Class from hell

Importance of N
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Terms in this set (44)
Importance of N
In TVM the payback period is an effective measure of investment risk.
Widely used when liquidity is an important criteria to choose a project
Predicting prepayments
Difficult to forecast because of path dependency.
LTV
Amount requested / estimated property value
Establishes borrowers down payment
Borrower and lender incur losses if defaulted
Sources of change in LTV
Variables that affect default risk
Determining if fixed IR or ARM can be made
Risky loans- denied, insured, or 3rd party guarantees?
Automated underwriting
Can save time, manual writing can take as long as 60 days to complete
Preferred b/c based on algorithms, eliminating human bias
IO strips
Interest high in beginning years, then declines over time
When prepayments increase, holders receive less cash flow
If loan is paid off, interest ceases, value of IO becomes zero
PO strips
Zero coupe rate, "principal only" security
If IR decline, higher probability that mortgage will be prepaid
Holders will receive more cash flow from early repayment
Increase in cash flow + decline in IR will increase PO prices
Underwriting
Process of evaluating a borrowers loan request in terms of potential profitability and risk. Considers borrower and property characteristics and how loan terms are established
Commercial underwriting
Loans are of greater value, creating greater risk/ return for lender
Much more involved than home mortgages
Terms of loan may be customized to reflect unique circumstances
Property characteristic are more important than borrower
CMOs
Collateralized Mortgage Obligations are debt instruments that are issued in multiple classes using a pool of mortgages for collateral. Issuer of a CMO retains ownership of the mortgage pool and issues bonds as debt against the mortgage pool.
The CMO is a pay-through security in that all amortization and prepayments flow through to investors.
Risk of commercial vs residential loansCommercial lenders do not bear as big of risk of refinancing or prepayment because it would be very expensive to do so Property is most likely generating revenue which makes borrower less important Residential loans are recourse where as commercial are non-recourseCMO TranchesPrioritization of payment of interest and principal among various classes of debt securities issued against the pool. Different stated maturity dates Some classes of investors receive cash flows, and others defer to later periodsPlanned Amortization Class Tranche (PAC)Offers greatest degree of cash flow certainty Receives fixed payments over a predetermined period of time under a range of prepayment scenariosTargeted Amortization Class Tranche (TAC)Corresponds to single "targeted" prepayment speedSupport TranchesWhere prepayments in excess amount are applied to Absorb any significant variation in prepaymentsRefinancingDepends on equity in home, credit, and debt to income ratioRESPAReal Estate Settlement and Procedures Act Law passed by congress to provide a uniform set of procedures & documents for buyers/borrowers of residential real estate. Lenders are required to provide prospective borrowers with an information booklet containing info on real estate closings and RESPA when a loan application is madeUPREITSREIT that owns a controlling interest in a limited partnership that owns the real estate, as opposed to a traditional structure in which REITs directly own the real estate Tax-deferred mechanism where you exchange buildings for sharesRegulatory constraints in REITsDistribution requirements Asset requirements Income requirements Ownership requirementsREIT distribution requirementsAt least 90% of a REITs annual taxable income must be distributed to shareholders as dividends. Necessary to pay tax on income just like any other corpREIT asset requirementsIn each quarter, at least 75% of value of a REITs assets must consist of RE properties, mortgages, cash, and government securitiesREIT income requirementsAnnually, 75% of gross income must be derived from income related to RE. 95% can include RE + other sourcesREIT ownership requirementsCan not be a closely held corporation. Shares in a REIT must be transferable and must be held by a min 100 ppl No more than 50% of stock may be held by 5 or fewer distinct share holders (5/50 rule) This prohibits shareholders from creating a monopolyFund From Operations (FFO)Defines the cash flow from operations Depreciation + amortization expenses + earnings Intended to compensate for accounting methods that may distort REITs true performanceBorrower vs property in commercial mortgageProperty is more important because borrower relies on property as income prop to provide cash to service the loan. If prop is making money relative to loan requirements, the loan will probably turn out ok even if borrower is a bit weakREITsRE company or trust that has elected to qualify for certain tax provisions Distributes to shareholders all of its earnings, in addition to any capital gains from sale of a property. REIT itself does not pay taxes, earnings only taxed once distributed Allows investors to invest in funds in a diversified portfolio of RE under professional management More liquidity than if property was owned outrightCommercial underwriting processInfo about borrower- income, assets, credit history, estimated housing expense, other obligations More importantly, criteria related to property- LTV, Debt service coverage ratio, break-even ratio, EBTCF, and multi year performa projectionMSB expects cash flow fromInterest in periodic paymentsOvercollateralizationIt ensures interest payments to security holders will continue, even if some mortgages are in default Ensures that as mortgages are prepaid, others will still be in the pool to replace them Agreed upon level, owner must replenish if market value falls below thisConsequences of tax-free dividends of REITsUnintended consequences, affect PV, cash flows, good for owners of shares of REITs, more companies would try and turn their companies into REITsMBS vs REITMBS are pool of mortgages issuing bonds to investors Safer investment than REIT bc issuer retains ownership and are issued with a fixed coupon rate and specific measuresResidential underwritingDetermine whether credit should be extended Primary importance is borrowers income Assets of borrows must be sufficient along with credit reportsRefinancingCalculate cost (prepayment penalty x existing loan amt) Add origination fees and discount points and recording fee of a new loan Calculate monthly savings due to refinancing (find monthly payments of existing loan and subtract from monthly payments of new loan) PV=cost to refinance N=term FV=0 PMT= difference in monthly payments Solve for IResidential v commercial mortgage poolsRMBS investor receives share of interest and principal payments CMO more risk/return RMBS greater prepayment/ credit riskPrepayment assumptionsPassed through to investors in securities Can be zero when interest rates increase Can accelerate rapidly when market IR decline If households refinance, mortgages are paid off and removed from poolPSADeveloped to simplify FHA prepayment model Based on monthly prepayment rates (which vary) Used to convey price and yield info to investors at time of issueDistinctions between mortgage related securitiesResidential- risk is prepayment, default backed by federal agency Commercial- risk is default, prepayment has significant penalty a and "lockout" provisions3 important mortgage pool characteristicsSecurity issuers and guarantors Payment patterns and securities for mortgage pools Borrower characteristics and loan prepaymentSecurity issuers and guarantorsOrganizations that originate mortgagePayment patterns and securities for mortgage poolsMost mortgages used in the pass-through security market are fixed IR loans secured by mortgages on single family homesBorrower characteristics and loan prepaymentHouseholds prepay loans as cost of housing adjusts Households respond to changes in IR Households may defaultConventional loansRequire 20% down no private mortgage insurance Can be conforming or non conformingFHA loans3.5% down PMI required maximum loan limit of around $275,000 No min credit scoreVA loansMust have served in US military No PMI No down payment Loans are assemble