Secondary mortgage markets: recent trends and research results

Federal Home Loan Bank Board Journal,  April, 1984  by James E. McNulty

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The development of an organized secondary market for conventional mortgage loans during the 1970s and early 1980s has opened up many new opportunites for savings institution managers. It has given the mortgage instrument a much higher degree of liquidity, which has provided much greater flexibility in managing the mortgage portfolio. More recently, selling loans in an active secondary market has provided institutions a way to continue to be mortgage lenders without incurring the risk of adding long-term, fixed-rate loans to their portfolios.

The development of this market has also created a fertile field for academic research. Researchers have been interested in the way in which the secondary market has affected mortgage rates and loan-terms--both their absolute level and the differences among regions. This article discusses the growth of the secondary market since 1970 and then reviews some recent research dealing with these questions. Growth of the Market

Some perspective on the growth of the secondary mortgage market can be obtained from Charts 1 to 3. Chart 1 shows the tremendous growth in the amount of mortgage pool securities outstanding from year-end 1970 to year-end 1982. These pools are represented by Government National Mortgage Association (GNMA) passthrough certificates and Federal Home Loan Mortgage Corporation (FHLMC) participation certificates, both of which have existed since the early 1970s, as well as the newer Federal National Mortgage Association (FNMA) passthrough certificates. After rising to $14.4 billion by the end of 1972, the outstanding amount of mortgage pool securities more than tripled to $56.8 billion by the end of 1977. At the end of 1972, mortgage pools represented 4.0 percent of total residential mortgage debt outstanding. (See Chart 2.) This increased to 8.9 percent at the end of 1977 and 16.1 percent at the end of 1982.

Even more impressive is the extent to which the growth in mortgage pools has contributed to the growth in outstanding mortgage debt. Chart 3 illustrates this by presenting a comparison of the change in the amount of mortgage pool securities with the change in total residential mortgage debt. For example, in 1977, mortgage pools increased from $40.7 billion to $56.8 billion (see Chart 1), while total debt increased from $544 million to $635 million. The $16.1 billion increase in mortgage pools thus represented 17.7 percent of the debt increase. In 1982, mortgage debt increased by only $46.9 billion, reflecting depressed conditions in the housing market. By coincidence, mortgage pools also increased by about $47 billion in 1982, so that, in effect, the secondary market accounted for all of the growth in mortgage debt in 1982.

Talk of the integration of the mortgage market into the general capital markets, which had been prevalent in financial circles since at least the mid-1970s, became a reality by the early 1980s. In fact, the above figures understate the size of the secondary market, since many secondary market transactions involve the sale of individual mortgages and do not result in the creation of market pools. On the other hand, in 1982, the figures are somewhat distorted because a large portion of the growth in mortgage pools reflects the success of the Federal Home Loan Mortgage Corporation's "guarantor" program, in which lenders swap older, low-rate mortgages for passthrough securities. In this situation, a mortgage pool is created without a corresponding amount of new lending activity. In previous years, pools were created primarily to fund new lending activity.

While there are some measurement problems, the growth of the secondary market--and its support of the primary market--is impressive, as these statistics make clear. For an increasing number of associations, the secondary market has become the mortgage market. It is common, for example, to hear of institutions which sell almost all of the fixed-rate loans they make to one of the mortgage agencies or to private sources. Impact on Mortgage Yields and Spreads

With this background, we can review the findings of some recent studies on such issues as the effect of the development of the secondary market on mortgage yields and on interregional differences in mortgage rates. In theory, the integration of the mortgage market into the Nation's overall capital market s should have two effects. First, by creating greater competition in the mortgage market and increasing the supply of mortgage funds, it should bring mortgage rates more in line with other interest rates. Secondly, it should reduce interregional differences in mortgage rates.

With regard to the first of these effects, a 1980 study by Hendershott and Villani argues that this is exactly what had happened by the late 1970s. According to the authors, the development of the secondary mortgage market "has improved interregional flows of mortgage funds and has given mortgage borrowers a greater access to capital markets generally. The principal result has been a decline in the mortgage rate relative to other market rates..." [2, p. 50]. This decline in the spread between mortgage rates and other interest rates to which Hendershott and Villani called attention is illustrated in Table 1. For example, from 1963 to 1965 (before the first period of disintermediation in 1966 and before the development of an organized secondary market for conventional loans), the spread between conventional mortgage rates on loans closed and rates on 10-year US government bonds ranged from 153 to 193 basis points. By 1978, the spread had declined to 113 basis points.