Several market experts discussed these topics during the Mortgage Bankers Association (MBA) Secondary and Capital Markets Conference and Expo 2023 in New York.
The buyers’ side
Steven Abrahams, a senior managing director at Amherst Pierpont Securities, a broker-dealer owned by Santander, said that before the Global Financial Crisis, the market was dominated by investment portfolios looking for the risk and return of MBS assets.
However, after the crisis, the Fed entered the MBS market, and new regulations encouraged banks to hold quality liquid assets, including MBS.
“What we’re looking at now is the initial phase of exit of those two policy investors and the return of the market to marginal pricing by portfolios that are in the game basically to make money,” Abrahams explained. “That’s the easiest way to think about why spreads have widened the way they have.”
Byron Boston, CEO and co-chief investment officer at Dynex Capital, Inc., said that “levered returns are very attractive today” and there’s a “huge demand for income,” which will keep MBS attractive to money managers.
“A 30-year fixed rate mortgage is an unusual beast,” Boston said. “But because our government is involved with it, all of us as American citizens have the pleasure of having it.”
The sellers’ side
As affordability is still an issue, originations will decline and affect the supply of MBS, panelists said. The MBA estimates that volumes will decline from the $4 trillion level in 2020 and 2021 to less than $1.8 trillion this year.
According to Jeana Curro, head of agency MBS research at Bank of America, mortgage rates are still very high and people that have walked into very low mortgage rates during the pandemic “are kind of stuck in their homes.”
“We’re forecasting about $268 billion a year in [MBS] net issuance. Last year, it was about $535 billion,” Curro said.
The secondary market experts have not seen any disruptions caused by the sale of MBS securities once held by banks that collapsed.
The Federal Deposit Insurance Corporation(FDIC) decided in early April to sell the $114 billion in MBS it retained after seizing control of failed regional banks Signature Bank and Silicon Valley Bank (SVB). BlackRock Financial Market Advisory has led the sales process.
Curro said that BlackRock has been smart in its executing a strategy that keep the size of offerings low and consistent while also actively communicating with the market.
“The bigger disruption that you want to be concerned about, beyond the mortgage market, is that we’re doing this within a global system that has an enormous amount of risk attached to it,” Boston said. “If you have another risk event that takes place on top of this – while we’re trying to clear the market of the banking problem – now we have a bigger issue.”
Boston added: “These are really good assets. It’s just a matter of what price ultimately will come about.”
Regarding the Fed’s MBS portfolio, Curro said that “We think what’s more likely to happen, and this is the Bank of America economist’s view, is that by the end of the first quarter of 2024, QT [quantitative tightening] is going to end and at that point, what they’re likely to do is take the mortgage pay downs and reinvest them into Treasuries.”
This article will explain the Big Short and the 2008 subprime mortgage collapse in simple terms.
This post is a little longer than usual–maybe give yourself 20 minutes to sift through it. But I promise you’ll leave feeling like you can tranche (that’s a verb, right?!) the whole financial system!
Key Players
First, I want to introduce the players in the financial crisis, as they might not make sense at first blush. One of the worst parts about the financial industry is how they use deliberately obtuse language to explain relatively simple ideas. Their financial acronyms are hard to keep track of. In order to explain the Big Short, these players–and their roles–are key.
Individuals, a.k.a. regular people who take out mortgages to buy houses; for example, you and me!
Mortgage lenders, like a local bank or a mortgage lending specialty shop, who give out mortgages to individuals. Either way, they’re probably local people that the individual home-buyer would meet in person.
Bigbanks, such as Goldman Sachs and Morgan Stanley, who buy lots of mortgages from lenders. After this transaction, the homeowner would owe money to the big bank instead of the lender.
Collateralized debt obligations (CDOs)—deep breath!—who take mortgages from big banks and bundle them all together into a bond (see below). And just like before, this step means that the home-buyer now owes money to the CDO. Why is this done?! I’ll explain, I promise.
Ratings agencies,
whose job is to determine the risk of a CDO—is it filled with safe mortgages,
or risky mortgages?
Investors, who buy part of a CDO and get repaid as the individual homeowners start paying back their mortgage.
Feel lost already? I’m going to be a good jungle guide and get you through this. Stick with me.
Quick definition: Bonds
A bond can be
thought of as a loan. When you buy a bond, you are loaning your money. The issuer of the bond is borrowing your money. In exchange for borrowing your money, the
issuer promises to pay you back, plus interest, in a certain amount of time.
Sometimes, the borrower cannot pay the investor back, and the bond defaults, or fails. Defaults are not
good for the investor.
The CDO—which is a bond—could hold thousands of mortgages in it. It’s a mortgage-backed bond, and therefore a type of mortgage-backed security. If you bought 1% of a CDO, you were loaning money equivalent to 1% of all the mortgage principal, with the hope of collecting 1% of the principal plus interest as the mortgages got repaid.
There’s one more key player, but I’ll wait to introduce it.
First…
The Whys, Explained
Why does an individual take out a mortgage? Because they want a home. Can you blame them?! A healthy housing market involves people buying and selling houses.
How about the lender;
why do they lend? It used to be
so they would slowly make interest money as the mortgage got repaid. But
nowadays, the lender takes a fee (from the homeowner) for creating (or originating) the mortgage, and then
immediately sells to mortgage to…
A big bank. Why do
they buy mortgages from lenders? Starting in the 1970s, Wall St. started
buying up groups of loans, tying them all together into one bond—the CDO—and
selling slices of that collection to investors. When people buy and sell those
slices, the big banks get a cut of the action—a commission.
Why would an investor
want a slice of a mortgage CDO? Because, like any other investment, the big
banks promised that the investor would make their money back plus interest once the homeowners began
repaying their mortgages.
You can almost trace the flow of money and risk from player to player.
At the end of the day, the investor needs to get repaid, and that money comes from homeowners.
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CDOs are empty buckets
Homeowners and mortgage lenders are easy to understand. But a big question mark swirls around Wall Street’s CDOs.
I like to think of the CDO as a football field full of empty buckets—one bucket per mortgage. As an investor, you don’t purchase one single bucket, or one mortgage. Instead, you purchase a thin horizontal slice across all the buckets—say, a half-inch slice right around the 1-gallon mark.
As the mortgages are repaid, it starts raining. The repayments—or rain—from Mortgage A doesn’t go solely into Bucket A, but rather is distributed across all the buckets, and all the buckets slowly get re-filled.
As long as your horizontal slice of the bucket is eventually surpassed, you get your money back plus interest. You don’t need every mortgage to be repaid. You just need enough mortgages to get to your slice.
It makes sense, then, that the tippy top of the bucket—which
gets filled up last—is the highest risk. If too many of the mortgages in the
CDO fail and aren’t repaid, then the tippy top of the bucket will never get
filled up, and those investors won’t get their money back.
These horizontal slices are called tranches, which might
sound familiar if you’ve read the book or watched the movie.
So far, there’s nothing too wrong about this practice. It’s simply moving the risk from the mortgage lender to other investors. Sure, the middle-men (banks, lenders, CDOs) are all taking a cut out of all the buy and sell transactions. But that’s no different than buying lettuce at grocery store prices vs. buying straight from the farmer. Middle-men take a cut. It happens.
But now, our final player enters the stage…
Credit Default Swaps: The
Lynchpin of the Big Short
Screw you, Wall Street nomenclature! A credit default swap sounds complicated, but it’s just insurance. Very simple, but they have a key role to explain the Big Short.
Investors thought, “Well, since I’m buying this risky tranche of a CDO, I might want to hedge my bets a bit and buy insurance in case it fails.” That’s what a credit default swap did. It’s insurance against something failing. But, there is a vital difference between a credit default swap and normal insurance.
I can’t buy an insurance policy on your house, on your car, or on your life. Only you can buy those policies. But, I could buy insurance on a CDO mortgage bond, even if I didn’t own that bond!
Not only that, but I could buy billions of dollars of insurance on a CDO that only contained millions of dollars of mortgages.
It’s like taking out a $1 million auto policy on a Honda Civic. No insurance company would allow you to do this, but it was happening all over Wall Street before 2008. This scenario essentially is “the big short” (see below)—making huge insurance bets that CDOs will fail—and many of the big banks were on the wrong side of this bet!
Credit default swaps involved the largest amounts of money in the subprime mortgage crisis. This is where the big Wall Street bets were taking place.
Quick definition: Short
A short is a bet that something will fail, get worse, or go down. When most people invest, they buy long (“I want this stock price to go up!”). A short is the opposite of that.
Certain individuals—like main characters Steve Eisman (aka Mark Baum in the movie, played by Steve Carrell) and Michael Burry (played by Christian Bale) in the 2015 Oscar-nominated film The Big Short—realized that tons of mortgages were being made to people who would never be able to pay them back.
If enough mortgages failed, then tranches of CDOs start to fail—no mortgage repayment means no rain, and no rain means the buckets stay empty. If CDOs fail, then the credit default swap insurance gets paid out. So what to do? Buy credit default swaps! That’s the quick and dirty way to explain the Big Short.
Why buy Dog Shit?
Wait a second. Why did people originally invest in these CDO bonds if they were full of “dog shit mortgages” (direct quote from the book) in the first place? Since The Big Short protagonists knew what was happening, shouldn’t the investors also have realized that the buckets would never get refilled?
For one, the prospectus—a fancy word for “owner’s manual”—of a CDO was very difficult to parse through. It was hard to understand exactly which mortgages were in the CDO. This is a skeevy big bank/CDO practice. And even if you knew which mortgages were in a CDO, it was nearly impossible to realize that many of those mortgages were made fraudulently.
The mortgage lenders were knowingly creating bad mortgages. They were giving loans to people with no hopes of repaying them. Why? Because the lenders knew they could immediately sell that mortgage—that risk—to a big bank, which would then securitize the mortgage into a CDO, and then sell that CDO to investors. Any risk that the lender took by creating a bad mortgage was quickly transferred to the investor.
So…because you can’t decipher the prospectus to tell which mortgages are in a CDO, it was easier to rely on the CDO’s rating than to evaluate each of the underlying mortgages. It’s the same reason why you don’t have to understand how engines work when you buy a car; you just look at Car & Driver or Consumer Reports for their opinions, their ratings.
The Ratings Agencies
Investors often relied on ratings to determine which bonds
to buy. The two most well-known ratings agencies from 2008 were Moody’s and
Standard & Poor’s (heard of the S&P
500?). The ratings agency’s job was to look at a CDO that a big bank created,
understand the underlying assets (in this case, the mortgages), and give the
CDO a rating to determine how safe it was. A good rating is “AAA”—so nice, it
got ‘A’ thrice.
So, were the ratings agencies doing their jobs? No! There are a few explanations for
this:
Even they—the experts in charge of grading the
bonds—didn’t understand what was going on inside a CDO. The owner’s manual
descriptions (prospectuses) were too complicated. In fact, ratings agencies
often relied on big banks to teach
seminars about how to rate CDOs, which is like a teacher learning how to
grade tests from Timmy, who still pees his pants. Timmy just wants an A.
Ratings agencies are profit-driven companies.
When they give a rating, they charge a fee. But if the agency hands out too
many bad grades, then their customers—the big banks—will take their requests
elsewhere in hopes of higher grades. The ratings agencies weren’t objective, but instead were biased by
their need for profits.
Remember those fraudulent mortgages that the
lenders were making? Unless you did some boots-on-the-ground research, it was
tough to uncover this fact. It’s hard to blame the ratings agencies for not
catching this.
Who’s to blame?
Everyone? Let’s play devil’s advocate…
Individuals: some people point the finger at homeowners, saying, “You should know better than to buy a $1 million house on a teacher’s salary.” I find this hard to swallow. These people, surrounded by the American home-ownership dream, were sold the idea that they would be fine. The mortgage lender had no incentive to sell a good mortgage, they only had an incentive to sell a mortgage. So, it’s hard for me to put too much blame on the homeowners.
Mortgage lenders: someone knew. I’m not saying that all the mortgage lenders were fully aware of the implications of their actions, but some people knew that fraudulent loans were being made, and chose to ignore that fact. For example, check out whistleblower Eileen Foster.
Big banks: Yes sir! There’s certainly blame here. Rather than get into all of the various money-grubbing, I want to call out one specific anecdote. Back in 2010, Goldman Sachs CEO Lloyd Blankfein testified in front of Congress. Here it is:
To explain further, there are two things going on
here.
First, Goldman Sachs bankers were selling CDOs to investors. They wanted to make a commission on the sale.
At the same time, other bankers ALSO AT GOLDMAN SACHS were buying credit default swaps, a.k.a. betting against the same CDOs that the first Goldman Sachs bankers were selling.
This is like selling someone a racehorse with cancer, and then immediately going to the track to bet against that horse. Blankfein’s defense in this video is, “But the horse seller and the bettor weren’t the same people!” And the Congressmen responds, “But they worked for the same stable, and collected the same paychecks!”
So do the big banks deserve blame? You tell me.
Inspecting Goldman Sachs
One reason Goldman Sachs survived 2008 is that they began buying credit default swaps (insurance) just in time before the housing market crashed. They were still on the bad side of some bets, but mostly on the good side. They were net profitable.
Unfortunately for them, the banks that owed Goldman money were going bankrupt from their own debt, and then Goldman never would have been able to collect on their insurance. Goldman would’ve had to payout on their “bad” bets, while not collecting on their “good” bets. In their own words, they were “toast.”
This is significant. Even banks in “good” positions would’ve gone bankrupt, because the people who owed the most money weren’t able to repay all their debts. Imagine a chain; Bank A owes money to Bank B, and B owes money to Bank C. If Bank A fails, then B can’t collect their debt, and B can’t pay C. Bank C made “good” bets, but aren’t able to collect on them, and then they go out of business.
These failures would’ve rippled throughout the world. This explains why the US government felt it necessary to bail-out the banks. That federal money allowed banks in “good” positions to collect their profits and “stop the ripple” from tearing apart the world economy. While CDOs and credit default swap explain the Big Short starting, this ripple of failure is the mechanism that affected the entire world.
Betting more than you have
But if someone made a bad bet—sold bad insurance—why didn’t they have money to cover that bet? It all depends on risk. If you sell a $100 million insurance policy, and you think there’s a 1% chance of paying out that policy, what’s your exposure? It’s the potential loss multiplied by the probability = 1% times $100 million, or $1 million.
These banks sold billions of dollars of insurance under the assumption that there was a 5%, or 3%, or 1% chance of the housing market failing. So they had 20x, or 30x, or 100x less money on hand then they needed to cover these bets.
Turns out, there was a 100% chance that the market would fail…oops!
Blame, expounded
Ratings agencies—they should be unbiased. But they sold themselves off for profit. They invited the wolves—big banks—into their homes to teach them how to grade CDOs. Maybe they should read a blog to explain the Big Short to them. Of course they deserve blame. Here’s another anecdote of terrible judgment from the ratings agencies:
Think back to my analogy of the buckets and the rain. Sometimes, a ratings agency would look at a CDO and say, “You’re never going to fill up these buckets all the way. Those final tranches—the ones that won’t get filled—they’re really risky. So we’re going to give them a bad grade.” There were “Dog Shit” tranches, and Dog Shit gets a bad grade.
But then the CDO managers would go back to their offices and cut off the top of the buckets. And they’d do this for all their CDOs—cutting off all the bucket-top rings from all the different CDO buckets. And then they’d super-glue the bucket-top rings together to create a field full of Frankenstein buckets, officially called a CDO squared. Because the Frankenstein buckets were originally part of other CDOs, the Frankenstein buckets could only start filling up once the original buckets (which now had the tops cut off) were filled. In other words, the CDO managers decided to concentrate all their Dog Shit in one place, and super glue it together.
A reasonable person would look at the Frankenstein Dog Shit field of buckets and say, “That’s turrible, Kenny.”
BUT THE RATINGS AGENCIES GAVE CDO-SQUAREDs HIGH GRADES!!! Oh I’m sorry, was I yelling?!
“It’s diversified,” they would claim, as if Poodle shit mixed with Labrador shit is better than pure Poodle shit.
Again, you tell me. Do the ratings agencies deserve blame?!
Does the government deserve blame?
Yes and no.
For example, part of the Housing and Community Development Act of 1992 mandated that the government mortgage finance firms (Freddie Mac and Fannie Mae) purchase a certain number of sub-prime mortgages.
On its surface, this seems like a good thing: it’s giving money to potential home-buyers who wouldn’t otherwise qualify for a mortgage. It’s providing the American Dream.
But as we’ve already covered today, it does nobody any good to provide a bad mortgage to someone who can’t repay it. That’s what caused this whole calamity. Freddie and Fannie and HUD were pumping money into the machine, helping to enable it. Good intentions, but they weren’t paying attention to the unintended outcomes.
And what about the Securities & Exchange Commission (SEC), the watchdogs of Wall Street. Do they have a role to explain the Big Short? Shouldn’t they have been aware of the Big Banks, the CDOs, the ratings agencies?
Yes, they deserve blame too. They’re supposed to do things like ensure that Big Banks have enough money on hand to cover their risky bets. This is called proper “risk management,” and it was severely lacking. The SEC also had the power to dig into the CDOs and ferret out the fraudulent mortgages that were creating them. Why didn’t they do that?
Perhaps the issue is that the SEC was/is simply too close to Wall Street, similar to the ratings agencies getting advice from the big banks. Watchdogs shouldn’t get treats from those they’re watching. Or maybe it’s that the CDOs and credit default swaps were too hard for the SEC to understand.
Either way, the SEC doesn’t have a good excuse. If you’re in bed with the people you’re regulating, then you’re doing a bad job. If you’re rubber stamping things you don’t understand, then you’re doing a bad job.
Explain the Big Short, shortly
You’re about 2500 words into my “short summary.” But the important things to remember:
Financial acronyms suck.
Money flowed from the investors down to the mortgage lenders, and the risk flowed from the mortgage lenders up to the investors. In between, the big banks and CDOs acted as middle men and intermediaries.
When someone feels like their actions have no risk, or no consequences, they’ll behave poorly (big banks, mortgage lenders) When someone is given what seems like an amazing deal, they’ll take it (individual home owners).
CDOs are like empty buckets. Mortgage payments are like rain, filling the buckets. Investors buy tranches, or slices, across all the buckets. If mortgages fail, then the buckets might not fill up, and the investors won’t get their money back.
CDOs are intentionally complex. So complex, that not even the people grading them understood what was going on (ratings agencies).
Buying insurance on something your do not own is a behavior with potential for abuse (big banks)
Buying insurance on something for more than it’s worth is a behavior with potential for abuse (big banks). This is where most of the money in the financial crisis switched hands.
And with that, I’d like to announce the opening of the Best Interest CDO. Rather than invest in mortgages, I’ll be investing in race horses. Don’t ask my why, but the current top stallion is named ‘Dog Shit.’ He’ll take Wall Street by storm.
Thank you for reading! If you enjoyed this article, join 6000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
Want to learn more about The Best Interest’s back story? Read here.
If you prefer to listen, check out The Best Interest Podcast.
The interest rate on home mortgages is running much higher than usual relative to the interest rate on long-term treasury bonds. Mortgage industry professionals wonder if the spread will return to normal—meaning lower mortgage rates so long as treasury interest rates remain stable. That will probably happen, but not in 2023.
The spread is wide by historical standards. Before the pandemic, the average spread over all available data was 1.69 percentage points. February 2019, for example, 10-year treasury bonds paid 2.68% interest. The average 30-year fixed rate mortgage cost the homeowner 4.37%, The difference was right at the long-term average of 1.69%. Most of the time the spread ranges between 1.5% and 2.0%.
The home buyer goes to a mortgage originator—usually a mortgage broker or bank—who quotes an interest rate. Then the originator sells the loan, usually to a government sponsored entity such as Fannie Mae or Freddie Mac. Like any middleman, the mortgage originator is paid for this service. The originator is paid a cash equivalent to the value of pushing the interest rate up. The first week of 2020, for example, the average mortgage interest rate was 3.72%. Fannie Mae’s average interest rate paid to investors was 2.61%. What happened to the difference between those two rates, the 1.11% spread? That paid the mortgage originator for his services. That payment can be thought of as the retail mortgage spread.
When Fannie or Freddie sells a bundle of mortgages to investors, the interest rate is based on supply and demand, of course. Investors generally think mortgages are inferior products compared to treasury bonds. Although both are deemed safe, the U.S. treasury will keep paying interest for the term of the bond. But homeowners have the option to refinance when mortgage rates drop. The option to refinance means that when interest rates drop, homeowners refinance. The investors no longer own an old mortgage with a high interest rate. Instead, investors now have cash that they have to reinvest at the new, low interest rates. Investors don’t like this.
When interest rates are rising, investors also have a problem. They are stuck with old, low-interest mortgages that nobody will pay off early. They would like to get their cash back and buy some of the new, high-interest mortgages, but that’s not happening.
MORE FROMFORBES ADVISOR
The option for homeowners to refinance their mortgages makes mortgage-backed securities an inferior investment option. So investors will buy them only if they offer a premium over treasury bond interest rates. That is the wholesale mortgage spread.
At any moment in time, the total spread is the sum of the retail spread and the wholesale spread. The total spread widened a good bit in the first half of 2020, when the Federal Reserve was pushing interest rates down while the government sent out stimulus checks. Homeowners refinanced their mortgages to take advantage of the lower interest rates. Apartment dwellers started shopping for homes, enabled by cash in their bank accounts plus low mortgage rates. The mortgage originators were swamped with business. They could not handle all of the mortgage refinancings that the public wanted, at least not right away. While they were adding staff and training the new hires, they boosted their profit margins. The retail spread rose a great deal, and the wholesale spread just a little. This was documented by William Emmons of the Federal Reserve Bank of St. Louis.
The wide total spread between mortgage rates and treasury bonds in early 2023 seems to be due to the wholesale level. Bond traders cite volatility of interest rates as the key factor. Remember that rising interest rates mean that mortgage-backed security owners receive few prepayments they most want them. Falling interest rates mean that mortgage-backed securities owners receive most prepayments when they least want them. So the prospect of interest rate changes in either direction spooks investors away from mortgage-backed securities.
At the retail level, some spread widening would be expected due to the mortgage originator’s interest rate risk. The borrower gets an interest rate quote, but then walks away if rates fall, leaving the first originator in the lurch. But if interest rates rise, that borrower holds the originator to the quote. In a more volatile interest rate environment, both spreads increase.
Over the last 52 weeks, the volatility of mortgage rates doubled compared to the preceding 52 weeks (measured as the standard deviation of the absolute value of the weekly rate change).
When does this wide spread return to normal? The key factor will be when interest rates stabilize. That will be after the Federal Reserve has finished its tightening, and then eased back to a stable path for future interest rates. As of March 2023, it looks like more tightening is in store. And at some point, probably in 2024, the Fed will drop rates to get the economy going again. Once they get rates to a level that can continue for years, the spread will narrow.
For prospective home buyers looking at their likely mortgage expense, or for new homeowners looking to refinance, the actual mortgage rate will fall when the Fed starts easing, or possibly earlier in anticipation of that easing. Mortgage rates would fall even if the spread remains wide. The narrowing of the spread, when it occurs, will add more downward pressure to mortgage rates. So mortgage rates will decline, probably gradually starting early in 2024 and continuing for two years or so.
The Federal Home Loan Mortgage Corporation, or FHLMC, is known as Freddie Mac, the entity created by Congress for the purpose of buying mortgages from lenders to increase liquidity in the market. Freddie Mac was created in 1970 and expressly authorized to create mortgage-backed securities (MBS) to help manage interest-rate risk.
Because the FHLMC buys mortgages, lenders don’t have to keep loans they originate on their books. In turn, these lenders are able to originate more mortgages for new customers. The mortgage market is able to keep capital flowing and offer competitive financing terms to borrowers because of this system. In other words, the market runs more smoothly because of Freddie Mac and its sister company, Fannie Mae, the Federal National Mortgage Association (FNMA).
If you want to know more about how this government-sponsored enterprise works and how it affects your money, read on for details on:
• What is the FHLMC and what are FHLMC loans?
• What is the difference between Freddie Mac and Fannie Mae?
• What are Freddie Mac mortgages?
• How does the Federal Home Loan Mortgage Corporation work?
Freddie Mac and Fannie Mae
These organizations, with their friendly-sounding nicknames, serve a very important purpose. Freddie Mac and Fannie Mae were created for the purpose of stabilizing the mortgage market and improving housing affordability. These government-sponsored enterprises (GSEs) do this by increasing the liquidity (the free flow of money) in the market by buying mortgages from lenders. Mortgages are then pooled together into a mortgage-backed security (MBS) and sold to investors. The process created the secondary mortgage market, where lenders, homebuyers, and investors are connected in a single system.
In the past, Freddie Mac and Fannie Mae operated as private companies, though they were created by Congress. Fannie Mae came first in 1938, followed by Freddie Mac in 1970. Freddie Mac’s addition in 1970 resulted in the creation of the first mortgage-backed security.
The federal government took over operations at both companies following the financial crisis in 2008. According to the National Association of Realtors, without government support of Freddie Mac and Fannie Mae, there wouldn’t be very much money available to lend for mortgages.
The Federal Housing Finance Agency (FHFA) has oversight of Freddie Mac and Fannie Mae. On a yearly basis, they assess the financial soundness and risk management of Fannie Mae and Freddie Mac.
What Is the Purpose of the FHLMC?
As mentioned above, the FHLMC, or Freddie Mac, makes the housing market more affordable, stable, and liquid by buying mortgages on the secondary market. When they buy these loans, the retail lenders they buy them from are able to originate more mortgages to new customers and keep the mortgage market flowing smoothly.
There are many types of mortgage loans; the ones that Freddie Mac buys are known as conventional loans. The mortgage loan must meet certain standards (such as loan limits) for Freddie Mac to guarantee they will buy these loans.
In general, the process of successfully obtaining a mortgage usually looks something like this once the buyer has made an offer on a house that’s been accepted:
• The consumer finds a lender, if they haven’t already done so, and will apply for a mortgage.
• The lender collects documentation required by the loan type and submits it to underwriting.
• The underwriter approves the loan.
• The homebuyer closes on the loan, and mortgage servicing begins
• The lender sells the loan on the secondary mortgage market to Freddie Mac (or Fannie Mae or Ginnie Mae, depending on what type of loan it is and from what type of lender it originated).
From a homebuyer standpoint, they will see the outward mortgage servicing, which is the entity to which they will send their monthly payment and who takes care of the escrow account. The mortgage servicer is the one who forwards the different parts of the mortgage payment to the appropriate parties.
Mortgage servicing can also be sold from servicer to servicer, but this is different from the sale of a mortgage to Fannie Mae or Freddie Mac.
Freddie Mac is also tasked with the responsibility of making housing affordable. There are specific mortgage programs guaranteed by Freddie Mac and offered by lenders.
• HomeOne®. HomeOne is a mortgage program that offers low down payment options for first-time homebuyers. There are no income or geographic limits.
• Home Possible®. Home Possible is a program for first-time homebuyers and low- to moderate-income homebuyers. It offers discounted fees and low down payment options.
• Construction Conversion and Renovation Mortgage. This type of loan combines the costs of purchasing, building, and remodeling into one loan.
• Manufactured Home Mortgage. For qualified buyers, Freddie Mac can guarantee mortgages when buying manufactured homes that meet their criteria.
• Relief Refinance/Home Affordable Refinance Program (HARP). For borrowers with a good repayment history but little equity, loans are available to refinance into a more affordable rate.
Recommended: What Is the Average Down Payment on a House?
Understanding Mortgage-Backed Securities
After a mortgage is acquired from a lender, Freddie Mac can do one of two things: either keep the mortgage on its books or pool it with other, similar loans and create a mortgage-backed security (MBS). These MBS are then sold to investors on the secondary mortgage market.
What’s attractive about a mortgage-backed security to an investor is how secure it is. Fannie Mae and Freddie Mac guarantee payment of principal and interest. Both Fannie Mae and Freddie Mac issue mortgage backed securities now.
Does the FHLMC offer Mortgage Loans?
Freddie Mac does not sell mortgages directly to consumers. You won’t see a Freddie Mac mortgage or an FHLMC loan advertised to consumers. Instead, the FHLMC buys mortgages from approved lenders that meet their standards.
Recommended: What Are the Conforming Loan Limits?
The Takeaway
The housing market in the United States arguably benefits from the role of the Federal Home Loan Mortgage Corporation. Lenders can essentially originate mortgages to as many borrowers as can qualify. The free flow of capital created by the FHLMC also means mortgages are less expensive for homebuyers all around. In short, the smooth operation of the housing market owes much of its success to Freddie Mac and Fannie Mae.
If you’re shopping for a home and looking for a lending partner, consider what SoFi has to offer. With dedicated loan officers, competitive interest rates, flexible terms, and low down payment options, SoFi Mortgage Loans can offer something for nearly every borrower.
SoFi Mortgage Loans: Simple, smart, flexible.
FAQs
What does FHLMC stand for?
FHLMC is an abbreviation of Federal Home Loan Mortgage Corporation. It is commonly referred to as Freddie Mac.
What type of loan is FHLMC?
Freddie Mac guarantees conventional loans that adhere to funding criteria, but it does not offer Freddie Mac mortgages directly to consumers.
What is the difference between FNMA and FHLMC?
Fannie Mae and Freddie Mac originated in different decades and initially had different purposes, but for the most part, they serve the same purpose today of helping to improve mortgage liquidity and availability.
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