Prime, Subprime Mortgages and Difference between Them - Assignment Example

PRIME, SUBPRIME MORTGAGES AND DIFFERENCE BETWEEN THEM Getting consumer credit through various financial s especially banks requires consumers to maintain a certain degree of credit rating in order to qualify for those loans. Unlike large corporate companies, consumers or rather individuals pose a different challenge and dynamics to financial institutions to cater their needs for credit and formal funding requirements of these individuals. It is because of this reason that various banks and financial institutions have developed their internal rating methodologies which they assign to various consumers asking for credit. Banks than through their internal as well external credit scores or ratings decide to whom they should provide the credit. These criteria of credit rating often are designed to be tough since Banks in order to avoid defaults, tighten their criteria to extend the credit to these customers. However, due to increasing needs of those customers, whose credit history or their credit ratings do not fall under the criteria laid down by the banks, banks try to accommodate them also. Sub-prime lending is the part of that phenomenon. “Sub-Prime lending typically has been characterized as lending at relatively costly interest rates and fees to credit impaired or otherwise high risk borrowers.” (Lax, Manti, Raca, & Zorn, 2004). Subprime loans are among the newly popular mortgage products, such as interest-only loans, for people with strained budgets, including first-time buyers. Homeowners increasingly use them to refinance and consolidate household debts when their credit scores fall in the wake of bankruptcy, high medical bills, or other setbacks. (Blanton, 2005). It is generally believed that the subprime borrowers emerge due to lack of the good credit history on their back and since there number grew historically therefore banks and financial institutions by spotting the opportunity started lending to them at higher interest rates due to the perceived risks involved in these subprime loans. The main difference between a prime loan and the subprime is therefore is that of the interest rates being charged to the borrowers. A prime borrower tend to avail best rates with less stringent financial as well as non-financial covenants whereas a subprime borrower, due to his inherent risk, tend to pay high rate of interest besides facing strict monitoring and other conditions from the lending institutions. Within the subprime mortgage market, there are market players who burden their customers with extra and difficult conditions thus sealing their fate as the subprime mortgage borrowers and restricting their access to the prime markets if their economic conditions improve. Subprime loans are among the newly popular mortgage products, such as interest-only loans, for people with strained budgets, including first-time buyers. Homeowners increasingly use them to refinance and consolidate household debts when their credit scores fall in the wake of bankruptcy, high medical bills, or other setbacks. (Blanton, 2005). It is generally believed that the subprime borrowers emerge due to lack of the good credit history on their back and since there number grew historically therefore banks and financial institutions by spotting the opportunity started lending to them at higher interest rates due to the perceived risks involved in these subprime loans. Not only these subprime borrowers pay higher interest rates but they also pay higher upfront fees also at the time of booking their loans. Due to this profitable alterative, financial institutions take the risk and lend to those customers who would otherwise can not qualify for obtaining loans from the banking channels in the ordinary course of the business. In nutshell, we can say that subprime lending is lending to those who do not deserve it. SECURITIZATION OF MORTGAGES Securitization is the process of securitizing an interest in the pool of mortgages. Securitization of the pools of assets is done mainly through the issuance of bonds called Mortgage backed securities. Instead of paying the regular coupon and principle payments, these securities pay out the cash flows generated from these pools of assets. It is the process by which mortgage loans are sold to the investors. Through securitization, the mortgage loans are converted into mortgaged backed securities. Typical processes through which the mortgages are re-packaged into different securities involve the use of various structuring of the securities. The basic pass through nature of the various securities involve that the interest payments on the underlying mortgages are used to pay the coupon payments on those bonds whereas principal payments are passed through to pay the principal on those bonds. In its essence it is the separation of credit risk of group of assets from the bankruptcy and the credit risk of the owner through issuance and sell of securities backed by the cash flows from these assets. (Hunton & Williams LLP, 2005). Securitization with respect to mortgages mainly takes place through two type of securitization. It is mainly done through true sale and or synthetic securitization of the mortgage assets. In plain true sale securitization, the asset originator i.e. the financial institution which is carrying these assets as mortgages in its balance sheet, sell them to the Special Purpose Vehicle entity which takes the legal ownership title of the assets. The said SPV collateralized the purchased portfolio of assets and than refinance it through the issuance of the multiple classes of mortgaged backed securities in different and customized tranches suiting the various players in the capital markets according to their risk appetite. (Jobst, 2006). This packaging and re-packaging of the mortgages take place in various ways and with the help of various security structures. The most widely used method is the issuance of the mortgaged back bonds called Collateralized Mortgage Obligation Bonds or CMO bonds. CMO bonds are now widely considered as the single most widely used method of repacking the mortgages. A CMO is largely dependent on the cash flows generated by the pools of the mortgages and the payment to the investors is made on the sequential basis. Further a traditional CMO is broken into various tranches like Class A which has the preferential rights and need to be paid first whereas Class B and all subsequent classes receive only coupons till the senior tranches are paid. The Class Z is the zero coupon bond which do not receive any coupon payments and are paid in lump sum at its expiry. This class of bonds are also known as accrual bonds as they provide liquidity to the senior bonds. (Kothari,2007). The next most important way of re-packaging the mortgage backed securitization is the issuance of the PO and IO stripes. These are basically issued to protect the investors from the prepayment risks. These securities are linked with the interest rates and their value fluctuates according to the changes in the interest rates in the market. Another method of repacking the mortgages is to issue to the floaters and inverse floaters. These kinds of securities also suit a particular class of investors and provide a good hedge against the interest rate risks as these bonds vary according to the changes in the interest rates. Further Mortgage backed securities also use overcollateralization and excess spreads to provide buffers to their investors. The MBS are also further restructured to allocate timing of the payments as the MBS can be structured in such a way to include multiple classes of the bonds. Banks also use a reverse process of resecuritization where pools of MBS and bonds are collateralized and backed up seprate classes of bonds. Shared Ownership Shared Ownership Housing Schemes are the schemes under which the proposed buyers part buy and part pay rent for their proposed home mortgage. These kinds of mortgages are mostly common for the first time purchasers of the homes and provide a very cheap alternative to the conventional mortgages which if sold on flexible rate of interests can be really costly and expensive to afford. The basic idea behind the introduction of the shared ownership housing schemes was to allow those who can not borrow or buy through traditional banking channels due to their low income. Initially the purchaser purchase a small share ranging from 25% to 75% of the shareholding in home and gradually when the payments increases, the ownership gradually increase with it also. Housing Authority of Malta launched its first Shared Ownership Mortgage scheme in 2005 and after witnessing the success of it in the Central Malta specially it was decided that all the future issues for sale would be on the shared ownership basis.(www.housingauthority.com.mt,2005). In Malta, the shared ownership of the mortgages is therefore largely exercised through the housing authority which rations the shared housing on the basis of the income level of the owners. (Micallef, 2008). Ginnie Mae Government National Mortgage Association Security or Ginnie Mae is the government agency in United States of America “functions similarly to the process of lending someone money to purchase a house or business. Ginnie Mae buys home mortgages from banks and financial institutions, bundles them together, and then markets portions of these bundles to investors.”(Investopedia, 2008). Ginnie Mae is considered as one of the most preferred and popular type of mortgage backed security because it is primarily guaranteed by the government of United States of America. Ginnie Mae claims that it makes affordable the housing for the low and moderate income holder of US by channeling global capital into the housing markets of the US. It allows the mortgage lenders to obtain a better price for their securities in the market thus enabling to channel those proceeds in making new mortgage lending.(Ginnie Mae,2008). Fannie Mae Founded in 1930s and Privatized during 1960s, the Federal National Mortgage Association or Fannie Mae is federally chartered company owned and run by the shareholder. Its basic purpose is helping the Americans to buy homes on mortgages. It is therefore responsible for maintain a secondary market for the mortgages in US. It does this through pooling and buying confirming loans thus enabling the ability of the mortgage lenders to lend long term mortgage loans. By doing so it ensures that mortgages passing set criteria are being actively traded between the lending institutions and investment banks. Freddie Mac Freddie Mac is the Federal Home Loan Mortgage Corporation. Created under the Emergency Home Finance Act of 1970, the aim was to open an institution which can create a secondary market for the conventional mortgages. Freddie Mac packages these conventional mortgages into the mortgage backed securities and resell them to the investors in secondary markets for MBS. The basic aim of Freddie Mac is therefore to make homes available at cheaper and lower cost to the general public. References 1. Hunton & Williams LLP. (2005). Securitization: An Introduction. Available: http://www.hg.org/articles/article_1122.html. Last accessed 03 April 2008. 2. Jobst,Andreas A. (2006). Asset securitization as a risk management and funding tool:What small firms need to know. Managerial Finance. 32 (9), pp:731-760. 3. Kothari, Vinod. (2007). Residential mortgage-backed securitization. Available: http://www.vinodkothari.com/secrmbs.htm. Last accessed 03 April 2008. 4. www.housingauthority.com.mt. (2005). Shared Ownership. Available: http://www.housingauthority.com.mt/Services/shared.htm. Last accessed 03 April 2008. 5. Micallef, Marisa. (2008). Housing in Malta. Available: http://www.timesofmalta.com/articles/view/20080224/local/housing-in-malta. Last accessed 03 April 2008. 6. Investopedia. (2008). What is a Ginnie Mae security?. Available: http://www.investopedia.com/ask/answers/04/032504.asp. Last accessed 03 April 2008. 7. Ginnie Mae. (2008). About Ginnie Mae. Available: http://www.ginniemae.gov/about/about.asp?Section=About. Last accessed 03 April 2008. 8. Lax, H., Manti, M., Raca, P., & Zorn, P. (2004). Subprime Lending: An investigation of Economic Efficiency. Housing Policy Debates , 15 (3), 533-571. 9. Blanton, B. K. (2005, August 3). Dark side of subprime loans Mortgages for those with bad credit leap in popularity despite high foreclosure rate. Retrieved April 04, 2008, from boston.com: http://boston.com/business/personalfinance/articles/2005/08/03/dark_side_of_subprime_loans/ Read More