Freddie Mac and Fannie Mae, officially known as the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae), are two government-sponsored enterprises (GSEs) in the United States. They play a pivotal role in the country’s housing finance system, particularly in providing liquidity and stability to the mortgage market. In this comprehensive exploration, we will delve into the origins, functions, and the reasons behind the financial difficulties that led to their failure and subsequent government intervention.
Part 1: Origins and Functions of Freddie Mac and Fannie Mae
1. Origins of Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac were both established by the U.S. government but had different origins:
- Fannie Mae (Federal National Mortgage Association): Fannie Mae was created during the Great Depression in 1938 as part of the New Deal under President Franklin D. Roosevelt. Its primary mission was to provide stability to the housing market by purchasing and guaranteeing mortgages from banks and other lenders. This allowed lenders to free up capital and make more loans to prospective homeowners.
- Freddie Mac (Federal Home Loan Mortgage Corporation): Freddie Mac was created in 1970 to provide additional competition in the secondary mortgage market. Its purpose was similar to Fannie Mae’s – to promote homeownership by purchasing mortgages from lenders, packaging them into securities, and selling those securities to investors. This activity helped provide a continuous flow of capital for mortgage lending.
2. Functions of Freddie Mac and Fannie Mae
Fannie Mae and Freddie Mac had several key functions within the U.S. housing finance system:
a. Mortgage Purchases:
Both entities purchased mortgages from primary lenders, including banks and credit unions. This provided liquidity to lenders, enabling them to issue new mortgages to homebuyers.
b. Mortgage Securitization:
Fannie Mae and Freddie Mac bundled the mortgages they purchased into mortgage-backed securities (MBS). These MBS were sold to investors, including institutional investors, foreign governments, and individuals, providing a way to indirectly invest in the U.S. housing market.
c. Guaranteeing Mortgages:
One of the critical roles of these GSEs was to guarantee the payment of principal and interest on MBS issued by them. This guarantee made MBS more attractive to investors, as it implied a lower level of risk.
d. Standardization:
Fannie Mae and Freddie Mac helped standardize mortgage lending practices by establishing guidelines for lenders to follow. This included setting criteria for borrower creditworthiness, down payments, and loan terms. These standards made it easier for borrowers to access mortgage financing.
e. Affordable Housing Mandate:
As part of their charters, Fannie Mae and Freddie Mac had an obligation to support affordable housing initiatives. They were required to allocate a portion of their lending activities to low and moderate-income borrowers.
3. Government-Sponsored Enterprises (GSEs)
It’s important to note that while Fannie Mae and Freddie Mac were private corporations, they were considered government-sponsored enterprises (GSEs). This unique status meant they operated with certain privileges:
- Implicit Government Backing: Investors and the public believed that the U.S. government implicitly guaranteed the debt issued by Fannie Mae and Freddie Mac. This perception helped them secure funding at lower interest rates than purely private corporations.
- Reduced Capital Requirements: GSEs had lower capital requirements compared to fully private financial institutions. This allowed them to operate with higher leverage, making their operations more profitable.
- Regulatory Oversight: While they operated as private companies, Fannie Mae and Freddie Mac were subject to regulatory oversight by the Office of Federal Housing Enterprise Oversight (OFHEO), later replaced by the Federal Housing Finance Agency (FHFA).
Part 2: Financial Difficulties and Government Intervention
While Fannie Mae and Freddie Mac played a crucial role in the U.S. housing market for decades, their financial difficulties and subsequent government intervention are rooted in several key factors:
1. Risky Mortgage Investments
One of the primary reasons for the failure of Fannie Mae and Freddie Mac was their significant investments in risky mortgage products, particularly during the housing bubble that preceded the 2008 financial crisis. Both entities purchased a large number of subprime mortgages and mortgage-backed securities, which were characterized by high default rates.
These risky investments were made to maximize profits and meet shareholder expectations, but they exposed the GSEs to substantial financial losses when the housing market collapsed. The collapse led to a sharp decline in the value of their mortgage-backed securities, eroding their capital reserves.
2. Lack of Sufficient Capital
Fannie Mae and Freddie Mac operated with relatively thin capital buffers compared to their massive balance sheets. This made them vulnerable to market downturns and significant losses. When housing prices declined, and mortgage defaults increased, the GSEs faced substantial losses that quickly depleted their capital.
3. Inadequate Risk Management
The GSEs also faced criticism for their inadequate risk management practices. They failed to accurately assess the risks associated with their mortgage investments, including the subprime mortgages they held. Their risk models did not account for the severity of potential downturns in the housing market.
4. Political Pressure to Promote Homeownership
Throughout their history, Fannie Mae and Freddie Mac faced pressure from politicians and policymakers to promote homeownership, especially among low and moderate-income individuals and minorities. This led to a loosening of lending standards and an increase in the purchase of riskier mortgages.
5. Accounting Scandals
Both GSEs were involved in accounting scandals that raised concerns about their financial transparency and management practices. Fannie Mae, in particular, faced allegations of accounting manipulation to meet earnings targets. These scandals eroded investor confidence and contributed to their financial woes.
6. Market Perception of Government Backing
The implicit government backing that Fannie Mae and Freddie Mac enjoyed had the unintended consequence of encouraging risk-taking behavior. Investors believed that the government would bail out the GSEs in the event of financial trouble, leading to moral hazard.
Part 3: Government Intervention and Conservatorship
As the financial difficulties of Fannie Mae and Freddie Mac escalated in 2008 due to the subprime mortgage crisis and the subsequent collapse of Lehman Brothers, the U.S. government intervened to prevent a complete collapse of the housing finance system. The government’s actions included:
1. Conservatorship
In September 2008, the Federal Housing Finance Agency (FHFA) placed both Fannie Mae and Freddie Mac into conservatorship. This meant that the FHFA assumed control of the GSEs’ operations and financial management. The conservatorship was intended to stabilize the housing market and protect taxpayers from further financial losses.
2. Financial Support
The U.S. Treasury Department provided financial support to Fannie Mae and Freddie Mac to ensure their continued operations. This support included purchasing preferred stock in the GSEs to inject capital and keep them solvent.
3. Limits on Portfolio Growth
Under conservatorship, the FHFA imposed limits on the size of Fannie Mae and Freddie Mac’s mortgage portfolios. These limits were intended to reduce their risk exposure and prevent them from taking on additional risky mortgage assets.
4. Retaining Earnings
The GSEs were required to retain their earnings rather than paying dividends to shareholders. This helped them rebuild their capital reserves over time.
5. Increased Oversight
The FHFA increased its oversight of Fannie Mae and Freddie Mac, implementing stricter regulatory controls to ensure their stability and adherence to sound financial practices.
Part 4: Ongoing Status of Fannie Mae and Freddie Mac
As of my last knowledge update in September 2021, Fannie Mae and Freddie Mac remain in conservatorship under FHFA oversight. However, discussions and plans for reforming the housing finance system in the United States have been ongoing for years. Key developments include:
1. Preferred Stock Purchase Agreements
Under the preferred stock purchase agreements (PSPAs) with the U.S. Treasury, Fannie Mae and Freddie Mac are required to send their profits to the Treasury, effectively preventing them from building capital. This arrangement has been a point of contention and discussion regarding their future.
2. Proposed Reforms
Various proposals for reforming the housing finance system have been debated in Congress, including plans to privatize Fannie Mae and Freddie Mac and reduce the government’s role in housing finance. However, achieving consensus on the best approach has proven challenging.
3. Affordable Housing Goals
Efforts to balance the GSEs’ mission to promote affordable housing while minimizing risk have also been a topic of debate. Policymakers have sought ways to ensure that underserved communities continue to have access to mortgage credit.
4. GSE Capital Requirements
There have been discussions about the appropriate capital requirements for Fannie Mae and Freddie Mac to enhance their stability and reduce taxpayer risk.
It’s important to note that the status and future of Fannie Mae and Freddie Mac may have evolved since my last update. These entities remain critical players in the U.S. housing finance system, and the ongoing debate over their role and reform will continue to shape the future of housing finance in the United States.
Conclusion
Fannie Mae and Freddie Mac have played vital roles in the U.S. housing finance system for decades, facilitating mortgage lending, providing liquidity to the market, and promoting homeownership. However, their financial difficulties and the subsequent government intervention in 2008 underscored the complex challenges and risks associated with their operations.
The failure of Fannie Mae and Freddie Mac was driven by a combination of factors, including risky mortgage investments, inadequate capital, lax risk management practices, political pressure to promote homeownership, accounting scandals, and market perceptions of government backing. The government’s conservatorship and financial support were necessary to stabilize the housing market and prevent a broader financial collapse.
The ongoing debate over the future of Fannie Mae and Freddie Mac reflects the complexities of housing finance policy in the United States. Achieving a balance between promoting homeownership, protecting taxpayers, and minimizing risk remains a significant challenge for policymakers and regulators. The ultimate resolution will have far-reaching implications for the U.S. housing market and the broader financial system.
