Three US Federal Housing Agencies account for nearly all the mortgage passthrough issuance in the US mortgage market. These agencies are formally known as the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), though they are usually referred to by their nicknames. GNMA differs from FNMA and FHLMC in several important ways.
Explicit versus implicit backing of the US federal government
First, while GNMA is explicitly backed by the full faith and credit of the federal government, the other two agencies are not. FNMA and FHLMC only have the implicit backing of the federal government.
This difference is very important and in recent years the marketplace has become more focused on its practical implications. If, due to some financial crisis, GNMA were hampered from honoring its guarantees, the law would require that the federal government honor the agency’s obligations for them.
The federal government does not have such an explicit legal responsibility in the case of FNMA or FHLMC. However, many marketplace participants believe that although there is not an explicit obligation, the federal government would nonetheless take action in a crisis, since these two agencies are so important to the mortgage market and the US economy.
Agencies as quasi-public corporations
Second, GNMA is a public federal agency whereas FNMA and FHLMC are federally chartered, publicly owned corporations. This means that one of FNMA’s and FHLMC’s primary goals is to produce a profit for shareholders. These two agencies are accountable, not only to the federal government, but also to their shareholders.
Mortgage Passthrough Securities
Agency mortgage passthrough securities are the most common type of mortgage and represent one of the largest capital markets in the world. To gain a better understanding of how these securities behave, it is useful to study the characteristics of the underlying mortgage loans.
The creation of mortgage passthroughs
As outlined earlier, the agencies create passthrough securities by securitizing residential mortgages. The agencies create pools of mortgages that are underwritten by the private sector and provide a credit enhancement to these pools. The process is going as follow.
Individual Home
Mortgages are loans secured by real property. 100% of the collateral consists of residential real estate, with single family homes representing 70% of the total.
Mortgage Deed
Two mortgage loan structures are most common: Fixed Rate and Adjustable Rate. In both cases, principal and interest are typically repaid in equal installments over 15-30 years.
Financial Institution
Commercial banks, savings and loans and insurance companies lend money collateralized by the property directly to the home owner.
US Agency
GNMA, FNMA and FHLMC are governmental agencies that provide liquidity and credit enhancement in the mortgage market. They purchase conforming mortgage collateral and
repackage it for resale in the securities market.
Investor
Pools of individual mortgages, now packaged in a standard, diversified form, are sold to institutional investors. These include pension funds, banks, governments, corporations and insurance companies.
The resulting passthrough securities represent a pro-rata share of the underlying pool of individual mortgages and receive a proportionate amount of the pool’s net cash flows. These cash flows are the payments made by borrowers into the pool less the fees associated with servicing (the processing of the mortgage payments), agency guarantees and any other costs. These resulting cash flows ‘pass through’ to the holders of the mortgage securities.
Mortgage characteristics
To understand how these cash flows behave and, consequently, how the passthrough security behaves, it is helpful to understand the structure of the underlying mortgages in the pool. The agencies have simplified their passthrough securities by only pooling together mortgages with similar structures. This underlying homogeneity eases some of the complexity in analyzing these securities and this simplification has led to increased trading and market liquidity.
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