Secondary mortgage markets: recent trends and research results

Secondary mortgage markets: recent trends and research results

James E. McNulty

The development of an organized secondary market for conventional mortgage loans during the 1970s and early 1980s has opened up many new opportunites for savings institution managers. It has given the mortgage instrument a much higher degree of liquidity, which has provided much greater flexibility in managing the mortgage portfolio. More recently, selling loans in an active secondary market has provided institutions a way to continue to be mortgage lenders without incurring the risk of adding long-term, fixed-rate loans to their portfolios.

The development of this market has also created a fertile field for academic research. Researchers have been interested in the way in which the secondary market has affected mortgage rates and loan-terms–both their absolute level and the differences among regions. This article discusses the growth of the secondary market since 1970 and then reviews some recent research dealing with these questions. Growth of the Market

Some perspective on the growth of the secondary mortgage market can be obtained from Charts 1 to 3. Chart 1 shows the tremendous growth in the amount of mortgage pool securities outstanding from year-end 1970 to year-end 1982. These pools are represented by Government National Mortgage Association (GNMA) passthrough certificates and Federal Home Loan Mortgage Corporation (FHLMC) participation certificates, both of which have existed since the early 1970s, as well as the newer Federal National Mortgage Association (FNMA) passthrough certificates. After rising to $14.4 billion by the end of 1972, the outstanding amount of mortgage pool securities more than tripled to $56.8 billion by the end of 1977. At the end of 1972, mortgage pools represented 4.0 percent of total residential mortgage debt outstanding. (See Chart 2.) This increased to 8.9 percent at the end of 1977 and 16.1 percent at the end of 1982.

Even more impressive is the extent to which the growth in mortgage pools has contributed to the growth in outstanding mortgage debt. Chart 3 illustrates this by presenting a comparison of the change in the amount of mortgage pool securities with the change in total residential mortgage debt. For example, in 1977, mortgage pools increased from $40.7 billion to $56.8 billion (see Chart 1), while total debt increased from $544 million to $635 million. The $16.1 billion increase in mortgage pools thus represented 17.7 percent of the debt increase. In 1982, mortgage debt increased by only $46.9 billion, reflecting depressed conditions in the housing market. By coincidence, mortgage pools also increased by about $47 billion in 1982, so that, in effect, the secondary market accounted for all of the growth in mortgage debt in 1982.

Talk of the integration of the mortgage market into the general capital markets, which had been prevalent in financial circles since at least the mid-1970s, became a reality by the early 1980s. In fact, the above figures understate the size of the secondary market, since many secondary market transactions involve the sale of individual mortgages and do not result in the creation of market pools. On the other hand, in 1982, the figures are somewhat distorted because a large portion of the growth in mortgage pools reflects the success of the Federal Home Loan Mortgage Corporation’s “guarantor” program, in which lenders swap older, low-rate mortgages for passthrough securities. In this situation, a mortgage pool is created without a corresponding amount of new lending activity. In previous years, pools were created primarily to fund new lending activity.

While there are some measurement problems, the growth of the secondary market–and its support of the primary market–is impressive, as these statistics make clear. For an increasing number of associations, the secondary market has become the mortgage market. It is common, for example, to hear of institutions which sell almost all of the fixed-rate loans they make to one of the mortgage agencies or to private sources. Impact on Mortgage Yields and Spreads

With this background, we can review the findings of some recent studies on such issues as the effect of the development of the secondary market on mortgage yields and on interregional differences in mortgage rates. In theory, the integration of the mortgage market into the Nation’s overall capital market s should have two effects. First, by creating greater competition in the mortgage market and increasing the supply of mortgage funds, it should bring mortgage rates more in line with other interest rates. Secondly, it should reduce interregional differences in mortgage rates.

With regard to the first of these effects, a 1980 study by Hendershott and Villani argues that this is exactly what had happened by the late 1970s. According to the authors, the development of the secondary mortgage market “has improved interregional flows of mortgage funds and has given mortgage borrowers a greater access to capital markets generally. The principal result has been a decline in the mortgage rate relative to other market rates…” [2, p. 50]. This decline in the spread between mortgage rates and other interest rates to which Hendershott and Villani called attention is illustrated in Table 1. For example, from 1963 to 1965 (before the first period of disintermediation in 1966 and before the development of an organized secondary market for conventional loans), the spread between conventional mortgage rates on loans closed and rates on 10-year US government bonds ranged from 153 to 193 basis points. By 1978, the spread had declined to 113 basis points.

By 1982, however, the spread between mortgage rates and US bond rates had widened considerably. For example, in that year, the effective rate on loans closed had risen to 212 basis points above the 10-year US government bond rate. This left this spread even higher than it was in the early 1960s. In fact, this comparsion understates that change. Rates on new mortgage commitments were even higher than rates on loans closed in 1982, and the commintment rate is a more accurate mortgage market indicator. (It is typical for a loan not to be closed until a few months or more after a commitment is made. As a result, the loans closed series lags behind the trend in market rates.)

As indicated in Table 2, the spread between the rate on new commitments and government bonds increased from 133 basis points in 1978 to 359 basis points in 1982, which is a very substantial increase. Similarly, the spread between rates on GNMA securities and 10-year US government bonds–instruments with similar risk characteristics–increased from 57 basis points in 1978 to 169 basis points in 1982.

In a later paper in 1982, Hendershott, Shilling, and Villani argue that the recent increase in the spread does not invalidate their earlier argument that the mortgage market has become integrated into the Nation’s capital markets. The authors attribute the increase in the spread to the fact that a mortgage has special characteristics not found in other debt instruments. The most important of these is the option the borrower has to repay the loan if rates go down, or to assume an existing loan if rates rise. According to the authors, “because interest rate volatility has increased so dramatically since 1978, it is reasonable to presume that the value of this option has increased” [1, p. 2]. The higher rate is thus seen as something that is necessary to compensate the lender for providing this option. The authors present empirical results which are consistent with this explanation.

In summary, economic theory suggests that by creating an increase in the supply of mortgage funds, the development of an organized secondary mortgage market will reduce mortgage yields relative to what they would otherwise be. Studies using statistical data through 1978 confirm this result. However, recent interest rate volatility appears to have increased the spread. It is interesting to note, for example, that in 1982 the spread between mortgage rates and US bonds was at the second highest level in at least the last twenty years. Interregional Differences

The development of the secondary mortgage market should also reduce interregional differences in mortgage rates and other loan terms. As noted by Meador [4] and Morrell and Saba [5], the Census Bureau in 1890 reported that interest rates in the western Mountain States exceeded those in New England by 380 basis points. Differentials, of course, have narrowed since then, but they have not disappeared.

Morrell and Saba found an average difference of approximately 40 basis points in contract rates and 50 basis points in effective rates on conventional loans between Northeastern SMSAs and those in the West for the period 1963-1978, taken as a whole. Such rate differences are usually considered to be the result of an excess supply of mortgage funds in the slow-growing Northeastern SMSAs and excess demand in the faster growing areas such as the South and West. As such, regional differences are considered necessary to allow capital to flow from one area to the other to allow borrowers in the capital-short areas to secure credit.

The effect of the development of the secondary market for conventional loans on interregional differences has been considered by Morrell and Saba, and by Rudolph, Zumpano, and Karson [6]. Interestingly, neither study found that the secondary market had had a major impact on interregional differences.

In the first study, Morrel and Saba developed a multiple regression equation in which interregional differeces were related to a secondary market variable and several regional variables, representing regional differences in various loan characteristics. (Multiple regression is a statistical technique which forms a mathermatical equation to test for the strength of a relationship among several variables.) The authors concluded that, while regional differences still existed (even after adjustment for differences in loan characteristics), the development of a secondary market for conventional loans has been partially successful in reducing such differentials.

In a related study, Rudolph, Zumpano, and Karson compared interregional mortgage rate differentials on conventional loans for 1968 and 1978 using data for 46 SMSAs. The authors also examined changes in other loan terms such as loan-to-value ratios, term to maturity, and initial fees and charges to ascertain if the development of the secondary market had any impact on these other loan characteristics.

The authors found, for example, that the standard deviation of the contract mortgage rate (a measure of interregional variation) actually increased in the sample of 46 SMSAs from 1968 to 1978. Part of this, however, was due simply to the increase in interest rates over the period. A relative measure, the coefficient of variation (calculated as the standard deviation divided by the mean) showed virtually no change between 1968 and 1978. Further examination of the data (using a technique known as analysis of variance) revealed no statistically significant change in the relationship among the variables between the two years. This suggested that no basic change in the structure of the mortgage market had occurred over this period. Finally, a regression test was performed. For three of the four regions, the development of the secondary market was found to have had no significant impact on the contract mortgage rate. There was also little effect on the other loan characteristics. The study concluded that the secondary market had not had much impact in reducing differeces among local markets. Concluding Comments

Economists stress that markets work in complex ways to allocate resources among various sectors of the economy. In fact, markets work in ways that are oftern unanticipated by the participants. For example, interences with market forces often produces results that are the opposite of what was intended. The effect which rent control–a policy designed to assist low income groups–has had in creating an acute shortage of housing in areas, such as New York City, is a case in point.

A similar situation involving unanticipated effects has occurred in connection with the secondary mortgge market. Savings and loan executives enthusiastically applauded the development of an organized secondary market for conventional loans in the early 1970s. Nonetheless, a decade later, many of the same people were expressing great concern that the existence of this market had made it much more difficult for savings institutions to develop a market in their local area for adjustable rate mortgages. The reason for this is that the primary requirement of pension funds and other buyers of loans in the secondary market is for fixed-rate loans.

Much of the same type of effect might have been expected in the areas discussed here–the impact on mortgage yields and interregional differences. For example, few, if any, S&L executives who supported the development of an organized secondary market expected it to reduce mortgage interest rates–their primary source of income. A review of the available studies suggests that it may have had precisely this effect, although the size of the effect has been relatively small and has apparently been mitigated in recent years by other factors. There also could have been some effect on interregional differences. If this had occurred, mortgage interest rates in capital surplus areas, such as the Northeast, would probably increase somewhat from what they would otherwise be, while those in capital short areas, such as the South and West, would decline. Again, however, the available research suggests that, if it exists, this effect has been small.

COPYRIGHT 1984 U.S. Government Printing Office

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