Homeownership is a major part of the U.S. economy, and the federal government encourages it. A stable, active real estate market makes it easier for people to buy and sell homes and supports the expectation that home values can rise over time.
The government supports homeownership through three federal agencies: Ginnie Mae, Fannie Mae, and Freddie Mac. These agencies work with banks and other lenders across the United States by purchasing mortgages from them. An example makes the benefit to the real estate market easier to see.
Assume you decide to buy a house. Unless you can pay cash, you’ll need a mortgage loan. Many buyers borrow from a local bank or lending institution. After the application process, your local bank lends you the money to buy the property. Once you move in, you make monthly mortgage payments to that bank.
Later, you might receive a letter from Fannie Mae stating that it bought your mortgage and that you’ll now send your payments to them (or to a servicer acting on their behalf). The loan terms don’t change - only the institution receiving your payments changes.
When an agency buys mortgages from banks, the banks receive large sums of cash that they can lend out again as new mortgages. In other words, the local bank that originally lent you money can now lend that same amount to another customer. This makes mortgage credit more available and tends to push interest rates lower.
To finance these purchases, the agencies sell securities - specifically, mortgage-backed securities (MBS). A common structure is the Pass-Through Certificate (PTC), which does what its name suggests: it passes through mortgage payments to investors.
To see how this works, consider another example. Freddie Mac wants to raise money to buy mortgages from banks across the United States. To do that, it issues PTCs, which typically have a denomination of $25,000 (but can be sold in as small as $1,000 denominations). Freddie Mac uses the money raised to purchase mortgages from several different banks and then places those mortgages into a portfolio.
Each homeowner whose mortgage was purchased by Freddie Mac makes monthly payments to Freddie Mac. Over the life of each mortgage, Freddie Mac receives monthly amounts of interest and principal.
Mortgage payments include both interest and principal:
Freddie Mac collects these mortgage payments, keeps a small amount to cover operating expenses, and passes the rest through to the MBS investors. As a result, MBS owners receive monthly payments of varying interest and principal. In effect, investors take the role of the original lender: they provided the funds (through the MBS) and now receive the homeowners’ payments.
MBSs are subject to two unique risks: prepayment risk and extension risk. With most standard (non-mortgage-related) bonds, you know the maturity date in advance. For example, a bond with a 20-year maturity cannot last more or less than 20 years (except for callable bonds).
With an MBS, investors don’t know the exact maturity. Even though many mortgages are written as 30-year mortgages, many don’t last 30 years. Homeowners may pay off their mortgages early by refinancing, selling the home, or making extra payments. In any of these cases, the mortgage ends when the homeowner repays the remaining principal.
Because of this, MBS investors don’t know how long their investment will last:
If interest rates fall, many homeowners refinance and pay off their old mortgages early. The MBS is likely to end sooner than expected. Investors dislike this because the MBS may have offered a higher yield than the current market (now at lower interest rates), but it ends earlier than expected. This is prepayment risk.
If interest rates rise, homeowners tend to keep their existing mortgages longer and avoid refinancing. Investors are left holding lower-yielding MBSs for longer because fewer homeowners pay off their mortgages early. This is extension risk.
Mortgage-backed securities are a type of asset-backed security. Asset-backed securities funnel payments from an underlying asset (like a mortgage) to their investors.
Imagine a similar product, but replace mortgages with auto loans, credit card balances, or student loans. Investors receive interest payments from these instruments in the same way mortgage-backed securities provide income.
As with mortgage-backed securities, asset-backed securities do not have a fixed maturity. The investment ends when all loans are paid off, which can happen at any time. Economic factors (like fluctuating interest rates) affect the speed of repayment. Still, the maturity of asset-backed securities cannot be known when an investment is purchased initially. ::::::
Ginnie Mae, officially known as the Government National Mortgage Association (GNMA), guarantees VA (Veterans Affairs) or FHA (Federal Housing Administration) insured loans. These loans are available only to certain borrowers (for example, low-income purchasers and veterans).
Because the risk is minimal, the U.S. government directly backs Ginnie Mae securities. Remember, the other agencies have indirect backing. Ginnie Mae securities are considered virtually free of default risk, similar to Treasury securities.
Fannie Mae, officially known as the Federal National Mortgage Association (FNMA), purchases insured (VA and FHA) and conventional (non-insured) mortgages. Freddie Mac, officially known as the Federal Home Loan Mortgage Corporation (FHLMC), purchases only conventional mortgages.
Because Fannie Mae and Freddie Mac handle a large volume of non-insured mortgages, they’re considered riskier than Ginnie Mae. They also have only indirect backing from the U.S. government. Fannie Mae and Freddie Mac are publicly traded companies. Although the U.S. government founded these organizations, they are owned by their stockholders.
Interest from U.S. government securities is typically subject to federal taxation but exempt from state and local taxes. Interest from agency-created MBSs is fully taxable (subject to federal, state, and local taxation). The main reason for this difference is that mortgage interest is tax-deductible to the homeowners making the monthly payments. The IRS won’t allow tax benefits for both the people making the mortgage payments and the people receiving those payments.
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