As the debate rages about whether or not we’re finally approaching a floor in home prices, let’s examine the value of another asset: The mortgage.
When considering a home-buying transaction, buyers (and sellers) typically worry most about the value of the house. Lenders, on the other hand, are much more concerned with the value of the mortgage.
From a lender’s perspective, the economic value of a loan is its expected future cash flow in the form of interest payments. The key word in that phrase -- and why a loan’s value isn’t purely derived from its rate -- is “expected.”
To a bank, a loan is just a product, like an iPod is to Apple or a BlackBerry is to Research in Motion. The value of that product is just how much someone will pay for it. Loans with higher coupons, adjusting for risk, are worth more than those with lower coupons, because they fetch more on the open market.
Mortgages, or debt of any kind, are priced relative to their face value, or “par.” A $100,000 mortgage that’s worth par would cost $100,000. Prices are then expressed as a percentage of par. That is, a loan with a face value of $100,000 that’s worth 102.50 (percent) would cost $102,500.
Subprime loans are often considered “bad,” while prime loans are presumed to be “good.” Many assume, therefore, that high-quality prime loans are worth more than those lousy subprime ones. This isn’t entirely accurate.
“Good” loans are the ones where you’re appropriately paid for your risk, whereas “bad” ones are those in which you’re on taking too much risk relative to return. As Professor Sedacca often says, “If you aren't being paid to take risk, don't take risk.”
Consider the following 2 mortgage situations, ask yourself which one a lender is likely to value more highly:
Borrower A has impeccable credit, can make a sizable 30% down payment on her family’s first home, but will have to stretch to make the monthly payments because her husband just quit his job to stay home with their second child. The mortgage carries a low 6.00% rate, or coupon, because of Borrower A’s good credit and the low loan-to-value ratio (loan amount divided by sales price).
Borrower B has poor credit, stemming from medical problems that put him out of work for the past 12 months. Credit-card bills piled up, payments were missed and he had a hard time making ends meet. Healthy now, Borrower B is looking to refinance his existing mortgage on the home he’s lived in for 20 years. He needs some extra cash to finish paying off bills and get back on track, so he's looking for a loan to value of 90%. The mortgage carries a high 9% coupon because of Borrower B’s bad credit and the loan’s high loan-to-value ratio.
I designed the examples to prove a point, but I would take Borrower B’s "subprime" mortgage over Borrower A’s every time. Even though Borrower A’s perceived risk (by the numbers) is less than Borrower B, Borrower A is probably more likely to default. Despite Borrower’s A big down payment, the low coupon may not cover the additional default risk.
Banks often write mortgages with the intent to sell them on the open market. Whether the loan is sold individually or packaged in a security, the higher the coupon, the higher the potential value for the ultimate owner (provided, of course, the risks are properly measured and evaluated).
Mortgage originators (both banks and brokers) and Wall Street firms used this concept to push bad loans onto borrowers. Whether Goldman Sachs (GS) wanted to issue a mortgage-backed security or Wells Fargo (WFC) planned to park the loan on its balance sheet, both earned more from higher coupon loans, so that's what they asked for from their salespeople and brokers.
One of the most highly sought-after types of mortgages were those with a high loan-to-value ratio, written for speculative investment properties where borrowers didn’t have to state their income. These loans carried a very high coupon because of the high perceived risk of default.
However, since homeowners in areas experiencing rapid appreciation like Phoenix, Las Vegas, Florida and California could easily sell their way out of a problem during the boom, the actual risk on these loans remained low. Wall Street demanded precisely this kind of loan, and brokers wrote them. Whether the borrower could really afford the payments didn't matter, since they could just sell the house at the first sign of trouble.
Of course, when appreciation stalled, actual risk shot up, and even high rates didn’t compensate banks for the risk these loans now carried.
Since Wall Street could earn far more packaging and securitizing these high-risk loans than they could on boring, low-coupon prime loans, they paid mortgage brokers and bankers higher commissions to write them. These originators, being good salespeople, aggressively marketed these loans to borrowers that fit these highly profitable criteria.
Homeowners, watching their neighbors get rich speculating on condos in Miami, had little to no financial incentive not to join in. That’s not to say there weren’t some who made responsible decisions - but enough people got caught up in the mania that, well, we are where we are right now.
So this brings us back to your mortgage. How much is it worth?
Remember to think about it from the bank's perspective.
The next time you hear offers like “no closing costs!” or “low introductory rate!”, think about why the bank would do this. If it’s not charging fees to close the loan, you can be sure it’s making up that lost income with a higher rate. If it’s offering a teaser rate, the higher payments you'll be making when the coupon adjusts upwards will more than make up for that low payment in the first few months.
The best way to get the best deal is to think about what loan will be worth the least to your lender. Low rate, low fees, low risk... Who wants that boring paper?
The answer: You do.
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