June 7th, 2011 7:48 PM by Narbik Karamian
A Brief History of the Modern American Mortgage Market & Today’s Financial Crisis
September 22, 2008
Presented By:
Alan R. Fowler, CMB
SuSheila Dhillon, CMB
Brian Handal, CMB
EMG
Emerging Market Consulting Group
Powered by CMBs
A Brief History of the Modern American Mortgage Market and Today’s Financial Crisis
By Alan R. Fowler, CMB; SuSheila Dhillon, CMB; & Brian Handal, CMB
The United States mortgage market is undergoing an unprecedented restructuring, forced by a series of painful events to try to reinvent itself into something that can still meet the demands of at least a large portion of the home buying public. The repercussions of the chaos in the mortgage markets have been felt around the world. A surprisingly diverse group, including investors, financial institutions, hedge funds and homeowners worldwide are suffering the effects.
The inevitable question in the time of crisis is "who is to blame?" In this case, there are not enough fingers to point at the complicit partners. Suffice it to say that a perfect storm of events came together at the same time to cause a crisis, the final result of which may not be known for years, and may never be fully understood.
This essay is not an attempt to explain every aspect of the mortgage crisis and its resulting financial impact. There will be no answer to the age old question: "Which came first, the chicken or the egg?" What we will attempt to do is give some historical perspective to the crisis, and perhaps by understanding a few key points to the story, we can avoid some of the costly mistakes made in the past as we restructure the industry, and as other economies around the world look for guidance as they try to build their own mortgage industry.
We will begin with a historical timeline of key events in the modern history of mortgage finance in the United States. From it we will draw some conclusions and attempt to learn some lessons so that the industry can move forward, stronger than it has ever been.
1934
1938
Although Fannie Mae began with just $1 billion in capital, the agency helped usher in a new generation of American home ownership, paving the way for banks to loan money to low- and middle-income buyers who otherwise might not have had the means to buy a home.
Initially, Fannie Mae operated like a national savings and loan, allowing local banks to charge low interest rates on mortgages for the benefit of the home buyer. Fannie Mae would buy the closed loans from the bank and either hold them in their portfolio or sell them to private investors. They would typically hold about 20% of the loans in their own portfolio.
Fannie Mae acted to equalize mortgage supply and demand in capital rich and capital poor areas. For example, funds from well capitalized banks in New York could be used to fund loans in Kansas, where the banks had limited funds. For the first thirty years following its inception, Fannie Mae held a veritable monopoly over the secondary mortgage market.
1946
1949
1954
1966
1968
market for residential mortgages and to bring liquidity to all mortgage credit markets. In its new structure, Fannie Mae answered to the US Department of Housing and Urban Development (HUD).
Simultaneously, the government created a new corporation called the Government National Mortgage Association (GNMA or "Ginnie Mae"). Ginnie Mae took many of the "Special Assistance" functions of Fannie Mae and began insuring FHA and VA loans, along with other special government lending programs.
1969 –
1970
Fannie Mae formed a new Board of Directors, with 10 members elected by the stockholders and five appointed by the President of the United States.
Also that year, GNMA issued the first ever Mortgage Backed Security (MBS). GNMA pooled similar loans and issued securities on those pools to private investors. GNMA insured that the investors in the securities received their "Pass Through" amount from the security each month.
1972
1979
In the years to follow, more innovative products were designed to allow more people to qualify for mortgages. Some examples of these new products include Buy-Downs (where the seller subsidizes the borrower’s payments for a short period of time), Graduated Payment Mortgages (where the payment starts at a lower level and annually increased), Negative Amortization Loans (where the payment is less than the amount needed to amortize the loan, so the difference is added to the balance of the loan each month) and others.
1983
NOTE: Pass Through Securities
The advent of the Pass Through Security added a dramatic new level of liquidity to the mortgage market. Lenders that wanted to quickly sell their portfolio of loans had limited buyers up to this point. Loans could be sold to large financial institutions, insurance companies and pension funds, but this market was not considered to be very liquid. This presented huge risks to lenders holding the portfolios, especially in regards to the interest rate environment. Lenders, whose capital comes mostly in the form of short term deposits, were forced to hold long term loans. As rates rose, they were forced to pay higher interest to their depositors, but could not raise the rates on their long term mortgages outstanding. Therefore their interest expenses would increase without a corresponding increase in interest income.
The ability to quickly package and sell their loans in the form of a pass through security greatly diminished this risk. Investors liked the securities as well, because there was a liquid market where their interests could be bought and sold quickly and with relatively low cost.
GNMA, as a government agency, receives a benefit (i.e. lower borrowing costs) when raising funds by issuing debt against mortgages because they are backed by the full faith and credit of the US government. Fannie Mae and Freddie Mac have enjoyed a similar advantage. Although they are private companies, the market has assumed that their obligations would also be backed by the government (even though that backing was not explicit). That assumption turned out to be correct in September of 2008. Another benefit Fannie Mae and Freddie Mac received was reduced costs in the form of decreased tax burdens (they paid no Federal income tax) and lighter financial reporting requirements
1983-1987
During this time, the mortgage industry exploded with new companies, new structures and new employees. We saw the rise of mortgage lenders who strictly originated loans and then sold the loans and their servicing rights to another lender, who would then package the loans for sale into the secondary market (Correspondent Lending). Also, there was a huge increase in the number of Mortgage Brokers, who would originate loans on an independent basis for other
lenders (Wholesale Lending). The result was an increase in the number of layers between the borrower and the provider of funds. Many of those layers had little or no incentive to see that the borrower was able to stay in the home and have the ability to repay the loan in a timely manner, nor concern about the performance of the MBS asset being created.
Also during this time, foreign investors increased their appetite for American Mortgage Backed Securities. Asian investors, in particular, invested many of the dollars they had been receiving through their imbalanced trade with the US into the US MBS market, providing ample liquidity for the increased demand for mortgages.
1986-1995 -
April 10, 1987
1987
1988 –
1989 –
and governed by the Federal Home Loan Bank Board (later reorganized into the Office of Thrift Supervision). FIRREA severed Freddie Mac's ties to the Federal Home Loan Bank System, created an 18-member board of directors to run Freddie Mac, and subjected it to HUD oversight. Also, The US government conducted studies of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. These studies laid the foundation for comprehensive regulatory modernization for both Fannie Mae and Freddie Mac in 1992.
1990 –
1992 –
The government was criticized by many people for setting the capital requirements too low, as they were roughly 1/5
1992-1999 –
There was a strong push across the country to increase the homeownership rate. After a steady increase in that percentage after World War II, homeownership declined in the 1980’s (see Chart 2 in Appendix 1). The new goal was to increase homeownership in the US to 70%. The time seemed right for such a goal. Property values were steadily increasing, interest rates were relatively low, mortgage money was flowing through new and traditional sources, mortgage programs had never been more diverse, and there was a mortgage industry full of people eager to earn a good living by filling the need for homeownership. Lenders derived a
higher and higher percentage of their production through the wholesale and correspondent channels, and the number of mortgage brokers grew at a tremendous rate. Unfortunately, many people also entered the industry that saw it as an easy place to make profits at the expense of others. Their transgressions were often either overlooked or ignored because increasing property values and steady, low interest rates kept problems from becoming too obvious. "Subprime" mortgages, or loans to borrowers with credit that would not allow them to qualify for prime rate mortgage products, increased from $35 Billion to $125 Billion in this period, according to
During this time, many began to worry that the GSE’s had grown too large, were making too many profits at the expense of the rest of the industry, were encroaching into the primary market (which is against their charter) and were posing too great a risk to the American and world economy if they were to fail. There was not a great deal of confidence in OFHEO’s ability to effectively regulate Fannie Mae and Freddie Mac. A group of major lenders and financial services companies began a group called "FM Watch" to shed light on the practices of the 2 GSE’s that they felt were threatening to the industry and the economy.
1998 –
2000 –
HUD, in a new rule, identified subprime borrowers as a market that could help Fannie Mae and Freddie Mac achieve the affordable housing goals HUD had set for them. The GSE’s continued to stretch their criteria as far as higher LTV’s and lower credit scores, and bought an increasing number of securities backed by sub-prime loans.
September 11, 2001 –
2002 –
2003 –
Also in 2003, according to OFHEO, Fannie Mae and Freddie Mac issued a record $1.9 Trillion in Mortgage Backed Securities, had $1.5 Trillion of mortgages in their portfolios and had $2.05 Trillion in MBS outstanding. The 1.9 trillion in MBS represented 50% of all mortgage originated that year, according to OFHEO’s 2004 report to Congress. Of the $3.8 trillion in originations, fully 60% were refinances. All together, Fannie and Freddie guaranteed or held over $6 trillion in US mortgage debt. That year OFHEO also enforced action against Freddie Mac, forcing out and filing charges against its executive leaders, over an accounting scandal. In response, OFHEO also requested documents from Fannie Mae to investigate their accounting practices.
2004
OFHEO took administrative action against Fannie Mae, forcing out its executive management over another accounting scandal. Earnings of both GSE’s remained high, but their market share slipped because of the significant growth in the issuance of "Private Label" MBS with loans that would not fit into Fannie or Freddie purchase parameters because of product guidelines.
2004 – 2006
1)
Subprime loans: The rates on these loans, though higher than rates on prime loans, began to go down and be more attractive to borrowers. Also, qualifying criteria eased. Many borrowers did not have to verify income in order to qualify. Also, Loan-to-Value ratios increased to, in some cases, 100%.This brought millions of new borrowers into homeownership, and allowed many others to refinance their current residences and pull out the equity they had built.
2)
Alternative Documentation Loans – These loans were designed for self employed borrowers with complicated financial reports. Traditionally, these loans required borrowers to have excellent credit histories and low loan to value ratios. Those standards relaxed significantly during this period.
3)
80/20 loans. These loans allowed borrowers to avoid buying "Private Mortgage Insurance" (PMI) that was usually required on any conventional loan with an LTV above 80%. In this scheme, borrowers received an 80% first mortgage and a 20% second mortgage.
4)
Option ARM loans: these adjustable rate loans contained options to repay that ranged from paying the principal and interest to amortize in a normal period to paying interest only for a period, for example 10 years, to a very low payment that would not even cover the interest due each month. The shortfall in those cases was added to the borrower’s principal so that they owed more at the end of the month than they did at the beginning. Often these loans came with "teaser rates" or rates as low as 1% for a very short period of time.
Volume of these products was extremely high during this period, and their performance to thatpoint was good. Remember, however, that home prices were increasing rapidly, so if any of these borrowers did have trouble paying their mortgage, they were able to sell the home for a profit. Another alternative was for the borrower to obtain second mortgages against the new equity in their homes.
"Predatory Lending," where a borrower is approved for a mortgage regardless of whether they can afford the payments over the long term, often with rates and terms that are unreasonably high, became prevalent, especially among mortgage brokers. The lenders, in a frenzy to continue their increased profits, continued to buy the loans. Wall Street firms such as Bear Sterns and Lehman Brothers continued to securitize them as the rating agencies like Standard & Poor’s gave the securities good ratings.
The market share of the GSE’s slipped from over 50% to below 33%. The new HUD goal for low and moderate income lending became 55% of units. In order to meet this goal, the GSE’s expand their criteria even further by lowering credit score tolerances and increasing Loan-to-value limits. Also, they actively purchase mortgage portfolios that have loans that help meet their targets. Many of those loans were sub-prime. The GSE’s had also found that the return on the securities backed by sub-prime mortgages brought high returns, helping them increase earnings for their shareholders
Home prices increased in 2006 by 5.9%, according to OFHEO. During the summer of 2006, most areas saw their home values peak and start to decline.
March, 2007
August, 2007
The market share of Fannie Mae and Freddie Mac began to rise sharply as the alternative sources of mortgage capital dried up. At the same, according to Bloomberg.com, shares of Fannie Mae hit a high of $77 a share.
September 2007 – March 2008 –
Banks and other financial firms with exposure to mortgages began to see their stock prices fall and they are unable to sell off any of the mortgage assets, even the ones that were performing. The list of mortgage companies that failed grew into the hundreds. The largest mortgage company in the US, Countrywide mortgage, was sold to Bank of America after its stock price plummeted due to its heavy exposure to subprime and option ARM loans.
March 2008 –
July 11, 2008 –
July 30, 2008 –
September 5, 2008 –
September 15, 2008 –
September 16, 2008 -
September 19, 2008
Appendix 1: Charts and Supplemental Information
Interest rates, homeownership rates, home prices and the mortgage market:
Below is a chart of 30 year fixed mortgage rates from 1971 – 2008:
Chart 1
Chart 2
U.S. Homeownership Percentage, 1900-2008
The post depression boom in housing caused the rapid increase in homeownership between1940 and 1970. Rising inflation in the 1970’s and high interest rates in the early 1980’s slowed the increase and caused a short period of decrease in homeownership rates.(Chart 2) Note the peak in mortgage rates at 18.5% in 1982 (Chart 1) and the rapid decent of those rates through 2003. That sustained downward trend in interest rates caused the mortgage industry to, for the first time, create substantial income from refinancing mortgages. As rates dropped, people with higher rates refinanced into lower rates. The short spikes in rates during the 1982-2003 period served to make a market of homeowners who would again need to refinance when rates returned to their downward trend. They were easily able to do this because of the rapidly appreciating property values at that time (Chart 3).
The result was that the mortgage industry grew in size and sophistication. The number of loans that were securitized grew to mammoth proportions. The industry began to heavily rely on the refinance business for much of its profit and Wall Street began to rely on the product to satisfy investor demand.
Once rates leveled off in 2003, the regular refinance business slowed. Lenders and Wall Street came up with new products, or expanded the criteria for existing products, that would replace that volume. Subprime loans began to allow higher Loan-to-Value ratio and offer lower rates relative to prime loans. “Alt-A”, or loans that required little or no asset and income documentation, allowed many people who would not qualify for the inflated property values to obtain financing. Option ARM loans, that had very low initial rates but would allow significant negative amortization, became popular in the highest cost areas of the country, like California.
Falling values, which began in 2006, would expose the flaws in the system: Many people were in homes that they could not afford; they started with little or no equity; once values began to fall, many owed more than their home was worth and; security holders began to see defaults far beyond what they expected based on the risk levels assigned to them. This led to the closing or devaluation of many financial firms and caused a liquidity crisis in financial markets around the world due to the sheer size of the mortgage securities market, and its complexity.
Appendix 2