Financial Markets and Institutions (2-downloads)

Conventional mortgages are 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

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Chapter 14 The Mortgage Markets

331

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 required in 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

is required and 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.

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Part 5 Financial Markets

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.

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Chapter 14 The Mortgage Markets

333

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.)

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Part 5 Financial Markets

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