1-1. Mortgage: A loan secured by property
- primary market (mortgage market) until 1970
- secondary market: mortgage-backed security (MBS), pass-through security
1-2. Lien Status: seniority in the event of foreclosure
- firs-lien status: mortgage lender
- second-lien status: less than 80% ownership
1-3. Original Loan Term: 30-year, 15-year, balloon payments option
1-4. Interest-Rate Type
- Fixed-Rate Mortgages
- Adjustable-Rate Mortgages (ARMs)
- Hybrid ARMs
1-5. Credit Guarantees
- Government Sponsored Entities (GSEs)
- Federal Housing Administration (FHA)
- Department of Veterans Affairs (VA)
1-6. Loan Balance
- Underwriting standards are primarily concerned with the maximum LTV (loan-to-value) ratio, payment-to-income ratio, & loan amount
- Nonconforming mortgage loans: agency securities that fail to meet the agency's underwriting standards
- Jumbo loans: balances larger than the conforming limits
1-7. Borrower Type
- Traditional borrowers: high credit scores & stable incomes
- Subprime borrowers: impaired credit
- Alternative A (Alt-A) borrowers: those who have decent credit, but unstable income levels. they do not provide the same level of documentation as traditional borrowers
1-8. Major Players in the Mortgage Industry
- Direct lender: underwriters who fund the loans; work with loan brokers through wholesale channel or work with borrowers through retail channel
- Depository institutions: using deposits to support loan practices <--> notdepository institutions who selling the loans to investors in the secondary mortgage market
- Originators underwrite & support loan production. They usually lends for a short-period time and unlimately ends up selling the loans to large banks
1-9. Loan Underwriting Process
i. evaluating of a borrower's creditworthiness
- credit score: FICO score (over 660 = prime credit)
- LTV (loan-to-value ratio):
LTV = Current Mortgage Amount / Current Appraised Value
**the lower LTV ratio, the more comfortable the mortgage lender is in making the loan
- income ratios: level of a borrower's income level compared to the total size of the mortgage payment; Front ratios & Back ratios
- documentation: inc. income, employment, & tax return; in the event of no or little documentation -> borrowers may not be denied credit, but the mortgage rate assigned will reflect the riskiness of the loan
**Front ratios: total monthly payments / monthly income on a pre-tax basis
**Back ratios: total loan payments inc. other borrower loans
2-1. Level payment mortgage
r = monthly interest rate
T = loan term (in months)
B(n) = original loan balance
***mortgage payment factor
**Monthly Payment Formula
- payments allocated more heavily to interest in the initial stages of the loan (fixed-rate loan)- over time, the loan balance is declining -> more of payment goes toward principal
2-2. ARM Payments
3. Mortgage & MBS Risks
3-1. Risk-Based Pricing
- separation of subprime borrowers from prime borrowers
- nontraditional borrowers: low FICO scores, riskier characteristics
3-2. Prepayment Risk
- payment in excess of the required payment or payment of the entire loan
- curtailments: prepayments for less than the outstanding principal balance
- prepayements or curtailments reduce the amount of interest the lender receives over the life of the loan.
*prepayment penalties not allowed for residential mortgage
Prepayments occur for the following reasons:
- The sale of the property
- The destruction of the property by fire or other disaster
- A default on the part of the borrower
- Curtailments
- Refinancing
3-3. Mortgage Pass-Through Securities
- a claim against a pool of mortgages (securitized mortgage)
- mortgates in the pool have different maturities & rates
- WAM (weighted average maturity) = weighted average of all the mortgages in the pool
- WAC (weighted average coupon) = weighted average of the mortgage rates in the pool
- pass-through rates: less than the average coupon rate of the underlying mortgages
**invetment characteristics: a function of cash flow featrues & strength of government guarantee
- liquid securities (through securitization)
- more than one class of pass-through securities my be issued against a single mortgage pool
- timing difference between the time the mortgage service provider receives the mortgage payments and the time the cash flows are passed through ot the security holders
3-4. Measruing Prepayments Speeds
Prepayments cause the timing & amount of cash flows from the mortage pool and MBS to be uncertain. The prepayment behavior is not constant over the life of a loan; unlikely to prepay immediately after the loan, but the propensity to prepay increases over time.
3-4-1. SMM & CPR
- single monthly mortality (SMM) measures the monthly principal prepayments on a mortage portfolio as a percentage of the balance at the beginning of the month in question
- conditional prepayment rate (CPR): most common metric used to describe prepayments. CPR increases at a constant and predetermined rate (ramp)
CPR = 1 - (1 - SMM)^12
3-4-2. PSA Model
The most common model for measuring prepayments in a ramping framework
*PSA(public security association -> bond market association)
- base PSA Model (100% of the model or 100% PSA)
- assumption: prepayments begin at a rate of 0.2% CPR in the first month, increase at a rate of 0.2% CPR per month until they reach 6.0% CPR in month 30, and remain at 6% CPR for the remaining term of the loan.
* 200% PSA: speeds double that of the base PSA model
- PSA model depends on the age of the loan or on the weighted-average loan age
e.g.) 4.0% CPR in month 20
=> 4.0% = 20 (0.2%) PCA -> 100% PCA
e.g.) 25th months CPR & SMM for 150% PSA
=> CPR(month 25) = 25 x 0.2% = 5%
150% PSA = 1.5 x 5% = 7.5%
SMM = 1 - (1 - 7.5%)^(1/12) = 0.6476%
**nonlinear relationship between CPR and SMM
***PSA standard benchmark is nothing more than a market convention. It is not a model for predicting prepayment rates for MBS. Empirical studies have shown that actual CPRs differ substantially from those assumed by the PSA bench mark
3-5. Credit Risk
Senior classes of private-label securities rated AAA because of credit guarantees from GNMA or GSEs, however, the analysis of mortgage credit is important for the following reasons:
- assessment of the credit quality of portfolio holdings & the adequacy of loss reserve level (lenders)
- evaluation of potential loss-adjusted returns (buyers of subordinated securities)
- an uderstanding of trends in mortgage lending and credit quality
3-6. Posteriori Evaluation of a Mortgage Pool
i. Stratifictions of Weighted-average credit scores & LTV ratios along with documentation style & geographic concentration
ii. Delinquencies measures
- percentage of the pool that is paying on time in relation to those who are delaying payments
- OTS (Office of Thrift Supervision) method: current (- 30 days) and 30/60/90+ days delinquent
iii. Default measures
- defaults quantified
CDR (conditional default rate): annualized value of the unpaid principal balance of newly defaulted loans over the course of a month as a percentage of the total unpaid balance of the pool at the beginning of the month
CDX (cummulative default rate): proportion of the total face value of loans in the pool that have gone into default as a percentage of the totoal face value of the pool
iv. Severity
- face value of the losses on a loan after the foreclosure process is completed and the property is disposed of
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