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The Past, Present and Future of the U.S. Mortgage Market


William R. Emmons
Tuesday, July 1, 2008

The U.S. mortgage market evolved through several distinct phases to reach its current status as the largest, most innovative and most complex home-financing market in the world. Broadly, there were five major eras during the last century. How the mortgage market evolves during the next few years depends in large part on whether the private-label mortgage-backed securities (MBS) market recovers and on the extent and nature of any potential federal government interventions into housing and mortgage markets.

The pregovernment era. Before the Great Depression, the mortgage market was strictly a private affair. There was no federal deposit insurance or federal regulation of mortgage lending. The homeownership rate was below 50 percent. Mortgage down-payment requirements of 50 percent were typical. Most mortgage loans were short-term, sometimes as short as five years, and were set up as balloon mortgages. Homeownership was not a viable option for most households.

The era of the Great Depression. The Great Depression damaged the entire financial system, especially the mortgage sector. By 1934, the mortgage-delinquency rate was about 50 percent nationwide, as banks, thrifts and mortgage lenders failed. The federal government responded by creating a host of regulations and institutions. Included were greater federal supervision of mortgage lending and depository institutions; federal deposit insurance; the Federal Housing Administration (FHA); the Federal Home Loan Bank System (FHLBS); the now-defunct Home Owners' Loan Corp. (HOLC); the Reconstruction Finance Corp. (RFC); and the Federal National Mortgage Association (Fannie Mae).

The era of federally insured depository institutions. Increased federal supervision and the introduction of federal deposit insurance greatly strengthened banks and thrifts. These depository institutions came to dominate mortgage lending after World War II, achieving a combined mortgage-market share of 75 percent by 1973. The predominant loan type became the long-term, self-amortizing, fixed-rate mortgage that was created by the FHLBS. The Veterans Administration and FHA guaranteed mortgages for a large number of households, contributing to a rising homeownership rate, which reached 64 percent by 1970.

The era of the GSEs and secondary markets. The key vulnerabilities of depository institutions were exposure to high default rates in local markets and an interest-rate mismatch between short-term deposits and long-term fixed-rate mortgages. An important policy response to these weaknesses was the creation of two government-sponsored enterprises (GSE)-Fannie Mae in 1968 and Freddie Mac (Federal Home Loan Mortgage Corp.) in 1970-while retaining Ginnie Mae (Government National Mortgage Association) as a government agency; together, these institutions created a secondary market for mortgages. The GSEs did not originate mortgages, but bought them from originators with the proceeds of bond issues made in national and international capital markets. The GSEs held some mortgages themselves and packaged and sold other mortgages in the form of "agency" MBS. By 2000, the GSEs funded or guaranteed more than half of all mortgages.

The era of private-label MBS and the "originate-to-distribute" business model. Despite the improvements in risk management represented by the GSEs, the homeownership rate remained unchanged, on balance, between 1970 and 1995. In part to encourage greater mortgage lending to nontraditional or underserved borrowers, and in part as a response to the rapid innovations in financial markets, a new business model emerged-private-label MBS. This so-called originate-to-distribute business model allowed different firms to specialize in the various parts of the mortgage-lending process, such as origination, securitization, guaranteeing, funding and servicing. By last year, more than 20 percent of the mortgage market was funded by private-label MBS.

The collapse of the subprime-mortgage market in 2007 triggered a broader credit-market crisis of confidence, which has persisted into 2008. The private-label MBS model has all but disappeared, buckling under the weight of misaligned incentives, significant doses of fraud and unrealistic expectations on the part of many of its participants.

There is no realistic prospect that the private-label MBS model will return to life in the near future. The most likely future for the U.S. mortgage market is a return to its past-namely, the bulk of mortgage funds will be provided by insured depository institutions and the GSEs. What is still unclear is whether, and to what extent, the federal government will intervene to create entirely new regulations and institutions that could usher in another era in the evolution of the mortgage market.