13-1 Mortgages Chapter 13

13-2 uStandard Fixed Rate uVariable Rate uRefinancing and Prepayments uMarketable Mortgages Mortgages

13-3 P = Principal M = Periodic payment Y = Interest rate Fixed Rate Mortgage 102…n PM…MM

13-4 P = $100, y = 10%, n = 20 Example Total Payments = (20)(11.75) = 235. Interest = 235 – 100 = 135 = Total – Principal.

13-5 Repayment Time P Interest of P = – = –

13-6 AM j = Amortization of principal in period j Amount of Repayment of Principal Called Amortization If n = 20, P = 100, y = 10%, j = 10

13-7 The interest in period j = I j I j = M – AM j $ Interest = – $ Amortization I 10 = – 4.12 = Mortgage Payment

13-8 Remaining Principal at time j = P j P j = [M][PVA n-j ] P 10 = [11.75][PVA 20-10,10% ] = [11.75][6.1446] =

13-9

13-10 Current rate = Index + Premium. Annual cap on change Lifetime cap + minimum Teaser rate Borrower bears risk of changing interest rates Variable Rate Mortgage, Floating Rate, Adjustable Rate

13-11  Due on sale clause  Assumable

13-12 Borrower has right to repay early. Reasons: A.Moving B.Lower interest rates C.Improved financial condition of borrower Prepayment Option

13-13 Refinancing Because of Lower Interest Rates Costs include points, loan initiation fees, legal costs, surveying, etc. j0n IssuedPrepayMaturity

13-14 P = $100, n = 20, y Old = 10%, y New = 7%, j = 10, costs = 6%. Refinancing Example – 10 Years Remaining

13-15 Prepayment Pattern Public Securities Association—PSA Constant Prepayment Rate—CPR Change in Interest Rates Moving & Other Lower Rates Lower Rates 0 Higher Rates % Prepaid

13-16 Phase 1 of Mortgage Market until 1980 Borrowers Bank or Savings & Loan Depositors

Bank or savings & loan holds mortgages and absorbs defaults. 2.Prime borrowers A.Sizable down payment B.Verified income C.Good credit rating 3.FDIC insures deposits. 4.Typically fixed-rate loans.

13-18 Phase 2 of Mortgage Market 1980 – 2000 Borrower Bank Savings & Loan Mortgage Originator Default Guarantees FHA, VA, GNMA, Private Pool of MortgagesInvestors

Typically fixed-rate loans  Investors bear prepayment risk. 2.Default guarantees make pools of mortgages  Essentially default free.  Trade like U.S. Treasuries except for prepayment risk.

13-20 Original pools – PassThroughs All investors share proportionally. Later pools divided into tranches or slices. Tranche 1 Tranche 2 Tranche 3

Many ways of setting up tranches. 2.Typically Tranche 1 gets first prepayments, then #2, etc. 3.Some tranches were divided into interest only and principal only parts.

13-22 Phase 3 of Mortgage Market 2000 – Now Borrower Bank Savings & Loan Mortgage Broker Pool Organizer TrustInvestors

Many floating-rate loans with teaser rates for first two years. 2.Many subprime and Alt-A mortgages  Prime has A.Down payment B.Verified income C.Good credit rate  Alt-A is missing one or two.  Subprime is missing all three. 3.Typically no default guarantee.

13-24 I.Qualifying 1)High credit score 2)Adequate down payment 3)Documented sufficient income II.Alt-A yMissing one or two of the above III.Subprime yMissing all three of the above Three Types of Mortgage Borrowers

13-25 Example Borrower 1Borrower 2Borrower 3Borrower 4 Originator 1Originator 2 Pool Organizer Trust Tranche 1Tranche 2Tranche 3 Rating Percent of Pool AAA A BB 60%20%

)Borrower lies. 2)Originator falsifies documents. 3)Originator gets fees from borrower and/or pool organizer. 4)Once mortgage is sold into pool, originator has no liability. 5)Pool organizer works with rating agency to set up tranches. Potential Problems

)Rating agency gets paid by pool organizer—may give rating agencies incentives to give higher ratings to attract more business. 7)Pool organizer has no liability once mortgages are put into the trust. 8)Originators and pool organizers have incentives to process as many mortgages as possible to maximize fees. Potential Problems

13-28 Advantages of Marketable Mortgages Advantage: Diversification Disadvantages: 1.Conflicts of Interest. 2.Asymmetric Information. 3.Moral Hazard.

13-29 EXAMPLES OF DIFFERENT TYPES OF TRANCHING 1. Sequential Pay 2. Planned Amortization Class 3. Principal Only and Interest Only

13-30 Sequential Pay Prepayments go to Class 1 until paid off. Then prepayments go to Class 2, then to Class 3. Suits some buyers better. Some get higher prepayment risk and some get lower prepayment risk. Size of each class is small, resulting in reduced liquidity.

13-31 Early classes have precisely defined cash flows. Residual class cash flows vary widely in timing. Planned Amortization Class (PAC)

13-32 Principal Only (PO) Interest Only (IO) Division of Principal and Interest Classes