TA B L E 1 4 . 2 Effective Rate of Interest on a Loan at 12% with 2 Discount Points Year of
Prepayment Effective Rate
of Interest (%) Year of
Prepayment Effective Rate of Interest (%)
1 14.54 6 12.65
2 13.40 7 12.60
3 13.02 10 12.52
4 12.84 15 12.45
5 12.73 30 12.42
.
1See Chapter 3 for a discussion on how loan payments are computed.
2For example, to compute the effective rate if the loan is prepaid after two years, find the FVif I= 11.5%, PV= 100,000, N= 360, and PMT= 990.29. Now set PVequal to 98,000 and compute I.
Divide this Iby 12, add 1, and raise the result to the 12th power.
$100,000, you will receive only $98,000 ($100,000 – $2000). Your payment is computed on the $100,000, but at the lower interest rate. Using a financial calculator, we find that the monthly payment is $990.29 and your monthly rate is 0.9804%.1The effec- tive annual rate after compounding is
As a result of paying the 2 discount points, the effective annual rate has dropped from 12.68% to 12.42%. On the surface, it would seem like a good idea to pay the points. The problem is that these calculations were made assuming the loan would be held for the life of the loan, 30 years. What happens if you sell the house before the loan matures?
If the loan is paid off early, the borrower will benefit from the lower interest rate for a shorter length of time, and the discount points are spread over a shorter period of time. The result of these two factors is that the effective interest rate rises the shorter the time the loan is held before being paid. This relationship is demon- strated in Table 14.2. If the 2-point loan is held for 15 years, the effective rate is 12.45%. At 10 years, the effective rate is up to 12.52%. Even at 6 years, when the effective rate is 12.65%, paying the discount points has saved the borrower money.
However, if the loan is paid off at 5 years, the effective rate is 12.73%, which is higher than the 12.68% effective rate if no points were paid.2
Effective annual rate⫽ 11.009804212⫺1⫽0.1242⫽12.42%
Loan Terms
Mortgage loan contracts contain many legal and financial terms, most of which pro- tect the lender from financial loss.
Collateral One characteristic common to mortgage loans is the requirement that collateral, usually the real estate being financed, be pledged as security. The lend- ing institution will place a lienagainst the property, and this remains in effect until the loan is paid off. A lien is a public record that attaches to the title of the property,
advising that the property is security for a loan, and it gives the lender the right to sell the property if the underlying loan defaults.
No one can buy the property and obtain clear title to it without paying off this lien. For example, if you purchased a piece of property with a loan secured by a lien, the lender would file notice of this lien at the public recorder’s office. The lien gives notice to the world that if there is a default on the loan, the lender has the right to seize the property. If you try to sell the property without paying off the loan, the lien would remain attached to the title or deed to the property. Since the lender can take the property away from whoever owns it, no one would buy it unless you paid off the loan. The existence of liens against real estate explains why a title search is an important part of any mortgage loan transaction. During the title search, a lawyer or title company searches the public record for any liens. Title insurance is then sold that guarantees the buyer that the property is free of encumbrances, any ques- tions about the state of the title to the property, including the existence of liens.
Down Payments To obtain a mortgage loan, the lender also requires the borrower to make a down paymenton the property, that is, to pay a portion of the pur- chase price. The balance of the purchase price is paid by the loan proceeds. Down payments (like liens) are intended to make the borrower less likely to default on the loan. A borrower who does not make a down payment could walk away from the house and the loan and lose nothing. Furthermore, if real estate prices drop even a small amount, the balance due on the loan will exceed the value of the collateral.
As we discussed in Chapters 2 and 8, the down payment reduces moral hazard for the borrower. The amount of the down payment depends on the type of mort- gage loan. Beginning in the mid 2000s the required down payment was often cir- cumvented with piggy back loans where a second mortgage was added to the first so that 100% financing was provided.
Private Mortgage Insurance Another way that lenders protect themselves against default is by requiring the borrower to purchase private mortgage insurance (PMI).
PMI is an insurance policy that guarantees to make up any discrepancy between the value of the property and the loan amount, should a default occur. For example, if the balance on your loan was $120,000 at the time of default and the property was worth only $100,000, PMI would pay the lending institution $20,000. The default still appears on the credit record of the borrower, but the lender avoids sustaining the loss. PMI is usually required on loans that have less than a 20% down payment. If the loan-to- value ratio falls because of payments being made or because the value of the prop- erty increases, the borrower can request that the PMI requirement be dropped. PMI usually costs between $20 and $30 per month for a $100,000 loan.
Ideally, PMI should have protected investors against losses on mortgage invest- ments, and it did until recently. PMI is usually only required on the first mortgage. By structuring loans so that the first mortgage loan was set at 80% loan to value with a second mortgage covering the remaining 20%, PMI was avoided.
Borrower Qualification Historically, before granting a mortgage loan, the lender would determine whether the borrower qualified for it. Qualifying for a mortgage loan was different from qualifying for a bank loan because most lenders sold their mortgage loans to one of a few federal agencies in the secondary mortgage market. These agencies estab- lished very precise guidelines that had to be followed before they would accept the loan.
If the lender gave a mortgage loan to a borrower who did not fit these guidelines, the lender would not be able to resell the loan. That tied up the lender’s funds.
The rules for qualifying a borrower were complex and constantly changing, but a rule of thumb was that the loan payment, including taxes and insurance, should not exceed 25% of gross monthly income. Furthermore, the sum of the monthly payments on all loans to the borrower, including car loans and credit cards, should not exceed 33% of gross monthly income.
Lenders will also order a credit report from one of the major credit reporting agencies. The credit score is based on a model that weights a number of variables found to be valid predictors of credit worthiness. The most common score is called the FICO, named after its creator, Fair Isaac Company. FICO scoresmay range from a low of 300 to a maximum of 850. Scores above 720 are considered good while scores below 660 were likely to cause problems obtaining a loan. The FICO score is deter- mined by your past payment history, outstanding debt, length of credit history, num- ber or recent credit applications, and types of credit and loans you have. It is interesting to note that simply applying for and holding a number of credit cards can significantly affect your FICO score.
When the competition to originate mortgage loans grew in the mid 2000s, a vari- ety of mortgage loans were offered that circumvented traditional lending practices.
For example, borrowers were offered No Doc loans (sometimes called NINJA loans for No Income, No Job, and No Assets) where income or assets were not required on the loan application. These lending practices have been largely abandoned as the search for quality borrowers has replaced the need for loan volume.
Mortgage Loan Amortization
Mortgage loan borrowers agree to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity. “Fully amortize” means that the payments will pay off the outstanding indebtedness by the time the loan matures. During the early years of the loan, the lender applies most of the payment to the interest on the loan and a small amount to the outstanding principal balance. Many borrowers are surprised to find that after years of making payments, their loan balance has not dropped appreciably.
Table 14.3 shows the distribution of principal and interest for a 30-year,
$130,000 loan at 8.5% interest. Only $78.75 of the first payment is applied to reduce the loan balance. At the end of two years, the balance due is still $127,947, and at the end of five years, the balance due is $124,137. Put another way, of $59,975.40 in
TA B L E 1 4 . 3 Amortization of a 30-Year, $130,000 Loan at 8.5%
Payment
Number Beginning
Balance of Loan Monthly
Payment Amount Applied
to Interest Amount Applied
to Principal Ending Balance of Loan
1 130,000.00 999.59 920.83 78.75 129,921.24
24 128,040.25 999.59 906.95 92.66 127,947.62
60 124,256.74 999.59 880.15 119.43 124,137.31
120 115,365.63 999.59 817.17 182.41 115,183.22
180 101,786.23 999.59 720.99 278.60 101,507.63
240 81,046.41 999.59 574.08 425.51 80,620.90
360 991.77 999.59 7.82 991.77 0
loan payments made during the first five years, only $5,862.69 is applied to the prin- cipal. Over the life of the $130,000 loan, a total of $229,850 in interest will be paid.
If the loan in Table 14.3 had been financed for 15 years instead of for 30, the pay- ment would have increased by about $280 per month to $1,279.59, but the interest savings over the life of the loan would be nearly $130,000. It is no wonder why so many borrowers prefer the shorter-term loans.
Types of Mortgage Loans
A number of types of mortgage loans are available in the market. Different borrow- ers may qualify for different ones. A skilled mortgage banker can help find the best type of mortgage loan for each particular situation.
Insured and Conventional Mortgages
Mortgages are classified as either insuredorconventional.Insured mortgagesare originated by banks or other mortgage lenders but are guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA).
Applicants for FHA and VA loans must meet certain qualifications, such as having served in the military or having income below a given level, and can borrow only up to a certain amount. The FHA or VA then guarantees the bank making the loans against any losses—that is, the agency guarantees that it will pay off the mortgage loan if the borrower defaults. One important advantage to a borrower who qualifies for an FHA or VA loan is that only a very low or zero down payment is required.
Conventional mortgagesare originated by the same sources as insured loans but are not guaranteed. Private mortgage companies now insure many conventional loans against default. As we noted, most lenders require the borrower to obtain pri- vate mortgage insurance on all loans with a loan-to-value ratio exceeding 80%.
Fixed- and Adjustable-Rate Mortgages
In standard mortgage contracts, borrowers agree to make regular payments on the principal and interest they owe to lenders. As we saw earlier, the interest rate sig- nificantly affects the size of this monthly payment. In fixed-rate mortgages, the inter- est rate and the monthly payment do not vary over the life of the mortgage.
The interest rate on adjustable-rate mortgages(ARMs) is tied to some mar- ket interest rate and therefore changes over time. ARMs usually have limits, called caps, on how high (or low) the interest rate can move in one year and during the term of the loan. A typical ARM might tie the interest rate to the average Treasury bill rate plus 2%, with caps of 2% per year and 6% over the lifetime of the mortgage. Caps make ARMs more palatable to borrowers.
Borrowers tend to prefer fixed-rate loans to ARMs because ARMs may cause financial hardship if interest rates rise. However, fixed-rate borrowers do not bene- fit if rates fall unless they are willing to refinance their mortgage (pay it off by obtain- ing a new mortgage at a lower interest rate). The fact that individuals are risk-averse means that fear of hardship most often overwhelms anticipation of savings.
Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk. Recall from Chapter 3 that interest-rate risk is the risk that rising interest rates will cause the value of debt instruments to fall. The effect on the value of the debt is greatest when the debt has a long term to maturity. Since mortgages are usually long-term, their value
is very sensitive to interest-rate movements. Lending institutions can reduce the sensitivity of their portfolios by making ARMs instead of standard fixed-rate loans.
Seeing that lenders prefer ARMs and borrowers prefer fixed-rate mortgages, lenders must entice borrowers by offering lower initial interest rates on ARMs than on fixed-rate loans. For example, in May 2010, the reported interest rate for 30-year fixed- rate mortgage loans was 4.75%. The rate at that time for 5-year adjustable-rate mort- gages was 3.625%. The rate on the ARM would have to rise 1.13% before the borrower of the ARM would be in a worse position than the fixed-rate borrower.
Other Types of Mortgages
As the market for mortgage loans became more competitive, lenders offered more innovative mortgage contracts in an effort to attract borrowers. We discuss some of these mortgages here.
Graduated-Payment Mortgages (GPMs) Graduated-payment mortgages are use- ful for home buyers who expect their incomes to rise. The GPM has lower payments in the first few years; then the payments rise. The early payments may not even be sufficient to cover the interest due, in which case the principal balance increases.
As time passes, the borrower expects income to increase so that the higher pay- ment will not be a burden.
The advantage of the GPM is that borrowers will qualify for a larger loan than if they requested a conventional mortgage. This may help buyers purchase ade- quate housing now and avoid the need to move to more expensive homes as their family size increases. The disadvantage is that the payments escalate whether the borrower’s income does or not.
Growing-Equity Mortgages (GEMs) Lenders designed the growing-equity mort- gage loan to help the borrower pay off the loan in a shorter period of time. With a GEM, the payments will initially be the same as on a conventional mortgage. However, over time the payment will increase. This increase will reduce the principal more quickly than the conventional payment stream would. For example, a typical contract may call for level payments for the first two years. The payments may increase by 5%
per year for the next five years, then remain the same until maturity. The result is to reduce the life of the loan from 30 years to about 17.
GEMs are popular among borrowers who expect their incomes to rise in the future. It gives them the benefit of a small payment at the beginning while still retir- ing the debt early. Although the increase in payments is requiredin GEMs, most mort- gage loans have no prepayment penalty. This means that a borrower with a 30-year loan could create a GEM by simply increasing the monthly payments beyond what isrequiredand designating that the excess be applied entirely to the principal.
The GEM is similar to the graduated-payment mortgage; the difference is that the goal of the GPM is to help the borrower qualify by reducing the first few years’
payments. The loan still pays off in 30 years. The goal of the GEM is to let the bor- rower pay off early.
Second Mortgages (Piggyback) Second mortgages are loans that are secured by the same real estate that is used to secure the first mortgage. The second mortgage is junior to the original loan. This means that should a default occur, the second mort- gage holder will be paid only after the original loan has been paid off and only if sufficient funds are available from selling the property.
Originally second mortgages had two purposes. The first is to give borrowers a way to use the equity they have in their homes as security for another loan. An alternative to the second mortgage would be to refinance the home at a higher loan amount than is currently owed. The cost of obtaining a second mortgage is often much lower than refinancing.
Another purpose of the second mortgage is to take advantage of one of the few remaining tax deductions available to the middle class. The interest on loans secured by residential real estate is tax-deductible (the tax laws allow borrowers to deduct the interest on the primary residence and one vacation home). No other kind of consumer loan has this tax deduction. Many banks now offer lines of credit secured by second mortgages. In most cases, the value of the security is not of great inter- est to the bank. Consumers prefer that the line of credit be secured so that they can deduct the interest on the loan from their taxes.
As mentioned earlier, a contributing factor in the mortgage market collapse was the use of second mortgage loans to reduce or eliminate the need for a down pay- ment. Borrowers who had no real equity in the home were willing to walk away once its value dropped or their income fell. The use of second mortgages represented a change in usual lending practices. Historically, borrowers had to prove they had the required down payment before the loan would move forward.
Reverse Annuity Mortgages (RAMs) The reverse annuity mortgage is an innov- ative method for retired people to live on the equity they have in their homes. The contract for a RAM has the bank advancing funds on a monthly schedule. This increasing-balance loan is secured by the real estate. The borrower does not make any payments against the loan. When the borrower dies, the borrower’s estate sells the property to retire the debt.
The advantage of the RAM is that it allows retired people to use the equity in their homes without the necessity of selling it. For retirees in need of supplemental funds to meet living expenses, the RAM can be a desirable option.
Option ARM The ARM discussed previously was subject to interest-rate risk but retained the basics of rational lending standards. In the mid 2000s the option arm was marketed under various names. In essence, it gave the borrower the “option” of reducing the monthly payment. As a result, instead of reducing the mortgage balance over time, as with a conventional mortgage, the amount owed steadily increased.
These loans were often packaged with initial teaser rates that set the initial inter- est rate very low, then increased it substantially after a year or so. For example, the payment on a $150,000 loan could be $125 to start, then jump to $900 after a year.
With the borrower exercising the option of reducing the payment, the loan balance would build by $775 per month.
Between 2004 and 2008 various mortgage loan options were offered that were intended to allow almost any borrower to qualify. The argument at the time was that home prices have usually gone up and if a borrower could not continue to afford the mortgage, they could simply sell the home at a profit. When the hous- ing bubble burst and prices fell, this was not an option and many loans defaulted.
Since 2008, the mortgage industry has largely stopped offering these high-risk loan options.
The various mortgage types are summarized in Table 14.4.
TA B L E 1 4 . 4 Summary of Mortgage Types
Conventional mortgage Loan is not guaranteed; usually requires private mortgage insurance; 5% to 20% down payment
Insured mortgage Loan is guaranteed by FHA or VA; low or zero down payment Adjustable-rate
mortgage (ARM)
Interest rate is tied to some other security and is adjusted periodically; size of adjustment is subject to annual limits Graduated-payment
mortgage (GPM)
Initial low payment increases each year; loan amortizes in 30 years
Growing-equity mortgage (GEM)
Initial payment increases each year; loan amortizes in less than 30 years
Second mortgage Loan is secured by a second lien against the real estate; often used for lines of credit or home improvement loans
Reverse annuity mortgage
Lender disburses a monthly payment to the borrower on an increasing-balance loan; loan comes due when the real estate is sold
Mortgage-Lending Institutions
Originally, the thrift industry was established with the mandate from Congress to pro- vide mortgage loans to families. Congress gave these institutions the ability to attract depositors by allowing S&Ls to pay slightly higher interest rates on deposits. For many years, the thrift industry did its job well. Thrifts raised short-term funds by attracting deposits and used these funds to make long-term mortgage loans. The early growth of the housing industry owes much of its success to these institutions. (The thrift industry is discussed further in Web Chapter 25.)
Until the 1970s, interest rates remained relatively stable, and when fluctuations did occur, they tended to be small and short-lived. But in the 1970s, interest rates rose rapidly, along with inflation, and thrifts became the victims of interest-rate risk.
As market interest rates rose, the value of their fixed-rate mortgage loan portfolios fell. Because of the losses the thrifts suffered, they stopped being the primary source of mortgage loans.
Another serious problem with the early mortgage market was that thrift insti- tutions were restricted from nationwide branching by federal and state laws and were forbidden to lend outside of their normal lending territory, about 100 miles from their offices. So even if an institution appeared very diversified, with thousands of differ- ent loans, all of the loans were from the same region. When that region had economic problems, many of the loans would default at the same time. For example, Texas and Oklahoma experienced a recession in the mid-1980s due to falling oil prices. Many mortgage loans defaulted because real estate values fell at the same time as the region’s unemployment rate rose. That other areas of the country remained healthy was of no help to local lenders.
Figure 14.2 shows the share of the total mortgage market held by the major mortgage-lending institutions in the United States. By far the largest investor are mort- gage pools and trusts. (Mortgage pools and trusts are discussed later in this chapter.)
Loan Servicing
Many of the institutions making mortgage loans do not want to hold large portfolios of long-term securities. Commercial banks, for example, obtain their funds from short- term sources. Investing in long-term loans would subject them to unacceptably high interest-rate risk. Commercial banks, thrifts, and most other loan originators do, how- ever, make money through the fees that they earn for packaging loans for other investors to hold. Loan origination fees are typically 1% of the loan amount, though this varies with the market.
Once a loan has been made, many lenders immediately sell the loan to another investor. The borrower may not even be aware that the original lender transferred the loan. By selling the loan, the originator frees up funds that can be lent to another borrower, thereby generating additional fee income.
Some of the originators also provide servicing of the loan. The loan-servicing agent collects payments from the borrower, passes the principal and interest on to the investor, keeps required records of the transaction, and maintains reserve accounts.Reserve accounts are established for most mortgage loans to permit the lender to make tax and insurance payments for the borrower. Lenders prefer to make these payments because they protect the security of the loan. Loan-servicing agents usually earn 0.5% per year of the total loan amount for their efforts.
In summary, there are three distinct elements to most mortgage loans:
1. The originator packages the loan for an investor.
2. The investor holds the loan.
3. The servicing agent handles the paperwork.
One, two, or three different intermediaries may provide these functions for any particular loan.
Mortgage loans are increasingly obtained from the Web. The E-Finance box dis- cusses this new source of mortgage loans.
Commercial Banks 26%
Savings and Loans 5%
Mortgage Pools and Trusts 53%
Federal Agencies and Other 14%
Life Insurance Companies 2%
F I G U R E 1 4 . 2 Share of the Mortgage Market Held by Major Mortgage- Lending Institutions
Source: Federal Reserve Bulletin, April 2010, Table 1.54.
Secondary Mortgage Market
The federal government founded the secondary market for mortgages. As we noted earlier, the mortgage market had all but collapsed during the Great Depression. To help spur the nation’s economic activity, the government established several agen- cies to buy mortgages. The Federal National Mortgage Association (Fannie Mae) was set up to buy mortgages from thrifts so that these institutions could make more mort- gage loans. This agency would fund these purchases by selling bonds to the public.
At about the same time, the Federal Housing Administration was established to insure certain mortgage contracts. This made it easier to sell the mortgages because the buyer did not have to be concerned with the borrower’s credit history or the value of the collateral. A similar insurance program was set up through the Veterans Administration to insure loans to veterans after World War II.
One advantage of the insured loans was that they were required to be written on a standard loan contract. This standardization was an important factor in the growth of the secondary market for mortgages.
As the secondary market for mortgage contracts took shape, a new interme- diary, the mortgage bank, emerged. Because this firm did not accept deposits, it was able to open offices across the country. The mortgage bank originated the loans, funding them initially with its own capital. After a group of similar loans were made, they would be bundled and sold, either to one of the federal agencies or to an insurance or pension fund. There were several advantages to the mortgage banks. Because of their size, they were able to capture economies of scale in loan
E - F I N A N C E
Borrowers Shop the Web for Mortgages
One business area that has been significantly affected by the Web is mortgage banking. Historically, bor- rowers went to local banks, savings and loans, and mortgage banking companies to obtain mortgage loans. These offices packaged the loans and resold them. In recent years, hundreds of new Web-based mortgage banking companies have emerged.
The mortgage market is well suited to providing online service for several reasons. First, it is information- based and no products have to be shipped or invento- ried. Second, the product (a loan) is homogeneous across providers. A borrower does not really care who provides the money as long as it is provided efficiently.
Third, because home buyers tend not to obtain mort- gage loans very often, they have little loyalty to any local lender. Finally, online lenders can often offer loans at lower cost because they can operate with lower overhead than firms that must greet the public.
The online mortgage market makes it much easier for borrowers to shop interest rates and terms. By
filling out one application, a borrower can obtain a number of alternative loan options from various Web service companies. Borrowers can then select the option that best suits their requirements.
Online mortgage firms, such as Lending Tree, have made mortgage lending more competitive. This may lead to lower rates and better service. It has also led lenders to offer an often confusing array of loan alternatives that most borrowers have difficulty interpreting. This makes comparison shopping more difficult than simply comparing interest rates.
Borrowers using online services to shop for loans must be aware that scam artists have found this an easy way to obtain personal information. They set up a bogus loan site and offer extremely attractive inter- est rates to draw in customers. Once they have col- lected all the information needed to wipe out your checking, savings, and credit card accounts, they close their site and open another.
origination and servicing. They were also able to bundle loans from different regions together, which helped reduce their risk. The increased competition for loans among these intermediaries led to lower rates for borrowers.
Securitization of Mortgages
Intermediaries still faced several problems when trying to sell mortgages. The first was that mortgages are usually too small to be wholesale instruments. The average new home mortgage loan is now about $250,000. This is far below the $5 million round lot established for commercial paper, for example. Many institutional investors do not want to deal in such small denominations.
The second problem with selling mortgages in the secondary market was that they were not standardized. They have different times to maturity, interest rates, and contract terms. That makes it difficult to bundle a large number of mortgages together.
Third, mortgage loans are relatively costly to service. Compare the servicing a mortgage loan requires to that of a corporate bond. The lender must collect monthly payments, often pay property taxes and insurance premiums, and service reserve accounts. None of this is required if a bond is purchased.
Finally, mortgages have unknown default risk. Investors in mortgages do not want to spend a lot of time evaluating the credit of borrowers. These problems inspired the creation of the mortgage-backed security,also known as a securitized mortgage.
What Is a Mortgage-Backed Security?
By the late 1960s, the secondary market for mortgages was declining, mostly because fewer veterans were obtaining guaranteed loans. The government reorganized Fannie Mae and also created two new agencies: the Government National Mortgage Association (GNMA, or Ginnie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac). These three agencies were now able to offer new securities backed by both insured and, for the first time, uninsured mortgages.
An alternative to selling mortgages directly to investors is to create a new secu- rity backed by (secured by) a large number of mortgages assembled into what is called a mortgage pool. A trustee, such as a bank or a government agency, holds the mortgage pool, which serves as collateral for the new security. This process is calledsecuritization. The most common type of mortgage-backed security is the mortgage pass-through,a security that has the borrower’s mortgage payments pass through the trustee before being disbursed to the investors in the mortgage pass- through. If borrowers prepay their loans, investors receive more principal than expected. For example, investors may buy mortgage-backed securities on which the average interest rate is 6%. If interest rates fall and borrowers refinance at lower rates, the securities will pay off early. The possibility that mortgages will prepay and force investors to seek alternative investments, usually with lower returns, is calledprepayment risk.
As is evident in Figure 14.3, the dollar volume of outstanding mortgage pools has increased steadily since 1984. The reason that mortgage pools have become so popular is that they permit the creation of new securities (like mortgage pass- throughs) that make investing in mortgage loans much more efficient. For exam- ple, an institutional investor can invest in one large mortgage pass-through secured by a mortgage pool rather than investing in many small and dissimilar mortgage contracts.
Funds in Mortgage Pools ($ billions)
0 1,000 2,000
1995 1993 1991 1989 1987 1985 3,000 4,000 5,000 6,000 8,000
7,000
1999
1997 2001 2003 2005 2007 2009
F I G U R E 1 4 . 3 Value of Mortgage Principal Held in Mortgage Pools, 1984–2010
Source: Federal Reserve Bulletin, various issues, Table 1.54, Line 55.
Types of Pass-Through Securities
There are several types of mortgage pass-through securities: GNMA pass-throughs, FHLMC pass-throughs, and private pass-throughs.
Government National Mortgage Association (GNMA) Pass-Throughs Ginnie Mae began guaranteeing pass-through securities in 1968. Since then, the popular- ity of these instruments has increased dramatically.
A variety of financial intermediaries, including commercial banks and mortgage companies, originate Ginnie Mae mortgages. Ginnie Mae aggregates these mortgages into a pool and issues pass-through securities that are collateralized by the interest and principal payments from the mortgages. Ginnie Mae also guarantees the pass- through securities against default. The usual minimum denomination for pass- throughs is $25,000. The minimum pool size is $1 million. One pool may back up many pass-through securities.
Federal Home Loan Mortgage Corporation (FHLMC) Pass-Throughs Freddie Mac was created to assist savings and loan associations, which are not eligible to orig- inate Ginnie Mae–guaranteed loans. Freddie Mac purchases mortgages for its own account and also issues pass-through securities similar to those issued by Ginnie Mae.
Pass-through securities issued by Freddie Mac are called participation certificates (PCs). Freddie Mac pools are distinct from Ginnie Mae pools in that they contain con- ventional (nonguaranteed) mortgages, are not federally insured, contain mortgages with different rates, are larger (ranging up to several hundred million dollars), and have a minimum denomination of $100,000.
One innovation in the FHLMC pass-through market has been the collateralized mortgage obligation (CMO).CMOs are securities classified by when prepayment is likely to occur. These differ from traditional mortgage-backed securities in that they are offered in different maturity groups. These securities help reduce prepayment risk, which is a problem with other types of pass-through securities.
CMOs backed by a particular mortgage pool are divided into tranches (French for “slices”). When principal is repaid, the investors in the first tranche are paid first, then those in the second tranche, and so on. Investors choose a tranche that matches their maturity requirements. For example, if they will need cash from their investment in a few years, they purchase tranche 1 or 2 CMOs. If they want the invest- ment to be long-term, they can purchase CMOs from the last tranche.
Even when an investor purchases a CMO, there are no guarantees about how long the investment will last. If interest rates fall significantly, many borrowers will pay off their mortgages early by refinancing at lower rates.
Real estate mortgage investment conduits (REMICs) were authorized by the 1986 Tax Reform Act to allow originators to pass through all interest payments tax free. Only their legal and tax consequences distinguish REMICs from CMOs.
Private Pass-Throughs (PIPs) In addition to the agency pass-throughs, interme- diaries in the private sector have offered privately issued pass-through securities. The first of these PIPs was offered by BankAmerica in 1977.
One mortgage market opportunity available to private institutions is for mort- gages larger than the maximum size set by the government. These so-called jumbo mortgagesare often bundled into pools to back private pass-throughs.
Subprime Mortgages and CDOs
Subprime loansare those made to borrowers who do not qualify for loans at the usual market rate of interest because of a poor credit rating or because the loan is larger than justified by their income. There can be subprime car loans or credit cards, but subprime mortgages have been highly publicized recently due to the high default rates realized when real estate values began dropping in 2006.
Before the securitized market made it easy to bundle and sell mortgages, if you did not meet the qualifications for one of the major mortgage agencies, you were unlikely to be able to buy a house. These qualifications were strictly enforced, and each element was verified to assure compliance. Once it became possible to sell bundles of loans to other investors, different lending rules emerged. These new rules gave rise to a new class of mortgage loans known as subprime mortgages.
According to the Mortgage Bankers Association, in 2000 about 70% of all loans were conventional prime, 20% were FHA, 8% were VA, and only 2% were subprime.
In 2006, 70% were still conventional prime, but now fully 17% were subprime, with
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G O O N L I N E
the balance being FHA and VA. The FICO score is computed for virtually every bor- rower. This score is computed by the different credit rating agencies as an index of credit risk. Though each agency uses a slightly different algorithm, all include pay- ment history, level of current debt, length of credit history, types of credit held, and the number of new credit inquiries made as criteria for rating credit worthiness.
The average subprime FICO score was 624 versus 742 for prime mortgage loans.
Several innovative lending practices have led to this increase in lending to less credit worthy borrowers. First, 2/28 ARMs (sometimes called “teaser” loans) became popular. These loans freeze the interest rate for 2 years, and then it increases, often substantially, after that. Piggyback loans, NoDoc, or NINJA (no income no asset loans), and variations on the graduated payment mortgage, as discussed in the last section, encouraged borrowers to commit to larger loans than they could realistically handle.
Many saw the increase in mortgage loans to less credit worthy borrowers as progress. If home ownership is the goal of every American, then relaxed lending stan- dards allowed more families to reach their goal. The downside was that the com- petitive nature of the market led mortgage sales people to target less financially sophisticated borrowers who were less able to properly evaluate their ability to repay the loans. Additionally, the relaxed lending standards allowed speculators to obtain loans without investing any equity.
The growth of the subprime mortgage was in part fueled by the creation of the structured credit products such as the collateralized debt obligation (CDO). These securities were first introduced in Chapter 8 as providing a source of funds for high risk investments. A CDO is similar to the CMO discussed above, except that rather than slicing the pool of securities by maturity as with the CMO, the CDO usually creates tranches based on risk class. While CDOs can be backed by corporate bonds, REIT debt, or other assets, mortgage-backed securities are common.
When real estate values were rapidly increasing, borrowers could easily sell their property if they found themselves unable to make the payments. Once the real estate market cooled in 2006 and 2007, it became much more difficult to sell property and many borrowers were forced into default and bankruptcy. As discussed more fully in Chapter 8, subprime lending was ultimately a leading cause of the financial crisis of 2007–2008 and led to a global recession.
The Real Estate Bubble
The mortgage market was heavily influenced by the real estate boom and bust between the years 2000 and 2008. Between 2000 and 2005 home prices increased an average of 8% per year. They increased 17% in 2005 alone. The run-up in prices was cause by two factors. The first was the increase in subprime loans discussed pre- viously. With more people now qualifying for loans, there was increased demand. Note that by 2004 subprime lending made up 17% of all new loans. This meant that over a very short period many new buyers were now qualified to purchase homes. While home construction increased, it could not keep pace with demand.
Real estate speculators were a second driver of the price bubble. People of all walks of life started noticing that quick and apparently easy money was to be made by buying real estate for the purpose of resale. The ability to obtain zero down loans allowed them to buy property easily and with little committed capital. They could then resell the property at a higher price. Many development projects were sold out before they were even started. The buyers were often speculators with no inten- tion of occupying the property. Condominiums were especially popular since they did
not require much upkeep by the owner until the next sale could be arranged. At times, speculators were selling to other speculators as the demand drove up prices.
As with most speculative bubbles, at some point the process ends. Default rates on the subprime mortgages increased and the extent of speculation started to make the news. Those left owning properties bought at the height of the market suffered losses, including lending institutions and investors in the mortgage-backed securities.
In the aftermath of a mortgage-fueled financial meltdown, lending policies have largely returned to selecting capable borrowers. One indication of this is the decline in global CDO issuance. It peaked at $520 billion in 2006. By 2008 it had fallen to
$62.9 billion. In 2009 it was $4.2 billion.
The securitized mortgage was initially hailed as a method for reducing the risk to lenders by allowing them to sell off a portion of their loan portfolio. The lender could continue making loans without having to retain the risk. Unfortunately, this led to increased moral hazard. By separating the lender from the risk, riskier loans were issued than had the securitized mortgage channel not existed. Individual firm risk may have been reduced, but systemic risk greatly increased.
S U M M A R Y
1.Mortgages are long-term loans secured by real estate.
Both individuals and businesses obtain mortgage loans to finance real estate purchases.
2.Mortgage interest rates are relatively low due to com- petition among various institutions that want to make mortgage loans. In addition to keeping interest rates low, the competition has resulted in a variety of terms and options for mortgage loans. For example, bor- rowers may choose to obtain a 30-year fixed-rate loan or an adjustable-rate loan that has its interest rate tied to the Treasury bill rate.
3.Several features of mortgage loans are designed to reduce the likelihood that the borrower will default.
For example, a down payment is usually required so that the borrower will suffer a loss if the lender repos- sesses the property. Most lenders also require that the borrower purchase private mortgage insurance unless the loan-to-value ratio drops below 80%.
4.A variety of mortgages are available to meet the needs of most borrowers. The graduated-payment mortgage has low initial payments that increase over time. The
growing-equity mortgage has increasing payments that cause the loan to be paid off in a shorter period than a level-payment loan. Shared-appreciation loans were used when interest rates and inflation were high.
The lender shared in the increase in the real estate’s value in exchange for lower interest rates.
5.Securitized mortgages have been growing in popu- larity in recent years as institutional investors look for attractive investment opportunities. Securitized mort- gages are securities collateralized by a pool of mort- gages. The payments on the pool are passed through to the investors. Ginnie Mae, Freddie Mac, and private banks issue pass-through securities. Securitized mort- gage securities separate the lending risk from the lender and lead to increasing risky loans.
6.Subprime loans increased in volume from being a neg- ligible portion of the mortgage loan volume in the 1990s to 17% by 2006. Zero-down loans along with underqualified borrows led speculative growth in home prices and a subsequent collapse when default rates and lack of real demand became public.
K E Y T E R M S
amortized,p. 324 balloon loan, p. 324
collateralized mortgage obligation (CMO),p. 338
conventional mortgages, p. 330 discount points, p. 325
down payment, p. 328 FICO scores, p. 329 insured mortgages, p. 330 lien,p. 327
mortgage,p. 324
mortgage-backed security, p. 336
mortgage pass-through, p. 336 private mortgage insurance (PMI),
p. 328
reserve accounts, p. 334 securitized mortgages, p. 336 subprime loans, p. 338
