PaymentBalanceInterest This year (Year 0)200,00020,000 Next year (Year 1)23,492200, ,000  23,492 = 196,508 19,651 Year 223,492196, ,651  23,492 = 192,667 19,267 Year 1023,492144,34814,435 Year 1923,49221,356 2,136 Year 2023,49221, ,136  23,492 21,356 +2,136 23,492 = 0 Mortgages  Based on the Previous Year’s Unpaid Balance This Year’s Balance = Previous Year’s Balance + Interest Paid on Balance  This Year’s Payment $200,000 mortgage 10 percent interest rate Claim: $23,492 annual payment Fixed rateVariable rateGraduated payment Fixed Rate Mortgage Mortgages and Fannie Mae

Variable (Adjustable) Rate Mortgages RealNominal Interest=Interest  RateRate 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 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 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. When inflation is present purchasing power is key. Inflation Rate 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.

Year 2028,15625, ,560  28,156 Year 1928,156 25,596 2,560 Year 828,156200, ,000  28,156 = 191,844 PaymentBalanceInterest This year (Year 0)200,00020,000 Next year (Year 1)20,000200, ,000  20,000 = 200,000 20,000 Year 220,000200, ,000  20,000 = 200,000 20,000 Year 720,000200,00020,000 = 0 Graduated (Escalating) Payment Mortgages Graduated (Escalating) Payment Payment for the first 7 years:$20,000 Payment for the next 13 years:$28,156 A $8,156, 40%, increase 25,596 +2,560 28,156

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.

A financial institution such as Fannie Mae, Bear Stearns, etc. buys a bunch of whole mortgages from “primary” lenders (banks). Each share of the MBS represents a fraction of each mortgage that have been cobbled together into the MBS. The owners of the MBSs earn income as the mortgages included in the MBS are repaid. Mortgage Backed Securities (MBS) Bank A “Whole” Mortgages Mortgage Hunter Mortgage Christin Mortgage Haley Bank B “Whole” Mortgages Mortgage Jayde Mortgage Mateo Mortgage Kate 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 Private parties including banks and other financial institutions Fannie Mae, Bear Stearns, etc. keeps some shares of the MBS for itself and sells others to private parties.

Loans480 Securities60 MBSs Net Worth = 590  510 = 80 Policy Change, Home Prices, and Mortgage Backed Securities (MBS) Bank A “Whole” Mortgages Mortgage Hunter Mortgage Christin Mortgage Haley Suppose that Bank: Sold Hunter’s and Haley’s mortgages to Fannie Mae. Used the proceeds to purchase mortgage- backed securities (MBSs). Reserves50 Vault Cash30 Dep at Fed20 Stock&Bonds60 Hunter20 Christin20 Haley20 Deposits500 Borrowing10 AssetsLiabilities 440 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. 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 government- subsidized 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. 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...

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 RateGraduated 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.

Question: How did this affect the market for new homes? D D S P Q Answer: The price increased. Question: What happens when the payment rises for the “not so credit worthy” home buyers who have a graduated mortgage? Graduated Payment Payment for the first 7 years:$20,000 Payment for the next 13 years:$28,158 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. Market for New Homes 40%, increase