Yield (RNY) National Average Contract Mortgage Rate

9. COFI index

10. Credit Guarantee Mortgages originated with credit guarantees by the federal government, government sponsored enterprises such as Fannie Mae or Freddie Mac or private institutions. Loans that are guaranteed by the Federal Housing Administration (FHA) and the Veterans Administration (VA) are direct obligations of the government and are known as government loans. FHA and VA offer a wide range of mortgage products that may appeal to low income individuals. These include 30 and 15 year fixed- rate mortgages, as well as ARMs. Insured by these government agencies, the loans’ low or no down payment terms are very appealing to purchasers.

11. Conforming Loan Limit One-family:$417,000 Two-family:$533,850 Three-family:$645,300 Four-family:$801,950

12. Mortgage Origination and Underwriting Standards Mortgages are originated by banks, credit unions, and mortgage bankers. Originators most likely sell the mortgages to Fannie Mae and Freddie Mac or other private conduits as these institutions repackage the pool of mortgages into MBS for resell to investors in a securitization process. Some banks tend to hold the mortgages they originate in their portfolio earning origination fees and servicing fees. However, it is costly for the bank to hold the mortgages in its balance sheet as regulator requires the bank to hold capital reserves of 4 percent (50 percent of 8% of minimum regulatory capital requirement) as conventional conforming loans are 50 percent risk weighted.

13. standards for placing the mortgage to conduits Loan to value ratio LTV Payment to income ratio PTI

14. Mortgage Loans  are callable bonds and exhibit an inverse price and yield relationship like any other bond.  they possess negative convexity; their upside potential is severely limited at times of falling rates as homeowners call the bond.  these bonds are expected to fall more in value at times of rising interest rates as homeowners stop prepayment as it makes no economic sense.

15. Credit Classification  A credit score of 750 or above entitles individual to a prime loan.  A credit score of 650 and below is associated with higher interest rate as sub-prime  Alternative –A loan is for credit score between prime and sub-prime of 625-680.  Credit Suisse reveals that Alt-A borrowers typically had 717 FICO credit scores while subprime borrowers were at 646.  Approximately $2.4 Trillion worth of Alt-A mortgages are going to reset in the next few years.

16. Underwriting Standard: Conforming Loans  Type of Loans  Type of property (residential, second home, investment)  Type of transaction (rate/term refinancing, cash-out refinancing, equity buyouts)  Loan to value ratio by type and transaction  Credit history of borrower  Documentation

17. Factors Influencing Mortgage Rates  Base interest rate derived from the yield in the 10-year Treasury notes.  Growth rate of GDP, higher GDP growth rate leads to higher interest.  Inflation directly impacts the cost of funds to the lender and cost of funds to the borrower is expected to go up  Changing supply and demand conditions for mortgages in the mortgage market.  Amount of mortgage loan (conventional, jumbo), the rate is higher for the jumbo loans.  Life of mortgage loan, the rate is lower by 50 to 100 basis points for 15 year mortgages  Credit history of the borrower; as low credit score raises default rates and the rate offered to potential buyers.  Change in the composition of index without a change in short term interest rates as elaborated earlier for the 11 th district cost of funds index.

18. Risk Associated with Investing in Mortgage Loans  Institutional investors such as banks, life insurance companies, and pension funds make up the bulk of investments in mortgage loans. Investors face:  credit risk,  market risk,  liquidity risk,  price risk, and  prepayment risk.

19. Shiller Index

20. Prepayment Risk  Contraction risk: This risk arises when homeowners decide to prepay the mortgage at times of falling interest rates through refinancing creating contraction risk as the life of mortgage has been cut short by homeowners.  Extension risk: when interest rates go up, refinancing comes to a halt. In this scenario homeowners with a mortgage rate well below prevailing interest rate have no incentive to prepay causing an extension risk as the actual life of mortgage is extended.