Chapter 6 Pickrell PowerPoint

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CHAPTER 6: MORTGAGE VALUATION Date: 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/cur

rent.htm

We can observe the breakdown of the four main types of mortgages

that the book points out:

Residential

Multifamily

Commercial

Farm

http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm






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 I NVESTMENT

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)



R ESIDENTIAL MORTGAGES

Fixed-rate mortgages (very common)

Adjustable Rate Mortgages

Balloon Mortgage

Interest-only mortgage



FIXED R ATE 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, wecan use the annuity payment formula to calculate the

payment.

SEE EXCEL FILE.



ADJUSTABLE R ATE 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 indexand 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.




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.




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 thatan 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 earnedon 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.

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