Understanding the Mortgage Market

Most homes and other real estate properties in the United States are purchased with the help of mortgages. A mortgage is a long-term loan that typically carries a fixed or adjustable rate of interest. The house or property serves as collateral for the loan. Mortgages are funded by mortgage lending institutions, such as banks, thrifts, savings and loans, credit unions, mortgage companies or state and local housing finance agencies. These primary lending institutions are called mortgage originators. Once an originator makes a mortgage loan, it has a choice. It can either hold the mortgage in its own portfolio or it can sell the mortgage into what is called the secondary market. Secondary market investors include Fannie Mae, Freddie Mac, Ginnie Mae, various pension funds, insurance companies, securities dealers and other financial institutions.

The secondary market serves two primary functions in the mortgage industry: First, the cash that the secondary market investors pay originators for mortgages can be used to originate more mortgages for home buyers. Second, the mortgages that are purchased are used to create Mortgage-Backed Securities (MBS). MBS are pools or packages of loans that are converted, or "securitized", into bonds and sold to mortgage investors.

The growth of the mortgage-backed securities (MBS) market has been explosive. Since 1980 the US Agency MBS market has grown $110 billion outstanding to over $3.5 trillion, with over $8 trillion in total residential mortgage debt outstanding. Money managers, thrift institutions, commercial banks, trust departments, insurance companies, pension funds, securities dealers, other major corporations and private investors are all players in this market.

When a mortgage investor buys a Mortgage-Backed Security, he or she is buying a bond that represents an ownership interest in these pools or packages of mortgage loans. In the most basic MBS structure, the principal and interest that the mortgagor is scheduled to pay each month, plus any unscheduled payments (such as prepayments from refinancings), are typically passed through to the MBS investors on a pro rata basis reflecting pool ownership percentage. This is why MBS are sometimes called "mortgage pass-through certificates."

Sometimes mortgage investors want to buy a bond with very specific characteristics, for instance a bond with an interest rate that changes every month. MBS can be created to cater to the needs of the marketplace by taking pools of mortgage loans and allocating the principal and interest to meet the needs of different mortgage investors. These bonds are called Collateralized Mortgage Obligations, or CMOs.

Just like a homeowner has a choice of fixed or adjustable rates of interest, so does the MBS investor have a choice of the kinds of mortgages that will be in the pools underlying the MBS. Fixed-rate bonds pay a fixed interest rate for the term of the bond. Adjustable rate mortgage bonds (ARMs) have an interest rate that changes periodically based on short term interest rates. CMOs can be created that pay floating or fixed rates of interest.

Fannie Mae and Freddie Mac are federally chartered, stockholder-owned corporations and together are the largest investors in home mortgage loans in the United States. Fannie Mae and Freddie Mac don't lend money directly to home buyers, but by buying mortgages from originators they are the nation's largest and most consistent source of financing for them. The two companies are called Government Sponsored Enterprises, or GSEs. GSEs receive no government funding or backing, but because of their government charter and their role in the housing market, they are treated as if there is an implied backing. Ginnie Mae, another important source of funding to the mortgage originators, is a wholly-owned government instrumentality and explicitly backed by the US Government. MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae are rated triple-A by bond rating agencies. The theoretical justification for the existence of the GSEs is that the absence of credit risk in MBS due to the explicit or implied backing of the government means that the MBS pay lower rates of interest; this in turn means that the originators pay less for their funding; this ultimately means that the rates paid by mortgage borrowers is lowered.

The GSEs finance the purchase of mortgage loans from primary lenders through the sale of MBS and the issuance of corporate debt and other securities and then either hold them in their own portfolios or they issue MBS. Lenders submit groups of similar mortgage loans to the GSEs for securitization. The GSEs first ensure that the loans meet their credit quality guidelines and their size limits and then securitize the pool of mortgages into liquid, very flexible instruments. The resulting MBS carry a guarantee of timely payment of principal and interest to the investor, whether or not there is sufficient cash flow from the underlying group of mortgages. The obligation under this guarantee is solely Fannie Mae's or Freddie Mac's and is not explicitly backed by the full faith and credit of the United States government.