Residential Mortgage Market

Global Capital Markets

Lecture by: Dr. Khalid Ul Islam

Assistant Professor
(IBSB, IFHE Bengaluru Campus)
khalid.islam@ibsindia.org
Ph.D. (Financial Economics, DSE, DU)
MFC (Finance & Control)
M.Com. (Accounting & Finance)
PGDIBO (International Business)
UGC-JRF/SRF, NET/SLET
AMFI (Mutual Fund Investing) Advisor
•Consultation Hours: Wednesday 3:00 to 4:15 pm
Mortgage Market

• Primary market and secondary market

• A mortgage is a pledge of property (real estate) to secure payment of

a debt.
ORIGINATION OF RESIDENTIAL
MORTGAGE LOANS
• Mortgage originator: is the original
lender
• Mortgage originators tend to be thrifts,
commercial banks, and mortgage
bankers

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ORIGINATION OF RESIDENTIAL MORTGAGE
LOANS (continued)

• The income from these loans is derived from:

• Origination fees (a percent of the borrowed
amount)
• Selling the mortgage for a higher price on the
secondary market (secondary market profit)
• Servicing fees, including escrow accounts,
with fees amounting to 50–100 basis points
• Only in rare cases is the mortgage now held
in the originator's loan portfolio

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ORIGINATION OF RESIDENTIAL MORTGAGE
LOANS (continued)
• The Mortgage Origination Process
• Underwriting standards: the requirements specified by the
originator to grant the loan
• The two primary factors in determining the creditworthiness
of the applicant are:
• Payment-to-income ratio (PTI)
• Loan-to-value ratio (LTV)
• If the lender decides to lend the funds, it sends a commitment
letter, (commitment fee- option to the applicant)

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ORIGINATION OF RESIDENTIAL MORTGAGE
LOANS (continued)
• The Risks Associated with Mortgage Origination

• Pipeline risks, consisting of adverse price risk (that the interest rates
rise after terms have been specified)

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ORIGINATION OF RESIDENTIAL MORTGAGE
LOANS (continued)
• The Risks Associated with Mortgage Origination

• Fallout risk (the possibility that the borrower will not accept the
deal if interest rates decline)
• fallout leaves the mortgagee without a contract to sell, however, to
protect himself the mortgagee can obtain, for a fee, an optional
delivery contract with a government sponsored entity or a private
company

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TYPES OF RESIDENTIAL MORTGAGE LOANS

• Lien Status
• The lien status of a mortgage loan indicates the loan’s seniority in the
event of forced liquidation due to default
• For a first lien, the lender would have first call on the proceeds of the
liquidation of the property
• A mortgage loan could also be a second lien or junior lien, whose
liquidation preference is subordinate to that of the first lien

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Classification
• Prime loan: a loan that is originated where the borrower is viewed to
have a high credit quality
• Subprime loan: a lower credit quality loan

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Classification
• Alternative-A loan (alt-A loan): the sector between the prime and
subprime sector.
• Creditworthiness is determined by among other things the borrower’s
FICO scores
• FICO (Fair, Isaacs & Company) the developer of this model which uses
45 criteria for credit worthiness

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Classification
• FICO scores range from 350 to 850
• The higher the FICO score, the lower the credit risk
• The LTV has proven to be a good predictor of default
• The higher the LTV, the greater the likelihood of default

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Classification
• Lenders use income ratios to assess creditworthiness
• The front ratio is computed by dividing the total monthly
payments by the applicant’s pretax monthly income
• The back ratio is computed in a similar manner, but it adds other
debt payments such as auto loan and credit card payments

• For a loan to be classified as “prime”, the FR and BR should be no

more than 28% to 36% respectively.
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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Classification
• Cash-out refinancing: when the loan amount requested exceeds the
original loan amount
• Rate-and-term refinancing (no-cash refinancing): If the loan balance
remains unchanged

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Interest Rate Type (Note rate):
• Fixed-rated mortgage, the interest rate is set at closing and remains
unchanged
• Adjustable-rate mortgage (ARM), the rate changes over the life of
the loan
• The rate is based on both the movement of an underlying rate called
the index or reference rate, and a spread over the index called the
margin

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Classification
• Adjustable-rate mortgage (ARM)
• The basic ARM is one that resets periodically
• The mortgage rate is affected by
• Periodic caps
• Lifetime rate caps and floors (5% to 6%)

• Hybrid ARM, where the rate is fixed for a specified period (3, 5-7, and
10 years), but then adjusts thereafter

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Amortization Type
• Amortization is the amount of the monthly loan payment that
represents the repayment of the principal
• Both fixed and adjustable rate mortgages are fully amortized loans

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Amortization Type
• Recently, new mortgage products have been introduced into the
market
• The most popular is the interest-only product, which requires only
interest payment for a predetermined lockout period

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Credit Guarantees
• Conventional loans: where there is no government guarantee
• A conventional loan can be insured by a private mortgage insurer

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TYPES OF RESIDENTIAL MORTGAGE
LOANS (CONTINUED)
• Loan Balances
• There are loan limits for government sponsored entities
• These limits are called conforming limits
• Loans larger than the conforming limit are referred to as jumbo loans

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CONFORMING LOANS
• Conventional loans that conform to the guidelines of government
sponsored entities are conforming loans
• Conventional loans in the market are either conforming conventional
loans and nonconforming conventional loans

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