FRBSF Economic
Letter
2006-38; December 29, 2006
Mortgage Innovation and Consumer Choice
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As 2006 draws to a close, one economic development
that stands out over the year is the slowdown in the
housing sector. In particular, the slowdown raises
concerns about the perceived shift households have
made toward "alternative" mortgage products,
which may leave them more exposed to negative effects
from higher interest rates and falling house prices.
In this Economic Letter, I take a somewhat longer view
and put alternative mortgages in the context of the
history of innovation in the U.S. mortgage market.
I then examine the ways in which this innovation may
be affecting the housing consumption decisions facing
U.S. households.
What are alternative mortgages?
The U.S. mortgage market offers a rich variety of
financing options that give homebuyers flexibility
in timing
their mortgage payments (see Green and Wachter 2005
for a survey of mortgage market developments with international
comparisons). The standard product in the U.S. has
long been the 30-year fixed rate mortgage (FRM). Because
the mortgage is scheduled to be paid off gradually
(amortized) over a long period, the household is not
exposed to the risk of having to renegotiate the loan
balance during bad economic times. Furthermore, because
the rate on the FRM is constant, the household's mortgage
payments will not rise if the overall level of interest
rates goes up. The 30-year FRM was originally designed
to avoid the refinancing risk that contributed to the
banking crisis during the Great Depression (ironically,
mortgages prevalent then were very similar to today's "alternative
mortgages," though the maturities typically were
shorter). But a main reason for its enduring popularity
is the long amortization period that results in lower
monthly payments, making it easier for more households
to qualify. Indeed, a constant theme in the history
of the mortgage market is that new products generally
serve to ease borrowers' credit constraints.
One such new product was adjustable rate mortgages
(ARMs), where the interest rate is reset periodically.
Although these instruments expose the household to
interest rate risk, they also typically offer lower
rates than FRMs and, therefore, lower initial mortgage
payments, which can help homebuyers qualify for larger
mortgages relative to their current income.
The term "alternative mortgage" is generally
applied to variants of the ARM, where households take
on interest rate risk and have some latitude for controlling
the amortization schedule of the loan; for example,
with hybrid loans, the interest rate is fixed for a
period before either being paid off with a balloon
payment or reverting to an adjustable rate, and with
interest-only loans, the monthly payments contain no
principal repayment for a set period. Another variation
is an option-ARM, which allows borrowers to make less
than the full monthly payment on the mortgage, rolling
the difference into the current principal balance;
this type of mortgage belongs to the general class
of "negative amortization" loans, where the
size of the liability can be allowed to increase during
the life of the loan.
 It is difficult to get a clear picture of the prevalence
of alternative mortgages. The only reliable and publicly
available source of data is for those mortgages that
have been pooled into mortgage-backed securities (MBS).
In 2006:Q2, this portion accounted for just under one-half
of the mortgage debt outstanding (see Figure 1). The
other half of the market is held predominantly by financial
institutions, such as banks (36% as of 2006:Q2), and "others," such
as real estate investment trusts and state and local
agencies (12% as of 2006:Q2).
About 60% of the outstanding MBS are insured or guaranteed
by government-sponsored enterprises (GSEs), such as
Fannie Mae and Freddie Mac. The GSEs have relatively
strict underwriting guidelines, and few, if any, of
their insured or guaranteed MBS will include the more
exotic and risky alternative mortgages. So for information
on the amount of alternative mortgages currently outstanding,
one turns to the "private-label" or "non-agency" piece
of the market. Private-label MBS have been growing
rapidly and currently account for about 40% of the
MBS outstanding. According to LoanPerformance (2006),
about 25% of the origination in 2006:Q2 pooled into
private-label MBS consisted of interest-only loans,
and about 7% allowed for negative amortization. These
percentages of new origination probably overstate the
share of these mortgages in the total private-label
MBS outstanding, because outstandings include loans
originated before these mortgages became so popular.
These figures do, however, provide an upper-bound estimate,
namely, that interest-only and negative amortization
loans make up about 10% and 3% of the total MBS outstanding,
respectively. As stated above, there is no comprehensive
public information on the composition of the 50% of
the mortgage market that is not in MBS.
Some motives for choosing alternative mortgages
One motive for choosing an alternative mortgage could
be related to the projected length of stay in the home.
If a buyer knows with certainty that she will move
in the next three years, an ARM is likely to be cheaper
than a 30-year FRM, since the "insurance" against
interest rate fluctuations she "buys" with
an FRM is for up to 30 years, much more than is needed.
The homebuyer could lower her payments further if she
took out an interest-only loan, and further still if
she took out an option-ARM loan and let her principal
rise. This option would have the additional benefit
of allowing the homeowner to smooth through temporary
shocks that affected her labor income or wealth.
Another possible motive for choosing an alternative
mortgage is to improve the match between payments and
expected income. For households expecting real income
to rise over time, it may be desirable to smooth housing
consumption by allocating a higher share of income
to housing early in life. Consider the income profile
of a 25-year-old college graduate who earns $50,000
a year (the median income is slightly lower). On average,
this individual can expect his income to nearly double
in real terms from age 25 to age 55; that is, his "permanent
income" is higher than his current income. If
he were to borrow $300,000 using a 30-year FRM at 6.5%
to buy a house today, the initial mortgage payments
would amount to just over 45% of current income. While
this purchase would result in an initial period of
being "house poor," the mortgage would be
much more manageable later in life as income grows.
However, even if the borrower is willing to endure
a period of high payments relative to income, lenders
may not be willing to lend to someone so exposed to
fluctuations in that income. If the lender imposes
limits—say, 35%—on the size of the mortgage payment
relative to current income, then the borrower would
be able to take out only a $230,000 loan. That limit
might mean buying a smaller house, and it could even
preclude the borrower from entering the market at all.
With an alternative mortgage, the borrower might
be able to lower the payment in the initial years to
levels
consistent with the 35% payment-to-income cap. While
payments can be expected to rise over time, the household
expects income to rise, too. The alternative mortgage
does shift risk to the borrower, but the trade-off
could be acceptable, since the payments are matched
better with future income. In this example, the borrower
can smooth housing consumption with the use of an
alternative mortgage loan.
Changes in housing consumption patterns
Sorting out the effects of the mortgage market developments
discussed here on actual consumer choices is difficult
for a number of reasons. First, the main consumer
surveys that contain useful information on demographic
characteristics
and housing consumption generally do not include
such fine details about the terms of the household's
mortgage.
Second, the growth of alternative mortgages has not
been the only mortgage market development over the
past decade. Other developments, such as the decline
in down payment rates and the ease with which consumers
can refinance, may also have played a role in recent
consumer behavior. Third, alternative mortgages have
become popular primarily in the past few years, and
there simply has not been enough time to observe
the full ramifications of these products on consumer
choice.
 For some households, however, we can already detect
important changes in consumption patterns that appear
to have coincided with the loosening of mortgage
market constraints. Doms and Krainer (2006) examine
data from
successive American Housing Surveys and report a
substantial increase in expenditures on housing relative
to income
between 1997 and 2005, when alternative mortgage
products took hold (Figure 2). This increase in expenditure
shares, which is observed for households of all ages
and education levels, is consistent with a general
increase in the demand for housing. To be sure, for
some households, these changes might reflect the
greater
liquidity of housing as an asset. Indeed, the extraction
of home equity has had some effect on the measured
share of housing costs to income, as homeowners tapped
built-up equity to reduce other debt and finance
other consumption.
What is notable in Figure 2 is the upward shift over
time in the housing expenditure shares for households
in the youngest age groups. These are also the households
which have enjoyed large gains in homeownership rates.
Doms and Krainer find that these results hold true
across all income quintiles and levels of educational
attainment and do not depend on market location;
that is, the higher expenditures do not simply reflect
higher
house prices. They also find that young households
are more likely to have primary mortgages with lower
interest rates than are similarly situated but older
households. More specifically, this incidence of
low mortgage interest rates is most prevalent among
young
households that have high incomes (relative to other
young households) and that are highly educated. These
results do not prove that young households are more
inclined to borrow through alternative mortgages,
though these are, of course, precisely the people expected
to have high permanent income relative to current
income
and, seemingly, those with the most to gain from
using alternative mortgages. What the research appears
to
confirm, then, is that households have a desire for
greater housing consumption than they had in the
past. Moreover, the shift is quite apparent among borrowers
that might be expected to be more constrained using
traditional mortgage loan options. This may be a
reason,
then, behind the consumer demand for alternative
mortgage products.
Conclusion
Alternative mortgage products represent another stage
in the long history of innovation in the mortgage
market. As with past innovations, these new products
have the
potential to ease credit constraints and better match
mortgage obligations with the personal characteristics
of borrowers. In this light, these products probably
enhance welfare because they enhance choice. But
there is also little question that these products convey
more risk onto the borrowing household. In the near
term, if the housing market or the economy were to
slow, an important question will be whether borrowers
and lenders have fully factored in these risks. John Krainer
Economist
References
Doms, M., and J. Krainer. 2006. "Innovations
in Mortgage Markets and Increased Spending on Housing." Federal
Reserve Bank of San Francisco manuscript.
Green, R., and S. Wachter. 2005. "The American
Mortgage in Historical and International Context." Journal
of Economic Perspectives 19(4), pp. 93-114.
LoanPerformance. 2006. "The Market Pulse." June.
Opinions expressed in this newsletter do not necessarily
reflect the views of the management of the Federal
Reserve Bank of San Francisco or of the Board of
Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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