2 13 the second business for the gses is mortgage

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13 The second business for the GSEs is mortgage investment. They buy and hold residential mortgages (or more often their own MBS). The funding for these investments comes overwhelmingly from issuing debt. They earn net income on the “spread”: the difference between the interest yield on the mortgages that they hold and the interest rate on the debt that they have issued. Because their debt is implicitly guaranteed by the U.S. government, GSE debt is relatively risk-insensitive. Further, the GSE shareholders do not pay a premium for these government guarantees nor bear the full cost of their failure. Hence, from the GSEs’ standpoint, the cost of issuing debt is less than the costs of issuing equity, and they have a strong incentive to try to leverage themselves as much as possible – to issue as much debt and as little equity – to the extent that their creditors and regulators will permit. 3 The timeline in the Appendix lays out the key reforms and events punctuating the evolution of U.S. housing finance policy from its inception in the 1930s all the way to the current state of affairs. There have been three somewhat distinct phases: (i) Beginnings (section 1.2) in the Depression era, which help understand how and why the federal government established a foothold in mortgage finance; (ii) Privatization of the GSEs (section 1.3) starting in the late 1960s, which paved the way for their expansion on the back of government guarantees; and, (iii) Drowning in Debt (section 1.4) starting 1992, when the GSEs were mandated to serve “mission” goals while simultaneously accorded highly favorable regulatory treatment with regard to their leverage. The end result was One Big Fat Subsidy (section 1.5) that ultimately resulted in the debacle of Fannie Mae, Freddie Mac, and U.S. housing finance. By owning these on-balance sheet mortgages, the GSEs are exposed to interest-rate risk as well as credit risk. 1.2 Beginnings The origins of Fannie Mae and Freddie Mac go back to the era of the Great Depression. The stock market crash of 1929-1933, and the failures of over 8,000 commercial banks, as well as thousands of savings and loan (S&L) institutions (which are frequently described as “thrifts”) inflicted widespread economic misery across the U.S. Among the victims of this trauma was the residential mortgage lending system. Prior to the mid 1930s, the standard mortgage loan had a five-year term, with interim interest payments and a required balloon payment for the full amount at the end of five years. The expectation was that the mortgage would be refinanced at that time. Banks and S&Ls were the primary originators and holders of mortgages, although life insurance companies also were significant holders of mortgages (especially of multi-family mortgages). The economic implosion of the
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14 early 1930s, however, meant that many lenders were unwilling to refinance, and many borrowers could not repay. Home foreclosures were widespread; and the losses on the foreclosed loans contributed to the failures of those thousands of banks and S&Ls.
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