Introduction to Mortgages and Mortgage Backed Securities

1

A Brief History of Mortgages

Abstract

The history of mortgages in the United States has been turbulent. Market disruptions arising from the Great Depression lead to the creation of government institutions that backed mortgages: the Home Owners Loan Corporation, The Federal Housing Administration, the Federal National Mortgage Association, and, indirectly, FDIC. The next disruptive period came in the middle 1960s, which led to the privatization of Fannie Mae and the invention of Freddie Mac and Ginnie Mae: Ginnie Mae invented the mortgage-backed security, which moved the market from being depository financed to capital market financed. Capital market financing appeared stable and sustainable, and the period from the middle 1980s through 2002 was quiescent for the mortgage market. But the strong performance of mortgages during this period led loan underwritings to become less stringent in their underwriting standards. Bad underwriting led to the mortgage crisis and subsequent financial crisis of 2007 to 2009.

Keywords

Fannie Mae; savings and loans; capital markets; lending

Chapter Outline

The Great Depression, the New Deal, and the Transformation of the American Mortgage Market

The Post World War II Era

References

Mortgages have been around for nearly 1000 years, if not longer. James Kent’s Commentaries of American Law, Volume 4, notes:

The English law of mortgages appears to have been borrowed in a great degree from the civil law; and the Roman hypotheca corresponded very closely with the description of a mortgage in our law. The land was retained by the debtor, and the creditor was entitled to his action hypothecaria (obtain the surrender of the thing mortgaged), to obtain possession of the pledge, when the debtor was in default; and the debtor had his action to regain possession, when the debt was paid, or satisfied out of the profits, and he might redeem at any time before a sale.

We can find references to mortgages in the United States stretching back at least as far as 1766, when the first mortgage was issued in St. Louis. The instrument has been around for a long time.

For the purposes of this book, however, our discussion will begin with the nineteenth century. Two things important for the development of mortgages in the United States occurred during this time: the development of legal recourse for lenders when borrowers failed to repay their mortgages, and the development of primary and secondary channels for financing mortgages.

Let us begin with the definition of a mortgage: it is a loan that is secured by real property. The word has its roots in French, where its literal meaning is dead (mort) pledge (gage). The pledge part of the word is straightforward, but the meaning of death is not. One interpretation is as follows:¹

The great jurist Sir Edward Coke, who lived from 1552 to 1634, has explained why the term mortgage comes from the Old French words mort, dead, and gage, pledge. It seemed to him that it had to do with the doubtfulness of whether or not the mortgagor will pay the debt. If the mortgagor does not, then the land pledged to the mortgagee as security for the debt is taken from him for ever, and so dead to him upon condition, &c. And if he doth pay the money, then the pledge is dead as to the [mortgagee].

Modern Americans might assume that death refers to the self-amortization feature of mortgages, but the fact is that mortgages generally did not amortize (there were exceptions) until the 1930s, in the overall scheme of things. Mortgages also tended to have short lives: Snowden (1987) showed that the average life of a mortgage ranged from 1.92 to 5.99 years, depending on region of the country. Rose and Snowden (2013) describe the typical method of mortgage finance for a good part of the nineteenth century:

The share accumulation plan was the contractual foundation of the building and loan movement in the U.S. In the earliest B&Ls, all members joined in order to eventually become borrowers. From the outset each member would commit to accumulate shares of the size he needed to pay for a home, through the payment of compulsory monthly dues. For example, if a member desired to accumulate $1000 for a house, he would subscribe for five shares with maturity value of $200 each. Members would then take turns in borrowing from the pot of money created by these dues. By the time it was a member’s turn to borrow, he would have already accumulated part of his shares (and retained dividends) that would eventually be used to pay off the loan in full.

Share accumulation loans were straight, balloon loans that also required the creation of a sinking fund in the form of shares to repay the loan at maturity. Thus, they were quite different than balloon loans offered by other lenders that did little to require borrowers plan for repayment. Of course, the B&L loan required not just monthly dues but also interest payments, on the full amount of the loan since that amount remained outstanding until the shares matured and the loan was cancelled. However, as a borrower’s sinking fund grew, it would accumulate retained dividends that in some sense offset the interest payments. The pace of these retained dividends would determine the maturity of the loan, which was indefinite.

Rose and Snowden go on to show that while mortgage amortization started to become a feature of some loans by 1893, it was still a fairly unusual phenomenon. Their best estimate of the share of direct reduction, or amortizing loans, just before the introduction of New Deal programs was about 20 percent, meaning that it had become an important but by no means ubiquitous method of mortgage finance. This would change with the introduction of New Deal programs.

Before moving on, it is important to recognize that mortgage laws developed quite differently across states, particularly with respect to the issue of foreclosure. Andra Ghent provides an excellent treatment of the development of mortgage law across the various states in the United States. We will discuss the issues of judicial and nonjudicial foreclosure as well as recourse and nonrecourse lending elsewhere in this book.

The Great Depression, the New Deal, and the Transformation of the American Mortgage Market

Five New Deal era programs provided the foundation for the modern US mortgage system. Four of these programs were specifically related to housing finance, and one restored confidence in the US banking system as a whole. The four programs related to housing finance were the Federal Housing Administration (FHA), the Home Owners’ Loan Corporation (HOLC), the Federal Home Loan Bank System, and the Federal National Mortgage Association. The program related to banking was the Federal Deposit Insurance Corporation (FDIC). We will discuss each in turn, except for the Federal Home Loan Bank System, which we will discuss when recounting the Savings-and-Loan era of home lending.

In 1933, many American banks were insolvent. The insolvency arose from many defaulted mortgages on bank balance sheets. Many of these defaults were maturity defaults. That is to say, borrowers made the payments required of them until their loans came due, but the same borrowers were unable to make the final balloon payment that was ultimately required of them.

In response to this, the Roosevelt administration was able to get Congress to authorize the HOLC. The HOLC got into the business of buying defaulted loans from banks using funds from the US Treasury. The government floated bonds for the purpose of raising money to purchase the defaulted mortgages. The HOLC bought loans at a discount—not so large that it threatened banks with insolvency, but large enough that the HOLC could offer principal reduction to borrowers. Rose (2011) shows that the HOLC used the mechanism of generous appraisals to make terms attractive to lenders. The HOLC discovered more value in houses than perhaps was warranted by market conditions, which gave it the fig leaf it needed to offer generous prices to banks for the mortgages it purchased.

The most important thing that the HOLC did to provide relief to borrowers, however, was to convert the mortgages from short-term loans with large balloon payments into self amortizing 15-year fixed payment mortgages. Although fixed payment mortgages existed before the New Deal, they were not ubiquitous, and usually had terms of less than 15 years.

The HOLC bought and reconstituted loans for four years, 1933 through 1936. After that, the mortgage finance system was considerably more stable and the HOLC no longer found it necessary to purchase loans. It stayed in business for another 15 years until the loans it had on the books were paid off and then in 1952 it put itself out of business. It was thus a rare example of a government agency that came into existence to solve the crisis, and then went out of business when the crisis was over. As we shall see one scene later, another example of such an agency, the Resolution Trust Corporation, was also put in business to solve a mortgage-related crisis, and again put itself out of business when the crisis was resolved. Courtemanche and Snowden (2011) and Crossney and Bartelt (2005) show that the HOLC was valuable to restoring macroeconomic stability.

The second important entity that arose from New Deal mortgage policy was the FHA, which was authorized in 1934. Lenders were wary of lending to borrowers who did not make large down payments. This prevented many Americans from acquiring a mortgage, which meant that it prevented many Americans from becoming homeowners. The FHA was created to insure loans that had relatively low down payments. Specifically, the government would collect insurance premiums that would go into a fund to ensure that lenders would not bear losses on defaulted loans. Beyond that, the federal government would put its full faith and credit behind the loans.

The first FHA loans required down payments of 25 percent. Seventy-five percent loan-to-value ratio loans were considered risky at the time. By allowing Americans to buy houses with a 25 percent down payment, the FHA program helped stabilize the housing market.

Finally, with respect to new mortgage institutions, Congress authorized the establishment of the Federal National Mortgage Association in 1938. The Federal National Mortgage Association, which would come to be known as Fannie Mae, was initially a government agency. Its purpose was to raise money through capital markets (with government backing), and then distribute mortgage funds throughout the country. Fannie Mae remained a very small entity for several decades, but would become considerably more important in the 1970s and especially in the 1980s.

Even though it was not invented specifically for this purpose, perhaps the most important institution for stabilizing housing finance was the FDIC. This entity, which was funded by bank fees and guaranteed by the federal government, assured depositors that their money was safe up to a certain limit. The initial limit was $2500.

The bank panic scene in It’s a Wonderful Life is among the most iconic scenes in film. The lesson of the scene was that even sound financial institutions can be ruined through depositor panic. Loans, even when sound, are not liquid. This means that if all depositors want their money back at one time, the bank will be unable to produce the cash necessary to fill its obligations.

The only reason however, that all depositors might want their money at once is a collapse in confidence. The invention of the FDIC allowed depositors to be confident about their ability to recover their money at any time from their federally chartered financial institutions; one of the remarkable things about the recent financial crisis was the absence of bank runs. Incidentally, the current ceiling on deposits insured by the FDIC is now $500,000 per depositor per institution.

These institutions evolved after World War II through mechanisms we will talk about next, and they became the backbone of housing finance for many years thereafter.

The Post World War II Era

In the aftermath of the invention of New Deal programs, housing markets stabilized. Prices, which had fallen 30 percent from peak to trough, started rising again. Even though housing markets did stabilize, they were hardly reignited. New construction remained at low levels in the late 1930s as the Great Depression lingered, and in the early 1940s, as materials were reserved for the war effort instead of consumer goods such as housing.

Housing did reignite immediately after World War II. The country faced a housing shortage, as very little had been built for 16 years. The condition of the country’s housing stock was also poor; for example, only around 60 percent of housing units had indoor plumbing (Census of Population and Housing 1940). At the same time, American incomes recovered robustly during World War II, but Americans spent relatively little on consumer goods because of rationing. Consequently, families demanded housing and had large amounts of savings with which to purchase it.

Simultaneously, Congress passed a law that came to be known as the GI Bill of Rights (the formal name of this law was the Servicemen’s Readjustment Act of 1944). Among other things, the GI Bill established the Veterans Administration (VA) loan program. The VA program was very much like the FHA program; it was an insurance program that allowed borrowers to get loans with small down payments because the loans were backed by the full faith and credit of the US government.

The VA program, however, went a step further than the FHA program in that it allowed veterans to buy houses with very low down-payment loans. In fact, veterans could buy homes with down payments as small as $150. Thus the program did two things; it allowed millions of veterans returning home from Europe and the Pacific to purchase a new home, and it provided an experiment for the success of very low down-payment loans. As it happened, the default rate on VA loans in the 1950s was too high to have been sustained by a private sector entity required to return profits to its owners, but not so high as to be ruinous. It is important to remember that the VA program was more than a housing program; it was also a subsidy to compensate veterans for their service.

The combination of a decade and a half of little housing construction, higher incomes, high levels of saving, and the VA and FHA programs led to a boom in housing construction from 1945 into the 1950s. At the same time, the homeownership rate rose sharply, from 43.6 percent in 1940, to 55 percent in 1950, to 61.9 percent in 1960 (Census of Population and Housing 1940, 1950, 1960).

Some scholars argue that federal programs not only allowed for a rapid increase in the demand for housing and a rapid increase in the homeownership rate, but also changed the composition of housing in the United States. In particular, they argue that housing finance encouraged movement from the cities to the suburbs. A few also argue that housing finance encouraged developers to move away from mixed-use development to court single-use development. These statements are somewhat controversial, but certain elements of the FHA and VA programs are consistent with them.

First, the appraisal guidelines for the HOLC, the FHA program, and the VA program all contained neighborhood grading schemes where grades were tied to race and ethnicity. For example, the map of Philadelphia (Figure 1.1) has red- and green-shaded areas. The areas shaded in red had a large African American population and were thus deemed by the government as being less desirable neighborhoods than those with smaller African American populations. Federal program documents encouraged appraisers to downgrade values in neighborhoods that were shaded in red. This discouraged capital from flowing into these neighborhoods. At the same time, suburban neighborhoods were shaded in green, reflecting the government’s perception that the neighborhoods were desirable, principally because of their ethnic makeup. Because suburban neighborhoods had small African American populations, in part because of the deplorable existence of restricted deed covenants, capital flowed easily to them.

FIGURE 1.1 Philadelphia map. Source: National Archives and Records Administration.

So at the margin, there is no doubt that the FHA and VA programs encouraged migration from central cities to suburbs. It is difficult, however, to evaluate the magnitude of this capital market effect. In other countries—countries that never had FHA or VA type programs—we have also seen substantial suburbanization in the post-World War II era. For example, the population of the city of Paris has shrunk since 1950, while the population of metropolitan Paris has nearly doubled since then.²

As for the issue of mixed use versus single use, it is true that FHA loans have only financed housing. This has generally been true of Fannie Mae loans as well. Some urbanists have argued that this led to the deteriorating market share of mixed-use development since World War II. However, the postwar era has seen Euclidean zoning become ubiquitous. Such zoning, which separates uses, is more likely the source of the decline of mixed-use development than are financing arrangements.

Between the end of World War II and the 1960s, housing finance in the United States worked quite well. Most housing finance came from depository institutions. Among depositories, the most important for housing finance were Savings and Loans (S&Ls). As Figure 1.2 shows, in 1970, more than 70 percent of all mortgages were held by depositories.

FIGURE 1.2 Market share of mortgage debt outstanding by holder Source: Flow of Funds Data Table L.218 and Author Calculations.

S&Ls were highly specialized institutions. They had certain limits placed upon them. For example, they were local institutions, and were not permitted to lend beyond a certain radius, although the radius got larger with time. They also were required to specialize in home lending. In exchange for these requirements, S&Ls got access to capital through the Federal Home Loan Bank system, were permitted to pay their depositors slightly higher interest rates than banks, and received certain tax benefits. It’s worth taking a little time to discuss each of these features.

The Federal Home Loan Bank system was organized as a cooperative system by the Hoover administration in 1932. The system created 12 banks whose function was to lend to lenders. It was essentially the first housing-related government-sponsored enterprise.

Each Federal Home Loan Bank has shareholders, which are the financial institutions that borrow money from the bank. Total liabilities of any one of the Federal Home Loan Banks are also the liabilities of the other banks; this is what it means to be a co-op. The Federal Home Loan Banks borrow money in capital markets, and then use that money to make advances to depositories that can be used to finance mortgages. The fact that the Federal Home Loan Bank system is jointly and severally liable for the debts of any one bank may explain why its creditors look so favorably upon it. However, as with other government-sponsored enterprises, the capital markets presume that the Federal Home Loan Bank system carries an implicit guarantee from the federal government and consequently issues very low-risk securities.

The ability of S&Ls to access capital through advances from Federal Home Loan Banks gave them a cost advantage relative to other financial institutions with respect to funding mortgages. This in part explains how they came to dominate the mortgage market for more than 20 years.

Beyond Federal Home Loan Bank advances, S&Ls use deposits to fund mortgages. From 1933 until 1986, the Glass-Steagall act, in particular, regulation Q—one of the regulations that implemented that act—prohibited depositories from paying depositors more than a ceiling amount of interest on savings accounts. S&Ls, however, were permitted to pay 50 basis points more in interest than banks. This allowed S&Ls, also known as thrift institutions, to attract capital they otherwise might not