Guest lecture on Residential Mortgage Finance

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  • 1. Residential Mortgage Finance: Products, Markets, Risk Assessment, Pricing, and Securitization Andrew Widman SVP, Enterprise Risk Management Countrywide Financial Corporation
  • 2. A foreword on the significance of housing finance
    • Housing is a basic human necessity and a critical component of every economy in all parts of the world
    • Home ownership builds social stability, serves as a store of value, and provides a source of income
    • Along with governmental, monetary, and property rights stability, a reliable system of housing finance is argued by some as a major aid to sustainable economic development
    • The US model with long-term financing and broad accessibility is a luxury not available in many countries
    • This document and today’s discussion reflect my views alone and not those of Countrywide Financial
  • 3. About Countrywide Financial, NYSE Ticker = CFC
    • Key Facts:
    • Mortgage-centered, diversified financial services company with rapid business growth during the 2000s, especially in non-traditional loans
      • Growth in PayOption and Sub Prime mortgages – more on these later
    • Servicer of nearly $1.5 Trillion in mortgage assets
      • Payment processing for 1 in 8 loans – #2 industry wide
    • Set to be acquired by Bank of America following precipitous 80+% decline in market value during 2007
      • http:// finance.yahoo.com/q/bc?s = CFC&t =2y&l= on&z = m&q = l&c =
      • January announcement with July consummation target
        • 100% stock transaction priced at 0.1822 shares of BAC per share of CFC
    • What’s the implication of CFC’s current stock price compared to the deal-implied price?
  • 4. What’s your favorite angle on the real estate debacle?
    • Toxicity?
    • http:// www.google.com/search?hl = en&q = toxic+mortgage
    • Victims and predators?
    • http:// www.google.com/search?hl = en&q = mortgage+predators+and+victims
    • Industry doomsayers?
    • http://ml- implode.com /
    • Cash infusions?
    • http://www.google.com/search?hl=en&q=mortgage+cash+infusion
    Humor? (warning: explicit!)
  • 5. Agenda
    • US residential real estate finance market
      • Real estate as an investment asset
      • Home financing basics and loan instruments
      • Primary and secondary markets, loan origination and disposition
    • Risk assessment and loan pricing
      • Default, loss severity, and prepayment risks
      • Option-embedded fixed income valuation
    • Mortgage securitization
      • Rationale, relation to other assets
      • GSEs, other credit enhancement, rating agencies,
      • Structures and issuer/investor considerations
  • 6. Residential real estate from an in investment perspective
    • Home ownership is encouraged by our government
      • Tax advantages on interest costs and capital gains
      • Post-depression “agencies” were created to bear risk
    • Provides diversification benefits as an asset class
      • Imperfect correlation improves risk-adjusted portfolio returns
      • But for many, real estate concentration is arguably too high
        • Mean/variance optimization would allocate a lower amount
    • Highly leveraged financing is now the norm
      • 10% house price change on 10% down = 100% return
        • Actual return depends on treatment of borrowing costs/expenses
        • Like buying stock on margin – without the margin call
    • Liquidity can be poor and markets inefficient
      • Thin markets, few transactions, no natural short position
      • Limited availability of hedges – note recent rise of CME futures
  • 7. House prices and the early 2000s experience
    • In the early 2000s, house prices offset losses in equities as cheap credit, investor interest, and loose underwriting standards prevailed
    • For most homeowners, their gains were unrealized
  • 8. House prices and the late 90s experience
    • In the mid-late 90s, housing stagnated as equities tripled
    • Assuming you were omniscient and bought at the bottoms and sold at the end, where did you make your best returns – S&P during the 1990s or on a house in DC in the 2000s?
  • 9. House prices and future prognostications
    • Economists across the board are bearish on housing activity and prices in the near-to-mid term
    • Few are as negative as Mark Zandi of Moody’s Economy.com
  • 10. Residential mortgage basics in the US
    • A residential mortgage is a long-term loan used to finance a home which serves as collateral
    • Traditionally, repayment is made through level monthly installments comprising both interest and principal
    • Until the recent housing boom, the most common loan was a fixed rate, 30-year, level-pay, fully amortizing mortgage
    • Useful Excel function for monthly, level, amortizing payment:
      • = pmt(rate/12, #months, loan amount)
      • = pmt(6%/12, 360, $250,000) = $1,499
    • In this example, a $250k loan at a fixed rate of 6% has a monthly payment of $1,499 and will be paid off after 30 years
  • 11. Time profile of a $250k, fixed rate 30-year mortgage at 6%
    • Interest due dominates the early payments as it takes more than 20 years to cut the balance in half
      • Most borrowers will have long since pre-paid by then
      • Average holding period for a fixed rate 30-year mortgage < 7yrs
  • 12. Non-traditional features grew during the boom in home prices
    • Down payment
      • Traditionally 20% covered by borrower funds and/or mortgage insurance
      • Increasingly secondary financing (aka piggyback lending) up to 100%
    • Income and asset documentation
      • Traditionally full verification of employment and financial assets
      • Increasingly no-income-no-asset (NINA)
    • Amortization features
      • Traditionally fully amortizing until maturity
      • Increasingly initial interest-only or negative amortization periods
    • Term to maturity
      • Traditionally 15 or 30 years – increasingly up to 40 years
    • Interest rate variability
      • Traditionally fixed – increasingly adjustable with teasers and resets
    • Prepayment option
      • Traditionally permissible to prepay the remaining balance any time
      • Increasingly penalized for early payment in exchange for “better” terms
  • 13. Adjustable rate mortgages (ARMs) allow lower initial payments
    • Common products: 1-yr, 3/1-yr, 5/1-yr, 7/1-yr, 10/1-yr
      • Loans with fixed periods >1yr commonly called “hybrid” ARMs
      • Rate typically offered at a discount to the 30-year fixed rate
        • Discount amount depends on shape of the yield curve
        • With a flat yield curve, the rate benefit is minimal
      • Interest rate and payment are fixed for the initial period
      • Rate reset is based on a reference rate plus a margin constrained by maximum periodic adjustment and ceiling
      • For example, a borrower with good credit and 20% down could get a 5/1-yr ARM with following terms as of April 2008
        • Initial rate: 5.75%
        • Margin over 1-yr constant maturity treasury: 2.75%
        • Maximum lifetime adjustment: 5.00%
      • The same lender offers a 30-year fixed rate loan at 5.875%
        • Are the borrower’s savings worth the added risk?
  • 14. Other popular loans with lower initial payments
    • Interest-only (IO) mortgages
      • Easy to think of as an add-on feature to ARMs
        • Increasingly popular feature now attached to >50% of new ARMs
        • The initial period specifies a fixed payment with no principal
        • At reset, the rate adjusts and an amortizing payment is required
        • If held to reset the new payment may rise by 30% or more
    • Negatively amortizing mortgages
      • Marketed as PayOptions, OptionARMs, and Pick-a-Payments
        • A low payment is permitted which causes the loan balance to rise
        • Let’s review the glossy literature
          • http://www.countrywide.com/pdf/050850_POA_brochure_70.06.pdf
        • In this instrument the actual accrual rate adjusts monthly
          • This feature makes it a popular bank investment product
        • Payment shock after the fifth year can be devastatingly large
      • Bank of America plans to discontinue after the CFC acquisition
  • 15. Even more ways loan payments were reduced
    • 3-2-1 buydowns, often offered by home builders
      • The builder effectively subsidizes the mortgage for 3 years
        • A 3% rate discount in year 1, followed by 2%, then 1%
      • Maybe a good deal for the borrower but more likely a signal that the borrower paid too much for the house
    • 40-year or greater terms-to-maturity
      • Longer terms require lower payments of principal
      • Not very common yet due to limited investor interest
    • All of the above products grew in popularity during the boom and almost certainly contributed to escalating prices
    • In many cases, interest rate risks more capably managed by financial institutions are now borne by private citizens
  • 16. The Primary Mortgage Market
    • Institutions/individuals who market, originate loans to borrowers comprise the primary mortgage market
    • Loan providers include
      • Traditional depositories
        • Banks, Savings & Loans, Credit Unions
        • Have the capacity to fund and portfolio loans (but may not)
        • May also perform loan servicing
      • Mortgage bankers
        • Generally mono-line companies that make, fund, and sell loans
        • May also perform loan servicing
      • Mortgage brokers
        • Independent agents who generally act as intermediaries
        • Generally don’t underwrite or put capital at risk
    • For the typical borrower, there is no universal, material advantage to any one type of loan provider
  • 17. The Secondary Mortgage Market
    • The secondary mortgage market is comprised of funding, buying, selling, servicing, and securitizing closed loans
    • This activity replenishes funds for making new loans
    • Secondary market mortgage participants include
      • Primary market participants
        • When they sell their loans and/or servicing rights
      • Fannie Mae and Freddie Mac (the GSEs)
        • When they guarantee and securitize loans (discussed later)
      • Investment banks
        • When they buy, structure, and securitize loans
    • Prior to the 1930s depression, loan sales were uncommon
    • Fannie Mae was the first institution created to ensure lenders funds for loans other than their own locally-based deposits
  • 18. Drawbacks and benefits of the Secondary Mortgage Market
    • The growth and robustness of the secondary market has improved the pricing and availability of mortgage credit
      • Risks can be allocated more optimally
        • Borrowers aren’t hindered by local economic weakness
      • Uniform performance data can be collected and analyzed
        • Models can be improved so the right borrowers are approved
      • International funds can flow more readily to mortgages
        • Increased supply of funds reduces borrowing costs
      • Innovation in mortgages and securitization is encouraged
        • Structures can be developed for borrowers and investors
    • The secondary market and structured securitization in particular have been criticized as primary to the housing bust
      • Critics say originators were too far removed from risks
  • 19. Interaction of primary and secondary markets
    • Participants are engaged in a relatively efficient market
      • Borrowers enjoy certain regulatory protections and transparency
        • RESPA, good faith estimates, HUD-1
        • The internet is a good source for finding the best loan terms
        • http:// www.amerisave.com/index.cfm , http://www.borrow123.com
      • Originators have multiple choices for loan placement
        • Hold for portfolio investment to profit from net interest margin (NIM)
        • Sell to a GSE or to an aggregator/issuer – a bigger institution
          • Sell the future stream of payments for their present value
          • “ Best execution” is the process for determining where to place different loans to achieve optimal value on a pool of loans
          • The aggregator may re-sell to a GSE or issue its own security
      • Parties typically engage in forward agreements to originate and fund/sell loans with specified terms/pricing at future dates
        • A borrower’s rate lock-in is a type of forward agreement
  • 20. Mortgages are grouped into several categories for secondary marketing
    • Conventional/Conforming (C/C)
      • Meets standards for loan features, credit quality, approval guidelines and size limits specified by the GSEs
        • C/C loans can be both fixed rate or ARMs
        • Interest-only loans were approved as C/C in the early 2000s
      • Many lenders have 12-month term agreements with GSEs to sell a representative mix of their C/C production for the coming year
        • Agreements are often dimensioned by relative share and loan/pool credit quality stipulations or loan/credit price adjustments
        • Lenders retain the ability to conduct best execution subject to the constraints of the GSE sales agreements
        • The GSEs closely monitor lenders’ selling behavior to watch for population skewness, a.k.a. adverse selection
  • 21. Other major mortgage categories
    • Conventional/Jumbo
      • Consistent in most respects with GSE guidelines with the major exception of loan size (currently > $417k)
        • Typically sold to an institution with security issuance capabilities (for later discussion); interest rates are usually 0.25% higher
        • Cannot be sold to GSEs
    • Alt-A (the label is hotly debated and often changing)
      • Generally represents loans made to prime quality “A” borrowers (typically defined by FICO score) but outside standard guidelines
        • e.g., 90% financing with cash out, investor occupancy, no-income-no-asset documentation (NINA), or other layered risk
        • Separate from the forward agreements GSEs may be willing to buy Alt-A loans on a pool-by-pool basis after close consideration
        • Otherwise Alt-A is portfolio-ed or sold to an aggregator/issuer
  • 22. Even more major categories of mortgage loans
    • Government guaranteed
      • Federal Housing Administration (FHA), Veterans Administration (VA), Rural Housing Service (RHS)
        • Primarily designated to finance modest housing for certain borrower segments, e.g., first time buyers, lower income, veterans, etc.
    • Manufactured housing (MH) loans
      • MH residing on leased land is not considered real estate
        • More like personal property lending, e.g. car loans, than housing
    • Sub prime mortgages
      • Typically outside guidelines due to ineligible borrower quality
        • Low FICO, recent bankruptcy, unpaid collection accounts, etc.
        • Formerly primarily home equity lending, i.e., poor credit quality but with reasonable equity in the property
        • More recently evolved into first time buyers and high LTV lending
        • Typically sold to an issuer of mortgage-backed securities
  • 23. Risk assessment and loan pricing – e.g., corporate debt
    • In the world of corporate lending, unsecured debt is commonly graded and priced according to risk
    • source: Vanguard
    • Lower grade corporate borrowers pay higher interest rates to account for a higher perceived probability of default and loss
    Rate Maturity
  • 24. Risk assessment and loan pricing in mortgage lending
    • Mortgages are also priced according to risk, though rate responsiveness is fairly minor among prime FICO borrowers
      • Like secured corporate debt, the mortgage collateral, i.e., house has a stabilizing effect on the interest rates offered
      • Credit quality below certain thresholds triggers sub prime rates
      • source: myfico.com
  • 25. Risk assessment and pricing models have evolved in the last decade
    • The practice of charging higher rates to compensate for higher risk has existed since the dawn of lending
    • Statistical performance models to determine mortgage pricing have become increasingly prominent in the last decade
      • Growth of the secondary market, creation of FICO scores, and increased data collection have enabled statistical sophistication
    • The modern-day application of the risk assessment entails supplying application data into models that predict:
      • Probability of borrower default, a.k.a. default rates
      • Loss given default, a.k.a. severity rates
      • Expected loan life, a.k.a. prepayment rates
  • 26. It’s helpful to think about loan performance intuitively
    • Why do borrowers default?
      • A borrower is likely to default on a mortgage if s/he
        • Can no longer afford the payments and
        • Cannot sell the property without a loss
    • Why do borrowers prepay?
      • Early payoff may be made for the following reasons
        • Rate incentive: a better rate becomes available
        • Mobility: the owner sells the home and moves
        • Cash out: the owner extracts home equity as cash
    • What losses are sustained in the event of default?
      • Severity rates are generally a function of
        • Property value deficiency relative to loan amount
        • Lost interest prior to property liquidation
  • 27. Significant origination predictors of default and severity in credit models
    • FICO : measure of borrower credit line performance
      • Most significant indicator of default rate along with LTV
    • Loan-to-value : ratio of loan amount to property value
      • Important to both default and severity rates
    • Loan purpose : purchase, refinance, or cash-out refinance
      • Cash-out usually considered riskier for default and severity
    • Occupancy : owner, investment, or second/vacation home
      • Investment considered a higher risk for default and severity
    • Documentation : full income/asset verification, or reduced
      • Reduced documentation may signal increased default risk
    • Payment-to-income : ratio of loan payment to income level
      • High ratio suggests increased default risk
  • 28. Significant origination predictors of mortgage prepayments
    • Among prime mortgages, in general, origination loan attributes that suggest higher credit risk also suggest slower prepayment or longer average life
      • Alternately stated, a borrower with a good credit profile and low-risk origination attributes may more readily relocate to another home or refinance when financially advantageous
    • Within the sub prime space, borrowers with weak loan attributes and commensurately high note rates generally prepay faster with a shorter average life
      • The phenomenon is referred to as “credit curing” whereby a borrower can lower her monthly payment by refinancing when her credit score improves
  • 29. Major macroeconomic predictors of mortgage performance
    • By and large, the most important factors that affect mortgage performance are house prices and interest rates
      • Favorable house prices
        • Reduce default and severity rates
        • Increase prepayment rates by increasing housing mobility
      • Stagnant or declining house prices
        • Increase default and severity rates
        • Reduce prepayment rates by lowering mobility
      • Low or declining interest rates
        • Create the incentive for borrowers to refinance (prepay)
        • Increase housing mobility by improving affordability
      • High or increasing interest rates
        • Reduce prepayment rates
        • Increase pay shock default risk with ARM borrowers
    • Inferences from origination loan attributes are excellent for determining ordinal pool performance; poor for cardinal
  • 30. House price and interest rate models
    • Monte Carlo simulation employs a multi-scenario approach
      • Single scenario assumptions fail to capture risk asymmetries
      • Variations in prices are dimensioned by volatility and random shocks
      • Interest rate models typically employ mean-reversion features
        • Volatility exists but invisible forces pull rates toward their long run averages
      • Each “path” produces a different level of defaults and losses
  • 31. Considering mortgages in a valuation framework
    • Mortgage cash flows can be valued similar to other assets
      • The value of a risk-free vanilla bond or annuity is equivalent to its PV of future cash flows; in this way a mortgage is no different
    • The key differentiating feature of mortgage valuation is uncertainty due to embedded options
      • The right to prepay is equivalent to a call option
      • The right to default is equivalent to a put option
    • In simple terms, a mortgage rate (or IRR) should be the sum of:
      • The underlying rate of a risk free annuity of the same maturity
      • The value of the embedded call option
      • The value of the embedded put option
    • Valuing these options is difficult in reality due to inefficient exercise
  • 32. The price-yield relationship and negative convexity
    • A plain vanilla bond possesses:
    • An inverse relationship between price and yield
    • Convexity properties that
      • accelerate increases in value in response to declining rates
      • Decelerate declines in value when rates increase
    • A mortgage loan possesses:
    • Negative convexity which
      • Constrains value increases in response to declining rates
      • As rates decline, prepayment incentives increase the value of the call option for the borrower
    Plain Vanilla Bond Mortgage Loan
  • 33. Asset securitization
    • “ Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors.”
    • Mark Fisher & Zoe Shaw, eds., Euromoney Books, London 2003
    • Securitization was first developed for US mortgages, but the basic principles are now applied worldwide to various assets such as
      • Credit card receivables
      • Car loans
      • Student loans
      • Tax liens
      • Gambling revenues
      • Royalties
  • 34. Mortgage securitization practices
    • US mortgage loans are securitized in two primary ways
      • GSE guarantor execution
        • Conventional/conforming loans sold to the GSEs are typically pooled together and issued as mortgage-backed securities (MBS)
        • MBS are guaranteed against credit losses and rated ‘AAA’ based on the perception of US Government backing of the GSEs
        • This form of credit enhancement, i.e., provided by corporate guarantee, is referred to as external enhancement
      • Private label execution
        • In private label MBS, enhancement is typically achieved internally
          • Subordination assigns sequential payment priority to senior classes
          • Overcollateralization describes the practice of absorbing losses by issuing securities with total value smaller than the underlying loans
          • Excess spread describes the reliance on excess interest payments to form a reserve to provide for coverage for pool losses
        • Credit rating agencies assign ratings based on the level of support
          • Enhancement structures are engineered to achieve desired ratings
  • 35. MBS cash flows – GSE execution example
    • Make monthly payments to servicers of P rincipal, I nterest, T axes, I nsurance (PITI)
    • Retain servicing fees to cover costs
    • Escrow and pay property taxes and insurance to third parties
    • Remit principal and remaining interest portion to next party
    • Earn ancillary income – interest on escrows, product cross-sales, late fees
    • Keep guarantee fees (g-fees) in exchange for protecting investors against default
    • Remit to MBS investor at pass-through rate
    • Receive guaranteed principal and interest at pass-through rate
    • Seller-Servicers and GSE portfolios are major MBS investors
    Borrowers Servicers Fannie/Freddie MBS Investors
  • 36. MBS cash flows – numeric GSE example
    • Pay PITI to servicer at 6% note rate
    • Retain 0.25% as servicing revenue
    • Remit P&I at 5.75% to Fannie or Freddie
    • Keep 0.25% as g-fee revenue
    • Remit to MBS investor at 5.5% pass-through rate
    • Receive guaranteed principal and interest at 5.5%
    Borrowers Servicers Fannie/Freddie MBS Investors To illustrate, assume... - 6% note rate - ¼% guaranty fee - ¼% servicing fee - 5½% pass-through rate
  • 37. Internal credit enhancement mechanics – further detail
    • In the most basic form, internal enhancement is achieved through sequential pay, senior/subordinate structures
      • The subordinates take on losses until their balances dry up
      • Because the subordinates are riskier, they pay higher yields
      • The bigger the subordinates, the more protected the seniors
      • The smaller the subordinates, the more profitable to the issuer
    • Credit rating agencies
      • Standard & Poors (S&P) and Moody’s exist to rate securities
        • they specify the required subordinate security sizings for the issuer to achieve certain ratings on the senior securities
      • In the process of preparing for securitization, an issuer will send to the rating agencies the underlying loan details for “sizing”
        • The riskier the loans the bigger the subordinate class required
  • 38. Internal credit enhancement mechanics – simplified example
    • Assume $100M pool of risky mortgages with an average rate of 6% (post servicing)
      • The rating agency specifies that 10% of potential losses must be covered to achieve the desired senior rating
    • Issue $90M senior security and $10M risky subordinate
      • Investors require 5% yield on the senior, 15% on the sub
    • The weighted average rate stays the same but the losses are redistributed
      • 90%*5% + 10%*15% = 6%
  • 39. Other practices in mortgage securitization
    • The three types of cash flows within mortgage pools, interest, scheduled principal, and prepayments can be assigned to different classes or tranches and subjected to different rules and triggers through time
    • In practice, collateralized mortgage obligations (CMOs) can strip-out and structure many types of instruments from highly predictable to highly unpredictable and risky
    • Some examples
      • Interest only (IO) bonds
        • On a separate note, loan servicing fees are a natural form of IO
          • Servicing can be retained or released (sold) upon loan disposition
          • Market standards regulate a minimum servicing fee
          • “ Excess” servicing beyond the minimum can be securitized
      • Principal only (PO) bonds
      • Planned Amortization Class (PAC) bonds
      • Non-Accelerating Senior (NAS) bonds
  • 40. Major advantages securitizing mortgages – issuer perspective
    • Liquidity
      • Uniform, well-understood securities are easier to value and trade than individual loans
    • Risk management
      • Credit risks and balance sheet issues, such as asset-liability matching can be more readily optimized per tolerance levels
    • Pricing
      • Cash flows can be restructured to suit investor demand and yield better all-in pricing – though arbitrage arguments disagree
    • Profit taking
      • Profits can be realized upon the sale of the assets rather than incrementally over the life of the mortgages
  • 41. Major advantages to securitization – investor perspectives
    • Improve diversification and risk-adjusted returns
      • Securitization can make ordinarily un-traded, weakly correlated assets available for investment managers as rated securities
        • Many managers are restricted to investment grade assets only
    • Risk management or speculation
      • Some instruments can serve as effective hedges for other investment or business activities ( negatively correlated asset)
      • The same instruments, absent an offsetting position, can allow investors to make highly leveraged bets on prepayment rates, interest rates, or loss levels
    • Investment repackaging
      • Collateralized debt obligations (CDOs) can pool and re-securitize securities to provide yet another form of investment