FIN 3334- Lender risk mitigation notes (lesson 4)

Provideborrowerswithmenuofloanoptions 2

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Unformatted text preview: tenance Fees and Defeasance? Practice Problems in Textbook (same for 6th and 7th editions): Review Questions: 6.2 ‐ 6.5, 14.1, 14.2, 14.4 Problems: 6.2, 6.3, 6.5 Lesson 4: How Do Lenders Mitigate their Exposure to Risk? I. Main Objective of Lenders: A. Charge an interest rate that meets or exceeds their ex ante yield on their next best opportunity 1. Provide Borrowers with Menu of Loan Options 2. Allow Borrowers Opportunity to Reveal Private Information B. Review of Three Main Risks of Mortgage Lending 1. Default Risk: 2. Interest‐Rate Risk: 3. Prepayment‐Risk: C. Other Possible Risks: 1. Liquidity Risk: Inability to Quickly Sell the Loan on Secondary Market 2. Legislative or Regulatory Risk: Change in Legal Environment (eg, taxes) II. Default Risk A. Loan Underwriting: Allow “Good” Types of Borrowers to Reveal Themselves 1. Costly to Obtain Information: Invest if Benefits > Costs a) Conforming Loans: Eligible for Purchase by GSEs (i) Determined by 3 C’s of Underwriting (see below) (ii) Loan Size Also Needs to be Less than $416,000 (otherwise called Jumbo) b) Subprime Loan: Borrowers with Poor Credit History c) Alt‐A Loans: Borrowers with Strong Credit, but (i) Purposely: Choose Riskier Loan Terms and Structure (ii) Examples: Low or No Downpayment, Choose Not to Reveal Income 2. Three Main C’s of Underwriting Considerations of Mortgage Loans a) Capacity (Payment‐ or Debt‐to‐Income Ratio): Ability to Repay (i) Housing Expense Ratio...
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