Historical Perspective on Mortgages

(Today's post is a bit long, but well worth it if you're trying to get a better grasp on the history, risk, and potential repurcussions of the housing/mortgage crisis).

The American Mortgage in Historical and International Context is a great 22-page University of Pennsylvania paper (written in 2005) on the history of mortgages in the 20th century, along with some comparisons between the American mortgage market and mortgage markets in select First-World nations. This is not a housing-bubble paper, it's more a defense of the role of government-backed lending. Still, it's a great read for perspective on the mortgage market, and some of the historical risks and benefits of the structure of the American mortgage market. There is also an explanation (perhaps a bit too technical, but I found it almost comprehensible) of how mortgages are securitized.

Prior to the Great Depression, "Home mortgages typically had very low loan-to-value ratios of 50 percent or less and thus did not, by themselves, place substantial stress on lenders, because when borrowers were short of cash, their property could be sold if necessary to redeem their loan. But during the Great Depression in the early 1930s, property values in the United States declined by 50 percent relative to peak values. Holders of these mortgages, knowing their positions were insecure, refused to refinance loans that came due; as a result, borrowers defaulted, having neither the cash nor the home equity necessary to pay the loans back. A wave of foreclosures resulted—typically 250,000 per year between 1931 and 1935. At the worst of the Depression, nearly 10 percent of homes were in foreclosure. Financial institutions would in turn attempt to resell the properties that they repossessed, which placed even further downward pressure on the housing market.

In response to these calamities, the federal government began intervening in the housing finance market."

Some relevant points in the paper:

Securitization (selling mortgages to investors as securities) allows for long-term, fixed rate loans. Without securitization, mortgages are made by banks, who have short-term, rate-sensitive deposits and are less willing to sell long-term, fixed rate loans because of the rate risk (and the Savings and Loan crisis was partly precipitated by the fact that S&Ls were making long-term, fixed rate loans from short-term deposits at a time when interest rates were rising).

Fixed-rate loans provide macroeconomic stability, because homeowners can plan their budgets long-term. Adjustable-rate loans create instability, particularly in housing, but also in the broader economy because housing is such a large portion of the consumer's budget and the nation's GDP.

Banks and thrifts were the traditional savings vehicle for Americans through much of the 1900's, but that began to change in the late 60's as mutual funds and money market funds became available to the average saver. Since bank deposits were a major source of mortgage funding, this shift in savings vehicles was a problem for mortgage banks - especially since savers were transferring funds from banks that had already made mortgage loans at low rates. Rising interest rates in the 70s became a major factor in the failure of S&Ls that were carrying low-rate, long-term mortgages.

80% Loan-to-Value, 30-year fixed mortgages are almost peculiarly American, owing largely to our system of letting the government guarantee many mortgages. In most countries, loan terms are shorter, rates are variable, and loan-to-value ratios are lower (although some countries have 100% - or more - financing available).

The shape of America's mortgage market is a direct result of the Great Depression. Government lending organizations were created during the Depression to rescue borrowers in foreclosure. Fixed rates and long repayment terms were designed to take the short-term, adjustable rate loans that the borrowers couldn't afford, and make it have a payment they could afford to pay. Extending the payment period from the then-traditional 5-year term to what I imagine was unimaginably long repayment term of 20 years, allowed people to stay in homes they could not afford under their original mortgage contract. (What could the government possibly do today for Option-ARM borrowers, that would lower their payments as much as the Depression-era mortgage bailout of quadrupling mortgage terms?)

Some interesting quotes from the paper (with my comments in italics and some key quotes bolded for emphasis):

"By the end of 2003, Fannie and Freddie either guaranteed or held more than $3.6 trillion of mortgages, or about 60 percent of the market in which they are allowed to participate and 43 percent of the overall market." So, in 2003, the mortgage market was approximately $8.4 Trillion dollars.

"The adjustable-rate mortgage (ARM) share of applications generally fluctuates with the yield curve: as the yield curve steepens, the ARM share increases, as the cost of ARMs drops relative to fixed-rate mortgates. The recent increase in the share of ARMs to a 10-year high of 36 percent, coupled with a flat yield curve, is anomalous, which raises questions as to its origin. Many variants of traditional ARMs have also been recently developed such as hybrid instruments, interest only loans and option ARMs, which allow negative amortization. Affordability pressures in some markets may be at work." Remember, this paper was published in 2005.

"Mortgages with a 110 percent loan-to-value ratio are possible, although risky, if they are underwritten as though they are consumer loans with the home as additional collateral." (If I interpret this correctly, they're saying that high-loan-to-value loans should be underwritten like unsecured consumer loans, with careful scrutiny of the borrower's ability to pay, rather than the home's ability to appreciate into adequate collateral. In other words, >100% LTV loans should only be offered to the most creditworthy borrowers. As I understand it, most recent 100%/125% loan-to-value mortgages were NOT underwritten as consumer loans, but, instead, were often offered to subprime and ALT-A borrowers, even as no-documentation and low-documentation loans. This would be extremely risky.)

"Funneling lower-than-market rate financial capital raises the risk that society will invest an inefficiently high amount in housing, and also that the risks of that investment are being underpriced by the market." (Like 2% "teaser" rates?)

"Indeed, in our view, one key to the array of choices being offered to mortgage borrowers is that, because of the funding advantage of Fannie Mae and Freddie Mac, low-risk borrowers are offered an appealing contract so they will participate in the same mortgage pool as higher-risk borrowers. Otherwise, higher- and medium-risk borrowers might face a very different menu of mortgage options than lower-risk borrowers."

"Finally, during periods of financial duress, the risk-based differentials would increase in the absence of mortgage-backed securities, which provide a safe haven for investors. For example, in the immediate aftermath of the 1997–1998 financial crisis and in the aftermath of 9/11, interest rate spreads related to risk widened for many corporate bonds, but the risk spreads of Fannie and Freddie securities changed very little. Similarly, in the wake of the Long-Term Capital Management financial crisis in of 1998, volumes in many debt markets fell dramatically, while they did not do so in the residential mortgage market." Government-backed mortgage securities have been a safe-haven for investors in financial crises when they don't know where else to park funds while the crisis resolves. Today, mortgages ARE the crisis.

"Perhaps most important, an entirely private market could well become one that led to an increased reliance on adjustable-rate mortgages. Work from the IMF (2004)—along with the fact that household balance sheets would be mismatched in an adjustable-rate mortgage heavy world—suggests that such an outcome could lead to macroeconomic instability." (Does this explain the introduction of "crazy" ARMS during the housing bubble, as home prices in some areas exceeded the caps on government-backed mortgages? Certainly a major driver of buyers taking ARMS and exotic ARMs was low initial payments, but perhaps mortgage companies rolled out exotic ARMs to entice borrowers into loans that didn't put lenders at risk of rising interest rates. Interest rates during the bubble were at historic lows as the economy expanded - it was a virtual certainty that rates would increase thereafter. Borrowers and lenders had opposite self-interests: buyers should have taken out fixed-rate loans while lenders wanted adjustable rates. Teaser rates and low initial payments were a compromise.)

"The implicit government guarantees for Fannie Mae and Freddie Mac create moral hazard problems; that is, risky loans may be made in the assurance that the government will not allow a default to occur."

"The International Monetary Fund (2004) pointed out that as more variable-rate mortgages are used to finance housing, the more volatile is the housing market, which can induce the credit risk that raises the chance of a systemic failure. Similarly, an illiquid housing market could lead to falling housing prices, which can increase credit risk, which could induce systemic failure."

If you are an investor, homeowner, homebuyer, or taxpayer trying to better understand the mortgage market and the economic risks related to today's mortgage crisis, I cannot recommend this paper highly enough. It's only 22 pages, a bit technical in some places, but overall very readable, and the information is extremely valuable for putting today's mortgage situation into context.