In 1938, the collapse of the national housing market led to the federal government’s formation of the Government Sponsored Enterprise (GSE) known as the Federal National Mortgage Association (a.k.a. Fannie Mae) to help rebuild the market. This was done through the agency’s bearing of mortgage default risk through government guarantees. Subsequently, two additional agencies were established – the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae).
Mortgages are sold by issuing banks to agencies or other organizations. These organizations issue pools backed by specific mortgages. Investors purchase shares of the pools. The shares receive monthly principal and interest payments consisting of the principal and interest payments made to the underlying mortgages minus servicing fees. The loans themselves are the collateral backing the MBS pool.
By buying the loans, the agencies remove the loans from the banks’ books. This transfers prepayment and default risk from the banks to the agencies, and gives the banks the money to make more loans, thus fueling home ownership. The agencies then recoup the money by selling shares of the pools, thus effectively transferring the debt and the prepayment risk back to the market itself. Default risk is retained by the agency.
In the event of a default, the agency has to make good on the principal and is compensated by the proceeds of the foreclosure. The agency incurs a loss if the foreclosure sale proceeds are less than the principal, but incurs no gain if the proceeds are greater than the principal (the excess goes to the homeowner).
When originally formed, Fannie Mae was a government agency. The guarantee it gave was backed by the U.S. government. In 1968, Fannie Mae was converted to a private corporation, largely to remove its liabilities from the federal government’s balance sheet. Nonetheless, its guarantees were considered to be in no danger of failing. The only default considerations applied to MBS pools were of homeowner default, which was only considered to cause prepayment, not losses.
The credit crisis has reversed the status of the agencies. Both Fannie and Freddie held huge volumes of Alt-A and subprime debt. When homeowner default skyrocketed and these positions deteriorated in value, the agencies lost enough to become insolvent. In fact, their 2008 losses were higher than their total profits from 1990 through 2007. On Sept. 7, 2008, the government stepped in and took ownership of both agencies.
The federal government formed the agencies in the wake of the housing market collapse of 1938. Now, in the wake of the most recent housing market collapse, the federal government is proposing to dismantle the agencies.
Would it not be more prudent to consider returning them to a prior incarnation, where the agencies gave support to the housing market through securitization of conforming loans instead of warehousing subprime debt (which, while profitable at the time, was also urged by the federal government)?
After all, it wasn't the agencies per se that caused the subprime crisis. The fuel was the leverage with which the banks maintained both positions in these loans as well as outright bets on them (synthetic positions).
With the focus on winding down the agencies instead of on overall market and bank risk management, aren’t we taking our eyes off the ball?
More information about the agencies and mortgage debt valuation can be found in my article Analysis of Mortgage-Backed Securities: Before and After the Credit Crisis, which can be found in the new book Credit Risk Frontiers: Subprime Crisis, Pricing and Hedging, CVA, MBS, Ratings, and Liquidity.
