Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Macro Handout 13: Mortgages and Fannie Mae

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1 Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Macro Handout 13: gages and Fannie Mae gages Types of gages Fixed Rate Variable (Adjusted) Rate Interest-Only Fixed Rate gage Question: How are mortgage payments determined for a conventional fixed rate mortgage? At the present time, suppose that you receive a $200, year home mortgage from a bank Presently, the interest rate on such a loan is about 4 percent For purposes of illustration, however, we shall use an interest rate of 10 percent to simplify the arithmetic Claim: With a 10 percent interest rate, your annual payment on 20-year, $200,000 mortgage would be $23,492 Let us see why: In general: This Previous Interest This Year s = Year s + Paid on Year s Balance Balance Balance Payment Based on the Previous Year s Unpaid Balance Payment Balance Interest This year (Year 0) 200,000 20,000 Next year (Year 1) 23, ,492 = Year 2 23, ,492 = Year 3 23, ,492 = Year 10 23, ,348 Year 19 23,492 21,356 Year 20 23, ,492 = The size of the annual mortgage payment is determined so when the final payment is made, the balance equals precisely 0 In a conventional mortgage, the interest rate is fixed over the entire life of the mortgage

2 2 Fixed Rate gages and Inflation But now recall that when inflation is present purchasing power is key The real interest rate accounts for inflation; that is, the real interest rate reflects purchasing power: Real Interest Rate = Nominal Interest Rate Inflation Rate In terms of purchasing power: What we expect to pay back to the bank and what the bank expects to receive depends on the inflation rate that we in the future What we actually pay back and what the bank actually receives depends upon the inflation rate in the future When actual inflation rate turns out to be greater than that expected Real interest rate is than expected In terms of purchasing power borrowers repay the bank is than expected Borrowers Lenders When actual inflation rate turns out to be less than that expected Real interest rate is than expected In terms of purchasing power borrowers repay the bank is than expected Borrowers Lenders Variable (Adjustable) Rate gages CPI Rate of Inflation: (percent) The experience of the 1970s prompted banks to offer variable rate mortgages The nominal interest rates are these mortgages are adjusted periodically to account for inflation

3 3 Graduated (Escalating) Payment gages $200,000 Graduated (Escalating) gage at a 10 Percent Interest Rate Graduated Payment Payment for the first 7 years: $20,000 Payment for the next 13 years: $28,156 A $ %, increase Payment Balance Interest This year (Year 0) 200,000 20,000 Next year (Year 1) 20, ,000 = Year 2 20, ,000 = Year 3 20, ,000 = Year 7 20, ,000 Year 8 28, ,156 = Year 19 28,156 25,596 Year 20 28, ,156 = Fannie Mae (Federal National gage Association) Fannie Mae is a government-sponsored enterprise plays a large role in the market for home mortgages It is more or less invisible to households holding mortgages because if does not does not provide mortgages directly to households Instead it: Purchases whole mortgages that that banks have previously issued on what is called the secondary market Keeps some of the whole mortgages and earns income from them as they are repaid Cobbles whole mortgages together into mortgage backed securities (MBSs) Keeps some of the MBSs for itself and sells the remainder to private financial institutions (Citibank, Bank of America, etc) Owners of the MBSs receive income as the mortgages are repaid We will now focus more closely on mortgage backed securities

4 4 gage-backed Securities (MBS) A financial organization such as Fannie Mae or Bear Stearns or o buys a bunch of whole mortgages from primary lenders (banks) o cobbles the mortgages together into a single mortgage back security (MBS) o can then sell shares of the mortgage back security (MBS) to others Each share of the security represents a fraction of all the mortgages that have been cobbled together into the security The monthly mortgage payments provide the revenue to pay those who purchased shares of the mortgage backed security (MBS) Bank A "Whole" gages Bank B "Whole" gages Hunter Christin Haley Jayde Mateo Kate Bear Stearns, Fannie Mae, etc Cobbles a large number of these mortages into a single mortgage-backed security (MBS) Splits the MBS into a large number of shares Each share of the MBS represents a fraction of each mortgage that have been cobbled together into the MBS Private parties including banks and other financial institutions The owners of the shares earn income as the mortgages included in the MBS are repaid Bank s take advantage of these mortgage backed securities: Bank sells Christin s and Haley s mortgages to Fannie Mae and buys mortgage backed securities with the proceeds Assets Liabilities Reserves 50 Deposits 500 Vault Cash 30 Dep at Fed 20 Securities 60 Stock&Bonds 60 Loans 480 Hunter 20 Christin 20 Borrowing 10 Haley 20 Total Assets 590 Total Liabilities 510 Net Worth = Total Assets Total Liabilities = = 80 Question: Why might a bank wish to sell some of its whole mortgages to purchase mortgage-backed securities?

5 5 Fannie Mae Eases Credit to Aid gage Lending By STEVEN A HOLMES New York Times: September 30, 1999 WASHINGTON, Sept 29 the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders The action, will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans Fannie Mae officials say they hope to make it a nationwide program by next spring Fannie Mae has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times But the government-subsidized corporation may run into trouble in an economic downturn Fannie Mae does not lend money directly to consumers Instead, it purchases loans that banks make on what is called the secondary market By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings Effect of the Policy Change Prior to 2007 Question: How did banks respond to Fannie Mae s new policy? Question: What type of mortgage would you expect most the less credit worthy households choose, fixed rate mortgages or graduated payment mortgages? To address this question compare the payment pattern for a 20-year $200,000 fixed rate and graduated payment mortgage: $200,000 gage at a 10 Percent Interest Rate Fixed Rate Graduated Payment Payment for the first 7 years: $23,492 $20,000 Payment for the next 13 years: $23,492 $28,158 Question: What would you expect the banks providing the loans to not so credit worthy households to do with these whole mortgages?

6 Question: How did this affect the market for new homes? Since more households could now get a mortgage, the demand curve for single family homes shifted right and the price rose Between 2000 and 2007: Price rose from about $190,000 to $310,000, $120,000 P Market for Homes S P* Question: What happens when the payment rises for the not so credit worthy home buyers who have a graduated mortgage? Graduated Payment Payment for the first 7 years: $20,000 Payment for the next 13 years: $28,158 Some of these home buyers discovered a few years after purchasing their homes that they could not afford the higher payments required by their graduated payment mortgages 300 Q* Real Price of Single Family Homes ($1,000): D Q Question: Was this a problem for the not so credit worthy home buyer between 2000 and 2007?