The American Mortgage System: Crisis and Reform

1. The Secondary Market for Housing Finance in the United States: A Brief Overview

C h a p t e r 1 The Secondary Market for Housing Finance in the United States: A Brief Overview Ingrid Gould Ellen, John Napier Tye, and Mark A. Willis Understanding both the current problems in the secondary market and the proposed solutions requires an understanding of the role of the secondary market in U.S. housing finance.1 In this chapter, we focus in particular on the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, which for decades were the largest players in the U.S. system.2 We first review the history of the secondary market and summarize the basic operations of the GSEs before they were placed into conservatorship by the U.S. Treasury in September 2008. We then outline the key arguments that are made about the strengths and weaknesses of the GSEs’ structures, for both the single-family and multi-family housing finance markets. A Brief History of the GSEs and the Secondary Market Fannie Mae and Freddie Mac are only two of many entities that bring capital to the housing market to help borrowers finance the purchase of single-family and multi-family homes. Until the 1930s, most loans for the purchase of residential property came from banks, which held the resulting mortgages 8 Ingrid Gould Ellen, John Napier Tye, and Mark A. Willis in their portfolios and financed these holdings through deposits. To supplement deposits as a source of funds to loan out, the Federal Home Loan Banks provided additional funding to their members through “advances,” which are loans secured by mortgages themselves.3 The problem with this system is that funds for mortgages were limited by the volume of local deposits, creating significant shortfalls and bottlenecks in some regions. This problem has only been compounded in recent years, as people have shifted their savings from banks into money markets , mutual funds, and other investments. Indeed, given the high demand for mortgages today and the level of bank deposits, it would be impossible for banks alone to provide the necessary funding for all U.S. mortgages. Consider that as of the end of 2009, total mortgage debt outstanding in the United States stood at $14.2 trillion (Federal Reserve Board 2010), whereas total bank deposits within the United States totaled $7.5 trillion (Federal Deposit Insurance Corporation 2009).4 During the Depression, the Federal National Mortgage Association— Fannie Mae—was created to allow banks to originate a greater number of mortgages, effectively launching a secondary market for housing finance.5 Fannie Mae would purchase loans insured by the Federal Housing Administration (FHA), another Depression-era agency, from banks so that the banks could fund additional mortgages. Until 1968, Fannie Mae was a government agency and so could borrow money in private capital markets based on the financial strength of the federal government. The Federal Home Loan Mortgage Corporation—Freddie Mac—was established in 1970 as part of the Federal Home Loan Bank system (a set of regional cooperatives owned by the banks) and so was able to raise capital based on the implicit backing of the federal government enjoyed by that system. Both GSEs used the money they raised to buy mortgages from banks and others who had originated them, thus allowing those originators to provide even more mortgages. As major buyers of mortgages, Fannie Mae and Freddie Mac helped to standardize the documents used to originate mortgages and, perhaps more important, the mortgage products that were offered and the underwriting standards that the property and the borrower had to meet. In 1968, Fannie Mae was privatized (thus removing its liabilities from the federal budget), but a portion of its activity was maintained as part of the government and was folded into a new agency called the Government National Mortgage Association (GNMA), or Ginnie Mae (Jaffee and Quigley 2010: 171). As a government entity, Ginnie Mae remained explicitly The Secondary Market for Housing Finance in the United States 9 backed by the full faith and credit of the federal government; therefore its securities traded with pricing close to that of the federal debt.6 Ginnie Mae carried on the role of helping to ensure liquidity for mortgages made under such federal programs as the FHA, the VA (Veterans Administration), and the RHS (Rural Housing Services), which already provided loan-level guarantees on the loans originated under their programs. These programs set their own underwriting standards for the loans they...