Who holds mortgages and therefore get hurt by a housing price downturn?
– mortgages used to be held by financial institutions (banks, S&Ls) that originated them. But in recent years, more and more of them are packaged into mortgage backed securities and sold to investors, including foreign investors. So if a downturn does occue, the pain will be more spread out, hence less severe at the investor level. Nonetheless, that will drive up the interest rate that investors demand, thus the mortgage rate.
— but there are twists here. For mortgages to be sold, it typically has a guarantee, and Fannie Mae and Freddie Mac have the largest market share that offer mortgage guarantees to conforming loans. Because Fannie and Freddie are government sponsored entities, that give investors the perception that mortgage debt has the implicit US government backing, so that reduces risk in buying mortgage backed securities guaranteed by Fannie and Freddie.
— In order for Fannie and Freddie to give that guarantee, it requires that Loan to Value ratio be lower than 80%. If a 20% downpayment is not made, then mortgage insurance is required in order to get that guarantee. PMI is the largest mortage insurance company in the US, I believe.
So consider that PMI and Fannie and Freddie are buffers to absorb shocks. They are in the front line. Mortgage insurers are the first.
But then another twist is the widespread practice of using piggyback loans to satisfy the 20% downpayment requirement and avoid paying mortgage insurance. So a layer of buffering is removed. In addition, some mortgages are so risky that it’s difficult to securitize them, and they are held by originators.
So who’ll get hurt? Mortgage insurers, banks and mortgage companies that issue a lot of piggyback loans, banks and mortgage companies that hold on to risky loans; Fannie and Freddie (partly because they hold a lot of mortgage backed securities themselves, the guarantee business starts to suffer then price goes down more than 20%, but that’s unlikely because they mostly only guarantee conforming loans, which means that they’d have low exposure to high priced areas like California)…investors who bought the less risky taunches of mortgage securities won’t likely lose their principle if they hold on to maturity.
