Chapter 9
Becoming a Market and Financing Expert
In This Chapter
• An overview of the two mortgage markets
• The economic trends you can’t ignore
• Financial markets beyond our borders
• What’s happening in your local housing market
 
Being a mortgage broker is more than just crunching numbers. You’ve got to become a financial analyst, studying the local, national, and international economic trends that will impact mortgage rates. You need to understand your own local housing market so you can advise your clients about their eligibility, preferably before they begin shopping for a home in your area.
In this chapter, you’ll learn how mortgages are financed and how to interpret the economic trends that affect rates.

The ABCs of the Mortgage Markets

As a mortgage broker, you are helping buyers find financing for their home purchases. Mortgages to home buyers are part of the primary mortgage market. These loans, in turn, are sold on the secondary mortgage market to investors. By selling the loans, funds are then made available for additional loans to be made in the primary mortgage market. It’s a cycle that is critical to a healthy housing economy.
def·i·ni·tion
The primary mortgage market makes loans to home buyers. It consists of mortgage originators like commercial banks, savings and loans, credit unions, and so on. The secondary mortgage market buys and sells first mortgage trust deeds for investment from primary mortgage lenders through conduits like Freddie Mac, Fannie Mae, and Ginnie Mae, as well as private investment banks.

Let’s Back Up a Little

A little history lesson will explain the importance of the primary and secondary mortgage markets. Changes in the underlying financial structure of the mortgage market over the last century have resulted in more home ownership, especially by those who would have previously been excluded.
Prior to the Great Depression, it was much more difficult to afford a home, and the result was that home ownership rates were low. Down payment requirements were about 40 percent of the purchase price and the loan had to be repaid within three to five years! (Contrast that to the current market that permits zero down payment, or more typically 10 to 20 percent, and some mortgages that don’t mature for 40 years.)
Until the mid-1970s, mortgage loans were primarily originated and kept in the portfolios of the depository institutions (as well as the portfolios of insurance companies). Typically, a buyer went to his local Savings and Loan Association to get his mortgage. The S&L was then able to fund new mortgages based on its ability to raise funds by managing their portfolios, as well as attracting new depositors and loan applicants. Legislation and regulation encouraged depository institutions to confine their loans to the local housing market. In time, however, this resulted in an unbalanced mortgage market with some regions having an excess of funds and low rates, and others having meager funds and high rates.
def·i·ni·tion
Depository institutions are commercial banks, savings and loans associations, savings banks, and credit unions.
The only way to mitigate this problem was to make the mortgage market less dependent on the depository institutions. But to do that you had to develop a strong secondary mortgage market that made it attractive to investors outside the depository institutions and insurance companies to invest. Mortgage-backed securities became the vehicle for attracting investors.

Enter Fannie, Ginnie, and Freddie

Again step back in time. In 1934, the federal government created the Federal Housing Administration (FHA), to help build or acquire single-family and multi-family properties. (After World War II, its mission was expanded to include urban renewal projects, hospitals, and nursing homes.) The FHA offered insurance against mortgage defaults, which reduced the credit risk for investors. But to get the insurance, the mortgage applicant had to meet certain standards. This is important because it was the first time mortgage terms were standardized—and standardization is essential for pooling mortgages, which is the underlying principal of a secondary mortgage market. (Later the Veterans Administration also insured mortgages.)
The second important change was that the FHA developed a new mortgage design: long-term, self-amortizing, fixed rate mortgage loans. Remember, previously, mortgage loans were short-term which meant that borrowers essentially had balloon payments at the end of five years, usually made by securing a new mortgage. But it also meant an increase in the possibility of default. To craft a liquid secondary market to buy these new FHA mortgages, Congress created a new government-sponsored agency: the Federal National Mortgage Association, Fannie Mae.
It was a start, but there were still problems. In periods of tight money, Fannie Mae couldn’t ease the housing crisis. So in 1968, Congress divided Fannie Mae into two organizations: Fannie Mae and Ginnie Mae, the Government National Mortgage Association. Ginnie Mae was to use the “full faith and credit of the U.S. government” to support FHA and VA mortgage markets. In 1970, Congress created the Federal Home Loan Mortgage Corporation, Freddie Mac, to support conventional mortgages, those not insured by the FHA, VA, or the Rural Housing Service.
The secondary mortgage market was then much more appealing to investors. The securities issued by institutions that pool mortgage loans were guaranteed by government (Ginnie Mae) or quasi-government agencies (Fannie Mae and Freddie Mac).
Ginnie Mae securities had the backing of the “full faith and credit of the U.S. government.” Fannie Mae and Freddie Mac, while not carrying the exact same backing, are still considered virtually risk-free. In effect, all of these mortgage-backed securities have the same credit risk as U.S. Treasury bonds but offer a higher yield.

Mortgage-Backed Securities

As a mortgage broker, you are interested in mortgage-backed securities because they reflect the current mortgage market. They don’t affect mortgage rates, but mirror the strength or weakness of the market and the economy as a whole.
def·i·ni·tion
Securitization is the creation of a security by pooling mortgage loans purchased from originators. These securities are sold as bonds and their value is derived from the original mortgages from which they are created.
Here’s how they work. Mortgage loans are purchased from banks, mortgage companies, and other originators, and assembled into pools by a governmental, quasi-governmental, or private entity. Then the entity issues mortgage-backed securities (MBSs) that represent claims on the principal and interest payments made by the borrowers of the loans in the pool. This is called securitization.
Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). There are also some private institutions, such as brokerage firms, banks, and homebuilders, who securitize mortgages. These are known as “private-label” securities.
Let’s take a simplified example of how mortgage-backed securities work.
• The home buyer takes out a mortgage from a local bank to purchase a home.
• The bank sells the mortgage to an investment banking firm that bundles a group of mortgages into a pool and then creates securities which are sold to a buyer like a pension fund. These securities are guaranteed by Freddie Mac.
• The local bank receives the value of the mortgage—which it can lend out to other borrowers.
• The home buyer continues to make monthly payments to the bank that originated the mortgage, but the interest and principal payment is passed through to the buyer of the mortgage-backed security.
• The local bank receives a small processing fee; the investment firm receives payment by offering a coupon on the bonds that is slightly less than the interest payments on the mortgage; and the securities buyer gets a return that is slightly higher than a corresponding 10-year Treasury note. The securities buyer doesn’t own the mortgage, but gets his return from the payments on mortgages.
 
There is little risk of default since most home mortgages are guaranteed by the Federal Housing Administration.

The International Component

Mortgage-backed securities appeal to institutional investors throughout the world. American real estate is considered a safe, profitable investment. Whereas at one time your local Savings and Loan Association was the primary player in funding home mortgages in a community, today, it’s just as likely that it’s a foreign institutional investor.
Overseas investors believe that American real estate is a safe and wise investment. On a simple level, it means that while housing and mortgage rates are affected by American economic trends, you have to factor in to your analysis the effect of a strong international secondary mortgage market.
033
Did You Know?
Ginnie Mae has guaranteed more than $2 trillion in mortgage-backed securities.

The National Economic Trends You Need to Watch

If you talk to three different economists, you’ll probably get three different economic forecasts. There is rarely universal agreement on what the various economic markers mean. What you want to do is get a feel for what is being measured by various national indexes and what those portend for the housing and mortgage markets.
For example, while there is not a direct cause-and-effect relationship between a rising unemployment rate and rising mortgage rates, you can see that if the economy is shrinking and layoffs are growing, then the housing market is probably falling, less new housing is being built, and less money is available. However, it’s not quite that simple. All this is tempered by the effects of a strong international secondary mortgage market.

The Consumer Price Index

An index is the measure of the relative average of a group of items to a base value. An index is used in economics to combine and compare diverse measures. It uses a weighted average rather than a straight arithmetical mean and compares it to a base value or period.
def·i·ni·tion
An index is a method of combining and comparing diverse measures to a base value or period. The Consumer Price Index measures the change in the cost of basic goods and services in comparison with a fixed base period.
The Consumer Price Index (CPI), as calculated by the federal Bureau of Labor Statistics (BLS), reflects spending patterns for each of two population groups: (1) all urban consumers (CPI-U) and a subset of that, (2) urban wage earners and clerical workers (CPI-W). The all urban group represents about 87 percent of the total U.S. population. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, retired persons, urban wage earners, and clerical workers. Not included in the CPI are the spending patterns of persons living in rural nonmetropolitan areas, farm families, persons in the armed forces, and those in institutions like prisons or mental hospitals.
The CPI-W subset, urban wage earners and clerical workers, is based on the expenditures of households included in the CPI-U definition that also meet two other requirements: More than one half of the household’s income must come from clerical or wage occupations and at least one of the household’s earners must have been employed for at least 37 weeks during the previous 12 months. The CPI-W’s population represents about 32 percent of the total U.S. population.
The BLS has classified all expenditure items into more than 200 categories, arranged in eight major groups:
• Food and beverages (breakfast cereal, milk, coffee, chicken, wine, service meals, and snacks)
• Housing (rent of primary residence, owner’s equivalent of rent, fuel oil, bedroom furniture)
• Apparel (men’s shirts and sweaters, women’s dresses, jewelry)
• Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
• Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
• Recreation (television, pets and pet products, sports equipment, admissions)
• Education and communication (college tuition, postage, telephone services, computer software and accessories)
• Other goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses)
 
The CPI does not include investment items like stocks, bonds, real estate, and life insurance because these items relate to savings and not to day-to-day consumption. It also can’t be used to compare levels of living costs or prices across areas. For example, if a family heats their home with solar heat, but fuel prices are rising more rapidly than other items, the family may experience less inflation than the general population. As the BLS explains, “a national average reflects all the ups and downs of millions of individual price experiences. It seldom mirrors a particular consumer’s experience.”
Most of the specific CPI indexes have a 1982-1984 reference base. That means the BLS sets the average price level for the 36-month period of 1982, 1983, 1984 as equal to 100. BLS then measures change relative to that period. So an index of 110 means there has been a 10 percent increase in prices since the reference period. An index of 90 means there has been a 10 percent decrease.
The CPI is one measure of inflation. The BLS defines inflation as the process of continuously rising prices (or equivalently, continuously falling value of money). The CPI measures inflation as experienced by consumers in their day-to-day expenses. Other measures such as the Producer Price Index (PPI), the Employment Cost Index (ECI), the BLS International Price Program, and the Gross Domestic Product (GDP) are all indexes that have been developed to measure different aspects of inflation.
How does the CPI impact on mortgage rates? The CPI is one of many indicators of economic trends. During periods of inflation, mortgage rates, like all other prices, tend to rise.

The Producer Price Index

Unlike the Consumer Price Index, which measures price change from the purchaser’s perspective, the Producer Price Index (PPI) measures change from the perspective of the seller. It is a family of indexes that measures the average change over time in the selling prices received by U.S. producers of goods and services. Over 10,000 PPIs for individual products and groups of products are released each month. PPIs now cover products of virtually every industry in the mining and manufacturing sectors, and are gradually being introduced for the products of industries in the transportation, utilities, trade, finance, and services sectors. Like the CPI, the Producer Price Index has a 1982-1984 reference base.
def·i·ni·tion
The Producer Price Index measures wholesale price levels in the economy.
The PPI differs from the CPI in two important ways: (1) the composition of the set of goods and services, and (2) the types of prices collected. The PPI measures the goods and services of U.S. producers—no imports are counted. The CPI measures goods and services purchased by consumers and includes exports. Furthermore, the price collected for an item in the PPI is the revenue received by its producer. Sales and excise taxes are not included because they don’t represent the revenue to the producer. In contrast, sales and excise taxes are included in the price of an item included in the CPI because that is the out-of-pocket expenditure for the consumer.
034
Heads Up!
When the CPI, PPI, and Unemployment Rate rise, expect to see mortgage rates moving upward as well. That’s because these indexes are early reflections of a change in the economic climate.
How does the PPI impact mortgage rates? As an economic indicator, PPIs capture price movements before the retail level (as measured by the CPI). It may foreshadow price changes for businesses and consumers. It can serve as a harbinger of a period of inflation in which mortgage prices may rise.

The Federal Reserve and Interest Rates

The Federal Reserve is the system of federal banks in charge of regulating the U.S. money supply, primarily by buying and selling U.S. securities and by setting the discount interest rate. That’s the interest rate at which the Federal Reserve lends money to commercial banks. As the cost of money rises to the bank, the increases are passed along in rising consumer loan rates. The Federal Reserve fights inflation by raising the discount rate and decreasing the money supply.
def·i·ni·tion
The discount interest rate is set by the Federal Reserve. It is the rate at which commercial banks can borrow money from the Federal Reserve.
How does the discount interest rate affect mortgage rates?
The discount interest rate doesn’t directly affect mortgages. Its greatest impact is on short-term loan rates. But as a mortgage broker, you pay attention to the discount interest rate as reflective of the overall direction of the economy. A growing economy, not riddled by inflation, is the best condition for mortgage rates.

The Stock Market

Risk versus reward. That neatly captures the dilemma faced by investors—both individuals and institutions. If the economy is growing, there’s greater interest in stocks as an investment. Individuals and institutions are willing to take the risk of investing in stocks with a bigger payoff, rather than in the safer mortgage bond market.
How does the stock market affect mortgage rates?
There is no direct effect, but a rising stock market usually results in falling bond prices because investors are putting their money into the higher risk, higher reward of stocks. When Treasury and mortgage bond prices fall, look for higher mortgage rates. Why? In order to attract investors, the yield rates on these fixed-income securities must rise. When yields rise, mortgage rates, which are linked to yield rates, follow.

Ten-Year Treasury Bills

The U.S. Treasury sells bonds with different maturity rates. Generally the shorter the maturity, the lower the yield because the investor’s money is under less risk. The basic idea is that if you tie up your money for a longer period of time, you should be rewarded with a higher yield for taking the higher risk. The investor has no idea what will happen in 30 years, for example, but if his money is tied up that long, he should see a bigger payoff.
The Ten-Year Treasury Bill is the one most associated with fixed mortgage rates. Most mortgages are paid off within 10 years (actually closer to 7½ years), even if they are 30-year mortgages. That’s because within 10 years, the borrower generally sells the house or refinances, either way paying off the loan.
Adjustable rate mortgages (ARMs) are generally tied to Treasury Bills of equal length. For example, if the ARM will adjust its rate at the end of five years, it’s tied to a Five-Year Treasury Bill.
How does the Ten-Year Treasury Bill affect mortgage rates?
It is the rate that is most closely associated with fixed rate mortgages. As it rises or falls, fixed mortgage rates generally follow.

Employment Numbers

The federal government conducts a monthly survey called the Current Population Survey (CPS) to measure the extent of unemployment in the country. A low unemployment rate, concurrent with strong level of new job creations, are indicators of a healthy economy.
How do the employment numbers affect mortgage rates?
The correlation between the two is not direct, but again gives you an idea of the general state of the economy. A healthy economy, with low unemployment, encourages home buying and investment.

Reading the Local Housing Market

Mortgage brokers need to understand the housing market where they are conducting business. On a very simple level, if the market is booming, hopefully so is your business; if the market is flat, you may need to work harder to get your share and expand your efforts into other communities.
A house appraisal is a key requirement for securing a mortgage. Familiarity with the housing market lets you know ahead of time whether the appraisal of the house’s value will be approved. If you are concerned that it won’t, then you have the opportunity to discuss possible options.
If there is a downturn in housing prices, owners who opted for “interest only” mortgages may be in serious trouble. For those who chose this type of mortgage because of limited finances, it can be a disaster. As an ethical mortgage broker you want to lay out all the options and explain the risks to your clients. Here’s the concern: the payments on certain loans (commonly called “Option ARM” for adjustable rate mortgage) don’t cover the full amount of interest due. The unpaid interest is added to the loan balance, effectively increasing the outstanding loan amount over time. These kinds of loans provide the borrower with much lower monthly payments, but the negative amortization means they are tacking on tens of thousands of dollars to their original loan. If housing prices drop, the homeowner faces the prospect of a mortgage that is higher than the value of the house.
def·i·ni·tion
Amortization is the gradual elimination of a debt, like a mortgage, with regular fixed payments over a specified period of time.
You need to know who is buying in your market: homeowners or investors. In 2004, nearly one fourth of house purchases were as investments. This phenomenon was primarily concentrated in a few areas. For example, in Las Vegas, 44 percent of home purchases were investments. The problem occurs if there is a hint of a downturn in property values. Owners who live in their homes may ride it out. Investors, who generally have little or no equity in properties, will sell quickly. A disproportionate number of investors versus residents in a community can skew the housing market in a tight economic period.
Mortgage brokers need to put together a complete picture of the area to judge if the housing market is on solid ground. Besides tracking gains in housing prices, you need to know what else is happening in your area: job growth, population growth or decline, median income, and affordability (who can afford to buy in your community).
For example, there is some concern that Boston is a risky housing market. According to PMI Group, a residential mortgage insurer, housing prices in Boston fell between 1992 and 2001, and then showed a relatively modest 7 percent annual appreciation. In contrast, nationally, the median price of an existing home rose 10 percent in the last year, and some areas saw a 15 percent or more jump. But Boston has other problems. The area has lost 200,000 jobs since 2000, and yet housing prices remain high (median home price is $398,000). Experts suggest that the area’s housing bubble may soon burst—and as a mortgage broker, you’d want to be on the alert.
To get a good understanding of your housing market, you should …
• develop good working relationships with local realtors and builders.
• study closely real estate ads (online and in newspapers).
• track real estate closings on homes in your area.
• read regularly local and trade newspapers for realtors and mortgage brokers, as well as financial newspapers like the Wall Street Journal.
• familiarize yourself with local zoning regulations so that you are prepared for client questions on properties. Check with the local, county, and state zoning boards to get copies of their regulations.
The Least You Need to Know
• A strong secondary mortgage market is vital to a healthy primary mortgage market.
• Mortgage brokers need to keep track of national economic trends in order to forecast the health of the housing market and the future of mortgage rates.
• Mortgage brokers should familiarize themselves with the housing market they service.
• A disproportionate number of investor owners (versus residents) in a community can skew the housing market in a tight economy.
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