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SECURITIZATION AND DERIVATIVES 

thrifts sell their mortgages. The legislation also authorized Fannie and Freddie to buy
“conventional” fixed-rate mortgages, which were not backed by the FHA or the VA.
Conventional mortgages were stiff competition to FHA mortgages because borrow-
ers could get them more quickly and with lower fees. Still, the conventional mort-
gages did have to conform to the GSEs’ loan size limits and underwriting guidelines,
such as debt-to-income and loan-to-value ratios. The GSEs purchased only these
“conforming” mortgages.
Before , Fannie Mae generally held the mortgages it purchased, profiting
from the difference—or spread—between its cost of funds and the interest paid on
these mortgages. The  and  laws gave Ginnie, Fannie, and Freddie another
option: securitization. Ginnie was the first to securitize mortgages, in . A lender
would assemble a pool of mortgages and issue securities backed by the mortgage
pool. Those securities would be sold to investors, with Ginnie guaranteeing timely
payment of principal and interest. Ginnie charged a fee to issuers for this guarantee.
In , Freddie got into the business of buying mortgages, pooling them, and then
selling mortgage-backed securities. Freddie collected fees from lenders for guaran-
teeing timely payment of principal and interest. In , after a spike in interest rates
caused large losses on Fannie’s portfolio of mortgages, Fannie followed. During the
s and s, the conventional mortgage market expanded, the GSEs grew in im-
portance, and the market share of the FHA and VA declined.
Fannie and Freddie had dual missions, both public and private: support the mort-
gage market and maximize returns for shareholders. They did not originate mort-
gages; they purchased them—from banks, thrifts, and mortgage companies—and
either held them in their portfolios or securitized and guaranteed them. Congress
granted both enterprises special privileges, such as exemptions from state and local
taxes and a . billion line of credit each from the Treasury. The Federal Reserve
provided services such as electronically clearing payments for GSE debt and securi-
ties as if they were Treasury bonds. So Fannie and Freddie could borrow at rates al-
most as low as the Treasury paid. Federal laws allowed banks, thrifts, and investment
funds to invest in GSE securities with relatively favorable capital requirements and
without limits. By contrast, laws and regulations strictly limited the amount of loans
banks could make to a single borrower and restricted their investments in the debt
obligations of other firms. In addition, unlike banks and thrifts, the GSEs were re-
quired to hold very little capital to protect against losses: only . to back their
guarantees of mortgage-backed securities and . to back the mortgages in their
portfolios. This compared to bank and thrift capital requirements of at least  of
mortgages assets under capital standards. Such privileges led investors and creditors
to believe that the government implicitly guaranteed the GSEs’ mortgage-backed se-
curities and debt and that GSE securities were therefore almost as safe as Treasury
bills. As a result, investors accepted very low returns on GSE-guaranteed mortgage-
backed securities and GSE debt obligations.
Mortgages are long-term assets often funded by short-term borrowings. For
example, thrifts generally used customer deposits to fund their mortgages. Fannie