I found this article, published in 1996, rather helpful in better understanding the role of the GSEs in the secondary mortgage market. 

 

Even though the housing GSEs have played a major role in integrating markets, they have also been a factor in segmenting the secondary (or resale) market for mortgages. That market is now divided along the lines of mortgage size, credit quality, and the public/private status of the intermediaries. The major mortgage market sectors are the conventional conforming market, the conventional jumbo market, and the Federal Housing Administration/Department of Veterans Affairs (FHA/VA) market. The federally sponsored housing GSEs are the link to the capital markets for the “middle market” of conventional mortgages that conform to the prime quality and size specifications required for purchase by Fannie Mae and Freddie Mac. A federal agency does not guarantee those “middle market” mortgages, even though a private mortgage insurer may guarantee them.

Jumbo mortgages are those that exceed the maximum-size mortgage Fannie Mae and Freddie Mac can purchase. The dividing line between conforming and jumbo mortgages is adjusted annually based on changes in U.S. housing prices.(7) For 1996, the conforming limit for single-family mortgages is $207,000 (the original principal amount). As shown in the upper right of Figure 1, fully private intermediaries link the jumbo market to the capital markets. About 30 of those conduits now serve the jumbo-loan market.

 

 

 

 The lower end of the market by size and credit risk is the province of the federal mortgage insurance programs of the FHA and VA. Securities backed by mortgages insured by the federal government are eligible to be guaranteed by the Government National Mortgage Association (GNMA, or Ginnie Mae), a federal agency. Like the housing GSEs, FHA/VA loans are subject to a restriction on size. In most regions of the country, the FHA cannot insure a loan for a single-family house in excess of $78,660. In high-cost regions, the FHA can go up to $155,250.(8) Although Fannie Mae and Freddie Mac purchase FHA/VA-guaranteed mortgages, the fully federal agencies largely handle that end of the market. Thus, mortgage size divides the market at $78,660 and $207,000.(9)

The lower end of the market by size and credit risk is the province of the federal mortgage insurance programs of the FHA and VA. Securities backed by mortgages insured by the federal government are eligible to be guaranteed by the Government National Mortgage Association (GNMA, or Ginnie Mae), a federal agency. Like the housing GSEs, FHA/VA loans are subject to a restriction on size. In most regions of the country, the FHA cannot insure a loan for a single-family house in excess of $78,660. In high-cost regions, the FHA can go up to $155,250. Although Fannie Mae and Freddie Mac purchase FHA/VA-guaranteed mortgages, the fully federal agencies largely handle that end of the market. Thus, mortgage size divides the market at $78,660 and $207,000.The dollar volume of mortgages financed at the end of 1995 illustrates the relative sizes of those intermediary markets: Fannie Mae, $770 billion; Freddie Mac, $570 billion; Ginnie Mae, $465 billion; and fully private conduits, $200 billion. Whereas Fannie Mae and Freddie Mac have about 65 percent of the market for mortgage intermediary services, they have virtually 100 percent of the market for securitizing conventional mortgages up to $207,000.(10)  

Alternative Funding Strategies and Risk

The housing GSEs have several methods of tapping into the capital markets for funds. They can either sell their own debt securities or they can issue mortgage-backed securities. Although both types of securities meet the objective of providing reliable links between financial markets, portfolio holdings financed with debt involve more risk than MBSs.

Funding Mortgages with Debt Securities

An intermediary that issues debt to finance a portfolio of mortgages has an opportunity to earn income from two sources. The first arises because interest rates in wholesale capital markets tend to be lower than in the retail mortgage markets. With free entry into the market, that intermarket difference tends to be close to the cost the intermediary incurs in moving the money between markets, including absorbing losses from mortgage defaults. The second source of income comes from the chance to bear interest rate risk. One way to take that risk is to use debt with short maturity to purchase and hold long-term, 30-year, fixed-rate mortgages. Because short-term interest rates are ordinarily lower than long-term rates, that mismatch of maturities between assets and liabilities can provide the intermediary with an advantageous interest rate spread. Yet that mismatch of maturities exposes a lender to danger from a rise in short-term rates that could wipe out the favorable spread between the cost of money and the return on the holdings of long-term mortgages. A mortgage lender that issues long-term bonds to finance long-term mortgages is also taking an interest rate risk: that rates will fall. If mortgage rates drop, borrowers will prepay their mortgages, leaving the lender with no investment opportunity that will generate sufficient income to pay the interest on long-term debt.

Early on, Fannie Mae elected the risky-debt strategy.(11) It used debt securities with short maturities to fund purchases of long-term mortgages. Portfolio lenders can and do use risk-reduction strategies to control interest rate risk, but those strategies are costly and reduce expected earnings.

Funding with Mortgage-Backed Securities

By contrast, Freddie Mac’s early funding strategy focused on the more limited gains from acting as an intermediary between local mortgage markets and the capital markets and from assuming the default risk on mortgages. In the process, Freddie Mac largely avoided debt financing. Its operating strategy was to acquire mortgages, bundle them into “pools,” and then resell guaranteed claims on the mortgage pools to investors in the form of MBSs, which Freddie Mac calls “participation certificates.” Those MBSs convey to an investor an undivided interest in the pool of mortgages and entitle the investor to receive a share of the cash flow of principal and interest from the mortgages. Freddie Mac guarantees payments to MBS holders against default.

In a further wrinkle, rather than obtaining mortgages by cash purchase, Freddie Mac would often simply “swap” MBSs to the mortgage lender for the underlying mortgages.(12) Freddie Mac was able to generate earnings from the difference between the rate paid by the mortgage borrower and the rate paid to the MBS holder. Once the mortgage pools are formed and the MBSs sold, that spread–which Freddie Mac records as guarantee and management fees–is locked in against most changes in interest rates, but not changes in mortgage default rates.

The Downside of Interest Rate Risk

The rapid and sustained rise in interest rates that occurred in the late 1970s and 1980s vividly demonstrates the destructive potential of interest rate risk on debt-financed mortgage portfolios. Interest rates on mortgages for new single-family homes not guaranteed by a federal agency rose from an average of 9 percent in 1977 to 14.7 percent in 1982. As rates rose, Fannie Mae, with its heavy reliance on short-term debt financing, had to roll over its maturing debt at interest rates that were higher than the rates being earned on the existing portfolio of old mortgages.

As an indication of the magnitude of the increase in rates, the yield on new three-month Treasury bills rose from 5.25 percent to 14 percent. Further, as interest rates rose, borrowers were less likely to prepay their mortgages. The losses from Fannie Mae’s negative interest spread between its old portfolio and its funding costs were compounded, therefore, by a lengthening in the effective maturity of its mortgage holdings.(13) By the early 1980s, the market value of Fannie Mae’s mortgages was $10 billion less than its outstanding debt.(14) By that measure, Fannie Mae was insolvent. Eventually interest rates declined, and Fannie Mae recovered.

After the early 1980s, Fannie Mae increased its use of MBSs at the same time that it expanded its portfolio lending. Today, both Fannie Mae and Freddie Mac use debt and MBS funding. In fact, they sometimes describe their two principal lines of business as portfolio investment (debt-financed holdings of mortgages and mortgage-related securities) and credit guarantees (MBSs). Portfolio lending (the original Fannie Mae strategy) has a profit margin that is four to five times higher than the MBS funding approach.(15) Sustained high earnings from portfolio lending with modest amounts of interest rate risk have also been observed on a smaller scale at another GSE, the Federal Home Loan Banks.(16)

The degree of interest rate risk that a GSE takes is a management decision. Interest rate risk is important to the enterprises because, by varying the level of risk exposure, GSE management exercises considerable control over expected earnings. A prime factor determining potential interest rate risk is the extent to which the GSE engages in debt-financed portfolio lending rather than MBS funding. Within their portfolios, the GSEs may reduce interest rate risk by using such hedges as issues of long-term callable debt. Those issues enable the GSEs to lock in the interest cost of funding for the life of the debt, but they also give the GSEs an option to prepay their debt if market interest rates fall.

Both Fannie Mae and Freddie Mac also make use of short sales of Treasury securities, currency and interest rate swaps, and derivatives such as “inverse floaters” to control interest rate risk.(17) By using those mortgage and nonmortgage derivative securities, management gains the ability to increase or decrease its interest rate exposure, consistent with its objectives for earnings. Derivatives also make the assessment of total risk exposure more complex for both management and the government.