Real Estate Investments Midterm 2

FIN 309

Adjustable-Rate Mortgage (ARM)

• A mortgage where the interest rate adjusts periodically based on changes in an observable index (in contract)

• The lender liked this option because as the bank’s average deposit cost rose so did the interest rate the lender received on the ______ loans.

  • _____ helped in managing the bank’s Net Interest Margin

Net Interest Margin (NIM)

Interest Income (rate|lend) - Interest paid to Depositors (rate|borrow)

Index

Rate series used to determine the base interest rate on the loan

Margin

spread added to index in determining the mortgage interest rate (usually expressed in basis points).

Fully Indexed Rate (FIR)

index + margin

Initial Rate

The rate on the mortgage before the 1st Reset date. This rate is usually below the Fully Indexed Rate (often called Teaser Rate)

Initial Reset Date

The 1st date that the loan resets to the index + the margin.

Reset Frequency

How often the mortgage resets. Typical reset periods are: Annually, Monthly

Initial Rate Cap

The highest change in interest rate from the initial rate to the new rate on the 1st rate reset date.

Periodic Rate Cap

The highest change reset dates not including the first reset

Life Rate Cap

The maximum increase that the loan can reset to relative to the initial rate during the life of the loan.

1 Year CMT (Constant Maturity Treasury)

most common index in US.

• It tracks the average yield on all US treasury securities that mature in 1 years time.

• It provides a good indication of the 1 year cost of borrowing

Other Indexes

• LIBOR

• COFI, the Cost of Funds Index (like Libor for local regions).

• Other CMT indices such as the 3yr CMT, 5yr CMT or 10yr CMT

A/B ARM

The first reset of the mortgage is A years from the origination date and it will reset every B years after that.

1/1 ARM

The first reset of the mortgage is 1 year from the origination date, and it will reset annually after that

3/1 ARM

The first reset of the mortgage is 3 years from the origination date, and it will reset annually after that.

3/3 ARM

The first reset of the mortgage is 3 years from the origination date, and it will reset every 3 years after that.

Fixed Rate

Hybrid ARM’s have a _____ for the first several years

ARM Mechanics

• The standard ARM has a 30-year amortization.

• After the initial period, most ARMs reset annually

• When calculating monthly mortgage payments with an ARM you must recast the loan every time the loan rate changes

Recasting

• The mortgage is re-amortized to reflect its current balance, new rate, and the same final maturity

• result we find provides a new mortgage payment for each month during the next period

True APR for ARM

is the IRR for the borrower assuming the index rate stays the same for the term of the mortgage

Option AMR

• Allows the borrower to reduce the initial loan payment below the fully amortizing level. The borrower can choose from a variety of payments specified in the contract.

• The PMT of the borrower may be interest only or less (Negative Amortization).

What the borrower does not pay in interest during this period is added to the loan balance

*** These ARMs are often created with very low initial rates.

Rate Caps

they provide to the borrower protection when interest rates are rising rapidly

Caps

The _____ are typically expressed like X/Y/Z (e.g. 2/2/5)

Initial Cap

Refers to what happens at the 1st reset date. The mortgage rate cannot increase more than 2.00% above the initial interest rate.

Periodic Cap

On every subsequent reset date the rate cannot increase more than 2.00% above the last rate on the mortgage.

Life Cap

The highest mortgage rate can ever increase to is 5.00% above the initial mortgage rate.

Key Step in How to Determine the Mortgage Rate (When Caps are Included)

Index + Margin </= Last Mortgagerate + Periodic Cap

Mortgage Refinance (ReFi)

• when a borrower replaces an existing mortgage with a new one, using the new borrowed loan to pay off existing balance.

• ______ typically requires the borrower pay new closing costs & fees.

• FRMs with lower rates have lower balances before maturity.

Why would you refinance?

• Borrowing Rate Declines

• Credit Improvement

• Cash Out (extract equity)

  • Choose to get out equity value of the property by increasing the principal amount borrowed

Costs of Refinancing

• Bank Fees, Appraisals, Filing Fees, Points, Etc.

• Prepayment penalties may exist.

• Past points and fees paid are sunk costs. At the time a borrower is considering whether to refinance past costs are irrelevant, only current and future costs are relevant.

Benefits of Refinance

lower interest rate & higher loan amount (if cash out)

NAHB

Home buyers remain in their purchased home around 12 years

Locked in Real Estate Value

Even if home values do not change, homeowners accumulate over time wealth

Cashout ReFi

Refinance the mortgage and ”transform” the accumulated wealth into cash for other investments (e.g. medical bills, college expenses etc.)

Loan Officer (Mortgage Broker)

Sells the loan

Loan Underwriter

assesses the loan

Loan Servicer

collects payment from the borrower, remits to lender, taxes and insurance into escrow account etc. Collect late fees

Loan Underwriting

• lender evaluates the eligibility of borrower to receive a loan.

• The underwriter assesses the risk of loss from borrower, considering the loan application and the appraisal

The Underwriter needs to assess the borrowers future:

• Ability to Pay

• Willingness to Pay

The borrower’s ability (ATP) to pay changes

Results from a change in income of borrower

The borrower’s willingness to pay (WTP) depends on the house value over the mortgage balance .

If House Value < Mortgage balance the borrower cannot sell house for more than he owes

Credit

• credit report

• FICO score 300-850

• A snapshot of risk that shows the credit history of the borrower.

• Ranges from 300 –850 (for consumers).

• Measures the borrowers’ WTP for their debt.

• Measures likelihood of being 60 - 90 days late on a payment.

• Main FICO Score providers: Experian, Transunion, Equifax.

Capacity

• ability to make payments

• Employment history, paystubs, bank statements etc. 

• PTI, TDR, (PITIM: Principal + Interest + Taxes + Insurance + Maintenance)

• Reserve Requirement

Collateral

• ______ value in case of default (WTP)

• Appraisal report

• LTV requirement, if LTV>80% need Private Mortgage Insurance (PMI)

Underwriters use the three C’s to determine:

• if you can be approved for a loan

• Loan terms (rate, points, max LTV etc.)

Breakdown of Credit FICO Score

35% - Payment history

30% - Credit Utilization – credit usage/credit availability ratio

15% -Length of credit history

10% -Types of credit used

10% -Recent Credit searches

PTI (Payment to Income)

(Front-End DTI) The ratio of the borrowers’ monthly RE-related payments, including the mortgage payment, property taxes, mortgage insurance and property insurance, homeowner association fees (HOA), to their gross monthly income.

TDR (Total Debt Ratio)

(Back-End DTI) Ratio of total debt payments (mortgage payments, car loans, credit card loans, student loans etc.) to their gross monthly income

LTV (Collateral)

• ratio of loan to value of the property.

• Higher LTV corresponds to higher probability of negative equity & default.

• Also, higher LTV leads to higher severity ratio for the lender

Documentation Quality [Underwriting Guidelines]

• Full Documentation

• Limited Documentation (Alt A)

• No Documentation

Type of Residency [Underwriting Guidelines]

• Primary Residence

• Secondary home

• Investment property

Type of Mortgage [Underwriting Guidelines]

• Purchase

• Refinance

Loan [Underwriting Guidelines]

• Conforming

• Jumbo

Who bear the risk of default of the borrower: Borrower, Lender, or Mortgage Insurer?

The Lender

Private Mortgage Insurance (PMI)

Premium between 30bps to 120bps of the mortgage’s principal amount

Government Insurance (FN or FH)

• If a mortgage is guaranteed by Government Insurance, then lender is protected from principal’s loss

• g-fee around 50 – 60 basis points (included in borrowing rate and goes to insurers to generate reserves for losses in the future)

Conventional (Conforming Mortgages)

• FNMA/FHLMC insured (FN/FH)

• Good FICO, low PTI, low LTV

• Backed by Government Sponsored Enterprises (GSEs).

• Regulated by Federal Housing Finance Authority (FHFA, est. 2008)

• If certain underwriting criteria (industry standard) are met, then the lender can pay g-fee to GSE and transfer the risk of loss from lender to the GSE.

• If the mortgage is pooled and sold to investors the guarantee gets transferred as well.

• Provide (generally) the lowest cost of borrowing

Government Mortgages

• FHA/VA insured (securitized by GNMA)

• Riskier (lower FICO, higher PTI, higher LTV). Usually a smaller mortgage

Jumbo Mortgages (Non-Conforming)

Above conforming limit (usually good credit)

Subprime Mortgages

Risky. Low FICO (Lower than 620)

Evidence for Lax Screening

• Check paper: “Did Securitization Lead to Lax Screening? Evidence from Subprime Loans”, published at QJE 2010

• FICO <620 loans are more difficult to securitize than FICO> 620 loans

  • Not all 620 FICO loans have the same risk

• Research Question: Careless screening for some 𝐹𝐼𝐶𝑂 > 620 loan borrowers?

• Identification Strategy: FICO 621 is very similar risk to 619, however it is much more likely to get approved

• Evidence: An easier to securitize portfolio of loans got defaulted 10%-25% more than a similar risk profile group. Evidence of lax screening