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Volume 2

Issue 3

December 1998

REGULATORY AND LEGISLATIVE

CHANGES IN THE MORTGAGE MARKET

Research & Analysis

Office of Thrift Supervision

Washington, DC
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 1 December 1998

INTRODUCTION•

In past issues of Mortgage Market Trends, we have focused on market developments

that might affect the credit-related performance of the mortgage portfolios held

by thrifts. In this issue, we focus on a different aspect of the mortgage market:

how current regulatory and legislative developments might affect the way thrifts

conduct their mortgage business in the future. We will look at three recent developments, high loan-to-value mortgages and OTS’s concerns, an expansion and

changes in FHA lending programs, and the Chicago Federal Home Loan Bank’s

Mortgage Finance PlanÒ (MPFÒ). Each of these may well change the way thrifts lend

in the future.

First, though, we look at current mortgage market conditions.

CURRENT MORTGAGE MARKET CONDITIONS

National Delinquency Rates Remain Low

Figure 1 plots the percentage of seriously delinquent (90 days past-due or in foreclosure) residential mortgages, using both the Mortgage Information Corporation

(MIC) and Thrift Financial Report (TFR) data. The MIC data comprise almost 24

million mortgages. Since the first issue of the Mortgage Market Trends, we have divided the MIC data into two groups: the market, which includes all MIC participants (Freddie Mac, Fannie Mae, and eighteen other large banks, thrifts, and

private mortgage lenders), and a subgroup, depository institutions, which includes

only the FDIC-insured MIC participants (a mix of S&Ls and commercial banks).

As the trend line in Figure 1 shows, the national delinquency rate improved in the

last quarter. Both the MIC depository and OTS-regulated (TFR) thrift delinquency rates improved as well.

Figure 1 also shows that depositories, as a group, have had a higher delinquency

rate than the national average for the entire period. The gap between the depository and the market delinquency rates has remained fairly constant since June

1997. The thrift industry, though, has improved its performance so much over the

last few quarters that its delinquency rate has dropped below the MIC national

rate (which is dominated by the GSEs’ portfolio of conforming mortgages) for

the last three consecutive quarters .

 

•

 Prepared by Jonathan Jones, John LaRocca, and Fred Phillips-Patrick, Research & Analysis Division, Office of Thrift Supervision. The opinions express here are those only of the authors and not of the agency.

Please email any comments or questions to fred.patrick@ots.treas.gov.
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 2 December 1998

Figure 1: Percentage of Seriously Delinquent Mortgages

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98

Depository

TFR

Market

Source: MIC and TFR. The Market contains the combined data of the depository and nondepository participants in MIC’s Loan Performance System. Depositories comprise both bank and

thrift MIC participants. The thrift MIC participants are very large institutions located primarily on

the East and West coasts. TFR represents all OTS-regulated institutions except one that specializes

in defaulted mortgages.

Figure 2 shows the regional detail behind the improvement of the overall thrift

delinquency rate. The West region experienced the greatest improvement, with

the Northeast and Southeast regions also registering significant declines. The

Central and Midwest regions maintained the lowest delinquency rates among the

regions. For the first time since we have been tracking these data, all regions reported a seriously delinquent rate below 1%.

Figure 2: OTS Regional Delinquency Rates

0.50%

0.70%

0.90%

1.10%

1.30%

1.50%

1.70%

1.90%

2.10%

Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98

N a tional N E SE Cen tral M idwest West

Serious Delinquencies Vary by Location and Product Type

In June 1998, the states with the highest rates of seriously delinquent loans (by

dollar value) were Maryland (1.68%), Hawaii (1.57%), New Jersey (1.50%), District of Columbia (1.49%), and New York (1.49%). The national average was

0.90%. California’s rate improved from 1.16% in March to 1.04% in June.
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 3 December 1998

In individual markets, Riverside, CA, leads the nation with a seriously delinquent

rate of 2.65%, followed by Memphis, TN (2.32%), and Scranton, PA (2.08%).

Among major markets, Miami (1.70%), New York (1.52%), and Los Angeles

(1.50%) are in the top ten in terms of delinquency rates.

Table 1 shows the percentage of mortgages that are seriously delinquent for different product types (conventional and government-backed, fixed rate and adjustable) based on whether the mortgages were made for purchase or

for refinancing. These data show

that fixed rate mortgages outperform adjustable rate mortgages;

15 year fixed rate mortgages outperform 30 year mortgages. Refinanced mortgages perform much

better than home purchase mortgages in all cases except one. The

one exception is COFI ARMs,

where the refinanced mortgages

have a slightly higher delinquency

rate than COFI ARM home purchase loans. The data also show that delinquency rates on government-backed

loans substantially exceed those on conventional loans. This issue will be explored

in more detail later in this report.

Market Share Data

Table 2 reports data on mortgage loan originations from HUD’s Survey of Mortgage

Lending Activity (SMLA). The fourth quarter 1997 data are the most recent available. In the fourth quarter of 1997, the thrift industry’s (Savings Banks and Savings Associations) market share of single-family residential mortgages fell from

17.9% to 15.6%, its lowest level ever. Commercial banks also declined in market

share, falling from 23.7% in the third quarter to 19.7% in the fourth quarter. The

market share for mortgage companies rose to 64.2% in the fourth quarter, the

highest level ever.

Table 1: Percent Seriously Delinquent, as of 6/98

Home Purchase Refinancing

Conv: Fixed Rate 0.61 0.27

 15-Yr Fixed 0.42 0.10

 30-Yr Fixed 0.64 0.37

Conv: Adj Rate 1.05 0.92

 T-Bill 0.95 0.78

 COFI 1.17 1.29

Government 3.40 2.07

 FHA 3.63 1.90

 VA 3.00 2.30

All Loans 1.06 0.43

Source: MIC, based on $ amounts

Table 2: Mortgage Market Shares

($ in millions)

Year CB Share SB Share S&L Share MC Share Total

1996 Q1 $43166 22.2% $6766 3.5% $28394 14.6% $114557 59.0% $194196

Q2 45927 22.0% 9120 4.4% 35064 16.8% 117583 56.2% 209140

Q3 42327 22.2% 9979 5.2% 30362 15.9% 106637 55.9% 190722

Q4 47128 24.6% 8036 4.2% 27895 14.6% 106962 55.9% 191271

1997 Q1 48116 28.0% 5651 3.3% 25015 14.6% 91819 53.5% 171787

 Q2 53150 26.8% 6286 3.2% 34411 17.3% 103294 52.0% 196910

Q3 52667 23.7% 5210 2.3% 34518 15.6% 128126 57.7% 221888

Q4 52648 19.7% 4680 1.8% 36893 13.8% 171371 64.2% 266910

Source: Survey of Mortgage Lending Activity, HUD

CB, Commercial Banks; SB, Savings Banks; S&L, OTS thrifts; MC, Mortgage Companies
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 4 December 1998

Interest Rate Changes

As evidenced by the narrowing spread between the ten-year constant maturity

Treasury (CMT) rate and the one-year CMT pictured in Figure 3, the yield curve

flattened sharply over the first six months of 1998. In June, the ten-year constant

maturity Treasury rate stood at 5.5%, barely higher than the one-year CMT rate of

5.41%. This flat yield curve favors fixed rate over adjustable rate mortgages.

Figure 3 also shows the spread between the Federal Home Loan Mortgage Corporation’s thirty day commitment rate for thirty-year mortgages and the ten-year

CMT. The two rates are of similar duration and often track each other closely. Of

note is the rise in the spread since June of last year. Although mortgage rates have

fallen (the FHLMC commitment rate was 7% in June vs.7.69% a year ago), the

rate is now higher, relative to the ten-year CMT, than it was a year ago.

At least three explanations have been offered for the recent increase in the mortgage commitment rate and the ten-year CMT spread. First, the demand for

Treasury instruments is exceptionally strong given the current turmoil in international markets. Second, the supply of new Treasury bonds has been lowered due

to the federal budget surplus, the first in almost 30 years. Both of these changes

will increase the price of Treasury

bonds and correspondingly decrease Treasury interest rates.

Third, prepayment speeds on

mortgages have been increasing

during the current refinancing

boom and this additional risk may

be reflected in a higher mortgage

commitment rate. All three reasons appear to help explain the

larger spread. How long the current, increased spread will remain

will depend on the duration of

these current trends.

Originations by Product and LTV

The Federal Housing Finance Board conducts its Mortgage Interest Rate Survey

(MIRS) monthly among mortgage lenders on the interest rates and terms of their

recently closed conventional (non-government-backed) mortgages. Table 3 reports the survey results for the months ending each quarter over the last eighteen

months.

Figure 3: Yield Spreads

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

Mar-96 Jun-96 Sep-96 Dec-96 Mar-97 Jun-97 Sep-97 Dec-97 Mar-98 Jun-98

10 Yr - 1 Yr Treasury Spread

Mortgage - 10 Yr Treasury Spread
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 5 December 1998

Table 3 shows that, for all three lender groups, mortgage effective interest rates

(which include the amortization of initial fees and charges over a ten-year period)

have declined sharply since the end of June 1997. For S&Ls, the current average

is 6.90%, for commercial banks, 7.21%, and for mortgage companies, 7.29%. The

average effective interest rate was substantially lower for S&Ls than that for the

commercial banks and

mortgage companies in

every quarter surveyed.

The flat yield curve

over the last three

quarters continues to

affect ARM originations. S&Ls have traditionally originated a

higher proportion of

ARMs than either

commercial banks or

mortgage banks, and

this pattern persists.

While more than half

of S&L’s originations

are typically ARMs, for

the first half of this

year, the percentage

had fallen below 40%.

At commercial banks

and mortgage companies, the decline in

ARM originations has been even more dramatic. Only 9% of the commercial

banks’ and 7% of the mortgage companies’ originations were ARMs during the

second quarter of 1998.

The distribution of originations by loan-to-value ratios can also create differences

in the effective interest rates between S&Ls and commercial banks and mortgage

companies. Over the last year and a half, S&Ls have traditionally originated a

much smaller percentage of their loans in the highest LTV category (greater than

90% LTV ratio) than the other two originators, and this continues. This difference between commercial banks and S&Ls should eventually be reflected in the

respective charge-off rates, as high LTV loans are riskier than low LTV loans. Because of their higher credit risk, higher LTV-ratio loans should carry a higher rate

and/or more fees and charges than lower LTV-ratio loans. This explains, in part,

the difference in effective mortgage rates between S&Ls and commercial banks.

Table 3: Mortgage Rates and Terms

(Conventional Home Purchase Mortgages)

Effective Rate Percent of Loans by LTV Class % Arms

< 70% 70-80 80-90 >90

S&Ls 90%

Mar-97 7.34 21 47 16 16 46

Jun-97 7.33 22 45 16 17 56

Sep-97 7.12 21 49 15 15 53

Dec-97 7.05 25 48 13 14 45

Mar-98 6.96 24 46 14 16 36

Jun-98 6.90 25 47 13 15 39

Commercial Banks

Mar-97 7.77 20 39 19 22 31

Jun-97 7.86 21 38 18 22 21

Sep-97 7.59 22 37 17 24 16

Dec-97 7.46 18 32 16 35 9

Mar-98 7.22 15 34 16 36 9

Jun-98 7.21 15 31 14 40 9

Mortgage Companies

Mar-97 7.92 19 34 17 30 14

Jun-97 8.03 18 36 17 28 16

Sep-97 7.77 19 36 18 27 13

Dec-97 7.51 19 36 17 27 8

Mar-98 7.28 20 37 17 27 6

Jun-98 7.29 19 37 16 28 7

Source: Mortgage Interest Rate Survey, Federal Housing Finance Board
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 6 December 1998

CURRENT MARKET AND REGULATORY DEVELOPMENTS

FHA Developments

In October 1998, the Department of Housing and Urban Development (HUD)

announced changes, approved by Congress, for the FHA mortgage loan program.

These changes are designed to allow more homebuyers to qualify for higher dollar

FHA mortgages. If these additional FHA mortgages continue recent historical

performance trends and perform the same as past FHA mortgages relative to

conventional mortgages, more mortgage delinquencies can also be expected.

Among the announced FHA program changes are higher FHA home mortgage

loan limits and lower minimum down payments. The FHA single family loan limit

is set at 95 percent of the area’s median house price, up to a loan limit. Metropolitan areas will now have limits ranging from $109,032 in low-cost housing areas to $197,621 in high-cost areas--up substantially from the limits previously in

effect that ranged from $86,317 to $170,362. Loan limits for special higher-cost

markets in Alaska, Guam, Hawaii and the Virgin Islands have been raised to

$296,431. Not all areas formerly at the old ceiling were raised to the new ceiling,

though, because of the 95 percent rule.

In addition to the new higher loan limits, FHA is moving from a complex mortgage down payment formula to a more simplified one that will enable homebuyers to purchase a home with a lower down payment. The minimum FHA

mortgage down payment will now be limited to 3 percent, whereas previously the

required down payment could go as high as 7 percent for the highest FHAinsured loans. For those loans well below the old ceiling, though, little change is

expected. But the effect on the larger loans in the high price areas is likely to raise

the LTV on such loans and thus their risk.

As Table 4 shows, U.S. Government-backed loans, particularly FHA loans, have

captured a larger share of the mortgage pool tracked by MIC. FHA mortgages

increased their share

of the MIC totals,

from 2.6% at the end

of 1994 to 7.7% in

June 1998. This may

reflect, in part, the

addition of several new firms to the MIC database, who, unlike the GSEs, hold

government-backed mortgages. It may also reflect an increased willingness to

hold government-backed mortgages.

According to HUD, the cumulative growth in all outstanding FHA mortgages

over this period has been substantial. The $409 billion of FHA mortgages outstanding in January 1998 are $72.2 billion greater than the amount outstanding in

December 1994 ($336.8 billion) – an average annual growth rate of over 6.7 percent, which matches the overall growth in home mortgages. According to HUD’s

Survey of Mortgage Lending Activity, as a percentage of all mortgages outstanding,

Table 4: Percent of Total Holdings (MIC, $)

Dec-94 Dec-95 Dec-96 Dec-97 Jun-98

FHA 2.59 3.38 5.44 7.93 7.67

Conventional 95.74 94.25 91.20 87.43 87.95
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 7 December 1998

FHA loans have remained at a fairly steady 11 percent of the total over the period.

FHA loans have experienced diametrically different trends relative to conventional mortgages. As seen in Table 5, over the past four and one-half years

through June 1998, the delinquency rate on FHA mortgages tracked by MIC has

steadily increased

while the delinquency

rate on conventional

mortgages has steadily declined. As a rule,

recently underwritten

mortgages tend to

paid on time. Given the recent growth in the FHA program, one would expect

that average delinquency rate to fall with the infusion of newly underwritten

loans. But that has not been the case with the FHA mortgages tracked by MIC.

Moreover, for the MIC participants, the trend in non-government, conventional

mortgages has been

toward fixed-rate

loans because of

lower interest rates

and a flatter yield

curve. But, as

shown in Table 6, adjustable rate mortgages (ARMs) have accounted for an increasingly higher portion of FHA mortgages tracked by MIC, rising to 26.6% by

June 1998. Adjustable rate mortgages tend to be riskier than fixed-rate mortgages.

However, even during this period of relatively low interest rates when ARM loans

typically perform well, there has been a significant increase in the percentage of

delinquent FHA

ARMs held by

MIC participants.

Table 7 illustrates

the increasing

trend in delinquencies with FHA ARMs, as opposed to a decline in delinquent conventional

ARMs. By June 1998, the FHA ARM delinquency rate was four times the rate of

delinquent conventional ARMs.

Table 5: Seriously Delinquent Mortgages (MIC, $)

Dec-94 Dec-95 Dec-96 Dec-97 Jun-98

FHA 2.82 2.57 3.30 3.28 3.34

Conventional 0.93 0.77 0.74 0.65 0.58

Table 6: ARMs as Percentage of Product Type (MIC, $)

Dec94 Dec95 Dec96 Dec97 Jun98

FHA ARMs 13.22 25.12 23.02 27.30 26.57

Conventional ARMs 25.52 18.30 19.56 17.88 16.55

Table 7: Percent Seriously Delinquent (MIC, $)

Dec94 Dec95 Dec96 Dec97 Jun98

FHA ARMs 1.10 2.09 3.37 3.40 4.07

Conventional ARMs 1.53 1.63 1.40 1.13 1.04
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 8 December 1998

Based on the number of loans, the highest percentage of FHA delinquencies held

by MIC participants is currently in the group of loans

between $100 thousand and

the conforming loan limit.

With the recently announced availability of

larger FHA loans with lower

down payments, more delinquencies in larger size

FHA loans could evolve,

particularly with those

ranging in size from over

$100 thousand to the conforming loan limit, which already exhibited the highest

delinquency rate of 3.49% at June 1998.

The increasingly high percentage of delinquent FHA mortgages tracked by MIC

relate to loans secured by all available property types, but has been most notably

for 2-4 dwelling

units. As can be

seen in Table 8,

whereas the delinquency rate on

conventional

mortgages has

been falling dramatically on these

types of units, the

rate has been rising dramatically

for FHA-insured

loans on the same type of properties. Consequently, the FHA delinquency rate of

4.9% at June 1998 for loans on these properties is over four times the rate for

conventional mortgages.

With a more aggressive FHA mortgage program now adopted, the need for close

attention to the possibility of higher delinquencies in FHA loans is crucial, especially if economic conditions deteriorate. The FHA portfolio appears particularly

vulnerable to any significant rise in interest rates due to the likely increased payment pressures on the growing portion of FHA ARMs.

Figure 4: Percent seriously delinquent, (MIC,#)

0

0.5

1

1.5

2

2.5

3

3.5

<$50 $50-$100 $100-Conf

FHA Conventional

Table 8: Delinquency Rates by Property Type (MIC,$)

Dec-94 Dec-95 Dec-96 Dec-97 Jun-98

FHA Mortgages

 SFR 2.82% 2.58% 3.30% 3.37% 3.49%

 Condo 2.78% 2.58% 3.09% 3.04% 3.01%

 2-4 Dwelling Units 2.28% 2.82% 2.59% 3.96% 4.90%

Conventional Mortgages

 SFR 0.80% 0.68% 0.67% 0.61% 0.56%

 Condo 1.49% 1.28% 1.08% 0.78% 0.64%

 Co-op 1.42% 1.20% 0.91% 0.54% 0.45%

 2-4 Dwelling Units 2.35% 1.98% 1.65% 1.31% 1.14%
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 9 December 1998

Recent Developments in High LTV Home Mortgage Lending

In a previous issue of Mortgage Market Trends, we showed that the loan-to-value

ratio is the most important determinant of home mortgage default rates. As the

LTV ratio increases, so does credit risk, and rather dramatically at higher LTVs.

High LTV (HLTV) home mortgage loans are typically defined as loans secured by

liens on or interests in 1-4 family owner-occupied residential real estate that, when

combined with any senior liens, exceed 90% of the value of the real estate collateral. Some observers have argued that

the recent increase

in HLTV lending

has been driven by

rising homeowner

demand for home equity loans to consolidate debt. Table 9 reports HLTV conventional home mortgage originations for S&L’s, commercial banks, and mortgage banks from December 1994 to June 1998. As shown in the table,

commercial banks have substantially increased the proportion of HLTV mortgages originated, while savings associations and mortgage bankers have decreased

their proportion of this kind of lending.

Table 10 reports the percentage of HLTV residential mortgage loans held in portfolio by the market and depositories from December 1994 to June 1998. In sharp

contrast to mortgage originations, both the market and depositories show a substantial increase in the

number of HLTV mortgages held in their portfolios. This increase in

HLTV mortgage lending

led OTS to issue Thrift Bulletin 72 in August of this year to provide guidance to

savings associations on high LTV mortgage loans. Some observers and participants in the home mortgage industry have viewed HLTV lending as an innovative

improvement in consumer financial technology that doesn’t involve substantial

increases in risk. Others have expressed concerns about increased risk due to consumers’ “reloading” (using credit cards to increase debt after an HLTV debt consolidation loan) and “churning” (using lower debt-to-income ratios resulting from

a HLTV debt consolidation to obtain another larger HLTV loan). OTS was particularly concerned that savings associations be aware of the numerous increased

risks associated with HLTV lending that differ substantially from traditional home

or consumer loans. Included among these increased risks are: (1) increased default risk, (2) inadequate collateral, (3) limited default remedies, (4) excess debt

burden incurred by the borrower, (5) untested performance, (6) large loan size,

and (7) limited and untested secondary market.

Table 9: Percentage of HLTV Mortgages Originated, (MIRS)

Date 12/94 1295 12/96 12/97 6/98

S&L’s 15 18 17 14 15

Commercial Banks 29 32 30 35 40

Mortgage Companies 33 24 27 27 28

Table 10: Percentage of HLTV Mortgages Held, (MIC $)

Date 12/94 12/95 12/96 12/97 6/98

Market 7.8 11.9 14.0 17.6 16.9

Depositories 7.3 16.7 18.9 20.0 19.0
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 10 December 1998

Table 11 reports seriously delinquent rates by LTV category. Overall, there is a

strong positive relation between the LTV ratio and mortgage delinquency rate.

These data highlight OTS’s concern about the increased credit risk associated

with HLTV lending. They challenge one of the conclusions put forth in a July

1998 academic study of HLTV mortgage lending entitled High Loan-to-Value Mortgage Lending: Problem or Cure? co-authored by Charles Calomiris and Joseph Mason.

In this study, the authors argued that high LTV lending does not increase consumer lending risk. However, our data show that credit risk increases substantially

as consumers put themselves into higher LTV categories due to their home mortgage finance decisions.

Tables 12 and 13 show how mortgage delinquency rates for all residential mortgages vary as a function of both LTV and loan size for June 1998. Seriously delinquent rates are reported for both the depositories (Table 12) and the market

(Table 13). These results show that the seriously delinquent rate increases as the

LTV ratio increases for each loan size. In contrast to FHA loans, there does not

appear to be support for the concern that credit risk increases as loan size increases. However, a U-shape characterizes the delinquency rate in the highest

LTV category for both the market and depositories. That is, the delinquency rate

falls as loan size initially increases from $50,000 to $100,000, remains relatively

flat from $100,000 to the conforming limit, but then rises as loan size increases

beyond the conforming to the $400,000 loan sizes. Generally speaking, the delinquency rates for depositories are higher than those for the market in each LTV

category for all loan sizes. The only exceptions are the highest LTV loans where

delinquency rates for the market and depositories are virtually the same.

Table 11: Seriously Delinquent Rates, 6/98, by $ amount, (MIC)

LTV 20-60 61-70 71-75 76-80 81-90 91-95 96-105

Market 0.20 0.41 0.57 0.49 0.98 1.30 3.39

Depositories 0.28 0.59 0.77 0.67 1.29 1.68 3.27

Table 12: Depositories – Seriously Delinquent Rates, 6/98, (MIC, $)

LTV 20-60 61-70 71-75 76-80 81-90 91-95 96-105

Loan Size

50 0.33 0.63 0.91 0.91 1.67 2.69 3.97

100 0.26 0.59 0.80 0.79 1.37 1.96 3.30

Conf. 0.24 0.53 0.75 0.74 1.33 1.51 3.14

400 0.27 0.54 0.76 0.53 0.98 1.21 5.41

Table 13: Market -- Seriously Delinquent Rates, 6/98, (MIC, $)

LTV 20-60 61-70 71-75 76-80 81-90 91-95 96-105

Loan Size

50 0.25 0.47 0.69 0.72 1.30 2.00 3.92

100 0.18 0.37 0.54 0.53 0.99 1.46 3.33

Conf. 0.17 0.35 0.54 0.47 0.96 1.18 3.37

400 0.23 0.47 0.69 0.47 0.94 1.14 5.36
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 11 December 1998

Mortgage Partnership FinanceÒ Plan

In June 1997, the Federal Home Loan Bank of Chicago (FHLBC) initiated a pilot

program that enabled members to divide the component risks of residential

mortgages in a novel way. They could now lay off those risks they thought were

mostly out of their control and retain those which they thought they could control more closely. This pilot program is under review by the regulatory agencies

and its features are subject to change. Nothing stated here should be construed as

presenting the official position of the OTS or other banking agencies, but rather

the private opinions of the authors of this report.

Funding, credit, interest rate, and prepayment risks are all part of the business of

residential mortgage lending. According to the FHLBC, under the Mortgage Partnership FinanceÒ

(MPFÒ) plan, participating thrifts would underwrite conventional

home mortgages as an agent for the Federal Home Loan Bank of Chicago. The

FHLBC would own the mortgages at closing, provide the funding, and bear the

interest and prepayment risks. The participant could service the loans, but the

loans would never appear on the participant’s balance sheet. However, the participant would provide a credit enhancement, guaranteeing the credit performance

of the mortgage, by putting itself in a second-dollar loss position. The FHLBC

would pay the participants a monthly fee for the credit enhancement.

Since June 1997, the MPF has grown quickly. Master commitments currently now

exceed $805 million. To date, FHLBC has funded over $430 million of mortgages

through its participating member institutions. The MPF has recently been

adopted as a national program, with a nationwide cap of $9 billion.

Under the MPF’s securitization structure (see Figure 5), the private mortgage insurer would be in the first dollar loss position (required if the LTV is greater than

80% at origination), followed by a spread account that would be set up to cover

normal and expected losses, then

the credit enhancement provided

by thrift. The size of the credit

enhancement would vary with the

quality of the mortgage pool. It

would be set equal to the subordination necessary for a security

based on the enhanced mortgage

pool to achieve a double-A rating.

The credit enhancement provided

by the thrift is currently expected

to be around 4% or 5% of the

loan pool, given the quality of

mortgages involved and the size

of the spread account. The

FHLBC bears the residual risk.

Figure 5: MPF's Credit Risk Structure

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Loss Layers

FHLBC

Thrift

PMI

Spread

Account
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 12 December 1998

Only fixed-rate mortgages that have balances at or below the GSEs’ conforming

limits are eligible for the MPF plan. Excluded are no- or low-documentation

loans, very high LTV (greater than 95%) loans, high LTV (80% to 95%) loans

without private mortgage insurance, B & C grade mortgages, and second liens.

Historically, the excluded mortgage products have had higher credit risk than

conventional conforming mortgages.

Capital Requirement Issues

From a thrift’s perspective, according to the FHLBC, the advantages of the MPF

plan are several. First, it lays off the interest rate and prepayment risks associated

with thirty-year fixed-rate mortgages, risks that the thrift may not have a comparative advantage in bearing. Second, the thrift retains its relationship with its

customer. Third, it benefits directly by good underwriting, as the thrift receives a

fee for providing assurances (the credit enhancement) about the credit quality of

the loans it originates. In this way, a thrift can capitalize on what should be its

competitive advantage, underwriting home mortgages well. Fourth, and perhaps

most controversial, is the current capital treatment of this arrangement. In a microcosm, the issues here are the very ones raised by the Notice of Proposed

Rulemaking on risk-based capital standards for recourse and direct credit substitutes (See Federal Register, Vol. 62, No. 214, November 5, 1997, pg. 59944-

59976.)

In simple terms, the credit enhancement provided by the thrift could be constructed so that the thrift bears virtually the same credit risk it would have borne

had it retained the mortgage pool. The main difference in credit risk between the

two positions is the spread account in the MPF plan that is junior to the thrift’s

credit enhancement. The larger the size of the spread account, the smaller the size

of any unexpected losses that would fall on the thrift. But current regulatory

capital requirements do not recognize this dependency when dealing with direct

credit substitutes.

For ease of exposition, assume the thrift has originated a $1 million pool of home

mortgages that qualify for inclusion in the 50% risk bucket. Its capital requirement would be $1m x 50% x 8% = $40,000. Now consider the alternative of

conveying the pool under the MPF plan, with the thrift providing a 5% credit enhancement. In other words, by providing the enhancement, the thrift stands ready

to absorb up to $50,000 (5% x $1 million) in losses after the spread account is exhausted.

If the credit enhancement is considered as a direct credit substitute, similar to a

standby letter of credit issued by a bank, then the capital requirement would be

based only on the face value ($50,000) of the credit enhancement, not the amount

of the assets enhanced. Banks that issue standby letters of credit currently receive

this capital treatment. As a direct credit substitute, the capital requirement is not

based on the size of the assets which the credit enhancement supports nor on its

subordination position in the risk structure, but just on its face value.

As a credit enhancement, the capital requirement would be the face value of the

credit enhancement, $50,000, placed in the appropriate risk bucket, 4% for qualifying mortgages, or $50,000 x 4% = $2,000. So by qualifying as a credit enhance-
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 13 December 1998

ment under current capital regulations, rather than as recourse arrangement, the

capital requirement drops from $40,000 to $2,000.

If the transaction were considered a transfer with recourse, however, the capital

requirement would be the smaller of capitalizing the recourse exposure ($50,000),

or the capital requirement on the grossed-up amount of the credit enhancement

(itself and all of the pool that it supports). With a small spread account, the capital

requirement would be near the original capital requirement ($40,000). So under

one set of capital rules (direct credit substitute), the capital requirement would be

$2,000; under another (recourse), almost $40,000, for credit risk positions that

could be constructed to be substantially the same.

One of the roles of regulatory capital is to act as a buffer against unexpected losses.

While this and prior issues of Mortgage Market Trends have provided only information on delinquency rates and not actual losses on mortgages, it is quite clear that

qualifying fixed-rate mortgages, and especially low-LTV fixed-rate mortgages are

very low risk assets, especially during the past five years.

Theoretically, whether a capital requirement of $2,000 is sufficient or $40,000 is

excessive to withstand unexpected losses (not reasonably expected losses -- which

should already be provisioned for in the spread account) depends both on the

frequency and the severity of unexpected losses. In the MPF plan, the size of the

spread account and whether it is prefunded or accumulates over time will determine in part how often and deeply the credit enhancement provided by the thrift

might be tapped. Likewise, the quality of the underwriting and unexpected swings

in the local economic conditions will also play a part. For example, with a high

quality mortgage pool on properties that rarely experience declines in value and a

sufficiently large spread account, the credit enhancement provided by the thrift

could be as safe as other types of whole assets and appropriately risk-weighted on

its face value.

The regulatory agencies are currently reviewing the capital treatment of the MPF

plan, which itself is subject to change.

CONCLUSION

High LTV lending, the expansion of the government insurance program for residential lending, and the financial innovations of the MPF plan can lead to greater

borrowing opportunities for would-be homeowners. Like any new opportunity,

these innovations can be abused to the detriment of the borrowers, the lenders,

or both. An undercapitalized thrift, an over-expanded government program, or an

over-extended borrower in default all have implications for our financial system

beyond the particular difficulties of the individuals involved. As the number of

choices increases, the need for information and thorough understanding also increases so that the appropriate decisions can be made by all partners to a transaction. But used properly, these three mortgage market developments offer exciting

possibilities for the future growth of homeownership.
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 14 December 1998

Mortgage Market Trends

Volume 2 Issue 3

December 1998

Data Appendix

National and Regional Trends in Mortgage Delinquency Rates

as of June 30, 1998
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 15 December 1998

Regional and State Analysis

Seriously Delinquent & Home Price Appreciation Rates as of 6/30/98

(Based on $)

MIC SD TFR SD Home Price Appreciation

Market Depositories TFR 1-Year 5-Year

National 0.90 1.22 0.85 5.2 19.2

Northeast 1.16 1.65 0.83

Connecticut 1.06 1.40 0.38 4.6 3.5

Delaware 0.84 1.30 0.53 4.1 6.4

Maine 0.76 1.36 1.03 6.1 10.5

Massachusetts 0.58 0.74 0.51 6.2 18.0

New Hampshire 0.47 0.70 0.46 6.7 12.9

New Jersey 1.50 2.24 1.26 4.3 8.2

New York 1.49 1.87 0.81 5.1 6.5

Pennsylvania 1.07 1.69 0.82 4.3 9.8

Rhode Island 0.77 1.01 2.15 4.9 3.8

Vermont 0.50 1.02 1.52 1.7 5.6

West Virginia 0.31 1.01 0.73 3.7 26.3

Southeast 1.08 1.42 0.84

Alabama 0.62 1.39 1.16 6.6 25.6

DC 1.49 1.70 2.26 3.6 3.1

Florida 1.22 1.40 0.59 5.6 16.5

Georgia 0.81 1.26 0.77 6.5 24.8

Maryland 1.68 2.26 1.87 3.5 6.8

North Carolina 0.75 0.98 0.46 5.2 27.4

Puerto Rico 0.92 2.79 6.73 * *

South Carolina 0.90 1.10 0.44 6.1 24.3

Virginia 0.86 1.12 0.69 3.3 9.6

Central 0.59 1.22 0.67

Illinois 0.84 1.33 0.80 3.2 20.7

Indiana 0.62 1.34 0.97 4.6 27.8

Kentucky 0.39 0.90 0.82 4.4 28.4

Michigan 0.22 0.47 0.71 5.9 39.9

Ohio 0.56 1.22 0.58 4.6 27.7

Tennessee 1.11 1.97 0.49 5.3 30.7

Wisconsin 0.27 0.69 0.26 4.1 33.6

Midwest 0.58 0.94 0.64

Arkansas 0.98 1.60 0.56 4.1 24.1

Colorado 0.35 0.50 0.23 5.7 45.7

Iowa 0.22 0.26 0.87 4.9 30.5

Kansas 0.47 0.73 0.28 4.5 30.5

Louisiana 0.96 1.83 0.34 6.2 30.5

Minnesota 0.37 0.55 0.32 5.2 28.1

Mississippi 0.80 2.32 0.90 6.8 27.2

Missouri 0.43 0.66 0.38 4.1 24.8

Nebraska 0.23 0.34 0.69 3.6 31.8

New Mexico 0.68 1.03 0.92 2.7 29.4

North Dakota 0.41 0.43 0.29 5.6 25.4

Oklahoma 0.74 1.23 0.46 4.9 22.6

South Dakota 0.49 0.80 0.73 4.4 30.2

Texas 0.78 1.18 0.91 4.7 15.3

West 0.92 1.03 0.99

Alaska 0.49 1.33 0.00 4.3 21.4

Arizona 0.55 0.74 0.40 4.1 29.2

California 1.04 1.12 1.06 7.8 3.0

Hawaii 1.57 2.26 1.72 1.0 -10.4

Idaho 0.64 0.70 0.16 4.4 29.8

Montana 0.62 1.19 0.51 3.3 35.8

Nevada 1.12 1.35 - 3.5 15.6

Oregon 0.32 0.33 0.39 5.1 48.7

Utah 0.60 0.87 0.81 5.8 64.6

Washington 0.56 0.57 0.28 6.8 25.3

Wyoming 0.41 0.56 0.38 2.2 34.5
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 16 December 1998

OTS Regions

Seriously Delinquent Mortgages (%)

Based on Thrift TFR Data by Location of Headquarters

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98

National NE SE Central Midwest West

Percent Home Price Appreciation

1997Q2 to 1998Q2

(Source: OFHEO Resale Database)

6.07 to 7.79 (9)

5.09 to 6.07 (10)

4.44 to 5.09 (10)

3.7 to 4.44 (11)

0.98 to 3.7 (11)
Mortgage Market Trends Volume 2 Issue 3

Research & Analysis 17 December 1998

National Cohort Performance by Quarter of Origination

Percent Seriously Delinquent after 24 Months

(Source: MIC)

0

0 . 2

0 . 4

0 . 6

0 . 8

1

1 . 2

1 . 4

1 . 6

J u n - 9 3 D e c - 9 3 J u n - 9 4 D e c - 9 4 J u n - 9 5 D e c - 9 5 J u n - 9 6

O r i g i n a t i on Q u a r t e r

Home Purchase Vs. Refinancing Mortgages

(Source: MIC, Percent Seriously Delinquent)

0

0 . 2

0 . 4

0 . 6

0 . 8

1

1 . 2

1991 1992 1993 1994 1995 1996 1997 M ar-98 Jun -98

Purchase

Refinancing

Fixed Vs. Variable Rate Mortgages

(Source: MIC, Percent Seriously Delinquent)

0

0.5

1

1.5

2

2.5

1991 1992 1993 1994 1995 1996 1997 Mar-98 Jun-98

Variable

Fixed