Real Estate and Consumer Lending

1
Real Estate and Consumer Lending

• Outline
• Residential real estate lending
• Commercial real estate lending
• Consumer lending
• Real estate and consumer credit regulation

2
Real estate lending

• Mortgage debt outstanding
• Mortgage is a written conveyance of title to real
  property. Property is collateral for the loan.
  Loans for 1-4 family residences, commercial real
  estate, farm property, and multifamily
  residences.
• Secondary mortgage market for securitizing loans
  tends to improve liquidity of residential
  mortgages and lessens cyclical disruptions in the
  housing market.
• Securitization transforms individual loans into
  marketable asset-backed securities.
• Banks can act as originators, packagers, and
  servicers.
• Cash flows to investors are guaranteed by banks,
  agencies (FNMA or Fannie Mae and FHLMC or Freddie
  Mac), and the government (GNMA or Ginnie Mae).
• Credit rating agencies rate the debt securities.

3
Residential real estate lending

• Characteristics of residential mortgage loans
• Down payment, or borrowers equity, is the market
  value of the property minus the borrowers
  mortgage debt.
• Loan-to-price ratio is 79.5 if a person puts a
  down payment of 47,000 for a new home with a
  purchase price of 209,400.
• Bank loans can be viewed as compound options,
  with rights to prepay (call option) and to
  default (put option). When interest rates fall,
  borrowers with fixed rate loans will want to
  exercise their call option and prepay such loans.
  While most home loans have maturities of up to
  30 years, their average life is only 12 years due
  to prepayments due to refinancing and moving.
• Some lenders require Private Mortgage Insurance
  (PMI) when the down payment is less than 20.
  This insurance protects the lender in the event
  of default.
• Residential real estate is good collateral
  because it is durable, easy to identify, and
  cannot be moved in most cases.

4
Residential real estate lending

• Types of residential mortgage loans
• Conventional mortgage loans are those not insured
  by the Federal Housing Administration (FHA) or
  guaranteed by the Veterans Administration (VA).
  Private insurance on conventional mortgages can
  be obtained.
• Fixed rate mortgages and adjustable rate
  mortgages (ARMs) -- fixed cash payments per month
  versus changes in payment terms that can
  fluctuate with movements in interest rates.
• Example monthly mortgage payment for a 1,000
  mortgage loan at 6 percent interest for 10 years.
  Because we are solving for a monthly payment, the
  number of payments over the 10 years is 120 (10
  years x 12 months per year). Moreover, only one
  twelfth of the 6 percent annual interest rate
  (0.06/12 0.005) is charged each month. The
  present value of the annuity is the 1,000
  mortgage loan in this example. The monthly
  payment is 11.10.
• PV of annuity PMT1 - (1 I)-n/i PMT1 -
  ( 1 0.005)-n/0.005 11.10
• 1,000 PMT1 - ( 1 0.005)-n/0.005
  11.10
• PMT 11.10
• where PV present value of the annuity, PMT
  payment per period, i interest rate per period,
  and
• n number of periods.

5
Residential real estate lending

• Types of residential mortgage loans
• Adjustable rate mortgages
• Changes in monthly payments, term of the loan,
  and/or principal amount.
• Benchmark interest rate tied to an index (e.g.,
  one-year Treasury yield).
• Caps on how much the interest rate or monthly
  payment can change annually or over the term of
  the loan.
• Margin is the percentage points added to the
  index rate.
• Initial interest rates on ARMs lower than fixed
  rate mortgages.
• ARMs shift some of the interest rate risk to
  borrowers from lenders (banks). However, ARMs
  may have higher default risk (and higher
  delinquency rate) to the bank.
• Other terms some mortgage loans are assumable,
  a buydown of the interest rate by paying points
  at closing, a due-on-sale clause that disallows
  the borrower from transferring the loan to a new
  buyer, late charges on delinquent accounts,
  settlement charges on transfer of title, and
  points at closing to cover mortgage origination
  costs of lenders (i.e., one point is one percent
  of the loan). Points increase the effective
  interest rate.

6
Residential real estate lending

• Types of residential mortgage loans
• Balloon mortgages with short-term maturities (say
  5 years). A new loan is negotiated at the end of
  the period.
• Graduated payment mortgages have fixed rates but
  with lower payments in early years and higher
  payments in later years. Good for younger
  homeowners whose income should rise over time.
  Negative amortization occurs in the early years
  (where the mortgage balance increases).
• Growing equity mortgages (GEMs) have increasing
  debt payments over time that reduces the
  principal balance faster than otherwise and
  reduces interest costs over the life of the loan.
• Shared appreciation mortgages (SAMs) allow the
  lender to share in the growth of equity value in
  the home with the borrower in return for lower
  interest payments.

7
Residential real estate lending

• Types of residential mortgage loans
• Reverse annuity mortgages (RAMs) offer the owner
  of a home fixed annuity payments against the
  equity value. Senior citizens use this type of
  mortgage.
• Second mortgage/home equity loans allows
  homeowners to use equity in their homes to
  collateralize business or consumer loans.
• Credit scoring loan requests
• Real estate and consumer credit scoring models
  using credit bureau data, loan to value ratios,
  and applicant information.
• Credit scores indicate the default risk to
  lenders of the borrower.

8
Commercial real estate lending

• Purposes
• Land, construction and real estate development,
  and commercial properties such as shopping
  centers, office buildings, and warehouses.
• Construction loans
• Disbursements on loans over time as phases of the
  project are completed.
• Known as interim financing for building phase
  and builder must obtain permanent (long-term)
  financing later.
• Land and partially completed structures serve as
  collateral for loans.
• Other sources of funds from life insurance
  companies, Fannie Mae, Freddie Mac, and
  retirement plans.
• Construction loans priced at prime plus
  additional interest for risk. Also, there is an
  origination fee of 1-3 percent.

9
Consumer lending

• Personal, household, and family loans
• Retail banking (for individuals and small
  businesses), as opposed to wholesale banking (for
  medium and large businesses).
• Characteristics
• Small dollar amounts
• No collateral in many cases
• Open-end lines of credit (e.g., credit cards)
• Closed-end loans (e.g., auto loans with fixed
  maturity)
• Risks
• Default risk is most important to lenders
• Very competitive market (in terms of interest
  rates and terms)
• Diversify risks over large geographic areas

10
Consumer lending

• Personal, household, and family loans
• Types
• Automobile loans -- installment loans with 60
  month maturities and 90 financing in many cases.
  Can obtain a repurchase agreement from a bank in
  which the customer has the option to return the
  auto to the lender or make a balloon payment at
  the end of the loan period. Auto loans can be
  securitized and sold into the financial markets.
• Revolving consumer loans -- borrower has a line
  of credit up to a certain amount (open-end
  credit) and can pay off the loan over an
  indefinite period of time. Flexible repayment
  terms are common. Many times interest is only
  required on funds not repaid within a grace
  period of 25-30 days.
• Credit cards (not to be confused with debit
  cards and prepayment or stored-value cards with
  no credit extended) offer consumers credit on
  their individual purchases. Credit scoring is
  used to determine who is sent credit card
  applications in the mail. Merchants present the
  sales draft to a bank at a discount (of up to 6
  of the purchase). Some cards have annual fees
  (say 50), plus other fees for cash advances,
  late payments, exceeding the credit line,
  returned checks, etc.

11
Consumer lending

• Personal, household, and family loans
• Types
• Other loans --
• Mobile home loans for moveable homes that are
  manufactured as a single unit.
• Noninstallment loans are single payment loans.
• Leases for consumer durables such as automobiles,
  trucks, airplanes, and boats.
• The bank owns the property and rentsit to the
  customer. Under an open-end lease the bank is
  responsible to sell the property at the end of
  the lease period. If the sale price is less than
  the previously agreed residual value, the
  customer pays the difference -- a balloon
  payment. In a closed-end lease the bank assumes
  this risk.

12
Consumer lending

• Personal, household, and family loans
• Finance charges
• The Truth in Lending Act (1968), which is
  implemented under Federal Reserve Regulation Z,
  requires lenders disclose finance charges and
  annual percentage rates (APR) to customers before
  they sign a loan agreement.
• The finance charge is the total dollar amount
  paid for the use of credit (i.e., amount repaid
  minus amount borrowed).
• Example You use a credit card to purchase 100
  of goods in May. On May 31st a bill arrives that
  can be paid by June 30 with no finance charge.
  On June 1 you make another 100 purchase. And,
  on June 15 you make a payment of 20 on the
  previous loan. The interest charge is 1.5 on
  unpaid balances (18 annually).
• Adjusted balance method Interest due equals
  1.5 x 80 1.20.
• Previous balance method Interest due equals
  1.5 x 100 1.50.
• Average daily balance method excluding current
  transactions Interest due equals 1.5 x 90
  (100 for 15 days and 80 for 15 days) 1.35.
• Average daily balance method including current
  transactions Interest due equals 1.5 x
  190(200 for 15 days and 180 for 15 days)
  2.85.

13
Consumer lending

• Personal, household, and family loans
• Finance charges
• Annual percentage rate (APR) is the percentage
  cost of credit on an annual basis, or the
  annualized internal rate of return (IRR) on the
  loan from the present value formula (where
  payments are discounted at the rate of interest
  and set equal to the principal loan amount.
• Monthly amortization is the gradual repayment of
  principal and interest on debt over time.
• Add-on loan rates include the finance charge in
  the amount borrowed.
• Discount loan rates deduct the finance charge
  from the amount borrowed, and the borrower
  receives the difference as the loan.

14
Real estate and consumer credit regulation

• Community Reinvestment Act (CRA)
• Facilitate mortgage loans and other credit to
  applicants regardless of race, nationality, or
  sex.
• Equal Credit Opportunity Act (ECOA or Federal
  Reserve Regulation B) and the Fair Housing Act
• Lenders cannot discriminate against borrowers on
  the basis of age, color, family status, handicap,
  marital status, national origin, race, receipt of
  public assistance funds, religion, sex, or any
  right under the Consumer Protection Act.
• Fair Credit Billing Act
• Customers must inform lenders of errors within 60
  days after the first bill is received. The
  lender has 90 days to respond.

15
Real estate and consumer credit regulation

• Home Mortgage Disclosure Act (HMDA or Federal
  Reserve Regulation Z)
• Make available to the public information about
  the extent to which lenders are serving housing
  needs in the community.
• Real Estate Settlement Procedures Act (RESPA)
• Lenders must inform buyers of real estate of the
  good faith estimates of settlement costs in
  writing.
• Truth in Lending (Federal Reserve Regulation Z)
• Lenders must disclose to individual consumers the
  amount of finance charges and annual interest
  rate (APR).
• Fair Credit Report Act
• Applicants denied credit due to information from
  a credit bureau have the right to examine the
  credit file and correct errors in it.