Yale School of Management
Emergence of the U.S. Mortgage
Market and its Impact on
Economic Growth
Zhiwn Chen
Professor of Finance
Yale School of Management
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Yale School of Management
Issues to consider
From 1960s to 90s, exports stimulated
economic development in Japan, Korea,
Singapore, Hong Kong and Taiwan. Same for
China in recent years.
While those countries or regions have to export
due to lack of domestic demand, some other
countries must have demand surplus.
Then, why is the US domestic demand been so
high?
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The importance of simple financial
instruments, e.g., mortgage loans
Export
Manufacturers
Salary
Income
Product
Demand
Consumer
Savings
Banks
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What does the Residential Mortgage tell us?
9000
China’s Total Outstanding Amount
of Residential Mortgage (RMB
100MM)
6000
8253
5598
3377
3000
1358
190
426
1997
1998
0
1999
2000
2001
2002
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Residential Mortgage
amounts to
“Securitizing one’s future income
flow”
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The U. S. Experience
 Prior to the 19th century, the United States was
mostly an agricultural society.
 After WWII, the United States became the No.1
Super Power
 One of the primary reasons:
Part of the growth power came from financial
innovations, Social Security Innovation, starting
from 1934.
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Figure 3: The US individual savings Rate
12%
10%
8%
6%
4%
2%
0%
2002
1998
1994
1990
1986
1982
1978
1974
1970
1966
1962
1958
1954
1950
1946
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Development of the Mortgage Market
 Residential Mortgage had been one of the standard
services since the beginning of banks.
 However, before 1930s, the term of Residential
Mortgage was capped by 5 years.
 The mortgage payment structure was also flawed. For
example, prior to maturity, the borrower only needed to
pay the incurring interest. At maturity, the borrower
would pay the total principle. “Balloon loans”
 With such a structure, banks would take on huge risks,
hence less willing to make loans. The borrower faced
too much lump-sum payment pressure.
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Stock Market Crash in October 1929
 During the stock market boom in 1920’s, many
individuals bought big houses with large mortgages.
 But, after the 1929 crash, companies went bankrupt,
and unemployment reached historical high (25%).
 Many households could not repay the “balloon” at
mortgage maturity.
 Then many banks and lending institutions went
bankrupt.
 Therefore, the “balloon” structure of mortgage loans
exaggerated the economic / financial crisis.
 Crisis: not many banks willing to lend mortgages 9
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The Crisis led to “New Deal” Legislations
Including:




Securities Act of 1933
Securities Exchange Act of 1934
Banking Act of 1933 (Glass-Steagall Act)
Social Security Act of 1935.
Revitalizing the housing market: the
“Federal Housing Act of 1934”
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Federal Housing Act of 1934 led to the Federal
Housing Administration (FHA)
 FHA provided mortgage insurance to low and mid
income families.
 Max mortgage term increased from 5 years to 30 years；
 Low and mid income families could buy houses when
starting a family
Generally, the longer the mortgage, the less payment
pressure, and the more beneficial for consumption
demand and hence for economic growth.
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Starting a Secondary Mortgage
Loan Market
 In 1938, the Federal National Mortgage Association
(Fannie Mae) was created to increase the liquidity of
mortgage loans. Its role was to make a secondary
market: buy mortgages from banks and other financial
institutions who make loans.
 Very important: banks then don’t have to worry about
outstanding mortgages or their liquidity, after lending
the mortgages.
 This encourages banks to make more loans.
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Mortgage-Backed Securities
 In 1970, Government National Mortgage Association (Ginnie
Mae), a entity spun off from Fannie Mae, started to issue
Mortgage Backed Securities.
 It pools together various mortgages from different regions, and
then issues securities to general public and institutional
investors.
 This was the first securitization innovation.
 It significantly increased the supply of mortgage loans.
Not only reduces borrowing costs for homeowners and increased
mortgage availability, but also provides banks with better risk
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diversification and better liquidity.
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Figure 4: Outstanding Amount of
Mortgages in the US
US$ 100MM
US$ 6053.5 bn
56000
42000
1960
28000
1965
14000
0
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1950
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Figure 5: Home Ownership in the US
70%
65%
63%
65%
67%
69%
60%
60%
55%
55%
50%
45%
44%
40%
1940
1950
1960
1970
1980
1990
2000
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Interest Rate Risk
 The extension to 30 years of mortgages brought risk
for banks, because, until 1980’s, mortgages had only
fixed-rates.
 Reason: what the bank lends to mortgage borrowers is
money from depositors.
 The bank pays interest to depositors, which is a cost to
the bank, while interest payment by mortgage
borrowers is income to the bank.
 The difference is the bank’s earnings
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Bankruptcy Risk for Lending Institutions
 Deposits normally are short term, whereas the
mortgage are longer term. There is a huge duration
difference between the bank’s liabilities and assets.
This leads to high bankruptcy risk.
 An example:
 In 1971, a 30-year $200K mortgage had a fixed rate of 6%.
 In 1981, deposit interest rate was up to 16%.
 The bank would pay out 16%, but receive only 6% from
the earlier mortgages.
 The loss in 1981 was 16%-6%=10%.
 Then, many banks bankrupted in 1980s.
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More Financial Innovations
 Beginning in 1981, floating-rate mortgages started.
Home buyers could choose among 1-year, 3-year or 5year floating rates.
 High interest-rate volatility in the late 1970s laid
foundation for another financial innovation:
In 1983, The Chicago Board of Trade (CBOT)
introduced long- and mid-term interest-rate futures,
followed by interest rate options.
 These innovations once again made it easier for lending
institutions to hedge interest rate risk.
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Outstanding Auto Loans in the U.S.
5000
4679
US$100MM
4000
3642
2835
3000
2108
2000
1120
1000
47
363
135 168 294
568
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 1999
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Of course, mortgage loans alone cannot
relieve all of residents’ saving pressure
 Consumers will be unwilling to spend if there is no
health insurance, unemployment insurance and social
security fund.
 In countries with under-developed financial markets,
consumers have no choice but rely on bank savings
accounts to “insure against future risks.”
 But, bank savings is a very inefficient way to achieve
“risk insurance”.
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