Chapter 10: Residential Mortgage Loans
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Chapter 10
Residential Mortgage Loans
1
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Origination of Residential Mortgage Loans
The original lender is called the mortgage originator.
The principal originators of residential mortgage loans are thrifts, commercial banks, and mortgage bankers.
Mortgage originators may service the mortgages they originate, for which they obtain a servicing fee.
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Origination of Residential Mortgage Loans (continued)
When a mortgage originator intends to sell the mortgage, it will obtain a commitment from the potential investor (buyer).
Two government-sponsored enterprises (GSEs) and several private companies buy mortgages.
Because these entities pool these mortgages and sell them to investors, they are called conduits.
When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized.
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Origination of Residential Mortgage Loans (continued)
Underwriting Standards
Originators may generate income for themselves in one or more ways.
They typically charge an origination fee.
Profit can be generated from selling a mortgage at a higher price than it originally cost.
This profit is called secondary marketing profit.
Third, the mortgage originator may hold the mortgage in its investment portfolio.
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Origination of Residential Mortgage Loans (continued)
Underwriting Standards
Mortgage originators can:
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
use the mortgage themselves as collateral for the issuance of a security
When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized.
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Origination of Residential Mortgage Loans (continued)
Underwriting Standards
A conforming mortgage is one that meets the underwriting standards established by these agencies for being in a pool of mortgages underlying a security that they guarantee.
If an applicant does not satisfy the underwriting standards, the mortgage is called a nonconforming mortgage.
Mortgages acquired by the agency may be held as investments in their portfolio or securitized.
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Origination of Residential Mortgage Loans (continued)
Payment-to-Income Ratio
The payment-to-income ratio (PTI) is the ratio of monthly payments to monthly income, which measures the ability of the applicant to make monthly payments (both mortgage and real estate tax payments).
The lower the PTI, the greater the likelihood that the applicant will be able to meet the required monthly mortgage payments.
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Origination of Residential Mortgage Loans (continued)
Loan-to-Value Ratio
The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property.
The lower this ratio is, the greater the protection for the lender if the applicant defaults on the payments and the lender must repossess and sell the property.
The LTV has been found in numerous studies to be the single most important determinant of the likelihood of default.
The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default.
Data on the behavior of bo
owers indicate that they have an increased propensity to voluntarily stop making their mortgage payments once the cu
ent LTV exceeds 125%, even if they can afford making monthly payments. This behavior is refe
ed to as a “strategic default” behavior.
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Types of Residential Mortgage Loans
There are different types of residential mortgage loans.
They can be classified according to the following attributes:
lien status
credit classification
interest rate type
amortization type
credit guarantees
loan balances
prepayments and prepayment penalties
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Types of Residential Mortgage Loans
(continued)
Lien Status
The lien status of a mortgage loan indicates the loan’s seniority in the event of the forced liquidation of the property due to default by the obligor.
For a mortgage loan that is a first lien, the lender would have first call on the proceeds of the liquidation of the property if it were to be repossessed.
A mortgage loan could also be a second lien or junior lien, and the claims of the lender on the proceeds in the case of liquidation come after the holders of the first lien are paid in full.
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Types of Residential Mortgage Loans
(continued)
Credit Classification
A loan that is originated where the bo
ower is viewed to have a high credit quality is classified as a prime loan.
A loan that is originated where the bo
ower is of lower credit quality or where the loan is not a first lien on the property is classified as a subprime loan.
While the credit scores have different underlying methodologies, the scores generically are refe
ed to as “FICO scores.”
FICO scores range from 350 to 850.
The higher the FICO score is, the lower the credit risk.
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Types of Residential Mortgage Loans
(continued)
Credit Classification
The LTV has proven to be a good predictor of default: a higher LTV implies a greater likelihood of default.
When the loan amount requested exceeds the original loan amount, the transaction is refe
ed to as a cash-out-refinancing.
If instead, there is financing where the loan balance remains unchanged, the transaction is said to be a rate-and-term refinancing or no-cash refinancing.
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Types of Residential Mortgage Loans
(continued)
Credit Classification
The front ratio is computed by dividing the total monthly payments (which include interest and principal on the loan plus property taxes and homeowner insurance) by the applicant’s pre-tax monthly income.
The back ratio is computed in a similar manner. The modification is that it adds other debt payments such as auto loan and credit card payments to the total payments.
The credit score is the primary attribute used to characterize loans as either prime or subprime.
Prime (or A-grade) loans generally have FICO scores of 660 or higher, front and back ratios with the above-noted maximum of 28% and 36%, and LTVs less than 95%.
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Types of Residential Mortgage Loans
(continued)
Interest Rate Type
The interest rate that the bo
ower agrees to pay, refe
ed to as the note rate, can be fixed or change over the life of the loan.
For a fixed-rate mortgage (FRM), the interest rate is set at the closing of the loan and remains unchanged over the life of the loan.
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Types of Residential Mortgage Loans
(continued)
Interest Rate Type
For an adjustable-rate mortgage (ARM), as the name implies, the note rate changes over the life of the loan.
The note 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.
Two categories of reference rates have been used in ARMs:
market-determined rates
calculated rates based on the cost of funds for thrifts
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Types of Residential Mortgage Loans
(continued)
Interest Rate Type
The basic ARM is one that resets periodically and has no other terms that affect the monthly mortgage payment.
Typically, the mortgage rate is affected by other terms that include:
periodic rate caps
lifetime rate cap and floo
A periodic rate cap limits the amount that the interest rate may increase or decrease at the reset date.
Most ARMs have an upper limit on the mortgage rate that can be charged over the life of the loan.
This lifetime rate cap is expressed in terms of the initial rate.
ARMs may also have a lower limit (floor) on the interest rate that can be charged over the life of the loan.
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Types of Residential Mortgage Loans
(continued)
Amortization Type
The amount of the monthly loan payment that represents the repayment of the principal bo
owed is called the amortization.
Traditionally, both FRMs and ARMs are fully amortizing loans.
What this means is that the monthly mortgage payments made by the bo
ower are such that they not only provide the lender with the contractual interest but also are sufficient to completely repay the amount bo
owed when the last monthly mortgage payment is made.
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Types of Residential Mortgage Loans
(continued)
Amortization Type
Fully amortizing fixed-rate loans have a payment that is constant over the life of the loan.
For example, suppose a loan has an original balance of $200,000, a note rate of 7.5%, and a term of 30 years.
Then the monthly mortgage payment would be $1,398.43.
The formula for calculating the monthly mortgage payment is
where MP = monthly mortgage payment ($), MB0 = original mortgage balance ($), i = note rate divided by 12 (in decimal), and n = number of months of the mortgage loan.
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Types of Residential Mortgage Loans
(continued)
Amortization Type
To calculate the remaining mortgage balance at the end of any month, the following formula is used:
where MBt = mortgage balance after t months, MB0 = original mortgage balance ($), i = note rate divided by 12 (in decimal), and n = number of months of the mortgage loan.
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Types of Residential Mortgage Loans
(continued)
Amortization Type
To calculate the portion of the monthly mortgage payment that is the scheduled principal payment for a month, the following formula is used:
where SPt = scheduled principal repayment for month t, MB0 = original mortgage balance ($), i = note rate divided by 12 (in decimal), and n = number of months of the mortgage loan.
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Types of Residential Mortgage Loans
(continued)
Amortization Type
EXAMPLE. Suppose that for month 12 (t = 12), we have MB0 = $200,000; i = XXXXXXXXXX; n = 360, then the scheduled principal repayment for month 12 is:
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Types of Residential Mortgage Loans
(continued)
Credit Guarantees
Mortgage loans can be classified based on whether a credit guarantee associated with the loan is provided by the federal government, a government-sponsored enterprise, or a private entity.
Loans that are backed by agencies of the federal government are refe
ed to under the generic term of government loans and are guaranteed by the full faith and credit of the U.S. government.
The Department of Housing and U
an Development (HUD) oversees two agencies that guarantee government loans.
The first is the Federal Housing Administration (FHA.
The second is the Veterans Administration (VA).
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Types of