Celebrating the Anniversary of Revolutionary Concepts

Unemployment at one of the highest levels in years. War in Iraq. Gasoline prices high. Tax reform bill before Congress. And the prospect of large federal budget deficits. While these may sound like recent headlines, these were also the stories in the news 20 years ago. In May 1983, the nation's unemployment rate stood at 10.1 percent, Iraq's invasion of Iran was stalemated, and gas prices were the equivalent of $2.31 per gallon in today's prices. Flat tax proposals were in vogue on Capitol Hill, and the federal budget deficit stood at $208 billion (constant dollars) for fiscal year 1983.

In the midst of this, Freddie Mac introduced two significant innovations to the mortgage industry that are largely taken for granted today. The two revolutionary concepts were daily pricing and multiclass mortgage-backed securities.

Daily Loan Pricing: March 15, 1983

Freddie Mac has had a long history of bringing innovation and technology to America's housing finance system. In 1971, Freddie Mac issued the first mortgage-backed security backed by conventional loans, and then worked with others in the industry to create uniform loan documents to transform mortgage loans into the commodity that they have since become. Throughout the early development of the secondary mortgage market in the United States, Freddie Mac posted a single price per week for each loan product that we purchased for cash. The "price" was represented as a "net yield" to Freddie Mac for loans delivered within a given time period, such as 30 days. The yields were "net" of the servicing fee retained by loan servicers.

In contrast, Freddie Mac issued more (mortgage-backed securities) in March of this year, $59 billion, than during that initial decade.

In the early 1970s, there were few reliable benchmarks for valuing mortgages on a frequent basis. Default and prepayment models were unsophisticated compared to today's models. Nascent trading volume in Freddie Mac and Ginnie Mae mortgage-backed securities had not developed sufficiently to provide adequate valuation data for real-time pricing. By the end of 1980, Freddie Mac's cumulative issuance of mortgage-backed securities had totaled $22 billion. In contrast, Freddie Mac issued more in March of this year, $59 billion, than during that initial decade.

Weekly mortgage pricing data were unavailable when Freddie Mac began. We began the weekly Primary Mortgage Market Survey in 1971 to overcome this information vacuum and provide pricing data for loans purchased through our cash window. Weekly pricing operates well during periods of capital market stability. The acceleration of inflation during the 1970s and the change in Federal Reserve operating procedures in 1979 (from federal funds to money-supply growth targeting) led to high and volatile interest rates, amplifying the need for more frequent repricing of mortgage loans. The financial problems of savings and loan institutions and the introduction of a loan-for-security "swap" program by Freddie Mac led to a blossoming of securities issuances deepening the secondary market and enabling capital market prices to serve as a reliable benchmark for cash window pricing.

Since Freddie Mac began daily pricing, the highest recorded net yield on 30-year, fixed- rate mortgages was 15.09 percent on May 30, 1984. The lowest yield was recorded earlier this year, on March 10 (just five days before the 30-year anniversary), at a net yield of 5.12 percent. That same week, the PMMS marked its lowest rate ever at 5.61 percent for 30-year, fixed-rate mortgages.

The start of daily secondary market pricing of mortgage loans was a significant step in the evolution of America's housing finance system. It helped to integrate the mortgage market into the broader capital markets, assuring a steady stream of capital flowing into housing, and keeping mortgage costs (relative to other financial assets, such as Treasury securities) as low and stable as possible.

First Multiclass Security: June 15, 1983

Freddie Mac revolutionized modern-day housing finance by issuing the first multiclass mortgage-backed security in June 1983. Dubbed the Collateralized Mortgage Obligation (CMO), it was the precursor to today's Real Estate Mortgage Investment Conduit (REMIC). To ensure liquidity for the various security classes, also known as "tranches," the initial Freddie Mac CMO had a large unpaid principal balance for its time — $1.0 billion, or about $1.9 billion in 2003 dollars. Since then, REMIC issuance has grown and become a dominant security form. During 2002, $539 billion in REMICs were issued in the capital markets. The exhibit shows the growth in REMIC issuance since 1985.

Did you know…..? "Tranche" is French for "slice." A multiclass security carves up the aggregate cash flow on the mortgage pool and redirects various slices to each security class, or "tranche."

An important innovation of the multiclass structure was the ability to tailor cash flows for a particular tranche to suit the needs of particular investors, thereby deepening the investor base. By directing all, part or none of the principal received on a mortgage pool to a tranche for a given period of time, the expected life of the tranche could be made very short or very long, for investors who preferred either short or long-lived mortgage assets.

Innovation and technological development is an ongoing process. It won't be long before we'll look back on the 20th anniversary of Freddie Mac innovations like Loan Prospector®, the first automated mortgage underwriting system; the first global debt funding calendar; and countless others.