Wall Street History

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Wall Street History

09/07/2007

History of the Mortgage Market

The other day in Jackson Hole, Wyoming, Aug. 31, Federal
Reserve Chairman Ben Bernanke gave a widely anticipated
speech about the housing market. Among his quotes addressing
the current mortgage crisis were:

“It is not the responsibility of the Federal Reserve – nor would it
be appropriate – to protect lenders and investors from the
consequences of their financial decisions. But developments in
financial markets can have broad economic effects felt by many
outside the markets, and the Federal Reserve must take those
effects into account when determining policy.”

“Obviously, if current conditions persist in mortgage markets,
the demand for homes could weaken further, with possible
implications for the broader economy. We are following these
developments closely.”

But the chairman also delved into the history of the mortgage
market, so I thought it would be appropriate to pass on his
thoughts for this column, Bernanke being a noted academic in
addition to his current job of overseeing our nation’s monetary
policy.

The following is a bit dry, but contains a nugget or two that
should be of interest to junior historians out there; including
myself in this group, of course.

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Ben Bernanke

[Excerpts]

The early decades of the twentieth century are a good starting
point for this review, as urbanization and the exceptionally rapid
population growth of that period created a strong demand for
new housing. Between 1890 and 1930, the number of housing
units in the United States grew from about 10 million to about 30
million; the pace of homebuilding was particularly brisk during
the economic boom of the 1920s.

Remarkably, this rapid expansion of the housing stock took place
despite limited sources of mortgage financing and typical lending
terms that were far less attractive than those to which we are
accustomed today. Required down payments, usually about half
of the home’s purchase price, excluded many households from
the market. Also, by comparison with today’s standards, the
duration of mortgage loans was short, usually ten years or less.
A “balloon” payment at the end of the loan often created
problems for borrowers.

High interest rates on loans reflected the illiquidity and the
essentially unhedgeable interest rate risk and default risk
associated with mortgages. Nationwide, the average spread
between mortgage rates and high-grade corporate bond yields
during the 1920s was about 200 basis points, compared with
about 50 basis points on average since the mid-1980s. The
absence of a national capital market also produced significant
regional disparities in borrowing costs. Hard as it may be to
conceive today, rates on mortgage loans before World War I
were at times as much as 2 to 4 percentage points higher in some
parts of the country than in others, and even in 1930, regional
differences in rates could be more than a full percentage point.

Despite the underdevelopment of the mortgage market,
homeownership rates rose steadily after the turn of the century.
As would often be the case in the future, government policy
provided some inducement for homebuilding. When the federal
income tax was introduced in 1913, it included an exemption for
mortgage interest payments, a provision that is a powerful
stimulus to housing demand even today. By 1930, about 46
percent of nonfarm households owned their own homes, up from
about 37 percent in 1890.

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The New Deal and the Housing Market

The housing sector, like the rest of the economy, was profoundly
affected by the Great Depression. When Franklin Roosevelt took
office in 1933, almost 10 percent of all homes were in
foreclosure, construction employment had fallen by half from its
late 1920s peak, and a banking system near collapse was
providing little new credit. As in other sectors, New Deal
reforms in housing and housing finance aimed to foster economic
revival through government programs that either provided
financing directly or strengthened the institutional and regulatory
structure of private credit markets.

Actually, one of the first steps in this direction was taken not by
Roosevelt but by his predecessor, Herbert Hoover, who oversaw
the creation of the Federal Home Loan Banking System in 1932.
This measure reorganized the thrift industry (savings and loans
and mutual savings banks) under federally chartered associations
and established a credit reserve system modeled after the Federal
Reserve. The Roosevelt administration pushed this and other
programs affecting housing finance much further. In 1934, his
administration oversaw the creation of the Federal Housing
Administration (FHA). By providing a federally backed
insurance system for mortgage lenders, the FHA was designed to
encourage lenders to offer mortgages on more attractive terms .
by the 1950s, most new mortgages were for thirty years at fixed
rates, and down payment requirements had fallen to about 20
percent. In 1938, the Congress chartered the Federal National
Mortgage Association, or Fannie Mae, as it came to be known.
The new institution was authorized to issue bonds and use the
proceeds to purchase FHA mortgages from lenders, with the
objectives of increasing the supply of mortgage credit and
reducing variations in the terms and supply of credit across
regions.

Shaped to a considerable extent by New Deal reforms and
regulations, the postwar mortgage market took on the form that
would last for several decades. The market had two main
sectors. One, the descendant of the pre-Depression market
sector, consisted of savings and loan associations, mutual savings
banks, and, to a lesser extent, commercial banks .Notably,
federal and state regulations limited geographical diversification
for these lenders, restricting interstate banking and obliging
thrifts to make mortgage loans in small local areas – within 50
miles of the home office until 1964, and within 100 miles after
that. In the other sector, the product of New Deal programs,
private mortgage brokers and other lenders originated
standardized loans backed by the FHA and the Veterans’
Administration (VA). These guaranteed loans could be held in
portfolio or sold to institutional investors through a nationwide
secondary market.

No discussion of the New Deal’s effect on the housing market
and the monetary transmission mechanism would be complete
without reference to Regulation Q – which was eventually to
exemplify the law of unintended consequences. The Banking
Acts of 1933 and 1935 gave the Federal Reserve the authority to
impose deposit-rate ceilings on banks, an authority that was later
expanded to cover thrift institutions .

The original rationale for deposit ceilings was to reduce
“excessive” competition for bank deposits, which some blamed
as a cause of bank failures in the early 1930s. In retrospect, of
course, this was a dubious bit of economic analysis. In any case,
the principal effects of the ceilings were not on bank competition
but on the supply of credit. With the ceilings in place, banks and
thrifts experienced what came to be known as disintermediation
– an outflow of funds from depositories that occurred whenever
short-term money-market rates rose above the maximum that
these institutions could pay. In the absence of alternative
funding sources, the loss of deposits prevented banks and thrifts
from extending mortgage credit to new customers.

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Under the New Deal system, housing construction soared after
World War II, driven by the removal of wartime building
restrictions, the need to replace an aging housing stock, rapid
family formation that accompanied the beginning of the baby
boom, and large-scale internal migration. The stock of housing
units grew 20 percent between 1940 and 1950, with most of the
new construction occurring after 1945.

In 1951, the Treasury-Federal Reserve Accord freed the Fed
from the obligation to support Treasury bond prices. Monetary
policy began to focus on influencing short-term money markets
as a means of affecting economic activity and inflation,
foreshadowing the Federal Reserve’s current use of the federal
funds rate as a policy instrument. Over the next few decades,
housing assumed a leading role in the monetary transmission
mechanism, largely for two reasons: Reg Q and the advent of
high inflation .

The impact of disintermediation on the housing market could be
quite significant; for example, a moderate tightening of monetary
policy in 1966 contributed to a 23 percent decline in residential
construction between the first quarter of 1966 and the first
quarter of 1967. State usury laws and branching restrictions
worsened the episodes of disintermediation by placing ceilings
on lending rates and limiting the flow of funds between local
markets.

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The Emergence of Capital Markets as a Source of Housing
Finance

The manifest problems associated with relying on short-term
deposits to fund long-term mortgage lending set in train major
changes in financial markets and financial instruments, which
collectively served to link mortgage lending more closely to the
broader capital markets. The shift from reliance on specialized
portfolio lenders financed by deposits to a greater use of capital
markets represented the second great sea change in mortgage
finance, equaled in importance only by the events of the New
Deal.

Government actions had considerable influence in shaping this
second revolution. In 1968, Fannie Mae was split into two
agencies: the Government National Mortgage Association
(Ginnie Mae) and the re-chartered Fannie Mae, which became a
privately owned government-sponsored enterprise (GSE),
authorized to operate in the secondary market for conventional as
well as guaranteed mortgage loans. In 1970, to compete with
Fannie Mae in the secondary market, another GSE was created –
the Federal Home Loan Mortgage Corporation, or Freddie Mac.
Also in 1970, Ginnie Mae issued the first mortgage pass-through
security, followed soon after by Freddie Mac. In the early 1980s,
Freddie Mac introduced collateralized mortgage obligations
(CMOs), which separated the payments from a pooled set of
mortgages into “strips” carrying different effective maturities and
credit risks. Since 1980, the outstanding volume of GSE
mortgage-backed securities has risen from less than $200 billion
to more than $4 trillion today. Alongside these developments
came the establishment of private mortgage insurers, which
competed with the FHA, and private mortgage pools, which
bundled loans not handled by the GSEs, including loans that did
not meet GSE eligibility criteria – so-called nonconforming
loans. Today, these private pools account for around $2 trillion
in residential mortgage debt.

These developments did not occur in time to prevent a large
fraction of the thrift industry from becoming effectively
insolvent by the early 1980s in the wake of the late-1970s surge
in inflation. In this instance, the government abandoned attempts
to patch up the system and instead undertook sweeping
deregulation. Req Q was phased out during the 1980s; state
usury laws capping mortgage rates were abolished; restrictions
on interstate banking were lifted by the mid-1990s; and lenders
were permitted to offer adjustable-rate mortgages as well as
mortgages that did not fully amortize and which therefore
involved balloon payments at the end of the loan period.
Critically, the savings and loan crisis of the late 1980s ended the
dominance of deposit-taking portfolio lenders in the mortgage
market. By the 1990s, increased reliance on securitization led to
a greater separation between mortgage lending and mortgage
investing even as the mortgage and capital markets became more
closely integrated. About 56 percent of the home mortgage
market is now securitized, compared with only 10 percent in
1980 and less than 1 percent in 1970.

Source: Federalreserve.gov

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Next week, back to bubbles.

Brian Trumbore

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