The originator can then decide whether to hold the

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arrangement, whereby the GSE will swap the securities for the mortgages from the originator. The originator can then decide whether to hold the securities, or to sell them in the secondary market. Similarly, when the GSE wants to hold mortgages in its portfolio, it most often buys back its own MBS from the secondary market; once the GSE posses its own MBS, in essence it just owns the underlying mortgages. 2 There will be some normal, background level of prepayment that is driven by households who choose to move because of new job offers in a different city, because of changes in family size, or because of the households’ changed economic circumstances. But, on top of this background rate, the ease of prepayment means that when interest rates decrease, mortgage borrowers will often refinance their mortgage at the lower rates, or households find that changed circumstances make selling their existing house (and repaying the mortgage) and buying another house more attractive – which means that the investor will not get the capital gain but instead will simply get the principal back, but at a time when reinvestment possibilities are less attractive (because of the lower prevailing interest rates). In essence, prepayments speed up just when investors wish that they would slow down. Conversely, when interest rates rise, prepayments for refinancing will disappear, and even normal prepayments will slow down, and the investor experiences an even larger loss of value, since this lower-interest security now has a longer expected life. In essence, prepayments slow down just when investors wish that they would speed up. 3 In other words, the famous Modigliani and Miller theorem of corporate finance that a firm’s cost of capital should be invariant to its mix of debt and equity is clearly violated in the case of the GSEs because the more debt that they have relative to equity, the more that they can exploit the value of government guarantees. (Modigliani, Franco, and Merton Miller, 1958 "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review 48 (3): 261–297.) 4 The savings and loan industry had largely avoided dealing with Fannie Mae; the S&L industry saw Fannie Mae as largely a vehicle to which mortgage companies (which came to be known as “mortgage banks”, even though they weren’t depository institutions) could sell mortgages that they had originated. The S&L industry lobbied Congress for a secondary mortgage institution that would be “theirs”. In 1970 the Congress complied and created a charter for the Federal Home Loan Mortgage Corporation (FHLMC, which subsequently acquired the nickname “Freddie Mac”). 5 Ralph Nader, How Fannie and Freddie Influence the political process, Chapter 6 of Peter Wallison, ed., 2001, Serving Two Masters, Yet Out of Control: Fannie Mae and Freddie Mac , AEI Press.
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Christopher Reinemann
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