The Effects of Securitization on Consumer Mortgage Costs

Article excerpt

Steven Todd [*]

We examine the effects of securitization on two dimensions of consumer mortgage costs: coupon rates and loan origination fees. We find no evidence that securitization reduces the coupon rates on fixed- or adjustable-rate mortgages. Instead, securitization appears to lower mortgage loan origination fees, resulting in substantial savings for consumers. Securitization activity includes passthrough creation and collateralized mortgage obligation (CMO) creation. We test for differences between the effects of passthrough and CMO creation on primary mortgage costs. Surprisingly, these activities appear to have indistinguishable effects on loan rates and origination fees, suggesting that a large derivatives market for mortgage loans is not creating value for consumers.

Securitization, the pooling of illiquid loans or assets into marketable securities, is one of the more powerful trends transforming the landscape of financial markets. Passthrough mortgage securities, first introduced by GNMA in 1970, and collateralized mortgage obligations (CMOs), first launched by FHLMC in 1983, now constitute a $2 trillion market, making the market for mortgage-backed securities nearly as large as the market for corporate bonds. [1] Within the last ten years, securitization has been applied to credit-card receivables, car loans, lease receivables, home equity loans, commercial mortgage loans and corporate bonds.

In theory, securitization creates value by reducing intermediation costs and increasing risk sharing and risk diversification (Hess and Smith 1988). As a result of securitization, mortgage assets are more liquid and mortgage risks are shared by a larger audience of investors. Studies by Amihud and Mendelson (1986), Merton (1987) and Kadlec and McConnell (1994) show there are gains associated with an increase in liquidity and the expansion of an investor base. These studies focus on equity markets, but their findings may well apply to fixed-income markets, especially mortgage assets, which are burdened by high information costs and heterogeneous valuations (Bemardo and Cornell 1997).

Previous research has examined whether securitization reduces the yields of fixed-rate mortgages or passthrough securities. This is the first study to test directly securitization's effect on loan origination fees. Fees are an important component of the cost of a mortgage loan, perhaps reflecting prepayment penalties or other adverse-selection costs faced by loan originators (Chari and Jagannathan 1989). Homebuyers paid more than $16 billion in mortgage fees in 1993 alone.

This is also the first study to test securitization's effect on adjustable-rate mortgage costs. Adjustable-rate mortgages merit study for several reasons. First, these loans constitute a large share of the overall mortgage loan market. More than half of the mortgages issued in 1984, 1985 and 1988 were adjustable-rate. Second, compared to their fixed-rate counterparts, adjustable-rate mortgages have been securitized more slowly. Finally, adjustable-rate mortgages differ from fixed-rate mortgages in their prepayment and interest-rate risk characteristics (Berk and Roll 1988; Cunningham and Capone 1990). Studies that bundle fixed- and adjustable-rate loans together potentially produce misleading results.

A principal goal of this paper is to examine the effects of CMO creation on consumer mortgage costs. If financial markets are incomplete and CMOs offer risk-return strategies that are otherwise unavailable to financial intermediaries, then mortgage originators should experience a reduction in their lending costs (Hess and Smith 1988). Furthermore, this reduction should be passed along to borrowers, provided the market for mortgage loans is competitive.

CMO issuer effects are worth studying for several reasons. First, the CMO market has spawned a number of important financial innovations which market practitioners claim have broadened the investor base for mortgage-backed securities (Ames 1997). …