Mortgage Markets and the Credit Crisis: What Went Wrong

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 9 is the one where everything comes together. Madura covers how mortgage markets work, the different types of mortgages, how they get packaged into securities, and how the whole system collapsed in 2008. If you want to understand the credit crisis, this is the chapter to read.

How Mortgages Work

A mortgage is a loan used to buy real estate, secured by the property itself. If you stop paying, the lender can seize your house. Financial institutions like savings institutions and mortgage companies originate mortgages. They assess your creditworthiness by looking at three things:

1. Your equity. The more you put down, the less likely you are to walk away. The loan-to-value ratio measures how much of the property is financed by debt.
2. Your income. Can you afford the monthly payments? Income levels change, and layoffs happen, so this is always uncertain.
3. Your credit history. Past problems predict future problems.

Mortgages are classified as prime (borrower meets traditional standards) or subprime (borrower does not). Subprime borrowers pay higher rates, typically 1.5 to 2.5 percentage points above prime rates. Between 2003 and 2005, mortgage companies aggressively expanded subprime lending to grow their business.

Mortgages can also be federally insured (through FHA or VA) or conventional (possibly with private insurance).

Types of Residential Mortgages

Madura walks through the main varieties:

Fixed-rate mortgages lock in your interest rate for the entire loan. Monthly payments are predictable. Early payments are mostly interest; over time, more goes toward principal. A 30-year, $100,000 mortgage at 8 percent costs about $734 per month. A 15-year mortgage on the same terms costs $956 per month, but total payments drop from $264,155 to $172,017. That is nearly $100,000 less in total payments.

Adjustable-rate mortgages (ARMs) have rates that change based on a benchmark, like the average T-bill rate plus 2 percent. The initial rate is lower than a fixed-rate mortgage. Borrowers who expect rates to stay stable or fall choose ARMs. Most ARMs have caps, like 2 percent per year and 5 percent over the mortgage’s life.

Graduated-payment mortgages start with low payments that increase over 5 to 10 years and then level off. Good for people expecting their income to rise.

Growing-equity mortgages also start low but keep increasing (about 4 percent per year), paying off the loan in 15 years or less.

Second mortgages are additional loans behind the first mortgage. They carry higher rates because the second lender has a lower priority claim on the property.

Shared-appreciation mortgages offer a below-market rate in exchange for the lender getting a share of the home’s price appreciation.

Balloon-payment mortgages require only interest payments for 3 to 5 years, then the entire principal comes due. Most borrowers refinance, which means they are gambling on future rates.

Mortgage Valuation and Risk

Like any security, a mortgage’s market price is the present value of its future cash flows. The discount rate depends on the risk-free rate plus a risk premium.

Three types of risk matter:

Credit risk. The borrower might not pay. Economic downturns increase defaults. During the crisis, about 25 percent of outstanding subprime mortgages had late payments.

Interest rate risk. Fixed-rate mortgages lose value when rates rise because they are locked in at the old, lower rate. Financial institutions funding long-term mortgages with short-term deposits are especially exposed.

Prepayment risk. When rates fall, borrowers refinance and pay off their old mortgages early. The investor gets their money back but has to reinvest at lower rates. This limits the upside from falling rates.

Mortgage-Backed Securities

Here is where it gets complicated. Instead of holding mortgages, financial institutions can package them into mortgage-backed securities (MBS) and sell them to investors. The mortgage payments pass through to the MBS holders (minus a servicing fee). This is called securitization.

Several types exist:

GNMA (Ginnie Mae) MBS are backed by FHA and VA mortgages. Ginnie Mae guarantees timely payment, making them very attractive.

FNMA (Fannie Mae) MBS are backed by conventional or federally insured mortgages. Fannie Mae buys mortgages in the secondary market, fueling more lending.

FHLMC (Freddie Mac) participation certificates do the same thing as Fannie Mae, channeling funds into conventional mortgages.

Collateralized mortgage obligations (CMOs) split the underlying mortgages into tranches based on maturity. The first tranche gets paid back first, then the second, and so on. Some CMOs are split into interest-only and principal-only tranches, which behave very differently when prepayments happen.

Collateralized debt obligations (CDOs) are similar but include non-mortgage debt too (auto loans, credit card debt). By 2007, CDO issuance was about $500 billion. The subprime mortgages that were commonly included in CDOs made them extremely risky when the housing market turned.

Valuing MBS was difficult because there was no centralized reporting system. Investors often relied on credit rating agencies instead of doing their own analysis. Many MBS that were rated AAA still suffered massive losses.

The 2008 Credit Crisis

This is the story of what went wrong, and Madura tells it step by step.

The setup (2003-2006). Low interest rates and a booming economy drove up home prices. Lenders lowered standards. Down payments shrank. Mortgage companies approved loans without verifying income. Everyone assumed home prices would keep rising, so even if borrowers defaulted, the property would cover the loan.

The turn (2006-2007). Home buyers pulled back. Supply exceeded demand. Prices started falling. Interest rates rose. ARM rates reset higher. Teaser rates expired. Homeowners who could barely afford their original payments suddenly could not keep up.

The collapse (2008). Mortgage defaults surged. By June 2008, 9 percent of American homeowners were behind on payments or in foreclosure. About 10 percent of subprime mortgages were in foreclosure. The collateral backing mortgages was worth less than what was owed.

Fannie Mae and Freddie Mac had invested heavily in subprime mortgages. By 2007, they held about $170 billion in subprime exposure. Their executives’ compensation was tied to performance, which incentivized risk-taking. This is a classic moral hazard: take risks, collect bonuses if it works, let the government bail you out if it does not. By September 2008, the government took over both agencies.

Systemic risk spread everywhere. Mortgage insurers lost money covering foreclosures. MBS values collapsed. Financial institutions could not use MBS as collateral for borrowing. Bear Stearns and Lehman Brothers could not fund their operations. Individual investors in mutual funds, pension funds, and hedge funds that held MBS suffered losses. Home builders went bankrupt. The economy weakened further.

The commercial paper market froze because MBS were no longer trusted as collateral. International investors who had bought U.S. subprime MBS took losses too. UBS, the Swiss bank, lost $35 billion from MBS positions alone.

Who Is to Blame?

Madura spreads the blame across the entire chain:

Mortgage originators approved loans without proper verification. Some did not even check borrowers’ income.

Credit rating agencies assigned AAA ratings to risky MBS. They were understaffed, did not monitor ratings over time, and were motivated to keep issuers happy because issuers paid their fees. Internal emails at rating agencies showed that some analysts knew their ratings were wrong.

Financial institutions that packaged MBS could have verified the ratings themselves but did not. They relied on the agencies or assumed housing prices would save them.

Institutional investors that bought MBS also failed to do independent analysis. They took ratings at face value.

Insurance companies that insured MBS did not verify the underlying mortgage quality. Some mortgages were fraudulent.

Speculators bought credit default swaps (CDS) betting that subprime mortgages would fail. They profited from the collapse, though they might argue the sellers of CDS contracts were the ones being greedy.

The Government Response

The Housing and Economic Recovery Act of 2008 helped some homeowners restructure their mortgages. “Short sale” programs let homeowners sell for less than owed. The Emergency Economic Stabilization Act of 2008 injected $700 billion through TARP (Troubled Asset Relief Program), buying MBS from institutions and investing in banks.

The Dodd-Frank Act of 2010 required lenders to verify borrower income, credit, and job status. It created the Financial Stability Oversight Council to monitor systemic risk. It required MBS issuers to retain 5 percent of the portfolio as skin in the game. Rating agencies got new disclosure requirements.

My Take

This chapter reads like a cautionary tale about every level of a financial system failing at the same time. Nobody checked anyone else’s work. Originators did not verify borrowers. Packagers did not verify ratings. Investors did not verify the underlying assets. Regulators did not verify the system.

The moral hazard problem with Fannie Mae and Freddie Mac is especially frustrating. Their executives earned tens of millions while taking risks with an implicit government guarantee. When everything blew up, the government did exactly what everyone expected: bail them out.

The credit crisis was not just about bad mortgages. It was about a system where every participant had an incentive to look the other way. That is the real lesson.

Previous: Bond Valuation and Risk Next: Stock Offerings and Investor Monitoring