Autor: Francisco Jareño. Profesor Titular de Universidad – Dpto. de Análisis Económico y Finanzas
Some decades ago, US authorities were concerned with the access to the homeownership by US families, so United States was a country with one of the highest increase in the percentage of homeownerships.
Thus, firstly, a good definition of mortgage is necessary. According to Fabozzi (2004), “a mortgage is a loan secured by the collateral of specified real state property, which obliges the borrower to make a predetermined series of payments” and “gives the lender the right of foreclosure on the loan if the borrower defaults”.
Different protagonists began to act in the mortgage market: borrowers or debtors, Government Sponsored Enterprises (GSEs), lenders (financial institutions) or “mortgages originators” and, finally, mortgages insurers. In this context, some measures adopted by the US government encouraged people to purchase homes, such as the creation of Government Sponsored Enterprises (GSE): Federal National Mortgage Association (Fannie Mae), Federal Home Loan Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae).
These agencies were aimed at reducing the cost of home mortgages for marginalized people (from the social and economic point of view). GSEs encouraged homeownership by providing a secondary market for (higher risk home loans) mortgages and also purchased loans from lenders and securitized them. So the existence of this secondary market encouraged lenders to create more loans, since they could easily sell them to the GSEs and use the profits to increase their lending.
Mortgages originators were, on one hand, financial institutions very similar to banks (S&Ls, Savings and Loans companies), savings banks and cooperative banks in Spain, and, on the other hand, intermediaries specialized in mortgage market –mortgage brokers- (without deposits and funded directly in capital markets). So, sources of revenue were: by charging an origination fee and by selling the mortgage at a higher price. Additionally, mortgages originators could (1) hold the mortgage in their portfolio, (2) sell the mortgage to an investor (to hold or to place it in a pool of mortgages to be used as collateral for the issue of a security), or (3) use the mortgage itself as collateral. Thus, when mortgage was used as collateral, the loan was said to be securitized.
As far as government agencies are concerned, they focused on conforming mortgages, characterized by the following standards, such as “mortgage size” (loans with a balance below 417.000 $), “mortgage amount” (80% of the appraisal value (maximum): Loan-to-Value (LTV) ratio), “repayment ability” (35-40% of the gross monthly income: Payment-to-Income (PTI) ratio), and “information about the financial ability of borrowers” (credit score, that is, credit evaluation of the applicant).
On the other hand, non-conforming home loans dissatisfied some standards and they were focused on some ethnic minorities (Afro- or Latin- American people), traditionally excluded from mortgage credits. In the 80’s, US authorities eliminated maximum interest rates to avoid possible discriminatory treatment, so they created the precedent of the well-known subprime mortgages.
With regards to mortgages insurers, when Loan-to-Value was over 80% (of the home’s fair market value), an insurance was needed. This was a guarantee in case of insolvency, so lenders demanded these insurances, but borrowers suffered higher interest rates/costs (although this interest rate decreased with the outstanding balance). Federal Housing Administration (FHA) and Veterans Administration (VA) –public institutions- insured mortgages and loans made by private lenders (full faith and credit).
First, public agencies focused on borrowers with low incomes, but later, private insurers plaid a key role in the explosion of subprime mortgages, taking into account the importance of the Loan-to-Value in order to estimate the probability of default (ability to pay back the borrowed funds).
As far as prime vs. subprime mortgages are concerned, on one hand, in prime mortgages or high-quality loans, the borrower paid interest and repaid principal in equal installments. Thus, at the end of the term the loan had been fully amortized, and the real estate property was the collateral. On the other hand, subprime mortgages or low-quality loans were mortgages with a higher risk. The contract rate was reset periodically in accordance with some reference rate plus a spread.
Thus, the main characteristics of both sorts of mortgages are collected in table 1.
These subprime mortgages had two relevant sorts of risks: (1) low interest “teaser” rates during 2-3 years, that could lead to a payment shock when higher interest rates took effect later on (financial institutions promoted interest-only mortgages, negatively amortizing loans in which many borrowers increased rather than paid down their debt and authorized loans with multiple layers of risk), and (2) the evolution of interest rates (LIBOR), that increased dramatically US Mortgage Delinquency Rates.
Financial experts affirm that the Financial Crisis was a consequence of different events: (1) a very relaxed monetary policy since 2001, with very low short-term interest rates in ARM (a trap for a lot of borrowers), (2) the appreciation of house-price and the revaluation expectations (cause of the subprime mortgages boom), and (3) the fact that Federal Reserve created conditions in which a housing bubble could burst. (4) Nevertheless, the evolution of the house-price in US seemed to have played an important role in this financial crisis, and it stopped a possible refinancing of the debt.
Regarding deregulation of financial institutions, US authorities incorporated changes in processes of evaluation of the borrowers’ creditworthiness: (1) high adjustable interest rate mortgages, in accordance with a riskier borrower, and (2) drop in the rejection rate of mortgages, and (3) automatic processes of creditworthiness evaluation (based on credit scoring). But these authorities had no experience about subprime mortgages in this context (high interest rates, financial turbulences, drop in the house-price…), and, also, mortgages originators did not have deposits, and they were funded directly in capital markets, without supervision of the Federal Reserve.
A new securitization process began…, but this topic will be analyzed in a forthcoming report.
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- Finanzas e Inversión: Why Spanish Banks Seem Immune to the Subprime Virus. Wharton Schoool y Universia. 20 febrero 2008 http://www.wharton.universia.net/index.cfm?fa=viewfeature&id=1470&language=english