Does mortgage securitization help borrowers?
Q. Lenders made bad loans during the years prior to the financial crisis because the loans could be sold as securities to unwary investors. Would most mortgage borrowers be better off if there were no secondary market in which to sell their mortgages?
A. Some might but most would not. Largely because of secondary markets, a knowledgeable and creditworthy homebuyer in the U.S. pays a rate only modestly higher than that charged to the U.S. Government. The rate spread between home mortgages and government bonds is lower in the U.S. than anywhere else in the world, with the possible exception of the U.K. and Denmark, which also have secondary mortgage markets.
Impact of Secondary Markets on Mortgage Prices
Secondary markets reduce mortgage interest rates in several ways. First, they increase competition by encouraging the development of a new industry of loan originators. Called different names in different countries (in the U.S. they are called "mortgage companies" or "mortgage banks"), they all have in common that they require little capital and tend to be aggressive competitors. Because of secondary markets, they can operate without permanent funding capacity.
Absent secondary markets, the only institutions originating mortgage loans are those with the capacity to hold them permanently, termed "portfolio lenders." During the 1920s, borrowers in small communities were often at the mercy of one or a few local banks or savings and loan associations. The entry of mortgage companies who can sell into the secondary market breaks up these local fiefdoms, much to the benefit of borrowers.
Secondary markets also increase efficiency by encouraging a specialization of lending functions that reduces costs. Portfolio lenders typically do everything connected to originating and servicing loans, even though they may do some things quite inefficiently. Secondary markets, in contrast, create pressures to break functions apart and price them separately, and this imposes a discipline on mortgage companies to concentrate on what they do best. Many mortgage companies have ceased servicing loans, for example, because they can do better selling the servicing to companies who specialize in that function.
In addition, conversion of mortgages into mortgage-backed securities permits a better distribution of the risk of holding fixed-rate mortgages. Historically, depository institutions were well positioned to originate mortgage loans but if the loans were long-term and had fixed rates, they were not well positioned to hold them because their deposits were short-term. Many pension funds, in contrast, were well positioned to hold long-term investments but were not equipped to originate and service mortgages. The development of markets in mortgage-backed securities eliminated this impasse.
Mortgage-backed securities also are "liquid" while mortgages themselves are not. This means that in most cases mortgage-backed securities can be sold for full value within the day whereas selling the same amount of mortgages would take four to eight weeks. Because most investors value liquidity and are willing to accept a lower yield to get it, converting illiquid mortgages to liquid securities puts downward pressure on the rates charged to borrowers.
In addition to generating downward pressures on mortgage interest costs, secondary markets also tend to eliminate regional rate differences. At the turn of the century, the Census of Housing showed mortgage rates to be about 2 percent higher in the western states than in the east. By the 1950s, however, the differential was down to one-quarter percent, largely because of the development of secondary markets. Today, regional differentials are negligible.
The Downside of Secondary Markets
But secondary markets do have a downside for borrowers. Shopping for a mortgage is much more challenging, because the prices borrowers pay are driven by prices in the secondary market, which are reset every day and sometimes within the day. In addition, prices vary with every loan, borrower, property and transaction characteristic that affects the cost or risk to security holders, and much of this is not understood by most borrowers. Much of what I do on my website is designed to offset these challenges to effective shopping.
Secondary markets have also eliminated the capacity of borrowers to select their loan servicer. This may be inconsequential for borrowers who make their payments on time every time, but it can be extremely important to borrowers who are trouble-prone.
But the most serious issue is that secondary markets made possible the "bubble" in home prices that led to the financial crisis. The social cost of that has been enormous, but it is a once-in-a-century phenomenon. Hopefully we have already had it for this century.
• Contact Jack Guttentag via his website at mtgprofessor.com.
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