Mortgage Finance (Concurrent Developments): Emergence of the GSEs and Rapid Evolution of the Secondary Mortgage Market
*This post is a part of a series of posts I have written. To start from the beginning, click [shorturl.at/hsF48].
In 1970, the U.S. government created the Federal Home Loan Mortgage Corp. (Freddie Mac). The U.S. government also expanded the charter of the Federal National Mortgage Corp (Fannie Mae), allowing the latter to purchase conventional mortgages for the first time.
A key element of their mission was to create and support an active secondary market for mortgages, thereby improving the liquidity in the housing sector. Those government-sponsored enterprises (GSEs) would buy loans from banks, thrifts and wholesale mortgage originators.
The GSEs would then package these loans into securities, often called pass-through certificates, thus assuming the credit risk for a small portion of the coupon.
These securities became enormously popular with institutional investors seeking customized cash flows to meet current and anticipated obligations.
In 1981 Freddie Mac and Fannie Mae stopped buying loans with prepayment penalties
Cash flows became unreliable as homeowners now had the option of prepaying their mortgages and refinancing whenever interest rates fell. Institutional buyers wanted some protection from prepayment risk and even more customized cash flows.
Wall Street obliged by carving up agency MBS into various derivatives — CMOs, Interest only (IO) strips, Principal only strips, inverse floaters, etc. The evolving market for these types of securities and favorable economic conditions in the mid- to late-1990s also led to the issue of private-label MBS, commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS).
ABS consist of securitized home equity, credit card, auto…