Real Estate Financing

Debt created to finance real estate purchases represents the largest component of outstanding debt in U.S. capital markets. Of the total debt outstanding in all domestic nonfinancial sectors at the beginning of 2000, real-estate mortgage debt accounted for more than 45%. Almost 70% of this amount represented home mortgages, which in turn constituted two-thirds of the total liabilities of all U.S. households. Thus real estate finance clearly ranks among the most important economic activities in the United States.

Mortgage Instruments

A mortgage loan is evidence of debt secured by real property. It may be granted to finance land development, new construction, the purchase of new or existing property, to refinance an existing mortgage, or for other purposes. Mortgage debt is secured by a wide variety of properties, including homes, apartment houses, office buildings, shopping centers, industrial structures, and farms. Each loan contract carries a package of credit terms that vary according to the type of loan, the mortgage market and general economic conditions, the borrower's creditworthiness, the type and location of property used as collateral, and the legal requirements.

Since the Great Depression of the 1930s, the traditional mortgage loan has been the fixed-rate, long-term, amortized, level-payment loan. The terms include the interest rate, down payment requirements, maturity, and prepayment options. Payments are made monthly or biweekly for the life of the loan (which generally has been 25 to 30 years, although 15-year mortgage schedules have become more common). The payment is fixed, with a portion representing interest on the outstanding balance and the remainder reducing the principal. Thus the loan is fully reduced or amortized at maturity.

During the 1970s and 1980s alternative kinds of mortgages were developed. The most successful of these has been the adjustable-rate mortgage (ARM). An ARM differs from a fixed rate mortgage in that the payment varies over the life of the loan. An ARM contract specifies the index used to adjust the interest rate, the repricing schedule, and the highest interest rate permitted over the life of the loan. The interest rate, and therefore the payment, is adjusted periodically, based on the repricing schedule an movement in the index. Some ARMs have limits, called caps, on the magnitude of the adjustment. If these caps prevent a full adjustment to the new interest rate, some loans allow the difference to be added to the principal. This is called negative amortization.

Other mortgage types include "graduated payment mortgages", for which the payment escalates during the early years on a prearranged basis, and "reverse-annuity mortgages," which specify periodic payments to be made to the homeowner; title to the property reverts to the lender on maturity. The latter mortgage type provides homeowners (typically elderly people) with a way to access the equity in their homes without having to sell them.

Mortgage Markets

Mortgage markets may be categorized as primary or secondary markets. The primary market includes the originators and holders of mortgages. The secondary market, which is dominated by government or government-sponsored agencies, consist of institutions that purchase existing mortgages and repackage or otherwise reconfigure them for resale. Main — institutions operate in both markets.

Historically, thrift institutions — savings and loan associations and savings banks — were the largest originators and holders of home mortgages. But innovations in mortgage finance and growth in the secondary markets — along with the thrift industry's financial problems — forced a realignment in the mortgage market in the 1980s. Mortgage companies originate almost 36% of all home loans, while commercial banks originate 33%. Thrift institutions originate about 30%. In the early 1990s the thrift industry held about 26% of the outstanding home mortgage debt in the country, while commercial banks held only about 16%. Mortgage companies, which mostly originate loans, themselves hold virtually no outstanding mortgage debt.

Many originators of home loans choose not to hold the loans in their portfolios. Rather, they sell the mortgages to other institutions or to the secondary market. In the secondary market, mortgages are pooled together, and shares of the pool are sold to investors. These shares, called mortgage-backed securities (MBSs), are more liquid and have both more stable payment streams and higher credit ratings than the original mortgages. Thus, they appeal to a broader range of investors. While mortgage pools do not actually provide the funds for mortgage lending, their development has tapped new sources of funding. By the early 1990s more than one-third of all home mortgages had been pooled. Many traditional mortgage lenders, such as thrift institutions, commercial banks, and insurance companies, are significant purchasers of MBSs.

Some mortgage-backed securities are structured to pass all principal and interest payments, as well as any prepayments, through to the investors on a prorated basis as the payments come into the pool. This kind of MBS is called a "passthrough" security. Another approach groups the shareholders of the pool into various classes, with certain classes receiving all the principal payments coming into the pool until their share is completely paid off. Payments are then directed to the next class of investors, and the process continues until all shares are paid off. Interest payments are shared on a prorated basis. This kind of security is called a collateralized mortgage obligation (CMO).

The Role of Government

The secondary markets are dominated by three government or government-sponsored agencies:

Each agency focuses on a different segment of the market, with GNMA buying and pooling mortgages guaranteed by the Veterans Administration or the Federal Housing Administration, and FNMA and FHLMC dealing in conventional mortgages. Because real estate financing has such great social ramifications, federal and state governments try to influence this activity both directly and indirectly. The supply and terms of mortgage credit are set by the Federal Reserve System, the Treasury Department, and financial services regulators as they set monetary and debt management policy. More directly federal tax policy fosters home ownership by making mortgage interest payments deductible on federal income tax returns.

The federal government administers various mortgage guarantee and mortgage insurance programs through the Veterans Administration, which fosters homeownership among armed services personnel and veterans, and the Federal Housing Administration, which directs its activities toward low- an moderate-income groups. Congress established the Federal Home Loan Bank System in 1933 to provide a reserve system for thrifts analogous to the Federal Reserve System for commercial banks. It also set up a system of federal deposit insurance to provide depository institutions with steady funding, part of it for home mortgage lending.

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