REAL 5100 Test 2 Study Guide

Why do borrowers struggle with mortgage decisions?

Borrower Confusion, Low financial literacy, borrowers are myopic (don't think about the future)

Borrower Confusion

struggle to understand key mortgage terms and features, leading to costly mistakes

Less financially sophisticated individuals pay more or less for their mortgage

more

The rate gap (sophisticated vs unsophisticated) does not change when shopping. t/f

True

Borrowers dont pay enough for rate reduction relative to actual holding period. t/f

False

Mortgage Decisions as investment decisions

Treat as investment, compare cash flows, Consider opportunity cost

What borrowers know

Interest rates, loan term length, loan amount

What borrowers miss

Rate caps & limits, index mechanics, payment change scenarios

Main Research Finding

Points prove to be a negative NPV investment on average

Most people do not

shop around

Shopping

Lowers rates for everyone

Treat as investment decision

mortgage decisions are investment decisions, not just loans

compare cash flows

analyze actual dollar amounts, not marketing slogans

Consider Opportunity costs

What else could you do with that money

Benefits of a shorter loan term

builds equity quickly, reduces total interest

Cons of a shorter term to consider

cash is tied up, limits other opportunities

Which loan length does Dave Ramsey prefer?

15-year

IBC answers the question:

What is the true cost of borrowing a little more money?

Refinancing

Pay off current loan with a new loan

Why refinance

access cash (cash out refi), contractual requirements, lower rate (rate-term refi)

Why is the break even rule incomplete?

1. Compares costs to expected savings now

2. ignores value of waiting for better opportunities

3. recommends refinancing too early

4. Can lead to large economic losses

Below Market Financing (Assumable Loans)

When a buyer takes over a sellers existing mortgage at favorable terms

Why would a seller benefit from a below market loan?

They can command a higher selling price

Why would a buyer benefit from a below market loan?

They pay a higher price for lower rates

Call

Prepayment

Put

Default

Rates fall-->

refinance

Rates rise-->

keep loan

Prepayment as a call option

Borrower can repay early, Typically exercised when interest rates fall (refinancing)

Economic implications of prepayment

• Creates prepayment risk for lenders

• Creates reinvestment risk when rates fall

Determinants of Option Value

fixed rate mortgages and higher interest rate volatility

Lender Responses to interest rate risk

interest rate swaps

interest rate swaps

1. Derivative contracts the offset when rates rise

2. Functions like insurance

Limitations to interest rate swaps

hedging is not free, does not hedge refinancing option

Ways lenders can mitigate prepayment risk

reducing embedded call option value

Reducing prepayment risk

Lockout Clauses, fixed ppp, variable ppp, YMF, defeasance

Fixed prepayment penalty

fixed % of RMB for specified period, reduces refi incentive, may over or under penalize, relies on market conditions

Lock-out clauses

restrict prepayment for specified period

PPP

price the borrower's right to refinance

Lock out clauses are common in

commercial real estate loans

YMF (Yield Maintenance Fee)

can nearly neutralize call option, penalty is tied to current rates, adjusts with rate movements

Loan Defeasance

1. Borrower buys treasury securities

2. securities replicate remaining loan cash flows

3. given to lender, mortgage released

Economic effect of loan defeasance

Completely eliminates lender's call risk--same cash flows received, collateral quality increases (treasuries), Expensive type of PPP

Why borrowers do loan defeasance

1. sell property before loan maturity

2. refinance or rebalance portfolio

3. cost may be small if little time remains

Put option interpretation

Borrower can effectively "sell" property to lender by defaulting

triggers of default

liquidity shocks, negative equity, double trigger theory,

Liquidity Shocks

Sudden demand for cash affecting financial stability.

negative equity

when the value of an asset falls below what is owed on it

double trigger theory

negative equity and liquidity shock necessary for default

Simple economic model predictions

1. deeper negative equity-->stronger incentive to default

2. positive equity--> sell don't default

3. deep underwater--> very high default rates

Evidence that deeper negative equity--> stronger incentive to default

-Strong support across many data sets

-Higher LTV ratios consistently predict higher default probability

Evidence that positive equity--> sell don't default

many borrowers still default and foreclose (puzzling)

evidence that deep underwater--> very high default rates

many deeply underwater buyers continue to pay

limitations of the one-period model

Liquidity shocks missing, timing value of option, own vs. rent dynamics

Important determinants of default (and option value)

-negative equity

-liquidity constraints

-option timing value

-property price volatility

-mortgage payment vs. rent

Mortgage Contract Rate

Stated interest rate in a loan agreement

Contractual Yield/YTM

Accounts for fees; assumes held to maturity

Realized Return (ex-post)

Depends on whether and when default occurs

Expected Return (ex-ante)

probability-weighted average; what lender prices at origination

Default Risk: Key Pricing Inputs

Probability of Default, Recovery rate, Loss Given Default

Probability of Default

Likelihood borrower stops paying

Recovery Rate

Fraction recovered if default occurs

Loss given default (LGD)

=1-recovery rate

Why does timing of default matter?

1. Reduces expected return

2. increases return volatility

3. Shortens payment duration

How do lenders price loans?

1. The lender compares expected return on the mortgage vs. required return (opportunity cost of capital)

2. If expected return is lower than the required return, the lender must charge a higher contract rate.

Charging higher rates may increase default risk. T/F

True

Adverse Selection

1. Rate increase

2. Safer borrowers exit

3. Riskier pool remains

4. Default risk escalates

Central question in commercial underwriting

How large of a loan will a rational lender make on the property?

To answer that central question, we need to estimate

1. property value (LTV constraint)

2. property cash flow (income constraints)

GIM Multiplier

Value=GIM x PGI

True or False: Recourse for a lender reduces the value of the put option for the mortgage borrow

True

Which is more important on commercial mortgage underwriting: the borrower or the property.

The property

True or false: The BTCF is also known as the property's dividend.

False

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