 Learning Objectives  Identify how the residential mortgage market supplies credit for individuals and families to build and buy homes Understand the problems faced by lenders in designing new home loan contracts that will protect them against inflation, economic recession, and other risks Consider how federal government agencies and government-sponsored mortgage firms support the development of the market for mortgage loans

Introduction Among the fastest growing of all financial markets today is the residential mortgage market, where individuals and families fund their purchases of homes. Originally a simple market that was primarily local and regional in character, the residential mortgage market has become an international capital market where home-mortgage-related instruments are traded around the globe

Recent Trends in New Home Prices and the Terms of Mortgage Loans Housing market is counter-cyclical: Refinance homes Use proceeds to increase spending Lessen downturn severity Conventional home mortgage loan: Not guaranteed by the government: Lender bears default risk Often have private insurance Secured loan Also mortgages through government agencies

Recent Trends in New Home Prices and the Terms of Mortgage Loans Relatively low home-mortgage loan rates: Average rate is about 6% on conventional mortgages About 2/3 of households own their own dwelling Record-high home prices prior to the credit crisis of 2007-2009: Average home price had more than doubled in the past two decades Average maturity of a conventional home mortgage is now close to 29 years

Recent Trends in New Home Prices and the Terms of Mortgage Loans

Structure of the Mortgage Market Residential mortgage: Loans secured by single-family homes Also includes other dwelling units Nonresidential mortgage: Loans secured by business and farm properties Less than one-fifth of mortgages outstanding Total value outstanding is approached $15 trillion

Structure of the Mortgage Market

Structure of the Mortgage Market

Mortgage Lending Institutions Most mortgages generate multiple potential cash-flow streams: Origination & commitment fees (when a mortgage loan is first applied for) Periodic loan repayments & loan interest Compensation for prepayment & default risks Service fees associated with collecting & recording amounts owed Net returns & fees from the securitization of a pool of mortgage loans

Mortgage Lending Institutions

Mortgage Lending Institutions A mortgage loan may be: Held in the originating lender’s portfolio: Earns the promised payments Sold to an investor: At a discounted value The originating lender may retain servicing rights Packaged with other, similar mortgage loans: Into a pool The lender receives residual interest income (and servicing fees)

The Roles Played by Leading Financial Institutions Savings and loan associations (S&Ls): Predominantly local lenders Often service the mortgage loans they made Commercial banks rank first as lenders: For purchases of homes, condominiums, and apartments For commercial mortgages Savings banks invest in: Government-guaranteed loans Conventional mortgage loans

The Roles Played by Leading Financial Institutions Life insurance companies make substantial investments: Commercial as well as residential mortgage properties Both nationally and internationally Moving more toward commercial and apartment mortgages with “equity kickers” Mortgage banking houses: Act as a channel for builders or contractors Meet their working capital needs

Government Activity in the Mortgage Market Major milestones include: 1932: Federal Home Loan Bank System: Supervised thrifts Extended loans to thrift institutions that were threatened with collapse by bank runs Spurred more affordable mortgage loan rates 1934: National Housing Act, Federal Housing Administration (FHA): The FHA was authorized to guarantee repayment of home loans up to some amount Helped develop standardized mortgage loans

Government Activity in the Mortgage Market 1938: Federal National Mortgage Association (Fannie Mae): Chartered for buying and selling FHA-guaranteed loans Encouraged private lenders to make FHA loans 1944: Servicemen’s Readjustment Act, Veterans Administration (VA): Designed to aid military personnel returning to civilian life Offered to insure mortgages to lower rates 22-16

Government Activity in the Mortgage Market 1968: Government National Mortgage Association (Ginnie Mae): Pass-through mortgages Popular with investors Safe, marketable securities with good returns 1970: Federal Home Loan Mortgage Corporation (Freddie Mac): Mortgage participation certificates (PCs) Guaranteed mortgage certificates (GMCs) Collateralized mortgage obligations (CMOs) And others including REMICs

Government Activity in the Mortgage Market Development of various types of securitized mortgages: Made mortgage securities more competitive with government and corporate securities Allowed many mortgage lenders to expand into the national and international capital markets New financial instruments have also increased the sensitivity of mortgage interest rates to national and international market conditions

Innovations in Mortgage Instruments Fixed-rate mortgages have fluctuating value: Fluctuates as interest rates change Also bias toward refinancing rates when interest rates drop Made banks very interest rate sensitive: Many of their liabilities are interest-rate sensitive Higher interest rates tend to increase liability payments while income is fairly fixed

Innovations in Mortgage Instruments This problem with fixed-rate mortgages (FRMs) led to new developments: Variable-rate mortgages (VRMs): Permit the lender to vary the rate on a mortgage loan as market conditions change Typically linked to a reference rate that is out of the direct control of the lender Adjustable mortgage instruments (AMIs): Maturity date may be altered The interest rate and monthly payments may be altered as well

Innovations in Mortgage Instruments Interest-only mortgages: Offer borrowers the option of only paying the interest on their home mortgages Doing so does not reduce the principle of the loan Reverse-annuity mortgages (RAMs) have been developed to help older families: Income to those who have paid off their mortgage Paid a monthly annuity as a portion of the property value Secured by an increasing mortgage

Innovations in Mortgage Instruments Option adjustable-rate mortgages: Designed to bring otherwise unaffordable home purchases within reach of more borrowers Choose among different mortgage payment plans each month There is a principal cap Even with all the new mortgage instruments, fixed-rate mortgages (FRMs) continue to hold a major share of the residential loan market: Primarily because consumers prefer transparency in financing

Pricing and Other Issues in Home Mortgage Lending 10-year U.S. Treasury bond rate is a key reference: Used by many mortgage lenders Determines the appropriate loan rate on new home loans A comparison of recent 10-year T-bond yields to home mortgage contract rates: Mortgage rates move closely with T-bond rates Maintain a yield spread of about 1.5 to 2 percentage points between them

Pricing and Other Issues in Home Mortgage Lending

Mortgage Lock-Ins, Loan Modifications, and Foreclosures Protect borrowers from an increase in loan rates during the house-buying process Usually 30 to 60 days Many lock-ins allow a ‘float down” option: Costs extra If rates fall before closing, the contractual mortgage rate will fall as well Sometime the lender will “give a little” even without a float down Bank does not want to lose customer

Mortgage Lock-Ins, Loan Modifications, and Foreclosures Lender takes possession of home and sells it to recoup mortgage Have increased greatly in number in the U.S. since the start of the 2007-2009 credit crisis Loan modification agreements: Alternative to foreclosure Aid troubled borrowers in avoiding foreclosure Add missed payments to principal Often stretch out payments

Refinancing Home Mortgages Many homeowners choose to refinance: Market interest rates fall House values increase The ability of a homeowner to refinance depends upon two factors: A strong credit history A significant amount of accumulated equity built up in the home to be refinanced Refinancing also works to transfer the burden of the mortgage to a latter date

Predatory Lending Some lenders appear to attempt to mislead and take advantage of borrowers: High-cost loans (subprime loans) Often their home are pledged as collateral The exploited borrowers are typically poorly informed and less educated The current debate on such predatory loans centers on two issues: Distinguishing predatory from legitimate lending practices Protecting the most vulnerable consumers

Markets on the Net Federal National Mortgage Association at www.fanniemae.com Get Smart at www.getsmart.com Government National Mortgage Association at www.ginniemae.gov The Guardian at www.guardian.co.uk/money Houses4sale-Online.com at www.houses4sale-online.com HSH Associates Financial Publishers at www.hsh.com

Markets on the Net InvestorWords.com at www.investorwords.com Lending Tree at www.lendingtree.com Mortgage Bankers Association at www.mbaa.org Mortgage Professor’s Web Site at www.mtgprofessor.com MortgagesInCanada.com at www.mortgagesincanada.com Federal Citizen Information Center at www.pueblo.gsa.gov CME Group at www.cmegroup.com

Markets on the Net U.S. Census Bureau at www.census.gov U.S. Department of Housing and Urban Development at www.hud.gov U.S. Department of Veterans Affairs at www.va.gov Access Mortgage Research & Consulting at www.wholesaleaccess.com Federal Deposit Insurance Corporation News at www.fdic.gov/consumers/consumer/news Federal Home Loan Mortgage Corporation at www.freddiemac.com

Chapter Review Introduction to the residential mortgage market Recent trends in new home prices and the terms of mortgage loans The structure of the mortgage market Volume of mortgage loans Residential versus nonresidential mortgage loans Mortgage lending institutions

Chapter Review The roles played by leading financial institutions in the mortgage market Savings and loan associations Commercial banks Life insurance companies Savings banks Mortgage bankers

Chapter Review Government activity in the mortgage market The impact of the Great Depression on government involvement in the mortgage market Launching the Federal Home Loan Bank system Setting up the Federal Housing and Veterans Administrations (FHA and VA) The creation of Fannie Mae (FNMA) The creation of Ginnie Mae (GNMA) The Federal Home Loan Mortgage Corporation (FHLMC)

Chapter Review Innovations in mortgage instruments Fixed-rate home mortgages Variable-rate and adjustable mortgage instruments Convertible mortgages Interest-only mortgages Reverse-annuity mortgages

Chapter Review Pricing and other issues in home mortgage lending Pricing home mortgages and the treasury security market Mortgage lock-ins, loan modifications, and foreclosures Refinancing home mortgages Predatory lending