Mortgage agencies

Homeownership is an American staple that the US government incentivizes. Real estate plays a significant role in the economy, and the government prefers to create a friendly real estate market environment. That way, Americans can freely buy and sell their homes and reasonably expect home values to increase over time.

The government incentivizes home ownership through three federal agencies: Ginnie Mae, Fannie Mae, and Freddie Mac. These agencies work with banks and lending institutions across the United States and purchase their mortgages. Let’s work through an example to understand how this benefits the real estate market.

Assume you decide to buy a house. You’ll need a mortgage loan unless you can pay for the home in cash. Many real estate purchasers work with local banks and lending institutions to borrow the necessary funds. After a lengthy application process, your local bank lends you money to buy the property. Soon after you move in, you make mortgage payments to your local bank to pay back the borrowed funds. Then, you receive a letter from Fannie Mae stating they bought your mortgage, and you will now make your mortgage payments to them. The loan remains the same, except for the institution receiving your payments.

When agencies buy mortgages from banks, the banks receive significant sums of money they can now lend out as new mortgages. The local bank that initially lent you money can now lend the same amount to another customer. This system makes borrowing money for home purchases more accessible, resulting in lower interest rates for everyone. To finance their activities, the agencies sell securities. Specifically, they sell mortgage-backed securities (MBS). The agencies typically issue Pass-Through Certificates (PTCs), a specific type of MBS. PTCs work exactly how they sound by passing through mortgage payments to their investors.

To better understand this concept, let’s work through another example. Freddie Mac wants to raise money to buy mortgages from banks across the United States. To do so, they issue PTCs, which typically have a denomination of $25,000 (but can be sold in as small as $1,000 denominations). Freddie Mac uses the raised capital to purchase mortgages from several different banks, then places them in a portfolio.

Each homeowner with a mortgage purchased by Freddie Mac starts making monthly payments to Freddie Mac. The agency receives monthly allotments of interest and principal over the life of each mortgage. Mortgage payments consist of part interest and part principal. At the beginning of a mortgage, a homeowner’s payment is mostly interest. Towards the end of a mortgage, the principal represents the largest portion of the payment.

Freddie Mac now receives mortgage payments from the homeowners. The agency charges a small amount to pay for operational expenses. The rest passes through to the owners of the MBSs. MBS owners receive monthly payments of varying interest and principal. Essentially, investors act like the bank that lent the homeowners their money and now collects their mortgage payments.

MBSs are subject to two unique risks: prepayment and extension risk. Investors who purchase standard, non-mortgage-related bonds know how long their bond will last. For example, a bond with a 20-year maturity cannot last more or less than 20 years (except for callable bonds). Investors who purchase an MBS will not know the exact maturity. While most mortgages are 30-year mortgages, most do not last 30 years. Many homeowners pay off their mortgages early, refinance, or sell their homes and pay off their mortgage. In these circumstances, the mortgage ends when the homeowner pays back the outstanding principal.

MBS investors do not know how long their investments will last. If interest rates fall, many homeowners refinance and pay off their old mortgages early. In this environment, these investments will likely end sooner than expected. Investors aren’t too happy about it, either. Their MBS had a higher yield than what the current market offers (lower interest rates) but is now ending earlier than expected. This is prepayment risk.

It can also go the other way if interest rates rise. When this occurs, homeowners generally keep their mortgages longer and avoid refinancing. Investors are stuck with lower-yielding MBSs that last longer due to fewer homeowners paying off their mortgages. This is extension risk.

Ginnie Mae, officially known as the Government National Mortgage Association (GNMA), only purchases VA (Veterans Affairs) or FHA (Federal Housing Administration) insured loans. Another part of the federal government insures these loans. They are only available to specific homeowners (e.g., low-income purchasers and veterans).

Due in some part to the minimal risk involved, the US Government directly backs Ginnie Mae securities. Remember, all other agencies have indirect backing. Ginnie Mae securities are virtually default-risk free, like 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), only purchases conventional mortgages.

With a significant amount of non-insured mortgages handled by these two agencies, Fannie Mae and Freddie Mac are considered riskier than Ginnie Mae. Plus, they only maintain indirect backing from the US Government. Interestingly, Fannie and Freddie are publicly traded companies. Although the US Government founded these organizations, they are owned by their stockholders.

Interest from US 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 primary reason for the difference - mortgage interest is tax-deductible to the homeowners who make their monthly payments. The IRS won’t allow tax benefits for those who make the mortgage payments and those who receive those payments!