 MORTGAGES WEEK 7

What is it?  Mortgage – The charging of real (or personal) property by a debtor, to a creditor as security for a debt (especially incurred by the purchase of property) on the condition that it shall be returned on payment of the debt within a certain period  Investment Value  Two components

Loan to Value  Loan to Value = Mortgage Amount / Appraised Value of Property  Banks typically require 75% LTV  Prevention of sale  Underwater Mortgage

Underwater Mortgages

Components of a Mortgage  Components (APR and Amortization)  Amortized depending on amount borrowed  Typically amortized monthly

Types of Mortgages (and others)

Fixed Rate Mortgages  Interest rate and your monthly payments remain fixed for the period of the loan  Term is fixed  Example

Adjustable Rate Mortgages  Interest rate / monthly payments change overtime (period of loan)  Changes based on defined index  Index established at application  New Interest Rate  Margin  Why adjustable rate?

Indices

Negatively Amortizing Loans  Different payment structure  Allows for smaller payments  Deferred interest  Contractual limit  Recalculation

Fixed Period ARMs  Same as ARM  Fixed + Adjustable period  After fixed period, adjusts based on index plus margin  Subject to IR cap structure after fixed period

Convertible ARMs  Similar to ARM  Option to convert  Usually charged fee  Beneficial in certain circumstances

Option ARM  No set payment  Begin with initial payment  4 options after (hence the name…)

Buydown Mortgages  Initial discount  Builder or seller  Lowers qualification

GPM  Initial low rate  Gradual increase  Usually 7-12% annually  Until desired rate reached

Structured Products  What is a structured product?  Highly Customized  Returns derived from underlying not issuer’s cash flow  Similar to other derivatives that we have discussed

Types of Securities  ABS – Asset backed securities  CMBS – Commercial mortgage backed security  RMBS – Residential mortgage backed security  MSR – Mortgage servicing rights

Benefits to Structured Products  Diversification  Liquidity  More efficient markets (Lower Mortgage Rates)

U.S. Debt Market

Size of Securitized Products

Securitization

Originator  Mortgage originators  Different types of originators  Operational differences

Originator Continued  Banks  Internal aggregation  Risk  Mitigation  Liability Transfer / Legality

Originator Continued  Hedging  Best efforts trade  Smaller originators

Aggregator  What is an aggregator?  Next in line  Close ties with WS

Aggregator Continued  Re-origination  Two Options  Mortgage Backed Securities (MBS) [GSE’s]  Securitize into private label MBS [WS]

Aggregator Continued  Hedging  Timeline of hedging  Entire pipeline  Profiting

Mortgage Fallout  Loans that do not close  Why is this important?  Fallout = Loans that do not close / Total Loans

Fallout Continued  Hedge until mortgage closes  Many loans do not end up closing  Variety of reasons..  Selling into secondary market

Prepayment Risk  Returning principal on loan early  In bundle, accelerates cash flows of MBS  Front-loads the mortgage cash flows (Principal and Interest)

Front Loading of Prepayments

Tranches  Divided into different tranches  Many different ways mortgages can be divided  Interest rate, risk, maturity, etc.

Tranche Division

Risk and Hedging  How are MBS’s hedged?  IR Future  MBS Option  TBAs (Fallout)

Securities Dealers  MBS sold to securities dealer  Most WS firms have a desk for MBS  Dealers wrap and bundle MBS  Eventual outcome…

Mortgage to Security

MSR (Mortgage Servicing Rights)  Servicing Rights  Sold by lender  Usually specializes in servicing

Investors  End users of mortgages  Types of investors  Diverse yields  GSE’s largest portfolio

Investor Breakdown

Refinancing  Replaces older loan with new loan  New payment scheme  Usually involves a penalty fee

Subprime  Low credit ratings (Below 600; 850 FICO is perfect)  Not given conventional loan  Higher IR  Much higher risk

Predatory Lending  Enticing borrower  High fees  High IR  Strips equities  Places borrower in lower credit rating (Charge higher IR)  Foreclosing Strategies

Thank you !