Chapter 3

Freddie Mac Provides Substantial Public Benefits

Freddie Mac and Fannie Mae bring enormous benefits to homebuyers, the housing finance system and the general public. Today, the United States enjoys the most advanced mortgage delivery system in the world, in large part because of Freddie Mac’s and Fannie Mae’s innovations, efficiencies, deep investor bases and their continuously available supply of mortgage credit to potential homebuyers. Each year, as a result of Freddie Mac’s and Fannie Mae’s activities, American homeowners save about one-half of a percentage point in mortgage interest; these savings amount to $10 billion annually. Moreover, the general public benefits from the smooth functioning of a stable and efficient mortgage market.

A. Freddie Mac and Fannie Mae Lower Mortgage Rates

Before buying a home or refinancing a mortgage, many consumers consult the real estate section of their local newspapers to compare mortgage interest rates. A quick perusal of a mortgage-rate table reveals important information about the cost of financing a home. First, on any given day, conforming mortgage rates are similar across institutions for fixed-rate mortgages. Second, jumbo rates for fixed-rate mortgages are higher than conforming rates at all institutions. Mortgage research confirms this systematic price difference: Conforming fixed-rate mortgages cost, on average, one-quarter to one-half of a percentage point less than jumbo mortgages.1 Often this price difference is even greater; as recently as December 1995, the average jumbo-to-conforming spread had widened to 0.59 percent. For very large mortgages, so-called super-jumbos, the spread widened to more than a full percentage point.2

Another way to think about the cost of financing a home is to compare the government’s and the homebuyer’s cost of funds. A small difference between these two rates is a strong indicator of a highly efficient housing finance system. Exhibit 3 shows that in the early 1980s, mortgage rates ranged between two and three percentage points above the comparable Treasury rate. In 1987, as the secondary market began to grow dramatically, the spread declined to less than two percentage points and has ranged between one and one and a half percentage points throughout the 1990s.

Since 1987, the difference between conforming mortgage rates and Treasury yields has remained low and stable despite the retrenchment of the thrift industry, the cyclical peak in mortgage rates in 1989 (when rates rose two percentage points above the 1987 low), the credit crunch in commercial and construction lending of the early 1990s and the unprecedented 1992-93 refinance boom. 3 Had any of these upheavals occurred prior to the creation of Freddie Mac and Fannie Mae, mortgage money would have been more difficult and more expensive to obtain. In 1993, Federal Reserve Chairman Alan Greenspan confirmed that

despite a massive contraction in the thrift industry since 1988, housing credit has remained readily available and, in fact, relatively inexpensive as a result of the further exploitation of financial innovations such as mortgage-related securities.4

Over time, the housing finance system has increased its capacity to weather huge increases in mortgage demand. During the 1986 refinance boom, when single-family mortgage originations reached $500 billion for the first time, the spread between mortgage and Treasury rates widened more than one percentage point, reflecting the more limited investor base at that time. In contrast, during the 1992-93 refinance boom, mortgage originations surpassed $1 trillion for 1993 alone but the spread remained low. Thus, the unprecedented demand for mortgages was met not only with an abundant supply of funds, but also with no increase in relative cost. This strenuous test of the resiliency of the mortgage market illustrates both the magnitude of the secondary mortgage market and the stability provided by Freddie Mac and Fannie Mae.

In stark contrast to the stability of the home mortgage market supported by Freddie Mac and Fannie Mae are the contractions and cost increases in the income-property mortgage market, that is, lending for multifamily and commercial properties. Beginning in the late 1980s, the phase-in of risk-based capital requirements for thrifts and rising losses incurred by depositories, life insurance companies and other income-property investors caused the flow of funds to that market to contract. As a result, rates on these mortgages rose. The spread between income-property mortgage rates and comparable Treasuries increased by more than 75 percent between 1989 and 1992, reflecting the lessened availability of credit.5 In contrast, credit costs remained relatively low and stable in the home mortgage market because of the strong secondary market provided by Freddie Mac and Fannie Mae.

B. Freddie Mac and Fannie Mae Eliminate Regional Disparities

Prior to the creation of Freddie Mac and Fannie Mae, a homebuyer in California likely paid significantly more for a mortgage than a homebuyer in Boston. This was because the geographic and institutional imbalances in the supply and demand for funds caused regional mortgage rates to vary widely. During the 1960s and early 1970s, the difference between the highest and lowest regional mortgage rates was generally above one percentage point, rising sharply during periods of disintermediation in 1969-70 and 1973-74. Beginning in the mid-1970s, Freddie Mac and Fannie Mae, with their national scope and ability to offer investors competitive returns, gradually surmounted these geographic and institutional constraints. By the late 1980s, the regional spread had narrowed to about 0.1 percentage point, as shown in Exhibit 4.

Freddie Mac and Fannie Mae keep mortgage funds flowing to America’s homeowners regardless of economic and business cycles. Not only do they finance homeownership in economically strong areas, they have demonstrated their ability and willingness to provide mortgage money during regional downturns. Although some financial institutions restrict their activity in distressed regions, Freddie Mac and Fannie Mae continue to purchase mortgages that meet their underwriting guidelines.

For example, when plummeting oil prices caused a recession in the oil-producing states in the 1980s, Freddie Mac and Fannie Mae did not back out, as did some financial institutions. In fact, Freddie Mac’s relative purchases of newly originated loans increased in Texas in 1987 despite a 10-percent decline in Texas house prices and a state unemployment rate of 8.4 percent.6 Likewise, when the New York economy began to weaken after 1987, and California’s economy weakened after 1989, Freddie Mac’s relative purchase activity in each state increased. Exhibit 5 shows these trends for California, New York and Texas, depicting the stress in the housing market by the annual rate of change in house prices and Freddie Mac’s relative activity by the purchase ratio.7

In 1989, Congress noted the important role played by Freddie Mac and Fannie Mae in providing stability to the nation’s mortgage markets:

The continuous presence of the FHLMC [Freddie Mac] and FNMA [Fannie Mae] in the secondary market in bad as well as good economic times provides assurances of a dependable and substantial funding source for home mortgages. 8

C. Benefits of Freddie Mac and Fannie Mae Are Widely Distributed

A wide range of neighborhoods and households have benefited from the conforming market’s lower costs and continuous access to mortgage funds. Wherever conforming mortgages are originated, Freddie Mac stands ready to buy them. In 1995, for example, 39 percent of Freddie Mac purchases financed 375,000 homes for low- and moderate-income families. Borrower incomes for Freddie Mac purchases ranged between $10,000 and $150,000 in 1995, and half of the families whose mortgages were purchased by Freddie Mac earned less than $53,000. Fifteen percent of Freddie Mac’s purchases were mortgages made to minority borrowers--the same as the minority share of owner-occupied households.9 Freddie Mac also purchased mortgages from low-, moderate- and middle-income census tracts in about the same proportion as primary market originations. The similarity between Freddie Mac’s purchases and the loans originated in the conventional market in terms of borrower and neighborhood incomes is illustrated in Exhibit 6.

Freddie Mac’s purchases also serve borrowers with a wide range of financing needs, from those making 5 percent down payments to those making 40 percent or larger down payments, as shown in Exhibit 7. Thus, the benefits that result from Freddie Mac’s activities are enjoyed by a diverse group of American homebuyers.

D. Mortgage Innovation Benefits Homebuyers

In order to purchase mortgages efficiently from a wide array of lenders across the country, Freddie Mac and Fannie Mae work together to bring standardization to the mortgage market. Prior to the development of the secondary market for conventional mortgages, lenders applied their own underwriting and appraisal standards to assess the quality of each mortgage application. Because each mortgage had to be reevaluated by each prospective purchaser, many investors were deterred from investing in housing finance.

Congress understood that greater uniformity in underwriting, appraisal and legal documentation was necessary for the successful development of a national secondary market for conventional mortgages. Accordingly, in 1970 Congress charged Fannie Mae and the newly formed Freddie Mac with performing the groundwork necessary to encourage the development of this market. 10 In 1971, Senator John Sparkman, Chairman of the Senate Banking Committee, envisioned that:

The development of these standard mortgage documents could be an historic event in home finance in America. If, as is expected, the development of a standard form for the use of the two secondary market corporations will result in its being universally adopted for all conventional mortgage transactions throughout the 50 States, we can proudly claim this as one of the greatest breakthroughs in home finance since the start of the FHA. 11

In establishing a secondary market for conventional mortgages, Freddie Mac and Fannie Mae led efforts to create uniform mortgage documentation, and each company developed national underwriting guidelines. The initial costs of establishing and obtaining acceptance for a system of standards are high, but the benefits are realized by every subsequent borrower in terms of reduced time and cost of obtaining a mortgage and greater ability to comparison-shop among lenders. Not only do individual borrowers benefit from the simplification of mortgage processing, but the entire system becomes more efficient through economies of scale. In this way, Freddie Mac and Fannie Mae have driven down the costs of financing homeownership.

Standardization of mortgage lending is an ongoing process. Freddie Mac and Fannie Mae regularly review and revise loan documentation standards.12 If these efforts were to cease, document uniformity would gradually decrease, eroding the fundamental viability of a national secondary mortgage market. Moreover, Freddie Mac in 1991 established a working group of industry and community organizations to provide ongoing review of our underwriting guidelines to remove remaining inefficiencies from the process, reduce borrower costs and expand the reach of the secondary market to include more borrowers and neighborhoods. This and other innovations introduced by Freddie Mac since our creation are highlighted in Exhibit 8. Homeowners are the beneficiaries of this constant improvement in the way mortgages are delivered and financed.

The application of computer technology to mortgage underwriting represents a significant innovation that will continue to shape the housing finance industry in the next century. After considerable study and investment, Freddie Mac made an automated underwriting service commercially available in 1995 to improve lending decisions, reduce costs and expand homeownership opportunities. The automation of what has been a cumbersome, paper-intensive process is lowering costs and enabling lenders to process more loans in less time. In addition, automated underwriting is helping increase access to the nation’s mortgage markets by taking uncertainties out of the underwriting process. While technology’s impact on credit quality will become apparent over the next few years, its impact on the loan origination process registered immediately. Today, many loans can be approved in minutes--not weeks--thereby reducing the minimum time between application and closing from 45 days in 1990 to just 5 days in 1995.13

Operating a large nationwide secondary market enables Freddie Mac and Fannie Mae to devote considerable resources to research and development and to continue to bring path-breaking innovations to the mortgage market. Freddie Mac and Fannie Mae make large up-front investments because they expect to realize the benefits over a large expected future volume of mortgage purchases.

E. Securities Innovation Benefits Homebuyers

A champion of innovation in mortgage lending, Freddie Mac also has broken new ground in the issuance of mortgage-backed securities. In 1970, Freddie Mac pioneered the first mortgage passthrough security backed by conventional loans, the Freddie Mac Mortgage Participation Certificate. Building on the wide success of this single-class security, Freddie Mac in 1983 issued the first multiclass security, designed to meet diverse investor needs and attract new sources of investment to housing finance. Freddie Mac is a leader in providing information to investors about the mortgages underlying the securities. Increased information makes Freddie Mac mortgage-backed securities more attractive to investors, ultimately reducing mortgage rates for homebuyers.

These and other innovations introduced over time by Freddie Mac have revolutionized the way housing is financed in America, as evidenced by the growth in mortgage-backed securities outstanding. Exhibit 9 shows that by year-end 1995, residential mortgage-backed securities outstanding totaled $1.8 trillion, nearly one-half of the size of the U.S. Treasury market.

Homebuyers are the ultimate beneficiaries of a vast and liquid mortgage securities market: Low-cost mortgages are available whenever borrowers need them. In addition, the prevalence of uniform mortgage securities benefits consumers by enabling them to lock in an interest rate when applying for a mortgage, well in advance of loan settlement. Lenders are willing to provide such lock-ins because Freddie Mac and Fannie Mae securities are sold on a "To Be Announced," or TBA, basis. This means that the buyer and seller commit today to a purchase and sale of securities that will not actually occur until up to 90 days later. This practice allows mortgage originators to hedge effectively against interest-rate risk by entering into securities sales contracts at the same time they extend mortgage commitments to borrowers. Thus, standardization of mortgages and mortgage-backed securities, which enables the securities to trade on a TBA basis, is fundamental to the consumer’s ability to lock in a mortgage rate while waiting for a home purchase to close.

Freddie Mac and Fannie Mae innovations in both mortgage lending and security issuance have broadened the investor base for mortgages, ensuring a stable supply of low-cost mortgages for homebuyers.

F. Attracting a Broad Investor Group Benefits Homebuyers

Before the development of a vibrant secondary market, the illiquidity of mortgage investments discouraged nontraditional investors, thereby restricting the access of mortgage borrowers to capital markets. As a result of ongoing standardization and innovation and the strength of their corporate guarantees, Freddie Mac and Fannie Mae mortgage-backed securities have become extremely liquid instruments. This has not only expanded investment by some existing participants in the housing finance system, it has attracted new types of investors as well. In 1980, residential mortgage debt outstanding totaled about $1 trillion, more than half of which was held by thrifts. 14 Today, about $4 trillion in mortgages and mortgage securities are held by a wide range of institutions, including commercial banks, life insurance companies and pension funds, as shown in Exhibit 10. Furthermore, approximately 5 percent of residential mortgage debt is held by foreign investors, primarily in the form of Freddie Mac and Fannie Mae securities.

Mortgage securities are popular investments because they facilitate portfolio management. For example, depositories hold both whole loans and mortgage-backed securities in their portfolios. Depositories can immediately sell mortgage-backed securities, which are highly liquid, or use securities to collateralize borrowings. In contrast, whole loans generally cannot be sold as quickly and require a larger discount when serving as collateral. In 1995, 32 percent of residential mortgage assets held by depositories were held as securities.15

The rise of the multiclass mortgage market has also attracted new investors to housing finance. By customizing mortgage cash flows to meet the investment objectives of particular investors, Freddie Mac and Fannie Mae further broaden the investor base. While passthrough securities appeal to mortgage investors interested in medium- to long-term investments, multiclass securities allow investors to choose among a much broader range of investment timelines.

A highly diversified investor base makes the system more resilient. When market or regulatory changes reduce the role of one investor group, such as thrift institutions, or dramatically increase the amount of credit needed by homebuyers, funds remain available to support loan demand, thus maintaining a stable supply of funds.

G. The U.S. Housing Finance System Is the Most Advanced in the World

With Freddie Mac and Fannie Mae acting as the linchpins of the housing finance system, American consumers can rely on a stable supply of low-cost mortgages. Not only does the U.S. housing finance system support a homeownership rate of 65 percent in the most populous, ethnically diverse industrial nation, it does so with a high degree of stability. Recent comparative studies illustrate the ingenuity of the U.S. model.

One study of the housing finance systems in different countries considered the degree of stability and several dimensions of efficiency, including pricing, operating costs, risk management and level of subsidies. The high level of efficiency in the U.S. market was attributed to the smooth functioning of a large secondary mortgage market and virtual integration of the housing finance and global capital markets.16

Housing finance in the United Kingdom also has achieved a high degree of efficiency, but lacks the stability of the American system.17 In fact, a "U.K.-style housing recession," in which real house prices declined by as much as 8 percent nationally in both 1990 and 1991, is unlikely in the United States because of the institutional stabilization provided by Freddie Mac and Fannie Mae. 18 In contrast, real house prices in the United States declined, on average, only 2 percent annually during the 1990-91 recession.19

Much of this stabilizing influence stems from the development of the secondary market that has occurred under the leadership of Freddie Mac and Fannie Mae. About one-half of single-family mortgage debt outstanding has been securitized in the United States.20 This achievement broadens the potential pool of investors in these assets and, consequently, provides more competitive mortgage rates for homebuyers. Securitization by Freddie Mac and Fannie Mae also facilitates national diversification, reducing risk overall. At the same time, securitization disburses interest-rate risk to investors according to the needs of their portfolios.

During 1992-94, the securitization rate in the United States was 60 percent, far exceeding the level in other nations, as shown in Exhibit 11. Securitization rates in other countries do not exceed 4 percent. The U.K. reportedly is discussing the creation of secondary mortgage market entities such as Freddie Mac and Fannie Mae to increase the liquidity--and efficiency--of their budding mortgage securities markets. 21 Other countries, including Israel, Mexico, Argentina and South Africa, are considering setting up their own secondary markets.

H. Freddie Mac and Fannie Mae Contribute to Stable Markets

In directing Freddie Mac and Fannie Mae to create a secondary market in conventional mortgages, Congress sought to bring greater stability to the nation’s housing and mortgage markets. Freddie Mac and Fannie Mae have succeeded in reducing mortgage rates and maintaining a consistent, reliable flow of mortgage funds despite ups and downs in the business cycle and the retrenchment of the thrift industry. Over time, their financing activities have helped create a robust system that is less susceptible to market disruptions. The decline in regional differences in mortgage rates, the decline in mortgage-to-Treasury spreads and the decline in the relative variability of mortgage rates demonstrate that the housing finance system is much more stable today than it was before the development of the secondary market for conventional loans. In ensuring the availability of credit throughout the business cycle, the integration of the home mortgage market with the broader capital markets has lessened the swings in housing construction in recent years. By reducing the severity of business-cycle troughs, the vibrant secondary market has contributed to greater economic stability.22 As Federal Reserve Chairman Alan Greenspan recently noted,

because housing construction is highly cyclical and particularly sensitive to credit conditions, its importance in the economy . . .[is] greater than its typical 4 percent share of gross domestic product would suggest.23

Homebuyers, the housing finance system and the general public have benefited in many ways from the congressional chartering of Freddie Mac and Fannie Mae. Not only do borrowers have access to a continual supply of low-cost mortgage funds, the public benefits as stable housing markets contribute to a stable economy. The next chapter describes how these benefits are realized without any cost and essentially at no risk to American taxpayers.

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

23.