Housing finance: a long-term perspective

Business Economics, July, 1997 by David Lereah

The 1990s have provided a favorable backdrop for the housing finance business. With an environment of steady economic growth and historically low mortgage rates, households exhibited a healthy appetite for home buying throughout this period, generating relatively high levels of residential mortgage originations for mortgage lending companies. Perhaps equally as important, the process of financing home buyers has shifted from individual mortgage issues by commercial banks and savings and loans (the portfolio lenders) to a host of new mortgage originators (mortgage banking companies and a securitization process led by Fannie Mae and Freddie Mac) that has expanded the mortgage market considerably in the 1990s. At year-end 1996, mortgage banking companies held a 56 percent market share of total industry originations, compared with only a 35 percent market share in 1990. And of the estimated $809 billion in total originations in 1996, $458 billion were secondary market transactions, compared with $276 billion of secondary market transactions in 1990.

The housing finance business also experienced other profound and rapid changes during this past decade, impacting mortgage lending companies and households in meaningful ways. Industry consolidation, advances in technology and narrow profit margins are just some of the developments that characterize the changes and challenges facing the housing finance marketplace of the 1990s.

Looking forward, the longer run prospects for the nation's housing finance business are favorable, promising to provide households with a varied menu of mortgage products and mortgage lenders with plenty of business. However, the obstacles and challenges that face the housing finance business today are clearly lined in the path of tomorrow. It is becoming increasingly clear that the housing finance industry has entered the "maturity" phase of the industry's life cycle. Excess capacity, industry consolidation and narrow profit margins are the observable residuals of this type of business environment. As in most mature industries, the surviving companies will be the low-cost producers, and a heavy investment in technology may help companies accomplish this objective.

The remainder of this paper will offer a long-run perspective of prospects for the housing finance marketplace. We first offer a review of this past year in the housing/housing finance markets to provide a benchmark for the longer-term prospects. We will then focus attention on the seminal/recurring forces that are expected to influence the nation's future housing finance needs and some selected business/policy issues that are expected to have a direct impact in the housing finance marketplace in the years ahead.

YEAR IN REVIEW

Looking back, mortgage lending flourished in 1996, beginning with a mini-refinancing boom early in the year, a surge in purchase originations in the middle of the year, and another mini-refinancing boom towards the end of the year. Although the economy and the housing markets provided a solid operating environment for mortgage banking companies, the operating environment remained fiercely competitive, exerting downward pressure on operating margins.

Thirty-year mortgage rates that began the year averaging 7.03 percent in January rose to 8.32 percent by July, only to fall to 7.7 percent in November. For the year, existing home sales totaled a record 4.09 million units, 7.6 percent above the 3.80 million existing homes sold in 1995 and exceeding the previous record of 3.98 million homes sold in 1978. Similarly, new home sales totaled 756,000 units in 1996, 13 percent above the 669,000 new homes sold in 1995, and the highest number of new homes sold since 816,000 new homes were sold in 1978.

With the demand for housing strong and the inventories of existing and new homes kept relatively lean, builders kept building homes during 1996. For the year, housing starts totaled 1.47 million units, 7.9 percent above the 1.36 million units started in 1995 and the highest level of starts since 1.49 million units were started in 1988.

The housing markets enjoyed a banner year in a year of rising and then falling mortgage rates. People bought homes in record numbers and builders built homes at near record numbers, while the housing pundits scratched their heads. The popular notion that the housing markets have become less vulnerable to interest rate increases because homeowners can dull the adverse impact of higher mortgage rates with adjustable-rate loans is an appealing explanation. However, surging consumer confidence supported by strong job and income gains is also an equally appealing notion for explaining the steady strength in housing demand throughout 1996.

The housing sector's robust performance in 1996 directly affected the mortgage lending business. Mortgage originations are now estimated to have totaled $809 billion, 29 percent above the $639 billion in originations in 1995 and the third best year ever. Further, purchase originations set a record, totaling a projected $574 billion, easily exceeding the $522 billion in purchase originations posted in 1994. Moreover, the industry also experienced two mini-refinancing booms, one early in the year and one towards the end of the year. In total, refinancings comprised about 29 percent of total originations, totaling about $240 billion, the third best refinancing year ever (tied with 1994). With fixed-rate/adjustable-rate spreads widening throughout the first seven months of the year (to about 215 basis points from an average of 188 basis points in 1995), the markets shifted emphasis away from fixed-rate mortgages and toward adjustable-rate mortgages (ARM). ARMs claimed an estimated 26 percent market share of total originations for the year.