The Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac)(referred to in this report jointly as the enterprises) are government-sponsored enterprises that play important roles in federal support of home ownership and America’s housing finance system. The primary role of the enterprises is to ensure that mortgage funds are available to home buyers in all regions of the country at all times. Congress has asked us to study the desirability and feasibility of repealing the federal charters of the enterprises, eliminating any federal sponsorship of the enterprises, and allowing the enterprises to continue to operate as fully private entities. The enterprises help ensure that mortgage funds are available to home buyers by buying mortgages from mortgage originators, such as savings and loans (thrifts), commercial banks, and mortgage bankers. The enterprises hold some of these mortgages in portfolio as direct investment on their own books and issue debt and equity securities to finance these holdings. Most mortgages that the enterprises buy from mortgage originators are “securitized”—that is, the enterprises package them into mortgage pools to support mortgage-backed securities (MBS). These mortgage pools receive the interest and principal payments from the mortgages in the pools and pass them on to the investors who purchased the MBS. The enterprises guarantee the timely payment of principal and interest payments from the mortgages in the pools to the investors and administer the payments. In September 1995, Fannie Mae and Freddie Mac either owned in portfolio or guaranteed about $1.3 trillion of the $3.9 trillion of outstanding residential mortgages in the United States. The enterprises are government-sponsored in that they operate under federal charters that convey certain benefits, impose certain restrictions, and permit the enterprises to earn a profit while serving public policy purposes, such as providing liquidity to mortgage markets. In 1992, Congress expanded the enterprises’ public purpose by requiring annual goals that are to be set, monitored, and enforced by the Department of Housing and Urban Development for the purchase of mortgages on housing purchased by very low-, low-, and moderate-income and other households that are underserved by the residential mortgage market. The enterprises’ charters exempt them from certain fees and taxes paid by other private sector firms. At the same time, the charters restrict the enterprises to buying mortgages that do not exceed a set dollar amount, known as the conforming loan limit. A major factor that enhances the enterprises’ profitability is the financial market’s perception that there exists an implied federal guarantee of their debt and other obligations (i.e., a perception that the federal government would act to ensure that the enterprises will always be able to meet their financial obligations on their debt and MBS guarantees). Investors perceive that this implied guarantee decreases the risk that the enterprises will ever fail to meet their financial responsibilities. Consequently, this perception lowers the enterprises’ borrowing costs because investors are willing to accept lower expected returns on enterprise debt than they would for private firms without government ties. Likewise, funding costs on MBS are also lowered by this perception. Their lower funding costs allow the enterprises to increase their purchases and give them a cost advantage over competitors. This perception of a federal guarantee remains even though the laws chartering the enterprises contain explicit language stating that there is no such guarantee. The perception of the implied guarantee is based on special federal ties to the enterprises, including government-sponsored status, each enterprise’s $2.25 billion conditional line of credit with the Treasury Department, and a belief that the federal government would consider such large institutions too big to fail. The federal charter also provides several explicit provisions that lower operating costs for the enterprises. For example, certain fees paid by other corporations to the Securities and Exchange Commission (SEC) are not levied against the enterprises since the enterprises do not need to register their issuances with the SEC. They are also exempt from state and local income taxes. In addition, they can use the Federal Reserve’s electronic payments system for transactions. These privileges, plus each enterprise’s $2.25 billion conditional line of credit with the Treasury, reinforce the market’s perception that the government will not let the enterprises fail. Given the lower funding costs created by this perception and the lower operating costs created by certain privileges and exemptions, the enterprises have cost advantages over any potential direct competitor. The mortgage market is made up of primary and secondary parts; and many institutions serve several roles within the overall market, as shown in tables 1.1 and 1.2. Consequently, institutions sell to, buy from, and compete with each other. As shown in table 1.2, the enterprises function as conduits and guaranteeing agencies in the secondary mortgage market. In the primary market, the home buyer applies to an originator for a mortgage. The originator can be a depository, such as a bank or thrift, or a mortgage banker. Traditionally, depositories originated mortgages and held them as direct investments in portfolio on their books. Their profits from holding mortgages were the difference between interest earned from the mortgages and their costs of funds, primarily interest paid to depositors after adjusting for other expenses. Mortgage bankers originate mortgages for immediate resale in the secondary market. They earn profits primarily from two sources. The first source is fees charged to originate mortgages and profits from the sale of mortgages (losses can also result from such sales). The second source is fees investors pay to mortgage bankers for “servicing” mortgages—collecting and processing mortgage payments. In recent years many depositories have also acted like mortgage bankers in that they originate mortgages and sell them to investors rather than hold them on their books. Mortgage insurers improve the liquidity of the market by compensating investors for losses caused by mortgage defaults—losses created when the net sales price of the house after foreclosure does not cover the outstanding balance on the mortgage. This compensation reduces risks and makes the market more liquid. FHA and VA are the primary federal government insurers. The private mortgage insurance companies provide insurance for conventional mortgages—that is, mortgages not backed by the federal government. The secondary mortgage market channels mortgages from originators to investors. The Government National Mortgage Association (Ginnie Mae), the enterprises and other private companies, acting as conduits, create mortgage pools and MBS that are sold to investors. From a pool of mortgages, the MBS investors receive their proportional shares of interest and principal flows. Private-label MBS are created by fully private (nongovernment-sponsored) conduits. As of September 1995, private-label MBS totalled about 13 percent of outstanding MBS. The mortgages that these private conduits securitize either exceed the enterprises’ conforming loan limit—$207,000 on one-unit, single-family properties—or do not meet the enterprises’ underwriting standards. A loan whose underwriting standards do not meet the standards of either enterprise or exceeds the conforming loan limit is called a nonconforming loan. A loan that exceeds the conforming loan limit is called a jumbo loan. Guarantees on MBS enhance the liquidity of the secondary market. Ginnie Mae guarantees timely payment of principal and interest for mortgage pools of FHA and VA insured mortgages for a fee. The enterprises and private-label conduits guarantee timely payment of principal and interest on conventional mortgages in pools backing their MBS. The guarantees are an enhancement that reduces the risk that any given mortgage will not be paid on a timely basis. Private-label conduits generally use risk-based guarantee fees, which are based on the expected incremental cost of guaranteeing a particular level of credit risk exposure for the investor. For example, the conduits charge lower fees on mortgages with large down payments (i.e., mortgages with low loan-to-value ratios) than on loans with small down payments. The enterprises said that their mortgage commitment policies move them partially, but not fully, toward a risk-based fee structure. Private-label conduits may enhance the liquidity of their MBS with other credit enhancements. Private mortgage insurance is a common form of credit enhancement to reduce risk. Another common private label credit enhancement is over-collateralization. This means that the principal amount of the mortgages backing the MBS exceeds the dollar amount of the MBS shares sold to investors. Other forms of credit enhancement for the private-label MBS include bank letters of credit, corporate guarantees,and private insurance of mortgage pools. The cash flows to investors generated by interest and principal payments from any pool may vary over time. As interest rates fall, households tend to prepay principal more quickly, which is called prepayment risk. As interest rates increase, prepayments tend to slow down and cash flows to investors decline, since homeowners are refinancing or selling their houses more slowly. This tendency is called extension risk. To address the need for more predictable cash flows, the enterprises and private-label conduits issue multiclass mortgage securities called collateralized mortgage obligations (CMOs) and Real Estate Mortgage Investment Conduits (REMICs). These multiclass securities can help investors better manage prepayment and extension risks by creating from the same mortgage pool several securities that receive different parts of the pool’s interest and principal payments. Investors more concerned about variations in cash flows over time can buy the classes that pay off more quickly or have a fixed payment period. Investors more willing to undertake prepayment and extension risks can buy classes with payments that vary with interest rates. The expected return on classes with prepayment and extension risks exceeds the expected return on classes without such risk. Multiclass securities can also redistribute credit risk so that one class can be designed to absorb all or much of the credit risk in return for a higher expected return. Because multiclass securities bring new investors who wish to avoid unpredictable cash flows into the market, they improve the market’s liquidity and help ensure continuing funding for home mortgages.