Pricing FHA Single- Family Mortgages. Final Report. Contract # C-OPC Task Order No. 17

Transcription

1 Pricing FHA Single- Family Mortgages Final Report Cambridge, MA Lexington, MA Hadley, MA Bethesda, MD Washington, DC Chicago, IL Cairo, Egypt Johannesburg, South Africa Contract # C-OPC Task Order No. 17 September 2001 Prepared for U.S. Department of Housing and Urban Development 451 Seventh Street, SW Washington, DC Abt Associates Inc. 55 Wheeler Street Cambridge, MA Prepared by Laura Duenes Austin Kelly James Wallace Meryl Finkel

2 Table of Contents Executive Summary... iii Background and Study Approach...iii Key Findings...iii Potential Impacts of increased Ginnie Mae Guarantee Fees...iii Presence of Excess Spread in FHA Servicing Fee...iv FHLB Mortgage Partnership Finance Program...iv Chapter 1: Introduction...1 Background...1 A Simple Pricing Model...1 Participants in the Mortgage Market...3 Overview of Current Industry Issues...5 Potential Impacts of Increased Ginnie Mae Guarantee Fee...5 Presence of Excess Spread in FHA Servicing Fees...6 Impact of Federal Housing Finance Board s Mortgage Partnership Finance Program...7 Study Approach...7 Project Goal...7 Methodology...7 Overview of Report...8 Chapter 2: Overview of Single-Family Mortgage Market...9 Functional Activities of the Single-Family Mortgage Market...9 Customer Acquisition...9 Underwriting...10 Funding/Closing...11 Servicing...11 Credit Risk Management...12 Interest Rate Risk Management...12 Pricing in the Single-Family Mortgage Market...14 Pricing Components...15 Pricing Process...17 Determinants of Pricing...18 Differences in Conventional and FHA Pricing...20 Abt Associates Inc. Table of Contents i

3 Chapter 3: Current Issues...23 Potential Impacts of Increased Ginnie Mae Guarantee Fee...23 Background...23 Potential Impacts...24 Presence of Excess Spread in FHA Servicing Fee...25 Background...25 Factors To Consider in Assessing Excess Spread...26 Market Value of Servicing...28 FHA Servicing Fees and Relationship to Steering...31 FHLB Mortgage Partnership Finance Program: Alternative to Existing Secondary Market Options...32 Background...32 Program Overview...32 Expansion of MPF...34 Program Impacts...35 Chapter 4: Conclusion...37 Current Trends and Impacts...37 Increase in Ginnie Mae Guarantee Fees...37 Excess Spread in FHA Servicing Fee...38 FHLB Mortgage Partnership Finance Program...38 Recommendations for Further Research...39 Appendix A Bibliography...41 Appendix B Interview Participants...42 Abt Associates Inc. Table of Contents ii

4 Executive Summary Background and Study Approach Abt Associates Inc. conducted research on Pricing FHA Single-Family Mortgages for the U.S. Department of Housing and Urban Development, under HUD Contract C-OPC-05978, Task Order 17. The study had two goals. The first goal was to develop a primer on the single-family mortgage market system. The study identifies the market segments and roles of key industry actors and describes the process and factors in pricing single-family mortgages. The second goal was to addresses the potential impacts of three policy issues that were of concern to the Department: the upcoming increase in the Ginnie Mae guarantee fee, the presence of excess spread in FHA servicing fees, 1 and the FHLB Mortgage Partnership Finance (MPF) program. Two approaches were used to address the study s research questions. First, the project team conducted a review of academic and industry literature on pricing of single-family mortgages. Second, the team conducted qualitative interviews with industry practitioners, including lenders, servicers, insurers, investors and secondary market agencies. Key Findings Below we present key findings on the three policy issues examined for the study. Potential Impacts of increased Ginnie Mae Guarantee Fees The current structure of the Ginnie Mae I mortgage-backed securities program requires a 50 basis point spread between the interest rate paid by the mortgage borrower and the interest rate paid to the securities investor. A 6 basis point Ginnie Mae guarantee fee is paid from this spread, leaving 44 basis points retained by the servicer. Effective October 1, 2004 the Ginnie Mae Guarantee Fee will be raised to 9 basis points, leaving 41 basis points for the servicer. Industry experts raised three potential outcomes of the increase. Most interview respondents thought that servicers would make up for the lost revenue through lower prices paid to originators for the right to service their loans. In this case, originators would most likely make up for the lost revenue through increases in rates and/or fees charged to borrowers. A second possible outcome is that originators or servicers would absorb the losses in revenue, thereby reducing the overall profitability of FHA and VA lending relative to conventional lending. The likelihood of this impact was thought to be remote. Finally, competing 1 In the mortgage business servicing fees are one of several forms of revenue for lenders and they do not necessarily bear a relationship to the cost of servicing. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report iii

5 enterprises might expand their presence in this market, offering more competitive terms than the 9 basis point fee which Ginnie Mae will be required to charge. Presence of Excess Spread in FHA Servicing Fee In the mortgage industry excess spread refers to fees or revenues greater than the normal range for that particular transaction or product. While the servicing fee for an FHA mortgage is 44 basis points, a conventional mortgage has a servicing fee of between 25 and 35 basis points. Some housing advocates have, therefore, described fees associated with FHA servicing as excess spread. Industry practitioners said that the higher FHA servicing fee appears to be justified because the costs associated with servicing FHA-insured mortgages are higher than for conventional loans. Management of delinquencies and the foreclosure procedure is the most costly component of servicing. Each of these rates is roughly four times higher for FHA loans compared with conventional mortgages, thus these activities have a much higher cost impact on FHA servicers. In addition, because FHA is a government agency, servicing FHA-insured loans requires more documentation and administrative steps than mortgages offered and insured by the private sector. Finally, originators sell FHA-insured mortgages with Ginnie Mae guarantees on a recourse basis, which means the servicer is required to advance payments to investors even on defaulted loans. (While FHA insurance eventually compensates the servicer for nearly all default-related expenses, the servicer must use its own capital to advance investor payments). In contrast, recourse is not required for securitized conventional loans. The securitizing GSE rather than the servicer is responsible for making timely payments during delinquency and the process of foreclosure. FHLB Mortgage Partnership Finance Program In 1997 the Federal Home Loan Bank of Chicago, developed the Mortgage Partnership Finance (MPF) program. The program has been expanded and now includes most of the FHLBs. The MPF program allows member institutions to sell pooled mortgages to an FHLB with no guarantee fee. In its first couple of years, it appeared that MPF could have a large impact in the area of purchase of FHA loans. For example, approximately $2 billion of MPF s first quarter 2000 volume was from FHA mortgages. However, more recent data show a reversal in this trend. Data from early 2001 show that MPF purchases of FHA and VA loans decreased significantly in late 2000 and early For example, In the third quarter of 2000 GNMA s share of new FHA/VA originations reached nearly 100 percent, followed by an 89.7 percent share in the fourth quarter, and a 93.3 percent share in the first quarter of If future MPF purchases of FHA loans increase again, the impact could be to decrease the liquidity of Ginnie Mae MBS. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report iv

6 Chapter 1: Introduction On behalf of the U.S. Department of Housing and Urban Development, Abt Associates Inc., conducted research on Pricing FHA Single-Family Mortgages Task Order 17 under HUD Contract C-OPC This final report represents our findings in this exploratory research effort. Background The U.S. mortgage finance market is a complex and evolving industry that continues to expand. Currently this market has $4.5 trillion in outstanding loans, 2 significant growth from early 1991 when outstanding loans totaled $2.74 trillion. 3 Composed of several market segments and a wide variety of industry actors, the single-family mortgage market has fueled growth through continuous innovation and change. Two changes of particular concern to HUD are the legislatively mandated increase in Government National Mortgage Association (GNMA or Ginnie Mae) fees which goes into effect in 2004, and the entrance of new participants, the Federal Home Loan Banks, in the resale market for mortgages or the secondary market. In addition, a recurring issue is the difference between servicing fees earned on FHA versus conventional mortgages. In this complex mortgage market, borrowers face a sometimes bewildering array of loan term and interest rate options when they shop for a mortgage. A 30-year, low downpayment, fixed-rate FHA loan will carry a different interest rate than will a 15-year, 10 percent downpayment, conventional loan, or a 20 percent downpayment adjustable rate loan with annual adjustments. Moreover, the rates may change at any time. This report explains the primary factors that determine the interest rates charged on various mortgage products, and how those rates are likely to change as a result of the changes such as those mentioned above. A Simple Pricing Model At its most basic level, the mortgage market can be viewed in terms of a borrower and a lender. As a concrete example, consider a young couple with bright prospects and few assets, purchasing their first home. A wealthy neighbor is willing to finance their purchase for appropriate compensation. What constitutes appropriate compensation? Heart of the Industry, March 15, Fabozzi, Frank J. and Franco Modigliani, Mortgage and Mortgage-Backed Securities Markets, (Boston: Harvard Business School Press, 1992), p.24. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 1

7 The potential lender is currently invested in 30-year Treasury bonds, paying 6 percent interest. He will not be willing to lend his funds out at any rate less than the rate he is currently earning on safe investments. Furthermore, a mortgage loan requires substantial time, processing and paperwork that is unnecessary for the owner of a bond. The lender must investigate the credit and capacity of the borrower, and establish the value of the asset. In addition, the lender must process monthly payments, send statements, prepare tax documents for the borrowers, register the loan with the local government, and be prepared to make time intensive collection efforts if the loan payments are late. This effort is referred to as servicing. Because of the extra required effort, the wealthy neighbor will not make a mortgage loan at 6 percent, but may be willing to make the loan if he can charge at least enough to cover the servicing costs. For example, if he thinks that 50 basis points 4 is sufficient to pay for the extra effort then he will charge at least 6.50 percent for the loan. A 30-year Treasury bond is a safe investment with respect to the stated interest being paid on a regular basis, and the principal being returned at the end of 30 years. A mortgage, on the other hand, contains credit risk. The borrowers may stop making payments on the loan, and efforts to reestablish payments may fail. In that case, the lender must spend money on the foreclosure process, takeover the property in lieu of receiving the agreed payments, and sell the property, usually at a loss. The risk of such losses is known as credit risk. The potential lender will not make the mortgage loan unless he charges an interest rate high enough to cover his servicing costs, and compensate him for the credit risk. The probability of a standard 20 percent downpayment mortgage going to foreclosure is about three-quarters of one percent per year, and the loss from a foreclosure averages about one-third of the loan balance. 5 Hence, a further one-quarter of a percent per year, 25 basis points, may be enough to compensate the potential lender for this credit risk. There is another risk that distinguishes mortgages from simple bonds. Prepayment risk a form of interest rate risk is not as obvious as credit risk, but is equally important to a discussion of mortgage pricing. If the potential lender invests in a 30-year Treasury bond, he will get 6 percent interest for each of the next 30 years, and get back his principal on the expected date. A typical mortgage, on the other hand, may be prepaid before its term. The young couple may borrow money for 30 years to make their home purchase, but if interest rates fall they may obtain a new mortgage at a lower interest rate, and pay off their old mortgage early. Their wealthy neighbor must then reinvest the proceeds at the current, lower interest rate. A 6 percent Treasury bond will continue to pay 6 percent throughout its life, but a 6 percent mortgage investment will yield at most 6 percent, and may yield less if there is a general decline in interest rates and the mortgage is refinanced. Hence, a lender will 4 5 A basis point is one-one hundredth of a percent. For example, 6.5 percent is 650 basis points. See Hedonic Mortgage, Chinloy and Megbolugbe 1994, for a discussion of these components of price, and their relative magnitudes for a typical mortgage. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 2

8 prefer to make the certain investment, unless the mortgage pays a high enough interest rate to compensate the lender for lost income should rates fall unexpectedly and initiate a prepayment. The techniques for assessing the magnitude of prepayment risk are complex and still evolving. For a standard 30-year fixed-rate mortgage it is estimated that it takes about 75 basis points to compensate a lender for prepayment risk. 6 After considering the above factors, the wealthy neighbor will lend mortgage money to the young couple only if he can charge them at least 7.5 percent interest. This will compensate him for the 6 percent he could have earned on a safe Treasury bond investment, plus pay him 50 basis points to cover his servicing costs, 25 basis points to cover his credit risk, and 75 basis points to cover his prepayment risk. This may also be described as a spread of 150 basis points over 30-year Treasury bonds. 7 So long as the costs of originating a mortgage are as stated above, the interest rate charged on mortgages will be about 7.5 percent. 8 If lenders charged interest rates much below this rate, they would find it preferable to invest in safe Treasury bonds instead of making costly and risky mortgage loans. If lenders charged a rate much above 7.5 percent, the profitability of mortgage lending would attract new lenders into the business and drive down the rate charged to borrowers. Any change in the above cost factors would eventually be reflected in the rate charged to borrowers. For example, an increase in the interest rates on Treasury bonds would make investments in bonds more attractive than investment in mortgages, reducing the willingness of lenders to originate mortgages, hence driving up the rate charged to mortgage borrowers, until mortgage lending again became attractive relative to purchasing safe Treasury bonds. Participants in the Mortgage Market One wealthy individual making one mortgage loan may find the preparation of monthly statements and tax documents daunting. Specialized lending institutions can achieve economies of scale in servicing. A savings and loan that processes thousands of loans a month will make the process routine and cheap. The mortgage market of the early 1900 s consisted primarily of depository institutions, such as banks and savings and loans, that provided 5-10-year balloon mortgages and held them in portfolio retained the liability on their books for the length of the loan. Lenders used Chinloy and Megbolugbe, op cit. Interest rates are usually quoted as a spread to the 10-year Treasury bond. This is because borrowers usually pay off their mortgage when they sell their home, so that 30 years is the maximum, not the typical, term of a 30 year mortgage. On average, 30-year mortgages are paid off after less than 10 years. The interest rate must also cover the costs associated with the difference in liquidity between a very liquid Treasury Bonds and a less liquid mortgage. This cost is relatively small compared with default, prepayment and servicing costs. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 3

9 balloon mortgages so that they reduced their exposure to interest rate risk, as they were only exposed to interest rate fluctuations over a 5 to 10 year time. They managed credit risk by knowing their borrowers and the geographic areas in which they operated, and by requiring substantial downpayments. Additionally, lenders sometimes required borrowers to purchase private mortgage insurance. In this way, another party, the private mortgage insurer, could take much of the credit risk, in return for the payment of a mortgage insurance premium. Poor economic conditions during the Great Depression precipitated massive defaults and foreclosures, and a wave of private mortgage insurer bankruptcies. The Federal Housing Administration (FHA) was created in 1934 to serve as a public sector mortgage insurer. Additionally, FHA pioneered the long-term, fixed-rate, level payment mortgage, demonstrating that lenders could take on additional interest rate risk. 9 The establishment of FHA, and the eventual reestablishment of a private mortgage insurance industry after the Depression, allowed credit risk to be separated from mortgages and held by parties other than the lender who originated the loan. Lenders could concentrate on finding cheap sources of funds, such as deposits, while allowing the government, through FHA, or private insurers to manage the credit risk in return for a fee. This ability to transfer risks to third parties is especially important for lenders such as community banks, which may be wiped out by a downturn in the local economy, even when the national economy is doing well. Parties that are geographically diversified are better able to bear credit risk than are undiversified local lenders. In a similar fashion, the establishment of secondary market agencies allowed the interest rate risk inherent in mortgages to be sold to parties other than the originating lender. Lenders could originate mortgages, and then sell them to a secondary market securitizer, who could resell the mortgages to large, sophisticated investors who are better able to measure and manage the interest rate and prepayment risks in fixed rate mortgages. Created in 1938, the Federal National Mortgage Association (Fannie Mae) was designed to act as a secondary market for mortgages that were government-insured. Over time the organization s role evolved and in 1968 the U.S. Congress split Fannie Mae in two, turning ownership of Fannie Mae over to private investors and creating the Government National Mortgage Association (Ginnie Mae). 10 Ginnie Mae s charter was to provide liquidity to the primary mortgage market by supporting the FHA, Veterans Administration (VA), and Farmers Home Administration (FmHA) 11 segments. With its full faith and credit of the U.S. government, Ginnie Mae guaranteed FHA-VA-FmHA mortgage pools that the originating Ibid, p.82. Brueggeman, William B. and Jeffrey D. Fisher. Real Estate Finance and Investments, (Boston: Irwin, 1993), 9 th ed., p.718. FmHA is now known as the Rural Housing Service (RHS), an agency within the Department of Agriculture. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 4

10 lenders then sold to investors in the form of mortgage-backed securities (MBS). In 1970, Fannie Mae was given authority to purchase mortgages that did not have government guarantees, and the Federal Home Loan Mortgage Corporation (Freddie Mac) was created to fulfill the same role for savings and loans, and eventually for all mortgage originators. 12 Servicing may also be transferred to third parties. A lender may originate a mortgage, and transfer the servicing rights to a third party that specializes in the servicing business. Large servicers can spread the cost of automated paperwork systems over a large portfolio of mortgages and reduce the cost per loan by exploiting economies of scale. The servicer receives the monthly mortgage payments from borrowers, retains a small part of the payments to cover their processing costs, and passes the rest of the payments on to the owners of the mortgages. Since the retained servicing fee generally exceeds the servicer s costs, servicers pay the lender for the right to service the loans and keep the servicing fee. In addition to the expansion of the agencies and their missions as well as the growth of private mortgage insurers, the mortgage industry continued to develop in other areas. Mortgage product innovation from the adjustable-rate mortgage to high loan-to-value mortgages has been characteristic of the industry over the last several decades. The industry has also expanded through new market developments such as the creation of automated underwriting systems and, perhaps most importantly, various methods of securitization of mortgages for sale to a broad range of investors. Overview of Current Industry Issues Today s single-family mortgage market continues to be a dynamic industry. Recent changes in the market, combined with existing features, create several important current industry issues for HUD. In this section, we provide an overview of these issues, which are examined in greater detail in Chapter 4. Potential Impacts of Increased Ginnie Mae Guarantee Fee Currently Ginnie Mae requires a 50-basis point (0.5 percent) spread between the interest rate FHA mortgage-backed securities carry and the interest rate on the underlying FHA-insured mortgage. This spread is split between Ginnie Mae, which receives 6 basis points for its guarantee of timely payment, and the servicer, which receives the 44 basis point residual. 13 However, legislation passed in 1998 will increase the Ginnie Mae guarantee fee paid by USC 1717 Section 302(b)(2) gives Fannie Mae the authority to buy conventional mortgages. Freddie Mac was created by the Federal Home Loan Mortgage Corporation Act, 12 USC 1451, Section 303. The Ginnie Mae fee is for guarantee of timely payment of principal and interest to MBS investors but does not cover a lender s credit risk. Credit risk is covered at various levels by FHA, VA, and RHS insurance guarantees. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 5

11 servicers from 6 basis points to 9 basis points in October The result is a decrease in the residual servicing fee from 44 basis points to 41 basis points for each loan serviced. Clearly the increased guarantee fee or decreased revenue of servicers has the potential to impact mortgage pricing and various stakeholders, particularly borrowers. Presence of Excess Spread in FHA Servicing Fees In contrast to the Ginnie Mae servicing fee of 44 basis points to FHA servicers, 15 Fannie Mae and Freddie Mac have established a minimum servicing fee of 25 basis points for fixed-rate conventional mortgages. The result is a 19-basis point difference between Ginnie Mae and the minimum servicing fees in the conventional market. Some in the housing industry have termed this difference in the fee excess spread and claim it leads to steering. They argue that the difference in the spread serves as a financial motivation for originators to steer borrowers particularly minority borrowers who may be less experienced with various mortgage products to FHA mortgages. Other industry professionals believe the higher Ginnie Mae servicing fees are necessary to offset higher Ginnie Mae servicing costs. To accurately evaluate this issue, it is essential to understand the costs and revenues associated with originating and servicing mortgages, and how those differ between FHA and conventional mortgage products. The income stream paid by the borrower consists of interest and principal. The stream of principal payments goes to the investor. The stream of interest payments gets split with the servicing fee payment stream going to the servicer and the rest going to the investor. The investor calculates a risk-adjusted present value for the principal stream and the investor portion of the interest stream to determine the value of the loan to him. The servicer calculates the risk adjusted present value of the difference between the servicing stream and the stream of expected costs of servicing the loan to determine the value of servicing to him. For any loan at given terms, as the servicing fee goes up, the stream of servicing payments rises and the stream of investor payments falls. The effect of this on the servicer and investor streams are of equal magnitude but opposite signs. Assuming there is no reason to believe that the servicer values an extra dollar more than the investor, then the effect on the present values of the streams of income offset each other. This implies that there is no incentive for the originator to pile up the servicing fees because the effect on the investor portion of the loan would be offsetting. The argument that originators make more on FHA loans because of higher servicing fees fails to account for the effect of higher servicing fees on the value of the remainder of the interest stream. Other considerations, such as insuring that the servicing costs are covered by the servicing fees, are more likely to be the determinants of the size of the fee The Higher Education Amendments of 1998, Section 972. The GNMA servicing fee for VA and RHS loans is also 44 basis points Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 6

12 Impact of Federal Housing Finance Board s Mortgage Partnership Finance Program In 1997 the Federal Housing Finance Board authorized the Mortgage Partnership Finance (MPF) program. The program provides member banks an alternative to their historic options of keeping loans in portfolio or selling to the secondary market agencies Fannie Mae, Freddie Mac or Ginnie Mae. Now member banks can sell their loans to the Federal Home Loan Banks if they find that their Home Loan Bank is offering more attractive pricing than that of the other secondary market agencies. As it ramped up in 2000, the entrance of the FHLB System into the secondary market looked like it would have a significant impact on the entire mortgage industry, particularly Ginnie Mae. However, new data show that nearly all new FHA and VA originations from early 2001 were securitized by Ginnie Mae. 16 Study Approach Project Goal The primary goal of the project is to develop a primer on the single-family mortgage market system. The primer identifies the market segments and roles of key industry actors and describes the process and factors in pricing single-family mortgages. Several current industry issues discussed in Chapter 1 motivated this research. This report explores these motivating issues and discusses their potential impacts on the mortgage industry. Methodology For several important reasons, the project team used qualitative research methodologies to conduct the assignment. First, the limited scope of the project prohibited quantitative analysis. Two of the issues increased Ginnie Mae guarantee fee and the FHLB Mortgage Partnership Finance program have not yet affected or are just beginning to impact the industry. Thus, there is a lack of data on which to base a thorough quantitative analysis. Second, a qualitative approach allowed for a broad inquiry on mortgage pricing combined with analysis of commentary from interviews with industry practitioners. The project team approached the assignment by first conducting a review of the academic and industry literature focused on pricing of single-family mortgages. A bibliography of the literature reviewed is contained in Appendix A. In addition, the team conducted qualitative interviews with industry practitioners, including lenders, servicers, insurers, investors and secondary market agencies. Interview candidates were selected in a purposive (non-random) manner with the assistance of knowledgeable HUD staff. A list of interviewees is included in Appendix B. 16 Inside Mortgage Finance, April 20, 2001 p. 4 Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 7

13 Overview of Report To understand the aforementioned issues and their potential impact on the mortgage industry, it is important to have a basic understanding of the single-family mortgage market and the elements of pricing. Our research provides the reader with a broad description of the functional activities, key players, and pricing elements in the single-family mortgage market a kind of primer. It then explores the current issues that are impacting today s mortgage market. The remainder of this report is organized into three chapters. Chapter 2 is an overview of the single-family mortgage market and its key players. In this chapter we provide a framework for understanding the functions of the mortgage market by describing each market segment and the roles played by various stakeholders. In addition, we analyze the primary factors that impact pricing of single-family mortgages and provide an overview of the pricing process. In Chapter 3, we address the motivating issues for this project, including increase of the Ginnie Mae guarantee fee, presence of excess spread in FHA servicing fees, and the impact of the Federal Home Loan Banks Mortgage Partnership Finance program, a new alternative to existing secondary market options. Finally, in Chapter 4 we provide conclusions of this exploratory research and recommendations for further research that can more fully address the issues raised in previous chapters. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 8

14 Chapter 2: Overview of Single-Family Mortgage Market This chapter provides an overview of the single-family mortgage market. It includes broad descriptions of key functional activities of the market. It also identifies key industry players including originators, mortgage insurers (private and government), servicers, secondary market agencies, and investors. We then present a discussion of pricing components, the pricing process for selling mortgages in the secondary market, and key determinants of pricing. Last, we analyze the key factors in pricing differences between FHA and conventional mortgage products. Functional Activities of the Single-Family Mortgage Market Today s single-family mortgage market consists of numerous industry stakeholders that undertake several key activities. These activities are necessary to originate the mortgage in the primary market and sell it in the secondary market. Each of these activities is associated with costs and revenues that affect the overall price that borrowers will eventually pay for a mortgage. These activities add value to the mortgage enhance it in a way that other key players and borrowers are willing to pay for and are considered pieces of the mortgage industry value chain. In this section, we provide general descriptions of each of these key functional activities, which are illustrated below in Figure 1. Figure 1. Mortgage Industry Value Chain Customer Acquisition Underwriting Funding/ Closing Servicing Credit Risk Management Interest Rate Risk Management Source: Posner, Kenneth. U.S. Savings and Loans/GSEs and Mortgage Finance, Morgan Stanley Dean Witter, February 4, Customer Acquisition The first functional activity undertaken to originate a single-family mortgage is acquiring the customer. This is the process of marketing mortgage products to consumers, identifying Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 9

15 potential mortgage applicants, and taking mortgage applications. Traditionally this activity was dominated by thrifts and commercial banks, which are institutions that had an appropriate customer base to target. In addition, mortgage brokers, life insurance companies and pension funds have been involved in this activity. Most recently, internet aggregators have appeared as players in customer acquisition. Aggregators are websites focused on mortgage lending and attract mortgage-seeking customers and then refer them to mortgage originators or serve as mortgage brokers themselves. 17 This is an example of new technologies seeking to lower the costs associated with mortgage origination. Underwriting Once the mortgage customer is acquired, the originator underwrites the loan to assess borrower risk and the profitability of the mortgage. Guidelines for underwriting mortgages are established by the originator. However, if the loan will be sold to an investor or requires mortgage insurance, the originator will also have to ensure the loan meets the guidelines established by the investor and/or insurer. In underwriting the mortgage, the originator attempts to assess the borrower s capacity to repay the mortgage, the collateral value, and the borrower s character. These are typically measured by analyzing qualifying ratios, loan-to-value ratio (LTV), 18 and the borrower s credit history. Qualifying ratios calculate monthly housing expenses (principal, interest, taxes and insurance) and total monthly payments toward debt stated as a percentage of the borrower s gross monthly income. These ratios are commonly referred to as front end and back end ratios, respectively. 19 The LTV is the loan amount stated as a percentage of the property s appraised value. 20 Lastly, the originator obtains a mortgage credit report from credit reporting agencies that details the borrower s credit history. The originator then analyzes these factors and assesses the overall credit risk of the borrower. Ten years ago the function of underwriting may have taken an originator four to five weeks 21 to complete. Underwriting in today s mortgage market has been transformed by the introduction and use of automated underwriting. Using statistical modeling, the industry has developed mortgage scoring systems that analyze applicant information and provide a risk Posner, Kenneth. U.S. Savings and Loans/GSEs and Mortgage Finance. The Internet Mortgage Report: New Models, New Opportunities, Morgan Stanley Dean Witter, February 4, Brueggeman, William B. and Jeffrey D. Fisher. Real Estate Finance and Investments, (Boston: Irwin, 1993), 9 th ed., p.194. Conventional front end and back end ratios are traditionally 28% and 36%, respectively. More recently, relaxation of the qualifying ratios on some products have pushed these ratios to 33% and 38%, respectively. FHA ratios are set at 29% and 41%, but can be higher with compensating factors. Mortgages with LTVs lower than 80% are viewed as less risky due to greater borrower investment, which replaces the credit enhancement provided by private mortgage insurance. Fabozzi, Frank J. and Franco Modigliani, p. 43. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 10

16 assessment on likely performance. 22 This score is used by many originators as one underwriting tool to help speed the loan approval process. With the advent of automated underwriting, originators are now able to take applications and close loans in very short timeframes from a couple of days to a few weeks. This is significantly different from traditional application to closing timeframes of 60 days. Automated valuation systems are now being introduced which may reduce the time and expense of the appraisal process, further speeding the process of mortgage origination. Funding/Closing Once originators have approved the mortgage, they formally close the loan. Closing is the process whereby the borrower finalizes all documentation related to obtaining the mortgage and purchasing the property. Until closing occurs, the borrower is not obligated to take the mortgage and, therefore, the lender is exposed to fallout risk the chance that the borrower may opt not to take the mortgage. After closing has occurred, the originator must provide the capital to fund the loan. Originators may use their own capital or take on a line of credit in order to fund the loan. The loan can then be retained in the originator s portfolio or can be sold to the secondary market. Servicing Largely an administrative activity, servicing consists of on-going management of mortgage payments and record keeping and reporting. Servicers must collect mortgage payments from borrowers and forward principal and interest payments to investors, tax payments to local tax authorities, hazard insurance payments to home insurers, and mortgage insurance premiums to mortgage insurers. In addition, servicers are responsible for mailing monthly statements to borrowers, managing escrow balances, notifying borrowers of late payments, and managing the process of delinquency, default and foreclosure. The latter activity is the largest component of expenses incurred by servicers. In exchange for the numerous administrative activities servicers perform, there are several forms of compensation. First, servicers receive a servicing fee based on the outstanding balance of the loan. This fee varies based on the type of mortgage, rate, and investor. For example, Ginnie Mae provides a servicing fee of 44 basis points on fixed-rate FHA mortgages while Fannie Mae and Freddie Mac provide for servicing fees ranging from 25 basis points up to approximately 35 basis points on conventional mortgage products. 23 Other sources of revenue earned by servicers include the interest earned on escrow balances, interest earned on mortgage payments from the time of payment receipt to payment made to investor, late fees charged to borrowers, and ancillary revenue from cross-selling of life insurance, credit cards and other products An important element of these mortgage scores is the consumer credit score. Ibid, p.65. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 11

17 Credit Risk Management Unlike the aforementioned activities, credit risk management is handled by several players throughout the mortgage origination and selling process. Managing credit risk requires analysis of the likelihood the borrower will default and efforts required to maintain acceptable levels of risk. Secondary market agencies, private investors, insurers, and originators all play a role in managing credit risk. On the higher risk loans, those with downpayments of less than 20 percent, credit risk is borne largely by the private mortgage insurers or government mortgage agencies that take the first loss when a borrower defaults. On lower risk loans, with downpayments of 20 percent or more (these are almost always conventional loans), the credit risk is borne largely by the originating lender if the loan is retained in portfolio, or by the securitizing agency if the loan is sold into the secondary market by the lender (unless there is some recourse provision). Even for loans with downpayments of less than 20 percent, the originating lender or secondary market securitizer is generally responsible for losses beyond those covered by mortgage insurance. Investors ultimately bear the risk that credit losses may exceed the level that can be borne by lenders or secondary market securitizers. The primary tools for controlling credit risk are the underwriting rules developed by the insurers, originators, and securitizers. Traditionally, loan to value ratios, debt to income ratios, and examinations of the borrowers credit history were used by insurers and originating lenders to decide whether to accept or reject a loan application. The secondary market securitizing agencies published similar underwriting guidelines, indicating the standards they would apply before purchasing loans from originators. In the last few years, many of these participants have developed automated underwriting systems, which allow for more sophisticated analysis of risk factors, such as automatically approving loans which may have one indicator of high risk (such as a high debt to income ratio), but which also have compensating factors, such as sterling credit or large downpayments. 24 Investors in mortgage backed securities typically rely on ratings from rating services such as Moodys or Standard & Poors - either the rating of the party guaranteeing the mortgage backed security, or the ratings placed by the rating agencies on the individual mortgage-backed securities. Interest Rate Risk Management The emergence of the secondary market has meant a shift of interest rate risk management from depository institutions that held loans on their books to secondary market agencies and other investors. Mortgages are long-term instruments, but in most cases they can be prepaid early, making their duration uncertain. Secondary market agencies and other large portfolio investors generally fund their purchases of mortgages with bonds that cannot be paid off 24 Bunce, Harold, Scheessele, Randall, and Reeder, William Understanding Consumer Credit and Mortgage Scoring: A Work in Progress at HUD presented at the June 1999 Fannie Mae Fair Lending Conference. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 12

18 early. Investors in mortgage backed securities issued by the securitizing GSEs also may fund their purchases with bonds that cannot be prepaid early. Hence, investors in mortgages must earn a spread over the interest rate on long term bonds in order to compensate them for the risk that interest rates will drop and their mortgage investments will prepay. Even investors who are not borrowing to fund their purchases of MBS must compare the uncertain returns from mortgage investments to the certain returns from investment in safe bonds and will only invest in the uncertain mortgages if the return is high enough to compensate them for the risk. Through direct purchase and securitization of mortgages, secondary market agencies and investors are primarily responsible for interest rate risk management. Interest rate risk management can take many forms. One possible strategy is to simply accept the risk, and earn the spread between the interest rate on mortgages and the interest rate on bonds as compensation for the risk. If a financial institution is weakly capitalized, however, it may fail if there is a substantial shock to interest rates. Interest rate risk was a major cause of the savings and loan crisis of the 1980 s. 25 A common strategy is the use of derivatives 26 to manage interest rate risk exposure. For example, an investor in MBS may buy futures on Treasury bonds. 27 These futures contracts will rise in price if interest rates fall, so the investor loses money on its mortgages but makes money on the futures contract. Buying derivatives whose value moves opposite to the value of a held asset is referred to as hedging. The investor lowers his or her overall risk, but at a cost. There is an explicit brokerage cost to purchasing futures, and the futures will decrease in value if interest rates do not fall. Managing interest rate risk is a complex and specialized task. In the same way that per unit servicing costs can be brought down by automating the process and spreading the costs of automation over a large volume, the cost of managing interest rate risk has been reduced by selling this risk to specialists. Specialists, such as the secondary market securitizers, can spread the cost of the specialized knowledge and expensive software over a large volume of mortgages, and can use their large volumes to negotiate favorable terms with brokers in derivatives markets. 25 Before the thrift crisis, S&Ls funded long term mortgages with short term deposits, earning the spread between mortgage rates and rates paid on deposits. When interest rates rose, the S&Ls had to pay higher rates on their deposits than they earned on their mortgages, causing them to lose money rather than earn a positive spread. Risk management strategies have changed substantially since the S&L bailout. 26 Derivatives are contracts that have a market value determined by the value of an underlying asset, reference rate, or index (called the underlying). Underlyings include stocks, bonds, agricultural and other physical commodities, interest rates, foreign-currency rates, and stock indexes. A futures contract on Treasury bonds is a derivative, where the Treasury bond is the underlying asset. 27 Swaps, callable bonds, callable FHLB advances, bond futures, and MBS futures are a few of the many ways that an institution might manage interest rate risk. See Fabozzi, F. and Modigliani, F. op. cit. p for a discussion of various ways of hedging interest rate risks. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 13

19 To a small degree, originators also manage interest rate risk for loans they sell to the secondary market as well as those held in portfolio. On mortgages sold to investors, the originator must bear the interest rate risk during the warehouse period. This term refers to the period of time between when the loan closes and when it is delivered to the secondary market purchaser or investor. If interest rates rise during the warehouse period, the originator will receive a lower price for the mortgages they deliver to investors. For example, if mortgage interest rates rise from 7 percent to 8 percent over the warehouse period, the originator will no longer be able to sell the mortgages to investors at a price as high as the loan balance (which is the amount the originator loaned to the borrower). 28 If investors can buy mortgages paying 8 percent interest, they will only buy mortgages yielding 7 percent if they are priced at a discount. Conversely, in a declining interest rate environment, originators may receive a premium when they sell. Because the warehouse period is short a few days to a few months, large changes in interest rates are rare, but do sometimes happen. Originators sometimes manage this risk by purchasing interest rate derivatives, such as swaps or futures on MBS or on bonds. These products reduce the risk for originators, but at a cost, in an analogous fashion to derivatives purchases for long term investors. For loans held in portfolio, lenders bear the interest rate risk throughout the life of the loan. Because interest rates may change substantially over a 30-year term, most lenders offer portfolio products on a very limited basis and, even then, these products are most often adjustable rate rather than fixed rate mortgages. Adjustable rate mortgages may be funded by short term debt, because the interest rate on the mortgages will rise and fall with the general level of interest rates, so that the rate on the mortgage will generally stay above the rate on the debt that the institution uses to fund the mortgage. Therefore, adjustable rate mortgages have much smaller interest rate risk than do fixed rate mortgages. Pricing in the Single-Family Mortgage Market The process of pricing single-family mortgages is complex and filled with variations depending on the investor, insurer, guarantee, and mortgage product. To simplify this discussion yet still demonstrate the primary elements of pricing on the majority of originations, our qualitative research focused on pricing of fixed-rate single-family mortgages that are sold in the secondary market. In this section, we discuss pricing components, process, and determinants as well as differences between pricing FHA and conventional mortgages. 28 The balance owed on a mortgage is usually referred to as its book value. The price at which the mortgage can be sold to an investor is referred to as its market value. When the market value and book value are the same, the mortgage is said to be priced at par. Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 14

20 Pricing Components The underlying interest rate or price of a mortgage that will later be sold in the secondary market consists of fees and revenues earned by a variety of industry players. The most important is the investor, who has the most impact on price based on stated yield or return requirements. In addition to earning a spread or return on investment, investors must be compensated for funding costs, option costs, and duration costs. Funding costs are the opportunity costs of investing funds (i.e., what the investor could earn in a safe alternative investment instrument), and serve as a floor for the mortgage interest rate. An investor will not invest in a risky mortgage when a safer investment, such as a Treasury bond, pays a higher interest rate. Option costs represent the interest rate risk (mostly prepayment risk) for which the investor must be compensated, while duration costs are the additional returns required to compensate for the long-term nature of the mortgage investment. 29 Servicers and guarantors also earn important though much smaller portions of the interest paid by borrowers. The servicers earn a servicing fee, ranging from a minimum of 25 basis points on conventional mortgages to 44 basis points on FHA-insured mortgages. Guarantees to insure timely payment of principal and interest are provided by Ginnie Mae, Fannie Mae, and Freddie Mac and earn the agencies important fees. These guarantee fees range from 6 basis points (earned by Ginnie Mae on FHA-insured mortgages) to basis points (earned by the GSEs on conventional mortgages). The Ginnie Mae guarantee costs less than Fannie Mae or Freddie Mac guarantee fees, but Ginnie Mae provides less credit risk insurance. While Fannie Mae and Freddie Mac are generally responsible for all the credit risk not covered by private mortgage insurance, Ginnie Mae securities leave this residual credit risk with the lender. Fannie Mae and Freddie Mac stand in the second position with respect to losses, bearing any loss after PMI, while Ginnie Mae stands in the third position, behind the government insurers (FHA and VA) and the lender. Ginnie Mae s guarantee pays only to the extent that the lender is financially impaired and cannot make good on its commitments. 30 While the Ginnie Mae guarantee fee remains constant, the GSEs negotiate guarantee fees based on factors such as experience with originator, type of mortgage pool, Davidson, Andrew S. and Michael D. Herskovitz. The Mortgage-Backed Securities Workbook, (Boston: McGraw Hill, 1996), p.7. For any mortgage sold by a lender, whether conventional or government insured, the lender may be responsible for any credit losses on a mortgage if there is evidence of fraud or a failure to meet terms specified in the sale. Lenders who sell conventional mortgages to Fannie Mae or Freddie Mac are generally relieved of other credit risk. For government insured loans, even after a sale the lender is responsible for all costs not covered by the government insurance. For FHA loans, the lender must initiate and pay for the foreclosure, and make regularly scheduled mortgage payments to the investors. After the foreclosure, the lender may recover most of its costs from FHA, but this recovery is subject to limits (for example, at most 6 months of accrued interest is paid, although the delinquency and foreclosure often takes a year or more). Similar rules govern VA and RHS loans. Additionally, VA and RHS, unlike FHA, provide only partial coverage of the mortgage principal. For RHS this is generally 90%, and for VA it is 25% to 50%, depending on the size of the loan. If a $100,000 VA mortgage with 50% coverage goes into foreclosure, and the lender recovers only $40,000 from the sale, VA will pay at most $50,000 (50% of $100,000), leaving the lender with a loss in excess of $10,000 ($100,000 mortgage, plus foreclosure costs, minus the $50,000 payment by VA and the $40,000 recovered in the sale of the property). Abt Associates Inc. Pricing FHA Single-Family Mortgages Final Report 15