Part One
Introduction to Mortgage and MBS Markets
CHAPTER 1
Overview of Mortgages and the Consumer Mortgage Market
Over the past few decades, the residential mortgage market in the United States has emerged as one of the worldâs largest asset classes. At its peak in the first quarter of 2008, the total face value of household mortgage debt exceeded $10.6 trillion dollars. The growth of the residential mortgage market reflected the rapid growth in the aggregate value of real estate between 2001 and 2006, along with consumersâ propensity to monetize their home equity through additional borrowing.
The composition and performance of the mortgage market has undergone profound shifts on several occasions, and can be divided into separate phases. The period between 2001 and early 2007 was characterized by numerous innovations in product features, pricing paradigms, and underwriting practices, which were underpinned by steady nationwide increases in home prices. The sudden and protracted decline in the credit performance of residential mortgage loans, which first became apparent in 2006, led to the recognition that many of the products and practices developed during the earlier period were fundamentally flawed, with their weaknesses masked by the strength in the residential real estate markets. This led to a retrenchment by mortgage lenders characterized by conservative lending practices and greater regulatory scrutiny. At this writing, most lending programs require high credit scores and (with the exception of some government-backed programs) relatively large down payments. Almost all programs currently require full documentation of income sources, while so-called âaffordability productsâ (which allow obligors to borrow increasingly large amounts relative to their income) have fallen out of favor and, in some cases, been outlawed entirely.
Despite the changes and dislocations experienced by the mortgage industry, however, it remains critical to the health of the housing market. Since most home buyers need to finance at least some of the purchase price, the availability and cost of mortgage money is a key factor driving sales volumes for new and existing homes. Moreover, the events of the past few years have demonstrated that familiarity with the primary mortgage market is important in understanding a variety of trends and factors influencing the market for securitized mortgage products.
The primary purpose of this chapter is to explain mortgage products and lending practices. The chapter introduces the basic tenets of the primary mortgage market and mortgage lending, and summarizes the various product offerings in the sector. In conjunction with the following chapter on mortgage-backed securities (MBS) and the mortgage-backed securities market, this chapter also provides a framework for understanding the concepts and practices addressed in the remainder of this book.
OVERVIEW OF MORTGAGES
In general, a mortgage is a loan that is secured by underlying assets that can be repossessed in the event of default. For the purposes of this book, a mortgage is defined as a loan made to the owner of a one- to four-family residential dwelling and secured by the underlying property (both the land and the structure or âimprovementâ). After issuance, loans must be managed (or serviced) by units that, for a fee, collect payments from borrowers and pass them on to investors. Servicers are also responsible for interfacing with borrowers if they become delinquent on their payments, and also manage the disposition of the loan and the underlying property if the loan goes into foreclosure.
Key Attributes that Define Mortgages
There are a number of key attributes that define the instruments in question, which can be characterized by the following dimensions:
- Lien status, original loan term
- Credit classification
- Interest rate type
- Amortization type
- Credit guarantees
- Loan balances
- Prepayments and prepayment penalties
We discuss each in the following subsections.
Lien Status
The lien status dictates the loanâs seniority in the event of the forced liquidation of the property due to default by the obligor. A first lien implies that a creditor would have first call on the proceeds of the liquidation of the property if it were to be repossessed. Borrowers have often utilized second liens or junior loans as a means of liquefying the value of a home for the purpose of expenditures such as medical bills or college tuition or investments such as home improvements.
Original Loan Term
The great majority of mortgages are originated with a 30-year original term. Loans with shorter stated terms are also utilized by those borrowers seeking to amortize their loans faster and build equity in their homes more quickly. The 15-year mortgage is the most common short-amortization instrument, although there has been fairly steady issuance of loans with 20- and 10-year terms.
Credit Classification
The majority of loans originated are underwritten to high credit standards, where the borrowers have strong employment and credit histories, income sufficient to pay the loans without compromising their creditworthiness, and substantial equity in the underlying property. These loans are broadly classified as prime loans, and have historically experienced relatively low incidences of delinquency and default.
Loans of lower initial credit quality, which are expected to experience significantly higher rates of default, are classified as subprime loans. Subprime loan underwriting often utilized nontraditional measures to assess credit risk, as these borrowers typically had lower income levels, fewer assets, and blemished credit histories. Issuance of the product declined precipitously after 2006, when it became evident that the sector was plagued by poor underwriting, fraud, and an excessive reliance on rising home prices.
Between the prime and subprime sector is a somewhat nebulous category referenced as alternative-A loans or, more commonly, alt-A loans. These loans were considered to be prime loans (the âAâ refers to the A grade assigned by underwriting systems), albeit with some attributes (such as limited income or asset documentation) that either increased their perceived credit riskiness or caused them to be difficult to categorize and evaluate. As with subprime, issuance of alt-A loans fell sharply with the post-2006 decline in home prices and mortgage credit performance.
Mortgage credit analysis employs a number of different metrics, including the following.
Credit Scores
Several firms collect data on the payment histories of individuals from lending institutions and use sophisticated models to evaluate and quantify individual creditworthiness. The process results in a credit score, which is essentially a numerical grade of the credit history and creditworthiness of the borrower. There are three different credit-reporting firms that calculate credit scores: Experian (which markets the Experian/Fair Isaac Risk Model), Transunion (which supports the Emperica model), and Equifax (whose model is known as Beacon). While each firmâs credit scores are based on different data sets and scoring algorithms, the scores are generically referred to as FICO scores, since they are based on Fair Isaacâs software and models. Underwriters typically purchase credit scores from all three credit bureaus, and apply the median figure to their analysis; in the event that only two scores are available, the lower of the two is used.
Loan-to-Value Ratios
The loan-to-value ratio (LTV) is an indicator of borrower leverage at any point in time. The LTV calculation compares the face value of the desired loan to the market value of the property. By definition, the LTV of the loan in the purchase transaction is a function of both the down payment and the purchase price of the property. In a refinancing, the LTV is dependent upon the requested amount of the new loan and the market value of the property as determined by an appraisal. (Note that if the new loan is larger than the original loan, the transaction is referred to as a cash-out refinancing; a refinancing where the loan balance remains the same is described as a rate-and-term or no-cash refinancing.)
The LTV is important for a number of reasons. First, it is an indicator of the amount that can be recovered from a loan in the event of a default, especially if the value of the property has not appreciated. The level of the LTV also has an impact on the expected payment performance of the obligor; a high LTV indicates a greater likelihood of default on a loan. The recognition of this phenomenon has caused mortgage analysts to distinguish between the original LTV (i.e., the LTV at the time the loan was originated) and the current LTV (CuLTV), which accounts for changes in the homeâs price after the loan is issued. (Data indicate that borrowers have a increased propensity to voluntarily stop servicing their loans once their CuLTV exceeds 125%, even if they can afford making monthly payments. This behavior, called strategic default, was not contemplated before the post-2006 decline in home prices.)
Analysis must also account for the presence of subordinated mortgage debt. A common supplemental measure is the combined LTV (CLTV), which accounts for the presence of second and third liens. As an example, a $100,000 property with an $80,000 first lien and a $10,000 second lien will have an LTV of 80% but a CLTV of 90%.
Income Ratios
In order to ensure that borrower obligations are consistent with their income, lenders calculate income ratios that compare the potential monthly payment on the loan to the applicantâs monthly income. The most common measures are front and back ratios. The front ratio is calculated by dividing the total monthly payments on the home (including principal, interest, property taxes, and homeowners insurance) by pretax monthly income. The back ratio is similar, but adds other debt payments (including auto loan and credit card payments) to the total payments. In order for a loan to be classified as prime, the front and back ratios should be no more than 28% and 36%, respectively. (Because consumer debt figures can be somewhat inconsistent and nebulous, the front ratio is generally considered the more reliable measure, and accorded greater weight by underwriters.)
Documentation
Lenders traditionally have required potential borrowers to provide data on their financial status, and support the data with documentation. Loan officers typically required applicants to report and document income, employment status, and financial resources (including the source of the down payment for the transaction). Part of the application process routinely involved compiling documents such as tax returns and bank statements for use in the underwriting process. Between 2001 and 2007, however, increasingly large numbers of loans were underwritten using relaxed documentation standards. While originally designed for self-employed borrowers that had difficulty documenting their income, these programs were extended to include wage earners that often were looking to borrow larger sums than could be supported by their incomes. Such programs ranged from simply not requiring pay stubs and bank statements from existing customers, to âstated-incomeâ programs (where income levels and asset values were provided but not independently verified) to âno incomeâno assetâ programs for which no income figures or bank balances were provided by the borrower. The devastating post-2007 decline in performance for these products forced lenders to return to requiring full documentation in almost all cases.
Characterizing Mortgage Credit
The primary attribute used to categorize mortgage credit has long been the credit score. Prime (or A-grade) loans generally had FICO scores of 660 or higher, income ratios with the previously noted maximum of 28% and 36%, and LTVs of 90% or less. Alt-A loans occupied a middle ground between prime and subprime products. The âalt-Aâ label was applied to a variety of products which typically combined relaxed documentation standards, nonoccupancy by the obligor (i.e., the home was either an investment property or a second home), and credit scores between 660 and 7...