History of Agency Mortgage Backed Securities

During the Great Recession the housing market essentially collapsed and the Roosevelt Administration wanted to figure out how to save this industry. At this point in history there was essentially no secondary market in the area of mortgages, which is where Fannie Mae, and later Freddie Mac, comes in. Fannie Mae was chartered as a government sponsored enterprise and was immediately thought to hold implicit backing by the government. The goal of Fannie was to used its' GSE standing in order to borrow cheaply and buy mortgages from bank balance sheets, thereby freeing up capital so banks could go and originate new mortgages. 

Fannie Mae

Fannie Mae was created in the late 1930’s in order to help stabilize the crumbling housing market in the U.S. This organization had an implicit backing by the Federal government that allowed them to borrow almost as easily and cheaply as the Federal government. “Evidence suggests that financial markets believe that the federal government would come to the rescue of Fannie Mae and Freddie Mac (and hence their creditors) in the event of financial difficulties” (Frame and White pg. 164).  This same paper later cited evidence that because of this implicit backing they have a 35-40 basis point funding advantage. They created the concept of a conforming loan by implementing basic standards for mortgages to meet and banks would structure the mortgages accordingly. “Several econometric studies have estimated this effect, and most found the interest rate differential to be about 20-25 basis points” (Frame and White pg. 164). Studies such as these provide empirical evidence for the claim that interest rates  were distorted to a degree than otherwise would’ve been without government intervention.  As the GSE’s became constrained they began creating special purpose vehicles in order to pool the mortgages they had bought and sell tranches, creating more liquidity to go and purchase more mortgages.

Ultimately any conforming loan, bond or mortgage backed security that was created by the GSE’s served the purpose of trying to overcome the asymmetric information that was prevalent in the mortgage industry before this conception. Market participants had found it difficult to gain specific information on particular mortgages before the GSE’s and were thus reluctant to pursue them in any grand scale. The GSE’s “solved” this problem by pooling the mortgages and diversifying the risk among investors, ultimately offering explicit insurance on them. This proved to be a façade at best. These new tactics did not solve the information problem; they were concealed behind government manipulation and implicit backing. This story revolves around the premise that the institutional regulations were such that maximizing homeownership was the goal and the GSE’s were the tools the government used. Friedrich Hayek believed the problem of government policy was not what we knew it would affect, but the unintended consequences of government action (Hayek “The Fatal Conceit”). The increase in liquidity created by the GSE’s created an artificial supply of money into the mortgage market that made it easier for homebuyers to purchase a home. This created a feedback loop where new money was being pumped into the housing sector and caused prices to rise faster than they otherwise would have.