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.

4 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

5 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.

6 Five important issues: 1. 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. 2. 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.

7 3. Subsidy content: The subsidy content of GSEs should be kept in line with subsidies to other mortgage market institutions (e.g., banks). 4. 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. 5. Participation. Restricting institutional participation vs. open charters.

8 Some Important Lessons 1. 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. 2. 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.

9 3. Controlling safety and soundness requires serious consideration of risk- based capital, not like the old accounting capital ratios, but really risk-based standards. 4. An important component of safety and soundness is not taking interest rate risk. 5. There is likely to be a conflict between the private ownership of GSEs and demands for social housing.

10 6. 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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12 Ideal Structures? 1. Banks and Bonds 2. SPVs and Securitization Both structures do much the same thing: 1. They put the government at the end of the queue. 2. They allow the institution that originates and manages the loans to take on the credit risk. 3. Neither requires the government guaranteeing individual loans. 4. Both allow risk to be controlled by capital and stress tests. 5. Banks and Bonds has some advantages in emerging markets.