Kuliah-9

Graduate School of Management

Faculty of Economics and Business
Universitas Indonesia
Overview of Mortgage
• Fixed term to maturity
• Basic characteristics:
• Loan amount
• Loan term
• Repayment schedule
• Contract interest rate
• Risks associated with lending
• Default risk
• Market risk --- interest rate fluctuations
• Mechanism to protect lender: collateral
The Mortgage Market
 Primary Mortgage Market
 A market where new mortgages are
originated
 Secondary Mortgage Market
 A market where existing mortgages are sold
 Relatively small and relatively inactive
Overview of Mortgage Contracts
 Mortgage ---- home ownership
 Collateral
 Regular payments (interest and outstanding principal)
 Basic players in mortgage markets:
 Lenders
 Borrowers
 Other players
 Mortgage insurance
 Government agencies
Lenders’ Risks: Default risk
 Lenders can minimize the probability of defaults by
taking some actions at the time application is made,
as follows:
 Collect information on borrower credit history and
other loans liabilities
 payment history
 level of existing debt
 Years of transaction with credit
 Records of delinquencies and default
 Nature of credit history (types of previous loans)
 Assessing the loan-to-value (LTV) ratio
Lenders’ Risks: Default risk (Cont’d)
 Examine the projected mortgage payments with
income and nature of employment
 Proportion of loans that are delinquent may depend on
the general economic condition and the level of
mortgage interest rates
 In the event of default---- lender will be able to foreclose
and take position of the home
 Loan recovery depends on the net proceeds that lender
able to get by selling the home
Lenders’ Risks: Default risk (Cont’d)
 Requiring the borrowers to obtain mortgage insurance
 Types of insurance:
 Private insurance --- part of life insurance
 Lender requires insurance and obtain it from mortgage
insurers (cost will be borne by the borrower!)
Lenders’ Risks: Prepayments
 Borrowers may choose to refinance their previously taken
loans
 Rationality: the loan rate > mortgage rate in the current
condition;
 When mortgage rate decrease --- loan prepayment will
increase ---- low interest mortgage loan
 Lenders might deal which such condition by:
 Charge with higher mortgage rate
 Hedge the interest rate exposure
 Sell the mortgage portfolio to buyers (government agency)
 Issuing adjustable rate mortgage loans that less affected by
prepayments
Lenders’ Risk: Interest rate risk
 Interest rate fluctuations
 Fixed-rate loan portfolio will lose value
when interest rates increase
Types of Mortgages
Fixed-rate mortgages (FRMs)
Adjustable-rate mortgages
(ARMs)
Fixed Rate Mortgages (FRMs)
 Maturity: 15 to 30 years
 Constant monthly payments for borrowers
 No uncertainty on mortgage obligations
 No change in interest rate
 FRM borrower could have locked in a level of
payments for the life of the mortgage
Fixed Rate Mortgages (FRMs)
 Benefits
 Monthly payment (interest and principal)
constant for the term of the mortgage
 The interest rate paid by borrower is the
same for the life of the loan, regardless of
the market behavior
Adjustable Rate Mortgages (ARMs)
 More complicated contracts
 Interest rate changes over the life of the
contract
 Rates are linked to certain index of
borrowing rates (COFI-cost of fund
index)
 Interest rates “float” depends on the
index level, generally every six months
Adjustable Rate Mortgages (ARMs)
 Rates are lower than equivalent fixed-rate mortgages
 Borrower is bearing some of the market risk relationship
 Market risk ---- Inverse relationship between interest
rate and bond price
 Interest rate
 Difficult to predict
 Invariant to the maturity of the asset
 Lenders---risk averse (risk premium on bonds)
Features of ARMs
 Interest rate is kept fixed during the first few years
 ARMs carry a life time cap on interest (above which , will
no charge on borrowers)
 ARMS carry year-to-year cap ---- borrowers’ interest
cannot exceed the previous year’s interest by more than a
certain percentage point
 ARMs will carry a margin over the index interest rate
 Typically, ARMs indexed to short-term interest rate
(Which is volatile)
 ARMs have a lower prepayment risk, since the rates are
indexed to market conditions --- lenders focus on
managing credit risk
Other classification of mortgages loans
 Size of initial loan taken
 LTV ratios
 Credit scores
 Level of documentation
 The ability of lenders to sell their mortgage loans to
federal agencies
 Underwriting standard employed at the time the loan
was extended
Mortgage cash flows and yields
 Semi annually coupon payments
 Quote rate: nominal annualized terms, semi
annual compounding
 Known as bond-equivalent yield (BEY)
 Semiannual BEY:
Mortgage cash flows and yields (Cont’d)
 Mortgage characteristics
 Pay monthly cash flows
 The cash flows include interest and
principal payments
 Therefore, yields are quoted in
annualized terms, monthly
compounding --- Mortgage-equivalent
Yields (MEY)
Mortgage cash flows and yields (Cont’d)

 With the assumption of no prepayments or default, each monthly

payment is the same (including interest and principal). The present
value of the sum of all payments is the value of the loan as follows:

Or
Mortgage cash flows and yields (Cont’d)
 Example 11.1
Mortgage cash flows and yields (Cont’d)
 Outstanding balance can be calculated as:

 The stated rate in the mortgage is the most important cost

for the borrowers
 Other costs are:
 Appraisal fee
 Property insurance cost
 Broker fees
 When all relevant factors are included ---- effective interest
rate will > stated interest on the mortgage
 Effective interest rate ---- annual percentage rate (APR)
Federal Agencies (Government-
Sponsored Enterprises – GSEs)
 GSEs are financial institutions that retain and
manage credit, interest rate, and liquidity risk
 They earn money through the following
operations:
 Credit guarantee
 Fannie Mae and Freddie Mac purchase mortgages
and issue mortgage based securities --- guarantee
timely payment of interest and principal
 It bears the credit risk of individual borrowers
defaulting on their mortgage s after losses
covered by private mortgage insurance
Federal Agencies (Government-Sponsored
Enterprises – GSEs)
 Mortgage investments
 GSEs purchase whole mortgages, mortgages based
securities, and other mortgage-related securities in the
capital market
 The risk of these investments are: credit risk, interest
rate risk, liquidity risk
 Liquidity risk is more significant for GSEs, since it needs
to sell as a package – mortgage based securities (do not
face prepayment risk)
 Motive for owning mortgages ---the spread between the
income from mortgages and the cost of issuing debt to
finance the purchase of mortgages
 Advances
 A secured loan created by the Federal Home Loan Banks
Federal Agencies (Government-
Sponsored Enterprises – GSEs)
 Segments of mortgage markets
 Primary mortgage market
 Originated/ created new mortgages
 Secondary mortgage market
 Buy and sell mortgages
Fannie Mae and Freddie Mac
 The federal national mortgage association
(Fannie Mae)
 Created in 1938
 A wholly-owned government corporation
 Provides secondary market for the Federal Housing
Association (FHA) and Veterans Administration
(VA) mortgage loans
 Provides additional liquidity to the mortgage
market
 Improve distribution of investment capital
 Fannie Mae was owned partly by private
shareholders and government
Fannie Mae and Freddie Mac
 Fannie Mae was split into the Government National
Mortgage Association (GNMA or Ginnie Mae) and
Fannie Mae, in 1968
 GNMA is wholly government owned
 Its operations are financed by treasury borrowings,
interest holdings, guarantee fees and other fees
 Freddie Mac was created in 1970
 It buys from savings and loan institution; mortgage
bankers, and commercial banks
 It sells mortgage pass-through securities
Fannie Mae and Freddie Mac
 Fannie Mae and Freddie Mac issue debt and
use proceeds from the sale of their debt to
purchase mortgage in the secondary market
 The debt is traded at interest rate only few
basis point more than that of otherwise
government debt.
Factors in assessing the risk of loan
 Payment to income ratio
 Monthly loan payment including taxes divided
by the borrower’s monthly income
 Ratio of larger than 25% considers as caused for
concern
 Debt to income ratio
 The ratio of all monthly debt expenses to
monthly gross income
 Ratio of more than 36% considered as caused for
concern
Factors in assessing the risk of loan
 Loan to value ratio
 Loan amount divided property by estimated
(appraised) value of the property
 Estimated property value – size of loan = down
payment
 If LTV ratio is 80% or lower is considered as
conventional
 The higher the ratio, the greater the risk of
default
 Size of loan
Pembentukan Second Mortgage Facility
(SMF) di Indonesia
 1983 --- diskusi awal
 Studi kelayakan ---- Pemerintah dan DepKeu 1993 sd 2005
 Keputusan Menteri Keuangan;KMK No. 132/KMK014/1998
 Membuka peluang berdirinya lembaga pembiayaan sekunder
perumahan
 Peraturan Pemerintah RI:
 No 5/2005, 7 February 2005 tentang penyertaan modal negara
 Peraturan Presiden No. 19/2005
 Berita Negara RI 30 Agustus 2005, No. 69
 Tambahan No. 9263: Pendirian PT. Sarana Multigriya
Financial (Persero) 22 Juli 2005
Second Mortgage Facility (SMF) di Indonesia
 Tujuan Pembentukan:

 Untuk membeli suatu kredit kepemilikan rumah (KPR)

dari bank, dikemas dalam suatu efek hutang, dan dijual
kepada investor
 SMF dibentuk oleh lembaga keuangan yang
melaksanakan kegiatan pembayaran sekunder
perumahan yang khusus didirikan untuk membeli aset
keuangan dan sekaligus menerbitkan efek beragun aset
(EBA --- Asset-backed securities)
SMF di Indonesia (Cont’d)
 Manfaat transaksi sekuritisasi bagi Penyalur KPR

 Mitigasi maturity mismatch antara sumber pendanaan

jangka pendek dengan KPR berjangka panjang
 Diversifikasi sumber pendanaan dengan sumber jangka
panjang yang berkesinambungan
 Meningkatkan kemampuan kemampuan/kapasitas
penyalur KPR
 Pengelolaan asset dan liabilities
 Meningkatkan keuntungan melalui fee based income,
bukan lagi interest margin
SMF di Indonesia (Cont’d)
 Manfaat transaksi sekuritisasi bagi investor

 Alternatif produk investasi dengan tingkat risiko yang

lebih baik karena berbasis portfolio aset
 Produk investasi Kelas A dengan rating idAAA dari
Pefindo
 Underlying aset portfolio yang kuat sesuai kriteria sehat
dari SMF
 Struktur transaksi yang solid dengan adanya Dukungan
Kredit dan Subordinasi
SMF di Indonesia (Cont’d)
 Manfaat transaksi sekuritisasi bagi pasar
modal
 Pengembangan produk investasi di pasar modal
yang berbasis portfolio aset
 Ketersediaan produk investasi bagi Investor
yang menginginkan produk jenis ini
Mekanisme Transaksi Sekuritisasi

Sumber: PT. Sarana Multigriya Finansial

Perkembangan Produk MBS --- Indonesia
 SMF – BTN – Danareksa
 September 2009 – IDR 645 billion; 3-month coupon payment;
10 year maturity (Feb 27, 2021); YTM 8.75%
 Sept 2009 --- BTN issued IDR 391 billion Securities Backed
Mortgages (RMBS)
 SMF – Bank Syariah Mandiri
 Pembiayaan Hunian Syariah
 Tahap 1: Rp 300 M Okt 2011
 Mekanisme Pembiayaan: Akad Mudharabah wal Murabahah
 Penempatan dana dari SMF ke BSM dengan bagi hasil
 SMF – Bank Muamalat
 14 Desember 2011; 3 tahun; Rp 100 M
 Mekanisme pembiayaan: sebagai shahibul maal (investor)
 BSM sebagai pengelola (Mudharib)
Overview of MBSs
 Securitization ----- creation of MBSs
 MBSs
 bonds that are secured (backed) by a portfolio of
underlying mortgage loans
 Each bond represents the future payments of a borrower
who has undertaken to make monthly mortgage
payments (interest and principal)
Securitization
 STEPS
 Pooling of individual residential mortgage loans
 Provision of credible guarantees
 Issuance of the MBS
 The goal of originator
 To move the loan portfolio out of their balance sheet and
into a special purpose vehicle (SPV)
Securitization
 Financial institutions:
 Maintaining the status of individual loans (pre-
payment, outstanding principal, delinquency records)
 Collecting scheduled interest, principal payments and
pre-payments
 Handling delinquencies, defaults and foreclosures
Steps in issuing of MBSs
 The originators forward the loan portfolio to GNMA with
the appropriate documentation, requiring GNMA’s
commitment to guarantee the securities to be backed by
the pooled mortgage portfolio
 GNMA reviews the application
 The originators transfer the mortgage documents to
custodial agents and send the required pool documents to
GNMA
 Anticipating the issuance of the GNMA guarantee
(advanced commitment s from dealers, investment banks,
etc)
 GNMA reviews the documentation and issue guarantee
Cash flows and market convention
 Cash flows from the underlying pool of mortgages to
the investors of the MBSs
 Scheduled interest
 Principal
 Pre-payments
 Service fees and guarantees fees will be subtracted
from the CF generated by the loan portfolio that is
backing the mortgage securities
 The payment to the MBS investors occur on the 15th of
the next month
Cash flows and market convention
 The quoted price refers to the percentage of the
outstanding principal balance in the underlying pool.
 It requires the calculation of the outstanding balance ---
requires compilation of the scheduled interest and
principal payments
 Accrued interest calculation:

 SD = settlement date
 M = the first day of the month within which t falls
 B = the principal balance
 c= the coupon rate
Risks – Prepayments
 Bank cannot predict with certainty the
future cash flows from its loan portfolio
 The option to prepay will be priced into the
loan by the bank, and borrower will pay a
higher interest rate on the loan as a
consequence
Risks – Prepayments: Measuring Prepayments
 The rate of prepayment may be determined by the
following measures
 Twelve – year retirement (the simplest and least
important)
 Constant monthly mortality --- the mortgage is assumed
to be paid following the next month’s scheduled
payments (0.5%) --- Single monthly mortality –SMM
Risks – Prepayments: Measuring Prepayments
 The probability that the mortgage will be
retired next month depends on 2 factors
 The probability that the mortgage will survive the first
month:
1 -5% =95%
 The mortality rate for month 2, given survive at the
first month = 0.5%
 Annual prepayment rate known as conditional
prepayment rate (CPR)
Risks – Prepayments: Measuring Prepayments
 The probability of survival = (1− SMM )12
 It equals to (1− CPR)
 Therefore, CPR can be written as:

or
The Federal Home Administration (FHA)
 The probability that the mortgage will be retired
during any given year t:

 The conditional probability that the mortgage will be

survived through the year t, given it has survived until
the year t-1:
Mortgage cash flows with prepayments
 Must consider that we are dealing with a pool of
mortgages.
 If the pool has a total number mortgages; with
outstanding balance of at time 0. The pool balance
is:
 Therefore, the pool balance at time t will be:
Factors affecting prepayments
 Refinancing incentive
 Seasonality factor
 Age of mortgage
 Family circumstances
 Housing prices
 Mortgage status
 Mortgage term
Valuation Framework
 Factors determined the value of fixed-rate mortgage:
 Coupon
 Time to maturity
 Amortization schedule
 Interest rates on comparable mortgages at the time of
valuation
Valuation of pass-through MBS
 Factors driven prepayments
 Single factor model --- prepayments is driven by
refinancing rate only
 Two- factor model --- refinancing rate and
housing prices
Procedure to value MBSs
 Compute CFs – and discounted them at the zero
coupon interest rate that is relevant for each
month t along path 1
 The zero rate for n periods in path i is as follows:

 The price of the security will be:

On the determinants of the value of call options on
default-free bonds (Buser et al, 1990)
 Examining alternative models for pricing debt options,
controlled for fundamental determinants of bond
option value .
 Traditional comparative static experiments --- economic
characteristics
 Sample: 3 different options:
 2-year call option on 10-year zero coupon bond
 2-year call option on a 30-year coupon bond
 The borrower’s option to prepay a 30-year fully
amortizing mortgage