of Chapter11
Sources Funds
for Residential Mortgages
McGrawHill/Irwin
Copyright2010byTheMcGrawHillCompanies,Inc.Allrightsreserved.
MortgagesandMortgageMarkets
11-2
TraditionalandModernHousingFinance
11-3
TraditionalandModernHousingFinance
11-4
Thrifts
Formerly backbone of mortgage finance
Dominated mortgage lending
Extremely localized
Fatal flaw: Funded long-term loans with
short-term savings
11-5
Thrifts(continued)
Flood of home loans in late 1970s - all fixed rate
Interest rates soared in war on inflation
Wide freedoms in 1980s starting with DIDMCA
Asset-liability mismatch severely damaged thrifts
Almost one-third failed
70% had disappeared by 2001
Collateral damage to elected officials, regulators,
taxpayers
Market share of home loans plummeted (1970s: over
50%, 2008: <10%)
11-6
CommercialBanks
Historically: Real estate needs of business
clients
Business-related real estate loans
Home loans
Personal investments
Assumed former roles of savings associations
Large-scale construction lending
11-7
CommercialBanks(continued)
Warehouse credit lines for mortgage bankers
Effects of bank deregulation
Enormous consolidation of the industry
Aggressive pursuit of real estate lending
Directly
Through mortgage banking subsidiaries
New powers to reenter real estate investment and
development
11-8
PortfolioandNonportfolioMortgage
Lenders
Portfolio Lenders (depository institutions)
Banks
Thrifts
Large credit unions
Non-portfolio lenders
Mortgage bankers
Mortgage brokers
May include credit unions and small banks
11-9
NonPortfolioLenders:MortgageCompanies
Mortgage banker: Not a bank accepts no
deposits
Originates loans to sell
Retains right to service the loan for a fee
Mortgage broker: Brings borrower and lender
together for a fee; never owns the loan
11-10
MortgageBanker
Originates and owns loans long enough to sell
Sell loans whole
Pool and securitize loans
Servicing is core profit center
Three-step process:
1. Issue mortgage commitment to potential
borrower
2. Close or originate loan (funding loan)
3. Sell loan
11-11
MortgageBankerasServicer
Collects monthly payments, remits to investor
Collects and remits payments for property taxes,
hazard insurance and mortgage insurance
Manages late payments, defaults, foreclosures
Receives fee of .25% to .44% (25 to 44 bps)
May accept loss at origination of a loan to obtain
servicing rights
11-12
PipelineRisk:SignatureRiskofMortgage
Banking
Pipeline risk: Risk between loan commitment
and loan sale
Two components
Fallout risk: Risk that loan applicant backs out
Interest rate/price risk: Risk that closed loans will fall in
value before sold
Mortgage bankers highly leveraged
Very sensitive to pipeline risk
Hedging necessary for survival
11-13
ManagementToolsforPipelineRisk
11-14
ThreeMortgageBankingPipelineRisk
Situations
11-15
EmergenceofMegamortgageBankers
Megabanks saw home mortgage lending as
profit center
Cyberelectronics imply huge economies
of scale
Four modes of operation:
Traditional face-to-face or retail lending
Wholesale mortgage banking
Internet lending
Lending through brokers
Tremendous consolidation in last decade
11-16
ConsolidationoftheTop20HomeMortgage
Lenders
11-17
MortgageBrokers
Places borrowers loan application with lender
Receives application fee
Receives part of lenders origination fee
Never owns and never services loan
Rapidly growing aspect of industry
Causes for concern about mortgage brokerage:
Front-loaded compensation
Few repeat customers
Low competency requirements
Wide-spread borrower abuse in recent years
11-18
EvolutionoftheSecondaryMortgageMarket
Pre-1970: Limited and informal
Lack of standardization a barrier
Large interregional differences in home
mortgage interest rates (100-200 bps)
Rising interest rates could shut down home
mortgage lending through disintermediation
11-19
BeginningoftheModernSecondary
MortgageMarket
Fannie Mae (1968): Spun off from HUD to
become a primary purchaser of FHA and VA
mortgage loans
Ginnie Mae (1968): Empowered to guarantee
pass-through mortgage-backed securities
based on FHA and VA loans
Freddie Mac (1970): Formed to purchase and
securitize conventional home loans from thrifts
11-20
MortgageBackedSecurities
Multiple mortgage loans in a single pool or fund
Security entitles investor to pro rata share of all
cash flows
Loans in a given pool will be similar:
FHA/VA; conventional
Same vintage (new or recent loans)
Similar interest rates
Nearly two-thirds of all new home loans have
been securitized in recent years
11-21
TheGinnieMaeMortgageBackedSecurity
Process
11-22
TheGrowthofHomeMortgage
Securitization
11-23
RoleofGinnieMaeintheSecondary
MortgageMarket
GNMA created first major pass-through MBS
program
Does not buy mortgages
Guarantees timely payment of interest and principal to
holders of GNMA securities.
Guarantees only securities based on FHA/VA loans
11-24
FannieMae
Original mission: Secondary market for FHA/VA
Became privately owned but still U.S. chartered
Public mission for housing
U.S. Treasury financial credit line available
Surpasses Mac Freddie in buying conventional
loans
Funded through both debt issues and mortgage
securitization
Has securitized and sold, or owns, about 23% of
outstanding home loans
Taken into conservatorship by U.S. in 2008
11-25
FreddieMac
Chartered by Congress
Deals exclusively in conventional loans
Securitized all loans purchased until recent years
Financially similar to Fannie Mae
Has securitized and sold, or owns, about 15% of
outstanding home loans
Taken into conservatorship by U.S. in 2008
11-26
ImportanceofFannieMaeandFreddieMac
Have brought about standardization in:
Mortgages and mortgage notes
Appraisal forms and practices
Underwriting procedures and standards
Also, influence practices and standards in nonconforming
mortgage markets
Have increased liquidity of mortgage markets
No interstate differentials in mortgage interest rates
No home lending disruptions when interest rates rise
New sources of mortgage funds in security investors
11-27
ImportanceofFannieMaeandFreddieMac
(continued)
Type of loans that GSEs buy heavily influences
what loans most lenders will make
Recent accusations against GSEs:
Too much influence on mortgage markets
Unfair competition due to their federal financial
backstops
Exceeding boundaries of their charters
Bearing too much undisclosed risk
11-28
PrivatemortgageConduits
Grew out of the market for non-conforming
Jumbo loans
Small market share until sub-primes emerged
Grew explosively post-2000, mainly for subprimes
Diminishing rapidly as sub-prime diminish
Likely to continue as a conduit for Jumbos
11-29
OtherSecondaryMarketPlayers
Federal Home Loan Banks
Originally the banking system for thrifts
Now a banking system for small banks and thrifts
Provide loans, called advances, to fund home
mortgage lending
U.S. Government agencies to support rural
housing
Farm Credit System
Federal Ag. Mortgage Corp. (Farmer Mac)
Rural Housing Services
11-30
TheU.S.HomeMortgageSystemToday
FourChannels
Local depository lending (very limited)
FHA/VA GNMA securitization process
Conforming conventional GSE process
Non-conforming conventional private security
process
11-31
MarketSharesoftheFourChannelsof
HomeMortgageLending
11-32
WhereDoYouGetaMortgageLoanin
TodaysComplexSystem?
No simple answer, except to shop aggressively
Portfolio lenders may offer cost and interest rate
advantage
Brokers may offer service and down payment
advantage
Depository lenders may have best ARM offers
Non-depositories may have best fixed-rate offers
SHOP!
11-33
LendersUnderwritingDecisions
Underwriting: Process of determining whether
the risks of a loan are acceptable
Three Cs of traditional underwriting:
Collateral: URAR appraisal
Creditworthiness: Credit report
Capacity: Ability to pay (payment ratios)
11-34
TraditionalPaymentRatiosforMortgage
Underwriting
Housing expense ratio = PITI/GMI
PITI is principal, interest, (property) taxes and
insurance
GMI is gross monthly income
Recent convention set maximum at:
28% for conventional loans
29% for FHA
Known as front-end ratio
11-35
TraditionalPaymentRatiosforMortgage
Underwriting
Total debt ratio = (PITI + LTO) GMI
LTO is long-term obligation
Recent convention set maximum at:
36% for conventional loans
43% for FHA
Known as back-end ratio
Note: GMI is critical. Its computation is closely
regulated by ECOA
11-36
ModernHomeLoanUnderwriting
Automated underwriting is dominant
Creation of single statistical score
URAR appraisal yields to automated valuation in
most cases
Credit report displaced by credit score
Single underwriting index incorporates: house
value, credit score, income and obligation data
Automated underwriting superior to traditional
methods
Remaining issue: How important is a cash down
payment requirement?
11-37
RecentUnderwritingFailures
News of fraud and extensive defaults have been
widely reported
Problems were not due to the procedures and
standards described above, but due to the
failure to use them:
Half of sub-prime loans had limited documentation
Most of Alt-A loans had limited or no documentation
(Came to be called liar loans)
Private securitization firms widely suppressed loan
underwriting
11-38
AffordableHousingPrograms
GSEs bought an array of affordable home loans
Vary by allowing override of one of traditional
underwriting guidelines:
House value
Credit score
Payment ratio
Targeted to different underwriting deficiencies
11-39
AffordableHousingPrograms(continued)
Programs are enabled by:
Automated underwriting
Accumulated knowledge base on affordable lending
GSE default rates on affordable loans
comparatively good.
11-40
SubprimeLending
Many households unable to qualify for affordable
home loans
Subprime originally targeted three borrower
deficiencies:
Lack of income documentation
Weak credit
Seeking financing for 100% LTV or higher
11-41
SubprimeLending(continued)
More expensive than standard home loans
Polar views of subprime lending:
Fills compelling, legitimate need (beats credit cards)
Hunting ground of predatory lenders
In any case, spun out of control, and to disaster
11-42
End of Chapter 11