Residential Mortgage Loans

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Nature of Mortgages

 What is a mortgage?
 What is a mortgage originator?

 Who can be a mortgage originator?

 Sources of income for mortgage originator

 Factors determining the lending decision

 Options of the mortgage originators

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What is a Mortgage?

 A mortgage is a loan secured by the collateral of

specified real estate property, which obliges the
borrower to make a pre-determined series of payments.

 The mortgage gives the lender (mortgagee) the right of

foreclosure on the loan if the borrower (mortgagor)
defaults.

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What is a Mortgage Originator?

 The original lender is called the mortgage originator.

 The mortgage originator reviews applications for
mortgage loans from different potential and present
homeowners.
 The mortgage originator is responsible to:
 underwrite the loan
 process the necessary documents
 provide the funds to the homeowner (borrower)

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Who can be a Mortgage Originator?

 Thethree largest originators for all types of residential

mortgages are:
 Thrifts
 Commercial banks
 Mortgage bankers
 Others
 Lifeinsurance companies
 Pension funds

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Sources of Income for Mortgage Originator

 Origination Fee
 The fee is expressed in terms of points, where each point
represents 1% of the borrowed funds.
 For example, an origination fee of two points on a $100,000 mortgage
represents $2,000.
 Originators also charge application fees and processing fees.
 Secondary Marketing Profit
 Profit might be generated from selling a mortgage at a higher
price than it originally cost.
 If mortgage rates rise, an originator will realize a loss when
the mortgage is sold in the secondary market.
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Factors Determining the Lending Decision

 The two primary factors in determining whether the

funds will be lent:
 Payment-To-Income (PTI) ratio
 Loan-To-Value (LTV) ratio

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Payment-To-Income (PTI) Ratio

 PTI, the ratio of monthly payments to monthly income,

is a measure of the ability of the applicant to make
monthly payments.
 The lower this ratio, the greater the likelihood that the
applicant will be able to meet the required payments.
 The lower, the better.

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Loan-To-Value (LTV) Ratio

 The LTV is the ratio of the amount of the loan to the

market (or appraised) value of the property.
 The lower this ratio, the more protection the lender has
if the applicant defaults and the property must be
reposed and sold.

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Options of Mortgage Originators After Origination

 Hold the mortgage in their portfolio.

 Sell the mortgage to an investor who wishes to hold the
mortgage or who will place the mortgage in a pool of
mortgages to be used as collateral for the issuance of a
security (i.e. securitized).
 Use the mortgage themselves as collateral for the
issuance of a security (i.e. securitized).

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Types of Mortgages and the Associated Risk

 Two types of mortgage loans

 Difference between Fixed Rate Mortgages (FRMs) and
bonds
 A typical FRM

 The breakdown between interest and principal

 Risk of fixed rate mortgage (FRM)

 Adjustable rate mortgage (ARM)

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Two Types of Mortgage Loans

 The conventional residential mortgage loans fall under

two categories:
 Fixed-rate mortgages (FRMs)
 Adjustable-rate mortgages (ARMs)

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Differences between FRMs and Bonds

 FRMs differ from other fixed-income securities with

promised common coupon payments. Typically,
Treasuries, corporates, agencies, and Eurobonds pay
semiannual or annual coupon payments.
 Mortgages typically pay monthly cash flows. In
addition, mortgages are amortizing, with payments
assigned toward both interest and principal.

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A Typical FRM

 The traditional mortgage is 30-year fixed-rate

mortgage with level monthly scheduled payments. This
is an amortizing loan, wherein level monthly payments
are scheduled over 360 months so that the loan is
retired at the end of 360 months.

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The Breakdown between Interest and Principal

 The pattern of scheduled interest and principal

payments varies over the life of a mortgage.
 Note that in the early part of the life of the
mortgage, most of the monthly payments are
applied toward repaying the interest component of
the loan.
 It is toward the end of the life of the mortgage that
the payments toward principal constitute a major
part of the monthly payments.

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Risk of Fixed-Rate Mortgage (FRM)
 Banks have sold an option to borrowers
 The lender extends loans to acceptable borrowers. Note
that such a loan portfolio, an asset in the bank’s balance
sheet, has a market value that is highly sensitive to the
levels of interest rates.
 This arises from the fact that the borrowers (homeowners)
have the option to refinance their loans by prepaying their
loans and taking on new loans when mortgage interest rate
falls.

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Risk of Fixed-Rate Mortgage (FRM) (cont’d)
 In addition, most of the bank’s liabilities are CDs,
FRNs, and other short-term instruments. This means
that the cost of funds to most financial institutions is
tied to the levels of short-term interest rates.
 On the other hand, the revenue from such mortgage-
loan portfolios is tied to longer-term interest rates,
as the mortgage rates on 15-year and 30-year FRMs
tend to be at a spread over respective Treasury
counterparts.

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Adjustable-Rate Mortgages (ARMs)
 ARMs permit the interest payments to be reset at
periodic intervals in accordance with some pre-
specified reference (typically short-term) interest
rate.
 Two categories of reference rates have been used in
ARMs:
 Market-determined rates – e.g. the constant maturity one-
year Treasury (CMT) rate
 Calculated rates – e.g. the National Cost-of-Funds Index
(COFI)

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Risk of ARMs (to Lenders)

 Since ARMs shift fluctuations in interest rates to the

borrowers, the asset-liability management problem of
lenders is mitigated.

 The only exposure the lender has with a plain-vanilla

ARM without caps is the exposure to interest rates
during the period between the resets.

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Risk of ARMs (to Borrowers)
 To the extent the interest-rate risk to the lender is
reduced, any resulting benefits will be passed onto
the homeowners as a lower cost of borrowing.
 However, since short-term interest rates are more
volatile, ARMs can subject borrowers to a
significant amount of risk if the rates increase
unexpectedly.
 If the homeowners are unable to meet the increased
monthly payments resulting from such increases in
short-term interest rates, default can occur.
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Risks Associated with Investing in Mortgages
 Credit Risk
 The risk that the homeowner/borrower will default
 Determinants of a mortgage’s likelihood of default:
 Loan-to-Value (LTV) Ratio – original LTV and current LTV
 Mortgage Term – the longer the mortgage term, the greater the
credit risk
 Mortgage Type – fixed-rate mortgages are considered prime
 Transaction Type – for cash-out refinancing vs. for purchase
 Documentation
 Occupancy Status

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Risks Associated with Investing in Mortgages (cont’d)
 Liquidity Risk
 Interest-Rate Risk
 Prepayment Risk
 Prepayments – payments made in excess of the scheduled
principal repayments
 Prepayments occur when:
 Homeowners sell their home
 Homeowners refinance the mortgages as market rates fall below
the contract rate
 Homeowners cannot meet their mortgage obligations
 A property is destroyed by fire or another insured catastrophe
 Cash flow from a mortgage is not known with certainty

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Mortgage Pass-Through Securities

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Cash Flow Characteristics

 A mortgage pass-through security is created when one

or more mortgage holders form a collection (pool) of
mortgages and sell shares or participation certificates in
the pool.
 The cash flow of a pass-through depends on the cash
flow of the underlying mortgages:
 Interest
 Scheduled repayment of principal
 Any prepayment

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Cash Flow Characteristics (cont’d)

 The monthly cash flow for a pass-through is less than

the monthly cash flow of the underlying mortgages:
 Servicing fees
 Guaranteeing fees
 The pass-through coupon rate is less than the mortgage
rate on the underlying mortgages.
 Because of prepayments, the cash flow of a pass-
through is not known with certainty.

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WAC and WAM

 Not all of the mortgages included in a pool have the

same mortgage rate and the same maturity.
 Weighted-average coupon rate (WAC) – weighting the
mortgage rate of each mortgage loan in the pool by the
amount of the mortgage outstanding
 Weighted-average maturity (WAM) – weighting the
remaining number of months to maturity for each
mortgage loan in the pool by the amount of the
mortgage outstanding

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Prepayment Conventions

 To value a pass-through, it is necessary to project its

cash flow (which is unknown because of prepayments).
 The only way to project a cash flow is to make some
assumption about the prepayment rate over the life of
the underlying mortgage pool.
 The prepayment rate assumed is called the prepayment
speed.
 Several conventions have been used as a benchmark
for prepayment rates.

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Conditional Prepayment Rate

 This benchmark assumes that some fraction of the

remaining principal in the pool is prepaid each month
for the remaining term of the mortgage.
 Conditional Prepayment Rate (CPR): it is based on the
characteristics of the pool (including its historical
prepayment experience) and the current and expected
future economic environment.

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Public Securities Association (PSA)
Prepayment Benchmark
 This benchmark is expressed as a monthly series of
annual prepayment rates.
 It assumes that prepayment rates are low for newly
originated mortgages and then will speed up as the
mortgages become seasoned.

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Factors Affecting Prepayment Behavior

 Prevailing Mortgage Rate

 Spread between contract rate and prevailing mortgage rate
 Refinancing incentive
 Path of mortgage rates  Refinancing burnout
 Level of mortgage rates  Housing turnover
 Characteristics
of the Underlying Mortgage Loans
 Seasonal Factors  Housing turnover

 General Economic Activity  Housing turnover

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Prepayment Risk

 Contraction Risk – when mortgage rates decline

 Negative convexity: the upside potential of a pass-through
security is truncated because of prepayments.
 The cash flow from prepayments must be reinvested at a
lower rate.
 Extension Risk – when mortgage rates rise
 Higher rates tend to slow down the rate of prepayment, in
effect increasing the amount invested at the coupon rate,
which is lower than the market rate.

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