Housing Finance & the Securitization of Mortgages

Photo courtesy of futureatlas.com (via flickr)

Photo courtesy of futureatlas.com (via flickr)

The financial crisis was the result of the collapse of a bubble in the US housing market. Therefore, in order to understand the financial crisis, we must start by exploring the way homeownership is financed in the US.  The US government has long promoted homeownership, making mortgages available through Federal Housing Administration and Veterans Administration loans, as well as by creating Fannie Mae, Freddie Mac, and related entities.  FHA and VA mortgages require lower down payments and offer lower interest rates than conventional mortgages due to a government guarantee on the former.  This enables lower income individuals to be able to afford home ownership.

Fannie Mae (the Federal National Mortgage Association) was created in 1938, as part of Roosevelt’s New Deal, to purchase and securitize government-sponsored (FHA and later VA) mortgages.1  In 1970, Freddie Mac (the Federal Home Loan Mortgage Corporation) was created to provide for conventional mortgages the same securitization that Fannie provided for government-backed mortgages.

Securitization reduces the risk of the underlying assets.  Consider a random selection of mortgages.  Firms in the mortgage business know from experience that a certain percentage of mortgages will experience payment difficulties such as late payments or even defaults.  The problem is that firms can’t identify in advance exactly which mortgages will become problematic.   Thus, the riskiness of a given mortgage is difficult to ascertain.  Securitization eliminates that uncertainty and allows the risk to be priced through higher interest rates.  By pooling together a random selection of mortgages, firms can reduce the overall risk they face since the risk of the pool will approximate the average payment difficulties known from experience.  By charging a higher interest rate, securities issuers can be compensated for the expected losses.

This is how Fannie Mae and Freddy Mac expand the depth and breadth of mortgage markets, increasing the likelihood that low income and underserved customers would obtain credit by expanding competition and volume in mortgage markets.  Both entities buy individual mortgages from mortgage lenders, then securitize them for sale in the secondary mortgage market.  This activity brings in funding from investors – both US and foreign – who wouldn’t buy individual mortgages, but will buy mortgage-backed securities.  This is especially the case when the securities are issued by government-sponsored enterprises like Fannie Mae and Freddie Mac with their implicit government guarantees.  The net result is more funding for mortgages across the board.

By the end of 2008, the US mortgage market had $14.6 trillion outstanding of which $7.6 trillion was mortgage-backed securities, including $5 trillion held or guaranteed by Fannie May and Freddie Mac, and $2.6 trillion in held by private entities.  An additional $5 trillion was held as individual mortgages by commercial banks, thrifts and life insurance companies.2

[ next section: The Subprime Mortgage Market ]

Footnotes:

  1. Originally Fannie Mae guaranteed FHA/VA mortgages, but in 1968, Fannie became a quasi-privately-owned enterprise and the guarantee responsibility went to the newly created Government National Mortgage Association (Ginnie Mae).
  2. The remainder of the $14.6 trillion in mortgages are held by various government agencies and individuals as individual mortgages.
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