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Home mortgages seem weird. Often the borrower seeks a loan through a mortgage broker rather than a bank. And even if a bank handles the mortgage, the borrower may send payments to some other company—and that other company may change from one year to another. And if there’s ever a problem, the bank or broker who originated the mortgage is not to one to call. And many consumers, and even mortgage professionals, don’t understand why.

Years ago, we lived with a simpler mortgage system. But that system collapsed, nearly devastating the housing sector. What replaced the old system looks weird and clunky, but ends up being resilient in different economic conditions—but still with some flaws.
 

Simple Mortgages Were Dangerous

Borrowers used to borrow from financial institutions, most often savings and loan associations (S&Ls). The S&Ls took in deposits, mostly short-term certificates of deposit (CDs). They might pay 4% interest on deposits, then turn around and lend money for the purchase of a home at 7% interest. The S&L earned 7% interest income and paid out 4% cost of funds; the remainder paid the cost of operations, bad loans and profits.

This worked very well in the 1950s and early 1960s when inflation mostly ran between one and two percent. Regulations limited the interest that banks and S&Ls could pay on deposits, so they did not compete with one another for funds to lend out, helping profits.

Then inflation increased, hitting four percent in 1968, then above five percent the next two years. Interest rates generally rose across different financial instruments, quite predictably, as those who saved money wanted compensation for diminishing purchasing power of their dollars. S&L depositors, though, could not earn more on the money due to the interest rate cap. Then in 1971 the first money market mutual fund was created, enabling people to earn market interest rates. Many depositors moved their money out of S&Ls.

The exit of deposits threatened the life of the S&Ls. They had good assets—the mortgages—but they could not call in the loans. That is, they could not demand that the borrowers pay back the money immediately. But depositors could ask for their money as soon as their CDs matured.

Regulatory agencies changed their rules to allow higher interest rates. That allowed the S&Ls to keep the money on deposit, but their profits turned negative. They had to pay higher interest rates on their deposits, but most of their income came from old mortgages made at low interest rates. In our earlier example, loans were made at 7% interest but deposits only cost 4%. By the early 1980s, when interest rate limits were ended, deposits might cost the S&L 10%—but those old mortgages still paid only 7% interest.

This is the crux of the problem: If depositors can demand money immediately, but homeowners pay fixed interest rates on a fixed schedule, then higher interest rates doom the financial institution.
 

Safe Mortgages Through Financial Engineering

The S&L crisis threatened the housing sector of the economy. S&Ls held, at their peak, 45% of home mortgages. As these institutions failed, economists worried that home construction would collapse.

The resolution of the problem involved financial engineering, or perhaps better described as financial surgery. Now a bank or mortgage broker provides cash to the borrowers for the purchase of homes. They bundle many mortgages together and sell them all to an institution like Fannie Mae or Freddie Mac. But these institutions don’t want to hold the mortgages any more than a bank does. Instead, Fannie or Freddie finds investors to buy the mortgages, piece by piece.

Think of a 30-year mortgage with monthly payments as a stack of 360 IOUs. A thousand of these stacks may be put together, then sorted by date. The first set of dates, due in one to 12 months, can easily be sold to money market mutual funds. The next couple of years’ payments can be bundled together and sold to banks and insurance companies that want two or three-year investments. The final payments, due 25 to 30 years from now, can be sold to university endowment funds or other very-long-term investors.

It’s not easy to tell the borrowers to send this payment to one company and the next payment to some other company, so a mortgage service company handles the money. This might be the bank that originated the loans, or it could be some other company. The servicing companies get fees for their efforts. They receive payments from borrowers and send it to whoever should get each payment. But the right to service the mortgages can be bought and sold, so sometimes a borrower gets a notice to send payments to a new servicer.
 

Mortgage Prepayments Add Complications

Mortgage prepayments make a critical complication. Borrowers can make extra payments, or they can pay off their entire balance, which typically happens when they refinance or sell their home. So an investor who bought the right to receive payments eight years after the mortgage began may get a lump sum years early. That often happens when interest rates fall, inducing many homeowners to refinance. For the investor, this is ugly. Just as interest rates are falling, the investor gets his money back and now has to re-invest it at lower interest rates.

All of the investors know that prepayments will happen, though none know the exact timing. Some will guess what percentage of future payments will be made early, and use their guess to decide whether the investment is a good deal. If interest rates rise, prepayments are not as common as previously expected. This also hurts the investor, who would like to have cash to invest at the new, higher interest rates.

Seemingly the prepayment option works to benefit borrowers at the expense of investors. But the investors know this going in. The price they pay reflects the risk they take. Borrowers could get a lower interest rate if they would commit to never prepay their mortgages, or if they agreed to pay an extra fee for a prepayment. That is not done on mortgages guaranteed by the federal government, but some private mortgages do require prepayment fees. In fact, business loans at fixed interest rates usually have prepayment fees.
 

Government’s Role In Mortgages

Various government sponsored entities (GSEs) buy packages of mortgages and sell the pieces to investors. These include Fannie Mae, Freddie Mac and Ginnie Mae, shortened forms of more complicated names. They provide guarantees of credit (accepting only mortgages that meet their standards) but do not guarantee the market value of the mortgages. (If interest rates rise, the value of old loans made at lower interest rates will drop.) Although the federal government would not be legally obligated to help the GSEs if credit losses exceeded the GSEs’ assets, investors assume that the government would step in. Estimates of the value of the implicit guarantee are not precise, but one-half a percentage point would be in the ball-park.

Homebuyers may find the process, including occasional changes in servicers, to be overly complicated. But it’s not easy to arrange a system where a homebuyer can get a long-term fixed rate loan, with prepayment option, in a world where inflation and interest rates can change substantially over 30 years.

The system of pooling mortgages and packaging them into different mortgage-backed securities enables borrowers to get the kind of loans they want, while protecting investors from interest rate fluctuations. Most mortgages up get a credit guarantee, backed by the government, but that’s not a critical part of the system. Though not absolutely necessary for the finances to work, the guarantee is extremely popular with the powerful real estate lobbies. So this system will likely last for many years to come.

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