Real Estate and Consumer Lending

1. Real Estate and Consumer Lending • Outline • Residential real estate lending • Commercial real estate lending • Consumer lending • Real estate and consumer credit regulation

2. Real estate lending • Mortgage debt outstanding • Mortgage is a written conveyance of title to real property. Property is collateral for the loan. Loans for 1-4 family residences, commercial real estate, farm property, and multifamily residences. • Secondary mortgage market for securitizing loans tends to improve liquidity of residential mortgages and lessens cyclical disruptions in the housing market. Securitization transforms individual loans into marketable asset-backed securities. Banks can act as originators, packagers, and servicers. Cash flows to investors are guaranteed by banks, agencies (FNMA or Fannie Mae and FHLMC or Freddie Mac), and the government (GNMA or Ginnie Mae). Credit rating agencies rate the debt securities.

3. Residential real estate lending • Characteristics of residential mortgage loans • Down payment, or borrower’s equity, is the market value of the property minus the borrower’s mortgage debt. • Loan-to-price ratio is 79.5% if a person puts a down payment of $47,000 for a new home with a purchase price of $209,400. • Bank loans can be viewed as compound options, with rights to prepay (call option) and to default (put option). When interest rates fall, borrowers with fixed rate loans will want to exercise their call option and prepay such loans. While most home loans have maturities of up to 30 years, their average life is only 12 years due to prepayments due to refinancing and moving. • Some lenders require Private Mortgage Insurance (PMI) when the down payment is less than 20%. This insurance protects the lender in the event of default. • Residential real estate is good collateral because it is durable, easy to identify, and cannot be moved in most cases.

4. Residential real estate lending • Types of residential mortgage loans • Conventional mortgage loans are those not insured by the Federal Housing Administration (FHA) or guaranteed by the Veterans Administration (VA). Private insurance on conventional mortgages can be obtained. • Fixed rate mortgages and adjustable rate mortgages (ARMs) -- fixed cash payments per month versus changes in payment terms that can fluctuate with movements in interest rates. Example: monthly mortgage payment for a $1,000 mortgage loan at 6 percent interest for 10 years. Because we are solving for a monthly payment, the number of payments over the 10 years is 120 (10 years x 12 months per year). Moreover, only one twelfth of the 6 percent annual interest rate (0.06/12 = 0.005) is charged each month. The present value of the annuity is the $1,000 mortgage loan in this example. The monthly payment is $11.10. PV of annuity = PMT[1 - (1 + I)-n]/i = PMT[1 - ( 1 + 0.005)-n]/0.005 = $11.10 $1,000 = PMT[1 - ( 1 + 0.005)-n]/0.005 = $11.10 PMT = $11.10 where PV = present value of the annuity, PMT = payment per period, i = interest rate per period, and n = number of periods.

5. Residential real estate lending • Types of residential mortgage loans • Adjustable rate mortgages Changes in monthly payments, term of the loan, and/or principal amount. Benchmark interest rate tied to an index (e.g., one-year Treasury yield). Caps on how much the interest rate or monthly payment can change annually or over the term of the loan. Margin is the percentage points added to the index rate. Initial interest rates on ARMs lower than fixed rate mortgages. ARMs shift some of the interest rate risk to borrowers from lenders (banks). However, ARMs may have higher default risk (and higher delinquency rate) to the bank. Other terms: some mortgage loans are assumable, a buydown of the interest rate by paying points at closing, a due-on-sale clause that disallows the borrower from transferring the loan to a new buyer, late charges on delinquent accounts, settlement charges on transfer of title, and points at closing to cover mortgage origination costs of lenders (i.e., one point is one percent of the loan). Points increase the effective interest rate.

6. Residential real estate lending • Types of residential mortgage loans • Balloon mortgages with short-term maturities (say 5 years). A new loan is negotiated at the end of the period. • Graduated payment mortgages have fixed rates but with lower payments in early years and higher payments in later years. Good for younger homeowners whose income should rise over time. Negative amortization occurs in the early years (where the mortgage balance increases). • Growing equity mortgages (GEMs) have increasing debt payments over time that reduces the principal balance faster than otherwise and reduces interest costs over the life of the loan. • Shared appreciation mortgages (SAMs) allow the lender to share in the growth of equity value in the home with the borrower in return for lower interest payments.

7. Residential real estate lending • Types of residential mortgage loans • Reverse annuity mortgages (RAMs) offer the owner of a home fixed annuity payments against the equity value. Senior citizens use this type of mortgage. • Second mortgage/home equity loans allows homeowners to use equity in their homes to collateralize business or consumer loans. • Credit scoring loan requests • Real estate and consumer credit scoring models using credit bureau data, loan to value ratios, and applicant information. • Credit scores indicate the default risk to lenders of the borrower.

8. Commercial real estate lending • Purposes: • Land, construction and real estate development, and commercial properties such as shopping centers, office buildings, and warehouses. • Construction loans: Disbursements on loans over time as phases of the project are completed. Known as “interim” financing for building phase and builder must obtain “permanent” (long-term) financing later. Land and partially completed structures serve as collateral for loans. Other sources of funds from life insurance companies, Fannie Mae, Freddie Mac, and retirement plans. Construction loans priced at prime plus additional interest for risk. Also, there is an origination fee of 1-3 percent.

9. Consumer lending • Personal, household, and family loans: • Retail banking (for individuals and small businesses), as opposed to wholesale banking (for medium and large businesses). • Characteristics: Small dollar amounts No collateral in many cases Open-end lines of credit (e.g., credit cards) Closed-end loans (e.g., auto loans with fixed maturity) • Risks: Default risk is most important to lenders Very competitive market (in terms of interest rates and terms) Diversify risks over large geographic areas

10. Consumer lending • Personal, household, and family loans: • Types: Automobile loans -- installment loans with 60 month maturities and 90% financing in many cases. Can obtain a repurchase agreement from a bank in which the customer has the option to return the auto to the lender or make a balloon payment at the end of the loan period. Auto loans can be securitized and sold into the financial markets. Revolving consumer loans -- borrower has a line of credit up to a certain amount (open-end credit) and can pay off the loan over an indefinite period of time. Flexible repayment terms are common. Many times interest is only required on funds not repaid within a grace period of 25-30 days. Credit cards (not to be confused with debit cards and prepayment or stored-value cards with no credit extended) offer consumers credit on their individual purchases. Credit scoring is used to determine who is sent credit card applications in the mail. Merchants present the sales draft to a bank at a discount (of up to 6% of the purchase). Some cards have annual fees (say $50), plus other fees for cash advances, late payments, exceeding the credit line, returned checks, etc.

11. Consumer lending • Personal, household, and family loans: • Types: Other loans -- Mobile home loans for moveable homes that are manufactured as a single unit. Noninstallment loans are single payment loans. Leases for consumer durables such as automobiles, trucks, airplanes, and boats. The bank owns the property and “rents”it to the customer. Under an open-end lease the bank is responsible to sell the property at the end of the lease period. If the sale price is less than the previously agreed residual value, the customer pays the difference -- a balloon payment. In a closed-end lease the bank assumes this risk.

12. Consumer lending • Personal, household, and family loans: • Finance charges: The Truth in Lending Act (1968), which is implemented under Federal Reserve Regulation Z, requires lenders disclose finance charges and annual percentage rates (APR) to customers before they sign a loan agreement. The finance charge is the total dollar amount paid for the use of credit (i.e., amount repaid minus amount borrowed). Example: You use a credit card to purchase $100 of goods in May. On May 31st a bill arrives that can be paid by June 30 with no finance charge. On June 1 you make another $100 purchase. And, on June 15 you make a payment of $20 on the previous loan. The interest charge is 1.5% on unpaid balances (18% annually). Adjusted balance method: Interest due equals 1.5% x $80 = $1.20. Previous balance method: Interest due equals 1.5% x $100 = $1.50. Average daily balance method excluding current transactions: Interest due equals 1.5% x $90 ($100 for 15 days and %80 for 15 days) = $1.35. Average daily balance method including current transactions: Interest due equals 1.5% x $190($200 for 15 days and $180 for 15 days) = $2.85.

13. Consumer lending • Personal, household, and family loans: • Finance charges: Annual percentage rate (APR) is the percentage cost of credit on an annual basis, or the annualized internal rate of return (IRR) on the loan from the present value formula (where payments are discounted at the rate of interest and set equal to the principal loan amount. Monthly amortization is the gradual repayment of principal and interest on debt over time. Add-on loan rates include the finance charge in the amount borrowed. Discount loan rates deduct the finance charge from the amount borrowed, and the borrower receives the difference as the loan.

14. Real estate and consumer credit regulation • Community Reinvestment Act (CRA) • Facilitate mortgage loans and other credit to applicants regardless of race, nationality, or sex. • Equal Credit Opportunity Act (ECOA or Federal Reserve Regulation B) and the Fair Housing Act • Lenders cannot discriminate against borrowers on the basis of age, color, family status, handicap, marital status, national origin, race, receipt of public assistance funds, religion, sex, or any right under the Consumer Protection Act. • Fair Credit Billing Act • Customers must inform lenders of errors within 60 days after the first bill is received. The lender has 90 days to respond.

15. Real estate and consumer credit regulation • Home Mortgage Disclosure Act (HMDA or Federal Reserve Regulation Z) • Make available to the public information about the extent to which lenders are serving housing needs in the community. • Real Estate Settlement Procedures Act (RESPA) • Lenders must inform buyers of real estate of the “good faith estimates” of settlement costs in writing. • Truth in Lending (Federal Reserve Regulation Z) • Lenders must disclose to individual consumers the amount of finance charges and annual interest rate (APR). • Fair Credit Report Act • Applicants denied credit due to information from a credit bureau have the right to examine the credit file and correct errors in it.