Mortgage-Backed Securities - The Role of the Mortgage Agencies

Part 1: The Role of the Mortgage Agencies

One of the largest fixed income markets is the mortgage-backed securities market. Mortgage-backed securities are backed by mortgage loans which, in turn, are backed by liens against real property. However, individual mortgages have a number of characteristics that tend to hinder their liquidity and appeal as potential investments.

For one, assessing the credit risk of mortgage loans can be somewhat expensive. When lenders consider mortgage loan applications, they normally have several reports prepared so that they’ll have the necessary information to evaluate the credit quality of those loans. Property appraisals, credit reports, verifications of employment, environmental reports and others can run $1,000 or more for each application. In addition, every time the loan is sold to a new investor, the perspective buyer will need to have the same reports prepared in order to evaluate the investment, incurring the same costs. Also, the average size of a new mortgage in the U.S. is more than $200,000, making investment in individual mortgages extremely expensive for most private investors.

The accounting issues associated with mortgages can also be a deterrent to individualized investment. Mortgages can be fixed-rate or adjustable, fully- or partially-amortizing, and can generally contain optional prepayment amounts. The portions of a mortgage payment that are applied to principal and interest invariably change every single month. The investor must separate the correct amount of interest and principal each month for both accounting and tax purposes. Thus, compared to normal bonds, mortgages require far more detailed and arduous recordkeeping.

Of all the problems associated with increasing the liquidity of individual mortgages, perhaps the most important one is the problem of evaluating the credit quality of the mortgage. To overcome this difficulty, the federal government facilitated the creation of several agencies and public corporations with government lines of credit. These agencies guarantee the credit quality of mortgages in order to make them easier for loan originators to package and sell to investors. By making them easier to sell, the government lowers the risk of making mortgage loans, which in turn lowers mortgage rates, thereby making it easier for people to buy homes.

The three government-sponsored mortgage guarantors are the Federal National Mortgage Association (FNMA, or Fannie Mae), the Government National Mortgage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, also known as Freddie Mac). Collectively, these three entities are commonly referred to as “the agencies” (although they technically aren’t agencies of the U.S. Government), and they are the major investors of the secondary market.

All three agencies either buy mortgage loans from originators in order to package and sell them to investors or provide credit guarantees for mortgage loans so that the originators can sell them to investors themselves. Only qualifying mortgages will be insured by the agencies; these are mortgages which meet certain agency-stipulated criteria concerning, most notably, the required down payment (expressed as a percentage of the property’s value), the loan-to-property value (LTV) ratio, and the maximum size of the loan.

Part 2 of this series will examine the creation and importance of mortgage pools.

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