Macro Lecture 13: gages and Fannie Mae Home gages We shall study three types of mortgages which are used today: Fixed rate Variable (adjusted) rate Graduated payment These mortgages differ in how they are repaid Review: Fixed Rate gage We begin with fixed rate mortgages because they are the most straightforward In this case, the repayment structure is simple The lender must repay the bank a fixed amount every month for a specified period in the future If the mortgage is a 20-year mortgage the fixed payment must be made for 20 years, if the mortgage is a 30-year mortgage the payment must be made for 30 years, etc Question: How are mortgage payments determined for a fixed rate mortgage? To address this question, suppose that you receive a $200,000 20-year home mortgage from a bank at the present time Today, 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 Also, to make the arithmetic more manageable assume that mortgage payments are made on an annual rather than monthly basis Claim: With a 10 percent nominal interest rate, your annual payment on a 20-year, $200,000 mortgage would be $23,492 Why isn t the annual payment $23,491 or $23,493? Why precisely $23,492? To explain this first note how mortgage interest is calculated Interest is calculated on the unpaid balance: This Year s Previous Year s Interest on This Unpaid = Unpaid + Previous Year s Year s Balance Balance Unpaid Balance Payment Interest Rate Previous Year s Unpaid Balance This year when the loan is first issued, the unpaid balance equals the full amount of the loan, $200,000 As time progresses the unpaid balance falls and hence the interest also declines as reported in table 131: Payment Unpaid Balance Interest This year (Year 0) 200,000 20,000 Next year (Year 1) 23,492 200,000 + 20,000 23,492 = 196,508 19,651 Year 2 23,492 196,508 + 19,651 23,492 = 192,667 19,267 Year 3 23,492 192,667 + 19,267 23,492 = 188,442 18,844 Year 10 23,492 144,348 14,435 Year 19 23,492 21,356 2,136 Year 20 23,492 21,356 + 2,136 23,492= 0 Table 131: Fixed rate mortgage calculations
2 The mortgage payment is determined so when the final payment is made, the unpaid balance equals precisely 0 In our example, an annual payment of $23,492 results in an unpaid balance of precisely 0 after 20 years Any payment greater than or less than $23,492 would not result in an unpaid balance of 0 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 you expect to pay back to the bank and what the bank expects to receive depends on the expected inflation rate What you will actually pay back to the bank depends upon the actual inflation rate in the future When actual inflation rate When actual inflation rate turns out to be greater turns out to be less than that expected than that expected Real interest rate is Real interest rate is less than expected more than expected In terms of purchasing power In terms of purchasing power borrowers repay the borrowers repay the bank less than expected bank more than expected Borrowers gain Borrowers lose Lenders lose Lenders gain Figure 131 illustrates the actual inflation rate for the last half century: The actual inflation rate spiked in the 1970 s These high actual inflation rates were a surprise Since they were unexpected, banks, the lenders, were hurt In terms of purchasing power, mortgage payments to banks were less than what the banks expected Many banks suffered financial difficulties as a result In response banks offered a new type of mortgage, variable rate mortgages 140 120 100 80 60 40 20 00 CPI Rate of Inflation: 1960 2012 (percent) Variable (Adjustable) Rate gages 20 With a variable rate mortgage, the 1960 1970 1980 1990 2000 2010 nominal interest rate is periodically Figure 131: CPI rate of inflation 1960-2012 adjusted during the life of the mortgage While the details are sometimes complicated, the idea is that when the actual inflation rate is high the nominal interest rate rises; alternatively when the actual inflation rate is low, the nominal interest rate falls In this way, the real interest rate is more or less stable Consequently, both the borrower and the lender are protected against unexpectedly high or low inflation
3 Graduated (Escalating) Payment gages The payments of a graduated payment mortgage increase over time by design The mortgage payments start off low and then increase The following example illustrates a very simple graduated payment mortgage in which the annual mortgage payment for a 20-year $200,000 is $20,000 for the first 3 years of the mortgage and then is $24,933 for the remaining 17 years: $200,000 Graduated gage at a 10 Percent Interest Rate Graduated Payment Payment for the first 3 years: $20,000 Payment for the next 17 years: $24,933 Nearly a 25% increase Table 132 reports the calculations: Payment Unpaid Balance Interest This year (Year 0) 200,000 20,000 Next year (Year 1) 20,000 200,000 + 20,000 20,000 = 200,000 20,000 Year 2 20,000 200,000 + 20,000 20,000 = 200,000 20,000 Year 3 20,000 200,000 + 20,000 20,000 = 200,000 20,000 Year 4 24,933 200,000 + 20,000 24,933 = 195,067 19,507 Year 5 24,933 195,067 + 19,507 24,933 = 189,641 18,964 Year 19 24,933 22,666 2,267 Year 20 24,933 22,666 + 2,267 24,933 = 0 Table 132: Graduated mortgage calculations Once again we see that the mortgage payments of the 20-year mortgage are structured so that after 20 years the unpaid balance equals precisely 0 Freddie Mac and Fannie Mae Freddie Mac (whose official name is the Federal Home Loan gage Corporation) and Fannie Mae (whose official name is the Federal National gage Association) are government-sponsored enterprises that play a large role in the market for home mortgages They do not give mortgages directly to households Instead, they purchase whole mortgages that banks have previously issued on what is called the secondary market Then, they keep some of the mortgages and earn income from them as they are repaid cobble whole mortgages together into mortgage backed securities (MBSs) sell the MBSs to private financial institutions (Citibank, Bank of America, etc) The private institutions earn income from them as they are repaid
4 gage-backed Securities (MBS) gage backed securities are created when a financial institution such as Fannie Mae, Bear Stearns, etc: Buys a bunch of whole mortgages from primary lenders (banks) Cobbles the mortgages together into a single mortgage backed security (MBS) Sell shares of the mortgage backed security to others Each share represents a fraction of all the mortgages that have been cobbled together into the mortgage backed security (MBS) Figure 132 depicts the procedure The monthly mortgage payments provide income to those who purchased shares of the mortgage back 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 Figure 132: gage backed securities (MBS) Summary of mortgage backed securities (MBSs): A financial organization such as Fannie Mae, Bear Stearns, etc o Buys a bunch of whole mortgages from primary lenders (banks) o Cobbles the mortgages together into a single mortgage backed security (MBS) o Sell shares of the mortgage backed security to others Each share of the mortgage backed 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)
5 Fannie Mae Changes Its Policy 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 expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D Raines, Fannie Mae's chairman and chief executive officer 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, prompting a government rescue similar to that of the savings and loan industry in the 1980's Fannie Mae, the nation's biggest underwriter of home mortgages, 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 Begin with our simplified balance sheet of the banking system: Assets Liabilities Reserves 50 Deposits 500 Vault Cash 30 Dep at Fed 20 Securities 60 Stock&Bonds 60 Loans 480 Hunter 20 Elaine 20 Borrowing 10 Brady 20 Total Assets 590 Total Liabilities 510 Net Worth = Total Assets Total Liabilities = 590 510 = 80
6 Next, let us see what happens when banks take advantage of the new policy: Banks provide mortgages to households that would not have received them previously, the less credit worthy households Question: What type of mortgage would you expect most the less credit worthy households choose, fixed rate mortgages or graduated (escalating) 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 3 years: $23,492 $20,000 Payment for the next 17 years: $23,492 $24,933 Answer: The annual payments for a graduated (escalating) payment mortgage are nearly $3,500 less for the first 3 years Since the less credit worthy households have fewer financial resources, they would no doubt find a graduated (escalating) payment mortgage more attractive Banks then sold some of these whole mortgages to Fannie Mae, Bear Sterns, etc In turn, Fannie Mae,, Bear Sterns, etc: o Kept some of the whole mortgages o Cobbles other whole mortgages together into mortgage backed securities (MBSs) o Sold the MBSs to private financial institutions (Citibank, Bank of America, etc) Prior to 2007: Bank sells Elaine s and Brady s mortgages to Fannie Mae and buys mortgage backed securities (MBSs) with the proceeds Assets Liabilities Reserves 50 Deposits 500 Vault Cash 30 Dep at Fed 20 Securities 100 60 Stock&Bonds 60 MBS 40 Loans 440 480 Hunter 20 Elaine 20 Borrowing 10 Brady 20 Total Assets 590 Total Liabilities 510 Net Worth = Total Assets Total Liabilities = 590 510 = 80 The loans component of the bank s balance sheet decreases by 40 from 480 to 440 and the securities component increases by 40 from 60 to 100 Question: Why might a bank wish to sell some of its whole mortgages to purchase a mortgagebacked security? Answer: Diversification
7 Question: How did this affect the price of homes? Answer: Since more families were now eligible for home mortgages, this increased the demand for homes resulting in increase in the price (see figure 133) As illustrated in figure 134 the price of homes rose dramatically between 2000 and 2007 P** P* P Market for Homes S D Q* D Q Figure 133: Market for Homes Consider a less credit worthy household, the Jones, who purchased a home in 2003 for $225,000 with a graduated mortgage In 2007, the higher mortgage payments kick in: the Jones payment rises by nearly 25 percent Question: Suppose that the Jones can t afford the higher mortgage payments Will this be a problem? Answer: No In 2007 the Jones can sell their home for $320,000 But they only owe $225,000 on their mortgage The sale of their home generates more than enough revenue to pay off their mortgage In fact, they have a tidy $95,000 left over to enjoy 300 275 250 225 200 Real Price of Single Family Homes 175 2000 2002 2004 2006 2008 2010 Figure 134: Real price of single family homes: 2000-2008