FM Commentary

FM Commentary

The Role of Government and the Private Sector in Mortgage Finance: Innovation

Noel Fahey

“Innovation and investment in the real economy normally increase productivity, welfare and income … while in the financial sector, they frequently lead to destabilizing speculation, price distortions and misallocation of resources.”

This was a finding of a recent report by the United Nations Conference on Trade and Development (UNCTAD).1 In December 2009, Paul Volcker previewed the UNCTAD report by famously remarking that the only socially productive innovation in the financial sector over the past 20 years was the ATM.2

This agnosticism about financial innovation applies more to private sector mortgage finance innovation than to innovation by government and quasi-government actors.

Over the last 80 years there have been significant innovations in the mortgage sector – with varying results. What is interesting is that when one reviews the more significant mortgage finance innovations during this period, the positive innovations are more directly tied to programs and actions by government and quasi-government actors than to private sector financial institutions.


When reviewing the history of modern mortgage finance, the story begins with the Great Depression. The typical mortgage up to the early 1930s was a short-term balloon that didn’t amortize. The competitive impact of the Homeowners Loan Corporation (HOLC), Federal Housing Administration and, later, the Veterans Administration changed all that.

As shown in Exhibit 1, FHA loans started out with an average maturity that was more than twice as long as was common in the private sector and increased from there, eventually resulting in the modern 30-year fixed rate mortgage.

A study in 1956 described what happened:

“A spectacular lengthening of the contract term of residential mortgages has been associated with the growing adoption of regular amortization during the past two decades. … Not only did HOLC, FHA, and VA loans provide for longer maximum contract terms than had been accepted before, but competition between [government] insured and conventional loans tended to extend the terms for conventional mortgages.”3

Exhibit 1: Average Term to Maturity of Mortgage Loans, by Selected Institutions, 1935-1959

Average Term to Maturity of Mortgage Loans, by Selected Institutions, 1935-1959

The 1956 study also documented the role of government agencies in the move from non-amortizing or partly amortizing to fully amortizing loans:4

“Much of this change came during the late thirties when the adoption of fully amortized loans in HOLC and FHA operations increased the popularity of this type of mortgage and when both lenders and borrowers, in the wake of depression experience with straight loans [i.e., non-amortizing balloons], began to recognize the importance of regular amortization.”5 (See Exhibit 2)

Exhibit 2: Amortization Status of Mortgages on Owner-Occupied Houses, 1934 versus 1950

Amortization Status of Mortgages on Owner-Occupied Houses, 1934 versus 1950

Between lengthening the term of the loan from as little as two years to close to 30 years and by popularizing the use of amortization, the government, through the HOLC, FHA, and VA, transformed the typical short-term balloon loan of the pre-Depression era into the long-term fixed-rate mortgage (FRM) that is the mainstay of the system today. This evolution into long-term, amortizing FRMs was the fundamental innovation for mortgage finance by these Depression-era government agencies.


Government involvement in the post-Depression, post-WWII mortgage market peaked in 1956.6 The heyday of the S&L industry followed. Every year between 1958 and 1979, thrift institutions held over half of single-family mortgage debt. However, these thrift institutions were financing these mortgage holdings with short-term deposits. This proved to be a profitable business strategy until 1979, when the Federal Reserve raised interest rates to unprecedented heights to combat inflation. After these rate increases, thrifts were caught in a deadly earnings squeeze – 85% of thrifts holding 91% of industry assets reported losses in 1981.7

During this time government and quasi-government actors were working to develop alternative funding mechanisms for mortgages. Starting in the early 1970s, Ginnie Mae and Freddie Mac pioneered pass-through mortgage-backed securities which forged a direct link between the retail borrower and the capital markets.8 Up until the early 2000s, Ginnie Mae and the GSEs were the foremost funding vehicles for fixed-rate mortgages.9

A major ancillary benefit of the increased role of the GSEs in the national secondary market was an accompanying standardization of underwriting and documents:

“Fannie and Freddie helped to standardize the documents used to originate mortgages, and, perhaps more important, the products that were offered and the underwriting standards that the property and the borrower had to meet.”10

Uniform underwriting standards and the structure of Fannie Mae and Freddie Mac as government-sponsored corporations also helped develop the so-called TBA (“to be announced”) market where mortgage-backed securities can be priced and marketed for delivery on a specified future date. The unique characteristics of this market allow borrowers to “lock in” rates on fixed-rate mortgages in advance of closing their mortgage loans.


Mortgage-backed securities are often described as an “originate-to-distribute” model where loans originated by lenders are distributed throughout the capital markets. The originate-to-distribute model has been blamed by many for the recent collapse of the mortgage market. But such a condemnation is painting with too broad a brush. The originate-to-distribute model encompasses two very different markets – the Agency market (including Ginnie Mae), where principal and interest payments on underlying mortgages are guaranteed by the agencies, and the PLS market where credit enhancement is generally internalized in the structure of the instrument.

As Exhibit 3 demonstrates, the Agency MBS sector has by far the lowest serious delinquency rates in the business. According to data compiled by federal bank regulators, the combined serious delinquency rate of the Agency MBS sector (6%) is one-quarter that of the PLS market (24%).


Exhibit 3: Serious Delinquency plus Foreclosure Rates, Agency versus Private Sector, Q2 201111

Serious Delinquency plus Foreclosure Rates, Agency versus Private Sector, Q2 2011

The PLS sector also developed a bewildering array of companion products such as collateralized debt obligations (CDOs), CDOs squared, and credit default swaps. These structured mortgage-related securities are often characterized as the major private-sector contribution to innovation in the secondary mortgage market.12

Many people today would regard the contribution of structured mortgage-related securities products to be negative, a view that is bolstered by the performance statistics of these products. When looking at the history of the mortgage finance sector going back to the Great Depression, quite often it has been government and quasi-government actors that have been a driving force for positive innovation.

Noel Fahey
Director, Economics and Strategic Research

1Trade and Development Report, 2011: Post-crisis Policy Challenges in the World Economy, United Nations Conference on Trade and Development (UNCTAD), callouts on page 92. Available at:
3Capital Formation in Residential Real Estate, Leo Grebler, David Blank and Louis Winnick, National Bureau of Economic Research, 1956, pages 232-3.
4Note that Building and Loan Associations had a proto-amortization system going back to the foundation of the Oxford Provident Building Society of Frankfurt, PA, in 1831. The procedures used (known as the “Building and Loan Method”) were more complicated than modern amortization. Borrowers purchased shares each month in the association until a sufficient amount (including accrued interim dividends) was accumulated to be applied against, and fully pay off, the loan balance. (See: Savings and Loan Fact Book, 1967, page 37; Elements of the Modern Building and Loan Associations, United States League of Local Building and Loan Associations, 1927, pages 5-7, 9-12 and 134-7). Essentially, the transaction involved an interest-only loan plus an accumulating sinking fund. The process was more expensive for borrowers than simple amortization since they might pay 7%, say, for their loan but only earn a 6% dividend on their contributions to paying off the principal. With simple amortization, in contrast, if the rate of interest on the loan were 7%, the payments to principal would effectively earn the same 7%. More problematic, the procedure involved major risk for the borrower. If the association ran into trouble, the borrower’s purchased shares might not be available to pay off the mortgage. This happened widely during the Depression as the losses from defaulted mortgages impaired the shares of other members and, in a downward spiral, lead to further defaults by borrowers who saw losses in the sinking fund part of their arrangement (giving a new ominous meaning to the term “sinking fund”). Prior to the Depression, about 10% of associations used modern direct-reduction amortization. FHA and HOLC required this practice for all their loans and thereby spread it to the rest of the industry in the 1930s. (See Kenneth Snowden in Finance, Intermediaries and Economic Development , Stanley Engerman et al., ed., 2003, page 187)
5Grebler, Blank and Winnick, ibid., page 232.
6 See:
7 The S&L Debacle, Lawrence J. White, Oxford University Press, 1991, Table 2-6, page 20.
8 During this period, Fannie Mae financed its mortgage holdings by issuing corporate debt until, like the S&Ls, it got caught with an interest-rate mismatch in the 1980s and reported losses for several years. Subsequently, it used a combination of MBS and better-hedged corporate debt to reduce its interest-rate risk exposure.
9 Banks and thrifts were major funders of adjustable-rate mortgages.
10 Improving U.S. Housing Finance through Reform of Fannie Mae and Freddie Mac: Assessing the Options, Ingrid Gould Ellen, John Napier Tye and Mark A. Willis, NYU Furman Center for Real Estate and Urban Policy, May 2010, page 2 (
11 In its Mortgage Metrics Report, the Office of the Comptroller of the Currency defines serious delinquencies as “loans 60 or more days delinquent or in bankruptcy and 30 or more days past due.” In Exhibit 3, loans in the process of foreclosure are added in to give the overall seriously distressed loan figure. The private-label MBS numbers are the market residual after taking out the numbers given by the OCC survey for GSE and FHA/VA loans serviced by large banks and thrifts and loans held in bank and thrift portfolios. (See:
12 See, for instance: Structured Finance, Issues of Valuation and Disclosure, International Monetary Fund, Box 2.2 pages 59-60 (at

December 8, 2011

Want to comment on this topic?

Send an email

Your contribution is subject to our Privacy Statement and Legal Disclosure.