Residential Mortgage Loans

Mortgage Loans

Mortgage loans are secured loans where repayments are linked to a specific real estate asset. The lending entity can take possession of this asset due to the rights provided by the first lien and security interest on the property if a borrower defaults. The process, known as foreclosure, helps the lender recover the outstanding debt by selling the property.

Loan-to-value Ratio (LTV)

The loan-to-value ratio is the ratio of the loan amount to the property’s valuation. The difference between the mortgage and the property’s buying price is the down payment (the buying price is higher). A lower LTV means increased equity for the borrower. For the lender, this means the borrower has a reduced likelihood of a default. The LTV changes over time as the loan’s outstanding balance decreases due to repayments, and the property’s market value fluctuates.

\[LTV\, = \frac{\text{Loan amount}}{\text{House price}}\]

Debt-to-income Ratio (DTI)

The debt-to-income ratio is an individual’s monthly debt payments ratio to their pre-tax income. A lower DTI shows that a borrower can manage their monthly payments and can manage more debt. A higher DTI could alarm lenders as it may mean the borrower is overly leveraged.

\[\text{DTI} = \frac{\text{Monthly debt payment}}{\text{Pre-tax income}}\]

Classification of Mortgages Based on Credit Quality

In nations like the United States, prime loans represent borrowers with solid credit backgrounds, lower DTIs, lower LTVs, and first lien on the property. Subprime loans are riskier with attributes like high DTIs or elevated LTVs.

Agency vs. Non-agency Residential Mortgage-backed Securities (RMBS)

Mortgages in MBS can be residential or commercial. RMBS arise from bonds backed by residential mortgages. In some countries, there is a difference between government-backed RMBS and those without this backing.

Agency RMBS

These RMBS come with a certain guarantee level regarding the punctual payment of interest and principal repayment. Agency RMBS can further be divided into two categories:

1. Guaranteed by a Federal Agency: The government guarantees timely interest payment and principal repayment. It is a firm assurance that the securities will fulfill their promised cash flows.
2. Guaranteed by Government-Sponsored Enterprises (GSEs): This category includes RMBS issued by GSEs. They do not have the full backing of the federal government. Instead, they offer guarantees for the punctual payment of interest and principal on the securities. As a service, GSEs typically charge a fee for this guarantee. It’s a promise based on the credibility and financial strength of the GSE rather than the government itself.

Non-agency RMBS

No federal agency or GSE guarantees these securities. Private entities like banks, financial institutions, or other businesses issue them. They have credit enhancements in the form of pool insurance, letters of credit, or subordination to appeal to investors. The mortgages backing non-agency RMBS are often termed as non-conforming mortgages. They might have higher Loan-to-Value (LTV) ratios or be associated with borrowers of lower credit quality.

Mortgage Contingency Features

Borrowers may have a prepayment or early repayment option that allows them to prepay all or part of the outstanding mortgage principal before maturity. This poses a prepayment risk for lenders as the exactness of cash flow timings, and amounts becomes unpredictable. To minimize this uncertainty, lenders often impose prepayment penalties. The penalties compensate for differences between the contract and prevailing mortgage rates.

The mortgage can default if a borrower fails to adhere to the payment schedule. This allows the lender to initiate foreclosure. The amount recovered after the property’s sale might be inadequate to cover the losses. In recourse loans, lenders can claim the difference between the outstanding amount and sales proceeds from the borrower. Non-recourse loans do not permit lenders to make such claims and can only recover the balance through the property. The type of loan, whether recourse or non-recourse, impacts the borrower’s likelihood of default, especially where the LTVs are higher than 100%. Depending on the nature of the mortgage, borrowers may consider a strategic default, where they intentionally default, weighing the consequences against potential benefits.

Underwater Mortgages

Negative equity or underwater mortgages are where the owed amount exceeds the property’s value. This situation means the homeowner owes more on the mortgage than the property is currently worth. Strategic default becomes more likely with non-recourse loans when LTV exceeds 100%.

A borrower can make a deliberate decision to stop making payments on a debt despite having the financial ability to make the payments. This is called strategic default. Strategic default becomes more likely with non-recourse loans as the borrower’s liability is limited to the property itself. Additionally, when the LTV is greater than 100%, meaning the property value is entirely overshadowed by the owed amount, the likelihood of a strategic default increases. underwater mortgages can be precursors to foreclosures and were prominent during the 2008-09 Global Financial Crisis.

Question

Which of the following best describes a recourse loan?

1. A loan in which the lender can claim only the property in case of default.
2. A loan in which the lender can claim the difference between the outstanding mortgage balance and property sale proceeds from the borrower’s other assets or income.
3. A loan that carries a prepayment penalty to compensate the lender if the borrower decides to pay off the loan earlier than the agreed schedule.

The correct answer is B.

A recourse loan allows the lender to claim the difference between the outstanding mortgage balance and the sales proceeds from the borrower’s other assets and/or income in case of a shortfall after selling the property.

A is incorrect: This describes a non-recourse loan, where the lender can only claim the property as collateral in the case of default and cannot go after the borrower’s other assets or income.

C is incorrect: While some loans carry a prepayment penalty, this feature is not specific to recourse loans and does not define the nature of recourse in a loan.