1. Fannie Mae Eases Credit To Aid Mortgage Lending
Late 2000’s Revisited
Review:
Fannie Mae Eases Credit To Aid Mortgage Lending
By STEVEN A. HOLMES
New York Times: September 30, 1999
WASHINGTON, Sept. 29— … the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.
The action … will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.
Effect of the Policy Change
Banks took advantage of the new policy providing mortgages to households who would not have received them previously. Let us call these households “less credit worthy” buyers.
Question: What type of mortgage would you expect these “less credit worthy” home buyers choose, fixed rate mortgages or graduated payment mortgages?
20 Year $200,000 Mortgage at a 10 Percent Interest Rate
Fixed Rate Graduated Payment
Payment for the first 7 years: $23,492 $20,000
Payment for the next 13 years: $23,492 $28,156
Answer: The “less credit worthy” home buyers chose graduated payment mortgages.

2. Answer: The price increased.
Question: How did this affect the market for new homes?
Market for New Homes P
Answer: The price increased. S D D Q
Question: What happens when the payment rises for the “less credit worthy” home buyers who have a graduated mortgage?
Graduated Payment
Payment for the first 7 years:
$20,000
Payment for the next 13 years:
$28,158
40%, increase
Answer: Some of these home buyers discovered a few years after purchasing their homes that they could not afford the higher payments required by their graduated payment mortgages.
Question: Was this really a problem?

3. Review: Graduated (Escalating) Payment Mortgages Graduated
Payment for the first 7 years ( ): $20,000
Payment for the next 13 years ( : $28,156
A $8,156, 40%, increase
Payment Balance Interest
This year (Year 0) 200,000
20,000
Year 7 20, ,000
Year 2 20, , ,000  20,000 = 200,000
Next year (Year 1) 20, , ,000  20,000 = 200,000
20,000
20,000
Question: Was this a problem for the “less credit worthy” home buyer between 2000 and 2007?
For example, consider a less credit worthy household that purchased a $200,000 home in 2007, but can’t afford the higher payment that will “kick in” in 2008.
Sell the house in 2007 for more than $300,000 and pay off the $200,000 mortgage balance.
Answer: No. Since home prices were rising a buyer could sell his/her home and have more than enough to pay off the mortgage.

4. Mortgage Backed Securities (MBS)
Bank A “Whole” Mortgages
Bank B “Whole” Mortgages
Mortgage Hunter
Mortgage Christin
Mortgage Haley
Mortgage Jayde
Mortgage Mateo
Mortgage Kate
A financial institution such as Fannie Mae, Bear Stearns, etc. buys a bunch of whole mortgages from “primary” lenders (banks).
Each share of the MBS represents a fraction of each mortgage that have been cobbled together into the MBS.
Fannie Mae, Bear Stearns, etc.
Cobbles a large number of these mortgages into a single Mortgaged Back Securities (MBS)
Splits the MBS into a large number of shares
Fannie Mae, Bear Stearns, etc. keeps some shares of the MBS for itself and sells others to private parties.
The owners of the MBSs earn income as the mortgages included in the MBS are repaid.
Private parties including banks and other financial institutions
Question: What would you expect the banks providing the loans to “less credit worthy” households to do with these “whole” mortgages?
Answer: Sell the “whole” mortgages to Fannie Mae, Bear Stearns, etc. who would create MBSs from them.

5. After 2007
The price of single family homes fell:
2007: $300,000
2011: $270,000
Question: What happens when the payment rises for the “less credit worthy” home buyers who have a graduated mortgage?
Answer: As before, some of these home buyers discovered a few years after purchasing their homes that they could not afford the higher payments required by their graduated payment mortgages.
Question: Was this a problem for the “less credit worthy” home buyer after 2007?
Answer: Yes.
2007: Less credit worthy households buys a $300,000 home with a graduated mortgage.
2011: Higher mortgage payments kick in and the balance of the mortgage is still $300,000.
But the price of the home has fallen to $270,000.
“Less credit worthy households” could not sell their homes for enough to pay off the mortgage.
These households defaulted on their mortgages and stopped making payments.
Eventually, they were eventually evicted from their homes.

6. Question: How were banks affected?
Question: How did the fall in home prices and the defaults accompanying them affect the MBSs held by banks?
Answer: When households stopped making their mortgage payments many MBSs could not make the payments that they promised and their values plummeted.
Question: How were banks affected?
Suppose the value of the bank’s MBSs fell by 30.
Bank A
Assets
Liabilities
Reserves 50
Deposits 500
Vault Cash 30
Borrowing 10
Dep at Fed 20
Two Types of Bank Crises: Liquidity and Solvency
Liquidity Crisis
Securities 100 70
Fractional reserve banking system
Stock&Bonds 60
Solvency Crisis: The bank’s net worth is negative.
MBSs 40 10
Net Worth = Assets  Liabilities
Loans 440
 What the bank owns and what others owe the bank 
What the bank owes others.
Christin 20
Net Worth = 590  510 = 80
The bank does not have enough assets to cover all its liabilities; that is, a bank does not have enough assets to pay everything that it owes others.
560 50
Question: How can a bank get into a solvency crisis?
The bank is bankrupt

7. American International Group
The effect of the MBSs defaults affect banks
Citigroup
Question: How did the default of the MBSs affect the stock of banks that had purchased the MBSs?
Answer: Since the net worth of these banks owning the MBSs would fall, the price of their stock would fall.
Citigroup was one bank that owned many MBSs.
The net worth of some banks fell below 0 and they were forced to declare bankruptcy: Bear Stearns and Lehman Brothers.
The effect of the MBSs defaults on insurance companies offering mortgage insurance
Many individuals and financial institutions that purchased mortgage backed securities (MBSs) also purchased mortgage insurance on these securities.
American International Group
Why?
Those who purchased MBSs didn’t really know what they were buying.
When the MBSs defaulted many insurance companies did not have the resources to make good on the promises their insurance policies made. Some had to declare bankruptcy.
American International Group (AIG) was one.

8. Consumer confidence and business confidence
Many homeowners were unable to make their mortgage payments 
Homeowners were evicted 
MBSs could not make their payments 
Banks teeter on bankruptcy  
Consumer confidence falls 
Business confidence falls
Question: How did the fall in consumer and business confidence affect the economy?

9. At a given inflation rate ()
Review: Business and Consumer Confidence
Claim: Changes in confidence shift the aggregate demand (AD) curve.
Increases in confidence shift the aggregate demand (AD) curve right.
Decreases in confidence shift the aggregate demand (AD) curve left.
FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy?
AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?
 (%)
 (%) FP
At a given inflation rate () AD
AD
r (%)
G&S
Consumer and/or business confidence decline
Households and/or firms purchase less
Fewer goods and services purchased
Aggregate demand (AD) curve shifts left   
 C and/or I down
 AD = C + I + G down

10. Question: Did the AD curve have to shift?
Late 2000’s
Unemp
Real
Actual Infl
Expected Infl
Govt
Productivity
Year
Rate (%)
GDP
Purch
Growth (%)
2006
3.1
2007
4.6
14,875
2.7
2,915
2008
5.8
14,835
2.0
2,995
0.8
2009
9.3
14,420
3,090
3.1
2.7
2.0
 (%)
Puzzle: The AD curve shift had to shift left. How could this occur when government purchases rose?
Next, the AD curve.
First, the AS curve.
AS2007
2007
3.0
AS2008
2.5
Question: Did the AD curve have to shift?
2008
2.0
Answer: Yes, left.
1.5
AS2009
AD2007
1.0
2009
AD2009
AD2008
GDP
14,400
14,600
14,800
15,000