Recent Developments in Mortgage Finance
By John Krainer
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As the U.S. housing market has moved from boom in the middle of the decade to bust over the past two years, the sources of mortgage funding have changed dramatically. The government-sponsored enterprises—Fannie Mae, Freddie Mac, and Ginnie Mae—now own or guarantee an overwhelming share of originations. At the same time, non-agency mortgage securitization and loans retained in lender portfolios have largely dried up.
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The period following the 2001 recession through 2006 is rightly called a housing boom. House prices and net borrowing by households surged in the early part of the decade, easily outpacing growth in household income. But, with the onset of the financial crisis and the failure of many mortgage market participants, access to mortgage finance declined dramatically. This Economic Letter summarizes some of the key ways that the mortgage market evolved during the boom years and during the ensuing housing market bust. It focuses on changes in the way loans were made and funded and how loan characteristics themselves changed.
Sources of mortgage finance
One of the distinguishing features of the U.S. housing finance system is the role played by the capital markets in funding residential mortgages (see Green and Wachter 2007). The direct link between housing finance and the capital markets is through securitization of home loans in various types of mortgage-backed securities (MBS). The pooling of mortgages into MBS permits the separation of loan origination and funding, as well as the transfer of risk. Also, depending on the type of MBS, securitization can facilitate the separation of credit risk—the possibility that borrowers default on their mortgages—and market risk, defined as changes in the value of a portfolio of mortgages as interest rates move and borrowers prepay. Securitization transforms relatively illiquid loans into highly liquid securities. In addition, pooling mortgages from different geographic regions serves as a way for investors to diversify away from shocks to local housing markets.
With the development of MBS and other types of structured financial products, banking institutions, including commercial banks, savings institutions, and credit unions, have slowly but steadily ceded market share to capital market investors in holding residential mortgage assets in portfolio. According to Federal Reserve flow of funds data, the banking institution share of total mortgage assets declined from a peak of about 75% in the mid-1970s to about 35% in 2008. Much of the decline in banking institution housing portfolios over this period was related to the expansion of the government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac, and Ginnie Mae. The GSEs purchase mortgages for securitization and guarantee MBS against credit risk.
Fannie Mae and Freddie Mac require that mortgages conform to certain standards to qualify for securitization. For example, mortgages must meet set size limits and underwriting guidelines. Ginnie Mae guarantees the repayment of principal and interest on MBS backed by federally insured loans, such as Federal Housing Administration (FHA) or Department of Veterans Affairs loans. Unlike Fannie Mae or Freddie Mac, Ginnie Mae is explicitly backed by the U.S. government.
Starting in the late 1990s, the GSEs’ near-exclusive hold on residential MBS issuance was challenged by so-called non-agency, or private-label, securities issued by brokerage firms, banks, and even homebuilders. Non-agency securitizations are conceptually very similar to agency securitizations. Lenders sell loans to an arranger, which then packages the loans, creates securities with claims to the cash flows of the loans, and sells the securities to investors (see Bruskin, Sanders, and Sykes 2000). However, in contrast to agency MBS, purchasers of non-agency securities are exposed to credit risk as well as market risk. Also, non-agency securitizations are more complex, involving many specialized parties. In recent years, securities were typically separated into tranches and structured to create different payoffs—more complicated arrangements than typical of agency securitizations. At its peak in late 2007, non-agency securitizations accounted for nearly 20% of outstanding mortgage credit.
An avalanche of research and commentary has examined why non-agency securitization grew so fast during the housing boom. One argument suggests that policymakers were worried that the GSEs were becoming too big and systemically important. These fears led to the imposition of caps on GSE portfolios, giving a boost to alternative sources of mortgage funding as the demand for housing finance boomed. Another story points to the decline in economic and financial market volatility that took place in the 1990s, especially in the first part of the decade. This phenomenon may have led to an increase in lending to previously marginal borrowers—a development that was probably not unique to mortgages but occurred in other asset markets as well.
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