Yale School of Management 1 Emergence of the U.S. Mortgage Market and its Impact on Economic Growth Zhiwn Chen Professor of Finance Yale School of Management

2 Issues to consider From 1960s to 90s, exports stimulated economic development in Japan, Korea, Singapore, Hong Kong and Taiwan. Same for China in recent years. While those countries or regions have to export due to lack of domestic demand, some other countries must have demand surplus. Then, why is the US domestic demand been so high?

Yale School of Management 3 The importance of simple financial instruments, e.g., mortgage loans Manufacturers Consumer Banks Savings Product Demand Salary Income Export

Yale School of Management 4 What does the Residential Mortgage tell us? China’s Total Outstanding Amount of Residential Mortgage (RMB 100MM)

Yale School of Management 5 Residential Mortgage amounts to “Securitizing one’s future income flow”

Yale School of Management 6 The U. S. Experience Prior to the 19 th century, the United States was mostly an agricultural society. After WWII, the United States became the No.1 Super Power One of the primary reasons: Part of the growth power came from financial innovations, Social Security Innovation, starting from 1934.

Yale School of Management 7 Figure 3: The US individual savings Rate

Yale School of Management 8 Development of the Mortgage Market Residential Mortgage had been one of the standard services since the beginning of banks. However, before 1930s, the term of Residential Mortgage was capped by 5 years. The mortgage payment structure was also flawed. For example, prior to maturity, the borrower only needed to pay the incurring interest. At maturity, the borrower would pay the total principle. “Balloon loans” With such a structure, banks would take on huge risks, hence less willing to make loans. The borrower faced too much lump-sum payment pressure.

Yale School of Management 9 Stock Market Crash in October 1929 During the stock market boom in 1920’s, many individuals bought big houses with large mortgages. But, after the 1929 crash, companies went bankrupt, and unemployment reached historical high (25%). Many households could not repay the “balloon” at mortgage maturity. Then many banks and lending institutions went bankrupt. Therefore, the “balloon” structure of mortgage loans exaggerated the economic / financial crisis. Crisis: not many banks willing to lend mortgages

Yale School of Management 10 The Crisis led to “New Deal” Legislations Including:  Securities Act of 1933  Securities Exchange Act of 1934  Banking Act of 1933 (Glass-Steagall Act)  Social Security Act of Revitalizing the housing market: the “Federal Housing Act of 1934”

Yale School of Management 11 Federal Housing Act of 1934 led to the Federal Housing Administration (FHA) FHA provided mortgage insurance to low and mid income families.  Max mortgage term increased from 5 years to 30 years ；  Low and mid income families could buy houses when starting a family Generally, the longer the mortgage, the less payment pressure, and the more beneficial for consumption demand and hence for economic growth.

Yale School of Management 12 Starting a Secondary Mortgage Loan Market In 1938, the Federal National Mortgage Association (Fannie Mae) was created to increase the liquidity of mortgage loans. Its role was to make a secondary market: buy mortgages from banks and other financial institutions who make loans. Very important: banks then don’t have to worry about outstanding mortgages or their liquidity, after lending the mortgages. This encourages banks to make more loans.

Yale School of Management 13 Mortgage-Backed Securities In 1970, Government National Mortgage Association (Ginnie Mae), a entity spun off from Fannie Mae, started to issue Mortgage Backed Securities. It pools together various mortgages from different regions, and then issues securities to general public and institutional investors. This was the first securitization innovation. It significantly increased the supply of mortgage loans. Not only reduces borrowing costs for homeowners and increased mortgage availability, but also provides banks with better risk diversification and better liquidity.

Yale School of Management 14 Figure 4: Outstanding Amount of Mortgages in the US US$ 100MM US$ bn

Yale School of Management 15 Figure 5: Home Ownership in the US

Yale School of Management 16 Interest Rate Risk The extension to 30 years of mortgages brought risk for banks, because, until 1980’s, mortgages had only fixed-rates. Reason: what the bank lends to mortgage borrowers is money from depositors. The bank pays interest to depositors, which is a cost to the bank, while interest payment by mortgage borrowers is income to the bank. The difference is the bank’s earnings

Yale School of Management 17 Bankruptcy Risk for Lending Institutions Deposits normally are short term, whereas the mortgage are longer term. There is a huge duration difference between the bank’s liabilities and assets. This leads to high bankruptcy risk. An example:  In 1971, a 30-year $200K mortgage had a fixed rate of 6%.  In 1981, deposit interest rate was up to 16%.  The bank would pay out 16%, but receive only 6% from the earlier mortgages.  The loss in 1981 was 16%-6%=10%. Then, many banks bankrupted in 1980s.

Yale School of Management 18 More Financial Innovations Beginning in 1981, floating-rate mortgages started. Home buyers could choose among 1-year, 3-year or 5- year floating rates. High interest-rate volatility in the late 1970s laid foundation for another financial innovation: In 1983, The Chicago Board of Trade (CBOT) introduced long- and mid-term interest-rate futures, followed by interest rate options. These innovations once again made it easier for lending institutions to hedge interest rate risk.

Yale School of Management 19 Outstanding Auto Loans in the U.S. US$100MM

Yale School of Management 20 Of course, mortgage loans alone cannot relieve all of residents’ saving pressure Consumers will be unwilling to spend if there is no health insurance, unemployment insurance and social security fund. In countries with under-developed financial markets, consumers have no choice but rely on bank savings accounts to “insure against future risks.” But, bank savings is a very inefficient way to achieve “risk insurance”.