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Background on Mortgage-Backed Securities and Fannie Mae and Freddie Mac
A mortgage pass-through security (or simply, pass-through) is created when one or more holders of mortgages form a collection (pool) of mortgages and sell shares or participation certificates in the pool. A pool may consist of several thousand mortgages or only a few mortgages. The cash flow of a pass-through depends on the cash flow of the underlying mortgages, which consists of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments.
Payments are made to security holders each month. The amount and the timing of the cash flow from the pool of mortgages and the cash flow passed through to investors, however, are not identical. The monthly cash flow for a pass-through is less than the monthly cash flow of the underlying mortgages, by an amount equal to servicing and other fees. The other fees are those charged by the issuer or guarantor of the pass-through security for guaranteeing the issue.
There are three major types of pass-through securities guaranteed by the following organizations: Government National Mortgage Association (“Ginnie Mae”), Federal National Mortgage Association (“Fannie Mae”), and Federal Home Loan Mortgage Corporation (“Freddie Mac”). The last two are federally sponsored credit agencies. The Government National Mortgage Association is a wholly owned U.S. government corporation within the Department of Housing and Urban Development. It is well-established that the full faith and credit of the U.S. Treasury stands behind securities issued or guaranteed by Ginnie Mae. The securities associated with these three entities are known as agency pass-through securities.
The first residential mortgage agency, created in 1932, was the Federal Home Loan Bank (FHLB) System. It was comprised of twelve regional FHLBs, with a governing body – the Federal Home Loan Bank Board (FHLBB) – located in Washington, D.C. Though its responsibilities were curtailed considerably in late 1989, the FHLB System was originally responsible for regulating and providing advances to the country’s savings and loan associations (S&Ls, or “thrifts”).
Currently, the main task of the FHLBs is to lend funds to thrift associations so that they can supply mortgages at low rates. To obtain the funding for this purpose, the FHLBs issue securities in the open market. These are backed by collateral of government securities, insured mortgages, or secured advances to the S&Ls; they are not guaranteed by the federal government, though a multi-billion credit line with the U.S. Treasury is in place.
In 1938, the federal government created Fannie Mae, the first federally sponsored agency whose primary purpose is to encourage the maintenance of an active secondary market for mortgages. A second agency with a similar purpose, Freddie Mac, was created in 1970. Fannie Mae and Freddie Mac purchase mortgages for sale to the secondary market and issue securities.
Both are owned by private stockholders but have large credit lines with the U.S. Treasury to provide support as needed. Nonetheless, unlike Ginnie Mae's, securities issued or guaranteed by Fannie Mae and Freddie Mac are not explicitly guaranteed by the U.S. Treasury.
Fannie Mae issues short-term discount notes, and coupon-bearing securities as far out as 30 years, some of which are callable. Though Freddie Mac still issues discount notes to fund its day-to-day operations, it has issued very few longer term securities since late 1986, instead concentrating its term activities in the pass-through market.
Agencies come to the market continuously to issue short-term discount notes for their day-to-day operational needs. They set the rates on those notes daily to reflect market conditions and their maturity preferences. Intermediate and long-term coupon-bearing securities are sold through subscription offerings (i.e., through a syndicate of commercial banks and broker-dealers). The agencies do not issue longer term securities on as regular a schedule as does the Treasury, and the maturities are considerably more flexible. Intermediate-term bonds are offered on a more or less monthly basis, and longer term bonds several times per year.
Agency securities, like the rest of the fixed income market, generally trade at a yield spread above Treasuries. Though federal sponsorship ensures fairly low credit spreads, agency liquidity is not as high as in the Treasury market. Investors in agency securities include numerous U.S. and foreign financial institutions and range from small community banks to foreign central banks.
Fannie Mae and Freddie Mac are the two largest financial institutions in the United States. According to the Office of Federal Housing Enterprise Oversight (OFHEO), the combined credit footprint of Fannie Mae and Freddie Mac rivals the liabilities of the Federal Reserve Banks (the Fed) and the U.S. Government. As of March 31, 2008, those two housing-related government sponsored enterprises (GSEs) had credit outstanding of $5.3 trillion. That was equal to the publicly held debt of the U.S. government. If the $1.2 trillion in consolidated system obligations of the Federal Home Loan Banks is included, the total debt stock and guaranteed obligations of the three housing-related GSEs amounted to $6.5 trillion at March 31, 2008, or roughly 23% more than the $5.3 trillion in the total publicly held debt of the United States of America. As of mid-May, the Office of Federal Housing Enterprise Oversight (OFHEO), the regulator of record for Fannie Mae and Freddie Mac, affirmed the fact that both companies were in compliance with their required capital requirements.
From our perspective, the three housing-related GSEs, Fannie Mae, Freddie Mac, and Federal Home Loan Banks, are too big to fail. It is estimated that currently they guarantee payments of about half of all U.S. mortgages. Because of their size and importance, we believe that the federal government would act (if necessary) to support their senior debt, even though it is currently not legally obligated to do so.
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