Mortgages and Fannie Mae
Mortgages
Fixed rate
Variable rate
Fixed Rate Mortgage
$200,000 mortgage
This
Year’s
Balance
Graduated payment
Previous
= Year’s
Balance
+

This
Year’s
Payment

Based on the
Previous Year’s
Unpaid Balance
10 percent interest rate
Claim: $23,492 annual payment
Payment
Interest
Paid on
Balance
This year (Year 0)
Next year (Year 1)
Year 2
23,492
23,492
Balance
200,000
200,000 + 20,000  23,492 = 196,508
196,508 + 19,651  23,492 = 192,667
Year 10
23,492
144,348
14,435
Year 19
Year 20
23,492
23,492
21,356
21,356 + 2,136  23,492
2,136
21,356
+2,136
23,492
= 0
Interest
20,000
19,651
19,267
Variable (Adjustable) Rate Mortgages
When inflation is present
purchasing power is key.
What we expect to pay back to the
bank and what the bank expects to
receive depends on the inflation rate
that we expect in the future.
What we will actually pay back to
the bank depends upon the actual
inflation rate in the future.
Real
Nominal
Interest = Interest 
Rate
Rate
When the actual
inflation rate turns out
to be greater than that
expected

Real interest rate is
less than expected

In terms of purchasing
power, borrowers
repay the bank less
than expected

Borrowers gain
Lenders lose
Inflation
Rate
When the actual
inflation rate turns out
to be less than that
expected

Real interest rate is
greater than expected

In terms of purchasing
power, borrowers
repay the bank greater
than expected

Borrowers lose
Lenders gain
The experience of the 1970s prompted banks to
offer variable rate mortgages.
The nominal interest rates are these mortgages are
adjusted periodically to account for inflation.
Graduated (Escalating) Payment Mortgages
Graduated
(Escalating)
Payment
$20,000
$28,156
Payment for the first 7 years:
Payment for the next 13 years:
Payment
This year (Year 0)
Next year (Year 1)
Year 2
20,000
20,000
Balance
200,000
200,000 + 20,000  20,000 = 200,000
200,000 + 20,000  20,000 = 200,000
Year 7
Year 8
20,000
28,156
200,000
200,000 + 20,000  28,156 = 191,844
Year 19
Year 20
28,156
28,156
25,596
25,596 + 2,560  28,156 = 0
25,596
+2,560
28,156
A $8,156,
40%, increase
Interest
20,000
20,000
20,000
20,000
2,560
Fannie Mae (Federal National Mortgage Association)
Fannie Mae is a government-sponsored enterprise plays a large role in the market for home
mortgages.
It is more or less invisible to households holding mortgages because if does not does not
provide mortgages directly to households.
Instead it:
Purchases whole mortgages that that banks have previously issued on what is called the
secondary market.
Keeps some of the whole mortgages and earns income from them as they are repaid.
Cobbles whole mortgages together into mortgage backed securities (MBSs)
Keeps some of the MBSs for itself and sells the remainder to private financial
institutions (Citibank, Bank of America, etc.).
Owners of the MBSs receive income as the mortgages are repaid.
We will now focus more closely on MBSs.
Mortgage Backed Securities (MBS)
Bank A
“Whole” Mortgages
Mortgage
Hunter
Mortgage
Christin
A financial institution
such as Fannie Mae, Bear
Stearns, etc. buys a bunch of
whole mortgages from
“primary” lenders (banks).
Mortgage
Haley
Bank B
“Whole” Mortgages
Mortgage
Jayde
Mortgage
Mateo
Fannie Mae, Bear Stearns, etc.
Cobbles a large number of these mortgages into
a single Mortgaged Back Securities (MBS)
Splits the MBS into a large number of shares
Fannie Mae, Bear Stearns,
etc. keeps some shares of the
MBS for itself and sells
others to private parties.
Mortgage
Kate
Each share of the MBS
represents a fraction of
each mortgage that have
been cobbled together into
the MBS.
Private parties including banks and
other financial institutions
The owners of the MBSs earn income as the mortgages included in the MBS are repaid.
Policy Change, Home Prices, and Mortgage Backed Securities (MBS)
Bank A
“Whole” Mortgages
Mortgage
Hunter
Mortgage
Christin
Mortgage
Haley
Assets
Reserves
Liabilities
50
Vault Cash
30
Dep at Fed
20
Suppose that Bank:
Sold Hunter’s and Haley’s mortgages to Fannie
Mae.
Used the proceeds to purchase mortgagebacked securities (MBSs).
100 60
Securities
Stock&Bonds 60
MBSs
40
440 480
Loans
Hunter
20
Christin
20
Haley
20
Net Worth = 590  510 = 80
Deposits
Borrowing
500
10
Question: Why might a bank wish to
sell some of its whole mortgages to
purchase mortgage-backed securities?
Answer: Diversification.
Fannie Mae Eases Credit To Aid Mortgage Lending
By STEVEN A. HOLMES
New York Times: September 30, 1999
WASHINGTON, Sept. 29— … the Fannie Mae Corporation is easing the credit requirements on
loans that it will purchase from banks and other lenders.
The action … will encourage those banks to extend home mortgages to individuals whose credit
is generally not good enough to qualify for conventional loans. Fannie Mae officials say they
hope to make it a nationwide program by next spring.
Fannie Mae … has been under increasing pressure from the Clinton Administration to expand
mortgage loans among low and moderate income people ...
In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly
more risk, which may not pose any difficulties during flush economic times. But the governmentsubsidized corporation may run into trouble in an economic downturn …
Fannie Mae … does not lend money directly to consumers. Instead, it purchases loans that banks
make on what is called the secondary market. By expanding the type of loans that it will buy,
Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit
ratings.
Effect of the Policy Change
Banks took advantage of the new policy providing mortgages to households who would not
have received them previously. Let us call these households “not so credit worthy” buyers.
Question: What type of mortgage would you expect these “not so credit worthy” home
buyers choose, fixed rate mortgages or graduated payment mortgages?
$200,000 Mortgage at a 10 Percent Interest Rate
Fixed Rate
Graduated Payment
Payment for the first 7 years:
$23,492
$20,000
Payment for the next 13 years:
$23,492
$28,156
Answer: The “not so credit worthy” home buyers chose graduated payment mortgages.
Question: What would you expect the banks providing the loans to “not so credit worthy”
households to do with these “whole” mortgages?
Answer: Sell the “whole” mortgages to Fannie Mae, Bear Stearns, etc. who would create
MBSs from them.
2000-2007
Question: How did this affect the market for new homes?
Market for New Homes
Answer: The
P
price increased.
S
Real Price of Single Family Homes ($1,000):
2000-2008
300
275
250
225
200
D
175
2000
D
2002
2004
2006
2008
2010
Q
Question: What happens when
the payment rises for the “not so
credit worthy” home buyers who Payment for the first 7 years:
Payment for the next 13 years:
have a graduated mortgage?
Graduated
Payment
$20,000
$28,158
40%,
increase
Answer: Some of these home buyers discovered a few years after purchasing their homes
that they could not afford the higher payments required by their graduated payment
mortgages.
Question: Was this a problem for the “not so credit worthy” home buyer between 2000 and
2007?
Answer: No. Since home prices were rising a buyer could sell his/her home and have more
than enough to pay off the mortgage.