By: Mark Semotiuk
(Editor’s note: This is the first post in a 3 part series. Look forward to the next installment this Wednesday)
In September 2008, just days before the subprime financial crisis, the Federal Reserve placed mortgage giants Fannie Mae and Freddie Mac into conservatorship. This act represented the collapse of a mortgage system that originated nearly eighty years earlier and arguably triggered the near collapse of the broader financial system. This series of three blog posts provides insight into the central role that Fannie and Freddie played in the collapse of the housing market, the largest asset class in the United States, and what the future of the mortgage industry may look like in the wake of their conservatorship.
Part I of this series discusses the history of Fannie and Freddie, the Government Sponsored Enterprises (“GSEs”) and modern securitization practice. Part II examines the roots of the financial crisis and discusses the impacts of the financial crisis on the mortgage market. Part III discusses what GSE reform may look like.
Part I: History of the Mortgage Market
After the First World War the United States entered into the “Roaring Twenties,” a period of expansive economic growth driven in part by the advent of modern credit. Mortgages, however, were still in their infancy. Prior to the Great Depression it was possible to obtain a three to five year mortgage directly from a bank with a 50% down-payment. Because the entire mortgage had to be repaid after three to five years, banks saw these loans as very risky and they carried high interest rates.
When the Great Depression hit property values and loan availability collapsed. Many property owners could not repay their loans when they became due. Banks foreclosed on these mortgages and property values and loan liquidity fell. This perpetuated a deflationary spiral. Congress created the Federal Housing Administration (FHA) in 1934 in part to combat this deflationary spiral.
The FHA was a vehicle by which the federal government could guarantee mortgages issued by banks. Federal insurance of mortgages had three impacts. First, the guarantee gave lenders the confidence to make loans again. Second, as insurance reduced the risk to lenders it lowered interest rates. Finally, it changed how mortgages were structured. Since the FHA was willing to guarantee loans with lower down-payments (20%) for longer periods of time (30 years) mortgage lenders were willing to structure their loans accordingly. As a result of these impacts, more people were able to qualify for loans and the mortgage market expanded. This helped combat the deflationary spiral.
The new model still had a problem. Mortgages were made directly from a bank to a property owner or buyer. Some banks had excess capital available for mortgages while others were short. There was no way for banks to exchange this capital. Consequently, mortgage availability and interest rates were very inconsistent from one bank to the next. This prevented competition and created inefficiency in property markets. In 1938, Congress created the Federal National Mortgage Association (Fannie Mae) in part to address this problem.
Fannie Mae, a government entity, bought government guaranteed FHA mortgages from banks as investments. When banks needed additional capital, they could now sell the mortgages on their books to Fannie Mae for a small profit and thus issue new mortgages. This ended the imbalance of mortgage capital from bank to bank and created a national secondary mortgage market.
Fannie Mae was privatized in 1968 to take its debt portfolio off the federal balance sheet. As a result, its business model also changed. Fannie Mae was authorized to purchase conventional mortgages, not just mortgages guaranteed by the FHA.
Further, the federal government provided an “implicit guarantee” to the privatized Fannie Mae. The market assumed that in the event that Fannie Mae went bankrupt the government would likely step in and cover Fannie Mae’s obligations. The implicit guarantee provided a competitive advantage. The perception of reduced risk allowed Fannie Mae to borrow at below market interest rates. This allowed Fannie Mae to amass and profit from a large portfolio of mortgages.
In an attempt to break Fannie Mae’s monopoly over the secondary mortgage market, Congress chartered the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1970. The GSEs (as they came to be known) competed against each other to buy mortgages from banks. Both, however, still benefited from being able to borrow at below market interest rates.
Mortgages remained a backwater investment until 1981 when interest rates skyrocketed to near 20%. Many banks in the business of issuing mortgages faced severe losses. In order to prevent a widespread bankruptcy, Congress created tax breaks to allow these banks to sell their mortgages at a loss. To accommodate the increased supply of mortgages for sale, Congress further authorized the GSEs and mortgage originators to sell mortgage backed securities to private investors (For an entertaining history of this please read Michael Lewis’ Liars Poker). In addition to purchasing mortgages, it was at this time that the GSEs became increasingly involved in their second line of business, issuing guarantees on mortgage backed securities for a fee.
Securitization allowed mortgages to be bundled into a security similar to a bond to reduce risk. Put simply, assuming ten of every 100 mortgages were forecast to lose their entire investment, there was a ten percent chance an investment in an individual mortgage would result in a complete loss. The same investment in a mortgage security provided a percentage ownership in a pool of one hundred mortgages. Instead of a ten percent chance of a complete loss, the security would provide investors with confidence that they would likely only face a ten percent loss.
Securitization also reduced risk by creating separate investment risk categories called tranches. For example, the pool of 100 mortgages would be separated into two investments: an investment grade tranche (AAA) and a junk tranche (BBB). The AAA tranche would take losses only on the last 90 mortgages whereas the BBB tranche would take losses on the first 10. That way, a conservative investor seeking the safety of being able to recoup his entire investment would pay a premium and buy the AAA tranche. Conversely, a risk seeking investor desiring high yields could buy the BBB tranche at a discount.
Finally, securitization also allowed private mortgage originators to sell mortgage securities directly to investors. So long as these originators “conformed” to the criteria specified by the GSEs, the GSE would issue a guarantee in exchange for a fee. The guarantee gave investors the
confidence to buy these securities directly from originators. As investors’ comfort in mortgage securities grew, a “non-conforming” market of privately issued mortgages that were not guaranteed by the GSEs also developed.