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MORTGAGESWEEK 7

What is it?

Mortgage – The charging of real (or personal) property by a debtor, to a creditor as security for a debt (especially incurred by the purchase of property) on the condition that it shall be returned on payment of the debt within a certain period

Investment Value

Two components

Loan to Value

Loan to Value = Mortgage Amount / Appraised Value of Property

Banks typically require 75% LTV

Prevention of sale

Underwater Mortgage

Underwater Mortgages

1 2 3 4 5 6 7 8 9 10 110

20,000

40,000

60,000

80,000

100,000

120,000

Loan Real Estate Value

Components of a Mortgage

Components (APR and Amortization)

Amortized depending on amount borrowed

Typically amortized monthly

Types of Mortgages (and others)

Fixed Rate

ARM

Convertible ARM

Fixed Period ARM

Hybrid Option ARM

Option Arm

Other

BuydownGPM

Fixed Rate Mortgages

Interest rate and your monthly payments remain fixed for the period of the loan

Term is fixed

Example

Adjustable Rate Mortgages

Interest rate / monthly payments change overtime (period of loan)

Changes based on defined index

Index established at application

New Interest Rate

Margin

Why adjustable rate?

Indices

Negatively Amortizing Loans

Different payment structure

Allows for smaller payments

Deferred interest

Contractual limit

Recalculation

Fixed Period ARMs

Same as ARM

Fixed + Adjustable period

After fixed period, adjusts based on index plus margin

Subject to IR cap structure after fixed period

Convertible ARMs

Similar to ARM

Option to convert

Usually charged fee

Beneficial in certain circumstances

Option ARM

No set payment

Begin with initial payment

4 options after (hence the name…)

Buydown Mortgages

Initial discount

Builder or seller

Lowers qualification

GPM

Initial low rate

Gradual increase

Usually 7-12% annually

Until desired rate reached

Structured Products

What is a structured product?

Highly Customized

Returns derived from underlying not issuer’s cash flow

Similar to other derivatives that we have discussed

Types of Securities

ABS – Asset backed securities

CMBS – Commercial mortgage backed security

RMBS – Residential mortgage backed security

MSR – Mortgage servicing rights

Benefits to Structured Products

Diversification

Liquidity

More efficient markets (Lower Mortgage Rates)

U.S. Debt Market

Size of Securitized Products

Securitization

Mortgage

Originator

Investors

Mortgage

Aggregator

Securities

Dealer

Originator

Mortgage originators

Different types of originators

Operational differences

Originator Continued

Banks

Internal aggregation

Risk

Mitigation

Liability Transfer / Legality

Originator Continued

Hedging

Best efforts trade

Smaller originators

Aggregator

What is an aggregator?

Next in line

Close ties with WS

Aggregator Continued

Re-origination

Two Options

Mortgage Backed Securities (MBS) [GSE’s]

Securitize into private label MBS [WS]

Aggregator Continued

Hedging

Timeline of hedging

Entire pipeline

Profiting

Mortgage Fallout

Loans that do not close

Why is this important?

Fallout = Loans that do not close / Total Loans

Fallout Continued

Hedge until mortgage closes

Many loans do not end up closing

Variety of reasons..

Selling into secondary market

Prepayment Risk

Returning principal on loan early

In bundle, accelerates cash flows of MBS

Front-loads the mortgage cash flows (Principal and Interest)

Front Loading of Prepayments

Tranches

Divided into different tranches

Many different ways mortgages can be divided

Interest rate, risk, maturity, etc.

Tranche Division

Risk and Hedging

How are MBS’s hedged?

IR Future

MBS Option

TBAs (Fallout)

Securities Dealers

MBS sold to securities dealer

Most WS firms have a desk for MBS

Dealers wrap and bundle MBS

Eventual outcome…

Mortgage to Security

MSR (Mortgage Servicing Rights)

Servicing Rights

Sold by lender

Usually specializes in servicing

Investors

End users of mortgages

Types of investors

Diverse yields

GSE’s largest portfolio

Investor Breakdown

Refinancing

Replaces older loan with new loan

New payment scheme

Usually involves a penalty fee

Subprime

Low credit ratings (Below 600; 850 FICO is perfect)

Not given conventional loan

Higher IR

Much higher risk

Predatory Lending

Enticing borrower

High fees

High IR

Strips equities

Places borrower in lower credit rating (Charge higher IR)

Foreclosing Strategies

Thank you !