paper about MBS

We are skeptics if the government was doctor

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Unformatted text preview: We are skeptics. If the government was Doctor Frankenstein, surely the GSEs were its monster. Born of a well-intentioned and economically efficient goal of creating liquidity in the secondary mortgage market, these institutions morphed into profit-taking firms that had the majority of their risks being backstopped by the government. While the majority of the government subsidies went to CEOs, shareholders, and wealthier homeowners, the costs were borne by society as a whole. As of 1970, when Fannie Mae had been recently privatized and Freddie Mac was newly created, they represented 4.4% of the mortgage market; by 1991, they captured 28.4%; by the time of the financial crisis, 41.3% with a combined $1.43 trillion mortgage portfolio and $3.50 trillion in mortgage-backed security (MBS) guarantees; and, as of August 2010, they had left the US taxpayers with a dent of close to $150 billion, with some projections anticipating that this figure will more than double in years to come, with substantial downside risk. 12 We start by describing what the GSEs do: what roles they play in the mortgage markets. We then trace the origins of Fannie Mae and Freddie Mac, what special features of these enterprises caused the financial markets to treat them specially, and what allowed them to register their staggering growth. 1.1 The Essence of the GSEs What exactly do Fannie and Freddie do? The GSEs are engaged in two somewhat related businesses: residential mortgage securitization (currently about $3.5 trillion) and residential mortgage investment (currently about $1.7 trillion). The GSEs’ securitization business operates as follows: They buy mortgages from originators (mostly fixed-rate, single-family home mortgages, although they do also buy some adjustable-rate mortgages and some multi-family mortgages); they form pools of these mortgages (so that the “law of large numbers” reduces the variability in outcomes that might arise from a single mortgage); and they issue (sell) “pass-through” mortgage-backed securities (MBS) that are formed from these pools to investors. These MBS represent claims on the interest and principal repayments that are “passed through” from the pool of mortgage borrowers to the securities investors (minus various fees). 1 Because the investors have no direct knowledge of the creditworthiness of the mortgage borrower, they need to be reassured that they will receive the promised interest and principal repayments. Both Fannie Mae and Freddie Mac provide guarantees to investors in their MBS against the risk of default by borrowers of the underlying mortgages. In return, both charge a “guarantee fee”. Although the GSE guarantee (so long as it can be honored) removes the credit risk from the securities, the MBS investor is still subject to interest-rate risk. Any long-lived fixed-rate debt instrument carries interest-rate risk: When interest rates for new securities are higher than the interest rate on an existing (but otherwise comparable) security, the value of the latter...
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We are skeptics If the government was Doctor Frankenstein...

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