Prerequisites for a Successful Secondary Mortgage Market:The Role of the Primary Mortgage Market by Michael J. Lea Instructor Professor Yao-Ming Chiang.

Prerequisites for a Successful Secondary Mortgage Market:The Role of the Primary Mortgage Market by Michael J. Lea

Instructor

Professor Yao-Ming Chiang

Anson Chen Sally Huang Allen Chen

The success of the secondary market in U.S has led both private and public sector officials in many countries to recommend its creation as a way of enhancing the flow of funds to housing

Traditional model

Modern model

The dependence of one functional entity on another means that mistakes are difficult to hide in a secondary mortgage market

Origination specialists also must be more cognizant of pipe line risk Pipeline risk:The risk associated with taking

applications from prospective mortgage borrowers who may opt to decline to accept a quoted mortgage rate within a certain grace period.

Erroneous documentation can lead to a lender having to repurchase a loan at a future date

The quality of mortgage produced in the primary market become much important than in secondary market

A successful secondary market is based on

Effective management of the basic functions

and risk involved in mortgage lending

The degree of competition in the primary market

Market structure Macroeconomic environment

The structure of mortgage market The interest rate on the mortgage must

be market determined and provide real,risk-adjusted rate of return

the cash flow must be predictable The mortgage market must be at a

sufficient stage of development to produce significance volume of loans

Macro stability:high inflation rate are typical features of volatile economy

The use of fixed-rate mortgage create a tilt effect

Variable-rate mortgage can reduce the effect but subject borrowers to potential shock

Indexed-mortgage can improve affordability but complex both for borrowers and lenders

Volatile economy also affect the the supply of funds and the characteristics of mortgage offer by the lenders

The lenders Reluctant to offer long term loans Only offering short-maturity loans—less

affordable Pipeline risk

Volatile economy also create difficulty for investors

investors prefer short-term asset because of the difficulties of forecasting the inflation and interest rate

Government policies Government policies determined the

competitive environment in which mortgage lending is done

Their preference often lead to the offering of mortgage at rate less than necessary to provide acceptable risk-adjusted returns for investors

Characteristics of the instrument

Standardization Facilitate large pool and more liquid Reduce the due diligence cost for investors and rating

agencies Heterogeneous magnify

transaction cost Processing cost

Many types mortgages are present but only sufficient volume are candidate for securitization

Common constraints

For example FRMs are not pooled with ARMs ARMs with diffident indices will not be pooled t

ogether Differed interest or negative amortization loans

will not be pooled with full amortization loans Range of loan maturities and loan coupon rate Constraint on loan purpose or LTV in order to a

chieve certain rating or credit enhancement objectives

Standardized documentation A barrier that exists in developing countries is

the imposition of transfer taxes or stamp duties on title and lien registration or transfer

In U.S, uniform residential appraisal report Credit reports:no specific guidelines reporting

FICO score ,employment verification , income verification

Title report In the event that a loan goes into default and

the investors find defect in the loan file,the seller will be required to repurchase the loan

FICO score Previous credit performance (35%)

Trade line information specific to payment history Current level of indebtedness (30%)

Current balance compared to the high credit Time credit has been in use (15%)

Opening date Types of credit available (15%)

Installment loans, revolving accounts, debit accounts Pursuit of new credit (less than 5%)

Inquiries Scores range from 350 (high risk) to 950 (low risk).

Mortgage origination All mortgage underwriting is based

on “3Cs”:collateral,credit reputation

and capacity described by Mahoney and

Zorn,1997

1C:collateral The lender could recoup enough

from the sale of the home to cover losses

Borrower equity

Foreclosure:The legal proceed initiated by a creditor to repossess the collateral for loanthat is in default

Appraisal The key factor in accessing the

adequacy of the collateral is the appraisal.

3 approaches to value: cost, market and income.

cost approach: market approach: income approach:

AssetIncomeMultiplier

IncomeAsset

IncomeMultiplierIncome

NetOperation IncomeCapitalization Rate

Value

How to judge the appraiser Another critical factor in valuation

is competence and professionalism of the appraiser.

<Sol>: Individual states certify and

license appraiser Lender may use in-house or

independent appraiser.

2C:Credit Reporting

1. Mortgage lenders rely on credit information compiled by national credit bureaus to ascertain a borrower’s track record of handling credit

2. Credit files contain extensive information about open an closed credit accounts.

3C:Capacity

1. Two ratios that express the percentage of an applicant’s income needed to cover monthly debt obligations.

2. sinHou gDebtFront end ratio

Income

TotalDebtBack end ratio

Income

Ex:housing related paymentEx:car payments and consumer installment debt

Foreclosure Rates Are Lower for Borrowers with Lower Total Debt-to

Income Ratios

Automated Underwriting

1. Lender electronically transmits loan application data to the investor which uses this information along with property information to determine the risk class of the loan.

2. Automated underwriting systems can reduce lender and borrower costs and risks.

Secondary Marketing-Functions

1. Secondary marketing : Functions as financing and selling the originated mortgage to institutional investors. In U.S the secondary mortgage market is

still dominated by the GSEs (Fannie Mae& Freddie Mac)

Secondary Marketing-Risk Management

Commitment risk:Pipeline risk:Documentation risk:Liquidity risk:

Secondary Marketing-Servicing

Function: *Collecting mortgage payments

*Accounting for all financial transactions *Collecting past due accounts *Remitting payments to investors *Foreclosing on seriously delinquent properties

*Disposing of foreclosed real estate

Secondary Marketing-Servicing Collections and Default Management1. The establishment of clear guidelines

for the collection of mortgage payments.Ex: dates, amounts ,terms..

2. Default management: 30-60days, 90days, 120+ days

Secondary Marketing-Servicing

Credit Enhancement Lenders(investors) can protect themselves

by losses by requiring insurances. Ex: FHA, VA & PMI

Information requirement loan quality and efficiency of operations is

critical to a servicer’s success. Services in U.S has become increasing automated.

MEXICO Instable macroeconomic environm

ent

Balkanized mortgage market

Battered by DEC. 1994 financial crises

DIM Dual-Indexed Mortgage Affordable to borrower Profitable for lender Payment: link to minimum wage index Amortization: link to either a short-ter

m Treasury bill (Cete) rate or the cost of funds of the banks (CPP)

The Problems

Having unforecastable and long duration cash flows

Carrying real rates well below that demanded by investors

UDI Mortgage A new legal unit of account for financi

al contracts, the Unidad de inversion(Units of Investment)

Fixed-real-rate loan Forecastable cash flows for investor Fixed real rate for borrower Payment shock

UDI UDIs were created as an alternative cu

rrency for accounting purposes to allow financial products such as mortgage to maintain a constant purchasing power (real value) in the face of inflation. The value of the UDI is published daily and grows in tandem with inflation.

Loan Documentation No standardization among the

Mexican commercial banks No title insurance available ;

however , U.S. companies are looking at the market

In larger banks , the loan application contains similar information to that found in the U.S. loan application

Credit Reporting No credit bureaus : banks are hesitant

to share credit information Information systems are not able to

provide the required management reports that properly summarized credit histories

No information interchange between databases

Multiple loans are taken out on a single property

Two of largest banks have installed computerized credit scoring systems purchased from U.S.

However , the existence of a model can’t overcome the problem that there are no data with which to populate it

The bulk of the portfolios have defaulted in the last three years

Many banks send investigators into the field to perform a more qualitative analysis of the borrower

A credit report may include information on a borrower’s work habits , a visual assessment of the borrower’s assets and even interviews with the borrower’s neighbors attesting to his moral character

Such reports are anecdotal and incomplete

Appraisal No enforced appraisal standards in

Mexico Appraisals are inexact due in large part

to the lack of a source for determining comparable prices from previous home sales

Appraisers will value based on the cost of building materials used and make a best guess to the value of the land

Most loans for housing in Mexico are for new units ; the resale market is very small

Independent appraisers base their fee on the value of the appraisal

Banks will adjust their maximum loan amount in an attempt to compensate for a potential inflated house values

Developing Infrastructure Some institutions are placing greater

emphasis on the quality of their loan files

A large sum investment will allow them to extract and manipulate loan information

The Mexican mortgage banks (SOFOLES) to create an industry standard loan file and servicing system

Servicing Problems Reliance on manual processes

Lack of legal recourse

Moral hazard created by government bailouts

Reliance on manual processes Mexican commercial banks have

been set up mainly to deal with large commercial accounts , this has resulted in an almost uniform lack of consumer orientation

Systems for originating and servicing consumer loans have remained fairly undeveloped

Many banks do the majority of their loan servicing in their retail branch offices

Loan balance information and payment histories are remitted on a periodic basis to the main office

Many banks have made a policy not to take partial payments

The distribution of most commercial bank branches is concentrated in major urban areas

This situation makes it difficult for borrowers living in smaller towns and in rural areas to make payments

Faced with losing their job if they missed work , borrowers would choose not to pay their mortgage

SOFOLES have had a much better track record than commercial banks in servicing FOVI loans , they report default rates of less than 5%as compared to rates over 20% for commercial banks

The SOFOLES goes to the client for payment rather than making the client go to the SOFOLES

Lack of Legal Recourse The foreclosure has been an irrelevant

alternative for most lenders Mexican courts are very unsympathetic

towards banks with the result that foreclosure proceedings take several years and involve significant cost

A significant reform in the foreclosure law has been passed federal government

States expedite procedures and put more teeth into foreclosure

Moral Hazards In 1996 , a restructuring plan has been

negotiated between the banks and the government wherein the government will subsidy up to 30% of the payments

Many restructured loans have defaulted and restructured yet another time

The lesson borrowers learn from this experience is that it is acceptable to default on the loan because the government will bail them out

Conclusion

It is not possible to have a sustainable secondary mortgage market until there is a healthy and well-developed primary market