Mortgages and mortgage markets Real Estate Finance, Spring, 2017

Overview What is real estate? Mortgage markets Current structure of markets A brief history of mortgage markets

What is real estate? Real estate can be defined in terms of physical terms as well as in a legal sense in terms of property rights Physical: Land and structural improvements which are permanently attached to the land Legal: The collection of rights and responsibilities connected to the property Many different parties can have rights on a given piece of real estate Property rights may be defined in terms of outcomes

Property rights Property rights provide a measure of the degree of control or use of a given piece of real estate or interest in real estate Right to sell property/interest Right to use the property Easement Right to use property/interest as collateral Secured interest Right to lease the use of property

Estates The extent to which rights and interests in real estate are owned are described by an estate If there is no definitely ascertainable date on which the estate ends, the estate is called a freehold estate Fee simple estate: Most complete form of ownership Sell Lease Use property as collateral Leased fee estate: The property in the transaction is currently subject to lease agreements The ownership rights are restricted by provisions of the lease If the estate expires on a certain date, it is called a leasehold estate Estate for years: Created by a lease specifying the exact duration for the tenancy

Limitations on property rights Government restrictions: Eminent domain Land use regulations Zoning ordinances Building codes Water/mineral rights

Mortgages What is a mortgage? Debt contract secured by the collateral of specified real estate property If borrower fails to make contractual payments, then the lender has the right to seize the property to ensure that debt is repaid A “dying obligation”

Notes and mortgages When a property acquisition is financed, owners often secure the financing by using their property as collateral The lender receives legal title to the property in a mortgage, the buyer receives an equitable interest in the property The legal title only serves to secure the property and does not convey any powers associated with the use of the property so long as the terms of the promissory note are met

Legal structure Two parts: Promissory note: contract between borrower and lender establishing terms of loan Mortgage deed: secures the debt by conveying a claim on ownership to lender Lien Title

Promissory notes Promise to pay Due-on-sale clause Subordination Funds for taxes and insurance Hazard insurance Prepayment penalties Acceleration clause Exculpatory clause

Prepayment penalties A prepayment penalty requires the borrower to pay a fee if the loan is retired prior to maturity or prior to the end of a lock out period Residential loans By law, conforming mortgages are not allowed to charge prepayment penalties When allowed, prepayment penalties usually take the form of a percentage of the outstanding balance Commercial loans Defeasance Yield maintenance

Exculpatory clause An exculpatory clause allows the borrower to surrender the property to the lender without personal liability Non-recourse loan Strategic default

Default Default can result from any breach of the mortgage contract Failure to make payments of principle and interest in a timely manner Failure to pay taxes or insurance payments Failure to keep security or fire mitigation systems in working order

Default Foreclosure Workouts Lender sues the borrower and obtains the right to sell the property, keeping whatever proceeds that are received up to the amount due If there are multiple claims on the property, payment is made according to priority spelled out in the note If the loan is securitized, foreclosure proceedings are overseen by the loan servicer Workouts Restructure debt Extend the term Personal recourse Voluntary conveyance Short sales

Mortgage markets Market structure Primary Secondary Underwriting and origination Secondary Securitization

Primary mortgage markets Mortgage origination and issuance takes place in the primary mortgage market Activities: Underwriting Origination Participants: Borrowers Lenders Commercial banks Mortgage banks S&L Mortgage brokers

Secondary mortgage markets Mortgages underwritten in the primary market are pooled and sold to financial intermediaries who then issue bonds to investors in the financial markets based on the cash flows received from the underlying loans Participants: GSEs Government agencies Private mortgage lenders Servicing companies Investment banks Investors

Secondary mortgage markets Mortgage servicing Commercial Banks Savings and Loans Mortgage Banks Fannie Mae Freddie Mac Ginnie Mae Private placement Investors Investment banks

Secondary mortgage markets Mortgage-pass through securities are bonds offering periodic interest and principal payments based on an underlying pool of residential mortgage loans Prepayment risk Uncertain timing of cash flows due to repayment of debt prior to maturity Default risk Uncertain future cash flows due to borrower default

Secondary mortgage markets Prepayment risk relates to the relationship between changes in the prevailing mortgage rate and the average life of mortgage loans within a pass-through security Contraction risk If interest rates fall, prepayment speeds increases and the average life of the mortgage pool shortens Extension risk If interest rates increase, prepayment speeds decrease and the average life of the mortgage pool increases

Secondary mortgage markets There was little demand for mortgage-backed securities structured as pure pass-through investments, why? Investors wanting long-term assets to match long-term liabilities were subject to contraction risk Investors wanting short-term assets to match short-term liabilities were subject to extension risk Solution: Structure cash flows from pass-through securities to mitigate prepayment risk for each type of investor Collateralized mortgage obligation (CMO)

Secondary mortgage markets The collateralized mortgage obligation, or CMO, is a class of mortgage derivative securities that reallocate interest and principal payments received from a pass-through security to mitigate prepayment risk A CMO offers many different classes, or tranches, each with a different expected average life Short term tranches Long term tranches Accrual bonds

Secondary mortgage markets Interest-only/Principal-only, or IO/PO, STRIPS The cash flows from the underlying mortgages are split into two categories: interest payments and principal payments The interest-only component receives all interest payments made by the borrower The principal-only component receives all the principal payments made by the borrower

Secondary mortgage markets Credit risk relates to the relationship between the ability and desire of borrowers to continue to make their principal and interest payments as scheduled Ginnie Mae pass-through bonds Fully modified Agency pass-through bonds (Fannie Mae, Freddie Mac) Modified Private placement pass-through bonds No guarantees are provided by issuers CDO structure relying on credit rating agencies

Secondary mortgage markets The collateralized debt obligation, or CDO, is a class of mortgage derivative securities that use a senior-subordinated structure to re-allocate default risk A CDO offers many different classes, or tranches, each with a different risk of default Senior tranches Investment grade bonds Mezzanine tranches Speculative grade bonds Equity tranches/Over-collateralization Unrated bonds

Secondary mortgage markets A CDO2 is a CDO constructed from the cash flows from the mezzanine and lower rated tranches from other CDO issues based on underlying loans A synthetic CDO is a CDO constructed from the cash flows received from credit-default swaps, or CDS, issued by insurers

Secondary mortgage markets Financial intermediaries such as investment banks purchase mortgage-pass through securities and issue bonds with payments that are determined by the underlying mortgages serving as the underlying collateral for the bonds Structuring of cash flows and/or seniority Obtain bond ratings from major rating agencies such as Moody’s, S&P, and Fitch Place bonds with investors in the financial markets Intermediaries may hold onto parts of the lower rated and/or unrated issues

Secondary mortgage markets Mortgage servicing involves collecting, tracking, and allocating the payments received from mortgage borrowers and overseeing default and foreclosure proceedings Servicer compensation is based on a percentage of the outstanding loan balance and reimbursement (including interest and penalties) for any fees paid on behalf of borrowers

Secondary mortgage markets What are the benefits associated with liquid secondary mortgage markets? Efficiency through specialization Underwriting and credit analysis Risk management Asset/liability management in banks Diversification benefits The net effects of liquid secondary mortgage markets Reduced cost of mortgage borrowing Greater variety in mortgage structure

Secondary mortgage markets What are the potential problems? Underwriting and moral hazard Entities underwriting and overseeing the loan origination process do not necessarily bear the cost if loans go bad or, if they do bear the risk, may not have adequate capital on hand to make good on bad loans Securitization and moral hazard Investment banks Rating agencies