The Debt Markets (part F)
by
Charles Lamson
The Secondary Mortgage Market and
Mortgage-Backed Securities
Secondary markets trade previously issued financial claims. Prior to 1970 only mortgages issued by the Federal Housing Administration (FHA) or the Veterans Administration (VA) were sold in secondary markets and these were sold directly to investors. The amount of market activity was very small. The Federal National Mortgage Association (Fannie Mae) had been created by Congress in 1938 but did not establish a secondary market for FHA and VA loans until 1972. Fannie Mae issued bonds and bought FHA- and VA-insured mortgages. Still the market did not grow to any significant extent and was even declining because of a decrease in VA loans.
In 1968, Congress created the Government National Mortgage Association (GNMA, or Ginnie Mae). In 1970, Ginnie Mae began a program in which it guaranteed the timely payment of interest and principal on bundles of $1 million or more of standardized mortgages. Small denomination mortgages (mortgages up to the FHA and VA limits) were standardized with regard to the debt-to-income ratios of borrowers and the loan-to-value ratios of properties. The standardized mortgages were packaged together in a bundle to be resold in secondary markets. Thus, Ginnie Mae guaranteed (for a fee) that the mortgage bundles would be repaid. The guarantee was backed up by the full faith and credit of the U.S. government. Ginnie Mae fostered the creation of large secondary markets that increased the liquidity of previously illiquid mortgages.
The secondary market in mortgages created by the Ginnie Mae guarantee operates as follows: Private financial institutions such as banks or savings and loans gather or pool several Ginnie Mae federally guaranteed mortgages into a bundle of say $1 million. They then sell all or parts of the $1 million security, called a mortgage-backed security, to third-party investors such as pension funds, mutual funds or individual investors. The principal and interest on the mortgage backed security are paid from the payments that borrowers make on the original mortgages. If investors need their funds back before the security matures, they can sell them in a secondary market for mortgage-backed securities. It operates similar to the secondary market in corporate bonds.
Despite the lack of default risk because of the government guarantee. Ginnie Mae securities are subject to an interest rate risk. Namely, since they are long-term instruments, if the interest rate rises after the securities have been issued, the value of the securities will fall.
Find information on the operations of the GNMA (Ginnie Mae) at www.ginniemae.gov.
In 1970, Congress authorized Fannie Mae to purchase conventional (non-VA or non-FHA-insured) mortgages. Congress also created the Federal Home Loan Mortgage Corporation (Freddie Mac) to lend further support to the VA, FHA, and conventional mortgage markets. Congress hoped to make housing more available by increasing the funds flowing into mortgages. The goal, which remains the same today was to expand the opportunities for low- and moderate-income families to purchase homes. Although Fannie Mae purchased and held mortgages, it did not pool the mortgages to create a mortgage-backed security until 1981. Freddie Mac issued their first mortgage-backed security in 1971. It resulted from a pool of conventional mortgages. Fannie Mae primarily buys the mortgages of thrifts.
Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs). They are exempt from state and local corporate income taxes. Fannie Mae and Freddie Mac provide loanable funds to the housing sector. They purchase conventional loans, package or pool the mortgages together, and issue mortgage-backed securities, using the pool of mortgages as collateral. The mortgages purchased by Fannie Mae and Freddie Mac may also be directly held by Fannie Mae and Freddie Mac as investments instead of being packaged and sold as mortgage-backed securities.
Investors who purchase Fannie Mae and Freddie Mac mortgage-backed securities can sell them in secondary markets if funds are needed before the securities mature. The secondary market for mortgage-backed securities are created by market makers who buy and sell previously issued mortgage-backed securities. Some mortgage-backed securities are traded on organized exchanges.
Information about Fannie Mae and Freddie Mac can be found on the Internet at www.fanniemae.com and www.freddiemac.com.
Collateralized Mortgage Obligations (CMOs)
Investors in mortgage-backed securities face the risk that the mortgages will be prepaid before they mature because the property is sold or refinanced and that the return will fall short of expectations. To reduce this risk, collateralized mortgage obligations have been developed by Freddie Mac. Collateralized mortgage obligations redirect the cash flows (principal and interest) of mortgage-backed securities to various classes of bondholders, thus creating financial instruments with varying prepayment risks and varying returns. Those who are most risk adverse can choose an instrument where the principal will soon be repaid. Those who are willing to bear more risk can choose an instrument where the principal will not be repaid until later and hence is subject to a greater prepayment risk. In exchange for more prepayment risk, the investor receives a higher return. Needless to say, such provisions make attractive choices available to a wider range.
Private Mortgage-Backed Securities
In 1984, some private groups started to issue their own mortgage-backed securities. The new securities did not rely on the backing of Ginnie Mae and were not issued by corporations like Fannie Mae or Freddie Mac that had ties to the federal government. Such issuers of private mortgage-backed securities include, among others, commercial bankers, and investment banking firms. Privately issued mortgage-backed securities may also be sold in secondary markets. Again, the secondary markets are created by market makers who trade the previously issued securities. Securities issued by private issuers are rated by the major credit rating agencies. The credit rating may also be improved by obtaining insurance that guarantees the timely payments of principal and interest on the securities.
Recap
Fannie Mae and Freddie Mac are government sponsored enterprises (GSEs) that issue mortgage-backed securities and use the proceeds to purchase mortgages. Ginnie Mae guarantees the timely payment of principal and interest on mortgage-backed securities put together by private lenders. Ginnie Mae securities have an explicit government guarantee. Other private groups issue mortgage-backed securities without government involvement. Secondary markets trade previously issued mortgage-backed securities. Collateralized mortgage obligations redirect the cash flows (principal and interest) of mortgage-backed securities to various classes of bondholders, thus creating financial instruments with varying risks and varying returns.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 416-418*
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