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The
Housing Finance System in the United States An Overview In the wake of the recession, on the one hand, lower interest rate prompts Americans buying and refinancing homes across the country. On the other hand, there may be more mortgage payment default due to the economic hardship some people face. Much attention has been turned to the housing and housing finance sector. Over 67% of Americans own their homes. Housing has always been an important sector in the US economy. In 2000, the housing sector as a whole contributed $1.2 trillion to the Gross Domestic Product, or 12.1% of the US economy. Home ownership creates jobs and national wealth not only at the moment a house is built, but also through the time the house is placed on the market, to the time the new owner furnishes and remodels it following the purchase. In 2000, housing construction generated 3.5 million full-time jobs, $113.8 billion in wages and salaries, and $60.9 billion in federal, state and local tax revenues and fees in the US. In 2000, owners of newly built single-family homes spent an additional $5.9 billion on furnishing, decorating and improving their houses in the US. For many people, buying a house is the largest purchase and investment in their life. And for most people, buying a house requires them to get a mortgage to finance the purchase. The mortgage rate moves together with the long-term bond rates. The mortgage rate an individual borrower gets also depends on the borrower's credit record, income, the ratio of loan amount to the value of the house, etc. How the US housing finance system works is not as simple as many think it to be--going to a bank and getting a 30-year mortgage with a rate of 7%. It is a system that involves a lot of different financial institutions and financial instruments that help channel investors' money into the sector and obtain additional funds for mortgage lending. It is a system where risks in mortgage lending and mortgage investment are transferred, shared, and managed. And finally, it is a system in which the government can achieve housing policy goals by regulating part of the industry. The housing finance system consists of three markets: the primary mortgage market, the secondary mortgage market, and the capital market. In the primary mortgage market, mortgages are created and funds are loaned directly to borrowers. In the secondary mortgage market, lenders and investors buy and sell existing mortgage loans and mortgage-backed securities (MBS). In the capital market, investors buy and sell long-term investment vehicles such as mortgages, MBS, stocks, and bonds. Put simply, the capital market is Wall Street. By investing in mortgages and MBS, capital market investors help increase the flow of funds available for mortgage lending. This article focuses on the secondary mortgage market. The reason is that people are more familiar with the primary mortgage market and almost every country (including China) has a primary market. Let us briefly talk about the primary mortgage market before we move on. Borrowers in the primary mortgage market are homebuyers. Lenders in the primary mortgage market are mortgage companies (usually as subsidiaries of commercial banks), commercial banks, credit unions, thrifts, life insurance companies, and pension funds. The functions of the lenders include origination, sale, and servicing of the loan. A mortgage is created when a homebuyer receives funds from a primary mortgage market lender and, in exchange, pledges his/her property as collateral for the loan. Lenders then can sell the mortgage loans in the secondary mortgage market. Mortgage servicing includes activities such as collecting mortgage payments, paying taxes, and following up on payment delinquencies. Fannie Mae (formerly known as Federal National Mortgage Association), Freddie Mac (formerly known as Federal Home Loan Mortgage Corporation), and other investors (including banks, insurance companies, pension funds, and foreign investors) make up the secondary mortgage market. Fannie Mae and Freddie Mac are the biggest players in this market. The two companies combined have a market share of about 40%. One cannot talk about the secondary mortgage market without talking about these two companies. The Secondary Mortgage Market The secondary mortgage market serves as the key link between the primary mortgage market and the capital market. Lenders can keep the new mortgages they created or sell them to secondary mortgage market investors. To purchase loans from lenders, Fannie Mae and Freddie Mac borrow funds in the capital market by issuing debt securities. They can keep the loans they purchase from lenders in their own portfolios. This is called mortgage portfolio investment. The income on portfolio investment is the difference or "spread" between the rate they earn on mortgages and the interest they pay to investors in their debt securities. For example, if the mortgage rate is 7%, and the bond Fannie Mae issues on Wall Street has a rate of 6%, then Fannie Mae earns 1%. Portfolio investment by Fannie Mae and Freddie Mac offers lenders liquidity. Lenders receive cash by selling the mortgages and thus have more funds available for making new mortgages. Besides portfolio investment, Fannie Mae and Freddie Mac also perform the function of mortgage securitization and loan guaranty. Specifically, a lender delivers a pool of mortgages to Fannie Mae or Freddie Mac. Fannie Mae or Freddie Mac issues a mortgage-backed security to the lender. The lender does not receive cash in this case. Instead, the lender swaps mortgage loans for a Fannie Mae or Freddie Mac mortgage-backed security and can then sell the mortgage-backed security for cash to investors through Wall Street dealers. The issuer of the mortgage-backed security-Fannie Mae or Freddie Mac-guarantees the timely payment of principal and interest to the investor (the holder of the mortgage-backed security) and in return receives a guaranty fee. For example, a lender originates a pool of 8% mortgage loans and services the loans. When the lender delivers the pool of loans to Fannie Mae, the payment Fannie Mae receives will be 7.75% because the lender takes 0.25% as servicing fee. Fannie Mae issues a mortgage-backed security to the lender who can then sell it to the investor (say, a pension fund). Fannie Mae guarantees that the investor will receive timely payment of principal and interest, but it passes only 7.5% to the investor, charging a 0.25% as the guarantee fee. Fannie Mae takes the credit risk in the event of a default by the borrower and as compensation receives a guarantee fee. What the mortgage-backed security investor receives as a pass-through is the amount the borrower paid, minus the lender's servicing fee, minus the guarantee fee. By securitizing loans, Fannie Mae and Freddie Mac (and other players in the secondary mortgage market) replenish the supply of funds lenders have available for creating new mortgages. All parties benefit from the mortgage securitization and guaranty business. Advantages for a lender to swap loans for mortgage-backed securities rather than hold whole loans in portfolio are as follows. Investors rarely purchase single loans from lenders as these loans carry both credit risk and interest rate risk, while mortgage-backed securities are more liquid than single mortgage loans and thus much more attractive to investors. Credit risk is either taken away or shared with the issuer of the mortgage-backed securities. If the mortgage-backed security is sold, the interest rate risk is assumed by the investors in the capital market who purchase the mortgage-backed security. And the lender receives cash, which can be used for additional mortgage lending. As compensation for credit guarantee on the mortgage-backed securities they issued, Fannie Mae and Freddie Mac collect guarantee fees. The monthly guarantee fee income is the apparent benefit for them. By supplying the market with securities that are in demand by investors, they increase the flow of funds into the mortgage market, and help drive down the mortgage rate for borrowers. Fannie Mae, Freddie Mac, and Government Regulation Fannie Mae was created as part of the federal government by the Congress in 1938 to bring stability to the US housing market. In 1968, Fannie Mae began its transition to a completely private company. That year, the Congress split Fannie Mae into two: the Fannie Mae of today, a federally chartered corporation, wholly owned by private shareholders and publicly traded on New York Stock Exchange; and Ginnie Mae (Government National Mortgage Association), a government corporation within the US Department of Housing and Urban Development (HUD). Freddie Mac was created by the Congress in 1970. Both Fannie Mae and Freddie Mac have experienced astronomical growth in their (relatively) short history of existence and are now among the largest corporations in the US. Owning in portfolio and securitizing more than a fifth of mortgages originated in the US, the Washington D.C. based Fannie Mae is the largest investor in home mortgages and the largest non-bank financial services company in the world. Fannie Mae and Freddie Mac operate two businesses in the secondary mortgage market: capturing and managing mortgage-related credit risk, and capturing and managing mortgage-related interest rate risk. Fannie Mae and Freddie Mac also provide information services to lenders and investors. Fannie Mae and Freddie Mac carry a public mandate of helping low and moderate income Americans, minorities, and Americans in underserved areas to realize home ownership. Both companies operate under a federal charter and are known as "government sponsored enterprises." Both companies are under regulation and oversight from the federal government. Loans purchased or securitized by Fannie Mae and Freddie Mac must meet specific requirements including loan limit. Loan limit is set every year based on national average housing price. In 2001, the loan limit for one-unit single family homes (single-family homes are buildings with 1-4 residential units) is $275,000. The regulatory oversight is performed by HUD. Specifically, the Office of Federal Housing Enterprise Oversight (OFHEO) within HUD is charged with examining and setting capital levels for Fannie Mae and Freddie Mac. OFHEO has authority over all matters relating to the safety and financial soundness of Fannie Mae and Freddie Mac. The other agency within HUD that regulates the two companies is the Office of the Secretary. The Secretary of HUD requires Fannie Mae and Freddie Mac to obtain HUD approval before implementing new programs. The Office of the Secretary also sets housing goals for low and moderate income housing, rural housing, and for housing in other underserved areas. In this manner, Fannie Mae and Freddie Mac help achieve public policy goals of expanding home ownership to the overlooked, the underserved, and the overcharged. Conclusion We have seen how the US housing finance system, and especially the secondary mortgage market, works. The secondary mortgage market links the primary mortgage market and the capital market by attracting those investors who traditionally have not invested in mortgages. It helps to accomplish the following objectives: 1). It increases the availability of funds for mortgage lending by increasing the liquidity of mortgage investment and by allowing lenders to originate mortgages for sale and not just to keep for their own portfolio. 2). The increase in the supply of funds for mortgage lending may help drive mortgage rate down and thus benefit homebuyers. 3). Investors and guarantors in the secondary market assume and manage mortgage-related credit and interest risks, and help to standardize loan origination guidelines. 4). The government sponsored enterprises in the secondary market help to serve the underserved in housing and mortgage finance. Housing sector reform in China has been going on for some time. And many Chinese are buying their homes using mortgage loans. But the housing finance system (and the financial market in general) is still at a very primitive stage. The source of mortgage funds is still primarily the deposits of banks. A lot of issues are yet to be addressed. A mature housing finance system such as that of the US may provide us useful references. (The author is an Economist with Fannie Mae in Washington, DC.)
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