Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Mortgage Corporation) exist to provide liquidity for financing mortgages. They operated as government-sponsored enterprises (GSEs) from 1968 until the housing crisis of 2008, when they were taken into conservatorship and placed under the management of the Federal Housing Finance Agency (FHFA).
What do these companies do? Broadly speaking, their role is to help stabilize the nation’s residential mortgage markets while expanding opportunities for home ownership. They do this by purchasing mortgages on the secondary market from banks, which they bundle into government guaranteed mortgage-related securities.
To help explain this process, let’s start at the bank level. Banks do not usually hold the mortgage loans they make. Instead, they sell those loans to institutional investors in order to free up their capital to make new loans. Fannie Mae and Freddie Mac buy up a majority of these loans that meet a set of risk guidelines. Such a loan is called a qualifying loan.
In turn, Fannie Mae and Freddie Mac package these mortgage loans into securities and sell them to both institutional and retail investors. Since Fannie Mae and Freddie Mac were GSEs' – private entities with implicit government backing – these securities were considered relatively safe investments. This mechanism keeps capital flowing into the housing market and helps to make credit (and therefore homeownership) relatively affordable for you, the aspiring homeowner.
So, how did we arrive at the current credit crunch? An increasing number of loans known as subprime mortgages were made in the 2000's with higher levels of risk – featuring homebuyers with typically non-qualifying credit scores, often below 600.
Why was this done? That is a great question to start a partisan argument.
Conservatives argue that government mandates to make housing as affordable as possible created the environment to extend too many loans to unqualified people. Liberals argue that private firms doing the same thing as Fannie Mae and Freddie Mac with higher-risk loans started the problem, and drew Fannie Mae and Freddie Mac (as well as others) into the problem by misrepresenting and hiding the risk levels of securities associated with the loans to investors.
Whatever your belief on the cause, the result was that the market partially collapsed under the weight of the recession, leaving people defaulting on a record number of mortgages, and causing Fannie Mae and Freddie Mac to incur huge losses – around $265 billion from January 2008 to March 2012. Over 60% of those losses were related to mortgage purchases in 2006-2007.
With Fannie Mae and Freddie Mac bordering on insolvency and the private market spooked, capital dried up for new loans. Home values plummeted, leaving more people underwater and propelling a downward spiral. The government took Fannie Mae and Freddie Mac into conservatorship to provide stability in the market, believing there was no reasonable private alternative.
Should Freddie Mac and Fannie Mae continue to exist? Many people argue no – but somebody must be the conduit between banks and investors to securitize loans and bring in private capital. Without that conduit, it is difficult for banks to provide affordable credit to homeowners. Currently, that conduit is the government through Fannie Mae and Freddie Mac – around 95% of all home loans in 2012 were government-backed.
Can private firms do better? They certainly didn't in the recent crisis – yet heavy reliance on government backing leaves taxpayers vulnerable for another bailout in the future.
So, while the value and future role of Fannie Mae and Freddie Mac remain contentious in Washington, these two mortgage titans continue to affect you directly as a homeowner. Their role in the overall market helps define your home value, and also affects overall market conditions. It also affects you as a taxpayer, since ultimately you pay for bailouts.
Regardless of your political views, keep an eye on the debate on Fannie Mae and Freddie Mac. Their role in the housing market will continue to affect you directly.
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