The Secondary Market and Government Sponsored Entities (GSEs)

Now that we have defined the basics of mortgages and the recent meltdown in the subprime markets, we will examine the secondary market and GSEs.

The secondary market is made up of Government Sponsored Entities (GSEs) and private institutions, like Bear Stearns, Solomon Smith Barney (nka Citigroup) and Bank of America.

The oldest of the three GSEs is Fannie Mae. Fannie Mae is a shareholder-owned company (NYSEFNMA) created in 1938, under President Franklin D. Roosevelt, at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America. Upon its creation, Fannie Mae was mandated to purchase Federal Housing Administration (FHA) insured and Veterans Administration (VA) mortgages for its portfolio.

Fannie Mae helped to standardize repayment contracts and credit underwriting procedures for mortgages. As of 1968, Fannie Mae is privately-owned and authorized to make loans and loan guarantees. It is not backed or funded by the U.S. government, nor do the securities it issues benefit from any explicit government guarantee or protection.

In 1968, Fannie Mae was privatized and Ginnie Mae was spun off as a separate agency to undertake some of Fannie Mae’s activities, assuming the financing of home loans not typically underwritten in the established loan market, like low-income housing. Ginnie Mae does not buy or sell loans or issue mortgage-backed securities.

Presently, Ginnie Mae makes affordable housing a reality for millions of low- and moderate-income households across America by channeling global capital into the nation’s housing markets. A Ginnie Mae guaranty allows mortgage lenders to obtain a better price for their mortgage loans in the secondary market. The lenders then use the proceeds to make new mortgage loans available.

Ginnie Mae guarantees investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans –mainly loans insured by the Federal Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA). Other guarantors or issuers of loans eligible as collateral for Ginnie Mae MBS include the Department of Agriculture’s Rural Housing Service (RHS) and the Department of Housing and Urban Development’s Office of Public and Indian Housing (PIH).

Importantly, Ginnie Mae securities are the only MBS to carry the full faith and credit guaranty of the United States government.

Ginnie Mae’s most significant activity began in 1970, when it started a mortgage pass through program. It was then that Ginnie Mae began to issue pass-through certificates to investors, giving each investor an undivided interest in a pool of mortgages used to repay investors all interest payments and scheduled or prepaid principal payments.

The Federal Home Loan Mortgage Corporation, also known as Freddie Mac, was established by Congress in 1970 to be a secondary market in mortgages for the savings and loans industry. It was privatized in 1989 into a private stockholder-owned corporation.

Fannie Mae and Freddie Mac are not backed by the full credit and faith of the US government.

Both institutions were created by the federal government and have federal corporate charters. The market perceives an implicit guarantee by the US government, because like other giant financial institutions, such as Bank of America, the government is unlikely to let these institutions fail in the event of financial problems. As a result, these institutions pay low credit risk premiums when they borrow in private capital markets.

The first MBS was brought to market by Ginnie Mae in 1970. Throughout the 1970s and early 1980s the major type of MBS security was the pass-through security. A major innovation for the MBS market occurred in 1983 when Freddie Mac issued the first Collateralized Mortgage Obligations (CMOs).

These new instruments appealed to investors with special maturity and cash-flow requirements. However, the first CMO issues faced complex tax, accounting and regulatory obstacles. Much of those legal issues were resolved with the passing of the Tax Reform Act of 1986 which included the Real Estate Mortgage Investment Conduit (REMIC) tax vehicle. After 1986 the issuance of CMOs grew enormously. The new tax law also allowed for the creation of other mortgage instruments such as STRIPs, floaters and inverse floaters.

Next: Agency Pass Through Securities