Financial Markets and Institutions (2-downloads)

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Part 5 Financial Markets

What Are Mortgages?

A mortgage is a long-term loan secured by real estate. A developer may obtain a mort-

gage loan to finance the construction of an office building, or a family may obtain a

mortgage loan to finance the purchase of a home. In either case, the loan is amortized:

The borrower pays it off over time in some combination of principal and interest pay-

ments that result in full payment of the debt by maturity. Table 14.1 shows the dis-

tribution of mortgage loan borrowers. Because over 81% of mortgage loans finance

residential home purchases, that will be the primary focus of this chapter.

One way to understand the modern mortgage is to review its history. Originally,

many states had laws that prevented banks from funding mortgages so that banks

would not tie up their funds in long-term loans. The National Banking Act of 1863

further restricted mortgage lending. As a result, most mortgage contracts in the

past were arranged between individuals, usually with the help of a lawyer who

brought the parties together and drew up the papers. Such loans were generally avail-

able only to the wealthy and socially connected. As the demand for long-term funds

increased, however, more mortgage brokers surfaced. They often originated loans

in the rapidly developing western part of the country and sold them to savings banks

and insurance companies in the East.

By 1880, mortgage bankers had learned to streamline their operations by sell-

ing bonds to raise the long-term funds they lent. They would gather a portfolio of

mortgage contracts and use them as security for an issue of bonds that were sold pub-

licly. Many of these loans were used to finance agricultural expansion in the Midwest.

Unfortunately, an agricultural recession in the 1890s resulted in many defaults. Land

prices fell, and a large number of the mortgage bankers went bankrupt. It became

very difficult to obtain long-term loans until after World War I, when national banks

were authorized to make mortgage loans. This regulatory change caused a tremen-

dous real estate boom, and mortgage lending expanded rapidly.

The mortgage market was again devastated by the Great Depression in the 1930s.

Millions of borrowers were without work and were unable to make their loan pay-

ments. This led to foreclosures and land sales that caused property values to collapse.

Mortgage-lending institutions were again hit hard, and many failed.

One reason that so many borrowers defaulted on their loans was the type of mort-

gage loan they had. Most mortgages in this period were balloon loans: The borrower

paid only interest for three to five years, at which time the entire loan amount became

due. The lender was usually willing to renew the debt with some reduction in prin-

cipal. However, if the borrower were unemployed, the lender would not renew, and

the borrower would default.

TA B L E   1 4 . 1

Mortgage Loan Borrowing, 2009