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Home » Home Buying, Invest, Market Terminology, Mortgages

What is Fannie Mae & Freddie Mac? Why Should I Care?

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What is Fannie and Freddie?

The US Treasury finally bailed out Fannie Mae and Freddie Mac. The markets are responding positively to the decision, as expected. So why this is such a big deal? Let’s start with what these two companies actually do:

Fannie Mae and Freddie Mac are two government sponsored enterprises (GSEs) that practically run the secondary mortgage market in the United States. They are private corporations owned and operated by stockholders that securitize about half of this country’s mortgage market.

Think of them as middlemen: Fannie and Freddie match up people who need home loans with a fixed rate of interest to investors who want low-risk bonds with a fixed rate of return. Let’s say Doris from Nebraska wants a 15 year $200,000 mortgage with a fixed 8% interest rate, and Kevin from Texas wants a 15 year $200,000 bond that pays 8% – Fannie or Freddie will loan Doris the money for her house and repackage the debt as a mortgage-backed security bond and sell it to Kevin. (Usually, each mortgage debt is split into multiple incremental bonds, like 200 x $1,000 bonds.)

How do Freddie and Fannie Make Money (or Lose it)?

fannie and freddieFannie and Freddie make money from these transactions by charging a ‘guarantee fee’, which means that the investor pays a premium for the bond to cut out all associated risk. Once Fannie and Freddie guarantees a bond, the investor (Kevin) will receive the principal and the interest regardless of whether the loaner (Doris) fulfills the mortgage payments. So Fannie and Freddie assume all of the risk, but in a stable economy or even a slightly recessive economy (where the housing market has historically been rock solid), these two corporations make a huge profit from the guarantee fees. This system also increases the liquidity of the mortgage market, making it possible for more homeowners to receive loans.

In this simplified model, it’s easy to forget the pivotal fourth party: the originating bank. Doris cannot just stride into Fannie Mae and demand a mortgage. What she actually does is walk into her local First National Bank, ask for a loan, and then the bank approaches Fannie Mae for the liquid cash. So as far as Fannie and Freddie are concerned, their lending guidelines theoretically extend through the originating bank to the loaner. But pragmatically, the bank (or holding company) regulates Doris and her friends. So even though Doris had been screened and categorized as eligible for a Fannie Mae mortgage, First National Bank of Nebraska probably still saturated the market with sub-prime mortgages for Doris’ friends who would not normally qualify for a loan.

Why are Fannie and Freddie in Such Big Trouble?

Herein lays the critical issue. When two companies control half of the US mortgage market, and assume all associated risk, and are responsible for maintaining the market’s liquidity, but have minimal control over what the other half of the market looks like … and then the housing bubble bursts … you have a major, major problem.

Doris friends started defaulting on their mortgages, and the foreclosures crashed the value of houses. As mortgage lenders went out of business, banks made their lending policies stricter, choking off any remaining liquidity in the non-Fannie and Freddie half of the market.

As the economy slid, Fannie and Freddie also began to see their mortgages defaulting at an exceptional rate, while new mortgages were non-existent because no one was purchasing real estate anymore. Suddenly, those bond guarantees looked awfully bad, as Kevin had to be re-paid the principal and the locked in 8% return while Doris and her friends were no longer able to pay their 8%. Fannie and Freddie pulled hard on their purse-strings and mortgage lending slowed to a trickle.

Why Should I Care About Fannie and Freddie?

Hopefully you or a mutual fund you own hasn’t owned Fannie and Freddie’s stock. In the 12 months since the sub-prime crisis hit (Aug ’07), Fannie Mae and Freddie Mac stocks have fallen by over 95%.

When economists started screaming about a possible housing market collapse, Fannie and Freddie should have raised a large amount of reserve capital to provide a buffer during the recession. This was never attempted, and partnered with the incongruous and inexplicable lack of government regulation of sub-prime mortgages over the last 5 years, a catastrophe of this magnitude was (in retrospect) unavoidable.

If Fannie and Freddie were to go under, all of the ‘guaranteed’ bonds sold by these two companies would become void and the trickling mortgage market would completely dry up. The ‘slow’ housing market would become a ‘dead’ housing market, and the US would fall even deeper (yes, it’s possible) into recession. And since a large percentage of the Fannie and Freddie bonds are owned by foreign investors, bankruptcy would have dragged an already floundering worldwide economy even deeper into the abyss.

The US Treasury wanted to avoid this inevitability, and initially tried to right the ship by throwing words of confidence behind the two companies. The stock continued to fall. The government then allowed Fannie and Freddie to tap directly into the super low interest rates of the Federal Reserve. The stock continued to fall. Finally, the Treasury took the most drastic of steps and took over control of both companies under a government Conservatorship where all of the debt will be assumed by the tax payers. This is the largest government bailout of a private company in US history, and by all accounts, it was long overdue.

The Short and Long Term Effects of Fannie and Freddie’s Bailout

Expect the stock market to rally over the next few weeks, and the credit market to loosen slightly, but do not expect the housing market to improve immediately. It will take time to fix this mess. Ultimately, mortgage rates should see a temporary drop that presents a good opportunity to buy if you’re a qualified buyer. What is almost certain is that as a taxpayer to the federal government, you will ultimately foot the bill for these companies troubles.

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3 Comments »
  • Craig Kessler says:

    Thanks for the great explanation concerning the ongoing issue. Being younger and not quite up to the point where I’m looking to purchase a house I have been confused with the situation and how it could potentially affect me. Is there a time line you think this will continue at till things look up?

    Craig

  • payplan says:

    According to Bush Fannie & Freddie going under would cause “an unacceptable risk” to the economy. Why? The two companies account for nearly HALF of the outstanding mortgages in the United States. And today the news of Lehman Brothers filing for Chapter 11 is another huge blow.

    Our global economy is fragile at the moment and we’re paying the price of nearly 20 years of stability and greed.

    Rocky times ahead.

  • Ki says:

    Although currently the largest bailout in history the Fannie Mae / Freddie Mac seems like small fries compared to the 700 billion bailout they are currently planning for the banks carrying all the bad debt.

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