US Mortgage Lending Model

In America – the largest and most developed mortgage lending market in the world, both in terms of organization and the number of financial instruments. The United States managed to occupy a leading position due to the formation of a transparent liquid secondary market and effective interaction between its participants.

The main participants in the US mortgage market are:

  • Borrower – buying a mortgage loan to buy a home.
  • Creditor (bank or other credit institution) – providing a loan to the borrower on the security of the acquired property.
  • The mediator is a mortgage agency that raises capital for borrowers and provides liquidity in the market.
  • Investors (mostly institutional ) acquiring securities issued on the basis of mortgage loans.

Primary and secondary mortgage market

Interaction at the level of the borrower – the bank – this is the primary mortgage market. His tool is traditionally a mortgage loan (mortgage). The most popular types of mortgages in the United States are:

  • Loan with a fixed interest rate (Fixed-rate Mortgage, FRM).
  • Variable interest rate loan (Adjustable-rate Mortgage, ARM).

For ARM loans, the rate is fixed for the initial period (usually 3, 5 or 10 years), after which the rate becomes floating and is adjusted depending on the market situation. The frequency of the interest rate revision is determined by the terms of the contract. Also, under the contract, the borrower has the right to early repay the loan (Mortgage Prepayment) with any amounts at any time.

Typical mortgage loans in the United States are issued at a rate of up to $ 200 thousand on conditions of up to 28% PTI and up to 80% LTV, where:

  • PTI (Payment-to-Income Ratio) – the ratio of the monthly payment on the loan to the monthly income of the borrower.
  • LTV (Loan-to-Value Ratio) – the ratio of the loan amount to the market value of the collateral.

A prerequisite for obtaining a mortgage in the United States is insurance of mortgaged property and title (risk of loss of ownership of the object). Life and work insurance is at the discretion of the borrower.

Interaction at the level of a  bank – an intermediary – an investor is a secondary mortgage market. Its instruments are mortgage securities issued by mortgage agencies (Mortgage Securities), secured by mortgage loans of the primary market. It is this two-tier scheme of mortgage lending (Two-level Mortgage) is valid in the United States. Due to the fact that it originated there, it is called the American mortgage model. In practice, it looks like this.

Two-tier model of mortgage lending

When a borrower appeals to a mortgage bank for a loan, the bank enters into an agreement with him at the same time demanding that he draw up and sign a mortgage.

  • Mortgage  is a registered security document certifying the rights of the mortgagee and guaranteeing creditors receipt of loan payments. If the borrower fails to fulfill the obligations, the funds are returned by selling the collateral.

After registration of ownership of the property, the bank becomes the legal owner of the mortgage. The bank combines such mortgages as they accumulate into “mortgage pools” and sells it to intermediaries – specialized mortgage agencies . In the US, these are government-supported organizations like Ginny Mae, Fannie Mae and Freddie Mack.

  • Mortgage Pool – a package of homogeneous mortgage loans with similar maturities, payments and interest rates.

This is one of the key differences between the American model of mortgage lending from the European one. In the US, lenders do not leave mortgage loans on their balance sheets and do not issue mortgage-backed securities they secured, but transfer this function to mortgage agencies.

Agencies reimburse the bank money paid to the borrower, and in return receive a stream of future payments from the borrower on the loan minus the bank commission. As a result, banks receive money to issue new loans, and intermediaries – the opportunity to earn money on mortgages.

To do this, use the right mortgage agency requirements for mortgages as collateral and release them under the debt – through mortgage-backed securities (Pass-Through Mortgage Backed Securities, MBS), also called by agency (Agency MBS). This process is known as securitization.

  • Securitization is a mechanism for converting an illiquid loan (mortgage, not a issuing paper) into a security circulating on the stock exchange and over-the-counter market.

The agencies issue the issued securities at the stock exchange, transferring to the investors who bought the papers the flow of payments from the borrower minus their commission. That is, the agency itself acts as an intermediary, similar to the mortgage bank. At the same time, the MBS payments transferred to the investor are guaranteed not by the real estate pledge, but by the mortgage agency.

Government support for mortgage agencies equates MBS in terms of reliability with government bonds . This makes them accessible to institutional investors providing liquidity to the secondary mortgage market. Along with conservative investors in agency MBS investing their money and mortgage real estate investment funds (Real Estate Investment Trust, REIT) .

  • PS March 12, 2014 it became known about the upcoming  reform of the mortgage market , involving the elimination of Fannie Mae and Freddie Mac. Instead, they will create a system of mortgage-backed securities with a federal guarantee, which will be owned by banks issuing mortgage loans. They will incur the first 10% of the loss before the new structure comes into play – the Federal Mortgage Insurance Corporation.
  • It is also assumed that certain standards should be observed when securitizing: for example, only a loan with a 5% down payment can repackage a bond, and 3.5% for first-time buyers.

Risks of the mortgage market

Credit risk Mortgage loans are used by borrowers to purchase real estate, which is also the collateral for them. The presence of such a pledge, along with the compulsory insurance of the risk of loss of property rights, makes it possible to assess credit risk as insignificant.

The most serious impact on the mortgage market is the interest rate risk that occurs when interest rates change.

Interest risk. A high interest risk for mortgage lending is associated with the right of the borrower to repay the balance of the debt at any time. This is beneficial for the borrower, but not beneficial for lenders and investors, as it deprives them of certainty in assessing the flow of future payments.

As a result, there is a  risk of early repayment (Prepayment Risk). How is this risk realized? Suppose an investor holds mortgage securities, receiving a 5% coupon on them when the market rate is 5%. What happens when the interest rate changes?

In the event that the rate starts to decline, the price of the mortgage paper will start to rise (the price of debt securities moves in the opposite direction to the interest rates). At the same time, the cost of mortgage paper will increase less due to the increased risk of early repayment.

  • With a decrease in market rates, new mortgage loans begin to be issued at a lower percentage. And it is more profitable for the borrower to repay the current loan ahead of schedule due to the opening of a new one with a lower rate.

If the rate on the market starts to grow, having increased, for example, to 8% per annum, the price of the mortgage paper will start to decline. At the same time, the fall in its price will be higher than that of a simple bond, due to a reduction in the volume of early repayable loans.

  • This additional risk of mortgage bonds is called negative duration or negative “bulge”.

It is more profitable for a borrower to deposit available funds at an interest rate of 8% and earn income due to the difference of 3% between the rates of placement (8%) and borrowing (5%). The investor, on the contrary, is interested in early repayment and return of the invested funds in the purchase of mortgage securities in order to place them at a higher interest rate.