Mortgage Backed Securities

A major change in the residential mortgage market in recent years has been the creation of an active secondary market for mortgages. Because mortgages have different terms and interest rates, they were not sufficiently liquid to trade as securities on secondary markets. To stimulate mortgage lending, in 1970 the Government National Mortgage Association (GNMA, called "Ginnie Mae") developed the concept of a pass-through mortgage-backed security when it began a program in which it guaranteed interest and principal payments on bundles of standardized mortgages. Under this program, private financial institutions such as savings and loans and commercial banks were now able to gather a group of GNMA-guaranteed mortgages into a bundle of, say, $1 million and then sell this bundle as a security to a third party (usually a large institutional investor such as a pension fund). When individuals make their mortgage payments on the GNMA-guaranteed mortgage to the financial institution, the financial institution passes the payments through to the owner of the security by sending a check for the total of all the payments. Because GNMA guarantees the payments, these pass-through securities have a very low default risk and are very popular, with amounts outstanding exceeding $500 billion.

Mortgage-backed securities are issued not only by the government agencies, but also by private financial institutions. Indeed, mortgage-backed securities have been so successful that they have completely transformed the residential mortgage market. Throughout the 1970s, over 80% of residential mortgages were owned outright by savings and loans, mutual savings banks, and commercial banks. Now only one-third are owned outright by these institutions, with two-thirds held as mortgage-backed securities.

Corporate Bonds. These are long-term bonds issued by corporations with very strong credit ratings. The typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. Some corporate bonds, called convertible bonds, have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date. This feature makes these convertible bonds more desirable to prospective purchasers than bonds without it, and allows the corporation to reduce its interest payments, because these bonds can increase in value if the price of the stock appreciates sufficiently. Because the outstanding amount of both convertible and nonconvertible bonds for any given corporation is small, they are not nearly as liquid as other securities such as U.S. government bonds.

Although the size of the corporate bond market is substantially smaller than that of the stock market, with the amount of corporate bonds outstanding less than one-fourth that of stocks, the volume of new corporate bonds issued each year is substantially greater than the volume of new stock issues. Thus the behavior of the corporate bond market is probably far more important to a firm's financing decisions than the behavior of the stock market. The principal buyers of corporate bonds are life insurance companies; pension funds and households are other large holders.

U.S. Government Securities. These long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government. Because they are the most widely traded bonds in the United States (the volume of transactions on average exceeds $100 billion daily), they are the most liquid security traded in the capital market. They are held by the Federal Reserve, banks, households, and foreigners.

U.S. Government Agency Securities. These are long-term bonds issued by various government agencies such as Ginnie Mae, the Federal Farm Credit Bank, and the Tennessee Valley Authority to finance such items as mortgages, farm loans, or powergenerating equipment. Many of these securities are guaranteed by the federal government. They function much like U.S. government bonds and are held by similar parties.

State and Local Government Bonds. State and local bonds, also called municipal bonds, are long-term debt instruments issued by state and local governments to finance expenditures on schools, roads, and other large programs. An important feature of these bonds is that their interest payments are exempt from federal income tax and generally from state taxes in the issuing state. Commercial banks, with their high income tax rate, are the biggest buyers of these securities, owning over half the total amount outstanding. The next biggest group of holders consists of wealthy individuals in high income brackets, followed by insurance companies.

Consumer and Bank Commercial Loans. These are loans to consumers and businesses made principally by banks, but—in the case of consumer loans—also by finance companies. There are often no secondary markets in these loans, which makes them the least liquid of the capital market instruments listed in Table 2. However, secondary markets have been rapidly developing.

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