Chapter 2

Freddie Mac Addresses Systemic Weaknesses in Housing Finance

Prior to 1970, America’s housing finance system was unstable and inefficient. Systemic weaknesses arising from the system’s high sensitivity to interest-rate changes and the nature of the mortgage product led to geographic and institutional imbalances in the supply and demand for mortgage credit. In directing Freddie Mac and Fannie Mae to create a secondary market for conventional mortgages, Congress sought to address these persistent weaknesses.

A. Interest-Rate Sensitivity and Illiquidity Characterize System

For the first 40 years of this century, U.S. homeownership rates averaged 46 percent, and only about 40 percent of those homeowners had mortgages.1 More common were families owning their homes free and clear; such families were either wealthy, or property heirs or living in low-cost, poor-quality housing. Two key weaknesses in housing finance prevented a vibrant mortgage market from developing and present continuing challenges today: the housing industry’s high sensitivity to changing interest rates and the illiquidity of mortgages as a financial asset.

One indication of the importance the government places on the housing industry is the monthly reporting of the number of new housing starts as well as the number of new and existing home sales. Along with interest-rate movements, these statistics are closely watched as a measure of the health of the economy. A relatively small increase in interest rates can precipitate a large decline in new construction as well as in the number of households that can afford to purchase homes. Other sectors of the economy, such as the automobile market, are far less adversely affected by similar interest-rate changes.2 Because of housing’s high degree of sensitivity to interest-rate movements, the financing mechanism that makes homeownership a reality for American households must be both extraordinarily resilient and flexible. The housing finance system must withstand sharp declines in credit demands as well as meet surges in mortgage needs--without substantially affecting the relative affordability of home mortgages. This helps dampen cyclical swings in housing activity and promotes stable economic growth.

In addition to housing’s high degree of sensitivity to interest-rate changes, housing finance must cope with the general illiquidity of mortgages, which discourages investment in individual loans. The liquidity of an asset refers to the ability to buy or sell the asset readily with little or no effect on price. For example, a house is generally considered an illiquid asset: While stocks or bonds generally can be sold quickly, most houses take weeks or months to sell unless a substantial price discount is offered. Likewise, compared to other financial instruments, such as a Treasury bond, individual mortgage loans are inherently illiquid and thus unattractive to most investors.

Investors also were discouraged from investing in mortgages because of the uncertain timing of the return of principal over long periods of time. Because borrowers may refinance their mortgages at any time--and millions do when interest rates fall--investors bear the risk of having their principal returned at inopportune times. For example, if a borrower refinances a 10-percent mortgage when mortgage rates drop to 8 percent, the investor l oses a high-paying investment and is forced to reinvest the funds at less attractive rates. In contrast, this reinvestment risk is generally absent from investments in corporate and government debt because these obligations generally preclude prepayments. Other mortgage features, such as their comparatively small balances and frequent payments, also make individual mortgages less attractive than alternative investments.

Before Freddie Mac and Fannie Mae, thrifts traded individual loans among themselves in a rudimentary form of a secondary market. Because of the complications of trading whole loans and the lack of standardization, this trading was not sufficient to resolve imbalances in the supply of mortgage credit and the demand for mortgage funds by homebuyers. Mortgage trading was hampered by the lack of uniform documents and underwriting guidelines; each mortgage loan, each borrower and each property had to be evaluated individually by each prospective purchaser. In addition, there was a general lack of uniformity in matters ranging from property appraisals to foreclosure rights. This inherent unattractiveness of mortgages discouraged investment by nondepository institutions. In fact, pension funds, mutual funds and other nondepository institutions were successfully attracting household savings away from housing finance.

Since the Great Depression, policymakers have wrestled with these challenges, seeking to promote a housing finance system that is both stable and efficient. A review of two periods in which the market failed to meet homebuyer needs illustrates that Freddie Mac was created to address systemic problems, thereby strengthening the capacity of the financial system to meet borrower needs. Our purpose was--and is--to ensure a steady flow of low-cost mortgages, compensating for the weaknesses that had led to credit shortages in the past.

B. Federal Response to the Ravages of the Great Depression

The disintegration of the real estate market during the Great Depression revealed severe weaknesses in the housing finance system. Rampant foreclosures caused institutional lenders to retreat from mortgage markets and paralyzed new home construction. Between 1929 and 1933, the stock of mortgage loans shrank by 15 percent and new home construction dropped by 80 percent. By 1933, it was no exaggeration to say that “the mortgage market had effectively ceased to function.”3

In addition to providing emergency assistance to lenders and borrowers, the federal government created new government institutions to address many underlying weaknesses of the housing finance system. The provision of mortgage insurance through FHA enticed lenders back into the market and led to the development of the long-term fixed-rate mortgage. The provision of deposit insurance through the Federal Savings and Loan Insurance Corporation restored depositor confidence, enabling savings and loan associations to attract funds and make mortgage credit available. To address mortgage illiquidity, Fannie Mae was created in 1938 as a government agency to serve as a secondary market outlet for FHA-insured loans.4 This ensured the replenishment of funds for government-insured lending.

The combination of deposit insurance and government-insured loans, supported by a secondary market, enticed new investors to housing finance. Between 1940 and 1960, single-family mortgage debt outstanding grew eightfold, from $17 billion to $142 billion,5 while homeownership rates rose from 44 to 62 percent.6 However, the systemic problem of providing a stable supply of low-cost mortgages resurfaced during the 1960s, requiring a more comprehensive federal response.

C. Federal Response to Credit Imbalances of the 1960s

The system that emerged from the Great Depression relied on depository institutions--primarily savings and loans--to offer long-term, fixed-rate mortgages. Depositories funded these long-term assets almost entirely by short-term deposits. As long as interest rates were stable, as they were from the 1950s to the mid-1960s, the depository model of housing finance worked reasonably well. However, the system was vulnerable to sharp increases in interest rates, which caused unavoidable losses for depositories or the flight of deposits to higher-paying alternatives. 7 Reliance on this approach threatened the stable flow of mortgages.

In contrast, the government mortgage market was largely insulated from such interest-rate shocks. Fannie Mae provided a secondary market outlet for lenders originating government-insured and guaranteed loans, ensuring an ample supply of funds during times of weak deposit growth. This enabled a wide array of lenders to participate in the government programs and provided a flexible supply of credit in the FHA-insured and VA-guaranteed markets. Comprising about 19 percent of the market during the 1960s, FHA-insured debt financed homeownership primarily for households needing low-balance or low-down-payment loans. 8 Available only to veterans, loans guaranteed by VA comprised roughly 15 percent of the market.9

Lacking the degree of standardization enjoyed by the government market and without a secondary market, the conventional market was quite vulnerable to sudden changes in interest rates. Depository reliance on savings inflows and the inherent illiquidity of mortgage investments caused imbalances in the supply of and demand for mortgage funds. These mismatches reflected two separate problems: a geographic and an institutional imbalance in savings and credit needs.

1. Geographic Imbalance

During the 1960s, the largest geographic mismatch was between the older, more settled regions in the north and northeast, with their surpluses of funds for lending and low rates of new home construction, and the western and southwestern regions, with their shortages of funds and high rates of construction. For example, in 1963 the average effective interest rate on conventional loans was 5.3 percent in Boston and 5.7 percent in New York, compared with 6.2 percent in Denver and 6.4 percent in Los Angeles. This mismatch represented a difference of 21 percent in interest costs between the lowest- and highest-rate markets. Such disparities characterized the decade, with regional differences in mortgage rates rising to a full percentage point during the tight-credit period of 1969-70.10

2. Institutional Imbalance

The surge in short-term interest rates in 1966 and again in 1969-70 exposed the housing finance system to broad economic changes and revealed its vulnerability to interest-rate shocks. From 1965 to 1966, net savings flows to savings and loan associations plummeted from an annual rate of $8.4 billion to $3.6 billion. For some months during that period, net inflows were zero. The problem of savers withdrawing their funds from depositories, called disintermediation, became acute as savers reinvested their funds directly in higher-yielding financial instruments. In addition, with little investor interest in mortgages, the nation’s homeowners were further distanced from broader capital markets. Housing starts declined from an annual rate of more than 1.5 million units at the start of 1966 to less than 900,000 units by early fall. This downturn was the clearest and most dramatic evidence of “the vulnerability of both the savings and loan industry and the housing market to monetary stringency and rapidly rising interest rates.”11

The 1968 Report of the President’s Committee on Urban Housing (the “Kaiser Committee”) made two important observations about the adequacy of the troubled housing finance system. First, given the high level of housing demand and the acute problem of disintermediation, an overall shortage of mortgage funds was likely. Second, cyclical swings--in which periods of severe shortage of funds alternated with periods of excessive inflow--would be a continuing danger.12

Despite a sharply rising demand for housing, the combination of rising inflation and mortgage interest rates plagued policymakers’ attempts to cushion the housing market against the problems in the broader financial markets. Housing starts plummeted again as conventional lending declined from an annual rate of $18 billion in the second half of 1968 to $6 billion by the fourth quarter of 1969. 13 Despite the contraction in the conventional market, the FHA and VA markets remained strong, thanks to a vibrant secondary market facility. In 1969, Fannie Mae’s FHA and VA mortgage purchases increased to $4.2 billion, approximately double its previous purchase record set during the 1966 credit crunch. This led Congress to observe that Fannie Mae had done

an outstanding job in creating and operating a secondary market facility for FHA and VA mortgages for over 15 years--and it has been the primary support for that market during the extreme credit conditions of the past two years.14

D. Freddie Mac and Fannie Mae Create a New Secondary Market

By the spring of 1970, President Richard Nixon and Congress agreed that the housing finance system was badly in need of repair. In his Second Annual Report on National Housing Goals, President Nixon strongly endorsed legislation to create a secondary market for conventional mortgages by creating Freddie Mac and extending Fannie Mae’s secondary market powers to conventional loans. In endorsing this proposal, the President emphasized the structural problems of the housing finance system:

No component in the whole complex of housing production is more essential to the accomplishment of our purposes than an adequate, steadily growing supply of mortgage funds at reasonable interest rates . . . .

The experience of every credit squeeze in recent times has shown that, as the Nation’s money markets have traditionally worked, tight credit and rising interest rates operate to disadvantage the mortgage market both selectively and disproportionately. Housing production then slumps out of proportion to other lines of endeavor . . . . [E]conomic affairs must be better arranged so that this discriminatory disabling of housing productivity will no longer be the result of a passing imbalance in the overall economy. 15

The Senate Banking Committee endorsed much of the President’s analysis. Recognizing that the systemic weaknesses were most acute in the conventional mortgage market, the committee stated:

Traditionally, the conventional market unassisted with Federal subsidies or Federal insurance or Federal capital market borrowing has produced well over 85 percent of the housing starts. High interest rates and shortages of mortgage credit for conventional financing has placed a serious hardship on middle-income families attempting to purchase a home. The principal source of capital for this segment of the market is the savings and loan industry and the mutual savings banks. Each of these groups has had sharp drops in savings flows, due to “disintermediation” . . . . Many savings and loan associations dropped completely out of the mortgage lending business in order to keep liquid and remain solvent.16

In 1970, the investor base supporting the conventional mortgage market was much narrower than the broad-based investment in government-insured and guaranteed mortgages. Exhibit 2 shows that almost 80 percent of all conventional mortgages was held by depositories (commercial banks, savings banks and savings and loan associations); of the remaining mortgage debt, individuals who had extended credit to homeowners comprised the largest source. Eighteen percent of loans to minority borrowers, and a disproportionately high share of loans made to lower-income borrowers, were financed by individuals.17 In contrast to the conventional market, holdings of government-insured and guaranteed debt were far more evenly distributed among institutional holders. Nondepositories--such as life insurance companies, Fannie Mae and other financial institutions--held 43 percent of the debt outstanding. The broader investor base reflected the greater standardization of the FHA and VA products, their full-faith-and-credit guarantees as well as the active secondary market supported by Fannie Mae.

In Senate testimony, Preston Martin, then-Chairman of the FHLB Board, stressed the need to attract pension funds and other institutional investors to conventional home mortgage loans. Chairman Martin described how long-term bonds could be used to attract nontraditional home mortgage investors to provide indirect funding for the housing finance system.18

To extend the benefits of a secondary market to conventional mortgages, Congress chartered Freddie Mac in 1970. At the same time, Fannie Mae, which had been privately capitalized in 1968, was authorized to begin purchasing conventional mortgages. Today both institutions operate under essentially identical charters. Congress directed them to:

• Provide stability in the secondary market for residential mortgages
• Respond appropriately to the private capital market
• Provide ongoing assistance to the secondary market for residential mortgages (including mortgages financing homes for low- and moderate-income families) by increasing the liquidity and improving the distribution of mortgage investment
• Promote access to mortgage credit throughout the nation19

The dream of owning one’s home is an enduring feature of American life, but financing that dream with readily available, low-cost credit presents systemic challenges. These challenges--arising from the system’s high sensitivity to interest-rate changes and the nature of the mortgage instrument--continue to exist today. The next chapter demonstrates the extraordinary ability of Freddie Mac to meet these challenges and fulfill a public purpose.

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