Comments

Lawrence J. White:

Housing and housing finance continue to be important topics for policy discussion in the United States.¹ One strand of the current discussion focuses on the role of Fannie Mae and Freddie Mac in the U.S. secondary mortgage markets. This comment provides some background information on modern residential mortgage finance and on Fannie Mae and Freddie Mac and thus complements the paper by Van Order.

The Components of Residential Mortgage Finance

In an important sense, the mortgage finance markets of the first decade of the twenty-first century are substantially different from those of three decades ago and earlier. To see this, consider the major components of mortgage finance:

• mdash Originating mortgages, which involves gathering information about the borrower, determining the creditworthiness of the borrower, setting the terms of the mortgage, and lending the money and thus issuing the mortgage,

• mdash Funding mortgages, which involves identifying and collecting funds from the investors and creditors who are the ultimate sources of the funds lent to the borrower,

• mdash Issuing deposits or other forms of liabilities to the funders,

• mdash Servicing mortgages, which involves collecting monthly payments from the borrower and forwarding them to the funders, as appropriate, and dealing with borrower delinquencies and defaults,

• mdash Providing guarantees to the funders (so as to reassure them with respect to the asymmetric information problems inherent in lending).

The "traditional" form of residential mortgage lending, which was the dominant form through the 1980s, was through a depository—a savings institution or a commercial bank—that was vertically integrated and combined all of the first four items in this list under the depository's roof. Thus the depository originated the mortgage, funded it by gathering deposits, issued deposit liabilities to savers, and serviced the mortgages. The federal government provided the guarantees to depositors: through the Federal Deposit Insurance Corporation (FDIC) for commercial banks, and through the Federal Savings and Loan Insurance Corporation (FSLIC) for savings institutions (mostly savings and loan institutions).²

Beginning in the early 1970s, and picking up steam in the 1980s and 1990s, the development of residential mortgage-backed securities (MBSs) and a secondary market in them changed this model.³ Although vertically integrated depositories still exist, the MBS model has created an alternative, vertically disintegrated process. Specialist originators—mortgage bankers, which immediately securitize or sell their originated mortgages—are present at the first stage.⁴ Fannie Mae, Freddie Mac, Ginnie Mae, and "private-label" securitizers can now tap the wholesale capital markets for the savings that will fund the mortgages at the second stage. The securitizers issue "pass-through" MBSs that represent a direct claim on the underlying principal and interest payments and (in the case of Fannie Mae and Freddie Mac) issue straight debt as the third-stage liabilities. Specialist servicers have arisen at the fourth stage to service the securitized mortgages. And, for Fannie Mae and Freddie Mac, the capital markets' belief that the federal government will not allow the two companies to fail financially has brought an implicit guarantee into the fifth stage.⁵

The Basics of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are publicly traded companies, whose shares are listed on the New York Stock Exchange. They have two primary businesses: (a) issuing MBSs, which entails offering guarantees to holders as to credit risk (default risk) in return for fees that have been in the range of 15-20 basis points (15-20 cents per $100 of outstanding principal), and (b) investing in large portfolios of residential mortgages, which are funded largely (97 percent) by debt.

Although the two companies are publicly traded, they are also quite special:

• mdash They have congressionally legislated charters (rather than, say, a Delaware charter).

• mdash The president of the United States can appoint five of their eighteen board members.

• mdash They pay no state or local income taxes.

• mdash Each has a potential line of credit with the U.S. Treasury of up to $2.25 billion.⁶

• mdash Their securities are "government securities" under the Securities Exchange Act of 1934.

• mdash They are not required to register their...