FI 413 Lecture Notes - Lecture 17: Home Insurance, Mortgage Insurance, Homeowner Association
Document Summary
Housing expense ratio = mortgage payment + homeowner s insurance + real estate taxes + mortgage insurance + homeowners association dues, divided by pre-tax income (everything measured per month) Suppose d = . 1, and the typical recovery rate on defaulted loans of this type is 20 cents on the dollar. The highest interest rates the borrower will pay is 15%, because they have been offered that rate elsewhere. Suppose the bank has a 6% required return and servicing costs are 2% of principal, and loan fees are zero. Should the bank make the loan? (1+k) = (1 + . 02)(1 + . 06)/[(1 - . 1) + . 1(. 2)] = 1. 1752. Diversification of risks is a basic principle of portfolio management. For banks, loans typically comprise well over half of total assets, so maintaining reasonable diversification of the loan portfolio is very important. To mitigate pure idiosyncratic risk, regulators require banks to limit their exposure to any one borrower: