Mortgage

So sweet was ne'er so fatal
(Othello -- Act V, Sc. II)

What is a mortgage?

A mortgage represents a loan taken to purchase a piece of a property, to be repaid over a specific period of time along with some interest. A lender gives a fixed sum called principal to a borrower. In return for this, the borrower will pay some interest over it. Each mortgage is associated with a term which represents the period of time over which the borrower is entitled to pay back the principal + interest to the lender. Thus, a mortgage represents the guarantee given by the borrower to the lender that he will pay back the sum borrrowed. Its similar in concept to a bond, except that, in case of a bond, the principal is paid at the end of the term and interest is what the lender receives periodically. While in case of a mortgage, interest + principal is paid in varying proportions over a fixed period of time, such that the total sum paid at each discrete interval is the same. mortgages are by nature designed to allow lenders to have a fixed amount of money every month.

Example: If you borrowed $100,000 from a lender with an agreement that at the end of 30 years you would repay the original loan amount plus 7%, then your total repayment would be $107,000. This is not how mortgage loans work. When money is loaned for 30 years, the mortgage agreement requires the borrower to make 360 periodic (monthly) payments to the lender. The payments must remain the same each month and fully repay both the interest and principal during the life of the loan. The quoted interest rate of 7.00% per year is compounded 12 times a year, resulting in a monthly rate of 0.58% (which is computed by dividing the note rate by 12).To calculate the interest due for a given month, the monthly rate is multiplied by the current loan balance. If you borrowed $100,000 at 7%, at the end of the first month your interest due would be $100,000 x (0.07 / 12).

The process of recalculating the interest and principal every month is called amortization.

It is shown in following diagram:

The reason why interest paid reduces every month is that, it is calculated on the total aount left to be paid back. Thus, It follows an exponentiontial as shown. To keep the total amount paid same, the principal is adjusted such that, the principal paid is less initially and more later.

New player: Financers

In the early years, around 1920's, big investors used to invest in the T-Bills, Which offer them the advantage of zero risk since they are completely backed by Govt. Also they used to offer a decent rate of interest, until things started being not as rosy as they always were. The interest rates offered on T-bills were guided by the Federal fund rates i.e. The rates at which one bank can lend money to other bank at federal Reserve. This federal fund rate is one of mechanisms used by Fed to regulate the flow of money in the market. If the Fed feels that there is not enough liquidity in the market, it may decrease the Federal fund rate, thus enabling other banks to borrow cheaply and thus lend more aggresively, bringing in liquidity. Conversely, to reduce the flow of money, it may increase the fund rate to make it difficult for banks to borrow, in turn causing lesser lending. Now, a low Fed rate maybe good news for the banks but not so much for our good old mighty lenders, who rely on these rates to fetch them enough interest on their excess capitals. So, when fed lowers the fund rates, like it recently did during last years crisis, (less than 1%!), lenders will say - “No, thank you.” to the ever-reliable T-bills. So they start looking for other avenues, and guess what, there are our poor little prospective homeowners looking to borrow some sum to buy their dream house. However, these lenders dont have direct exposure to these small borrowers. Furthermore, they dont have the expertise to analyse the quality of the borrower, his ability to pay back, to predict the fluctuations in the prices of the homes, factors affecting them and so on. All they have is a mountain of money to lend. So, the next logical step is to find a middleman who can provide such services. There come our greedy banks, who always look to dip in their hands where ever they can. They say, “We will find prospective borrowers for you. You give us the money and we lend it to them. Further, we will also provide you with an array of other intelligent servies. In return, we will charge you a service fee of 1%”. Now the lenders think, “I am getting a cool 8% return from each of my borrower, and i just have to shell out a paltry 1% to the banks. Huh! Not a bad deal”. So there we have our new flow – Borrowers <=> Banks <=> Lenders. The banks think they have found a golden ghoose! They get a cool 1% on every deal just by joining the two ends of the chain. Everyone stays happy and the world is suddenly all green! Now, acting a middleman is not the only thing banks do. (Infact a part of this work is now delegated to local brokers who in-turn meet the borrowers with the banks). These banks actually borrow huge sums from these lenders themselves at a specific rate and in-turn lend it to the homeowners at a higher rate, thus enabling them to earn much more than mere 1% of the stake. Thus, banks write these mortgages onto their own books. However, tides may turn against them anytime, when big daddy Fed decides to increase the fund rates. This makes it costlier for the banks to borrow. However, since the mortgages they offered were for say 30 years at fixed rate of 6%, these banks now find themselves in an ominous position wherein they are borrowing at a higher rate than what they are lending at. And since they are borrowing for a shorter period but lending for a longer period, their expenses rose much faster than their profits. This has, in past, caused many banks to fail. Thus, banks have now become wary of avoiding this scenario and many of them write these mortgages off their books and pass them on to other investors. Just by adding one new player, we see how a simple concept of the bond-like mortgages can be made more structured resulting in exotic mortgages ultimately.

Prepayments and Refinancing

a. Sometimes, the homeowners may find the rates ofthe mortgages too strintgent or maybe the period of repayment to be too less. To counter such situations, homeowners may choose to refinance. Refinancing means - “Right now i owe a mortgage of Rs 100,000 at 6% for 30 years. Since the interest rates are lower outside offlate, let me borrow 100,000 at 5.5% from outside and payback the entire lumpsum at one shot. I can then save 0.5% every month on my payments.” So the homeowner basically refinanced his existing loan with a new loan at more favourable terms. Refinancing can also be undertaken to increase the term of repayment by taking a longer period loan. There are other reasons for refinancing too, like converting a floating-rate mortgage to a fixed-rate one, to avoid the consequences of fluctuating interest rates. However, these details stay out of the scope.

b. House mortgages are generally given for a long duration like 30 years or so. However, not many mortgages last till their maturity as people may shift, die, get married, get promotions etc. And thus changes houses. In such cases, homwowners choose to prepay their loan by paying back all the pending principal. Such prepayments are a bad news for lenders who rely on these monthly payments for maybe some other investment they may have made somewhere else. Thus, they suddenly find themselves in a position where their one source of income has stopped. However, prepayments are not always so bad to our dear lenders. Only if the interest rates are falling, will it be treacherous for the lender. Because now, he is forced to push his money into some avenue which does not offer as much returns as the previous one did. However, if interes rates are rising, then the lenders are more than happy to get their money back and put it elsewhere where they get better interest. Having said this, if the interest rates were indeed rising, then the homwowners aint that stupid to let go of a good mortgage for some other “little bad” mortgage. So, we see that things can often go round in circles, with each previous entity depending upon next entity.

There are several factors leading to prepayments. Infact, whole lot of mathematical models have been built around predicting risk of prepayments. Few of these facotrs are:

1. Interest rates. (as we saw above. Infact, as it may be obvious, refinancing leads to prepayments)
2. Size of mortgages: All other factors remaining same, larger mortgages prepay faster than smaller ones, since they are more often than not, taken out by wealthier individuals who ay get good promotions elsewhere and decide to move on.
3. “assumable” mortgages: If mortgages have a clause that, they can be transfered to a new owner without any change in the terms and conditions of payment, then its called assumable. If a homwowner wants to sell his house anyway, even if interest rates are sky high, then he hasa good option of finding another home buyer who can take on the mortgage from there on, instead of taking a new one at higher rates from market. Thus, prepayment speed of “assumable” mortgages will be lower than “non-assumable” mortgages during high interest rates.
4. Economic strength of region: Regions with very high and very low economic strength both exhibit high speed of prepayments. High, because wealthier individuals can quickly afford to prepay and move on. Low, because there will be large no. Of defaults and since mortgages are often insured, Govt. Will prepay them. (Note that such an insurance on a mortgage backed security is nothing but a Credit Default Swap).

New player: Credit Rating agencies

As seen above, a mortgage lender has quite a bit of research to do before lending the mortgage to some new homeowner. Because, if the borrower defaults, then there is not much the lender can do except for some basic loss recovery which too is not 100% guaranteed. Thus, it becomes mandatory, to have some metric of comparison between different borrowers. Some may have high probability of repaying back while some have their heads hardly above water to even think of repaying back. This is where a Credit Rating agency comes into picture. These are generally govt established/backed agencies whose role is to assign some credit-level to each borrower. This rating determines their ability to pay back. In case of mortgages, it becomes easier for the banks to market these mortgages to the investors if they have some sort of credibility attached to them from a standard agency. These agencies may play two types of roles – 1. They may just give the credit rating for a mortgage thus helping the mortgage originators to sell the mortgage to investors. 2.) they may themselves buy these mortgages and write them into their books (thus acting as middle investors) and then they will sell it to the investors as a package.
Example of such credit rating agencies are: Ginnie mae, Freddie Mac, Fannie Mae.

New player: Investors

Till now,what we have seen is that, banks give mortgages to homwowners. These banks in turn finance their mortgages from big lenders (typically investment banks) who are then said to have “bought these mortgages”. Buy buying these mortgages, they get the interest paid on these mortgages by the home owners every month, after deducting the middleman feels of banks and brokers and credit rating agencies. Now these lenders may have bought thousands of such mortgages. So what they have now is nothing but a pool of mortgages. Now, based upon the credit rating given by the agencies and using some of their own calculations, these lenders will divide these mortgages into three categories broadly namely – safe, bit risky and risky. Since the risky bucket has more probability of defaulting associated with it, it offers the lenders more money per month than the safe buckets. Now, these lenders do not really want to hold these mortgage pools into their accounts. So after doing all the setting and shaping of the mortgage pool, they market it as what we call a CDO – Collateral Debt Obligation. So now, what originated as a mortgage from a homwowner, has taken shape of a well structured security like any other stock in the market. Investors will then buy these CDO slices in varying percentages. These investors pay the lenders in return and using the money they receive, the lenders will payback any loans they might have taken, and finally will have some profit marginto their name. So, ultimately, the money for the mortgage comes from these end investors.

The origin of sub-prime mortgages

When interest rates are low, it becomes easier for banks to borrow cheap credit from Fed. With so much of surplus of credit, the banks go crazy. They go on a mad spree of lending mortgages to anyone and everyone. Further more, if this is not enough, then banks use this credit to get more leverage. In order to understand leverage, consider this example. Clever Joe will buy one box for Rs. 10000 and sell it to another person, for Rs. 11000. Thus he earns a profit of Rs. 1000. However, Crafty Joe will go and buy 100000 more rupees by keeping his Rs 10000 as a collateral. He will then buy 10 boxes for it. He will then sell these 10 boxes for Rs. 110000. he earns a profit of Rs 10000. He will then pay the interest on the Rs 100000 which is Rs. 1000. And the rest 9000 rupees go in his pocket. This is what we call leverage. So by getting more and more leverage, these banks go about giving mortgages to even those who are almost sure of not being able to repay back. This whole businesss was based on a simple assumption that house prices will keep on increasing in the long term. So even if the home owners default, then the banks could sell thier house and recover their money. However, things done stop here. What happened was more and more no. Of people starting defaulting. So, within a locality of say 10 houses, 7 people defaulted. So, the bank decides to sell their house. This is where the demand-supply law comes into picture. More demand for a commodity plummets its prices while less demands causes the prices to increase. So, with so many houses on sale, their prices started falling down. So, the banks suddenly found themselves in a situation where they were left with a battery of abandoned houses which no soul was ready to buy. This is not it. Because of the 7 houses that were forsakened, the price of the remaining 3 houses in the locality also start dropping. So those stable homeowners start to think, “Why the hell are we paying a 100000 Rs mortgage for a house which is not even worth 30000 Rs now!”. So they raise their hands up. Now what this has done is, it has stopped the monthly flows of interests to the lenders and in turn to the investors. Further more, these guys may not even be able to recover back the total principal. So the banks go bust. Now, the investors who is left with a pool of such useless mortgages will try to sell them up to the investors. Investors raise their hands up too. So, the lenders who have already borrowed millions and billions of rupees from other lenders, are not able to pay them back and declare bankruptcy. Noone in the chain is spared. The investors may, in all probability, already holding lot of such mortgage backed securities. So these investors arent able to do anything with these dead securities. So they too get tapped out. Now whos left in the chain? The credit rating agencies. These agencies were ideally formed by the Govt. To give ratings to the mortgages to differentiate between the good ones and the not so good ones. However, since the greed for money spared no single man, these agencies started writing these mortgages onto their books instead of just giving services. So, when the mortgages went down-and-out, these guys too got busted. This is because as opposed to the popular public opinion that these agencies are backed by govt. flows, it wasnt a 100% truth. With the exception of Ginnie Mae, Freddia Mac and Fannie Mae were simply "eligible" for a Fed stimulus. But knowing the nature of toxic assets these agencies had undertaken on their books, Fed just said "Ward off!", and let them go down in the Dec of 2008, in a way headstarting the journey downwards for the rest. So, in this way, we see how one futile assumption that the house prices will always rise, caused the entire system to come down.