CHAPTER 6: MORTGAGE VALUATIONDate: 2/17/2011

Presented by: Josh Pickrell

LOAN TYPES

There are three common loan types: Pure Discount Loan: borrower receives $X today and agrees

to pay back $X +$I dollars tomorrow. Interest Only Loan: borrower pays interest periodic interest

payments and pays the principal back at the end of the loan. Amortized Loan: borrowers periodic payments include

interest and principal.

MORTGAGE LOANS

A mortgage loan is, typically, an amortized loan that is backed by collateral. The lender can take control of the collateral if the borrower

does not fulfill the contractual obligations. A lien is placed on the property – the lien prevents the

borrower from selling or transferring the property until the loan is paid.

Loans for which the borrower posts collateral are known as secured loans.

TOTAL MORTGAGE DEBT OUTSTANDING

According to the Federal Reserve Release, there is approximately $13.947 trillion worth of mortgage debt outstanding. http://www.federalreserve.gov/econresdata/releases/mortoutstand/cu

rrent.htm We can observe the breakdown of the four main types of mortgages

that the book points out: Residential Multifamily Commercial Farm

TOTAL MORTGAGE DEBT OUTSTANDING

What does the data tell us? The $ amount of total mortgage debt has been declining since

the middle of 2009. Most of the outstanding mortgages are one-to-four family

residences and most of the mortgage debt is held by major financial institutions and Federal and Related Agencies.

The residential sector represents the majority of mortgage debt outstanding.

SECURED LENDING AND DEFAULT

Mortgages that have LTV ratios less than 100% are said to be over collateralized. There is an direct relation between the LTV ratio and the

borrower default rate. Escrow payments can be added into your monthly payment.

Escrow includes insurance costs and property taxes. Distressed collateral – it is common for homeowners, in

foreclosure, to have caused physical damage to the property or they may just neglect the property.

PREPAYMENT OPTION

Most mortgage include an embedded option – prepayment option – which allows the borrower to pay off the mortgage at any time and without penalty. A borrower may prepay for liquidity reasons or financial

reasons. A borrower may find it advantageous to refinance the

mortgage loan. Home equity loans Lower cost of borrowing

MORTGAGE ORIGINATION AND INVESTMENT

Origination: the loan application process (underwriting) Servicing: monitoring the mortgage loan, and collecting

the payments Investment: make sure the portfolio of mortgage loans is

profitable.

DISINTERMEDIATION

Disintermediation means that one financial institution does not have to be responsible for all three major aspects of a mortgage loan. Instead, they can choose to specialize in one or two of the

components. Disintermediation has led to substantial growth in the

mortgage market.

SECURITIZATION

Securitization has resulted in lower borrowing rates, and it allows funds to flow more efficiently between DSUs and SSUs. Securitization has also facilitated disintermediation in

financial markets.

MORTGAGE BACKED SECURITIES (MBS)

The process of securitization: Mortgage loans are purchased from lenders and banks. The mortgage loans are then pooled together The pool of mortgages is securitized into mortgage backed

securities

The two main sub-types of MBS: A pass-through mortgage-backed security A collateralized mortgage obligation (CMO)

RESIDENTIAL MORTGAGES

Fixed-rate mortgages (very common) Adjustable Rate Mortgages Balloon Mortgage Interest-only mortgage

FIXED RATE MORTGAGES

Three critical components of a fixed rate loan: Principal balance Interest rate Time to maturity

Using equation 6-2 (page 129), we can calculate the principal balance remaining at the end of any month.

THE AMORTIZATION SCHEDULE

A fixed rate mortgage requires the borrower to pay a fixed dollar amount each month. This payment includes both an interest payment and a

principal payment. A mortgage loan can be thought of as an annuity; thus, we

can use the annuity payment formula to calculate the payment.

SEE EXCEL FILE.

ADJUSTABLE RATE MORTGAGE

Unlike a fixed rate mortgage, the interest rate on an ARM can change over the life of the loan. This means that the borrowers monthly payment may rise or fall

over the life of the loan depending on the related market interest rate.

The ARM contract must specify a specific market interest rate index and margin. LIBOR, 1-Year Constant Maturity Treasury security, The Cost of Funds

Index The margin may differ from one lender to another, but it is usually constant

over the life of the loan.

ADJUSTABLE RATE MORTGAGE

The ARM contract will specify the re-pricing frequency. Typically, 12 months (annually). Not uncommon to see semi-annual re-pricing or every two

years.

Many ARMs are being originated as fixed-adjustable hybrids. For example, a 7/1 ARM will have a fixed rate for seven

years, and then it will re-price annually for the reminder of the loans life.

ADJUSTABLE RATE MORTGAGE

Most ARMs contain a rate cap and rate floor to protect both the borrower and lender from significant changes in interest rates.

In addition, some ARMs will have a periodic re-pricing limit.

Watch out for the “teaser rate” – the ARM offers an artificially low initial interest rate that is much less than the current index rate plus the spread.

ARM EXAMPLE *TIME PERMITTING*

Problem 22. What is the scheduled P&I payment for the next two years of a two-year ARM with a remaining principal balance of $220,000, a remaining maturity of 13 years, the two-year constant maturity Treasury yield is 2.4% (index value), and a fixed margin of 300 basis points (or 3%). If two years from now, the index has risen to 3%, what will be the new monthly payment on this loan?

OTHER TYPES OF MORTGAGES

A balloon mortgage is one that has a fixed-rate and scheduled payments calculated for 30 years, but requires repayment of the remaining principal in full after a certain period of time.

Interest-only mortgage requires no repayment of principal until the maturity date. The borrower will build no equity beyond the initial down

payment, unless the property value increases.

MORTGAGE VALUATION

Valuation of a mortgage portfolio is complicated by the fact that they have a prepayment option.

In order to value a single mortgage, we would need to know: Credit quality of the borrower (proper default risk premium) Time of the anticipated prepayments must be determined

MORTGAGE PORTFOLIO VALUATION

The text uses an adjusted cash flow approach to valuing a mortgage portfolio, which requires you to estimate the expected future cash flows for the portfolio of mortgages.

The PV of the mortgage portfolio is found by discounting these expected future cash flows using the appropriate discount rate.

MORTGAGE PORTFOLIO VALUATION

Prepayments and defaults can significantly effect the E[CF] of the mortgage portfolio.

The discount rate should represent the market return that an investor would earn on an alternative investment with similar characteristics, maturity and risk, to the portfolio being valued.

The textbook argues for the use of the 10-year Treasury Note yield as a reasonable discount rate for the expected cash flows of a fixed-rate mortgage portfolio.

MORTGAGE PRICING CHARACTERISTICS

For bonds with no embedded options, fixed income investors analyze the YTM, duration and convexity. For mortgages, and bonds with embedded options, we have to

adjust the calculations. YTM is not a useful measure of the return that will be earned

on a mortgage (portfolio). There is no established market price for a mortgage (portfolio); thus,

we cannot calculate a YTM.

MORTGAGE DURATION

Mortgages are more sensitive to change in interest rates because of the prepayment option.

Bond investors (no embedded options) versus mortgage investors – the effect of rising and falling interest rates…

We must rely on effective duration for mortgage portfolios.

MORTGAGE DURATION

The duration of an ARM portfolio is approximately one-half the average re-pricing frequency of the ARMs in the portfolio.

For example, a portfolio that contains a two-year re-pricing arm, will have duration of approximately 1.

MORTGAGE CONVEXITY

Convexity improves upon the duration estimate. Figure 6-8 in the text, shows that the present value of a real

mortgage portfolio is concave. Mortgages exhibit negative convexity, which means that the PV of

the mortgage portfolio is always lower than predicted by the duration estimate.

In other words, duration is an optimistic measure for the PV of a mortgage portfolio.