Mortgages & Mortgage-Backed Securities Part-1

1. Mortgages & Mortgage-Backed Securities Part-1

2. Definition of a Mortgage • What is a mortgage? • It is a loan that is secured by the pledge of a specific piece of real estate property. • The borrower called the `mortgager’ pledges the property on account of the loan taken from the lender, who is known as the `mortgagee’.

3. Title vs Lien • When the property is pledged is the title to the property transferred to the lender. • It depends. • In some states in the U.S., this is actually the case. • In other states, the lender merely has lien on the property that is pledged.

4. Mortgage Markets • These are markets where funds are borrowed to finance the acquisition of houses. • A mortgage is a pledge of property to secure payment of a debt. • Such loans are made by banks and financial institutions, and are collateralized by the property so acquired.

5. Mortgages • In 1990 the mortgage finance market in the U.S. was larger than the markets for U.S government securities and U.S. corporate bonds combined.

6. Importance • Why is the market for home loans important? • One of the most important goals for many families is the acquisition of a home. • Typically, such real estate purchases are financed by partly borrowing the funds required.

7. Importance (Cont…) • Why do people aspire to own homes? • An investment in a home serves as a long-term hedge against inflation. • It has been observed that the market value of homes has risen substantially faster than the rate of inflation in the long run. • Besides the interest paid on home loans is tax deductible. • This reduces the after-tax interest cost.

8. Disadvantages? • Owning a home is not without its negatives however. • Homes are difficult to sell, that is the market is relatively illiquid compared to security markets. • A home typically constitutes a family’s largest investment. • This makes diversification of wealth difficult. • Home values tend to fluctuate with the economy and with changes in their age and condition.

9. The Mortgage Loan Market

10. Market (Cont…) • In 1982 residential mortgages accounted for 82.1% of the loans that were outstanding. • The balance 17.9% was on account of loans secured by business and farm properties.

11. A Standard Mortgage • The traditional mortgage loan is characterized by: • A 30 year period (in the U.S.) • A constant or level monthly payment (EMI) • Such mortgages are called: • Level payment, fixed rate mortgages (FRM)

12. A Standard Mortgage (Cont…) • A standard mortgage is repaid by a series of constant monthly payments during its life. • Each payment consists partly of principal and partly of interest repayment. • The process of repayment in this fashion is called `Amortization’.

13. A Standard Mortgage (Cont…) • For a given loan amount, the higher the mortgage rate the greater will be the monthly payment. • In the initial years most of the EMI consists of interest payment. • As the mortgage progresses however, the EMIs will consist mainly of principal repayments.

14. Features of Amortized Loans • Mortgages are usually for 30 years (360 months). • The interest component is equal to one twelfth the annual rate of interest multiplied by the amount outstanding at the beginning of the previous month. • With the payment of each installment, the interest component will keep declining and the principal component will keep increasing.

15. Features…(Cont…) • The installment payments form an annuity whose present value is equal to the original loan amount. • A Amortization Schedule is a table that shows the division of each payment into principal and interest, and the outstanding loan balance after each payment.

16. Calculating The Installment • Consider a loan of $L to be repaid by way of N installments of $A each. • Let the periodic interest rate be `r’. • L = A x PVIFA(r,N) =

17. Example • A person has taken a loan of $10,000. • It has to be paid back in 5 equal annual installments. • Interest rate is 10% per annum. • L = A x PVIFA(10,5) = A x 3.7908 • A = 2,637.97

18. Amortization Schedule

19. Illustration • A lender has advanced $227,150 for the purchase of a home. • The annual interest rate is 7.77% • The term of the loan is 25 years. • What is the monthly amount? 227,500 = A x (1 – 1 ) ________ ___ ____ 0.006475 (1.006475)300 = 1721.36

20. Illustration (Cont…) • The EMI on a mortgage of $155,000 is $1550. • What is the annual interest rate. 155,000 1 (1 - 1 ) _________ = ______x ______ 1550 i (1+i)360 i = 0.96875%

21. Illustration (Cont…) • A mortgage loan for $235,000 has been made. • The interest rate is 7.875% per annum and the EMI is 2093.44. • How long will it take to fully amortize the loan?

22. Illustration (Cont…) 235,000 = 2093.44 (1 - 1 ) _______ X __________ 0.0065625 (1.0065625)N N = 204 months

23. Amortization (Cont…) • Let UPBn be the unpaid balance at the end of n periods. • The loan is for a total of N periods. • The monthly payment is MP. • The principal component of the nth EMI is Pn. • The interest component of the nth EMI is In.

24. Amortization (Cont…) • UPBn = MP 1 - 1 ______ x [ ______] r (1+r)N-n Pn = UPB0 x r x (1+r)n-1 _________________ (1+r)N - 1 In = UPB0 x r x [(1+r)N - (1+r)n-1] _________________ (1+r)N - 1

25. Illustration • Consider a 30 year 8.88% loan for $225,000. • Calculate the principal and interest components of the 180th payment. P180 = 471.57 I180 = 1319.44

26. Bi-weekly Payment Mortgages • Americans get paid on a bi-weekly basis, that is, once a fortnight. • In a bi-weekly mortgage the EMI is calculated assuming that payments are made monthly. • Half of the calculated EMI is the bi-weekly payment. • Since there are 26 fortnights in a year the bi-weekly interest rate is 6/13 of the monthly rate.

27. The life of the mortgage is then calculated as follow. MP x PVIFA(r,M) = MP ___ x PVIFA(rα, N) 2 N = 545 fortnights Ξ 21 years

28. Alternative Mortgage Structures • One alternative to a standard 30 year mortgage is a 15 year fixed rate mortgage. • In this case the interest rate continues to be fixed. • But the amortization period is 50% of that of a 30 year mortgage.

29. Alternative…(Cont…) • Due to the shorter amortization period, the EMIs of the 15 year mortgage contain a larger percentage by way of principal repayments as compared to a 30 year mortgage. • The faster repayment and the shorter maturity makes such 15 year loans attractive for lenders.

30. Alternative (Cont…) • Hence 15 year mortgages tend to be offered at a lower rate as compared to a 30 year mortgage. • Tax reforms in the U.S. also had an impact. • When the marginal tax rate is lowered the deductibility of mortgage interest payments for tax purposes becomes less attractive. • Thus the advantage of 30 year loans over 15 year loans was reduced.

31. Alternative…(Cont…) • The 1980s in the U.S. were characterized by high inflation. • Consequently, mortgage lending rates were also high. • Due to high and uncertain inflation, lenders could not offer 30 year fixed rate loans.

32. Alternative…(Cont…) • It must be remembered that most lenders like banks were financing long-term mortgage loans with short-term deposits. • Thus there was a asset-liability mismatch. • Lenders therefore wanted to offer loans with shorter maturities.

33. Alternative…(Cont…) • From the borrowers’ perspective, due to higher interest rates, the EMIs were becoming large and unaffordable. • This lead to the creation of ARMs or adjustable rate mortgages. • In general an ARM has a 30 year amortization period • But interest rates are adjustable – usually on an annual basis.

34. Alternative…(Cont…) • The interest rate adjustment is based on an index rate plus a spread called `margin’. • The index may be a: • T-bill rate • Or a cost of fund index

35. Alternative…(Cont…) • Although rates can be adjusted, usually there is a band within which changes can be made. • A majority of ARMs have a cap

36. Alternative…(Cont…) • A Graduated Payment Mortgage (GPM) is also an alternative to an FRM. • A GPM has a 30 year maturity. • But a lower EMI in the initial years as compared to an FRM. • The interest rate on the loan will steadily rise for a specified period (so will the EMI) and will then level off.

37. Alternative…(Cont…) • Because of lower payments in the earlier years, GPMs exhibit negative amortization. • That is, in the earlier years, the EMIs are inadequate to cover even the interest that is due. • Consequently, instead of declining, the principal amount actually increases.

38. ARMs (Cont…) • To induce borrowers to accept an ARM and to compensate them partially for future payment uncertainty, lenders offer them at a lower interest rate as compared to fixed rate mortgages. • The initial rate is known as a Teaser Rate. • It is typically 50-100 b.p below the rate for a fixed rate mortgage.

39. ARMs (Cont…) • Periodic interest rate caps and floors limit the amount by which the rate on the ARM may change. • A cap fixes the upper limit while a floor fixes the lower limit. • There are two types of Caps • Periodic caps • Lifetime caps

40. ARMs (Cont…) • There are two types of periodic caps • Rate caps and payment caps • Rate caps limit the amount that the contract rate may increase or decrease at the reset date. • The most common rate cap on an annual reset loan is 2%

41. ARMs (Cont…) • Payment caps are less common • These limit the change in the monthly mortgage payment rather than in the interest rate on the reset date. • Payment caps may lead to negative amortization.

42. ARMs (Cont…) • Lifetime caps and floors. • These impose upper and lower limits on the contract rate that could be charged over the life of the loan. • The lifetime cap is expressed in terms of the interest rate • The cap is typically 5-6%. • Thus if the initial rate is 7% and the cap is 5% the maximum rate chargeable is 12%.

43. Mortgage Originators • The entity that initiates the mortgage loan is called the Originator. • Originators include: • Commercial Banks • Life Insurance Companies • Pension Funds • Savings & Loan Institutions or Thrifts

44. Origination (Cont…) • What does an originator look for? • He considers the following • Debt-to-Income Ratio • The current income of the borrower is compared with the monthly expense incurred in connection with owning the house. • These expenses are referred to as PITI. • That is: • Monthly payment of principal plus interest • Property taxes • Insurance premia • As a rule of thumb, the debt to income ratio should not exceed 25%.

45. Origination (Cont…) • In addition, the originator will consider the other long-term as well as short-term liabilities of the borrower. • A party who is substantially in debt would be offered a loan only if he were to have a lower debt to income ratio.

46. Origination (Cont…) • The credit history of the borrower is also a factor. • This usually includes the payment history of the credit cards owned by the borrower, and other short-term loans taken by him. • Property Appraisal is yet another factor. • The appraised market value of the house is also a key decision variable. • As part of the loan application the value of the house as appraised by a professional property appraiser should be supplied. • This value should be significantly higher than the amount that is sought to be borrowed.

47. Origination (Cont…) • The down payment is a key factor as well. • Typically the lender will finance only 80-90% of the cost of acquisition. • The ratio of the loan amount to the purchase price is called the LTV – Loan to Value ratio.

48. Major Mortgage Lenders • Originators can be divided into three categories: • Commercial Banks • Savings & Loans or Thrifts • Mortgage Bankers

49. Lenders…(Cont…) • Commercial banks and thrifts are known as depository lenders • That is they accept deposits from the public and make loans to homeowners • Mortgage bankers are non-depository lenders • They fund originations from short-term lines of credit obtained from commercial banks • These loans are repaid by selling the newly originated mortgages.

50. Primary vs. Secondary Markets • The market where the lenders or the originators deal with borrowers is called the Primary Mortgage market. • The market where newly originated loans are sold to investors is called the Secondary Mortgage market.