The Impact of the GNMA Pass‐through Program on FHA Mortgage Costs

Abstract

of the instrument, giving rise to market and marketability risk, respectively. Residential mortgages are debt instruments with a peculiarly interesting set of characteristics compared to Treasury securities. Although a mortgagor may be contractually obligated to amortize his indebtedness over, say, 30 years, prepayments of principal are common. Moreover, some mortgagors prepay more quickly than others, so an investor cannot be certain that actual payments will correspond even to an expected accelerated amortization schedule. Thus, the investor bears both reinvestment (because the mortgage may be paid off faster than expected) and market and marketability risks (because the mortgage may be paid off slower than expected). The combination of reinvestment and market risks stemming from uncertain cash flows on a mortgage will be called risk in the remainder of this paper. There are differences between Treasury securities and mortgages other than timing risk. In general, a mortgage bears credit because the mortgagor may not make payments as promised and because the liquidated value of the collateral property may be less than the remaining principal balance if default occurs. Even when a mortgage is insured, as in the Federal Housing Administration (FHA) program, an investor suffers losses from default when his claim for the remaining principal is not satisfied promptly. To guard against such losses, an investor must evaluate each individual mortgage he buys. The cost of such investigation impairs secondary market transfers of mortgages, implying the instruments bear greater marketability relative to Treasury securities. Finally, the costs of servicing mortgages, that is, obtaining and recording the payments of interest and amortization of principal, are substantially greater than the costs of servicing an investment in Treasury securities. The presence of timing risk, credit risk, and