Since most people do not have the means to buy their homes outright, they rely on mortgage loans. Mortgage markets are markets where mortgage loans are made to buy buildings and houses. They are originated in primary markets and traded in secondary markets.
Mortgage loans are generally divided into agricultural loans, nonagricultural loans, nonresidential loans, which include commercial real estate, and residential real estate loans. Residential mortgage loans are generally divided into loans for multifamily properties and loans for one- to four-family properties.
Residential mortgages account for the largest share of outstanding mortgage debt and are therefore highlighted in this text. Because developments in residential mortgages contributed to the recent financial crisis, we now discuss the fundamentals of mortgage markets.
Mortgage loans are government-insured or conventional mortgages. If a borrower defaults on his or her mortgage, government insurance guarantees repayment of the loan to the bank that originates the mortgage loan.
The Federal Housing Administration (FHA) and the Veterans Administration (VA) provide insurance for FHA and VA mortgage loans. Lenders originating conventional mortgage loans may assume the risk of borrower default or purchase private insurance to protect against borrower default.
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Types of Mortgages and Mortgage-Backed Securities
The purchase of houses in the United States traditionally has been financed with a fixed interest rate, and long-term loans. A fixed-rate mortgage typically has a fixed interest rate and constant monthly payments over the life of the loan, which is typically 15 or 30 years. A loan that is repaid in equal payments over a specified time period is referred to as an amortized loan.
The traditional fixed-rate residential mortgage loan also required a sizeable down payment, typically 20 percent of the house purchase price, at the time the loan was made.
Holders of fixed-rate mortgages benefited by knowing that their monthly mortgage payment would not change over the loan’s life, and thus they could plan and budget for the contractual monthly payment amounts.
As a result, the default rate, or failure to make timely periodic payments, was low on fixed-rate mortgage loans. However, the benefits of fixed-rate mortgages were offset, in part, by the fact that only a portion of the U.S. population could qualify to purchase their own houses.
During the past couple of decades, a period of generally high fixed-rate mortgage loan interest rates and a time in which it was desired to extend housing ownership to more individuals in the United States, the use of adjustable-rate mortgages grew.
Adjustable-rate Mortgage (ARM)
An adjustable-rate mortgage (ARM) has an interest rate that changes or varies over time with interest rates set by the market based on a U.S. Treasury bill or other debt instruments.
The interest rate on an ARM is often adjusted annually to reflect changes in U.S. Treasury rates (or other interest rate benchmarks). In addition, lenders typically offer ARMs with floating interest rates for one to five years, with the option to change to a fixed rate during the remaining term of the ARM.
Because ARMs typically offer lower initial interest rates and lower monthly payments, more individuals may qualify to purchase a home. However, due to potential changes in market-determined interest rates and potential conversions to fixed rates, individuals who were initially able to make low monthly mortgage payments may no longer be able to make their mortgage payments if interest rates are adjusted upward.
Mortgage loans are originated in the primary mortgage markets by mortgage brokers, mortgage companies, and financial institutions, which include banks, savings and loan associations, savings banks, and credit unions.
Mortgage brokers and mortgage companies generally sell the mortgage loans they originate in secondary mortgage markets. Commercial banks, which are the predominant type of depository institutions that originate mortgage loans, either hold and collect periodic payments from borrowers on the loans they originate or sell the loans in the secondary mortgage markets.
In some instances, banks and other mortgage lenders “pool” together loans they originated into securities. Other financial intermediaries “repackage” mortgage loans into securities. Securitization is the process of pooling and packaging mortgage loans into debt securities.
A mortgage-backed security is debt security created by pooling together a group of mortgage loans whose periodic payments belong to the holders of the security. Some mortgage-backed securities “pass-through” the interest and principal payments to the owners of the securities. Payments on the underlying mortgages are made to the financial institution that created the mortgage-backed security.
The institution, in turn, pays or passes through the payments to the investors or owners of the securities. In some mortgage-backed securities, the issuer separates or “strips” the interest and principal payment streams into separate securities. Cash flows from interest and principal payments are dependent on continued mortgage payments by the borrowers on the underlying mortgage loans.
The uncertainty of mortgage payments is further increased when mortgages are prepaid during periods of declining interest rates.
Credit Ratings and Scores
A credit rating indicates the likely likelihood that a borrower will miss interest or principal payments and possibly default on its debt obligation in the form of a loan, mortgage, or bond. Credit ratings are issued by private organizations to individuals, financial institutions, businesses, and government entities.
A credit rating for an individual is usually expressed in terms of a credit score, a number that indicates a person’s creditworthiness or the likelihood that a debt will be repaid according to the terms originally agreed upon.
The credit score reflects an individual borrower’s ability to pay, character, and collateral to the lender. Some borrowers may be able to pay, but may not be trustworthy enough to be sure they will pay.
Credit scores are based on an individual’s credit history as reflected in credit reports (e.g., payments on credit cards, auto loans, mortgages) and public records (e.g., bankruptcies, tax garnishments).
There are many different credit scoring systems, all of which attempt to distinguish between high, moderate, and low-quality borrowers. For example, a credit scoring system may range from 500 to 1,000 points in 100-point increments.
Mortgage loans made to borrowers with credit scores above 700 points may be considered prime mortgage loans.
A prime mortgage is a home loan made to a borrower with a relatively high credit score, indicating a relatively high probability that mortgage payments will be made when due. The higher the credit score, of course, the higher the borrower’s credit rating, with scores above 900 representing the highest credit rating.
Mortgage borrowers with credit scores of 700 or less, for example, might be considered subprime borrowers.
A subprime mortgage is a home loan made to a borrower with a relatively poor credit score, indicating a higher likelihood that the borrower will be unable to make the mortgage payments due.
Mortgage lending to subprime borrowers is a risky business in that an event such as an economic downturn in the form of a recession could result in a large percentage of subprime borrowers being unable to make their mortgage payments and even defaulting on their home loans.
Major Participants in the Secondary Mortgage Markets
Banks and other financial institutions originate mortgage loans and sometimes package mortgages to create mortgage-backed securities that often are sold in the secondary mortgage markets.
Also, the federal government has played an active role in the development of secondary mortgage markets. The Federal National Mortgage Association (Fannie Mae) was created in 1938 to support the financial markets by purchasing home mortgages from banks so that the resulting funds could be lent to other borrowers.
The Government National Mortgage Association (Ginnie Mae) was created in 1968. Ginnie Mae issues its own debt securities to obtain funds that are invested in mortgages made to low-to-moderate-income home purchasers.
The Federal Home Loan Mortgage Corporation (Freddie Mac) was formed in 1970 to purchase and hold mortgage loans. Freddie Mac acquired both prime mortgages and subprime mortgages over time.
Ginnie Mae and Fannie Mae issue mortgage-backed securities to fund their mortgage purchases and holdings. The securitization of mortgage loans by pooling and packaging the loans into mortgage-backed securities by Ginnie Mae and Fannie Mae aided in the development of the secondary mortgage markets.
As default rates on mortgage loans and mortgage-backed securities increased sharply after the housing price bubble burst, both Ginnie Mae and Freddie Mac suffered liquidity problems. In mid-2008, in an effort to avoid a financial meltdown, the Fed provided rescue funds for both Ginnie Mae and Freddie Mac, and the federal government took over control of both organizations.