Mortgage Liquidity: Financing for 50 Million Homes

In chartering Freddie Mac and Fannie Mae, Congress gave us the responsibility of being a continual presence in the mortgage marketplace. Freddie Mac does that by providing a stable supply of low-cost mortgage funds whenever and wherever qualifying families need them – and we've been doing it for 37 years. In recent months, Freddie Mac reached an important milestone: the financing of our 50 millionth home. These mortgage investments have supported homeownership in communities around the country, as well as financed apartment units affordable to millions of low- and moderate-income families.

Read more: Our Role State-by-State

Our continuous presence in the market also promotes affordability. As can be seen from a quick scan of the Internet or newspapers, conventional fixed-rate mortgages eligible for sale to the GSEs typically bear lower interest rates than mortgages above the conventional conforming loan limit.¹⁸ A study [PDF 142K] co-authored for us by former OMB Director James Miller estimates that these lower rates save American homeowners between $16 and $21 billion in housing costs every year.¹⁹ Low-cost mortgages provided by Freddie Mac have also enabled families to refinance their mortgages into lower-cost instruments, saving consumers billions of dollars in mortgage interest and prepayment penalties over the years.

Notwithstanding novel developments in mortgage finance, the classic fixed-rate mortgage remains the product of choice for many consumers because it protects them from upward swings in mortgage interest rates – and allows them to refinance whenever they want without penalty. At the end of 2005, fixed-rate mortgages, the market heavily supported by the GSEs, comprised more than 80 percent of outstanding prime conventional conforming mortgages. In contrast, fixed-rate mortgages comprised less than 40 percent of higher-balance jumbo mortgage debt, and only one-fourth of subprime debt.²⁰

The widespread availability of low-cost fixed-rate mortgage financing is largely the result of a well-functioning GSE system of housing finance. As secondary market entities, the GSEs purchase conforming mortgages, which banks and other primary market originators do not wish to hold on their own balance sheets. We provide this outlet by offering an attractive "take out" bid for the conforming mortgages originated by banks. In this way, GSEs are constantly replenishing the funds available for home purchase and refinancing.

Banks typically hold adjustable-rate mortgages (ARMs) in their own portfolios and sell "long tail-risk" mortgages, such as the prepayable 30-year fixed-rate product, to the GSEs. In this way, banks can reduce the amount of interest-rate risk they must hedge. GSEs take on this interest-rate risk and diffuse it through domestic and international capital markets through securitization or the use of hedging instruments.

The transfer of interest-rate risk from mortgage originators to the GSEs is vital to the long-term viability of the housing finance system – and to the prospects of sustainable homeownership. ARMs typically pose much less interest-rate risk for portfolio investors; instead, the challenge of dealing with changes in interest rates is borne by ARM borrowers. In flat or declining rate environments, the risk to the consumer is usually manageable. However, as mortgage rates rise, these risks can be extremely difficult for families to manage, as demonstrated by the subprime market today.

The subprime market has grown markedly in recent years. On the demand side, many subprime consumers sought mortgage products with low monthly payments, largely in response to the run-up in house-price inflation. As long as house prices continued to rise, home equity was building up and the transactions costs associated with refinancing could be absorbed. On the supply side, subprime investors were driven by a nearly insatiable demand for yield, which is a function of the higher risks associated with subprime mortgages. To manage these risks, highly structured and complex subprime securities were developed that diffuse these risks to an increasingly large and global investor base.

The confluence of strong consumer demand for low-payment mortgages and strong investor appetite for high-yielding securities fueled the origination of 2/28 and 3/27 hybrid ARMs. Because of their short reset periods, floating rates, prepayment penalties and high margins, these mortgages were well suited to investor securitization needs. In times of low mortgage interest rates and rising home prices, many consumers fared well in this market. However, as we are seeing now, the combination of rising short-term interest rates and softening house prices has made these mortgages much more onerous for many credit-impaired borrowers.

The point here is not to make adverse comparisons to adjustable-rate products or the subprime market. Both serve important consumer needs. Rather, there is a distinction between the segment of the mortgage market supported by the GSEs and alternative market solutions to the challenge of providing long-term mortgage financing. Over time the GSE market has evolved to serve household needs, and there is no better example than the high share of low-cost fixed-rate mortgages made possible by GSE mortgage purchases and investments. In contrast, the subprime market, as we know it today, is largely investor-centric. Investor demand tends to drive what gets originated. Further, when yields dry up, investors will look for better opportunities elsewhere. This is not the case in the GSE market, where we ensure a continuous presence. This responsibility to serve markets in good times and bad is a responsibility not shared by private equity funds, hedge funds, non-bank financial institutions or even depositories. These institutions have the freedom, and indeed an obligation to their owners, to deploy their assets as they wish.

In summary, the GSEs statutory requirement to provide liquidity to the nation's mortgage markets remains a highly important aspect of their congressional charter. Mortgages financed by the GSEs are lower cost, highly available, and permit consumers to shift interest rate risk – at will – to financial institutions that are highly qualified to manage it.

¹⁸ The real estate section of The Washington Post on March 10, 2007 (Section G, page 2) showed that, among the lenders listed, quoted rates for 30-year, fixed-rate mortgages up to $417,000 (the current conforming loan limit) were on average 26 basis points lower than rates on 30-year, fixed-rate mortgages above $417,000.

¹⁹ James C. Miller III and James E. Pearce, "Revisiting the Net Benefits of Freddie Mac and Fannie Mae," at 24-25 (November 2006).

²⁰ Loan Performance, a subsidiary of First American Real Estate Services, gives the fixed-rate share of prime conventional conforming debt as 83 percent as of December 31, 2005, of prime jumbo debt as 30 percent from its servicing database, and of subprime debt at 26 percent from its securities database. OFHEO has estimated that 85 percent of conventional conforming debt was fixed-rate as of the end of 2005, and that 15 percent of jumbo debt was fixed-rate (http://www.ofheo.gov/Research.aspx).