The Early Years
The Federal National Mortgage Association, commonly known as Fannie Mae, was created at the request of President Franklin D. Roosevelt in 1938. At the time, the mortgage market was segmented and the availability of funds to borrowers was inconsistent. As a government agency, Fannie Mae was authorized to borrow funds to buy Federal Housing Administration (FHA) insured mortgages from the institution that originated them, thereby providing additional funds to the loan originators and creating a secondary market for mortgages. Fannie then held these mortgages in its portfolio, receiving income as borrowers repaid interest and principals. The agency’s authority was later extended to enable purchases of Veterans Administration (VA) guaranteed mortgages.
From 1938 to 1968, Fannie Mae held a monopoly on secondary mortgage market operations in the United States. In 1968, Fannie Mae was privatized (but still regulated), and some of its responsibilities were shifted to Ginnie Mae, the Government National Mortgage Association, which was created as part of an effort by the U.S. Department of Housing and Urban Development (HUD) to use the “full faith and credit of the U.S. government” to support the FHA and VA mortgage markets. Ginnie Mae operated differently from Fannie in that it did not hold mortgages purchased as part of its portfolio, but instead, pooled them and sold securities backed by this pool to investors.
In 1970, Fannie Mae’s authority was further extended to allow for the purchase of conventional mortgages (non-government-insured loans) for its portfolio. To increase liquidity and stability in the mortgage market, Congress chartered the Federal Home Loan Mortgage Corporation, known as Freddie Mac, in 1970, and authorized it to purchase and pool conventional mortgages. Freddie modeled its programs after those of Ginnie Mae. Fannie continued to hold all of the mortgages it purchased until 1981, when it began to pool mortgages.
In 1992, the Office of Federal Housing Enterprise Oversight (OFHEO) within HUD was created to regulate Fannie and Freddie. Among its responsibilities, OFHEO was authorized to place Freddie or Fannie into government conservatorship if it decided either agency was critically undercapitalized.
Prior to the government takeover, Fannie Mae and Freddie Mac were funded with private capital and their debt securities were not guaranteed by the federal government. They were stockholder-owned corporations listed on the New York Stock Exchange (NYSE). However, they were also government-sponsored enterprises (GSEs) owned by their shareholders, but regulated by government agencies.
Primary Versus Secondary Markets
Mortgage markets are divided into primary and secondary markets. In primary markets, loans are originated by lending institutions often mortgage banks, savings and loan associations, commercial banks, or credit unions. These lending institutions typically obtain the funds they loan from individual, business, or government deposits or mortgages sales in the secondary markets.
Both Fannie Mae and Freddie Mac operate in the secondary mortgage markets. They provide liquidity to the market by borrowing money to purchase the loans originated by lending institutions. They then either hold the mortgages in their portfolio or pool the mortgages and sell securities backed by these pools referred to as mortgage-backed securities (MBS) by Fannie and participation certificates (PC) by Freddie to investors. The pooling process is known as “securitization.” As of 2008, these mortgage giants either own or guarantee $5.2 trillion or approximately half of the U.S.’s $12 trillion mortgage market.
An MBS or PC provides an investor with an attractive option for participating in mortgage markets. First, they are actively traded through a network of dealers. This provides investors with a mortgage alternative that is highly liquid. Second, Fannie Mae and Freddie Mac guarantee the timely payment of principal and interest on the mortgages they securitize. Investors pay a guarantee fee and eliminate credit risk. Thus, these two mortgage giants increase the amount of funds available in the mortgage market, and provide an attractive mortgage alternative for investors.
How Did it Go Wrong?
Fannie and Freddie’s GSE status benefitted them in several ways. First, they were able to borrow at low interest rates because of the implicit government guarantee and purchase higher-yielding mortgages. This positive spread typically provided a nice profit. Second, they were able to operate at much higher levels of debt than most “private” firms. By the end of 2007, their combined capital of $83.2 billion supported debt and mortgage guarantees of about $5.2 trillion.
However, Fannie and Freddie faced certain risks, mainly interest rate, credit, and pre-payment risks. Interest rate risk is the risk that interest rates will rise, causing the value of a loan portfolio to fall. Credit risk is the risk that borrowers will default on their mortgages. Pre-payment risk is the risk that the borrower will pay off a mortgage earlier than anticipated. Interest rate risk was of particular concern to Fannie and Freddie, given their high debt-to-equity ratios; a small drop in the value of their assets could wipe out their equity, making them insolvent. However, by pooling mortgages and selling securities backed by these pools, they were able to minimize this risk. But even with pooling, credit risk remained as Freddie and Fannie guarantee the timely payment of interest and principals. This risk was minimized as their government mandate stated that they were only allowed to purchase mortgages from individuals offering down payments and possessing good credit ratings. Pre-payment risk exists for the buyer of an MBS, as its price is based on the anticipated life of the mortgages. If borrowers pay off their mortgages early, the return to the investor is negatively impacted since the amount of interest generated by the mortgage is decreased. Interest is paid on outstanding principals no principals, no interest.
During the late 1990s, Freddie and Fannie modified their operations by buying MBSs issued by others, including those containing sub-prime mortgages. Freddie’s investment grew from $25 billion in 1998 to $267 billion by the end of 2007. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion by the end of 2007. These activities exposed them to interest rate, credit, and pre-payment risks.
To minimize credit risk, they purchased insurance; to minimize interest rate risk, they purchased derivative contracts. However, insurance firms are also suffering. Moody’s and Standard & Poor’s recently downgraded the ratings of many insurers based on faltering financial strength, making the value of this insurance questionable. In addition, the value of their $2.3 trillion derivative contracts depends on the ability of their counterparties who are unnamed to pay up. Given that both Fannie and Freddie have reported a loss on hedging transactions, the value of this “insurance” is also unclear.
Too Big to Fail?
Officially, the U.S. government did not guarantee Fannie Mae and Freddie Mac’s securities. Unofficially, it had long been assumed that due to the size of their holdings and their importance to the mortgage market, these GSEs were too big to fail. They enjoyed the widespread perception of being federally-backed financial agencies. Vernon L. Smith, the 2002 Nobel Laureate in economics, called these two agencies “implicitly taxpayer-backed agencies.”
Critics have long argued that Fannie and Freddie did not adequately offset their financial risk because they were seriously undercapitalized. As early as 2002, The Wall Street Journal expressed concern about the size of the outstanding debt of these two GSEs, as well as their increasing dependence on derivatives. However, they were able to circumvent congressional efforts to increase oversight due to many believe their deep and vast political connections. Both Fannie and Freddie were particularly hard hit by the current subprime mortgage crisis. As home prices continued to fall and delinquencies increased, the impact on their balance sheets became obvious. In the nine months that ended on March 31, 2008, the combined losses of Fannie and Freddie soared to more than $11 billion.
The share prices of both mortgage giants were buffeted by speculation that either they would have to issue additional stock to offset losses, leading to greater dilution of current shares, or the government would have to bail them out, causing current shares to become worthless. To compound their problems, Lehman Brothers yes, the recently deceased Lehman Brothers announced on July 7, 2008 that a change in accounting rules would require them to raise billions of dollars in new capital. By July 8, Fannie’s shares had lost 76 percent of their value and Freddie’s shares 80 percent.
The Bailout: Step 1
On July 13, 2008, Secretary of the Treasury Henry Paulson unveiled an emergency plan to support Fannie Mae and Freddie Mac. Secretary Paulson noted that without government intervention, the housing market could lose major players, the banking system could face new losses, and foreign investors could flee the country. Roughly $1.5 trillion of Fannie and Freddie’s AAA-rated debt, along with that of other U.S. “government-sponsored enterprises” is now in foreign hands.
The emergency plan was followed weeks later by action the American Housing Rescue and Foreclose Prevention Act passed by Congress and signed by President Bush. The act had three purposes: to prevent foreclosures, increase home purchases, and aid Fannie Mae and Freddie Mac. It included most of the provisions in the Treasury’s plan, albeit with some limitations. First, it set up a new regulator, the Federal Housing Finance Agency (FHFA), to oversee Freddie and Fannie. Second, it authorized the Treasury Department to increase its lending to Fannie and Freddie, and to purchase stock in the two corporations if necessary. However, the aid could not cause a breach in the federal debt ceiling, a constraint meant to limit taxpayer losses. Third, it authorized Treasury to restrict dividend payments to shareholders and approve the salaries of top executives. Last, the act permanently increased the cap on mortgages that Fannie and Freddie can purchase in high-cost markets to $625,500.
The lobbying efforts of these two quasi-government institutions appeared to have been successful. Not only did they benefit from the rescue package, but Congress did not impose any changes in their management, nor were there any penalties to be paid by shareholders. The lack of accountability for the executives of these two companies stands today. As Robert Reich, former Secretary of Labor under President Clinton, remarked, “We’ve created the worst of socialized capitalism private gains combined with public losses.”
In the last election cycle, Freddie Mac’s political action committee (PAC) contributed $202,997 to federal candidates (evenly split between Democrats and Republicans) and Fannie Mae’s PAC contributed $617,900 (59 percent to Democratic candidates). Opponents of the bailout sited the danger of the government and the financial markets becoming too cozy. Republican Senator Jim DeMint proposed an amendment to the housing bill that would have banned Fannie and Freddie from making political contributions if they received a bailout. However, the Democratic leadership refused to allow a vote on his proposal.
The Bailout: Step 2
The first market response to the housing act was positive. Fannie and Freddie saw the value of their shares increase and they were able to borrow at a reduced premium over Treasury securities. However, the positive outcome soon turned, and on September 7, the government placed Fannie and Freddie in conservatorship in order to prevent a financial meltdown. This provided access to loans, secured by their assets, until the end of 2009. In addition, Treasury assumed the role of buyer of last resort for bonds packaged by Fannie and Freddie, in case there was a slack in demand.
The immediate market reaction was positive. The Dow Jones Industrial Average gained over 300 points, the cost of Fannie and Freddie’s borrowing dropped 40 basis points, and the mortgage rate dropped 50 basis points. However, there were losers. The chief executives of both organizations were replaced, although controversy continues over the multimillion-dollar severance packages they are slated to receive and the U.S. Federal Bureau of Investigation announced it is investigating them for possible fraud. The share price of Fannie plunged to $0.73 and the share price of Freddie fell to $0.88, with the takeover expected to further diminish their value. Shareholders suffered, but bondholders, including foreign central banks, were protected.
Given the current turmoil in U.S. capital markets and the faltering housing market, the U.S. government was left with little choice but to rescue Fannie Mae and Freddie Mac. Market observers suggested that the failure of either mortgage giant would substantially decrease the amount of available mortgage funds and increase the cost of funds to home buyers. In addition, the impact on the confidence of foreign investors in U.S. capital markets would be disastrous given the agencies’ implicit government support. However, this step was not enough to stabilize financial markets. The financial crisis soon spread from Wall Street to Main Street, leading to the passage of the $700 billion rescue package by Congress.
The question now is: what will Fannie and Freddie look like after the credit markets stabilize? Several ideas are being discussed both openly and behind closed doors. Some Democratic lawmakers, including Senator Christopher Dodd and Representative Barney Frank proposed that few structural changes be made. Although they have provided no specifics, Dodd and Frank suggest that Fannie and Freddie be nursed back to health and returned to their former structure with additional safeguards. Some have suggested that they shrink in size and become public utilities. In this scenario, their profits and activities would be tightly regulated and their investment portfolios reduced. Others have suggested that Fannie and Freddie should be nationalized, i.e., transformed into government agencies similar to Fannie’s original incarnation. They would then be managed by government-appointed officials, with their profits turned over to the Treasury. Finally, some suggest that after the crisis passes, Fannie and Freddie should be liquidated. Private sector institutions with no government support would then replace them in the marketplace.
At this time, we return to the original question: Who or what are Fannie Mae and Freddie Mac? They have been important organizations within the housing market, but they are evolving. In the future, what you will see is not necessarily what you will get.
 Economist.com, End of Illusions, http://www.economist.com/finance/displaystory.cfm?story_id=11751139.
 James Hagerty and Serena Ng, “Mortgage Giants Take Beating on Fears over Loan Defaults” The Wall Street Journal, July 8, 2008, at A1.
 Vernon Smith, “The Clinton Housing Bubble” The Wall Street Journal, July 22, 2008.
 “Fannie Mae Enron” The Wall Street Journal, February 20, 2002, at A22.
 The Economist, July 12, 2008, 12.
 Robert Reich, “A Modest Proposal for Ending Socialized Capitalism” Robert Reich’s Blog, http://robertreich.blogspot.com/2008/07/modest-proposal-for-ending-socialized.html. (no longer accessible).
 Richard Simon, “Congress Tosses a Life Preserver to the Housing Market” The Los Angeles Times, July 27, 2008, at A1.
 Economist.com, Suffering a Seizure, http://www.economist.com/finance/displaystory.cfm?story_id=12078933.
 Walter Hamilton, “Wall Street Applauds Takeover” The Los Angeles Times, September 9, 2008, at C1.
 Stephen Labaton and Edmund Andrews, “Reinventing Mortgage Giants: A Big Rebuild or a Teardown?” The New York Times, September 9, 2008, at A1.