Prerequisites for a Successful Secondary Mortgage Market:The Role of the Primary Mortgage Marketby 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
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 together • 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 achieve 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 loan that 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:
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 • Mortgage lenders rely on credit information compiled by national credit bureaus to ascertain a borrower’s track record of handling credit • Credit files contain extensive information about open an closed credit accounts.
3C:Capacity • Two ratios that express the percentage of an applicant’s income needed to cover monthly debt obligations. Ex:housing related payment Ex:car payments and consumer installment debt
Foreclosure Rates Are Lower for Borrowers with Lower Total Debt-to Income Ratios
Automated Underwriting • 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. • Automated underwriting systems can reduce lender and borrower costs and risks.
Secondary Marketing-Functions • 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 Management • The establishment of clear guidelines for the collection of mortgage payments.Ex: dates, amounts ,terms.. • 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 environment • 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-term 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 financial 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 currency 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