An Overview of the Housing Finance System in the United States
Released: 2017-01-18T00:00:00

Introduction

One critical housing decision that households make is whether to rent or to own. Multiple factors influence the decision, such as a household's financial status and expectations about the future. Homeownership offers advantages such as tax deductions, the possibility of increasing wealth through price appreciation, and relatively stable housing costs. In contrast, purchasing a home has expenses, such as a real estate agent's commission, the time and effort involved in searching for a new home, the cost of a home inspection, and various state and local fees, which might deter homeownership. Furthermore, homeowners also face the risk that house prices could decrease. These costs can make homeowners less mobile than renters and less able to move elsewhere to take advantage of employment opportunities.

Few homebuyers have sufficient financial resources to make the purchase without borrowing money. Most need to take out a loan known as a mortgage. This report serves as a primer that explains how the system of housing finance works. It focuses on single-family, owner-occupied housing not on rental, commercial, or multi-family real estate.

Historically, the government has played an important role in the housing finance system, both supporting the system and regulating it. As described in more detail in the " Lender Protection " section, the government provides explicit support to certain homeowners through government agencies such as the Federal Housing Administration (FHA) and implicit support to others, such as through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Advocates of government support for homeownership argue that homeownership strengthens ties to community and may allow households to accumulate wealth. The government's support attempts to balance two competing objectives: (1) expanding access to homeownership for qualified borrowers and (2) minimizing the risk and cost to the government.

The government's regulation of the housing finance system is divided across the different levels of government. Some issues, such as the foreclosure process, are primarily regulated by the states, while other issues, such as certain borrower protections when taking out a mortgage, are regulated at the federal level. This report largely focuses on the federal role in supporting housing finance, not on its role in the regulation of it.

The housing finance system has two major components: a primary market and a secondary market . Lenders make new loans in the primary market, and loans are bought and sold by financial institutions in the secondary market. The next section describes the primary market, explaining what a mortgage is and how a mortgage is made. The following section describes the secondary market. The Appendix provides a glossary of terms used in this report as well as other common mortgage terms.

The Primary Market

In the primary market, a lender extends a loan to a borrower to purchase a house. Many different types of lenders, including banks, credit unions, and finance companies (institutions that lend money but do not necessarily accept deposits) make home loans. A loan that uses real estate as collateral is typically referred to as a mortgage . When a borrower applies for a mortgage, the lender will underwrite, or evaluate, the borrower.

The lender may consider multiple factors, such as the applicant's credit history, income, debts, assets, and the value of the house being purchased. The underwriting process usually takes several weeks or a month as the borrower assembles various financial documents, such as tax returns, that the lender requires.

The mortgage application process can be relatively expensive for borrowers. The borrower pays a variety of upfront fees for items such as credit reports, an independent appraisal, a land survey, a title search, and lender fees. The borrower generally has to pay additional costs when the mortgage documents are signed at what is called a closing . Collectively, these are referred to as settlement costs or closing costs . The borrower and the seller can negotiate who will pay which fees, but the borrower is generally responsible for at least some closing costs. By law, the lender is required to provide a standardized form to the borrower at closing that shows the itemized closing costs associated with the mortgage.

Mortgage Characteristics

A mortgage has four basic characteristics:

1. the amount of the loan (the principal), 2. the length (or term) of the loan, 3. the schedule for the loan's repayment (monthly installments or lump sum), and 4. the interest rate.

Different types of mortgages vary across these characteristics. A fixed-rate mortgage is a mortgage in which the interest rate does not change over the life of the loan. An adjustable-rate mortgage has an interest rate that is tied to an underlying index; at agreed-upon intervals, as the index adjusts, so does the interest rate and the monthly payments. A balloon mortgage has a lump-sum amount, or a balloon payment , due at the end of the loan.

The most common type of mortgage in the United States is the 30-year, fixed-rate, self-amortizing mortgage, in which every payment is the same amount and pays some of the interest and some of the principal until the loan is paid off. For example, if a borrower takes out a $200,000 mortgage with a 6.5% fixed interest rate to be repaid over 30 years, the borrower's monthly payment is about $1,264. After 360 months of making monthly payments of $1,264 (one payment per month for 30 years), the mortgage is completely paid off.

Although the typical mortgage contract may have a 30-year term, most mortgages are paid off early. Borrowers pay off a mortgage in several ways. First, a borrower can repay the loan in full over the prescribed time period or earlier if the borrower makes extra payments. Second, the borrower can refinance the mortgage. In a refinance, the borrower takes out a new mortgage (usually with better terms than the original, such as a lower interest rate), using the new mortgage to repay the original mortgage. The borrower then makes payments on the new mortgage. Third, a borrower can sell the home and use the proceeds to repay the mortgage.

Lender Protection

When taking out a mortgage, the house that is being purchased is pledged as collateral. If the borrower is unable or unwilling to pay, the lender can seize the house and sell it to recoup what is owed. To increase the probability that the sale of the house will be sufficient to recover the amount of the mortgage outstanding (and to reduce the advantage to the homeowner of defaulting), the lender will generally require a down payment . The down payment also serves as a buffer to protect the lender in the event that house prices fall. For example, if a borrower wants to purchase a $400,000 house, the borrower might make a $100,000 down payment (25%) in order to borrow the $300,000 needed. As long as the house can be sold for more than the amount of the mortgage outstanding, the lender faces little risk of not being repaid. A larger down payment results in a lower loan-to-value ratio (i.e., the ratio of the amount of the mortgage to the value of the home).

Although lenders typically require a 20% down payment, a borrower could use mortgage insurance instead, if he or she does not have enough for a 20% down payment. Mortgage insurance, an insurance policy purchased by either the borrower or the lender (though usually by the borrower), compensates the lender in the event that the borrower defaults. It provides greater assurance to the lender of being repaid. Borrowers typically purchase mortgage insurance from private businesses ( private mortgage insurance or PMI) or the federal government.

Government mortgage insurance coverage varies depending on the agency providing the insurance, but most programs have lower down payment requirements than other types of mortgages or may not require a down payment at all. The three main agencies that provide government mortgage insurance are

Federal Housing Administration (FHA) . FHA, an agency within the Department of Housing and Urban Development (HUD), provides mortgage insurance on loans that meet its requirements (including a minimum down payment requirement and an initial principal balance below a certain threshold) in exchange for fees, or premiums, paid by borrowers. If a borrower defaults on an FHA-insured mortgage, FHA will repay the lender the entire remaining principal amount it is owed. FHA is the largest provider of government mortgage insurance. Department of Veterans Affairs (VA) . VA provides a guaranty on certain mortgages made to veterans. If a borrower defaults on a VA-guaranteed mortgage, the VA will repay the lender a portion (but not all) of the remaining principal amount owed. Because it is limited to veterans, the VA loan guaranty program is smaller and more narrowly targeted than FHA. U.S. Department of Agriculture ( USDA ) . USDA administers a direct loan program for low-income borrowers in rural areas, and a loan guarantee program for low- and moderate-income borrowers in rural areas. If a borrower defaults on a USDA-guaranteed loan, USDA repays the lender a portion (but not all) of the remaining principal amount owed. The USDA program is more narrowly targeted than FHA in that it has income limits and is limited to rural areas.

Mortgage Servicing

After a loan is made, the borrower is responsible for making the required payments. In the housing finance system, a mortgage servicer is usually hired by the lender to function as the intermediary between the lender and the borrower. The servicer receives a fee out of the monthly proceeds for its work. The role of the servicer may be performed by the same institution that made the loan to the borrower or by another institution.

When a borrower is current (making the required payments on time), a mortgage servicer collects payments from the borrower and forwards them to the lender. If the borrower is behind on the payments (i.e., is delinquent ), the servicer may offer the borrower a workout option to potentially allow the borrower to stay in his or her home. Examples of workout options include loan modifications, such as principal balance reductions and interest rate reductions, as well as repayments plans, which allow borrowers to repay the amounts they owe over a period of time to become current on their mortgage payments. If the borrower is in default , which can be defined in different ways but generally means that the borrower has missed a certain number of mortgage payments, the servicer may pursue a mortgage liquidation option. Mortgage liquidation options include a foreclosure or alternatively a short sale , a process in which the borrower sells the home and uses the proceeds to satisfy the mortgage debt even if the sale proceeds are less than the amount owed on the mortgage.

The process by which a mortgage holder forecloses on a delinquent borrower is governed by state law. Because the foreclosure process is largely governed at the state level, the foreclosed home is sold under different procedures in different states. For example, in some states, delinquent mortgages are auctioned off on the courthouse steps, while in other states, other bidding processes are used. Other aspects of the foreclosure process may depend on the type of mortgage involved. For example, FHA requires servicers to consider delinquent borrowers for specific types of loss mitigation options before initiating the foreclosure process. Other types of mortgages may have their own requirements for considering loss mitigation options prior to a foreclosure.

In theory, any funds received from a foreclosure that exceed the unpaid mortgage balance and allowed expenses are returned to the foreclosed borrower. In practice, the legal costs and property maintenance costs are so great that this very rarely happens.

Mortgage Classifications

Mortgages can be classified into several categories based on their characteristics. The broadest distinction is between government-insured mortgages and conventional mortgages . Government-insured mortgages have mortgage insurance from a government agency, such as FHA, VA, or USDA, whereas conventional mortgages do not have government insurance. As previously noted, this insurance pays the lender if the borrower defaults. Borrowers can also be classified into two broad groups based on their credit history: prime and non-prime. Although there is no single agreed-upon definition, prime borrowers generally have very good credit and are offered more attractive mortgage terms, such as better interest rates, than non-prime borrowers. Non-prime borrowers exhibit one or more factors that make them appear riskier to lenders, such as past credit problems or a lack of complete income and asset documentation.

Conventional mortgages can be broken down into two additional groups, conforming and nonconforming mortgages. Conforming loans are loans eligible to be purchased in the secondary market by Fannie Mae and Freddie Mac, two GSEs that are discussed later in this report. To be a conforming loan, the mortgage must meet certain creditworthiness thresholds (such as a minimum credit score ) and be less than the "conforming loan limit," a legal cap on the principal balance of the mortgage that can vary based on the geographic area where the house is located. Borrowers with conforming loans are usually prime borrowers.

Nonconforming loans can be broken down into three additional categories depending on the reason they are not conforming. First, nonconforming loans above the conforming loan limit are called jumbo loan s . Second, Alt-A loans are for near-prime borrowers who may have credit problems or who do not have complete documentation for income or assets. Third, subprime loans are generally for the riskiest borrowers; they either have low credit scores, documentation issues, or some other factor that makes them appear to be riskier to lenders. Subprime borrowers are likely to be charged a higher interest rate to compensate the lender for the additional risk.

Risks Associated with Holding Mortgages

When a lender originates a mortgage, it accepts certain risks. The three major risks are credit, prepayment, and funding risk.

Credit risk refers to the risk that the lender bears if a borrower does not repay the mortgage on time. Prepayment risk is the risk that a mortgage will be paid off sooner than expected, typically by a borrower refinancing the mortgage or selling the home. This is more likely to happen when interest rates fall, because borrowers are more likely to refinance their mortgages to take advantage of lower interest rates. When a borrower refinances, the lender is paid in full the amount owed, but it now has to reinvest those funds at a time when its expected return on new investments is lower because interest rates have fallen.

Although prepayment risk is a risk associated with falling interest rates, there are also risks for lenders that come from rising interest rates. One of these risks, called funding risk , arises because some lenders borrow money in the short term to fund long-term investments, such as 30-year mortgages. Short-term interest rates are typically lower than long-term interest rates because of the additional risk associated with lending money for a longer period of time. Lenders, therefore, can profit from the difference, or spread, between the short-term and long-term rates. If interest rates rise, then the lender will have to borrow funds at a higher interest rate, while still earning the same interest rate on the mortgage. As long as the short-term rate stays below the long-term return, the lender would profit on the difference, although its profits would be lower than if the short-term interest rates had not increased. If short-term rates increase above the fixed return on the mortgage, then the investment would no longer be profitable.

Another lender's risk associated with rising interest rates is opportunity costs. If interest rates rise, but lender's money is tied up in long-term mortgages made at lower interest rates, then the lender is missing out on higher returns that it could be earning if it were able to originate mortgages or make other investments at the higher current interest rate.

The lender that originates a mortgage does not necessarily have to bear all of the associated risks. In some cases, the borrower could bear some of these risks. Adjustable-rate mortgages, for example, transfer the risk that interest rates might rise from the lender to the borrower. Lenders can also sell mortgages to investors, who then bear the risks associated with the mortgage. The market for buying and selling mortgages is called the secondary market, which is described below.

The Secondary Market

After a lender originates a mortgage loan, the lender has several options. The lender could choose to hold the mortgage in its portfolio or sell it to another entity. Mortgages are bought and sold in the secondary market to domestic and international investors. When a mortgage is sold, the mortgage servicer may change. In any case, the borrower continues to send monthly mortgage payments to the mortgage servicer. The servicer remits the payments to the entity that purchased the mortgage.

The secondary market plays an important role in providing funding for loans made in the primary market. When a mortgage is sold in the secondary market, the lender can use the proceeds to fund additional new mortgages in the primary market. If the lender holds the mortgage in its portfolio, the lender has fewer available funds to make new mortgages. Furthermore, selling the loan to another entity allows the lender to transfer mortgage lending risks to the buyer.

Securitization

When a lender sells a mortgage in the secondary market, the new mortgage holder can hold the mortgage as a whole loan . When held as a whole loan, the mortgage is in the portfolio of the new mortgage holder, and the new mortgage holder bears the risks associated with the mortgage.

Alternatively, the new mortgage holder may choose to securitize the mortgage instead of holding it as a whole loan. Mortgage securitization comes in many different forms, but generally speaking, the process involves a financial institution acquiring and combining (pooling together) many different mortgages and then issuing a mortgage-backed security (MBS). An MBS can be divided into different pieces, or tranches , that are sold to investors. The investors do not own the underlying mortgages but are buying the right to receive the future stream of payments that come from those mortgages. A servicer collects the payments of all the borrowers whose mortgages are part of the security and remits the payments to the investors.

For investors, purchasing MBS offers several benefits compared with holding whole mortgages. Most notably, an MBS is generally more liquid than whole mortgages, meaning it is easier to quickly sell an MBS at the current price. Because the market for MBS is more liquid than the market for whole mortgages, MBS might be attractive to investors who would not otherwise choose to invest in mortgages. More investors in the mortgage market, in turn, can mean more funding is available for lenders to offer mortgages. More funding available in the primary market, and the existence of a secondary market where lenders know they can easily sell the mortgages they make, can result in lower interest rates that lenders charge to borrowers.

Although securitization may have several advantages, it may also present several disadvantages. Securitization—and the secondary market in general—requires additional participants to facilitate the flow of credit than when a loan is held by the originator. Additional participants, with some acting on behalf of others, can increase costs and introduce competing incentives for the various participants and potential conflicts of interest. For example, more participants in the transaction may result in a principal-agent problem, a situation in which one entity (the agent) is supposed to work on behalf of another entity (the principal), but the agent may have an incentive to act in its own best interest rather than in the best interest of the principal. For example, mortgage servicers act on behalf of investors to evaluate a borrower for mortgage workout options or to begin the foreclosure process when a borrower falls behind on mortgage payments, as specified by a contract between the investor and the servicer. However, in some cases, a servicer may have an incentive to choose the option that is in its own best interest rather than in the best interest of the investor, and the investor might not be well positioned to police the servicer's actions.

Types of MBS

The securitization process can take many different forms, but three broad categories are described below: Fannie Mae and Freddie Mac, Ginnie Mae, and private-label securitization (PLS). The underlying loans that comprise the MBS are related to the mortgage classifications described in " The Primary Market " section of this report: generally, conforming mortgages are included in Fannie Mae and Freddie Mac MBS, government-insured mortgages in Ginnie Mae MBS, and nonconforming mortgages in private-label MBS, although there are exceptions.

When mortgages are securitized, investors generally take on the risks associated with the mortgage loan, such as credit risk and prepayment risk. However, in some cases, an entity other than the investor might guarantee the MBS, in which case the entity providing the guaranty takes on the credit risk while investors bear the risks associated with rising and falling interest rates. Investors in Fannie Mae, Freddie Mac, and Ginnie Mae MBS do not bear credit risk because of the guarantees those entities provide, but PLS investors and holders of non-guaranteed mortgages are exposed to credit risk.

Fannie Mae and Freddie Mac

During the Great Depression, Congress created Fannie Mae (officially, the Federal National Mortgage Association, or FNMA) as a government agency to encourage mortgage lending. In 1968, Congress divided Fannie Mae into two parts: (1) a government corporation, the Government National Mortgage Association (or Ginnie Mae) and (2) a government-sponsored enterprise that retained the name Fannie Mae. In 1970, Congress established Freddie Mac (officially, the Federal Home Loan Mortgage Corporation, or FHLMC) as part of the Federal Home Loan Bank System , owned by member banks.

Fannie Mae and Freddie Mac do not originate mortgages, a process that occurs in the primary market. Instead, the GSEs purchase conforming mortgages, which meet their eligibility criteria. The GSEs either hold the mortgages in their own portfolios or pool the mortgages into MBS, which are sold to investors or retained by the GSEs as investments. The GSEs guarantee that investors in these MBS will receive timely payment of principal and interest even if the borrower becomes delinquent on the underlying mortgage. The GSE guarantee transfers the credit risk (i.e., the risk that some borrowers might default and not repay their mortgages) from the investors to the GSEs. To compensate the GSEs for their guarantee, the GSEs receive a guarantee fee . The GSE guarantee makes their MBS more easily traded and worth more to investors, increasing investors' demand for GSEs' MBS. The support provided by GSEs in the secondary market can translate to lower rates for borrowers in the primary market.

Both Fannie Mae and Freddie Mac are private companies, even though both have congressional charters that contain special privileges and certain special responsibilities to support affordable housing for low- and moderate-income households. As private companies, their employees are not government employees, and their debts are explicitly not backed by the federal government. Despite the explicit disclaimer, it was commonly believed that the federal government would, in fact, back the GSEs if necessary. In September 2008, Fannie Mae and Freddie Mac were in extreme financial difficulty and agreed to be placed in voluntary conservatorship , which allows the federal government to run them. The stated goals of the conservatorship are to run the GSEs in ways that meet their public policy goals, conserve the enterprises' assets, and return them to stockholder control or dissolve them via receivership.

Ginnie Mae

Congress established Ginnie Mae in 1968 when it divided Fannie Mae into two separate entities. Ginnie Mae remains a government agency as part of the Department of Housing and Urban Development.

Ginnie Mae guarantees MBS made up exclusively of mortgages insured or guaranteed by the federal government, namely FHA, VA, USDA, or HUD's Office of Public and Indian Housing. Similar to the GSEs, Ginnie Mae guarantees investors in its MBS timely payment of principal and interest payments in exchange for a guarantee fee. By providing a secondary market for government-backed mortgages, Ginnie Mae increases the amount of capital available in the primary market for lenders to offer government-backed mortgages. Unlike Fannie Mae and Freddie Mac, Ginnie Mae does not purchase or securitize mortgages; rather, it guarantees the MBS issued by certain issuers (such as banks or credit unions) that have been approved by Ginnie Mae. Furthermore, Ginnie Mae's employees are government employees, and its guaranty is explicitly backed by the full faith and credit of the U.S. government. This means that, if Ginnie Mae were unable to fulfill its obligations, its MBS investors would be paid from the U.S. Treasury funds.

Private-Label Securitization

PLS is a form of securitization that typically uses nonconforming mortgages, meaning mortgages that do not conform to the GSE standards either because they are too large (jumbo loans) or they do not meet the necessary credit standards (typically these loans will be Alt-A and subprime). PLS is similar to GSE and Ginnie Mae securitization—all involve the pooling of mortgages and the issuing of securities—but private-label securities do not have an explicit or implicit government guarantee.

Unlike with PLS, GSE and Ginnie Mae securities provide a guarantee that minimizes the credit risk to the investor. PLS MBS instead often rely on alternative forms of "credit enhancement" to minimize the credit risk to investors. For example, a private-label MBS may purchase insurance from a private insurer to guarantee the investor's payment. Alternatively, the credit risk could be minimized for some investors by structuring the MBS so that there are multiple tranches, with the most senior tranche entitled to the first stream of payments that borrowers make (and assuming the least amount of risk) and the lowest tranche entitled to the remaining payments (and assuming the most risk).

In addition to MBS, there are other types of products that private-label securitizers create that are derived from mortgages. For example, instead of pooling together mortgages to issue an MBS, a securitizer could pool together different tranches of MBS as a collateralized-debt obligation (CDO). Securitizers can also pool together CDOs to create even more types of products.

Table 1 summarizes the relationship between the different types of MBS and the different classifications of mortgages.

Investors

Investors that purchase mortgages and MBS are an important source of funding for mortgages originated in the primary market. Investors in MBS are typically large institutional investors , such as pension funds, domestic banks, foreign banks, and hedge funds. Investors choose which of the types of MBS to purchase based on the type and amount of risk the investor wishes to bear and on the expected return from their investment.

GSE, Ginnie Mae, and PLS MBS are generally divided into two broad categories: agency MBS , which includes GSE and Ginnie Mae MBS, and non-agency MBS , which is only PLS. Investors purchase agency and non-agency MBS in different ways.

To-Be-Announced Market

Agency MBS are typically purchased by investors through the to-be-announced (TBA) market . The TBA market is a forward market: the specific mortgages in the MBS that are being purchased are unknown on the date the trade is agreed to. Instead, the buyer and seller agree on six basic criteria. These criteria are

1. issuer (Fannie Mae, Freddie Mac, or Ginnie Mae as guarantor), 2. coupon (the annual MBS interest rate), 3. maturity (when the MBS will be paid off in full), 4. price (the price being paid for the MBS), 5. par amount (the total amount borrowed by the homeowners), and 6. settlement date (the date the buyer will pay for the MBS and receive it).

The trade may not be settled (or completed) for several weeks. Two days before the trade is settled, the seller informs the buyer about the specifics of the mortgages in the pool being sold. The pool being sold must satisfy the original criteria agreed to in accordance with the settlement guidelines established by the Securities Industry and Financial Markets Association (SIFMA), an industry trade group.

The TBA market provides several different benefits to the housing finance system. The establishment of a large and liquid secondary market can boost the demand for MBS by investors, which in turn can lower the interest rate charged to borrowers in the primary market. In addition, by providing several weeks between when a trade is agreed to and eventually settled, the TBA market allows sellers of MBS to know the price and amount of MBS that they will sell at a future date. This can reduce the uncertainty sellers face in determining how many new mortgages to purchase or originate in the primary market and at what price. The time between when a trade is agreed to and when it is settled also helps borrowers to lock in interest rates a month or more before their loan is finalized.

Specified-Pool Market

Non-agency MBS are issued and sold by private companies to investors. They are ineligible for the TBA market and instead sell through a specified-pool market in which the details of the specific bonds are known when a trade is made. Some agency MBS also sell in a specified-pool market, although most agency MBS trade through the TBA market. Non-agency MBS tend to be less liquid than agency MBS, meaning it is more difficult to sell non-agency MBS without reducing the price. The relative illiquidity of specified-pool markets compared with the TBA market may be due to the structure of the market, the absence of a large forward market for non-agency MBS, or the type of securities being traded (i.e., securities that do not have a perceived or explicit government guarantee).

Appendix. Glossary