CHAPTER 6: MORTGAGE VALUATION
Date: 2/17/2011
Presented by: Josh Pickrell
LOAN TYPES

There are three common loan types:
Pure Discount Loan: borrower receives $X today and agrees
to pay back $X +$I dollars tomorrow.
 Interest Only Loan: borrower pays interest periodic interest
payments and pays the principal back at the end of the loan.
 Amortized Loan: borrowers periodic payments include
interest and principal.

MORTGAGE LOANS

A mortgage loan is, typically, an amortized loan that is
backed by collateral.
The lender can take control of the collateral if the borrower
does not fulfill the contractual obligations.
 A lien is placed on the property – the lien prevents the
borrower from selling or transferring the property until the
loan is paid.
 Loans for which the borrower posts collateral are known as
secured loans.

TOTAL MORTGAGE DEBT OUTSTANDING

According to the Federal Reserve Release, there is
approximately $13.947 trillion worth of mortgage debt
outstanding.
http://www.federalreserve.gov/econresdata/releases/mortoutstand/cur
rent.htm
 We can observe the breakdown of the four main types of mortgages
that the book points out:

Residential
 Multifamily
 Commercial
 Farm

TOTAL MORTGAGE DEBT OUTSTANDING

What does the data tell us?
The $ amount of total mortgage debt has been declining since
the middle of 2009.
 Most of the outstanding mortgages are one-to-four family
residences and most of the mortgage debt is held by major
financial institutions and Federal and Related Agencies.
 The residential sector represents the majority of mortgage
debt outstanding.

SECURED LENDING AND DEFAULT

Mortgages that have LTV ratios less than 100% are said
to be over collateralized.
There is an direct relation between the LTV ratio and the
borrower default rate.
 Escrow payments can be added into your monthly payment.
Escrow includes insurance costs and property taxes.
 Distressed collateral – it is common for homeowners, in
foreclosure, to have caused physical damage to the property
or they may just neglect the property.

PREPAYMENT OPTION

Most mortgage include an embedded option –
prepayment option – which allows the borrower to pay
off the mortgage at any time and without penalty.
A borrower may prepay for liquidity reasons or financial
reasons.
 A borrower may find it advantageous to refinance the
mortgage loan.

Home equity loans
 Lower cost of borrowing

MORTGAGE ORIGINATION AND INVESTMENT
Origination: the loan application process (underwriting)
 Servicing: monitoring the mortgage loan, and collecting
the payments
 Investment: make sure the portfolio of mortgage loans is
profitable.

DISINTERMEDIATION

Disintermediation means that one financial institution
does not have to be responsible for all three major
aspects of a mortgage loan.
Instead, they can choose to specialize in one or two of the
components.
 Disintermediation has led to substantial growth in the
mortgage market.

SECURITIZATION

Securitization has resulted in lower borrowing rates, and
it allows funds to flow more efficiently between DSUs
and SSUs.

Securitization has also facilitated disintermediation in
financial markets.
MORTGAGE BACKED SECURITIES (MBS)

The process of securitization:
Mortgage loans are purchased from lenders and banks.
 The mortgage loans are then pooled together
 The pool of mortgages is securitized into mortgage backed
securities


The two main sub-types of MBS:
A pass-through mortgage-backed security
 A collateralized mortgage obligation (CMO)

RESIDENTIAL MORTGAGES
Fixed-rate mortgages (very common)
 Adjustable Rate Mortgages
 Balloon Mortgage
 Interest-only mortgage

FIXED RATE MORTGAGES

Three critical components of a fixed rate loan:
Principal balance
 Interest rate
 Time to maturity


Using equation 6-2 (page 129), we can calculate the
principal balance remaining at the end of any month.
THE AMORTIZATION SCHEDULE

A fixed rate mortgage requires the borrower to pay a
fixed dollar amount each month.
This payment includes both an interest payment and a
principal payment.
 A mortgage loan can be thought of as an annuity; thus, we
can use the annuity payment formula to calculate the
payment.


SEE EXCEL FILE.
ADJUSTABLE RATE MORTGAGE

Unlike a fixed rate mortgage, the interest rate on an ARM can
change over the life of the loan.
This means that the borrowers monthly payment may rise or fall
over the life of the loan depending on the related market interest rate.
 The ARM contract must specify a specific market interest rate index
and margin.

LIBOR, 1-Year Constant Maturity Treasury security, The Cost of Funds
Index
 The margin may differ from one lender to another, but it is usually constant
over the life of the loan.

ADJUSTABLE RATE MORTGAGE

The ARM contract will specify the re-pricing frequency.
Typically, 12 months (annually).
 Not uncommon to see semi-annual re-pricing or every two
years.


Many ARMs are being originated as fixed-adjustable
hybrids.

For example, a 7/1 ARM will have a fixed rate for seven
years, and then it will re-price annually for the reminder of
the loans life.
ADJUSTABLE RATE MORTGAGE
Most ARMs contain a rate cap and rate floor to protect
both the borrower and lender from significant changes in
interest rates.
 In addition, some ARMs will have a periodic re-pricing
limit.
 Watch out for the “teaser rate” – the ARM offers an
artificially low initial interest rate that is much less than
the current index rate plus the spread.

ARM EXAMPLE *TIME PERMITTING*

Problem 22. What is the scheduled P&I payment for the
next two years of a two-year ARM with a remaining
principal balance of $220,000, a remaining maturity of
13 years, the two-year constant maturity Treasury yield
is 2.4% (index value), and a fixed margin of 300 basis
points (or 3%). If two years from now, the index has
risen to 3%, what will be the new monthly payment on
this loan?
OTHER TYPES OF MORTGAGES

A balloon mortgage is one that has a fixed-rate and
scheduled payments calculated for 30 years, but requires
repayment of the remaining principal in full after a
certain period of time.

Interest-only mortgage requires no repayment of
principal until the maturity date.

The borrower will build no equity beyond the initial down
payment, unless the property value increases.
MORTGAGE VALUATION
Valuation of a mortgage portfolio is complicated by the
fact that they have a prepayment option.
 In order to value a single mortgage, we would need to
know:

Credit quality of the borrower (proper default risk premium)
 Time of the anticipated prepayments must be determined

MORTGAGE PORTFOLIO VALUATION
The text uses an adjusted cash flow approach to valuing
a mortgage portfolio, which requires you to estimate the
expected future cash flows for the portfolio of
mortgages.
 The PV of the mortgage portfolio is found by
discounting these expected future cash flows using the
appropriate discount rate.

MORTGAGE PORTFOLIO VALUATION

Prepayments and defaults can significantly effect the
E[CF] of the mortgage portfolio.

The discount rate should represent the market return that
an investor would earn on an alternative investment with
similar characteristics, maturity and risk, to the portfolio
being valued.

The textbook argues for the use of the 10-year Treasury
Note yield as a reasonable discount rate for the expected
cash flows of a fixed-rate mortgage portfolio.
MORTGAGE PRICING CHARACTERISTICS

For bonds with no embedded options, fixed income
investors analyze the YTM, duration and convexity.
For mortgages, and bonds with embedded options, we have to
adjust the calculations.
 YTM is not a useful measure of the return that will be earned
on a mortgage (portfolio).


There is no established market price for a mortgage (portfolio); thus,
we cannot calculate a YTM.
MORTGAGE DURATION

Mortgages are more sensitive to change in interest rates
because of the prepayment option.

Bond investors (no embedded options) versus mortgage
investors – the effect of rising and falling interest rates…

We must rely on effective duration for mortgage
portfolios.
MORTGAGE DURATION

The duration of an ARM portfolio is approximately onehalf the average re-pricing frequency of the ARMs in the
portfolio.

For example, a portfolio that contains a two-year repricing arm, will have duration of approximately 1.
MORTGAGE CONVEXITY
Convexity improves upon the duration estimate.
 Figure 6-8 in the text, shows that the present value of a real
mortgage portfolio is concave.

Mortgages exhibit negative convexity, which means that the PV of
the mortgage portfolio is always lower than predicted by the
duration estimate.
 In other words, duration is an optimistic measure for the PV of a
mortgage portfolio.
