1. KATIE SCHUBERG AND LISA SHANNON Mortgage Designs

2. Agenda Fixed Rate Mortgage (FRMs)  Two main issues with FRMs Adjustable Rate Mortgage (ARMs)  Interest Only Balloon/Reset Mortgage Sub-Prime Mortgage  Subprime Meltdown

3. Importance of Understanding Mortgage Designs 97% of houses purchased in 2001 were funded through loans Only 1.6% were purchased using cash As we have seen in recent events different mortgage designs can cause a dramatic effect on the United States economy! “U.S. foreclosures reached 274,399 in January, the 10th straight month in which more than a quarter-million filings were processed, RealtyTrac Inc., the Irvine, California-based provider of real estate data, said in a statement yesterday. Foreclosure filings soared to a record last year, surging 81 percent to 2.3 million, as home prices fell and mortgage standards tightened. “ RealtyTrac Inc.  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aC7x_GWO2ic8 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aC7x_GWO2ic8

4. Fixed Rate Mortgage System Pay interest and principal in equal installments over a determined period of time. Most traditional mortgage design; though it is not the most popular. Was the founding mortgage design; the following mortgages took off from the principals behind the FRM

5. Two main issues of Fixed Rate Mortgages Mismatch Problem  Concept of borrowing short and lending long.  Interest rate risk: Risk that depository institutions will misjudge future interest rates and take positions that may create a negative spread when rates change. Tilt Problem  Fixed payments create a greater burden at the beginning of mortgage.

6. Mortgage Design Comparison Mortgage TypeMonthly PaymentInterest RateRate ChangesTotal Interest Paid Build Equity 30-Year Fixed- Rate Mortgage Average Never changesAverage 40-Year Fixed- Rate Mortgage Notably lowerSlightly higherNever changesHigherSlower 15-Year Fixed- Rate Mortgage Notably higherNotably lowerNever changesNotably lowerNotably faster 5/1 Adjustable- Rate Mortgage (ARM) Lower for first 5 years, then may change each year LowerFixed for the first 5 years (then may change once a year) Varies depending on interest rates Average 3/1 ARMLower for the first 3 years, then may change each year Notably lowerFixed for the first 3 years (then may change once a year) Varies depending on interest rates Average NET 5® (5/1 Initial Interest- Only Payment) ARM Notably lower for first 5 years because only interest is required, then may adjust each year LowerFixed for the first 5 years (then may change once a year) Varies depending on interest rates Does not build equity for the first 5 years

7. Adjustable-Rate Mortgage System (ARMs) Most popular design in the United States Interest rates are reset every month, six months, every year, two years, or longer Shifts the interest rate risk from the lender to the borrower  Do not know how the interest rates are going to react in the markets

8. ARMs continued Interest Rate Caps and Floors  Rate Cap  Limits the amount that the interest rate may increase or decrease at the reset date (typically expressed in percentage points).  Rate Floors  The lowest amounts charged on the lifetime of the loan

9. Adjustable vs. Fixed Mortgages Fixed Rate Mortgage Amount of the loan: $ 250,000 Annual percentage rate of interest: 7% Number of years: 30 Payment Information:  Your monthly mortgage payment will be: $ 1663.26 Adjustable Rate Mortgage PerBeg. Bal. Int.PmtEnd Bal. Int. Rate 1$250,000$1042$1342$249,70 0 5.00% 120$210,468$1272$1660$210,07 9 7.25% 146 $200,011 $1333 $1754 $199,590 8.00% 198 $175,0031313 $1864 $174,452 9.00% 294 $100,752924 $2019 $99,657 11.00% 360$203220$2053012.00%

10. Interest Only Loans ARM design in where payments are comprised of just interest for the first period of the loan, typically five years. In that first period no equity is earned besides the initial down-payment. Enables payments to be notably lower than those of a traditional mortgage design. Payment comparison What issues can you foresee with a design like this?

11. Additional Mortgage Designs Primarily deal with the tilt problem of the FRM Payments account for inflation  Graduated-payment mortgage- nominal payments increase each month for portion of loan and then level off at fixed rate.  Price-level-adjusted mortgage- payments fixed at real rate opposed to nominal rate (price level measured on index)  Dual-rate mortgage- payments start very low then rise at rate of inflation( computed on floating short-term rate)

12. Balloon/Reset Mortgages Borrower is given a long term financing, but at the specified date (which is a while before the actual maturity date of the mortgage) the loan is paid off and the lender agrees to continue financing for the remainder of the term at a new mortgage rate.  Lender and borrow figure out re-negotiation periods at the time the contract is written up  At the time of re-negotiation, they decide what the new interest rates are going to be

13. Sub-prime Mortgage System For people with lower credit ratings (typically below 600) Do not qualify for conventional design (FRM) These people did qualify for the non-traditional mortgages  Payment option ARMs  Interest only mortgages  Balloon mortgages Because:  Lenders lessened standards to subprime candidates  High default risk  Affordable payments with record-low interest rates

14. Sub-prime Meltdown However, the historical low rates at time of issuance increased throughout the 3 to 5 year period. Borrowers faced with much higher payments + high default risk + housing market depreciation = Sub-prime Meltdown

15. Explain why someone would want to choose: -Fixed rate mortgage -Adjustable rate mortgage -Interest only mortgage -Balloon/reset mortgage