Lecture 8 Outline

Mortgage Market S&Ls and crisis Credit Unions Commercial banks Mortgage banks Risks Mortgage brokers Mortgage insurance Secondary market Fannie, Ginnie and Freddie

Mortgage Market
Mortgage debt outstanding in US (2005):
Residential = $9.1tr
Compared to $20tr of total residential market value

Apartment buildings = $647bn Commercial = $1.8tr Farm = $151bn

Savings and Loans (Thrifts)

Get money from local depositors
Governments provide deposit insurance

Lend locally
Primarily for residential mortgages

Dominated mortgage lending prior to 80s Severe asset-liability mismatch:

Borrow short-term, lend long term through FRM

S&L Crisis
Late 70s: Inflation + tight monetary policy
Send interest rates higher Big S&L losses due to asset-liability mismatch

Compounded by bad investments

Deposit insurance encouraged overly risky loans

1300 thrifts failed, costing taxpayers $50bn Fallout:

Regulation: Risk-based capital requirements Industry consolidation Interest rate risk management

Credit Unions
Credit union: Financial institution owned and controlled by its members Canada: highest per capital use of credit unions in the world! Caisses Populaires Desjardins
6th largest financial institution in Canada Biggest in Quebec

Commercial banks
Take deposits
Insured by governments Make loans Short-term loans to corporations Construction loans Commercial mortgages Residential mortgages
Sell their FRM into secondary market

Home equity loans Line of credit to mortgage bankers

Mortgage bankers
Specialize in mortgage origination and servicing Originiation: creating the loan
Loan is sold into the secondary market

Servicing: collecting monthly payments, and remitting them to mortgage purchasers Where do they get their money?
Bit of equity But mostly: line of credit from a commercial bank

Mortgage banking risk

Borrowers can sometimes lock-in a fixed rate on their mortgages before the mortgage closes These mortgage commitments are in the lenders mortgage pipeline Pipeline risk: What happens if interest rates rise before the loans are sold into the secondary market?

Hedging mortgage banking risk

How do mortgage bankers hedge pipeline risk? Forward commitment:
Sell the loans forward to a secondary market participant at a predetermined price

But what happens if interest rates go down? Standby forward commitment:

Gives mortgage banker option, but not obligation to sell the loans Costs a premium

Servicing risk
Ignoring pipeline risk, how are mortgage bankers still exposed to changes in interest rates? How do they hedge against this risk?

Mortgage brokers
Mortgage broker:
specialized intermediary between borrower and lender Do not make loans themselves

Do they have fiduciary duties to the borrower?

Mortgage insurance
Mortgage insurance:
Insurance policy that compensates lenders in case of default Costs a premium: Can be paid by borrower or lender

Federal Housing Administration (FHA) insurance:

Founded in US after great depression to protect lenders, boost housing market, promote construction, employment

Veterans Affair (VA) insurance:

Insurance for war veterans in the US

Canada Mortgage and Housing Corporation (CMHC):

Provides mandatory insurance for loans where down payment is less than 20%

Secondary market
Prior to 70s: not well established
Main problem: lack of standardization across states Exception: Fannie Mae and FAH and VA loans

Lack of secondary market

Liquidity problem for originators Leads to higher required yields Inhibited flow of funds across geographic regions
Some areas have excess savings, other areas have excess borrowing needs

How does secondary market fix these problems?

Fannie Mae
Fannie Mae: Federal National Mortgage Association Established after great depression as secondary market for FHA and VA insured loans
But this was only a small segment of the mortgage market

In 1968: Fannie Mae mandate changes

Create secondary market for conforming loans Conforming: meets certain requirements
(example maximum size, no jumbo mortgages)

Ginnie and Freddie

Ginnie Mae: Government National Mortgage Association

Spin off of Fannie Mae in 1968

Maintain secondary market in FHA and VA loans

Freddie Mac: Federal Home Loan Mortgage Corp.

Created to compete against Fannie

Fannie, Freddie and Ginnie

Examples of Government Sponsored Enterprises