CHAPTER 10

RESIDENTIAL MORTGAGE LOANS

CHAPTER SUMMARY

When purchasing a home, the major portion of the funds must be borrowed. The market where
these funds are borrowed is called the mortgage market. This chapter and the two that follow
describe residential mortgage loans and the various securities created by using mortgage loans as
collateral. This chapter concentrates on the characteristics of mortgage loans, the participants in
the mortgage market, the more popular mortgage loan designs, and the market for mortgage
loans.

WHAT IS A MORTGAGE?

A mortgage is a loan secured by the collateral of specified real estate property, which obliges the
borrower to make a predetermined series of payments. The mortgage gives the lender (the
mortgagee) the right of foreclosure on the loan if the borrower (the mortgagor) defaults.

When the lender makes the loan based on the credit of the borrower and on the collateral for the
mortgage, the mortgage is said to be a conventional mortgage. The lender also may take out
mortgage insurance to provide a guarantee for the fulfillment of the borrowers obligations.

The types of real estate properties that can be mortgaged are divided into two broad categories:
residential and nonresidential properties. The former category includes houses, condominiums,
cooperatives, and apartments. Nonresidential property includes commercial and farm properties.

PARTICIPANTS IN THE MORTGAGE MARKET

In addition to the ultimate lenders of funds and the government agencies, there are three groups
involved in the market. These groups are: mortgage originators, mortgage servicers, and
mortgage insurers.

Mortgage Originators

The original lender is called the mortgage originator. Mortgage originators include thrifts,
commercial banks, mortgage bankers, life insurance companies, and pension funds.

Originators may generate income for themselves in one or more ways. First, they typically
charge an origination fee. The second source of revenue is the profit that might be generated
from selling a mortgage at a higher price than it originally cost. This profit is called secondary
marketing profit. Third, the mortgage originator may hold the mortgage in its investment
portfolio.

A potential homeowner who wants to borrow funds to purchase a home will apply for a loan

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from a mortgage originator. The two primary factors in determining whether the funds will be
lent are the payment-to-income (PTI) ratio and the loan-to-value (LTV) ratio. The PTI is the
ratio of monthly payments (both mortgage and real estate tax payments) to monthly income. It is
a measure of the ability of the applicant to make monthly payments. The LTV is the ratio of the
amount of the loan to the market (or appraised) value of the property. It is a measure of the
protection the lender has if the property must be repossessed and sold.

Mortgage originators can either (i) hold the mortgage in their portfolio, (ii) sell the mortgage to
an investor who wishes to hold the mortgage or who will place the mortgage in a pool of
mortgages to be used as collateral for the issuance of a security, or (iii) use the mortgage
themselves as collateral for the issuance of a security. When a mortgage is used as collateral for
the issuance of a security, the mortgage is said to be securitized.

When a mortgage originator intends to sell the mortgage, it will obtain a commitment from the
potential investor (buyer). Two federally sponsored credit agencies and several private
companies buy mortgages. As these agencies and private companies pool these mortgages and
sell them to investors, they are called conduits.

The two agencies, the Federal Home Loan Mortgage Corporation and the Federal National
Mortgage Association, purchase only conforming mortgages. A conforming mortgage is one
that meets the underwriting standards established by these agencies for being in a pool of
mortgages underlying a security that they guarantee. Three underwriting standards established by
these agencies in order to qualify as a conforming mortgage are a maximum PTI, a maximum
LTV, and a maximum loan amount. If an applicant does not satisfy the underwriting standards,
the mortgage is called a nonconforming mortgage. Mortgages acquired by the agency may be
held as investments in their portfolio or securitized.

Mortgage Servicers

Every mortgage loan must be serviced. Servicing of a mortgage loan involves collecting monthly
payments and forwarding proceeds to owners of the loan, sending payment notices to
mortgagors, reminding mortgagors when payments are overdue, maintaining records of principal
balances, administering an escrow balance for real estate taxes and insurance purposes, initiating
foreclosure proceedings if necessary, and furnishing tax information to mortgagors when
applicable.

Mortgage servicers include bank-related entities, thrift-related entities, and mortgage bankers.
There are five sources of revenue from mortgage servicing. The primary source is the servicing
fee. This fee is a fixed percentage of the outstanding mortgage balance. The second source of
servicing income arises from the interest that can be earned by the servicer from the escrow
balance that the borrower often maintains with the servicer. The third source of revenue is the
float earned on the monthly mortgage payment. Fourth, there are several sources of ancillary
income. Fifth, there are other benefits of servicing rights for servicers who are also lenders. Their
portfolio of borrowers is a potential source for other loans, such as second mortgages,
automobile loans, and credit cards.

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Mortgage Insurers

There are two types of mortgage-related insurance. The first type, originated by the lender to
insure against default by the borrower, is called mortgage insurance or private mortgage
insurance. Lenders on loans with LTV ratios greater than 80% usually require it. Mortgage
insurance can be obtained from a private mortgage insurance company or, if the borrower
qualifies, from the FHA,VA, or FmHA.

The second type of mortgage-related insurance is acquired by the borrower, usually with a life
insurance company, and is typically called credit life. Unlike mortgage insurance, the lender
does not require this type of insurance.

ALTERNATIVE MORTGAGE INSTRUMENTS

There are many types of mortgage loans from which a borrower can select. The interest rate on a
mortgage loan (called the contract rate) is greater than the risk-free interest rate, in particular
the yield on a Treasury security of comparable maturity. The spread reflects the higher costs of
collection, the costs associated with default, which are not eliminated despite the collateral,
poorer liquidity, and uncertainty concerning the timing of the cash flow.

Level-Payment Fixed-Rate Mortgage

The basic idea behind the design of the level-payment fixed-rate mortgage, or simply level-
payment mortgage, is that the borrower pays interest and repays principal in equal installments
over an agreed-upon period of time, called the maturity or term of the mortgage. Each monthly
mortgage payment for a level-payment mortgage is due on the first of each month and consists of
(i) interest of one-twelfth of the fixed annual interest rate times the amount of the outstanding
mortgage balance at the beginning of the previous month, and (ii) a repayment of a portion of the
outstanding mortgage balance (principal).

When a loan repayment schedule is structured so that the payments made by the borrower will
completely pay off the interest and principal, the loan is said to be fully amortizing. The
schedule of all payments is referred to as an amortization schedule. This schedule shows the
portion of the monthly mortgage payment applied to interest declines each month and the portion
applied to reducing the mortgage balance increases.

The monthly cash flow from a mortgage loan, regardless of the mortgage design, can be
decomposed into three parts. These parts are: the servicing fee, the interest payment net of the
servicing fee, and the scheduled principal repayment. To compute the monthly mortgage
payment for a level-payment mortgage requires the application of the formula for the present
value of an ordinary annuity formula. Redefining those terms in that formula for a level-payment
mortgage, we have:

-n
1- (1+ i)

MB0 = MP
i

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where MP = monthly mortgage payment ($), n = number of months, MB0 = original mortgage
balance ($), and i = simple monthly interest rate (annual interest rate / 12).

Solving for the monthly mortgage payment (MP) and algebraically rearranging the expression
inside the brackets gives:

i (1 + i ) n
MP = MB0 .
(1 + i ) n - 1

The term in brackets is called the payment factor or annuity factor. It can be referred to as the
monthly payment for a $1 mortgage loan with an interest rate of i and a term of n months.

Adjustable-Rate Mortgage

An adjustable-rate mortgage (ARM) is a loan in which the contract rate is reset periodically in
accordance with some appropriately chosen reference rate, typically one based on a short-term
interest rate. Outstanding ARMs call for resetting the contract rate every month, six months,
year, two years, three years, or five years. The contract rate at the reset date is equal to a
reference rate plus a spread. The amount of the spread reflects market conditions, the features of
the ARM, and the increased cost of servicing an ARM compared with a fixed-rate mortgage.

Two categories of reference rates have been used in ARMs: (i) market-determined rates and (ii)
calculated rates based on the cost of funds for thrifts. Market-determined rates have been limited
to Treasury-based rates. The reference rate will have an important impact on the performance of
an ARM and how they are priced.

Cost of funds for thrifts indexes are calculated based on the monthly weighted average interest
cost for liabilities of thrifts. The two most popular are the Eleventh Federal Home Loan Bank
Board District Cost of Funds Index (COFI) and the National Cost of Funds Index, the former
being the most popular.

To encourage borrowers to accept ARMs rather than fixed-rate mortgages, mortgage originators
generally offer an initial contract rate that is less than the prevailing market mortgage rate. This
below-market initial contract rate, set by the mortgage originator based on competitive market
conditions, is commonly referred to as a teaser rate.

A pure ARM is one that resets periodically and has no other terms that affect the monthly
mortgage payment. However, the monthly mortgage payment, and hence the investors cash
flow, are affected by other terms. These are due to (i) periodic caps and (ii) lifetime rate caps and
floors.

Balloon Mortgages

In a balloon mortgage, the borrower is given long-term financing by the lender, but at specified
future dates the contract rate is renegotiated. The balloon payment is the original amount
borrowed less the amount amortized.

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Prepayment Penalty Mortgages

Most mortgages outstanding do not penalize the borrower from prepaying any part or all of the
outstanding mortgage balance. However, there are prepayment penalty mortgages (PPMs) that
are available to borrowers. The laws and regulations governing the imposition of prepayment
penalties are established at the federal and state levels.

The basic structure of a PPM includes a specified time period during which prepayments are not
permitted except for the sale of the mortgaged property. This time period is called the lockout
period. Typically, this period is either three or five years. Depending on the structure, a certain
amount of prepayments can be made during the lockout period without the imposition of a
prepayment penalty.

The motivation for the PPM is that it reduces prepayment risk for the lender during the lockout
period. It does so by effectively making it more costly for the borrower to prepay. In exchange
for this reduction in prepayment risk, the lender will offer a mortgage rate that is lower than an
otherwise comparable mortgage loan without a prepayment penalty.

Reverse Mortgages

Reverse mortgages are designed for senior homeowners who want to convert their home equity
into cash. Fannie Mae, for instance, offers two types of reverse mortgages for senior borrowers.
The Home Keeper Mortgage is an adjustable-rate conventional reverse mortgage for borrowers
who are at least 62 years of age, and who either own the home outright or have a low amount of
unpaid principal balance. The other type of reverse mortgage, Home Keeper for Home Purchase,
enables senior borrowers to buy a new home with a combination of personal funds and a
calculated amount of reverse mortgage that is based upon the borrowers age, number of
borrowers, the adjusted property value, and the equity share option chosen.

NONCONFORMING MORTGAGES

There are alternative mortgage designs that have been introduced by mortgage originators for
those homeowners who could not qualify for or do not want a conforming mortgage. Basically,
nonconforming mortgages are available for those who do not satisfy one or more of the
underwriting standards of Fannie Mae, Freddie Mac, and Ginnie Mae.

Loans larger than the conforming limit are classified as jumbo loans. Mortgage lenders make
funds available to credit borrowers who fail to qualify for a mortgage due to the underwriting
standards relating to credit worthiness. Subprime refers to borrowers whose credit has been
impaired but generally have sufficient equity in their homes to mitigate the credit exposure,
allowing the lender to place less weight on the credit profile in making the lending decision.

An alt-A loan refers to loans made to borrowers who generally have high credit scores but who
have variable incomes, are unable or unwilling to document a stable income history, or are
buying second homes or investment properties. In such respects, alt-A loans allow reduced or

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alternate forms of documentation to qualify the loan. The typical alt-A borrower has an excellent
credit rating referred to as an A rating, and hence the loan is referred to as an alt-A loan, which is
especially important to the originator because the credit quality of the borrower must compensate
for the lack of other necessary documentation.

Traditionally for a conventional, conforming loan, borrowers were required to make a down
payment of 20% when qualifying for a mortgage. However, today a borrower with good credit
has the option of making a lesser or no down payment, resulting in loans with higher LTVs.
Hence, these mortgage loans are called high LTV loans.

RISKS ASSOCIATED WITH INVESTING IN MORTGAGES

Investors are exposed to four main risks by investing in mortgage loans: credit risk, liquidity
risk, interest rate risk, and prepayment risk.

Credit Risk

Credit risk is the risk that the homeowner/borrower will default. Rating agencies need to evaluate
the magnitude of a potential loss of a pool of loans in order to assign a credit rating to a security
backed by a pool of mortgage loans. While there is a wide range of mortgage designs, rating
agencies in their credit analysis establish a benchmark to assess the credit risk of mortgage pools.

A mortgages loan-to-value (LTV) ratio has been found in numerous studies to be the single
most important determinant of its likelihood of default, and therefore the amount of required
credit enhancement. At one time, rating agencies and other participants in the mortgage market
considered the LTV only at the time of origination (called the original LTV) in their analysis of
credit risk. Because of periods in which there has been a decline in housing prices, the current
LTV has become the focus of attention. The current LTV is the LTV based on the current unpaid
mortgage balance and the estimated current market value of the property.

Mortgages taken out for cash-out refinancings are considered riskier than mortgages taken out
for purchases, chiefly because the homeowner is reducing the equity in the home. Borrowers
must supply documents to lenders in order to obtain a loan. Full documentation generally means
that the borrower has supplied income, employment, and asset verification sufficient to meet the
underwriting standards of Fannie Mae and Freddie Mac.

Although loan originators place a great deal of emphasis on borrowers credit histories, these
data are not available to the rating agencies. The Fair Credit Reporting Act restricts access to
such information to parties involved in a credit extension decision. As a result, the agencies use
credit proxies such as the debt-to-income ratio, the mortgage coupon rate, past delinquencies or
seasoned loans, or either originators credit scores or credit scores by vendors.

Liquidity Risk

Although there is an active secondary market for mortgage loans, the fact is that bid-ask spreads
are large compared with other debt instruments (i.e., mortgage loans tend to be rather illiquid

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because they are large and indivisible).

Interest-Rate Risk

Because a mortgage loan is a debt instrument, and long term on the averageindeed, one of the
longestits price will move in the direction opposite to market interest rates.

Prepayment Risk

Homeowners do pay off all or part of their mortgage balance prior to the maturity date. Payments
made in excess of the scheduled principal repayments are called prepayments. Prepayments
occur for one of several reasons. Homeowners prepay the entire mortgage when they sell their
home. The effect of prepayments is that the cash flow from a mortgage is not known with
certainty. This is true for all mortgage loans, not just level-payment fixed-rate mortgages.

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 ANSWERS TO QUESTIONS FOR CHAPTER 10
(Questions are in bold print followed by answers.)

1. Answer the following questions.

(a) What are the sources of revenue arising from mortgage origination?

Originators may generate income for themselves by charging an origination fee. This fee is
expressed in terms of points, where each point represents 1% of the borrowed funds. For
example, an origination fee of two points on a $100,000 mortgage represents $2,000. Originators
also charge application fees and certain processing fees. Another source of revenue is the profit
that might be generated from selling a mortgage at a higher price than it originally cost. This
profit is called secondary marketing profit. Finally, the mortgage originator may hold the
mortgage in its investment portfolio.

(b) What are the risks associated with the mortgage origination process?

The second source of revenue is the profit that might be generated from selling a mortgage at a
higher price than it originally cost. However, there is risk in doing this. If mortgage rates rise, an
originator will realize a loss when the mortgages are sold in the secondary market. If the
mortgage originator holds the mortgage in its investment portfolio, then the value of this
investment declines when interest rates rise.

2. What are the two primary factors in determining whether funds will be lent to an
applicant for a mortgage loan?

A potential homeowner who wants to borrow funds to purchase a home will apply for a loan
from a mortgage originator and supply financial information used to perform a credit evaluation.
The two primary factors in determining whether the funds will be lent are the payment-to-
income (PTI) ratio and the loan-to-value (LTV) ratio. The PTI, the ratio of monthly payments
(both mortgage and real estate tax payments) to monthly income, is a measure of the ability of
the applicant to make monthly payments. A lower ratio indicates a greater likelihood that the
applicant will be able to meet the required payments. The difference between the purchase price
of the property and the amount borrowed is the borrowers down payment. The LTV is the ratio
of the amount of the loan to the market (or appraised) value of the property. The lower this ratio,
the more protection the lender has if the applicant defaults and the property must be repossessed
and sold.

3. What is a conventional mortgage?

When the lender makes the loan based on the credit of the borrower and on the collateral for the
mortgage, the mortgage is said to be a conventional mortgage. The lender also may take out
mortgage insurance to provide a guarantee for the fulfillment of the borrowers obligations. A
conventional mortgage can take many forms. For example, the Home Keeper Mortgage is an
adjustable-rate conventional reverse mortgage for borrowers who are at least 62 years of age, and

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who either own the home outright or have a low amount of unpaid principal balance. This loan,
like all conventional mortgages, is based on the credit of the borrower and on the collateral for
the mortgage. What is conventional can change over time. For example, traditionally for a
conventional, conforming loan, borrowers were required to make a down payment of 20% when
qualifying for a mortgage. However, today a mortgagor with good credit has the option of
making a lesser or no down payment, resulting in loans with higher LTVs.

4. What can mortgage originators do with a loan after originating it?

Mortgage originators can do one of three things. First, they can hold the mortgage in their
portfolio. Second, they can sell the mortgage to an investor who wishes to hold the mortgage or
who will place the mortgage in a pool of mortgages to be used as collateral for the issuance of a
security. When a mortgage originator intends to sell the mortgage, it will obtain a commitment
from the potential investor (buyer). Two federally sponsored credit agencies and several private
companies buy mortgages. As these agencies and private companies pool these mortgages and
sell them to investors, they are called conduits. Third, they can use the mortgage themselves as
collateral for the issuance of a security. When a mortgage is used as collateral for the issuance of
a security, the mortgage is said to be securitized.

5. What are a conforming mortgage and a nonconforming mortgage?

A conforming mortgage is one that meets the underwriting standards established by these
agencies for being in a pool of mortgages underlying a security that they guarantee. Three
underwriting standards established by these agencies in order to qualify as a conforming
mortgage include a maximum PTI, a maximum LTV, and a maximum loan amount. The two
agencies, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage
Association, purchase only conforming mortgages.

A nonconforming mortgage is a mortgage where an applicant does not satisfy the underwriting
standards. Jumbo loans are loans that exceed the maximum loan amount and thus do not qualify
as conforming mortgages.

6. What are the sources of revenue from mortgage servicing?

Mortgage servicers include bank-related entities, thrift-related entities, and mortgage bankers.
There are five sources of revenue from mortgage servicing. These are described below.

The servicing fee is the primary source of revenue. This fee is a fixed percentage of the
outstanding mortgage balance and declines over time as the mortgage balance amortizes. The
second source of servicing income arises from the interest that can be earned by the servicer
from the escrow balance that the borrower often maintains with the servicer. The third source of
revenue is the float earned on the monthly mortgage payment. This opportunity arises because of
the delay permitted between the time the servicer receives the payment and the time that the
payment must be sent to the investor.

Fourth, there are several sources of ancillary income such as (i) a late fee charged by the servicer

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if the payment is not made on time, (ii) commissions received from cross-selling their borrowers
credit life and other insurance products, and (iii) fees generated from selling mailing lists. Fifth,
there are other benefits of servicing rights for servicers who are also lenders. For example, their
portfolio of borrowers is a potential source for other loans, such as second mortgages,
automobile loans, and credit cards.

7. Why is the interest rate on a mortgage loan not necessarily the same as the interest rate
that the investor receives?

The interest rate on a mortgage loan cover a number of costs including those not encountered by
the investor who invests in a portfolio of mortgage loans. For example, there is a servicing fee
that is charged in addition to the interest payment net of this fee.

8. Answer the following questions.

(a) What are the two types of mortgage insurance?

There are two types of mortgage-related insurance. The first type, originated by the lender to
insure against default by the borrower, is called mortgage insurance or private mortgage
insurance. Lenders on loans with LTV ratios greater than 80% usually require it. The amount
insured will be some percentage of the loan and may decline as the LTV ratio declines. Although
the lender requires the insurance, its cost is borne by the borrower, usually through a higher
contract rate. Mortgage insurance can be obtained from a private mortgage insurance company
or, if the borrower qualifies, from the FHA, VA, or FmHA.

The second type of mortgage-related insurance is acquired by the borrower, usually with a life
insurance company, and is typically called credit life. Unlike mortgage insurance, the lender
does not require this type of insurance. The policy provides for a continuation of mortgage
payments after the death of the insured person, which allows the survivors to continue living in
the house. Because the insurance coverage decreases as the mortgage balance declines, this type
of mortgage insurance is simply a term policy.

(b) Which is the more important type of insurance from the lenders perspective?

Although both types of insurance have a beneficial effect on the credit worthiness of the
borrower, the first type is more important from the lenders perspective. The lender seeks
mortgage insurance when the borrower is viewed as being capable of meeting the monthly
mortgage payments but does not have enough funds for a large down payment. For example,
suppose that a borrower seeks financing of $180,000 to purchase a single-family residence for
$200,000, thus making a down payment of $20,000. The LTV ratio is 90%, exceeding the
uninsured maximum LTV of 80%. Even if the lenders credit analysis indicates that the
borrowers PTI ratio is acceptable, the mortgage loan cannot be extended. However, if a private
mortgage insurance company insures a portion of the loan, the lender is afforded protection.
Mortgage insurance companies will write policies to insure a maximum of 20% of loans with an
LTV ranging from 80% to 90%, and a maximum of 25% of loans with an LTV ranging from 90%
to 95%. The lender is still exposed to default by the borrower on the noninsured portion of the

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mortgage loan, and in the case of private mortgage insurers, exposed as well to the risk that the
insurer will default.

9. Answer the following questions.

(a) What are the components of the cash flow of a mortgage loan?

The monthly cash flow from a mortgage loan, regardless of the mortgage design, can be
decomposed into three parts: the servicing fee, the interest payment net of the servicing fee, and
the scheduled principal repayment.

(b) Why is the cash flow of a mortgage unknown?

To the extent credit risk is present in a mortgage, the cash flows are uncertain. Also, lenders have
the option to prepay early adding further uncertainty to the cash flows over time.

10. What is a prepayment?

Homeowners can and do pay off all or part of their mortgage balance prior to the maturity date.
Payments made in excess of the scheduled principal repayments are called prepayments. While
most mortgages outstanding do not penalize the borrower from prepaying any part or all of the
outstanding mortgage balance, there are prepayment penalty mortgages (PPMs) that are
available to borrowers. The laws and regulations governing the imposition of prepayment
penalties are established at the federal and state levels. Usually, the applicable laws for fixed-rate
mortgages are specified at the state level. Some states do not permit prepayment penalties on
fixed-rate mortgages with a first lien. Other states do permit prepayment penalties but restrict the
type of penalty. For some mortgage designs, such as adjustable-rate and balloon mortgages,
federal laws override state laws.

11. In what sense has the investor in a mortgage granted the borrower (homeowner) a call
option?

Homeowners have the right to pay off the mortgage. They will do this in the course of time for
unexpected personal reasons ranging from employment to family change. They will also do this
for economic reasons if interest rates fall. For the latter situation, borrowers will exercise their
option and sell their home. They will then take out a new home loan at a lower mortgage rate.

12. Answer the following questions.

(a) What are the two categories of reference rates used in adjustable-rate mortgages?

The two categories of reference rates used in adjustable-rate mortgages (ARMs) are market-
determined rates and calculated rates based on the cost of funds for thrifts. Market-determined
rates have been limited to Treasury-based rates. Cost of funds for thrifts indexes are calculated
based on the monthly weighted average interest cost for liabilities of thrifts. The reference rate
will have an important impact on the performance of an ARM and how it is priced. More details

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on the two most popular thrifts indexes are supplied below.

The two most popular thrifts indexes are the Eleventh Federal Home Loan Bank Board District
Cost of Funds Index (COFI) and the National Cost of Funds Index, the former being the most
popular. The Eleventh District includes the states of California, Arizona, and Nevada. The cost of
funds is calculated by first computing the monthly interest expenses for all thrifts included in the
Eleventh District. The interest expenses are summed and then divided by the average of the
beginning and ending monthly balance. The index value is reported with a one-month lag. For
example, Junes Eleventh District COFI is reported in July. The contract rate for a mortgage
based on the Eleventh District COFI is usually reset based on the previous months reported
index rate. For example, if the reset date is August, the index rate reported in July will be used to
set the contract rate. Consequently, there is a two-month lag by the time the average cost of funds
is reflected in the contract rate. This obviously is an advantage to the borrower when interest
rates are rising and a disadvantage to the investor. The opposite is true when interest rates are
falling.

The National Cost of Funds Index is calculated based on all federally insured S&Ls. A median
cost of funds is calculated rather than an average. This index is reported with about a 1.5-month
delay. The contract rate is typically reset based on the most recently reported index value.

(b) Which category of reference rate would you expect to increase faster when interest rates
are rising? Why?

You would expect the market-determined rate to increase faster. This is because there is a two-
month lag by the time the average cost of funds is reflected in the contract rate. This works to the
advantage of the borrower when rates are rising and the advantage of the investor when rates are
falling.

13. What types of features are included in an adjustable-rate mortgage to restrict how the
contract rate may change at the reset date?

A pure ARM is one that resets periodically and has no other terms that affect the monthly
mortgage payment. However, the monthly mortgage payment, and hence the investors cash
flow, are affected by other terms. These are due to periodic caps and lifetime rate caps and floors.
Rate caps limit the amount that the contract rate may increase or decrease at the reset date. A
lifetime cap sets the maximum contract rate over the term of the loan.

14. Answer the following questions.

(a) What is a hybrid mortgage?

A hybrid mortgage is a mortgage that combines features of a fixed-rate mortgage and a

variable-rate mortgage. These are also known as intermediate ARM loans. These loans are fixed
for 2, 3, 5, 7, or 10 years and then revert to a variable rate for the balance of the mortgage term.
More details are given below.

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An ARM mortgage design that has become extremely popular is the hybrid ARM. In this
mortgage design, the mortgage rate is fixed for a period of time and floats thereafter. For
example, for a 30-year mortgage, a hybrid mortgage can have a fixed rate for three years and
then become an ARM after year 3. While the frequency of resetting after year 3 can be any
length of time, typically it is one year. These mortgages are typically referred to as 3/1, 5/1, 7/1,
and 10/1 ARMs, where the first term refers to the period in years during which the mortgage rate
is fixed and the second term refers to the frequency of reset during the adjustable-rate period.

(b) What is an interest-only hybrid mortgage?

An interest-only hybrid mortgage is a variation where the mortgage is designed to reduce the
homeowners initial monthly payments. With an interest-only hybrid ARM, the homeowners
mortgage payment consists of only the interest associated with the loan until the reset date. At
the end of the fixed period, the principal is amortized at a floating rate over the remaining life of
the loan.

(c) Why would you expect that an interest only hybrid mortgage would have greater credit
risk than an adjustable-rate mortgage?

An interest-only hybrid mortgage does not amortize the principal until later in time. This
increases the risk because principal is not paid off until this later time. Also, if the float rate is
greater than the fixed rate, then borrowers may have more difficulty making payments.

15. Answer the following questions.

a. Does a prepayment penalty mortgage prohibit prepayments?

A prepayment penalty mortgage (PPM) does not necessarily prohibit prepayments since some
state laws do not allow prepayment penalties. Thus, any penalty would not be legally enforceable
and thus would not deter a prepayment if otherwise allowed. Also, the basic structure of a PPM
includes a specified time period during which prepayments can be allowed for the sale of the
mortgaged property. More details are given below.

Other than PPMs, most mortgages do not penalize the borrower for prepaying any part of the
mortgage balance. The laws and regulations governing the imposition of prepayment penalties
are established at the federal and state levels. Usually, the applicable laws for fixed-rate
mortgages are specified at the state level. Some states do not permit prepayment penalties on
fixed-rate mortgages with a first lien. Other states do permit prepayment penalties but restrict the
type of penalty. For some mortgage designs, such as adjustable-rate and balloon mortgages,
federal laws override state laws.

The basic structure of a PPM includes a specified time period during which prepayments are not
permitted except for the sale of the mortgaged property. This time period is called the lockout
period that is usually either three or five years. Depending on the structure, a certain amount of
prepayments can be made during the lockout period without the imposition of a prepayment
penalty.

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b. What are the benefits of a prepayment penalty mortgage from the perspective of the
borrower?

One benefit of a prepayment penalty mortgage (PPM) is that it gives borrowers another option
and this option may be the best (if not the only) alternative that can be chosen. Another benefit is
that under certain circumstance the prepayment penalty may not be legally enforceable or the
borrower can pay the lesser penalty of several options. Even if the prepayment penalty holds it
may involve a lesser cost compared to the advantages of prepaying. Prepaying would be like
exercising an option to receive a higher pay-off and would thus be beneficial to the borrower.
Finally, in exchange for this reduction in prepayment risk, the lender will offer the borrower a
note rate that is lower than an otherwise comparable mortgage loan without a prepayment
penalty. This serves to benefit the borrower who does not expect that they will want to prepay.

c. How does the lender benefit from a prepayment penalty mortgage?

The lender obviously benefits due to constraints placed on the borrower from prepaying early
when this is not desired. The motivation for the PPM is that it reduces prepayment risk for the
lender during the lockout period. It does so by effectively making it more costly for the borrower
to prepay.

16. What is the motivation for the creation of a reverse mortgage?

The major motivation is to help homeowners (usually older borrowers who may be retired) who
want to receive a cash flow from the equity in their home. For these homeowners a reverse
mortgage is the best way of achieving their goal. More details are supplied below.

Reverse mortgages are designed for senior homeowners who want to convert their home equity
into cash. Fannie Mae, for instance, offers two types of reverse mortgages for senior borrowers.
The Home Keeper Mortgage is an adjustable-rate conventional reverse mortgage for borrowers
who are at least 62 years of age, and who either own the home outright or have a low amount of
unpaid principal balance. The other type of reverse mortgage, Home Keeper for Home Purchase,
enables senior borrowers to buy a new home with a combination of personal funds and a
calculated amount of reverse mortgage that is based upon the borrowers age, number of
borrowers, the adjusted property value, and the equity share option chosen.

17. Answer the following questions.

a. Explain why you agree or disagree with the following statement: Only borrowers with
highly impaired credit can obtain a high LTV loan.

One would disagree with this statement that only borrowers with good credit would be expected
to obtain a high LTV loan (where the LTV is the ratio of the amount of the loan to the market
value of the property). Everything else equal, a lower LTV loan provides more protection to the
lender if the property must be repossessed and sold. Borrowers with impaired credit would be
expected to put down more money making the LTV ratio lower. An exception might be a

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situation where insurance can be obtained so as to counterbalance the situation of the borrower
with impaired credit.

Traditionally for a conventional, conforming loan, borrowers were required to make a down
payment of 20% when qualifying for a mortgage. However, today a borrower with good credit
has the option of making a lesser or no down payment, resulting in loans with higher LTVs. For
borrowers interested in conventional, nonconforming loans, programs available for 103% LTV
require no down payment because 100% of the homes price, as well as an additional 3% for
closing costs, can be financed into the mortgage.

b. Explain why you agree or disagree with the following statement: An alt-A loan is a
conventional, conforming loan.

Let us begin by defining conventional and conforming loans. A conventional loan is when the
lender makes the loan based on the credit and collateral of the borrower (and for which the
lender also may take out mortgage insurance to provide a guarantee for the fulfillment of the
borrowers obligations). A conforming mortgage is one that meets the underwriting standards
established for being in a pool of mortgages underlying a security that the pool guarantees.

Given the above definitions for conventional and conforming, one would tend to disagree with
the statement. First, an alt-A loan refers to loans made to borrowers who generally have high
credit scores but who have variable incomes, are unable or unwilling to document a stable
income history, or are buying second homes or investment properties. In such respects, alt-A
loans allow reduced or alternate forms of documentation (that often accompany conventional and
conforming loans) to qualify the loan. Second, the typical alt-A borrower has an excellent credit
rating referred to as an A rating, and hence the loan is referred to as an alt-A loan, which is
especially important to the originator because the credit quality of the borrower must compensate
for the lack of other necessary documentation found in conventional and conforming loans.

c. Explain why you agree or disagree with the following statement: An alt-B loan is a
subprime loan.

Subprime loans refer to loans to borrowers whose credit has been impaired but generally have
sufficient equity in their homes to mitigate the credit exposure, allowing the lender to place less
weight on the credit profile in making the lending decision. Thus, a subprime loan allows
mortgage lenders to make funds available to credit borrowers who fail to qualify for a mortgage
due to the underwriting standards relating to credit worthiness. Alt-B loans refer to a fast-
growing product area consisting of loans to borrowers with both modestly impaired credit and
less rigorous documentation. Thus, strictly speaking one would disagree with the statement that
an alt-B loan is a subprime loan, because recipients of subprime loans may have less impaired
credit compared to recipients of alt-B loans. However, for both an alt-B loan and a subprime
loan, less rigorous documentation is required.

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18. Why is an alt-A loan obtained?

An alt-A loan is obtained by borrowers who cannot supply necessary documents. While
generally having have high credit scores, these borrowers have variable incomes, are unable or
unwilling to document a stable income history, or are buying second homes or investment
properties. Thus, an alt-A loan allows this type of borrower a reduction in conventional
documentation (or the option of supplying alternate forms of documentation to qualify the loan).
The typical alt-A borrower has an excellent credit rating referred to as an A rating, and hence the
loan is referred to as an alt-A loan, which is especially important to the originator because the
credit quality of the borrower must compensate for the lack of other necessary documentation.

19. Answer the following questions.

(a) What is a balloon mortgage?

A balloon mortgage is a mortgage with a final payment notably larger than the other periodic
payments. The borrower is given long-term financing, but at a specified future date the contract
rate is renegotiated. Thus, the lender is providing long-term funds for what is effectively a short-
term loan. The length of the short-term borrowing depends on the frequency of the renegotiation
period. The balloon payment is the original amount borrowed less the amount amortized.

(b) What is the actual final maturity of a balloon mortgage?

In a balloon mortgage, the actual maturity is shorter than the stated maturity. A balloon mortgage
is usually rather short, with a term of five to seven years, but the payment is based on a term of
30 years. There are a couple of popular institutional loan products that have balloon payments.
One is the 30-year loan that's due in 5 or 7 years. The interest rate on this mortgage product is
usually lower than found on a conventional 30-year fixed rate mortgage due in 30 years. The
monthly payments on the short-term mortgages are amortized on a 30-year basis. However, at
the end of the 5 or 7 years, a large balloon payment is due.

20. Explain why in a fixed-rate level-payment mortgage the amount of the mortgage
payment applied to interest declines over time while the amount applied to the repayment
of principal increases.

Each fixed-rate level-payment consists of an amount that is greater than the interest owed. This
means that the remainder of the payment reduces the principal balance. Accordingly, the interest
owed next period is small and so the fixed-rate level-payment will pay down more of the
principal balance than paid in the preceding year. Thus, the interest declines over time while the
amount applied to the repayment of principal increases.

21. Consider the following fixed-rate level-payment mortgage: maturity = 360 months,
amount borrowed = $150,000 and annual mortgage rate = 8%. What is the monthly
mortgage payment?

The monthly mortgage payment (MP) is given by the following equation:

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 i (1 + i ) n
MP = MB0
(1 + i ) n - 1

where n = number of months, MB0 = original mortgage balance (in $), and i = simple monthly
interest rate (i = annual interest rate / 12). The term in brackets is called the payment factor or
annuity factor. It is the monthly payment for a $1 mortgage loan with an interest rate of i and a
term of n months.

For our problem, we have n = 360, MB0 = $150,000, and i = 0.08 /12 = 0.0066667. Inserting
these values in to our monthly mortgage payment equation and solving gives:

i (1 + i ) n
0.0066667( 1.0066667 )360
MP = MB0 = $150,000 = $150,000
(1 + i ) n - 1 360
( 1.0066667 ) - 1
0.0067708( 10.935729 )
= $150,000[0.0073376458] = $1,100.65.
10.935729 - 1

22. For the following fixed-rate level-payment mortgage, construct an amortization

schedule for the first 10 months: maturity = 360 months, amount borrowed = $100,000,
annual mortgage rate = 10% and monthly mortgage payment = $877.57.

The exhibit below shows for selected months how each monthly mortgage payment is divided
between interest and repayment of principal for the first 10 months of the loan.

Exhibit: Amortization Schedule of a Level Payment Fixed-Rate Mortgage

Mortgage loan: $100,000
Mortgage rate: 10.00%
Monthly payment: $877.57
Term of loan: 30 years (360 months)
Scheduled Ending
Beginning Monthly Monthly
Month Principal Mortgage
Mortgage Balance Payment Interest
Repayment Balance
1 $100,000.00 $877.57 $833.33 $44.24 $99,955.76
2 $99,955.76 $877.57 $832.96 $44.61 $99,911.15
3 $99,911.15 $877.57 $832.59 $44.98 $99,866.18
4 $99,866.18 $877.57 $832.22 $45.35 $99,820.82
5 $99,820.82 $877.57 $831.84 $45.73 $99,775.09
6 $99,775.09 $877.57 $831.46 $46.11 $99,728.98
7 $99,728.98 $877.57 $831.07 $46.50 $99,682.48
8 $99,682.48 $877.57 $830.69 $46.88 $99,635.60
9 $99,635.60 $877.57 $830.30 $47.27 $99,588.32
10 $99,588.32 $877.57 $829.90 $47.67 $99,540.65

At the beginning of month 1, the mortgage balance is $100,000, the amount of the original loan.

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The mortgage payment for month 1 includes interest on the $100,000 borrowed for the month.
Because the annual interest rate is 10.00%, the monthly interest rate is 0.10 / 12 = 0.0083333.
Interest for month 1 is therefore $100,000 (0.0083333) = $833.33. The $44.24 difference
between the monthly mortgage payment of $877.57 and the interest of $833.33 is the portion of
the monthly mortgage payment that represents repayment of principal. [NOTE. The monthly
mortgage payment of $877.57 is computed using the equation for MP given in the previous
problem.] The $44.24 difference in month 1 reduces the mortgage balance. The mortgage
balance at the end of month 1 (beginning of month 2) is then $100,000 $44.24 = $99,955.76.
The interest for the second monthly mortgage payment is the monthly interest rate (0.00833333)
times the mortgage balance at the beginning of month 2 ($99,955.76). We have: 0.083333
($99,955.76) = $832.96. The difference between the $877.57 monthly mortgage payment and the
$832.96 interest is $44.61, representing the amount of the mortgage balance paid off with that
monthly mortgage payment. Similarly, we can compute the remaining numbers shown in the
Exhibit which stops after ten months.

23. What is the most important factor that has been found to gauge the risk that a
borrower will default?

A mortgages loan-to-value (LTV) ratio has been found in numerous studies to be the single
most important determinant of its likelihood of default, and therefore the amount of required
credit enhancement. The rationale is straightforward: Homeowners with large amounts of equity
in their properties are unlikely to default. They will either try to protect this equity by remaining
current or, if they fail, sell the house or refinance it to unlock the equity. In any case, the lender is
protected by the buyers self-interest. On the other hand, if the borrower has little or no equity in
the property, the value of the default option is much greater.

24. Answer the following questions.

(a) What is the original LTV of a mortgage loan?

The original LTV of a mortgage loan is the LTV at the time of origination. The LTV is the ratio
of the amount of the loan to the market (or appraised) value of the property. The lower this ratio,
the more protection the lender has if the applicant defaults and the property must be repossessed
and sold.

(b) What is the current LTV of a mortgage loan?

The current LTV is the LTV based on the current unpaid mortgage balance and the estimated
current market value of the property.

(c) What is the problem with using the original LTV to assess the likelihood that a seasoned
mortgage will default?

The problem with using the original LTV to assess a seasoned mortgage is that the LTV can
change over time if the value of the property changes. At one time, rating agencies and other
participants in the mortgage market considered the LTV only at the time of origination in their

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analysis of credit risk. Because of periods in which there has been a decline in housing prices,
the current LTV has become the focus of attention by rating agencies. Specifically, the concern is
that a decline in housing prices can result in a current LTV that is considerably greater than the
original LTV. This would result in greater credit risk for such mortgage loans than at the time of
origination.

25. In assessing the credit risk of a pool of mortgage loans, the rating agency compares a
pool to a pool of prime loans. What is meant by a prime loan?

Rating agencies in their credit analysis establish a benchmark to assess the credit risk of
mortgage pools. Specifically, rating agencies compare a mortgage pool to a pool of what is called
prime loans. A prime loan is a 30-year fixed-rate mortgage with a 75% to 80% loan-to-value
ratio that is fully documented for the purchase of an owner-occupied single-family detached
house. These characteristics describe the most common mortgage type generally associated with
the lowest default rates. Loans with almost any other characteristic generally are assumed to
have a greater frequency of default.

26. Answer the following questions.

(a) What is meant by a FICO score?

A FICO score refers to how financial institutions rank the credit worthiness of a borrower. More
details are given below.

Although loan originators place a great deal of emphasis on borrowers credit histories, these
data are not available to the rating agencies. The Fair Credit Reporting Act restricts access to
such information to parties involved in a credit extension decision. As a result, the agencies use
credit proxies such as the debt-to-income ratio, the mortgage coupon rate, past delinquencies or
seasoned loans, or either originators credit scores (e.g., A, B, C, or D) or credit scores by
vendors. The most frequently used credit score developed by financial institutions is the one
developed by Fair, Isaacs & Company. The score, referred to as the FICO score, uses 45 criteria
to rank the credit worthiness of an individual.

(b) What is the relationship between FICO scores and credit risk?

FICO scores range from 350 to 850. There is an inverse relation between a FICO score and a
firms credit risk. Thus, if a firm receives a high FICO score this means it has low credit risk.

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