This industry covers establishments primarily engaged in originating mortgage loans, selling mortgage loans to permanent investors, and servicing these loans. They may also provide real estate construction loans.
522292 (Real Estate Credit)
522390 (Other Activities Related to Credit Intermediation)
The mortgage loan industry differs from other industries in its passivity: whereas new products and services can create new markets in other industries, the mortgage industry remains at the mercy of homeowners and buyers, who almost never buy on impulse. Instead of creating new markets, mortgage bankers must respond to existing markets and anticipate marketplace changes, transforming their services in reaction to larger societal forces, such as population demographics and interest rates. This passivity forces the industry to be dynamic, constantly shifting to meet new demands, such as rising rates of first-time homebuyers, and take advantage of new opportunities, such as e-commerce. At its core, the mortgage industry remains solid because home ownership represents an enduring aspect of American life.
The mortgage financing industry experienced record-high results for combined purchase and refinancing transactions of $1 trillion in 1993; 1998 results surpassed this watershed mark, and a new record of $2.3 trillion was set in 2001. Double-digit interest rates still existed in 1993, thus refinancing fueled that year's record transactions. In 1998, refinancing still accounted for some transactions, as borrowers took advantage of low interest rates to decrease their mortgage payments from above 8 percent to below 7 percent. When average interest rates dipped below 7 percent in 2001 and below 6 percent in 2002, the industry saw an unprecedented spike in refinancing activity, which fueled a record volume of mortgage originations in both years. These low interest rates also sparked growth in new transactions, particularly by the growing segments of first-time homebuyers, low-income buyers, minorities, and immigrants. Lenders realized that fair and affordable lending not only made ethical sense, but also made very good business sense.
As liaisons, mortgage bankers are more than just loan brokers, because they maintain a responsible presence from the time mortgage loans are created until they are paid in full. The mortgage banker functions in a continuum extending from the seller/builder of the property to the seller's agent, to the mortgage borrower, to the mortgagee (the mortgage banker), and to the mortgage investor. Mortgage bankers specialize in the origination or production of mortgage loans for sale to the secondary mortgage market. Many mortgage lenders make or buy loans, while some sell loans, and others service loans. Mortgage bankers link the three functions.
The housing finance system in the United States includes many private and public institutions and several levels of market activity. The mortgage lending/investment process involves the provision of housing credit to borrowers by institutions and individuals who hold housing loans in their portfolios. However, a number of institutions may come between the ultimate investors, and the characteristics of the mortgage asset may be transformed along the way as insurance and guarantees are attached and as securities replace the original mortgage loans.
Residential mortgage loans are made (originated) in primary markets where lenders and borrowers conduct business. Borrowers get mortgage credit in these markets mainly from depository institutions or mortgage banking companies. Since the 1930s, mortgage loans made in primary markets typically have been long-term, fixed-rate instruments with level payments that pay off (amortize) the principal balance over the term of the loan. However, new types of mortgage instruments emerged recently to serve the various needs of borrowers and investors. Most of the new mortgage instruments provide for adjustable interest rates, graduated payment schedules, or some combination of these features.
Institutions operating in primary mortgage markets may hold the mortgages they originate, adding them to their asset portfolios. In many cases, however, originators sell their loan production on secondary markets, thereby replenishing their supplies of loanable money. Transfers of outstanding mortgages among mortgage investors also take place in secondary markets.
Sales of mortgage loans from originators to investors inevitably involve some cost, but such transfers are often necessary for the effective functioning of the housing finance system. Secondary market transactions may be needed to correct interregional imbalances in the supply of and demand for mortgage credit, or to move mortgage assets from one type of institution to another within the same market area. The latter need arises within a system characterized by specialization and division of labor. One type of institution may perform a mortgage banking function, specializing in mortgage origination and servicing and selling assets to investors who choose not to perform these functions. Such a division of functions can be encouraged by federal or state regulations governing the activities of various types of institutions.
There are several types of loan instruments available to individual and institutional investors:
Fixed-Rate Mortgages. Historically, 30-year fixed-rate mortgages have been the loan instrument of choice for many borrowers. The changing conditions in the mortgage market, however, coupled with sharp fluctuations in interest rates, have increased the demand for shorter maturities, more interest-sensitive loans, and nontraditional mortgage instruments.
Adjustable-Rate Mortgages (ARMs). Because of the thrift crisis in the late 1980s, lenders began offering adjustable rate mortgages. Lenders, buffeted by interest rate risk, looked to shift the risk to the borrower. In exchange, they offered borrowers a lower initial rate. What was once an instrument designed to keep housing affordable during periods of high interest rates turned into an interest rate gamble for a growing number of borrowers. Borrowers that opt for fixed-rate loans anticipate stable or increasing interest rates. If they are wrong, they can refinance later. Borrowers that choose adjustable plans believe that rates will decline. In its brief history, the ARM has shown resilience as a loan product and unexpected risk for borrowers and lenders.
Convertible ARMs. These instruments have been available for years, but have been marketed aggressively only during high interest rate periods. This type of mortgage vehicle gives the borrower the benefit of a low initial rate with the option to refinance to a fixed-rate mortgage at about half the typical refinance cost. The convertible ARM may be attractive to lenders with loan-servicing portfolios, since they would be less likely to see refinance business go elsewhere. If the borrower switches to a fixed-rate mortgage when rates are low, however, the lender will have a portfolio of low-rate, fixed-rate loans.
Shorter Term Mortgages. Fixed-rate mortgages with terms shorter than the traditional 30-year instruments have become tremendously popular since the early 1980s. They are expected to become increasingly popular as borrowers see the value of their mortgage interest deductions decline as they move into lower tax brackets. Moreover, during periods of low inflation, borrowers can pay down their principle in cheaper dollars. The 15-year loan historically had rates between 40 and 50 basis points (a basis point is equal to 0.01 percent) below the 30-year loan, and has lower overall financing costs. The higher monthly costs make the 15-year loan available mainly to affluent borrowers. This has helped keep default rates low, making it a good intermediate term asset for portfolio lenders and attractive to investors. Industry estimates place default rates on 15-year loans at about half that of 30-year mortgages.
Bi-Weekly Mortgages. Bi-weekly mortgages are similar to 15-year or 30-year mortgages except that the borrower pays half of the scheduled monthly payments every two weeks. This creates the equivalent of 13 monthly payments a year, resulting in a much faster pay-off. A 30-year mortgage would be paid off in 19 years with this instrument. Virtually all bi-weeklies are fixed-rate loans, and much of the bi-weekly volume is generated by refinancing. Borrowers take advantage of declining rates to lock in a fixed-rate, shorter term loan with slightly lower monthly payments. Lenders target sophisticated, second-and third-time homebuyers for this product. The loan usually is tied to a checking or deposit account from which payments are debited directly. Delinquency rates on this instrument are extremely low, especially in cases in which the financial institution requires one or two payments to be kept in the deposit account at all times.
Home Equity Loans. Since the passage of 1986 tax reform legislation, home equity loans have become increasingly popular. These loans generally are tied to the prime rate, and may be tax deductible. They are usually revolving lines of credit with little standardization. Because of this, there is not an active secondary market for home equity loans. Investors are wary of potentially high default rates, as well as how legislators will respond to the collection process.
Portable Mortgages. A loan for movers, the portable mortgage traveled to the United States from Canada (as did the bi-weekly). With a portable loan, the lender hopes to keep the mortgage loan even in the event of relocation by the borrower. A borrower who moves to another house may take this loan with him without paying additional points. In the event that a borrower needs additional money, they are added to the loan at the prevailing rates, making a portable blend.
For most of its history, the mortgage banking business was comprised of a relatively small number of independent firms who acted as intermediaries between borrowers and permanent mortgage investors. The major part of their activities concentrated on residential loan origination, and most of that consisted of Federal Housing Administration (FHA) and Veterans Administration (VA) loan production. Savings and loan associations dominated most of the conventional residential market and there were few sources of mortgage capital besides such traditional mortgage investors as thrifts and life insurance companies. It was, for the most part, a private market where available capital disappeared when interest rates rose and capital availability tightened.
Before 1970, the Federal National Mortgage Association (Fannie Mae) provided one of the few national secondary markets through its whole-loan purchase and sale program. Even that program, however, was limited to government loans. The establishment of the Federal Home Loan Mortgage Association (Freddie Mac) in 1970 and the entrance of Fannie Mae and Freddie Mac into the conventional secondary market in 1972 initiated the expansion and rise in importance of secondary market activities for all mortgage lenders. This factor manifested itself through the standardization of loan documentation and under-writing criteria and a consistent market presence that the private secondary market had never achieved.
The 1980s were a transitional period for mortgage bankers. The first great challenge was the high level of interest rates that all but shut down origination volume. Creative lenders took advantage of liberalized lending regulations, and the result was a vast expansion in the menu of mortgage banking products, including more than 200 types of adjustable rate mortgages and a sometimes bewildering profusion of graduated payment, growing equity, shared equity, wrap, and second mortgage loans. As so often happens, the wishes of consumers and investors were diametrically opposed: investors demanded loans that would adjust immediately to the market, while consumers sought out loans that looked as fixed as possible (with lower interest rates of course). For a long while mortgage bankers despaired as thrifts dominated the origination market with teaser rate adjustable rate mortgages.
The marketplace eventually winnowed the product menu down to a few manageable choices, and the lower interest rates of the late 1980s increased the popularity of fixed rate loans. The competitiveness of mortgage bankers was enhanced not only by the return of a fixed rate environment, but also by two other factors that dramatically changed the industry: the savings and loan crisis and the rise to dominance of mortgage-backed securities (MBS).
The thrift industry was at once a blessing and a bane: while thrift investors were primary outlets for whole loan products, thrift originators were frequently unbeatable competitors. However, the same shortsighted impulse that led thrifts to aggressively push market teaser rate ARMs (some of which had caps below the prevailing level of fixed rates) led to a multitude of other dubious business decisions that sealed their fate. At the same time that thrifts were diminishing in importance as investors, the MBS was coming into its own. By the late 1980s, even ARMs and jumbo loans were being packaged into generic MBS and resold through Wall Street to institutional investors, many of whom would never dream of investing in a whole loan product. Early fears that the thrift investor base could never be replaced proved groundless. The MBS products provided an ongoing source of capital.
By the mid-1980s, government deregulation, lax underwriting standards, and some of the more dubious products offered earlier in the decade were producing catastrophic results. Lenders passed on risks to mortgage insurers, many of which failed to adequately monitor the situation. Losses mounted because of the growing number of loan defaults. Industry analysts pointed to payment shock or equity erosion or other factors as the reason. It eventually became clear that equity was the single most important determination of credit risk. As underwriter ratios were tightened, many underwriters complained that the insurance companies were punishing them for the borrowers' sins. Gradually, insurers analyzed the delinquency and default experience of millions of loans and arrived at sensible standards that protected the interests of borrowers, lenders, insurers, and investors.
Just as the early 1980s were dominated by the effects of high interest rates, the second half of the decade was strongly influenced by declining interest rates. This had several profound effects. Origination and refinance volume soared, and this opened up many profitable opportunities for mortgage bankers. As a result, new products began increasing the investor base for mortgage loans, while at the same time dampening the volatility of most mortgage bankers' earnings.
As a result of economic fluctuations of the 1980s and early 1990s, mortgage banking and the mortgage finance industry began to undergo fundamental changes that altered the role of traditional participants, opened the market to new players, saw Wall Street emerge as a major provider of mortgage capital, and radically changed the nature of the secondary mortgage market.
The dramatic changes in mortgage banking have been driven by a series of developments that have affected all financial services. Each development would have been significant in its own right, but in combination they have altered mortgage financing beyond recognition.
Mortgage Securities and Wall Street. Mortgage lenders recognized long ago that the original secondary market lacked the ability to consistently provide mortgage capital in the amounts needed or the geographic distribution required to adequately meet the housing needs of the nation. With no central marketplace, an awkward and non-liquid investment vehicle, and non-standard documentation, mortgages could not compete in the capital markets when demands for capital exceeded the available supply from thrifts and other portfolio lenders.
Mortgage-backed securities, which offered access to the broad investor base and capital formation abilities of Wall Street, were revived with the creation of the Government National Mortgage Association (GNMA, or Ginnie Mae) in 1968 and the issuance of the first GNMA pass-through securities in 1970. Mortgage-backed bonds had once been widely used in the 1920s, but had a dismal record in the depression of the 1930s. With the government guarantees on the underlying mortgage collateral and on the securities themselves, GNMA securities traded on Wall Street began to attract nontraditional mortgage investors. At about the same time, Freddie Mac initiated pass-through securities backed by conventional residential mortgages. By the mid-1970s, residential mortgages, government and conventional, had been accepted as viable security collateral by the investment community. The result was a rapid growth in the volumes and types of mortgage securities in the marketplace.
In addition to reaching a huge investor base and new sources of capital, the securities markets offer a speed of execution and efficiency of pricing that the traditional secondary mortgage markets cannot match. As a result, the securities markets have been outlets for increasingly large percentages of residential mortgage production. Securities markets drive mortgage pricing nationwide, heavily influence mortgage product design, and reduce the mortgage finance industry's reliance on mortgage portfolio lenders.
Economic Influences. Since the early 1980s, as mortgage securities were assuming a major role in mortgage financing, changes occurred in the basic economics of all financial markets that have forced major alterations in the way mortgage banking operations are planned and managed. The magnitude of interest rate movements and the speed with which they occur have reached levels unknown and unanticipated before the 1980s. The collapse of mortgage security prices in the spring of 1987 illustrated the potential volatility of the market, which can be influenced by factors unrelated to mortgage rates or the housing capital markets.
This volatility made the mortgage banker's job of risk management much more complex and difficult. Mortgage bankers put together strategies and operating procedures, which include sophisticated reporting systems, to monitor and control the risk exposure of their operations.
Further complexities have been added to the business with the wider variety of mortgage products offered to borrowers, whose preferences often shift from one loan type to another as the economic climate and expectations change. This tendency is illustrated by the changing market share of originations by fixed-rate, adjustable-rate, and balloon loans. As mortgage rates fall, fixed-rate products and balloon loans tend to dominate the market. As rates rise, lower initial rates bring adjustable products a larger share of the market. The mortgage banker's risk position changes with each shift, and swift action is required to maintain prescribed risk exposure limits.
As the economics of the marketplace changed, so have the economics of mortgage banking. The industry has become a complex financial services business requiring analytical skills, financial modeling, and forecasting abilities far beyond the levels necessary in the past. The resources required to compete effectively made it challenging for the small, independent firm to survive and nearly all of the medium and large mortgage banking operations are now subsidiaries of larger diversified institutions.
With the dominant role of mortgage securities and the impact of economic changes felt in all sectors of the mortgage finance industry, the composition of the participants in the industry has also changed. Wall Street firms, commercial banks, nonfinancial corporate giants, and traditional portfolio lenders are playing a part in mortgage banking with various degrees of influence and success.
Securities dealers have become the primary market makers as the bulk of residential mortgage originations are used to collateralize mortgage securities, primarily through secondary loans originating from Freddie Mac, Fannie Mae, and Ginnie Mae. Many major Wall Street firms ventured into primary, or direct, mortgage banking activities in the 1980s, establishing their own mortgage banking operations, and buying and selling mortgages and loan servicing rights. Most of these ventures disappeared or are serving small, specialized markets, and Wall Street's emphasis returned to mortgage securities and the derivative securities that developed as the mortgage security markets matured. Some of the industry leaders in this area include: Goldman Sachs, Salomon Brothers, and The First Boston Corporation.
In 1996, Fannie Mae held a portfolio of more than $286 billion in secondary home mortgages and Freddie Mac held a $610 billion portfolio. Countrywide Credit Industries, Inc. led the primary lending market in 1996 with roughly $22 billion in loans concentrated in California.
Thrift institutions and the thrift industry have been decimated by the consequences of the excesses, incompetence, and fraud of the 1980s. They are no longer the major source of mortgage capital and their market share dropped from 41 percent of the loan origination market in 1987 to 24 percent in 1992. About 2,000 viable institutions remained after the cleanup was completed, but their presence in the market has been severely diminished. Most thrifts will continue to maintain a mortgage loan portfolio, but not on a scale that will make them primary sources of mortgage money as they had been before the 1980s.
Commercial banks, particularly such large national banks and bank holding companies as Fleet National, Chase Manhattan/Chemical, and Bank of America, emerged as major players in mortgage banking. Many of the nation's largest mortgage banking operations are subsidiaries of these institutions. The banks view mortgage banking as a natural extension of their mortgage lending operations and as a cross-selling opportunity, while the mortgage banking operations benefit from the credit facilities and financial presence of the parent institution in the marketplace.
Nonfinancial corporations and holding companies acquired or built some of the largest mortgage banking operations in the country with mixed results. Some operations have done very well and continue to prosper, but others have struggled. As in the case of commercial banks, the parent organization has to understand the business of mortgage banking and the operating disciplines that it requires if the mortgage banking operation is to succeed.
Life insurance companies and pension funds have long been viewed by mortgage bankers as prime sources of mortgage funds, but tapping these sources has not been easy. Life insurance companies returned to residential mortgage investment in the 1980s, after effectively leaving the field 20 years earlier, but most did so by setting up their own mortgage companies. Like Wall Street's venture into mortgage banking, most of these operations have been closed or shut down, although several life insurance companies, such as Prudential Home Mortgage and Metropolitan Life, have had success in the mortgage banking segment. Pension funds rarely provide mortgage bankers with direct access to money and tend to invest in mortgages through mortgage securities.
Investment in mortgages by individuals has grown faster than all expectations. Individuals generally prefer Ginnie Mae securities and often invest through mutual funds. As with pension funds, individual investors funnel money directly to the mortgage market. In doing so, individuals receive a higher yield on their investment than they would by depositing their money in savings institutions.
Like the broader financial services industry, the mortgage industry continued to be swept by changes during the 1990s. These changes were driven by deregulation, competition, and technological advances. Since the 1980s, private mortgage companies that do little but originate loans have become the main source of mortgage lending. There were approximately 4,000 of these companies in the United States in 1996 (out of about 12,000 total organizations making mortgage loans) and they accounted for nearly 60 percent of all new mortgage loans, or originations. This is nearly double the share that mortgage companies had in 1987. The next largest source by volume of mortgages was commercial banks, followed by the thrift industries, which as recently as 10 years earlier had dominated the industry. Other mortgage lenders included credit unions and life insurance companies. During 1996, some $784 billion in one-to-four-unit residential mortgage loans were originated in the United States. That is somewhat below the peak of just over $1 trillion worth of loans originated in 1993, but the record year had been strongly influenced by a wave of refinancings as mortgage rates dipped to their lowest point in years.
While the cost of entry into loan origination continues to be low, the financial sources necessary to compete and succeed as a full service mortgage banker increased dramatically. As a result, the industry is increasingly dominated by the largest players, including behemoths like General Motors Acceptance Corporation (GMAC), which in 1996 originated more than $3.4 billion of new residential loans representing more than 30,000 home loans.
Although there may always be a profitable niche for small originators, that niche may be in mortgage brokerage, and the outlook for the medium-sized mortgage banking firm that services its own loans is much less certain.
A number of the largest mortgage bankers grew very quickly in the late 1980s and early 1990s through bulk purchases of loan portfolios. The secondary market for mortgage loan securitization fueled the growth in origination volume. Although the volume of mortgages sold into the secondary market tends to vary with changes in the volume of fixed-rate lending (as opposed to variable rate loans), the percent of home loans sold through the secondary market in 1996 was 56 percent. That was down from a peak of 65 percent during 1993, but it represents a sizable increase over the 33 percent level of 1988, when the market was not as mature.
Consolidation transformed the mortgage loan industry in the 1990s. Between 1980 and the late 1990s, 7,000 banking institutions merged, though few of these mergers centered around mortgage financing. However, the consolidations did affect the industry: in 1990, 28 percent of home loans originated from 25 lenders; as of September 1998, the top 25 lenders accounted for 53 percent of home loans. In October 1999, Intuit Inc. of Mountainview, California, paid $370 million in stock to buy out market leader Rock Financial Corp. of Bingham Farms, Michigan, which generated 1998 revenues of $90 million and closed more than $2.3 billion worth of residential loans in 1998. Intuit merged Rock's Web site, RockLoans.com, with its own loan site, QuickenMortgage.com. In addition to consolidations, the industry experienced spin-offs: in 1998, for example, Ford Motor Co. spun off Associates First Capital Corp., which earned $387 million in the third quarter of 1999, a 22 percent increase over third quarter 1998, due at least in part to the success of this spin-off.
The process of consolidation did not always create more efficiency, though; often, newly consolidated companies experienced growing pains, and the quality of their service declined. In this climate, niche lenders and small, local specialists thrived. For example, companies responsive to the Hispanic market stood to gain from the demographic and economic growth of this sector. Whereas Hispanics made up 11 percent of the population in the late 1990s, this population accounted for 18 percent of all new homeowners from 1996 through 1998. In the first half of the decade, Hispanic owner-occupied housing units increased 34 percent. The U.S. Bureau of the Census forecasted the Hispanic population to grow to 15 percent of the total U.S. population by 2015 and 25 percent by 2050. Companies such as Countrywide Home Loans, Inc., of Pasadena, California, benefited from these demographics by employing bilingual employees and translating loan literature into Spanish.
Another niche market in the late 1990s was the emergent trend of the so-called money-back home loan, which allowed borrowers' monthly payments to be placed in an insurance policy rather than against the principal of the loan. At the end of the term, the value of the policy could potentially exceed the principal of the loan and provide the borrower with a cash payment of the surplus. This method was common in international markets such as the United Kingdom but was still relatively new in the United States.
At the turn of the twenty-first century, forecasts called for the continued growth of total outstanding mortgage debt, which would increase by 7 percent to 9 percent annually, according to Fannie Mae. The Board of Governors of the Federal Reserve pegged the total outstanding mortgage debt at $4 trillion at the end of 1997; this figure grew to $7.5 trillion in 2001 and $7.9 trillion in 2002. That year, according to the Bond Market Association, mortgage companies accounted for approximately $4 trillion of that debt; commercial banks, $1.9 trillion; savings institutions, $740 billion; individuals, $721 billion; federal and state agencies, $396 billion; and life insurance companies, $245 billion.
What most forecasters did not predict were the record low interest rates that the prolonged economic downturn fostered in 2002. In September of 2002, the average fixed interest rate on a 15-year mortgage totaled 5.31 percent, compared to 8.25 percent in May of 2000. Over the same time period the average fixed interest rate for a 30-year mortgage fell from 8.55 percent to 5.92 percent. With mortgage rates at their lowest point since the 1960s, one-to-four family mortgage originations exceeded $2 trillion for the first time in history, reaching $2.03 trillion in 2001. Refinancing accounted for 57 percent of that total, compared to the 19 percent of one-to-four family mortgage originations it had secured a year prior. The number of new homes sold grew from 877,000 in 2000 to a record 908,000 in 2001 and 976,000 in 2002. Despite a weakening economy, along with growing levels of unemployment, the historically low interest rates helped propel the average sale price of homes in the United States to a peak of $226,700 in 2002.
Another factor impacting the industry was the advent of electronic commerce via the Internet in the late-1990s, which significantly transformed mortgage financing by allowing customers to apply for loans online and receive responses much more quickly than in the past. One of the first Web-based mortgage companies, E-Loan, was founded in 1997. Over the next two years, the concept of transacting mortgages online gained credence, prompting other major lenders to set up their own Web sites. One popular site, LendingTree.com, allowed customers to submit a single application for which three or four lenders would compete. According to Massachusetts Mortgage Bankers Association Executive Director Kevin Cuff in the October 2002 issue of Boston Business Journal, "Obviously, the online application process in the last 12 months has skyrocketed, and the reason for that is the interest rate is dropping and the refinance rate is rising. It's the only way for people to keep up."
"In Brief: Associates 1st Reports 22 percent Rise in 3Q Profits." American Banker, 13 October 1999.
"Intuit in $370M Deal for Rock Financial; To Sell Loans at Quicken Mortgage Site." American Banker, 8 October 1999.
Mortgage and Market Data. Washington, D.C.: Mortgage Bankers Association, 2003. Available from http://www.mbaa.org .
Mortgage Debt Outstanding. Washington, D.C.: Bond Market Association, 30 June 2002. Available from http://www.bondmarkets.com .
Mozillo, Angelo R. "Mortgage Milestones in the Year Ahead." Mortgage Banking, 1 January 1999.
Pratt, Mary K. "Online Mortgage Originations on the Rise." Boston Business Journal, 18 October 2002.