Pricing, Valuation and Hedging Analysis of Fixed Rate Mortgages, (1) Introduction A year ago, Pyramid Mortgage Finance Company (PMFC) originated four balloon mortgages, each having a face value of $500,000. Such loans are known in the industry as conforming loans because their face value does exceed the maximum allowable loan value limit that Fannie Mae and Freddie Mac are permitted to buy, as mandated by Congress. The conforming loan limit for the contiguous 48 states for 2022 as stated by Federal Housing Finance Agency (FHFA) is $647,200, for one-family (single) mortgages. The four mortgage loans mentioned above are identical in their features and they 1 all came from the same market area. The mortgages have an original amortization period of 25 years (300 months) with monthly payments. However, the original term-to-maturity of the mortgages is 11 years (132 months), which means that the outstanding loan amount of each mortgage is due at the end of the 11th year making them balloon mortgages. The prevailing market interest rate for such loans at the time the mortgages were originated was 8%. However, instead of charging the market interest rate, the Senior VP for mortgage finance, Ms. Elizabeth Greenwood, priced each mortgage loan with a along with loan amount requested of $500,000 at the time of mortgage origination. The market interest along with loan amount requested of $500,000 at the time of mortgage origination. The market interest origination audit of its mortgage portfolio. There are several issues confronting the PMFC. For example, were the mortgages properly priced a year ago using a combination of 7% interest rate and 5 points? Should the mortgages be liquidated (sold) now, particularly since PMFC needs cash? If the mortgages are to be liquidated now, what should be the maximum liquidation value (fair market value) or price for the mortgages that PMFC could ask? What is the appropriate mechanism to use to hedge interest rate risk associated with the mortgage investment if they are to be kept in PMFC's portfolio? Your task is to help PMC analyze and resolve these issues for PMFC. To aid in your analysis you have identified the following key issues or tasks: 2. Effective Interest Rate (EIR) and Effective Annual Yield (EAY) Analysis with points financed instead of paid upfront: PMFC wants to know the expected yield on the mortgages if they are held in its portfolio until maturity. To analyze this problem, calculate (a) the EIR or APR to be disclosed to the borrower, (b) the Effective Annualized Yield (EAY) to be earned by PMFC, and (c) and he Bond Equivalent yield (BEY). Briefly interpret the meaning of these interest rates or yields, and discuss any shortcomings associated with each of the yield metrics. Pricing, Valuation and Hedging Analysis of Fixed Rate Mortgages, (1) Introduction A year ago, Pyramid Mortgage Finance Company (PMFC) originated four balloon mortgages, each having a face value of $500,000. Such loans are known in the industry as conforming loans because their face value does exceed the maximum allowable loan value limit that Fannie Mae and Freddie Mac are permitted to buy, as mandated by Congress. The conforming loan limit for the contiguous 48 states for 2022 as stated by Federal Housing Finance Agency (FHFA) is $647,200, for one-family (single) mortgages. The four mortgage loans mentioned above are identical in their features and they 1 all came from the same market area. The mortgages have an original amortization period of 25 years (300 months) with monthly payments. However, the original term-to-maturity of the mortgages is 11 years (132 months), which means that the outstanding loan amount of each mortgage is due at the end of the 11th year making them balloon mortgages. The prevailing market interest rate for such loans at the time the mortgages were originated was 8%. However, instead of charging the market interest rate, the Senior VP for mortgage finance, Ms. Elizabeth Greenwood, priced each mortgage loan with a along with loan amount requested of $500,000 at the time of mortgage origination. The market interest along with loan amount requested of $500,000 at the time of mortgage origination. The market interest origination audit of its mortgage portfolio. There are several issues confronting the PMFC. For example, were the mortgages properly priced a year ago using a combination of 7% interest rate and 5 points? Should the mortgages be liquidated (sold) now, particularly since PMFC needs cash? If the mortgages are to be liquidated now, what should be the maximum liquidation value (fair market value) or price for the mortgages that PMFC could ask? What is the appropriate mechanism to use to hedge interest rate risk associated with the mortgage investment if they are to be kept in PMFC's portfolio? Your task is to help PMC analyze and resolve these issues for PMFC. To aid in your analysis you have identified the following key issues or tasks: 2. Effective Interest Rate (EIR) and Effective Annual Yield (EAY) Analysis with points financed instead of paid upfront: PMFC wants to know the expected yield on the mortgages if they are held in its portfolio until maturity. To analyze this problem, calculate (a) the EIR or APR to be disclosed to the borrower, (b) the Effective Annualized Yield (EAY) to be earned by PMFC, and (c) and he Bond Equivalent yield (BEY). Briefly interpret the meaning of these interest rates or yields, and discuss any shortcomings associated with each of the yield metrics
