In this episode of The REconomy Podcast™ from First American, the sixth in the Summer School series, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi trace the journey of mortgages, shedding light on how the U.S. stands out with its 30-year, fixed-rate mortgage, while exploring how this unique loan product shapes the accessibility and stability of the nation’s housing market.

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Listen to the REconomy Podcast™ Episode 97:

“By pooling together many mortgages into securities, the risk is transferred, as we say, to a broad base of investors, many of which are even outside this country, while those investors get the benefit of a diversified income stream. At the same time, it's a win-win that helps keep mortgage money flowing, making it easier for people to buy homes.” – Mark Fleming, chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 97 of The REconomy Podcast, our sixth session of the Summer School series, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American, and here with me is Mark Fleming, chief economist at First American. Mark, I can't believe we've reached the second-to-last summer school episode. Fall and back to school are just around the corner.

Mark Fleming - Hi Odeta, I agree. I'm looking forward to football, but this summer semester sure did fly by. So far in our Summer School series, we've covered the Complete Guide to Home Purchase and Closing, Homeownership Drivers and Benefits.

Odeta Kushi - And then, of course, we had Xander join us to talk about What Makes Real Estate “Commercial”? and to discuss the Trinity of Commercial Real Estate Returns. 

Mark Fleming - That episode just keeps reminding me of the Matrix movies -- Trinity and the Matrix movie. But, finally, in the last episode, we talked all about Cracking the Code of House Prices and Affordability, but I think it's pretty clear that our curriculum is missing a discussion of one very critical topic in housing. 

Odeta Kushi - I think you're right, Mark. Many of the topics that we cover come back to a discussion of interest rates. So, in today's episode, we're going to be covering the life cycle of a mortgage. Specifically, we'll trace the journey of the 30-year, fixed-rate mortgage and discuss how the loan product shapes the accessibility and stability of our U.S. housing market.

Mark Fleming - Yes, I think this episode will be of interest to our audience. 

Odeta Kushi - Yeah, oh yes, I bet they'll be fixed on every word.

Mark Fleming - Touche, he says. All right, so before we get into the life cycle of a 30-year, fixed-rate mortgage, we need to go back in time. What led the United States to the 30-year, fixed-rate mortgage, and why is it so popular? According to Freddie Mac, nearly 90% of us home buyers choose a 30-year, fixed-rate mortgage when they get a loan.

Odeta Kushi - So nearly everyone. Well, let's go back in time to a world before the 30-year, fixed-rate mortgage. As we've discussed in prior episodes, a typical mortgage in the early 1900s might have had a term of five years and require a 50% down payment, plus they were usually structured with interest-only monthly payments and a balloon payment for the entire principal at the end of the term. It's pretty unthinkable today. I mean, imagine taking out a five-year mortgage and making interest only payments for the first five years and then covering the entire principal in the form of a lump-sum, balloon payment at the end of those five years. 

Mark Fleming - Never, that's crazy talk. Interest-only loans with very short terms and mostly with variable interest rates. That really sounds like something we actually tried again in the go-go housing boom days about 20 years ago. Not reasonable for most people in the housing bubble, and it wasn't even reasonable way back then, either. Many homeowners during this time in the early 20th century would just refinance into another five-year mortgage. All well and fine, as long as the variable rate was generally stable. 

Odeta Kushi - So this was the norm until the Great Depression hit, but then banks stopped lending and borrowers couldn't refinance.

Mark Fleming - Hmm, I'm reminded of the Great financial Crisis in 2008. Housing history doesn't repeat itself, but it sure seems to rhyme. Okay, so Great Depression credit crunch. Enter President Franklin Delano Roosevelt, who launched the New Deal in 1933 to stabilize the housing market and to buy failing mortgages and convert them into longer term loans with payments that included interest and principal. The U.S. government created the Homeowner's Loan Corporation in 1933 and then came the Federal Housing Administration, aka FHA, in 1934, which created the 15-year mortgage and then pushed to 20 years, and finally to a term of 30 years. 

Odeta Kushi - A 30-year, fixed-rate mortgage means predictable payments made over a longer period for the borrower. But, why would a lender ever agree to it? I mean, we know that banks borrow money and pay interest to depositors, and that's not fixed.

Mark Fleming - That's where the National Mortgage Association of Washington, aka Fannie Mae, as we know it today, comes into the story. Established in 1938, Congress authorized them to buy mortgages from lenders, assuming the credit risk and creating liquidity in the mortgage market. Banks could sell loans, mostly FHA-insured ones, to Fannie Mae, and use the proceeds to make another loan, and so on and so on, which removes the risk from the bank. There's more to the history of the mortgage secondary market. In the late '60s and early '70s, with the creation of Freddie Mac and Ginnie Mae, but that's a digression from the story of the 30-year, fixed-rate mortgage. 

Odeta Kushi - Indeed, now about the amortization schedule of a 30-year, fixed rate mortgage. It is pretty interest heavy at the beginning. By that, I mean while the payment on the 30-year, fixed-rate mortgage is fixed, the composition of the payment will change monthly until the loan term ends. You're paying mostly interest at the beginning, but mostly principal towards the end of the loan term. But the fact that you're paying mostly interest in the beginning means that a lender is getting accelerated interest payments for the 30-year term, even if the borrower doesn't take the loan all the way to term. Right?

Mark Fleming - That is one interesting way to entice lenders to sell and secondary market investors to buy 30-year, fixed-rate mortgages. Interest income comes up front, essentially. I think in discussing the history, we've inadvertently also discussed part of the mortgage life cycle. So, let's jump into that.

Odeta Kushi - Okay. Well, since the Olympics are still fresh on my mind, I already miss them, I'm gonna go with a running analogy here. Think about the 30-year, fixed-rate mortgage as the marathon runner of loans, unlike those 15-year sprinters. So, we begin at the starting line, or origination. You've got your shoes tied, your mortgage application in hand, and your lender is like the coach, giving you a thumbs up to start. During the origination process, the lender assesses the borrower's creditworthiness. The borrower must provide financial information and documentation, such as tax returns, credit card information, payment history and bank balances, the lender uses this information to determine the type of loan and interest rate that the borrower is eligible for.

Mark Fleming - You may have heard of something called an origination fee. Lenders typically charge an origination fee for processing the loan, which is usually a percentage of the total loan amount. The fee compensates the lender for services such as processing and all of that underwriting of the loan that you just discussed.

Odeta Kushi - Right. So, in underwriting, all of the buyer's information, such as income, credit score and debt levels, will be verified in that underwriting process. So once that is done, and you get the green light, the lender funds the loans, and you're off to the races.

Mark Fleming - Do I really have to keep this marathon analogy going here?

Odeta Kushi - No, no, I think it's run its course. 

Mark Fleming - I did really set you up for that one. All right, we digress. What's next?

Odeta Kushi - Servicing your loan enters the servicing phase, which is where the lender or another company manages the day-to-day details of your mortgage. They'll collect your monthly payments, keep track of your balance and handle your escrow account, if you have one. This is like the customer service part of your mortgage, making sure everything runs smoothly for the next 30 years, or however long you hold on to that mortgage.

Mark Fleming - So, now we get to securitization, one of the least understood parts, I suspect, of the whole mortgage lifecycle process. Your lender likely will sell that mortgage to Fannie Mae or Freddie Mac, and they will package your mortgage together with others and sell them on to investors. As we explained before the marathon, this helps the lender get their money back quickly, so that they can make more loans. 

Odeta Kushi - Those bundles of mortgages, called mortgage-backed securities or MBS, are bought and sold by investors. So, once your mortgage is bundled into an MBS and sold in the secondary market, it becomes an investment product. Investors, like pension funds, insurance companies, or even regular folks through mutual funds, buy these MBS for a few reasons. First, they earn income, like dividends, from the interest payout payments homeowners make each month when you pay your mortgage. A portion of that payment goes toward the principal and a portion goes toward interest. The interest payments are what make these securities attractive to investors because they provide a steady income stream over time, but there's more to it. The value of an MBS can also fluctuate based on a few factors, like changes in interest rates. If rates go up, newer mortgages might have higher interest rates than the ones in existing MBS securities, making those older securities less attractive because the interest income is lower than what they can earn on newer, higher interest securities. Conversely, if rates go down, those older securities with higher rates become more valuable.

Mark Fleming - And one of the reasons why mortgage-backed securities are popular is that they help spread out the risk of lending. When your mortgage is part of a big bundle of loans from all over the country, the risk that you might miss a payment, or worse, default on the loan is shared among thousands of other loans in the same bundle. If one homeowner in the bundle defaults, it's a small blip compared to the overall performance of the entire bundle. This diversification makes mortgage-backed securities less risky than holding a single mortgage, as the chance of many loans defaulting at the same time is much lower. So, by pooling together many mortgages into securities, the risk is transferred, as we say, to a broad base of investors, many of which are even outside this country, while those investors get the benefit of a diversified income stream. At the same time, it's a win-win that helps keep mortgage money flowing, making it easier for people to buy homes.

Odeta Kushi - That is right. Now that 30-year, fixed-rate mortgage that we've been talking about is also pretty unique. This is a good time to grab the PDF handout for this episode and turn to the third page for Episode Six. Here you'll see a chart that's taken from an analysis done by the Federal Reserve Bank of Dallas. They point out that, while long-term, fixed-rate mortgages tend to predominate in the U.S., France and Germany, variable-rate and short-term, fixed-rate mortgages are common in Australia, the U.K. and other European countries. The Canadian market, for example, is dominated by five-year, fixed-rate mortgages.

Mark Fleming - And the good thing about this unique 30-year, fixed-rate mortgage product is that when inflation rises, as it has over the last several years, you've got a built-in inflation hedge in your fixed-rate mortgage. 

Odeta Kushi - That's right. The largest share of one's monthly expense is typically their housing cost, whether a mortgage or rent, but your principal and interest on long-term mortgage debt should remain fixed. So, while the cost of groceries, gas or even rent is going up, your housing cost is staying the same.

Mark Fleming - True, but theoretically that also weakens the Fed's monetary policy transmission mechanism. Raising rates are passed on in the form of higher monthly financing costs to more households faster in countries that have short-term, variable-rate mortgages, as the households are forced to refinance more quickly with their shorter-term mortgages. In the U.S., on the other hand, consumers can wait it out for as much as 30 years with that 30-year, fixed-rate mortgage.

Odeta Kushi - That's a great point, and exactly what we see happening in the U.S. market today, where we've got 86% of homeowners who are rate-locked into rates below 6% All right, well, I think we've thoroughly covered the history, uniqueness and importance of this loan product. So, I hereby award a gold medal to the 30-year, fixed-rate mortgage.

Mark Fleming - Queue the 1981 hit, Chariots of Fire. Okay, add it to the playlist.

Odeta Kushi - And the silver medal to Mark for sneaking in an '80s reference in the last minute of the episode. Well done.

Mark Fleming - Just in time and keeping the streak alive.

Odeta Kushi - Indeed, because this concludes the sixth episode of The REconomy Summer School series. Join us for the final episode, where we cover Urban Economics 101. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.