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180 Years’ Evolution of the US Mortgage Banking System 171

NTERNATIONAL

EAL

STATE

EVIEW

2007 Vol. 10 No. 1: pp. 171-212

180 Years’ Evolution of the US MortgageBanking System: Lessons for EmergingMortgage Markets

∗

Man Cho

The KDI School, Seoul, Korea; man_cho@jhu.edu

This study is structured around two objectives: surveying the 180years’ evolution of the US mortgage intermediation system (MIS); and,extracting the lessons to be learned by emerging mortgage markets.To that end, I first discuss three pillars of a well-functioning MIS as aconceptual underpinning - intermediation efficiency, affordabilityenhancement, and risk management. The historical survey proceedsbased on four reasonably distinct time periods – (1) the era ofexploration (pre-1930s or pre-Great Depression era), (2) the era ofinstitutionalization (1930s to 1960s), (3) the era of market-making(1970s and 1980s), and (4) the era of expansion and efficiency gain(1990s to Present). Based on the survey done, the lessons for othercountries are organized under five topics: developing conformingmortgage product and market; extending the service to non-conforming segments; managing default and prepayment risks;managing systemic risk; and, developing an efficient intermediationprocess. The concluding remarks in the final section comprise theissue of right sequencing: that is, through what steps an MIS in agiven country can be evolved toward a more market-based one thatcan deliver a higher degree of consumer welfare.

∗

The author thanks to those colleagues and mentors who provide comment on the earlierversion, in particular, Robert Buckley, Peter Linneman, Bertrand Renaud, Tyler Yang, andSusan Wachter. The usual disclaimer applies in that views and opinions expressed in the paperare solely the author’s and not Fannie Mae’s.

172 Cho

Keywords

mortgage banking and intermediation;

housing affordability;

risk management

Introduction

The US Mortgage Intermediation System (henceforth, the USMIS) is one of the largest and most complicated financial systems in the world. It managesan extensive portfolio of $8.8 trillion mortgage debt outstanding (MDO) asof the end of third quarter 2005, which amounts to nearly 70% of nominalGDP during the period; is highly efficient with the competitive primarymarket for loan production and servicing and with the liquid secondarymarket for funding; and, offers consumers with various affordable loanproducts such as high LTV loans for wealth-constrained households,subprime mortgages for those with impaired credit records, and reverseannuity loans for house-rich cash-poor senior citizens.In recent years, the system also served as a stabilizer to the macroeconomy,as evidenced by several studies. That is, aided by the strong home priceappreciation and the low mortgage interest rates since the late 1990s, theUSMIS enabled a large number of households to liquidify their homeequities for consumer spending and for capital investment (Case, Quigley,and Shiller (2001) and Leung and Zeng (2005)) The net mortgage equityextraction - the total amount of newly-originated loans minus the total repaidloans – also jumped to $800 billion in 2004, about 170% increase from $300billion in 2000. (Greenspan and Kennedy (2005))The USMIS experienced a tremendous growth since the early 1990s andachieved further maturity in its key functions of lending, funding, servicing,and risk management. However, the system has a long history of evolution,over 180 years from the first recorded institutional lending in the 1830s.Throughout that evolution, economic shocks often stimulated discrete policyshifts, which in turn led to innovations in product development and risk sharing arrangement. The main objective of this study is two-fold: first, tosurvey the milestone events that shaped the USMIS over time; and, second,to extract lessons to be learned by emerging mortgage markets from the USexperience.I believe that the historical survey of this sort can shed light as to how agiven sector in economy – the mortgage banking industry in our context –started in the first place, and what events, whether they are driven byinstitutions or by markets, triggered structural changes in the industry. Not

180 Years’ Evolution of the US Mortgage Banking System 173

surprisingly, there are a number of good references on the history of the USmortgage market (Jacobides (2001), Lea (1994), Weicher (1988), andHendershott and Villani (1977)). Building upon these studies, I aim toextend the analysis in several fronts. First, I survey the recent period of 1990-2005 in a greater detail, more so than others, as it represents the era of another big shift in the landscape of the USMIS caused by the advancementof Information Technology (IT) and other innovations. Second, the studyalso attempts to come up with a set of performance indicators in gauginghow well-functioning a given MIS is in terms of serving its promised socialand private functions. The lessons for other countries are organized alongthese performance indicators.The following list represents main findings from the study.

•

As an organizing concept throughout the study, Section 2elaborates three pillars of a well-functioning MIS – intermediationefficiency, affordability enhancement, and risk management. A setof success factors for each dimension, both qualitative andquantitative, is listed and used in subsequent analyses. The trade-off between risk and affordability in the context of marketsegmentation and expansion is one of the core issues discussed.

•

The historical survey in Section 3 starts with the analysis of long-term trend (1895 to 2004) of the yield spread between residentialreal estate loans and high-quality corporate bonds in the US. Thetrend indicates that USMIS has achieved a comparable level of intermediation efficiency over time to that of the corporate debtsector: that is, the spread has been stabilized over time with zero to50 basis points (bps) premium; and, there are several small peaks inthe recent years that correspond to the heightened prepayment risksin holding mortgage portfolio in those periods, which in generaldoes not exist in the corporate sector due to various call protections.The historical survey in Section 3 is done for four distinct timeperiods – (1) Era of Exploration (Pre-1930s or Pre-GreatDepression Era), (2) Era of Institutionalization (1930s to 1960s), (3)Era of Market-Making (1970s and 1980s), and (4) Era of Expansion and Efficiency Gain (1990s to Present).

•

The 180 years’ evolution of the USMIS has brought about anumber of outcomes that enhance the welfare of both consumersand investors:

Heightened liquidity with the rise of the secondary market, asevidenced by the increase of MDO from $1.5 trillion in 1980 toalmost $9 trillion in 2005;