Understanding the Mortgage Market (4Hr)

Supply and Demand

The supply of capital is finite. Real estate borrowers must compete with the government, businesses, and other consumers for available capital/funds. If mortgage money is in short supply, mortgage interest rates rise. A cause is the placement of potential capital/mortgage money in other markets that are paying higher interest rates. Another cause is when spending authorized by the U. S. Congress exceeds current tax revenues. The Congress and the President accomplish this spending by borrowing in the capital markets and increasing the direct and indirect national debt that reducing available capital for private investment.

Government Intervention Can Redirect the Supply

Between late 1989 and the mid-1990s, a “credit crunch” occurred in a portion of the real estate market primarily because the federal government, through re-regulation including capital reserve requirements imposed on depository institutions under Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), redirected available capital to residential mortgage lending. The capital reserves required for residential mortgage loans secured by 1 to 4 dwelling units ranged from 2% to 4%, depending primarily on whether the loan was insured or indemnified by a federal agency. The reserve requirements for commercial properties jumped to as much as 8%.

Accordingly, lenders rushed to make residential mortgage loans and avoided loans secured by commercial properties, including those that are characterized as industrial or as land loans. Residential income properties were treated more favorably with reduced capital reserve requirements, although higher than the reserves required for residential mortgage loans. 

The flow of capital to residential mortgages helped cause “refinance mania” beginning in the mid-1990s and continuing through the middle 2000s. The Fed’s policy of holding interest rates at historically low levels also contributed to “refinance mania.” This flow of money mitigated the “credit crunch” that occurred in the early 1990s. 

In addition, home purchase transactions increased substantially during the period from 1999 through most of 2006, increasing the demand for residential mortgage loans.

The "Mortgage Meltdown"

During the 1990s, with interest rates hovering in the 5 to 6% range and with a strong national economy, a wave of homebuyers entered the market. Housing prices rose significantly in many areas and speculators entered the market with the expectation of "flipping" houses to make a quick profit. Subdividers, developers and builders significantly expanded the housing supply by increasing new housing inventory through residential subdivision development. 

As prices rose, new and more exotic loan products became popular such as "pay option" adjustable-rate mortgages (ARMs), or "option ARMS", stated income, stated asset, and other alternative mortgages or non-traditional loan products.

With many of these non-traditional loan products, borrowers were not required to prove their income or their ability to pay the mortgage loan debt service. Some loan products were geared to borrowers who could not qualify for conventional loans due to low credit scores, high debt-to-income ratios, limited equity, inadequate down payments, or other factors. But many of these "non-traditional" or "alternative mortgage" loan products were also marketed to and used by conventional borrowers to increase their purchasing power as buyers of residential real properties to allow home purchases that would not have conformed with the standards imposed by conventional loan products, or to allow home purchases at higher prices than previously available to buyers traditionally qualifying to purchase homes.