Journal of Housing Research Volume 1, Issue 1 117

Mortgage Securitization Trends

Dwight M. Jaffee and Kenneth T. Rosen*
Introduction
Securitization is a process that can transform illiquid loans and similar
financial instruments into actively traded capital market securities.
Securitization has been mainly applied to residential mortgage loans, al-
though a limited amount of other types of loans have been securitized.
The securitization of mortgages has been important for several reasons.
First, securitization has created a more competitive mortgage market and
has encouraged new firms to enter the mortgage origination business. This
has lowered mortgage interest rates and thereby raised consumer demand
for housing. At the same time, by lowering mortgage yields, increased
competition has reduced thrift institution profits from holding fixed-rate
mortgages. Second, thrift institutions have securitized and sold mortgage
portfolios to balance their mortgage holdings with their deposit funds.
Third, to reduce portfolio risk and increase liquidity, thrifts and other
financial institutions have purchased large quantities of mortgage
securities. In these ways, securitization has allowed active secondary
market trading of mortgages to develop, which has helped integrate the
mortgage market with the overall capital market.
Mortgage securitization accelerated dramatically during the 1980s, cover-
ing about one-half of new mortgage originations by the end of the decade.
The accelerated pace of securitization of the mortgage market was spurred
by several factors, including a rising mortgage credit gap (an excess
demand for fixed-rate mortgage funds relative to the supply of funds avail-
able from traditional thrift lenders); an increased use by thrifts of mortgage
securities as interest rate and credit risk management tools; innovations
in financial technology, which have increased the demand for mortgages
by nontraditional investors; and an increased federal presence in the
mortgage market.
* Dwight M. Jaffee is professor of economics in the Economics Department at Princeton
University and Kenneth T. Rosen is professor of business administration and chairman of the
Center for Real Estate and Urban Economics at the University of California at Berkeley.
Parts of this paper have been adapted from Securitization and the Mortgage Market by
Kenneth T. Rosen.
118 Dwight M. Jaffee and Kenneth T. Rosen
In this paper, we analyze the future prospects for securitization in the
residential mortgage market, focusing on the next ten years. We will see
that the sources of securitization growth during the 1980s will continue
to be relevant during the 1990s. More importantly, several new factors are
likely to play key roles. These factors include, among others, the reduced
role of the thrift industry, the higher capital ratios required of thrift in-
stitutions, the growth of adjustable-rate mortgages (ARMs), the potential
securitization of multifamily mortgages, the imposition of risk-adjusted
capital requirements for all regulated financial institutions, and the rising
default rates on residential mortgages.
The paper is divided into four sections. This section provides an introduc-
tion to the topic. The second section briefly surveys the techniques of
securitizing residential mortgages. The third section analyzes the sources
of mortgage securitization growth during the 1980s and the role of these
sources in the 1990s. The final section evaluates the newly developing
factors that will also affect the growth of mortgage securitization during
the 1990s and beyond.
Origins and Techniques for Securitizing Residential
Mortgages
An active secondary market for trading mortgages was a major policy goal
in the United States from the end of World War II. To reach this goal, a
group of government and quasi-government agencies was created, includ-
ing Fannie Mae, the Government National Mortgage Association (GNMA),
and Freddie Mac. At first, these agencies tried to buy and sell mortgages
directly, but they succeeded primarily in buying mortgages, not selling
them. This helped support the mortgage market, but failed to create a
true secondary market with a substantial demand for mortgages from new
investors.
In the early 1970s, a new strategy was initiated, based on the securitiza-
tion of Federal Housing Administration (FHA) and Department of Veterans
Affairs, formerly Veterans Administration (VA), mortgages under the
GNMA pass-through program. In the following years, Freddie Mac, Fannie
Mae, and various private conduits introduced similar pass-through
securities for mortgages. These pass-through securities represent the basic
building block of mortgage securitization. Collateralized mortgage obliga-
tions (CMOs) and real estate mortgage investment conduits (REMICs)
were later adapted from pass-through securities to increase investor
demand. We will now consider the features of each of these securities.
Mortgage Securitization Trends 119
Pass-through Securities
A mortgage pass-through certificate represents an ownership interest in a
pool of mortgage loans. The individual mortgage loans represent debt
obligations of households, while the mortgage pool results from the com-
bined sale of these loans by the mortgage originator. The holder of a pass-
through certificate receives regularly scheduled monthly payments of
principal and interest from the mortgages in the pool. Any prepayments
of the mortgage loans in the pool are also passed through to the certifi-
cate holder.
Regarding default risk, the GNMA, Fannie Mae, and Freddie Mac
programs provide, in effect, a federal government guarantee of the timely
payment of all principal and interest payments to the certificate holder.
Certificates issued by private financial institutions also provide a cash
advance provision, in which the issuer states that its own funds will be
advanced to the certificate holder to cover any delinquencies in mortgage
loan payments. This provision, subject to reimbursement by an insurance
policy, thus provides for the timely payment of principal and interest on
these certificates.
Pass-through securities compare favorably with U.S. treasury securities
with regard to return and risk. The investor is, in particular, assured a
minimum cash flow because of the scheduled monthly payments of prin-
cipal and interest. As a result of unscheduled repayments of loan principal,
however, pass-through certificates do not provide a fixed schedule of pay-
ments.
There are essentially four major categories of pass-through securities:
GNMA, Freddie Mac, and Fannie Mae pools, and publicly issued certifi-
cates by private financial institutions. Most outstanding mortgage pass-
through certificates have the guarantee of the three government or
quasi-government agencies: of all residential mortgage securities outstand-
ing by the end of 1989, GNMA accounted for just under 42 percent; Fannie
Mae, 25 percent; and Freddie Mac, 29 percent. In contrast, private finan-
cial institutions accounted for only 4 percent of all pass-through mortgages
(see tables 1 and 2).
Starting at virtually zero in 1970, the aggregate amount of mortgage pool
certificates outstanding reached almost $100 billion of mortgage debt by
1979 and almost $1 trillion of such debt by 1989over 37 percent of all
outstanding residential mortgage loans. In 1986, the year with the highest
new-issue volume, more than $260 billion in mortgage pass-through cer-
tificates were created. Even excluding pass-through certificates backed by
seasoned loans, the annual flow in 1986 totaled almost $200 billion, 45
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Mortgage Securitization Trends 121
122 Dwight M. Jaffee and Kenneth T. Rosen
percent of all new mortgages that year. In comparison, these agencies rep-
resented just 10 percent to 15 percent of the mortgage market in the late
1970s.
GNMA initiated the pass-through securities market based on government-
insured FHA and VA mortgages. Later, during the 1970s, Freddie Mac
became a major issuer of mortgage pools backed by conventional
mortgages. Until 1981, Freddie Macs major securitization program in-
volved divided interests in specific pools of mortgages that Freddie Mac
held. Since 1981, Freddie Mac has initiated a highly successful mortgage
guarantor program similar to the GNMA program. In 1985, Freddie Mac
also started a securitization program for multifamily mortgages, although
the volume is still small compared with that of single-family mortgages.
In 1981, Fannie Mae became the second major issuer of mortgage pools
backed by conventional mortgages. The Fannie Mae mortgage-backed
securities programwhich is also similar to GNMAs basic pass-through
programsecuritized more than $200 billion in residential mortgages
through 1989.
Private financial institutions are the last and smallest source of mortgage
pass-through securities, with about $33 billion outstanding at the end of
1989. This activity primarily represents the pooling of mortgages that do
not conform to the standards (such as loan-size limits) of the quasi-govern-
ment agencies. The potential for increased securitization by private in-
stitutions will continue to be limited by the dominant position of the federal
agencies.
Collateralized Mortgage Obligations
CMOs are debt instruments, collateralized by mortgage pass-through cer-
tificates or individual mortgage loans, that combine the positive features
of mortgage pass-through securities and those of corporate bonds. The
major difference between a CMO and a mortgage pass-through security is
the mechanism by which interest and principal are paid to the security
holder. The traditional pass-through certificate pays a pro rata share of
interest and principal each month to the holder, because the security rep-
resents ownership of a fractional interest in a pool of mortgages. The CMO
structure radically alters this pro rata distribution mechanism and sub-
stitutes a sequential retirement of bonds.
A typical CMO has four classes or tranches. The first three classes receive
interest payments, with principal payments going first to the fast-pay class
of bonds. After the first class of bonds is repaid, principal payments are
used to retire the remaining classes sequentially. The fourth class of bonds,
Mortgage Securitization Trends 123
an accrual or Z bond, does not receive any interest or principal pay-
ments until all previous classes of bonds are retired.
The advantages of the CMO structure are clear. The CMO has turned a
long-term, monthly payment instrument into a series of semiannual pay-
ment, bondlike securities with short, intermediate, and long maturities
and average lives. The multiple-maturity classes reduce the uncertainty
of cash flows for any particular maturity class, allow investors to adapt
to different-shaped yield curves, and provide a degree of call protection for
the longer maturity classes. The CMOs thus attracted nontraditional in-
vestors to the mortgage market by offering a broader maturity range of
investments with less repayment uncertainty and greater call protection.
Collateralized mortgage obligations, which first appeared in mid-1983,
rapidly became a major instrument for mortgage securitization. Almost
$50 billion in CMOs were issued in the peak year of 1986 (see table 3).
CMOs were issued by Freddie Mac, investment bankers, savings institu-
tions, mortgage bankers, home builders, insurance companies, commercial
banks, and mortgage conduits.
Table 3. Issuance of CMO and REMIC Securities
(dollars in billions)
Year CMOs or REMICs Issued
1983 4.7
1984 11.0
1985 15.8
1986 48.7
1987 57.0
1988 76.4
1989
a
78.4
Source: Salomon Brothers, unpublished research from the Bond Market Research Depart-
ment.
Real Estate Mortgage Investment Conduits
Despite the rapid development of the CMO market, there were substantial
tax constraints to the widespread use of CMOs. The Internal Revenue
Service (IRS) created an additional level of taxation for any trust issuing
multiple-class securities that divided ownership of investment assets (such
124 Dwight M. Jaffee and Kenneth T. Rosen
as mortgages) or the cash flow from a pool of assets into non-pro rata
pieces. To avoid such double taxation, CMOs typically were issued as col-
lateralized debt securities. However, these debt securities generally repre-
sented a liability on the issuers balance sheet, creating accounting and
regulatory problems for some issuers. Moreover, tailoring CMO structures
to satisfy the IRS test for a true debt instrument normally reduced the
CMOs efficiency by limiting the amount of CMO bonds that could be issued
against a particular pool of mortgage collateral.
The new tax law eliminated these constraints by authorizing the creation
of REMICs that allow the multiple-class mortgage securities structure to
qualify as assets sold, thus avoiding the constraints applied to debt
securities. REMICs also removed other structural inefficiencies that
hindered CMOs. REMICs provided issuers with tremendous flexibility to
create new types of mortgage securities tailored to meet specific investor
needs.
REMIC structures now include the following:
1. Alternative payment frequencies (monthly, quarterly, etc.)
2. Securities with senior/junior structures
3. Securities with securities removed (coupon stripping)
4. Floating-rate securities
The dramatic growth of REMICs is evident (see table 3). This growth has
bolstered the demand for mortgage securities and opened the mortgage
market to an even broader range of institutional investors than did the
CMO.
Sources of Growth of Residential Mortgage Securitization
The phenomenal growth of residential mortgage securitization during the
1980s can be attributed to four major factors:
1. A rising mortgage credit gap for thrift institutions
2. Increased use of mortgage-backed securities as interest rate and credit
risk management tools by thrift institutions
3. Development of derivative securities that have increased the demand
for mortgages by nontraditional investors
4. Increased federal presence in the mortgage market
We will now look at each of these factors.
Mortgage Securitization Trends 125
Mortgage Credit Gap
In recent years, the supply of fixed-rate mortgage loans from traditional
thrift institution lenders has fallen substantially below the corresponding
loan demand of borrowers. Factors reducing available funds for fixed-rate
mortgages include the low rate of national savings in the U.S. economy,
the low percentage of these savings allocated to thrift institution deposits,
and the reluctance of savings institutions to hold fixed-rate mortgages.
This imbalance between demand and supply in the fixed-rate mortgage
market has been reconciled by adjusting the terms on mortgage loans (in-
terest rate, loan-to-value ratio, and maturity), by the entry of new nonthrift
lenders, and/or by fundamental changes in the structure of mortgage
markets, most importantly the use of mortgage-backed securities.
This mortgage credit gap for the thrift industry is measured by comparing
the cash flow to the thrift industry each year with the thrifts mortgage
originations (see table 4). Cash flow is defined as net new deposit flow
plus interest credited plus repayments of existing mortgages. The dif-
ference between cash flow and originations must be funded through either
Table 4. Components of Net Change in Mortgage Holdings
FSLIC-Insured Institutions
(dollars in billions)
Year
Net deposit
flow and
interest Mortgage New Mortgage
Mortgage
credited repayments cash flow originations credit gap
1975
$ 41.9 $ 28.2 $ 70.1 $ 53.4
1976 49.5 37.3 86.8 77.1
1977 50.0 48.5 98.5 105.3
1978 44.0 52.2 96.2 108.3
1979 38.7 49.7 88.4 99.0
1980
40.6 40.7 81.3 71.3
1981 13.3 34.4
47.7
52.3
1982 37.2 43.1 80.3 53.4
1983 106.7 97.2 203.9 151.1
1984 111.2 104.2 215.4 181.3
1985 51.5 115.1 166.6 196.7
1986 50.1 162.2 212.3 265.5
1987 46.4 148.3 194.7 253.4
1988 43.8 127.2 171.0 240.2
1989
a
(39.7) 108.7 69.0 194.1
$ 16.7
(6.8)
(12.1)
(10.6)
10.0
(4.6)
26.9
52.8
(30.1)
(53.2)
(58.7)
(69.2)
(125.1)
Source: Federal Home Loan Bank Board; Office of Thrift Supervision Journal (various issues).
a
Estimated for the year based on data through the third quarter.
34.1
9.7
126 Dwight M. Jaffee and Kenneth T. Rosen
net loan sales, a reduction in the holding of other assets, or borrowing
from Federal Home Loan Banks or other sources. A large mortgage credit
gap has existed since 1985, and it reached more than $125 billion in 1989,
compared with a credit surplus or small deficit in most previous years.
With such a credit gap, the thrift industry must sell mortgages or increase
other borrowings. Large net loan sales were made each year from 1985,
with a high of over $100 billion in 1986 (see table 5). This is how the
Table 5. Savings Institutions Secondary Market and Borrowing Activity
(dollars in billions)
Year
Purchases of Mortgage
mortgages sales
Net change
Federal
Net
Home Loan
mortgage Bank Other
sales advances borrowings
1975 $ 8.5 $ 5.2
$ (0.4) $ (0.1)
1976 12.8 8.4
(4.4) (1.8) 0.2
1977 14.5 13.8 (0.7) 4.2 4.4
1978 11.0 15.5 4.5 12.1 2.9
1979 12.0 18.3 6.3 8.5 3.9
1980 13.0 15.9 2.9 6.7 2.9
1981 10.5 12.6
2.1 15.9 8.7
1982 23.3 53.4 30.1 7.6
1983 45.8 55.4 9.6 (6.7)
(0.4)
0.9
7.3
1984 64.2 63.8 15.0 24.0
1985 62.4 104.6 42.2 13.2 7.7
1986 69.1 169.8 100.7 15.6 23.6
1987 64.5 123.4 58.9
16.3 36.6
1988 55.0 106.1 51.1 17.8 31.6
1989
a
39.2 81.6 42.4
29.8 16.7
Source: See table 4.
a
Estimated for the year based on data through the third quarter.
thrift industry spawned the securitization surge. Federal Home Loan Bank
and other borrowings were also sustained at high levels during the same
years. As a result of these actions, the net change in mortgage loans held
by the thrift industry has been relatively low since 1985 (see table 6).
A different view of the same process shows that the thrift industry was
able (until 1989) to retain its traditional share of mortgage originations,
just below 50 percent of the total (see table 7). However, the share of
$ (3.3)
Mortgage Securitization Trends 127
Table 6. Change in Savings Institutions Portfolio Holdings
(dollars in billions)
Year
Change in
mortgage
loans held
a
Mortgage-
backed securities
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
b
$57.8 $ 2.3
50.9 3.5
42.3
3.9
26.9
6.9
14.9 5.8
(25.6)
29.0
59.9 29.1
95.5
21.8
51.8 2.8
6.7 42.7
24.1 43.6
43.0 13.2
25.4 3.0
Source: See table 4.
a
Adjusted for change in accounting method in 1982.
b
Estimated for the year based on data through the third quarter.
Table 7. Share of Long-Term Residential
Mortgage Originations by Lender Type
(percent of total)
Year
Savings
institutions
Mortgage Commercial
bankers
banks
1975 58.3 17.9 18.6
1976 60.4
13.9 21.7
1977 58.6 15.9 22.7
1978 53.7 18.6 23.8
1979 49.1
24.2 21.8
1980 49.7 22.3 21.7
1981 46.8 24.4 22.4
1982 40.0 28.9
26.0
1983 45.7
29.6 22.3
1984 53.5
23.4 20.6
1985 51.0 25.6
20.9
1986 45.6 29.0 23.7
1987 46.3
24.5 27.6
1988 49.7 22.8
25.5
1989
a
43.8
19.5 34.9
Source: U.S. Department of Housing and Urban Development, Survey of mortgage lending
activity (various issues).
128 Dwight M. Jaffee and Kenneth T. Rosen
mortgages held by the thrift industry has been falling, reflecting the large
quantity of mortgages sold (see table 8). Compared with the early 1970s,
both mortgage bankers and commercial banks now hold larger shares of
mortgages.
Table 8. Share of Residential Mortgages Outstanding
(Percent of total mortgages outstanding)
Whole mortgages
Whole mortgages and
agency securities
Year
Savings
institutions
Federally
supported
agencies
a
Savings
institutions
1975 56.4
13.8
1976 56.9
14.4
1977 56.6
15.2
1978 55.0
16.2
1979 52.3
17.9
1980 50.0
19.2
1981 47.9
20.3
1982 42.5
25.1
1983 40.6
29.1
1984 40.2
30.3
1985 38.1
33.5
1986 34.0 38.7 43.2
1987 31.1 40.4 41.3
1988 30.6 39.9 40.2
1989
b
30.0 46.6 39.3
Source: Board of Governors of the Federal Reserve, Federal Reserve Bulletin ( various issues).

Theoretically, with the deregulation of interest rates on deposit liabilities,
the industry could offer higher deposit rates and attract more funds to
hold mortgages in its portfolio. However, most of the industry is now dedi-
cated to duration-matching strategies in which adjustable-rate mortgages
take the lead. Thrift institutionsmutual savings banks and savings and
a
Include mortgage pools.
b
Estimated for the year based on data through the second quarter.
Mortgage Securitization Trends 129
loan associationsmaintain an important position in originating adjus-
table-rate mortgages (see table 9). Most thrift institutions are likely to
continue selling their fixed-rate mortgages while holding their adjustable-
rate mortgages.
Table 9. Percent of Conventional Loans in ARMS, by Originator
Year
Mutual Savings
savings banks and loans
Mortgage
companies
Commercial
banks
1985 72.6 54.3 44.2 36.8
1986 46.8 38.4 9.4 23.3
1987 71.3 54.0 27.4 25.1
1988 76.2 70.6 43.3 43.1
1989 61.3 62.4 24.4 35.3
Source: See table 3.
The mortgage credit gap is likely to continue as a source of securitization
during the 1990s because thrifts are likely to continue unbundling their
services. Given the dramatic restructuring of the mortgage lending en-
vironment, spread management is no longer enough to generate profits.
With rising deposit rates, falling mortgage rates, and rising operating
costs, profitability based on interest rate spreads has become difficult even
for savings institutions that hold predominantly adjustable-rate mortgages.
But their information regarding local markets and customers still may
enable thrift institutions to maintain a comparative advantage in originat-
ing and servicing mortgages. Thus, traditional mortgage lenders will most
likely rely increasingly on originating and servicing income as sources of
profitability. The industry has moved from a make them and hold them
to a make them and move them environment.
Interest Rate and Credit Risk Management
At the same time that the thrift industry has been selling most of its
fixed-rate mortgage loans, it has also been substantially increasing its
holdings of mortgage-backed securities (see table 6). Mortgage-backed
securities provided thrifts with a highly liquid, credit-risk-free portfolio.
These securities also gave thrifts easier access to the wide range of sophis-
ticated interest rate risk-management tools. Not only will thrift
130 Dwight M. Jaffee and Kenneth T. Rosen
institutions demand for mortgage-backed securities continue throughout
the 1990s, it will likely expand because of the structure of thrift capital
ratios, as we will discuss later.
Development of Derivative Securities
The development of derivative securities represents a third reason for the
surge in securitization. CMO and REMIC issuance was approaching $80
billion by 1989 (see table 3). By changing the legal, technical, and cash
flow attributes of pass-through securities, these instruments substantially
boosted both the demand and the supply for mortgage-backed securities.
A related development concerns the separation of pass-through certificates
into interest only (IO) and principal only (PO) components. When interest
rates and prepayment rates change, the two parts tend to respond in op-
posite directions. For example, when interest rates rise, prepayment rates
generally fall, thus extending the expected life of each mortgage. As a
result, an IO strip will rise in value, because the period for receiving in-
terest payments is extended. In contrast, a PO strip will fall in value,
because the waiting time to receive the principal payments is similarly
extended.
The importance of derivative securities for the growth of securitization
during the 1990s will depend primarily on the volatility of interest rates.
If interest rates continue to fluctuate as they have in the pastor at least
if investors continue to expect them to fluctuatethe demand for deriva-
tive securities will remain strong.
Federalization of the Mortgage Market
Finally, securitization has been a response to the increasing federalization
of the mortgage market. In addition to GNMA, the mortgage-backed
security programs of Fannie Mae and Freddie Mac have captured sig-
nificant market shares. Part of this success reflects the relatively high
level of Fannie Mae/Freddie Mac loan limits. For example, between 1985
and 1989, the loan limit rose by 63 percent, while median house prices
increased by only 24 percent (see table 10). Using data collected by the
National Association of Realtors on the selling prices of existing homes,
the Fannie Mae/Freddie Mac loan limit in 1989 would have been $142,600
rather than the authorized $187,600. Thus, at least part of the increase
in securitization results from expanding the definition of the conforming
loan market.
Mortgage Securitization Trends 131
Table 10. Conforming Loan Market
Year
Mortgage
Year to Median Year to
loans non-
Freddie Mac/ year change house year change conforming
Fannie Mae (percent) price
a
(percent) (percent)
1980 $ 93,750
98,500 1981
1982 107,000
1983
108,300
1984
114,000
1985 115,300
1986 133,250
1987 153,100
1988
1989
b
168,700
187,600
5.1 $62,200 11.67
9.9 66,400
6.75
1.2 67,800
2.11
1.2 70,300
3.69
5.3 72,400 2.99 24.5
1.1 75,500
4.28 26.5
15.6 80,300
6.36 24.8
14.5 85,600 6.60 23.4
10.2 89,300 4.32 22.6
11.1 93,400 4.59 19.6
Source: See table 4.
a
From National Association of Realtors, Home sales (various issues).
b
Estimated for the year based on data through the third quarter.
Given the close connection between mortgage securitization and mortgage
market federalization, the demand for securitization during the 1990s will
depend heavily on the future of mortgage market federalization. At this
point, the likely outcome is that federalization of the mortgage market will
be maintained, implying strong demand for securitized mortgages. The
discussion in the following section, however, notes several factors that
might lead to reduced federalization.
Securitized Mortgages during the 1990s to the Year 2000
We have examined the factors that created the large growth in securitiza-
tion during the 1980s and have indicated why these factors will generally
produce continuing demand for securitization in the year 2000. We will
now look at additional factors that are likely to come into play during the
1990s. These factors primarily concern the thrift institution crisis and re-
lated developments in the mortgage market.
Thrift Institution Capital and Regulatory Requirements
As the 1980s progressed, a growing number of thrift lenders found their
lending and borrowing powers restricted by statutory capital requirements
and limitations on expansion of asset growth. In order to continue provid-
132 Dwight M. Jaffee and Kenneth T. Rosen
ing mortgage credit, they were forced to sell assets, in many cases through
securitization. The higher capital requirements imposed by the Financial
Institutions Reform, Recovery and Enforcement Act of 1989 will substan-
tially magnify this process during the 1990s.
Specifically, two aspects of the new capital regulations for thrifts will affect
securitization in the 1990s. First, when the requirements are fully imple-
mented, 3 percent of core capital will have to be held against assets. Nearly
1000 thrifts now fail to meet this requirement. It is widely believed that
thrifts will generally meet this requirement by reducing size through asset
sales in a securitized format. Another one-third of the thrift industry will
just barely meet the 3 percent capital requirement and will have little
incentive to grow and add mortgage assets to their portfolio.
With nearly two-thirds of the industry severely capital constrained, the
ability of thrifts to remain the preponderant holder of residential
mortgages in the 1990s is seriously in doubt. The total share of thrift
holdings of mortgages had already dropped from 50 percent in 1980 to 41
percent by the end of 1988. By the end of the next decade, the remaining
thrift industry may hold 30 percent or less of all outstanding residential
mortgages. This will probably occur despite the offsetting effect of the in-
creased proportion of residential mortgages that must be held by thrifts
(from 60 percent to 70 percent) to meet the qualified lender test.
The declining role of the thrift industry does not in itself translate into
increased securitization. Commercial banks and life insurance companies
will certainly increase their holdings of unsecuritized residential
mortgages. It is our view, however, that the vast majority of the thrift
shortfall will be made up by the securitized market. This factor alone
would increase the securitized share of the market to 50 percent by the
year 2000.
An additional factor that will certainly affect the amount of securitization
is the credit-based capital requirements for commercial banks and thrifts.
By the early 1990s, these institutions will have a risk-weighted capital
requirement of over 8 percent. Securitized residential mortgage instru-
ments are favorably treated in the new law: as a percentage of stand-
ardized capital, GNMA securities require zero capital, Fannie Mae and
Freddie Mac securities require 20 percent, single-family whole loans re-
quire 50 percent, and multifamily whole loans require 100 percent. If all
else is equal, this situation should further accelerate the securitization of
residential mortgages, especially for capital-short institutions. On the other
hand, securitized mortgages usually yield substantially less than whole
mortgages. Institutions, therefore, will have to trade off profitability
Mortgage Securitization Trends 133
against capital requirements. On balance, the risk-based capital require-
ments will accelerate securitization in the 1990s.
Securitization and Adjustable-Rate Mortgages
Nearly all the factors discussed so far seem to favor increased securitiza-
tion in the next decade. One factor that may work in the opposite direction
is the increased importance of ARMs. In recent years, ARMs have at times
accounted for over 60 percent of newly originated mortgages. Only a small
volume of ARMs have been securitized, perhaps because thrifts and com-
mercial banks have wanted to hold ARMs directly in their portfolios. The
demand for ARMs from general capital market investors is limited. The
reason is readily apparent: cost-of-funds-indexed ARMs are specialized in-
struments that help meet the objectives of asset-liability management
primarily for depository institutions. Treasury-indexed ARMs are more
amenable to securitization, but annual and lifetime caps make them in-
ferior to other short-term indexed investment instruments.
Because the ARM share of total mortgage originations continues to be
relatively high and because a relatively small percentage of ARMs are
securitized, there is an upper limit on the market share of securitized
instrumentsto perhaps 60 percent of the residential market. Wall Street,
which so ingeniously developed the market for fixed-rate residential
securities, may surprise us, but the securitized ARM product does not
appear to be in demand now.
Multifamily Mortgages and Securitization
Over $300 billion in multifamily mortgages were outstanding by the end
of 1989, yet only 4 percent of this market was securitized. Clearly, this
represents a great potential for further securitization during the 1990s.
The problems in securitizing multifamily loans have been examined in a
recent article (Godner and Rosen 1989). Essentially, the problem in
securitizing multifamily loans revolves around credit risk and underwrit-
ing standards. The multifamily mortgage market lacks, at least in relative
terms, standardized documentation for underwriting, mortgage insurance
(no private insurance and limited FHA insurance), and actuarial data to
allow investors and federally sponsored credit agencies to assess default
risks adequately. However, we believe that the agencies will expand this
market during the 1990s, and that multifamily mortgages have perhaps
the greatest growth potential in the securitized residential market during
the 1990s.
134 Dwight M. Jaffee and Kenneth T. Rosen
The Impact on Thrift Institutions
We have just seen several ways in which the thrift crisis will have impor-
tant impacts on securitization during the 1990s. It is also important to
realize that securitization can have important impacts on thrift institu-
tions. Because the securitization process fully integrates mortgages into
the overall capital market, thrift institutions no longer operate in a seg-
mented milieu, but must compete instead in a fully capital-market-driven
environment, vying with nontraditional investors on a long-term and cycli-
cal basis. Thus, securitization has become one of a number of factors
threatening the viability of thrifts.
Changing patterns for deposit rates, mortgage yields, and operating costs
have combined in recent years to reduce profit margins of thrift institutions
(see table 11). For example, between 1981 and 1989, the thrift institution
profit margin fell from 2.62 percent to 0.37 percent. Individual thrift in-
stitutions do not have substantial control over the deposit rate they pay
to attract funds or the mortgage rate they receive when lending funds.
Table11. The Economic Fundamentals for Thrift Institutions
(percent)
Year
[1]
Long-term
conventional
mortgage rate
[2]
Savings
deposit rate,
FSLIC-
insured
institutions
[3]
Operating
expense ratio
[4]
Profit margin
[1] [2] [3]
1975 9.00 6.21 1.12 1.67
1976 9.00 6.31 1.20 1.49
1977 9.02 6.39 1.18 1.45
1978 9.56
6.56
1.21 1.79
1979 10.78 7.29 1.25 2.24
1980 12.66 8.78 1.28 2.60
1981 14.70
10.71
1.37 2.62
1982 15.14 11.19 1.46 2.49
1983 12.57 9.71 1.63 1.23
1984 12.38 9.93 1.74 0.71
1985 11.55
9.03 2.08 0.44
1986 10.17 7.84 2.03 0.30
1987 9.31 6.92 2.08 0.31
1988 9.19
7.22
1.84 0.14
1989 10.13 7.88 1.88 0.37
Source: Federal Home Loan Bank Board; Office of Thrift Supervision Journal (various issues);
and United States League of Savings Institutions Fact book (various issues).
Mortgage Securitization Trends 135
Thus, in a capital-market-driven environment, only thrifts with low-cost
operations will survive as portfolio holders of mortgages.
It is here that the fundamental public policy issue and the one potential
constraint on securitization arise. There is no question that securitization
emanating from fundamental economic and technological change should
be encouraged. However, a substantial impetus for securitization results
from the policy of federally guaranteeing a large volume of mortgages for
middle- and upper-income homeowners. With 80 percent of the market
now affected by the legislated Fannie Mae/Freddie Mac loan limits and 50
percent of annual mortgages securitized by the federal or quasi-federal
agencies, it is apparent that federal involvement in the housing finance
system has tripled since 1980.
There is certainly reason to question the consistency and efficiency of a
public policy that subsidizes the origination of fixed-rate mortgages for
middle- and upper-income households. The recent rise in delinquency and
foreclosures at these agencies also raises issues concerning the
governments potential liability if GNMA, Fannie Mae, and Freddie Mac
should experience losses that exceed their capital reserves (see table 12).
Table 12. Mortgage Foreclosures by All Lenders
Year
Loans in the foreclosure process
(percent)
1975 0.38
1976 0.40
1977 0.37
1978 0.31
1979 0.29
1980 0.38
1981 0.44
1982 0.67
1983 0.67
1984 0.73
1985 0.81
1986 0.98
1987 1.06
1988 .95
1989
a
.99
Source: Mortgage Bankers Association of America, National delinquency survey (various is-
sues).
a
Based on estimated data through third quarter.
136 Dwight M. Jaffee and Kenneth T. Rosen
These concerns may result in an attempt to reexamine the role of the
agencies. It is time for participants in the housing and housing finance
systemthe administration and Congress, realtors, home builders,
mortgage bankers, and the thrift industryto focus on the appropriate
role of agencies in the marketplace.
In summary, to the extent that securitization is an outgrowth of market
forces and technological change, it will improve the efficiency of the asset
markets being securitized. Although this will hurt the inefficient players,
it is a necessary result of a changing financial system. On the other hand,
where federal subsidy is the driving force, a closer examination of public-
sector goals and private-sector alternatives is required. Such a reevalua-
tion might reduce governments role in the securitization process during
the next decade and so limit the securitization of the residential mortgage
market.
The Market for Securitized Mortgages during the 1990s
Our discussion has identified a number of factors that should cause the
market for securitized mortgages to continue to grow through the year
2000. Three of the factors that stimulated strong growth during the
1980sa mortgage credit gap, pass-through securities as instruments for
interest rate and credit risk management, and the development of deriva-
tive securitiesshould continue to exert a strong influence on the market
for securitized mortgages. We also pointed out that new factors deriving
from the thrift institution crisissuch as higher capital requirements
should also stimulate mortgage securitization.
At the same time, other factors exert a negative influence on mortgage
securitization. These include rising mortgage foreclosure rates, ARM
securities that do not enter into the securitization process, and a poten-
tially decreased role for federalization in the mortgage market. We do not
forecast that any of these factors will actually have a strong negative effect
on mortgage securitization. However, if our evaluation of mortgage
securitization prospects during the 1990s should prove too optimistic, it
would likely be on the basis of one of these factors.
References
Board of Governors of the Federal Reserve, Federal Reserve Bulletin (various
issues). Washington, D.C.
Godner, Julie, and Kenneth Rosen. 1989. Mobilizing the multifamily secondary
markets. Secondary Mortgage Markets 6, no. 2 (Summer).
Mortgage Securitization Trends 137
Mortgage Bankers Association, National delinquency survey (various issues).
Washington, D.C.
National Association of Realtors, Home sales (various issues). Washington, D.C.
Office of Thrift Supervision, Office of Thrift Supervision Journal (various issues).
Washington, D.C.
U.S. Department of Housing and Urban Development, Survey of mortgage lending
activity (various issues). Washington, D.C.
United States League of Savings Institutions, Fact book (various issues).
Washington, D.C.