1. Mortgages and mortgage markets
Real Estate Finance, Spring, 2017

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

3. 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

4. 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

5. 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

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

7. 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”

8. 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

9. 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

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

11. 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

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

13. 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

14. 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

15. Mortgage markets Market structure Primary Secondary
Underwriting and origination
Secondary
Securitization

16. 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

17. 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

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

19. 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

20. 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

21. 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)

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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