Public Policy and Secondary Mortgage Markets

1
Public Policy and Secondary Mortgage Markets

• By Robert Van Order
• Freddie Mac
• March 2003

2
Introduction

• The major contribution of the secondary market in
  the United States is that it has opened the
  mortgage market to long term lending.
• While most of the institutions that participate
  in the secondary market are privately owned, the
  system receives considerable government support.
• A key policy question is the desirability and
  extent of support. Focus is on Fannie Mae and
  Freddie Mac in the U.S.

3
Themes

• Unbundling
• Principal/agent problems
• From a public policy perspective the secondary
  market is just a vehicle for allocating capital.
  It should be judged on how well it does that.
• What U.S. experience has shown, both before and
  after the advent of secondary markets, is that
  with the right legal and regulatory framework and
  a reasonably stable macro-economy, you can make
  money in single family mortgages.

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History and Economics

• GSEs
• Fannie Mae
• Ginnie Mae
• Freddie Mac
• Pooling
• CMOs
• Debt Funding
• Unbundling and Agency Problems
• Credit Risk and Equity
• Interest Rate Risk
• Capital and Risk

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Government Role

• Principal/agent issues are likely to be more
  formidable in developing markets. This makes
  secondary markets more difficult to operate, and
  it puts more stress on the legal structure.
• If you want people to have good housing, you have
  to be able to take it away from them.

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Five important issues

• Risk Allocation. Getting capital to flow to its
  most valuable use by balancing risk and return.
  If risks are not managed by those who ultimately
  bear them, then this balance is not likely to be
  well done.
• Ownership. A GSE structure with private ownership
  and value-maximizing incentives is likely to be a
  more efficient long run way of providing
  guarantees and supporting a mortgage market than
  is a state-owned corporation.

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• Subsidy content The subsidy content of GSEs
  should be kept in line with subsidies to other
  mortgage market institutions (e.g., banks).
• Risk. Safety and soundness as a way of keeping
  subsidies under control and limiting risk-taking,
  so as to achieve the right risk-return balance in
  allocating capital.
• Participation. Restricting institutional
  participation vs. open charters.

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Some Important Lessons

• It is the function, connecting mortgage and
  capital markets, especially the long term market,
  rather than institutional (e.g., charter)
  details, that is important, and there are several
  different ways of getting the function done.
• While working on the back end, e.g., doing some
  deals and getting some mortgages off banks
  balance sheets may be a good idea, it is the
  getting the front end right that is the sine
  qua non of developing good mortgage markets.

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• Controlling safety and soundness requires serious
  consideration of risk-based capital, not like the
  old accounting capital ratios, but really
  risk-based standards.
• An important component of safety and soundness is
  not taking interest rate risk.
• There is likely to be a conflict between the
  private ownership of GSEs and demands for social
  housing.

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• Diversification and insurance. Fannie and
  Freddie have benefited because they have been
  able to spread their risks across a variety of
  local economies, which are often larger than
  those of some countries. Insurance also involves
  principal/agent problems because third party
  insurers risk being selected against, and
  insurance does not make risk go away, it simply
  relocates it.

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Ideal Structures?

• Banks and Bonds
• SPVs and Securitization
• Both structures do much the same thing
• They put the government at the end of the queue.
• They allow the institution that originates and
  manages the loans to take on the credit risk.
• Neither requires the government guaranteeing
  individual loans.
• Both allow risk to be controlled by capital and
  stress tests.
• Banks and Bonds has some advantages in emerging
  markets.