Homeowner Education

Homeowner Education

Check your Metropolitan Statistical Areas (MSA) Home Price Increase (HPI) 

How to Repair a Poor Credit Score

Homeowners over the years have had many choices when it comes to mortgage products.  These mortgages can be broken down into 3 basic categories:  Conventional loans, which are made up of Fannie Mae and Freddie Mac loan products; Government sponsored programs, such as Federal Housing Authority (FHA), Veterans Administration (VA) and United States Department of Agricultural (USDA);  lastly, portfolio or private label mortgage products, which are loans originated outside of Fannie Mae, Freddie Mac or government sponsored loans.  These are loans that, after origination, banks either retain on their books or securitize them into Mortgage Backed Securities.

After years of very poor underwriting standards and irresponsible lending, current mortgage products have come back to more traditional standards.  These standards are full documentation loans with credit scores above 620 and down payments between 3.5% for FHA and up to 20% for conventional and portfolio loans.   

As a homeowner it is vital to understand what type of loan you have or are applying for.  How does it work and what events in the future could affect its sustainability and your ability to continue to make the payments.  Is the loan a fixed rate or ARM?  If it is an ARM, what type of ARM and what are the index and margin?

This chart represents all possible characteristics of mortgage products from 1995 through the financial crisis to present.  There is no longer negative amortization, stated income, no ratio, no income/no assets, no doc or 100% financing.  Additionally, loan products with credit scores below 620 middle credit scores are rare.  The red arrows represent the less risky to the most risky characteristics.  

Only full documentation loans are available

 Full Doc: A mortgage loan that requires proof of income and assets.  Debt to income ratios are calculated. 

 Stated income: A mortgage loan is a specialized mortgage loan where the mortgage lender verifies employment, but not income. 

 No Income / No Asset: A mortgage loan with a type of reduced documentation mortgage program which allows the borrower to state on the loan application what their income and assets are without verification by the lender; however, the source of the income is still verified

 No Ratio:  A mortgage loan that documents employment but not income.  Income is not listed on the application and no debt to income ratios are calculated.  

 No Doc: A mortgage loan that requires no income or asset documentation.  Neither is stated on the application and fields for such information are left blank.

 DTI: Debt to income is used to qualify mortgage payment and other monthly debt payments versus income. (Debt to Income Calculator) 

 ARM: Adjustable Rate Mortgage which usually has a fixed rate period (1,2, 3, 5,7 or 10 year), then converts to a fully adjustable loan.

 FICO:  A number score of the default risk associated with a borrower's credit history

• LTV:  The ratio expresses the amount of a first mortgage lien as a percentage of the total appraised value of real property.

• Index: The market index on which an adjustable rate is based once it goes adjustable. 

• MTA: Monthly Treasury Average. A twelve month running average of the 12 Month Treasury.

• 1 Year T-Bill: The one year US Treasury Bill.

• 12 Month LIBOR: The London Inter Bank Offer Rate. The rate banks in Europe charge each other for a 12 month loan.

• 6 Month LIBOR: The London Inter Bank Offer Rate.  The rate banks in Europe charge each other for a 6 month loan. 

• Margin: Also known as spread. This is the bank's profit over the index on an Adjustable Rate Mortgage. 

• Neg AM: Negative Amortization is a feature where a loan is allowed to go negative amortizing with deferred interest. This means the interest is put onto the back of loan which causes it to grow over the original balance. These were usually capped at 105% up to 125% of the original loan balance.

• P+I: Principal and interest payments are payments associated with a fully amortized loan. The payment includes both principal and interest payments. 

Interest Only: A payment that offers interest only payments for a fixed period then converts to a fully amortized payment with principal and interest.   

Another important item in the home buying process surrounds interest rates for mortgages and what drives them.  This largely depends on what type of loan you’re obtaining.  The most common type of financing is Fannie Mae or Freddie Mac, which account for about 63% of all new loans originated.  FHA, VA and USDA account for another 23%, leaving 14% of new loans originated as private label or portfolio loans.  

The funds for home financing flow from the bond market, known as the Chicago Board of Trade (CBOT) to Fannie Mae, Freddie Mac, FHA and other loan programs.  In these markets Fannie Mae and Freddie Mac sell Mortgage Backed Securities (MBS) made up of mortgages originated via Fannie Mae and Freddie Mac underwriting systems.  Investors buy and sell these securities consistently.  When there is more demand for them the price of the MBS goes up and the yield or interest rate goes down.  Conversely, when there is less demand, the price of the MBS drops and the rate goes up.  This is basic supply and demand theory. 

As the interest rates rise or fall on a daily basis, so do rates for Fannie Mae and Freddie Mac mortgages.  This is why interest rates on mortgages can and often do change over time and the demand increases or decreases for MBS’s. 

What drives demand for MBS’s?  There are many factors that can drive this demand from weak economic data in the US or globally to the Federal Reserve entering the MBS market as a buyer to suppress interest rates.  When the economy is weakening and there is the potential for deflation and lower earnings from corporations then this would add risk to stock prices falling as companies have a more difficult time meeting their earnings.    So, usually investors transition their investments from stocks to bonds as they are seen as a safe investment in tough economic times.

One of the main reasons for this is that if an investor buys a bond that is yielding them a 3% interest rate and deflation is 1%, i.e. the price of goods and services are falling, then they are effectively earning 4% (3%+1%).  Conversely, if there is inflation and the price of goods and services are going up, investors usually rotate out of bonds and into stocks.  The reason for this is that if you have the same bond paying you 3% but the cost of goods and services are going up by 1%, then you are effectively earing 2% (3%-1%).  Additionally, as prices are going up, this usually means companies earnings are as well, which is good for stock prices.

In our global economy, money moves freely from one country to another which means global macroeconomic events can have an effect on the US bond market.  An example of this would be the sovereign debt crisis in Europe and more recently Cyprus and the continued troubles in Greece.  The reason these events had a positive impact on the US bond market was that the risk of Greece or Cyprus leaving the European Union would have very likely caused a banking crisis in Europe. 

The prospect of this event caused European investors to get nervous and sell European bonds in favor of buying US bonds.  The reason for this was that they did not want to lose any value in the European bonds they held nor in the currency in which they are denominated. 

A good example of this would be an investor who held what is seen as the safest bond in Europe, a German Bond.  This bond is priced in Euros and so if there were a banking crisis caused by Greece or Cyprus leaving the European Union this would a negatively affect almost all banks in Europe and so the German government would likely have to come to the rescue.  This means Germany would have to borrow more money to bail out their banks and likely others. 

In this event the Euro would lose value relative to the dollar and likely the safe German bond would also lose value.  This means a European investor would have been better off buying a US Treasury Bill (T-Bill) since it is denominated in Dollars.   As value of the T- Bill would goes up, the investor makes money, and the value of the Dollar would go up relative to the dropping value of the Euro.  Ultimately in this example a European investor would have made money on the value of the T-Bill going up and the value of the dollar going up against the Euro since the T-Bill is priced in Dollars.

So as we can see there are many factors influencing the bond market and therefore interest rates.  Below is a snapshot of the bond marker for Fannie Mae (FNMA) MBS, FHA and VA (GNMA ) and the 2 year T-Bill (Note) and 10 year T-Bill (Note). 


 

The top chart provides useful information on  several types of securities with different coupon rates.  For example, observe the market information on Fannie Mae (FNMA) ranging from the FNMA 30 Year 2.5% to the FNMA 30 Year 4%. The 3.0% rate is above the 2.5% rate in this chart since currently this forms a reference point where most FNMA mortgage rates are priced.  Each one of these different rate coupons (2.5%, 3%, 3.5% and 4%) has a different “last sale” price.  The sale price is the actual price of the bond and the rate is what is paid as interest or yield.  If the demand for a bond increases then the prices go up and the yield declines.  

The middle chart is known as Japanese Candlesticks.  Traders use these charts across many different markets to trade the “technicals” of the market.   For example,they are used in the commodities market, stock market, foreign exchange market and bond market.  We can observe the daily moving averages (DMA) over the 10(red), 25(green), 40(gray), 50(black), 100 (orange) and 200 day (blue) period.  Additionally listed on the chart are resistance levels (R1 and R2) and support levels (S1 and S2). 

Chartists believe that charting the DMA can be used to represent technical floors (S1/S2) of support or ceilings (R1/R2) of resistance.  We can see how these appear to create “channels” that indicate the market is range bound until a new breakout, either to the upside or downside. Chartists believe that If the market does break through a resistance level (R1/R2) then that resistance level converts into a support (S1/S2) level. 

What is a Credit Default Swap?

Credit default swaps can be thought of as an insurance against the default of some underlying instrument, or as a put option on the underlying instrument such as a residential mortgage. In a typical credit default swap the party selling the credit risk (or the “protection buyer”) makes periodic payments to the “protection seller” of a negotiated number of basis points, times the notional amount of the underlying bond or loan. The party buying the credit risk (or the “protection seller”) makes no payment unless the issuer of the underlying bond or loan defaults. In the event of default, the “protection seller” pays to the “protection buyer” a default payment equal to the notional amount, minus a pre-specified recovery factor.

Since a credit event, usually a default (say of the residential mortgage) triggers the payment, this event should be clearly defined in the contract to avoid any litigation when the contract is settled.  The payment is sometimes fixed by agreement, but a more common practice is to set it at par, minus the recovery rate.

A variant of the credit default swap is the “first-to-default” put. The loans are chosen such that default correlations are very small, i.e., such that there is a very low ex-ante probability that more than one loan will default over the time until the expiration of the put, say two years. A first-to-default put gives the Bank the opportunity to reduce its credit risk exposure, by being compensated in case one of the loans in the pool of four loans defaults at any time during the two-year period. If more than one loan defaults during this period, the Bank is only compensated for the first loan that defaulted.