Mortgages

Mortgages
vsgirish@mtnl.net.in
Agenda
• Overview of the mortgage market

• Mortgage marketplace
• Mortgages Products
• Originators: the distribution channel
• The role of the Servicer
• Compliance
Executive Summary
• The mortgage market in the United States is vast

• Marketplace characteristics are driven by borrower and
investor demands
• Mortgages Products
• The mortgage banking business links the borrower to the
investor creating high market liquidity
• Servicers move the cash
• U.S. residential mortgage-backed securities, now
account for some 20 percent of the global fixed income
market
Overview of the Mortgage Market
U.S. Mortgage Market
The mortgage market – Vast: in excess of $6 trillion of mortgage
has two primary
sectors: retail and loans outstanding
commercial.
– Demand for mortgage product high: over
6.4 billion single-family homes purchased in
Single-family both 2002 and 2001
constitutes the retail
sector. Multi-family – Government sponsored entities (Agencies)
comprises part of the
commercial sector. facilitate highly liquid securitization market
– Securities market deep: over $ 1 trillion in
securities issued in both 2002 and 2001
– Mortgage products highly standardized with
virtually no penalty for prepayment
Market Demands Drive Product
Market liquidity also • Investors

drives innovation in
•Borrowers / Home Buyers
product development . – Invest in mortgage product without
– Lowest all-in rate
business infrastructure
– Broadest selection of
product type – Large pools of standardized, small
dollar product
– Lowest out-of-pocket costs
– Low, well-diversified credit risk
– Efficient, reliable delivery of
product – Well-collateralized investment
– Ease of access
– Additional credit enhancement
– Transparency
– Highly liquid investment
– Efficient delivery
– Managed prepayment volatility
U.S. Mortgage Banking Industry
Mortgage Banking
connects the needs of
borrowers with the
Mortgage Banking
demands of investors to
provide a deep and liquid
mortgage marketplace in
the U.S.
Originations
Borrowers /
Investors
Home Buyers
Servicing
Key Differences: U.S. vs. Europe
U.S. Market European Market
– Government-sponsored – Limited secondary

entities create a liquid market, assets
Although the underlying securitization market: retained
characteristics are • Credit risk sold • Credit risk retained
similar across the two
regions, fundamental
• Need not be self-funded • Funded through
differences exist in the • Standardized product bond issuances
two markets.
– Virtually no prepayment – Prepayment
penalties penalties
• Results in high refinance • Limits refinance
market market and
origination volume
– Capital requirements low
– Capital requirements
high
U.S. Borrowers’ View of Mortgage Product
– 1st liens on real property (e.g., collateral specific)

– Typically no penalty for prepayment
– Variety of basic terms:
• Fixed rate mortgages: predominantly 15 year or 30 year
• Adjustable rate mortgages: ARM and ARM hybrids
• Other hybrid products:
– Interest only payments
– Reverse mortgages
– Balloon principal
Borrowers’ Decisions
The most prevalent are

– Interest type:
fixed rate mortgages • Fixed, floating or hybrid
where the payments are
both principal and – Payment type:
interest.
• Principal and interest or interest only
30 year mortgages are
common although the
– Current interest rates (purchase or
current low interest rate refinancing)
environment has resulted
in an increase in shorter – Tenor (various including 15 year and 30 year)
tenors.
– Cash contributed to property purchase
(equity)
• Loan to property value (LTV) < 80% – standard
• LTV > 80% requires borrower to buy insurance
– Cash paid at closing (fees, points, etc.)
Sub Prime Loans
• A mortgage granted to a borrower
considered sub prime, that is, a person
with a less-than-perfect credit report
• Sub prime borrowers have either missed
payments on a debt or have been late with
payments. Lenders charge a higher
interest rate to compensate for potential
losses from customers who may run into
trouble or default
Sub Prime Loans
• Last year, 13.5 percent of mortgages originated
in the U.S. were sub prime, according to the
Mortgage Bankers Association, compared to 2.6
percent in 2000
• Overall, the sub prime market was $600 billion in
2006, 20 percent of the $3 trillion mortgage
market, according to Inside Mortgage Finance
• In 2001, sub prime loans made ups just 5.6
percent of mortgage dollars
• By the end of 2006, sub prime delinquencies
more than 60 days late jumped to almost 13
percent, compared to 8 percent a year earlier
Sub Prime
• US dose not have high unemployment, high interest
rates or a slowing economy, but is seeing the number of
foreclosure filings pushed above historic averages
• Investors have been drawn into the riskier subprime
pieces of these mortgage-backed securities that yield
higher payoffs, instead of sticking with highly rated
mortgage securities
• Particularly troubling for investors is the rapidly
deteriorating quality of subprime vintages originated in
2005 and 2006, years when lenders were downright
promiscuous about who they loaned money to
Sub Prime Issue
• The scariest part of that statistic is the fact
that 2006 borrowers are still in their fixed-
rate period. What will they do when their
payment starts to rise?
• The worry is that somebody, somewhere
has been overly aggressive in their
subprime investments and goes belly up,
spooking investors and sparking a world
financial crisis
MORTGAGE PRODUCTS
What is a mortgage?
• A mortgage is an instrument in which
the title to real estate is held as a
security against the repayment of a
debt
• A lien is a legal claim on the property
that allows the lien holder to satisfy
the debt through foreclosure and
sale of the property, if necessary
Mortgage Deed And Promissory
Note
• All mortgages are basically composed of two parts:
1) the mortgage deed or deed of trust, and

2) the promissory note
– The mortgage deed describes the real estate to be used as

collateral against the repayment of the note.
– A deed of trust is similar to a mortgage deed except that the
borrower creates a trust and conveys the title of the property to a
trustee who holds it as security for the benefit of the lender.
– The promissory note is a personal promise to repay the note,
and even in the absence of any real estate security, the borrower
would still have an obligation to repay the note.
• The note spells out the financial terms of repayment as well as the
rights and interest of the lender and borrower
Title Theory And Lien Theory
• There are two general approaches used in most states to establish
the legal relationship between a borrower and a lender.
– One is called title theory, where title is held by, or

rests with, the mortgagee (lender).
– The other is called lien theory, where the mortgagor

(borrower) retains title and the mortgagee merely has
a lien against the property.
– Lien theory is more modern in origin and the most

common approach in most states, although many
states have a hybrid approach encompassing both
theories in part
Determinants of Mortgage Interest
Rates
• Real rate of interest- the required rate at which economic
units save rather than consume
• Rate of inflation
• Nominal rate or constant rate i= r+f
• Nominal rate= real rate plus a premium for inflation
• Default risk- creditworthiness of borrowers
• Interest rate risk- rate change due to market conditions
and economic conditions
• Prepayment risk- falling interest rates
• Liquidity risk
• i=r+ f+ P…
Types of Mortgages
• Fixed-rate mortgages
– Maturity (30 year and 15 year)
– Type (conforming and non-conforming)
• Adjustable-rate mortgages
• Key terms:
– LTV
– Points
– Lock
– APR
Glossary
• The loan-to-value (LTV) ratio is a
mathematical calculation which expresses
the amount of a first mortgage lien as a
percentage of the total appraised value of
real property. For instance, if a borrower
wants 130,000 to purchase a house worth
150,000, the LTV ratio is 130,000/150,000
or 87%
• Combined Loan To Value (CLTV) ratio
Glossary
• Points - Points are fees the borrower pays the
lender at the time the loan is closed, expressed
as a percent of the loan. On a 100,000 loan, 3
points means a payment of 3,000. Points are
part of the cost of credit to the borrower, and part
of the investment return to the lender
• The more points you can pay up front, the lower
your interest rate will be
• Not Used anywhere else in the world except the
US
• There are two types of points: Origination Points
and Discount Points
Points
• Origination points are charged to recover some costs of
the loan origination process. Typically, Loan Officer's
compensation is based on the Origination points.
Depending on the lending institution, the Origination
Points may be negotiable in whole or in part
• Discount Points are used to "buy" get interest rate lower.
This is known as a rate "buydown." A general rule of
thumb is that one full Discount Point will lower the fixed
interest rate .250% or adjustable rate .375%. These
points lower the interest rate for the entire term of the
loan. There is usually some flexibility by the lending
institution in determining the actual buydown formula, but
less than with Origination Points
Points
Interest Rate Points
• For example, 5.125 3.75
schedule covering 5.25 3.25

5.375 2.75
30-year fixed-rate 5.5 2.375
mortgages (FRMs) 5.625 1.875

5.75 1.375
offering all of the 5.875 1
following 6 0.625
6.125 0.375
combinations: 6.25 0
6.375 -0.375
6.5 -0.5
6.625 -0.875
6.75 -1.25
6.875 -1.5
Points
• Some borrowers have little or no leeway
– They are "cash-short" or "income-short"
– If cash-short, are obliged to avoid points so that they will have
enough cash to complete the deal
– If income-short, must accept the lowest rate available so that the
mortgage payment won't be viewed as excessive relative to
income
• If expect to have mortgage a long time, paying points to
reduce the rate makes economic sense because you are
going to enjoy the lower rate for a long time
• If time horizon is short, avoid points and pay the higher
rate because won’t be paying it for long
Glossary
• Lock - the monthly mortgage payment depends in part
on interest rates
• The rate on the loan isn't necessarily set when you apply
for a mortgage. Until you explicitly "lock" in your loan
pricing, the rate on your pending loan will "float" with
financial market conditions. Your monthly payment may
end up being higher or lower than it would have been
under the conditions that prevailed when you applied for
the loan
• Lender's guarantee that the mortgage rate quoted will be
good for a specific amount of time. The home buyer
usually wants the lock to stay in effect until the date of
the closing
• Generally, you can lock in your loan pricing any time
after application but at least five days before your
scheduled closing
Glossary
• APR - Annual Percentage Rate – Apart from the
interest rate, Origination fees, points, mortgage
insurance premiums, inspections, prepaid
interest and other items may also be required to
obtain a mortgage
• APR is a standardized method of calculating the
cost of a mortgage, stated as a yearly rate which
includes such items as interest, mortgage
insurance, and certain points or credit costs
Fixed - Rate Mortgages
• A fixed-rate mortgage has a fixed-rate of interest for the
term of the loan.
• Loan terms can vary from 15 to 30 years, although other

terms are available as well.
• There are several variations of amortizing mortgages.
– Constant payment mortgage (CPM)

– Constant interest mortgage (CIM)
– Constant amortization mortgage (CAM)
Constant Payment Mortgage
• Constant monthly payment on original loan

• Fixed rate of interest for a given term
• Amount of amortization varies each month
• Completely repaid over the term of the
loan
Constant Amortization Mortgage
• Constant payment
• Interest computed on the monthly loan
balance
• Constant amortization amount
• Total payment= constant amortization
amount plus monthly interest
Comparative Mortgage Designs
The Constant Payment Mortgage
Other Mortgage Types
• Graduated payment mortgages
• Shared appreciation mortgages
• Reverse annuity mortgages
Graduated Payment Mortgage
• A graduated payment mortgage loan, often referred to as
GPM, is a mortgage with low initial monthly payments which
gradually increase over a specified time frame
• These plans are mostly geared towards young men and
women who cannot afford large payments now, but can
realistically expect to do better financially in the future
• For instance a medical student who is just about to finish
medical school might not have the financial capability to pay
for a mortgage loan, but once he graduates, it is more than
probable that he will be earning a high income
• It is a form of negative amortization loan
Shared Appreciation Mortgage
• A shared appreciation mortgage is a mortgage in
which the lender agrees as part of the loan to
accept some or all payment in the form of a
share of the increase in value (the appreciation)
of the property
• In the UK a shared appreciation mortgage is a
mortgage arranged as a form of equity release.
The lender loans the borrower a capital sum in
return for a share of the future increase in the
growth of the property. The borrowers retain the
right to live in the property until death
Shared Appreciation Mortgage
• In the US a shared appreciation mortgage is a
mortgage in which the lender agrees to an
interest rate lower than the prevailing market
rate, in exchange for a share of the appreicated
value of the collateral property
• The share of the appreciated value is known as
the contingent interest, which is determined and
due at the sale of the property or at the
termination of the mortgage
Reverse Annuity Mortgage
• An arrangement in which a homeowner

borrows against the equity in his/her home
and receives regular monthly tax-free
payments from the lender. also called
reverse mortgage or home equity
conversion mortgage
Reverse Annuity Mortgages
• Residential property value $500,000
• Loan amount (to be disbursed
in monthly installments) $250,000
• Term 10 years 120 months
• Interest Rate 10%
• Calculator solution:
– FV=-250,000
– i=10%/ 12
– PMT= ?
– n=120
– Solve for payment $1220.44
Equity Sharing Agreement
• An Equity Sharing Agreement is a written

agreement between two (or more) parties
pursuant which they agree to
purchase real estate together, divide the
financial responsibilities, and share the
profits and losses in a particular way
Jumbo Mortgage
• In the United States a jumbo mortgage is a mortgage
with a loan amount above the industry standard definition
of conventional conforming loan limits
• This standard is set by the two largest secondary market
lenders, Fannie Mae and Freddie Mac
• Loans above the conforming limits may be offered by
seller servicers of these wholesale institutions as well as
Wall Street conduits who provide warehouse financing
for mortgage lenders. The loan amounts reflect average
loan sizes nationwide
Jumbo Mortgage
• Jumbo mortgages apply when agency limits don't cover
the full loan amount
• Fannie Mae (FNMA) and Freddie Mac (FHLMC) are
large agencies that purchase the bulk of residential
mortgages in the U.S. They set a limit on the maximum
dollar value of any mortgage they will purchase from an
individual lender
• As of 2006, the limit is $417,000, or $625,500 in Alaska,
Hawaii, Guam, and the U.S. Virgin Islands. This leaves a
portion of the market to look elsewhere for placement.
Other large investors, such as insurance companies and
banks, step in to fill the need with maximum mortgage
amounts going to the $1 million or $2 million range. The
average interest rates are typically greater than normal
for conforming mortgages, and vary depending on
property types and mortgage amount
Important Clauses In Uniform
Mortgages
• Acceleration Clause - The section of a mortgage
document that allows the lender to speed up the
payment date in the event of a default, making
the entire principal amount due
• Defeasance Clause - Substitution
• Prepayment Clause
• Subordination Clause - Clause in some
mortgages which allows subsequent mortgages
on the same property to have higher claim than
the current mortgage
• The Estoppel Clause
Estoppel
• Estoppel is a doctrine which protects a party
who would suffer detriment if:
– The defendant has done or said something to induce
an expectation
– The plaintiff relied (reasonably) on the expectation...
– ...and would suffer detriment if that expectation were
false
• A builder might inform a buyer that fees has
been reduced, for example, if there is
construction or a lapse in utility services. If the
tenant relies on this advice, the builder could be
estopped from collecting fees retroactively
Adjustable-rate Mortgages
• ARMs differ from fixed-rate mortgages in that
the rate on the mortgage varies every month or
year (depending on the terms of the ARM).
• There are a number of variations on the

adjustable rate mortgages (also known as
variable rate mortgages).
• Adjustable rate mortgages are not as popular in

the current low interest rate environment, but
may return to popularity when interest rates
begin to increase
Features of ARMs
• ARM Indexation
• Adjusting the ARM Payment
• Adjustable Rate Mortgage with Capped
Payments
• Adjustable Rate Mortgage Terms
Adjustable Rate Mortgage (ARM)
Interest rate is not fixed but linked to market index

But it is different from floating-rate loan
Floating-rate Loan
One-to-one relation between interest rate and index
Index , interest rate , and vice versa
ARM
No one-to-one relation between interest rate and index
Index , interest rate may still be 
Features of ARM
Initial Rate
Interest rate applicable to the initial period
Initial period may be 1M to 5Y
Often set below the market index (“teaser rate”)
Adjustment Period
Period for which interest rate is reset
It may be 1M to 1Q
Index
Market interest rate to which loan interest rate is linked
e.g. 1Y CMT, COFI, LIBOR, Lender’s own cost index
Margin
Spread added over Index
Types of ARM
Hybrid ARM
Interest-only ARM
Capped ARM
Interest rate cap
Payment cap
Hybrid ARM
Two parts in loan’s life

Fixed rate for
First part: interest rate is fixed 3Y
Second part: interest rate is adjustable
The periods are indicated by numbers 3 / 27
Sometimes Adjustment Period is indicated
Fixed rate for Adjustable Period is 1Y
3Y for the next 27Y
3/1
Interest-only ARM
In the beginning period, only interest is paid

Beginning period can be 1Y to 10Y
Principal amortization starts after the beginning period
Payment amounts will be less in the beginning period …
… and more in the later period
Capped ARM
The “cap” here is different from “cap” in interest options
“cap” in interest rate options:

Absolute limit on the interest rate
“cap” in ARM:
Postponement of rate increase to later periods
Two versions of capped ARMs
Interest rate cap
Payment cap
Interest rate ARM
Cap is on interest rate per period
Two distinct caps
Periodic Adjustment Cap (PAC)

Cap applies to Adjustment Period
e.g. cap of 2% means that rate cannot rise more than 2%
Unadjusted hike in rate is carried over
Carryover is adjusted in future periods
Lifetime Cap (LC)

Limit on cumulative rise in interest rate for the life
By law, all ARMs must have LC
An Example
30Y ARM Adjustment Period 1Y PAC 2% LC 6%
PACPAC allows
allows onlyonly 2% rise
2% rise
1Y 2Y Balance
3Ykept
Balance
Carryover
Rate 4Y1% 5Y2%becarried
6Y
carried
cannot
the same 7Yover
soover
adjusted
that
because
carryover
rateishit
cleared
the LC
Change in index … 2% adjusted
+3% +4% from
0% 0% carryover
1% +1%
Chargeable rate 6% 8% 10% reduced

Carryover 12% 12%by
12%
2% 12%
Carryover … 1% 3% 1% 1% 0 1%
Rate cannot be raised because

of LC but carried over
Payment Cap ARM
Cap is on installment amount, not on interest rate
e.g. payment cap of 7.5% and initial monthly PMT = 1199
Next monthly PMT is capped at: 1199 1.075 = 1289
Next monthly PMT is 1462
Actual PMT is capped at 1289 and 173 is carried over
The above applies to one “recast” period
At the end of recast period, carryover is added to balance
This is called negative amortization
Securitization
Transfer of pvt. financial claims into traded securities
assets = ABS
mortgages = MBS
Originator SPV Investor
financial Securitized
claims assets
Securitization
Why SPV?
It is asset sale by originator, not financing arrangement
Credit risk of originator must be eliminated
Claims must be diversified
Claims must be made homogenous
Claims must be credit-graded (“credit tranched”)
Claims must be credit-enhanced
SPV is a bankruptcy-remote entity
Collateralized Mortgage Obligation
• A CMO is a financial debt vehicle that was first created in

June 1983 by investment banks Salomon Brothers and
First Boston
• Legally, a CMO is a special purpose entity that is wholly
separate from the institutions that create it
• The entity is the legal owner of a set of mortgages,
called a pool
• Investors in a CMO buy bonds issued by the entity, and
receive payments according to a defined set of rules
• The mortgages themselves are called the collateral, and
the bonds are called tranches (also called classes), and
the set of rules that dictates how money received from
the collateral will be distributed is called the structure
• The legal entity, collateral, and structure are collectively
referred to as the deal
Collateralized Mortgage Oblig (CMO)
a.k.a. Real Estate Mortgage Investment Conduits (REMIC)
To start with, there is a mortgage loan (an annuity)

Mortgages are pooled and issued as MBS
(a.k.a. pass-through securities or participation certificates)
CMOs are guaranteed by GNMA or GSEs (FNMA, FHLMC)
Mortgage loans are annuities and subject to prepayment
CMOs are tranched for prepayment
All tranches receive regular interest payments
Principal payments (regular & prepaid) are tranched
Credit Protection
• Credit Tranching
– The most common form of credit protection is called Credit
Tranching
– In the simplest case, credit tranching means that any credit
losses will be absorbed by the most junior class of bondholders
until the principal value of their investment reaches zero
– If this occurs, the next class of bonds absorb credit, and so forth,
until finally the senior bonds begin to experience losses
– More frequently, a deal is embedded with certain "triggers"
related to quantities of delinquencies or defaults in the loans
backing the mortgage pool
– If a balance of delinquent loans reaches a certain threshold,
interest and principal that would be used to pay junior
bondholders is instead directed to pay off the principal balance
of senior bondholders, shortening the life of the senior bonds
Credit Protection
• Overcollateralization
– In CMOs backed by loans of lower credit
quality, such as sub-prime mortgage loans,
the issuer will sell a quantity of bonds whose
principal value is less than the value of the
underlying pool of mortgages
– Because of the excess collateral, investors in
the CMO will not experience losses until
defaults on the underlying loans reach a
certain level
Credit Protection
• Excess Spread
– Another way to enhance credit protection is to issue bonds that
pay a lower interest rate than the underlying mortgages
– For example, if the weighted average interest rate of the
mortgage pool is 7%, the CMO issuer could choose to issue
bonds that pay a 5% coupon
– The additional interest, referred to as "excess spread", is placed
into a "spread account" until some or all of the bonds in the deal
mature
– If some of the mortgage loans go delinquent or default, funds
from the excess spread account can be used to pay the
bondholders. Excess spread is a very effective mechanism for
protecting bondholders from defaults that occur late in the life of
the deal because by that time the funds in the excess spread
account will be sufficient to cover almost any losses
Prepayment Tranching
tranche (French)= slice
A portfolio of credit instruments divided into many tranches
slices
Each tranche has different seniority relative to others
Class A
Class B
Portfolio
Class C
Class Z
Exhibit : Mortgage-Backed Securities (MBS)
Pass-through
Pool of Mortgages
“cut the cake vertically”
CMOs
“cut the cake horizontally”
Pool of Mortgages I I I I
Interest-only (IO)
I I I I I I
SMBS
I
I P
P
P P P P P
Principal-only (PO)
P
P P P P
CMO Structures
Planned Amortization Class (PAC) tranche
Insulated from unscheduled prepayment
Ergo, yield and average life are stable
Targeted Amortization Class (TAC) tranche

Similar to PAC but inferior to it
Companion tranches
Absorb prepayment variability removed from PAC/TAC
Z-tranche (a.k.a. accrual bonds or accretion bonds)
No interest during “lock-out” period
Interest and principal starts after earlier tranches are out
Interest-only (IO) and Principal-only (PO) strips
Prepayment Tranching
• Investors in CMOs wish to be protected from interest
rate risk as well as credit risk. To facilitate this, CMOs are
structured such that prepayments are allocated between
bonds using a fixed set of rules. The most common
schemes for prepayment tranching are
– Sequential Tranching (or by time)
– Parallel Tranching
– Z bonds
– Schedule bonds (also called PAC or TAC bonds)
– Very Accurately Defined Maturity (VADM) bonds
– Non-Accelerating Senior (NAS)
– NASquential
Sequential Tranching (or by time)
• All of the available principal payments go to the first

sequential tranche, until its balance is decremented to
zero, then to the second, and so on
• There are several reasons that this type of tranching
would be done:
– The tranches could be expected to mature at very different times
and therefore would have different Yields that correspond to
different points on the Yield Curve.
– The underlying mortgages could have a great deal of uncertainty
as to when the principal will actually be received since home
owners have the option to make their scheduled payments or to
pay their loan off early at any time. The sequential tranches each
have much less uncertainty
Parallel Tranching
• This simply means tranches that pay down pro rata
• The coupons on the tranches would be set so that in
aggregate the tranches pay the same amount of interest
as the underlying mortgages
• The tranches could be either fixed rate, or floating rate
• If they have floating coupons, they would have formulas
that make their total interest equal to the collateral
interest
• For example, with collateral that pays a coupon of 8%,
you could have two tranches that each have half of the
principal, one being a floater that pays LIBOR with a cap
of 16%, the other being an inverse floater that pays a
coupon of 16% minus LIBOR
Z bonds
• This type of tranche supports other tranches by
not receiving an interest payment
• The interest payment that would have accrued to
the Z tranche is used to pay off the principal of
other bonds, and the principal of the Z tranche
increases
• The Z tranche starts receiving interest and
principal payments only after the other tranches
in the CMO have been fully paid
• This type of tranche is often used to customize
sequential tranches, or VADM tranches
Schedule bonds (also called PAC
or TAC bonds)
• This type of tranching has a bond (often
called a PAC or TAC bond) which has
even less uncertainty than a sequential
bond by receiving prepayments according
to a defined schedule. The schedule is
maintained by using support bonds (also
called companion bonds) that absorb the
excess prepayments
Planned Amortization Class
• Planned Amortization Class (PAC) bonds have a principal payment
rate determined by two different prepayment rates, which together
form a band (also called a collar)
• Early in the life of the CMO, the prepayment at the lower PSA will
yield a lower prepayment
• Later in the life, the principal in the higher PSA will have declined
enough that it will yield a lower prepayment
• The PAC tranche will receive whichever rate is lower, so it will
change prepayment at one PSA for the first part of its life, then
switch to the other rate
• The ability to stay on this schedule is maintained by a support bond,
which absorbs excess prepayments, and will receive less
prepayments to prevent extension of average life. However, the PAC
is only protected from extension to the amount that prepayments are
made on the underlying MBSs. When the principal of that bond is
exhausted, the CMO is referred to as a "busted PAC", or "busted
collar"
Target Amortization Class
• Target Amortization Class (TAC) bonds are

similar to PAC bonds, but they do not
provide protection against extension of
average life
Very Accurately Defined Maturity
• Very Accurately Defined Maturity (VADM) bonds

are similar to PAC bonds in that they protect
against both extension and contraction risk, but
their payments are supported in a different way
• Instead of a support bond, they are supported by
accretion of a Z bond
• Because of this, a VADM tranche will receive the
scheduled prepayments even if no prepayments
are made on the underlying
Non-Accelerating Senior (NAS)
• NAS bonds are designed to protect investors from
volatility and negative convexity resulting from
prepayments
• NAS tranches of bonds are fully protected from
prepayments for a specified period, after which time
prepayments are allocated to the tranche using a
specified step down formula
• For example, an NAS bond might be protected from
prepayments for five years, and then would receive 10%
of the prepayments for the first month, then 20%, and so
on
• Recently, issuers have added features to accelerate the
proportion of prepayments flowing to the NAS class of
bond in order to create shorter bonds and reduce
extension risk. NAS tranches are usually found in deals
that also contain short sequentials, Z-bonds, and credit
subordination
NASquential
• NASquentials were introduced in mid 2005 and
represented an innovative structural twist, combining the
standard NAS (Non-Accelerated Senior) and Sequential
structures
• Similarly to a sequential structure, the NASquentials are
tranched sequentially, however, each tranche has a
NAS-like hard lockout date associated with it
• Unlike with a NAS, no shifting interest mechanism is
employed after the initial lockout date
• The resulting bonds offer superior stability versus regular
sequentials, and yield pickup versus PACs
• The support-like cashflows falling out on the other side of
NASquentials are sometimes referred to as
RUSquentials (Relatively Unstable Sequentials)
IO/PO Split
• A special case of parallel tranching is known as the
IO/PO split
• IO and PO refer to Interest Only and Principal Only
• In this case, one tranche would have a coupon of zero
(meaning that it would get no interest at all) and the
other would get all of the interest
• These bonds could be used to speculate on
prepayments
• A principal only bond would be sold at a deep discount (a
much lower price than the underlying mortgage) and
would rise in price rapidly if many of the underlying
mortgages were prepaid
• The interest only bond would be very profitable if few of
the mortgages prepaid, but could get very little money if
many mortgages prepaid
Stripping
Separate the coupon from principal
principal
Consider 7Y coupon bond, HY coupon payments
How many strips will result? (7  2) + 1 = 15
All 15 of themmaturity
will be independent
in years ZCBs
coupons per year
Combine all interest strips into one structure
What type of FIS will that structure be? Annuity
C C C Annuity IO strip
P ZCB PO strip
coupon bond ZCBs
Assume now that the underlying bond is callable
IO and PO Strips
Price of IO + Price of PO = Price of Callable Bond
(arbitrage restriction)
When market rates rise …
Probability of prepayment falls or rises
Price of PO strip falls or rises
Price of IO strip falls or rises
When
Is market
it reallyrates
so? fall … Don’t think it: just look at this
Probability of prepayment ?rises
What if PO and Callable Bond fall by the same amount?
Price of PO strip rises dramatically Why?
(1) Higher prepayment prob.  lower life
(2) Lower life  higher present-value
Price of IO strip falls dramatically
When the principal is prepaid, interest vanishes
A Picture of Them
Price
callable bond
IO strip
PO strip
Rate
Reverse Mortgages
• Loan against your home that you do not have to pay

back for as long as you live there
• Turn the value of your home into cash without having to
move or to repay the loan each month
• Cash can be paid to you in several ways-
– all at once, in a single lump sum of cash;
– as a regular monthly cash advance;
– as a "creditline" account that lets you decide when
and how much of your available cash is paid to you;
or
– as a combination of these payment methods
Reverse Mortgages - Contd
• No matter how this loan is paid out to you, you typically

don't have to pay anything back until you die, sell your
home, or permanently move out of your home.
• To be eligible for most reverse mortgages, you must

own your home and be 62 years of age or older
Islamic Mortgages
• Ijara is based on a “lease-to-own”

• Musharaka is based on a “shared ownership”
Home Equity Loan (HEL)
• Loans with second charge on the house

• Financed against the “equity”
– Difference between the market value and the liability
on the first loan
• Sub-prime mortgages are those with less than perfect
credit record
• For example, if your home is worth 150,000 and you still
owe $30,000 on your mortgage; your home equity is
120,000
Home Equity Line of Credit (HELOC)
• Loan in which -
– The lender agrees to lend
– A maximum amount within an agreed period (called a term),
– Where the collateral is the borrower's equity in his/her house
• Differs from conventional home equity loan –
– Borrowing Mechanism
• The borrower is not advanced the entire sum up front,
• Uses the line of credit to borrow sums
• That total no more than the amount, similar to a credit card
– Interest Rate
• Variable based on an index such as prime rate
• During Draw Period –
– Funds can be borrowed "on demand"
– Pay back only what you use plus interest
– Minimum monthly payment requirement
– beyond the minimum, it is up to you how much to pay and when to pay
• End of the draw period –
– Pay back the full principal amount borrowed either in a lump-sum balloon payment or
according to a loan amortization schedule
• HELOCs are second mortgages
• Interest on a HELOC is calculated daily rather than monthly
Risk in MBS
Risks in MBS
• Pricing a vanilla corporate bond is based on two
sources of uncertainty: default risk (credit risk)
and interest rate (IR) exposure
• The MBS adds a third risk: early redemption
(prepayment)
• The number of homeowners in residential MBS
securitizations who prepay goes up when
interest rates go down
• One reason for this phenomenon is that
homeowners can refinance at a lower fixed
interest rate. Commercial MBS often mitigate
this risk using call protection
Interest Rates And Loan
Prepayment Speed
• Mortgage prepayments are most often made
because a home is sold or because the
homeowner is refinancing to a new mortgage,
presumably with a lower rate or shorter term
• Prepayment is classified as a risk for the MBS
investor despite the fact that they receive the
money, because it tends to occur when floating
rates drop and the fixed income of the bond
would be more valuable (negative convexity)
• Hence the term: prepayment risk
Interest Rates And Loan
Prepayment Speed
• To compensate investors for the prepayment risk
associated with these bonds, they trade at a spread to
government bonds. This is referred to as an Option
Adjusted Spread
• There are other drivers of the prepayment function (or
prepayment risk), independent of the interest rate, for
instance:
– Economic growth, which is correlated with increased turnover in
the housing market
– Home prices inflation
– Unemployment
– Regulatory risk; if borrowing requirements or tax laws in a
country change this can change the market profoundly.
– Demographic trends, and a shifting risk aversion profile, which
can make fixed rate mortgages relatively more or less attractive
Mortgage
Marketplace
Mortgage Banking Roles
•Originations •Servicing
– Source qualified borrowers – Collect payments from
– Underwrite mortgages borrowers
– Fund mortgages – Remit principal and interest to
– Pool mortgages by type investors
– Sell mortgages to investors – Remit taxes and insurance to
• through Agencies appropriate parties
• through private – Pursue delinquent loans
securitization vehicles – Initiate foreclosure proceedings
– No credit exposure
Who are the Agencies?
– Primary roles:
• Attract investors to the mortgage marketplace to ensure

adequate funding and liquidity for mortgage market needs
• Increase home ownership by making home mortgages more
affordable
• Minimize regional disparities through high standardization
– The Agencies
• Ginnie Mae (GNMA)
– US Government agency – fully guaranteed by the US
Government
• Fannie Mae (FNMA) & Freddie Mac (FHLMC)
– US Government-sponsored agency
– Indirect guarantee by the US Government
Investors’ View of Mortgage Product
• Conforming (Agency)
– Highly standardized to facilitate securitization
• Agencies specify guidelines
• Loan to property value < 80% unless insured
• Prime loans to customers of high credit quality
• Size limitations on individual loans (< $322,000)
• Non-conforming (includes many types)

– Private securitization vehicles (“private-label”)
• Jumbo mortgages (principal exceeds conforming limit)
• Sub-prime: borrowers ineligible for conforming loans
• Hybrid products
Investor Decisions
– Invest in mortgages without business

infrastructure
– Low, well-diversified credit risk
– Highly liquid investment
– Investment well-collateralized
– Risk vs. return profile (Agency vs. non-
conforming securities)
• Initial market development facilitated by Agencies
• Private-label market now well-developed
Originators
The Distribution Channel
Market Drivers to Volume
– Home Purchases
• Real estate transaction-based
• Nearly all home purchases
– Mortgage Refinancings
• Lower interest rates
• Change other terms
• Leverage equity in property
• Underlying collateral remains unchanged
Cultural Influences on Market
Drivers
– Purchase business
• Labor market is less regulated
America’s consumer
culture significantly • High geographic mobility
influences the mortgage
marketplace. • Relocation from region to region is not
uncommon
• Homes are viewed as an investment or a
commodity
– Refinancing business
• Highly liquid retail financial services
marketplace
• Consumers are financially savvy
• Consumers expect variety of products for
different circumstances and needs
• Mortgage brokers serve as financial advisor to
mortgage consumers – monitoring market
developments
Purchase Mortgages: Steady Growth
1200
1000 CAGR = 8.77% ↑
800
Bilions of USD
Purchase
600
Trendline
400
200
0
1991
1992
1993
1994
1995
1996
1998
2000
2001
2002
1997
1999
2003 E
Source: Mortgage Bankers Association of America
Origination Channels
• Optimal price and efficiency achieved through

standardized mortgage products and processes
– Origination channels
• Neighborhood stores (branches)

• Mortgage brokers (wholesale)
• Correspondent banks
• Internet access
Origination Channels
100%
90%
80%
70%
60%
Correspondent
50% Retail
40% Broker
30%
20%
10%
0%
2003 2004 2005
Source: Inside Mortgage Finance
Origination Profitability: Channel Costs
Channels have different relative costs:
Additional/Ongoing benefits:
• Retail footprint provide cross selling opportunities
• Retail structure and employee base have other roles
3,500
3,000
2,500
2,000 Broker
USD
Retail
1,500
Correspondent
1,000
500
0
Source: MBA/Stratmor Peer Group Survey Cost/Loan
Net Margin: Infrastructure Costs
– Primary infrastructure costs

• People resources
• Facilities
• Technology
• Processing costs
– Primary scalable cost: people resources
• Mortgage brokers – commission-based payments
• Temporary staff
• Overtime
The role of the Servicer
What is the role of the Servicer?
• Ongoing connection between borrowers and

investors
– Collect principal, interest, tax and insurance payments
from borrowers
– Remit principal and interest to investors
– Protect mortgage collateral, and investors, through:
– Remitting tax payments to taxing authorities
– Remitting insurance payments to insurers
– Initiating foreclosure proceedings, if appropriate
– No credit risk retained
Servicing Process Flow
Agency or
Investors
Borrower Servicer Pass Thru
(Bond Holders)
Vehicle
 Conforming:
 Retains service
 Pays Agency retains a  If securitized,
Servicer fee to cover
guarantee fee in investors
principal, costs to service
exchange for receive
interest &  Remits principal,
accepting default principal and
escrow security interest
risk stated
and guarantee  Non-conforming: security
fee to agent
primary coupon
 Remits taxes and
structures – pari interest
insurance to
passu, senior
appropriate
subordinated or
authorities
seller retains
credit risk.
What is the borrower’s mortgage payment?
Commonly
Casualty insurance on the
borrowers pay collateral property to protect the
monthly. Some investors in the mortgage (some
servicers permit borrowers pay direct to insurer).
twice monthly
payments that Escrow
ultimately reduce
interest costs to States tax property owners and
the borrower. government liens are senior. To protect
investors, servicers often collect and
remit taxes due.
Principal
Virtually all consumer

mortgages require at least
monthly remittance of
principal.
Interest
Interest remitted is based upon

unpaid principal balance
outstanding.
Where does the Servicer remit the monies?
The Servicer holds these funds

as a non-interest bearing
Escrow deposit (escrow) until payment
to tax or insurance entities.
Principal
The Servicer holds these

funds as non-interest bearing
deposits (float) until remitted
to the agent and investor
Interest (monthly).
Illustration of Remittance of Interest Spread
Interest paid by the Borrower’s

borrower is the source of Interest
fee income to Payment Guarantee Fee: Paid to the
participants in the Agency as the compensation for
securitization process. credit enhancing the security
.15 % issued.
Primary variables are
mortgage coupon and
security coupon. .35 %
Guarantee fee and Servicing Fee: Retained by the
servicing fee have less Servicer as compensation for
variability. Mortgage collecting and remitting
Coupon payments.
Interest
= 6.0% 5.50 %
Security Coupon Interest:
Remitted to the investor in the
mortgage-backed security.
Servicing Process Flow – Example
Proceeds are invested to earn Float (interest) income between the collection
of the payment from the customer and remittance. Typically between 5 and
10 days.
Remits Remits
Pays
principal and principal
Servicer
and 5.50%
principal & 5.65% in
interest in interest
interest (6%) Agency or
Investors
Borrower Servicer Pass Thru
(Bond Holders)
Vehicle
 Retains 35 bps of  Investors receive

 Agent retains a principal and 5.50%
6% coupon to cover guarantee fee of 15
costs to service in coupon
bps in exchange for payments for initial
 Holds Escrow
default risk investment
deposits at no cost  Pass thru vehicle
until remitted retains portion of
cash flows to
absorb default risk
Key Components in the Servicing Income
• What are the cash components of servicing

income?
– Servicing fee income: fixed spread of unpaid principal
balance (typically 30-35 bps)
– Float: interest earned on mortgage payments
received (prior to remittance)
– Escrow: low cost source of funds (prior to remittance)
– Ancillary income: account fees such as late charges
– Cross-selling: maintaining the account relationship
provides opportunities to cross-sell other products of
the servicer
The Mortgage Origination
Timeline
Approval Process Pipeline Warehouse
0 to 14 days 30 to 45 days 30 to 45 days
Application Lock Date Funding Date Sale Date
Lender pools
mortgages
Borrower Lender extends Lender funds Lender

applies for irrevocable mortgage delivers
mortgage commitment to fund mortgage to
mortgage agent
Borrower may decline Sale process
with no penalty complete
Mortgage banks
typically “sell forward”
expected production
Accounting for Mortgage
Originations (US)
Approval Process Pipeline Warehouse
Application Lock Date Funding Date Sale Date
No entries – Lender recognizes Lender funds Gain or loss

no commitment and mortgage and on sale
accounting related hedges recognizes on recognized
event has (initial value balance sheet
occurred typically zero)
Lender marks Any unhedged

commitment and declines in loan
related hedges to fair value are recognized
value through immediately in
earnings earnings
Credit Quality
Credit quality is rated by a specialist rating agencies
S&P Moody’s etc
Sovereigns are risk-free and hence no rating domestically
… but needs to be rated for foreign investors
All non-sovereign bonds need rating for domestic and fgn.
Higher the rating, the better the quality
… ergo, lower the risk, lower the rate
Cut-off grade for Investment Grade is BBB/Baa
Credit rating is a lucrative business

Rating agencies do not guarantee credit quality
And they are not rated themselves
AAA Extremely strong
AA Very strong
A Strong but is susceptible to adv. econ conditions
BBB Adequate but adv econ. conditions will weaken the
capacity
BB Vulnerable to nonpayment and faces uncertainties to
adv. biz, fin. and econ conditions
B More vulnerable than BB but currently has the capacity
to meet its obligations
CCC Currently vulnerable to nonpayment
CC Currently highly vulnerable to nonpayment
C Payments are being continued but bankruptcy petition is
filed or similar action initiated. This rating is assigned for
preferred stock in arrears on dividend or sinking fund
payments that is currently paying
D Payment default has already occurred
TS shapes
Rate
Humped
Normal ST  LT
ST  MT > LT
Flat
ST = LT
ST > LT
Inverted
Term
Which of them is beautiful? And which useful?
Credit Appraisal and Credit Scoring
• Credit Appraisal
– Process of decision making prior to grant of loan
• Credit Scoring
– Asesses the credit worthiness of an individual,

corporation, or even a country.
– Credit ratings are calculated from financial history and
current assets and liabilities.
– Tells a lender or investor the probability of the subject
being able to pay back a loan
Factors Affecting Credit Rating
• Ability to pay a loan
• Amount of credit used
• Saving patterns
• Spending patterns
6 C’s Principal for credit
• Character
• Capacity
• Capital
• Credit worthness
• Contactability
• Competancy
FICO Scores
• FICO is an acronym for Fair Isaac Corporation
• Best-known credit score model in the United States.
• Calculated by applying statistical methods, to information in

one's credit file.
• Primarily used in the consumer banking and credit industry.
• Banks and other institutions use scores as a factor in their

lending decisions
• If the scores are low they may deny granting of loan or

charge higher interest
FICO Scores …..Cont
• A FICO score generally ranges from 300 to 850
• It exhibits a US median around 723
• The performance of the scores is monitored and the scores

are periodically aligned so that a credit grantor normally
does not need to be concerned about which score card was
employed
Credit Score Factors for FICO
Credit Score Factor
10%
10%
35%
15%
30%
On Time Payments Capacity Used Length of Credit History

Types of Credit Used Past Credit Applicants
Bankruptcy Vs Insolvency Vs Default
• "Default" essentially means a debtor has not paid a debt.
• "Insolvency" is a
– legal term
– debtor is unable to pay his debts.
• "Bankruptcy" is a
– legal finding
– imposes court supervision
– over the financial affairs of those who are insolvent or
in default.
Rules and Regulations
Regulations for bad loans are:
For Secured loans
- Upgrading possibility
– Court notice to the customer
– Collaterals are taken in to possession through court
– Transfer of collateral title on bank
– Selling / auction of collateral to recover the loan proceeds
Mortgage Funding – Process Flow
• Eligibility calculation
• Backround verification
• Valuation and inspection of property
• Proposal sent to risk department
• Sanction / Rejection
• Disbusment of loan
Equal Credit Opportunity Act (ECOA)
• Law was enacted in 1974

– Prohibit creditors to discriminate in any aspect of a
credit transaction on the basis of sex or marital status
• Amended in 1976
– Extend the prohibition of discrimination on the basis of
race, color, religion, national origin, age, receipt of
public assistance and good faith exercise of rights
under the Consumer Credit Protection Act
• Applies to any extension of credit
ECOA – Contd.
• Operation of ECOA is through the Regulation B of the

Federal Reserve –
– Describes Prohibited, permitted and required lending

practices
– checklist against which the compliance to ECOA –
reviewed
Provisions of ECOA
• Lender Cannot –
– Make oral or written statements that would discourage a
prospective applicant from pursuing the application
– ascertain the status of sex other than requesting the designation
(Ms, Mr, Mrs) for the title
– Ascertain not race, color, religion or national origin
– Applicant’s refusal to provide such information cannot be the
basis for declining the credit
– Ask for information like likelihood of child-bearing or child-rearing
and the assumption of diminished income because of them
cannot be obtained
• Lender can -
– Request information about the former spouse if the applicant is
dependent on alimony, child support or maintenance payments
from the former spouse as a basis for the repayment of the loan
– Only on community property state like Washington, the lender
can ask for marital status.
Rules on Application Evaluation
• Age or receipt of public assistance can be used only to

determine credit worthiness, but not prohibition
• Child-bearing or child-rearing assumptions and the

consequent diminished or interrupted income cannot be
used in evaluation
Rules on Credit Extension
• Lender should not refuse credit based on sex, marital

status or any other prohibited basis to creditworthy
applicant.
• Change of surname or not changing name consequent

to marriage cannot be the reason for refusal of credit.
• Lender should not require the signature of applicant’s

spouse or another person, other than a joint applicant,
on any credit instrument if the applicant qualifies under
the lender’s standards of creditworthiness.
Rules on Consumer Notifications
• Effective from December 1993, lender must notify the

applicants of their right to receive a copy of their
appraisal on loans
• Lender must notify the applicant within 30 days of action

taken
Fair Housing Act
Act prohibits discrimination by :
• Race or color
• Religion
• Sex
• National origin
• Familial status, or
• Disability.
For granting of Mortgage Loans
Fair Debt Collection Practices Act
Act Prohibited conduct:
• Contacting the customer outside 8 AM – 9 PM

• Using abusive lang.
• Contacting at work place if told not to
• For adding extra fees
• Threatening customer of legal action
• Adding the name and address to Bad Debts list
and publishing
• Revealing false information to other credit etc.
Other Acts
• Fair Credit Reporting Act
• Gramm-Leach-Bliley Act
• Home Ownership and Equity Protection Act (HOEPA)
• Truth in lending act
• Freddie Mac - Nickname for Federal Home Loan
Mortgage Corp. A financial corporation chartered
by the federal government to buy pools of
mortgages from lenders and sell securities
backed by these mortgages
• Ginny Mae - A government-owned corporation
within the U.S. Department of Housing and
Urban Development (HUD). Created by
Congress in 1968, GNOME has responsibility for
the special assistance loan program known as
Ginny Mae
• Fannie Mae - Nickname for Federal
National Mortgage Association. It is a
government-chartered non-bank financial
services company and the nation's largest
source of financing for home mortgages. It
was started to make sure mortgage money
is available in all areas of the country
Thank you

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Mortgages

• Overview of the mortgage market

• The mortgage market in the United States is vast

Market liquidity also • Investors

– Managed prepayment volatility

U.S. Market European Market

– Government-sponsored – Limited secondary

– 1st liens on real property (e.g., collateral specific)

The most prevalent are

1) the mortgage deed or deed of trust, and

– The mortgage deed describes the real estate to be used as

– One is called title theory, where title is held by, or

– The other is called lien theory, where the mortgagor

– Lien theory is more modern in origin and the most

schedule covering 5.25 3.25

mortgages (FRMs) 5.625 1.875

• Loan terms can vary from 15 to 30 years, although other

• There are several variations of amortizing mortgages.

– Constant payment mortgage (CPM)

• Constant monthly payment on original loan

• Graduated payment mortgages

• Shared appreciation mortgages

• Reverse annuity mortgages

• An arrangement in which a homeowner

• An Equity Sharing Agreement is a written

• There are a number of variations on the

• Adjustable rate mortgages are not as popular in

Interest rate is not fixed but linked to market index

Two parts in loan’s life

In the beginning period, only interest is paid

“cap” in interest rate options:

Periodic Adjustment Cap (PAC)

Lifetime Cap (LC)

Chargeable rate 6% 8% 10% reduced

Rate cannot be raised because

Originator SPV Investor

SPV is a bankruptcy-remote entity

• A CMO is a financial debt vehicle that was first created in

To start with, there is a mortgage loan (an annuity)

“cut the cake horizontally”

Targeted Amortization Class (TAC) tranche

• All of the available principal payments go to the first

• Target Amortization Class (TAC) bonds are

• Very Accurately Defined Maturity (VADM) bonds

• Loan against your home that you do not have to pay

• No matter how this loan is paid out to you, you typically

• To be eligible for most reverse mortgages, you must

• Ijara is based on a “lease-to-own”

• Loans with second charge on the house

• Attract investors to the mortgage marketplace to ensure

• Non-conforming (includes many types)

– Invest in mortgages without business

The Distribution Channel

1000 CAGR = 8.77% ↑

• Optimal price and efficiency achieved through

• Neighborhood stores (branches)

Source: Inside Mortgage Finance

– Primary infrastructure costs

• Ongoing connection between borrowers and

Virtually all consumer

Interest remitted is based upon

The Servicer holds these funds

The Servicer holds these