Question

In acting to help create a secondary mortgage market, how was the size problem initially solved–the problem that mortgages are usually too small to be of interest to institutional investors?

1) By pooling mortgages together, Fannie Mae created a new financial instrument called a mortgage pass-through.
2) By functioning as the loan servicer, Ginnie Mae collected the payments from various mortgages and created a nice, even, steady stream of payments to the institutional investors.
3) By requiring loan originators to make sure only FHA, VA, or other government-qualified mortgages were included in mortgage pools, Freddie Mac attracted institutional investors.
4) Ginnie Mae and Freddie Mac were created to service bundled loans for institutional investors.

Answer 1

To interest institutional investors, mortgages were pooled into larger financial instruments known as mortgage-backed securities (MBS) by entities like Fannie Mae and Freddie Mac. Securitization allowed for the risks to be off-loaded from lenders to investors and facilitated a steady income stream if borrowers repaid loans. However, lenient ratings from credit agencies led to the underestimation of risks, contributing to the financial crisis.

Step-by-step explanation:

To address the issue that mortgages are usually too small to be of interest to institutional investors, and consequently to help create a secondary mortgage market, a few key strategies were implemented. The fundamental solution was securitization, which involves the pooling of mortgages. This pooling was executed by entities such as Fannie Mae, Ginnie Mae, and Freddie Mac. They would take the individual mortgages, bundle them together, and create larger financial instruments often referred to as mortgage-backed securities (MBS). This made the investment large enough to be attractive to institutional investors.

In particular, Fannie Mae created a new financial instrument called a mortgage pass-through, which allowed the cash flows from the pooled mortgages to pass directly through to investors. This aligned with Fannie Mae's role in the mortgage market. Ginnie Mae, meanwhile, guaranteed securities backed by mortgages that were insured or guaranteed by federal agencies, smoothing the cash flow to investors. Additionally, Freddie Mac added value by requiring its loans to adhere to federal underwriting standards, instilling further confidence in investorsThe system enabled a steady stream of income to investors, provided the borrowers kept repaying their loans. This securitization also allowed the initial lenders to off-load the mortgage risks to investors, an appealing prospect given the growing real estate marketHowever, the credit agencies were criticized for being too lenient in their ratings of many securitized loans, and in hindsight, the risks associated with these mortgage-backed securities were underappreciated, contributing to the financial crisis in the late 2000s.