Meet Fannie & Freddie

Over the last few weeks, more attention has been put on dismantling Fannie Mae and Freddie Mac. Why? Because FNMA and FMAC have been singled out as one of the main causes of the national housing meltdown. Early on, during the early days of the financial crisis, the federal government had to step in and take control of these two mortgage financiers and set them up in a conservatorship. Starting with the bailout, the two companies required roughly $150 billion in taxpayer support to stay solvent, while the government was able to keep the housing market afloat by backing more than 95 percent of all home loans made in the United States.

The mortgage giant has now been turning a profit. This year it has had an $18.2 billion profit, its sixth-straight quarter with positive results. Fannie Mae has repaid the US Treasury nearly $95 billion—close to the $117 billion it originally drew. Freddie Mac has also been profitable. So, if they’re profitable, that means that they are near paying off their debt, because the profits go back to pay their bailout, correct?

It turns out they don’t. So where does it go? The chief beneficiary of Fannie’s profits, is the federal government—the same entity that bailed it out at the height of the financial panic nearly five years ago. The payback was not set up as a loan, with debt payments towards paying off the initial debt as most notes are done. Part of the agreement was that the government took senior preferred shares of the company. Fannie Mae now has to pay nearly all of its profits, save a small capital cushion, to the government in dividends. This doesn’t pay back the draw; it is just a dividend. In turn the federal government decides where the money should go. This does not necessarily go to paying off the original debt.

So, should we do away with them, because of the financial meltdown? Let’s start with a basic understanding of who they are and what they do.

What do Fannie Mae and Freddie Mac do?

Fannie MAE and Freddie MAC remain two of the largest financial institutions in the world, responsible for a combined $5 trillion in mortgage assets.

FNMA was founded in 1938 during the Great Depression as part of the New Deal, in response to mass bank failures. FMAC was created in the early 70’s to help create a secondary market to package mortgages to investors. Before the depression most mortgages were held by local and regional banks with little to no insurance or federal backing should the real estate market turn against them. FNMA is a government-sponsored enterprise (GSE), though it has been a publicly traded company since 1968. The primary function of Fannie Mae and Freddie Mac is to provide liquidity to the nation’s mortgage finance system. Fannie and Freddie purchase home and residential loans made by private firms (provided the loans meet strict size, credit, and underwriting standards), package those loans into mortgage-backed securities, and guarantee the timely payment of principal and interest on those securities to outside investors. Fannie and Freddie also hold some home loans and mortgage securities in their own investment portfolios.

The theory is, since the mortgage lenders (firms) don’t have to hold these loans on their balance sheets, they will have more capital available to make loans to other creditworthy borrowers, in turn stimulating the local, regional and national economy. These lenders, because of the implied backing of the federal government, also added incentives in the package of 30 years notes, a unique form of long term mortgages in the world of finance, unique primarily to the US. This ability to offer safe and sustainable products—namely long-term, fixed-rate mortgages – exists because lenders know Fannie and Freddie will likely purchase them. Since Fannie and Freddie guarantee payments in the event of a default – for a fee, of course – investors don’t have to worry about credit risk, which makes these mortgages a particularly attractive investment.

Outside the United States, fixed-rate mortgages are less popular, and in some countries, true fixed-rate mortgages are not available except for shorter-term loans. For example, in Canada the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities (the length of the loan) are commonly 25 years. Britain and its mortgage industry has traditionally been dominated by building societies, whose mortgages require at least 50% deposits, so lenders prefer variable-rate mortgages to fixed-rate mortgages to reduce asset-liability mismatch due to interest rate risk. Lenders, in turn, influence consumer decisions which already prefer lower initial monthly payments, driven by higher down payments.

Under the current US finance system, mortgage credit was continuously and easily available well into the late-1990s under terms and at prices that put sustainable homeownership within reach for most American families. This philosophy was part of the ‘American Dream’: to own a portion of land with your own house, independent of a landlord. Housing became viewed as a ‘safe investment’, so Wall Street figured out how to purchase and securitize mortgages without needing Fannie and Freddie as intermediaries, leading to a fundamental shift in the U.S. mortgage market and causing other issues.

Did FNMA/FMAC play a major role in the housing bubble?

Contrary to most arguments, the answer is that their role contributed very little. During the bubble, loan originators backed by Wall Street capital began operating outside the FNMA / FMAC system that had been working for decades by packaging and selling large quantities of high-risk subprime mortgages with terms and features that drastically increased the chance of default. (Many financial institutions were trading these mortgage backed securities with little to no concern over the higher level of risk in these portfolios. Those people and institutions that invested in them did not always realize the higher risk). Many of those loans were predatory products such as hybrid adjustable-rate mortgages with balloon payments that required serial refinancing, or negative amortization, mortgages that increased the unpaid balance over time and the famous ‘liar loans’ (no stated income / no financial history loans, etc).

Wall Street investment banks in turn packaged these high-risk loans into securities, had the credit-rating agencies bless them (allowing higher risk than normal investments to go undetected), and then passed them along to investors, who were often unaware or misinformed of the underlying risks and failure rate of their portfolios. It was the poor performance of the loans in these “private-label” securities—those not owned or guaranteed by Fannie and Freddie—that led to the financial meltdown, according to the bipartisan Financial Crisis Inquiry Commission, among other independent researchers looking for the underlying reason for the financial meltdown of 2006.

What people fail to view is the facts: FNMA and FMAC lost market share as the bubble grew. The companies backed roughly 50% of all home-loan originations in 2002 but just 30% in 2005 and 2006. In an ill-fated effort to win back market share and with ill advised support and insistence of the legislative branch, FNMA and FMAC made strategic mistakes later in the underwriting. Starting in 2006 and 2007 (just as the housing bubble was reaching its peak) – FNMA/FMAC increased their exposure and began investing in certain subprime securities that credit agencies incorrectly deemed low-risk. There was also a lot of discussion and pressure from the legislative side to put more people in homes, people who might not have been able to qualify otherwise.

In taking this action, FNMA/FMAC also lowered their qualifying underwriting standards in their securitization business, purchasing and securitizing so-called Alt-A loans. While Alt-A loans typically went to borrowers with good credit and relatively high income, they required little or no income documentation, opening the door to fraud (which was often perpetrated by the mortgage broker rather than the homebuyer). When the market reversed, these decisions contributed to the companies’ massive losses, but all this happened far too late to be a primary cause of the housing crisis.

Then why did FNMA / FMAC require a bailout?

Fannie and Freddie failed in large part because of the above bad decisions in underwriting towards the end of the boom. Remember over fifty of the largest lenders consolidated into four, and over 580 small, regional and national lenders failed because they held insufficient capital and insurance to cover their losses. Also, unlike most private investment firms with a larger base of industries, Fannie and Freddie had only one line of business—residential mortgage finance—and thus did not have other sources of income to compensate when residential prices began to fall.

When the housing market did begin to fail in 2007, over 50% of the losses came from the Alt-A loans, despite those loans accounting for just 11% of the companies’ total business. But those losses were only the beginning: Between January 2008 and March 2012, Fannie and Freddie would lose a combined $265 billion, more than 60 percent of which was attributable to risky products purchased and underwritten in 2006 and 2007. By mid 2008—about a year after the start of the housing crisis—Wall Street firms had all but abandoned the US mortgage market, while pension funds and other major investors throughout the world continued to hold large amounts of Fannie and Freddie securities. If Fannie and Freddie were allowed to fail, experts agreed that the housing market would collapse even further, paralyzing the entire financial system. The Bush administration in September 2008 responded by placing Fannie Mae and Freddie Mac into government conservatorship, where they remain today.

Have FNMA / FMAC improved?

Yes! As stated earlier their profits have improved dramatically. Fannie Mae has made $95 billion of its $117 billion debt, and Freddie Mac has paid $30 billion of its $72 billion debt. So the short answer is about $65 billion is left on their debt. This potentially could be repaid in less than a couple of years. However in the interim the U.S. Treasury Department has changed the terms of the government bailout. Under the previous agreement, Fannie and Freddie drew money from the Treasury Department as needed to bolster its capital reserves. In exchange, the companies issued preferred stock to the government on which they paid a mandatory 10 percent dividend. Under the new rules, Treasury will simply claim all of Fannie and Freddie’s profits at the end of each quarter and provide capital when necessary in the event of a quarterly loss. All this uncertainty has led many key staff to leave and has caused underinvestment in necessary infrastructure and systems, in essence making a weaker business.

What should we do with Fannie and Freddie?

The federal government is currently backing nearly every home loan (90 to 95%) made in the country today. That is not a sign of a healthy mortgage market. The federal government is underwriting the housing recovery, rather than private equity or the banks. Economists, analysts, and politicians agree that the current level of government support is unsustainable in the long run, and private equity will eventually have to assume more risk in the mortgage market. That leaves two critical questions before policymakers today: what sort of presence should the federal government have in the future housing market, and what do we need to do to transition responsibly to a new system of housing finance and backing.

Understand this: private equity cannot compete with the artificial ‘low’ rates of the government. Also when suggested proposals of written off mortgages by the government are suggested, equity does not want to underwrite those standards either. No one wants to lose money!

FNMA / FMAC has billions of dollars of mortgages at record low lending rates. Who wants to buy those investments when they know that rates will be better in the future? Again, another roadblock into convincing private industry to lend.

Most agree that the private equity needs to take more responsibility. History is a helpful teacher here. Prior to the introduction of the government guarantee on residential mortgages in the 1930s, mortgages typically had 50 percent down-payment requirements, short durations, and higher interest rates—putting homeownership out of reach for many families. Prior to government backing, the housing finance system was subject to frequent panics during which depositors demanded cash from their banks, leaving lenders insolvent. That volatility is one reason why every other developed economy in the world has deep levels of government support for residential mortgage finance.

All are in agreement that removing government support would almost certainly mean the end of the 30-year fixed-rate mortgage, now a pillar of the U.S. housing market. Upward mobility for decades has depended on the security and affordability of this product, which allows borrowers to fix their housing costs and better plan for their futures. Most experts agree that this highly beneficial product would largely disappear without a government guarantee.

So ultimately how does this affect me?

Currently rates are increasing, and by taking government backing out, private industry would in all likelihood have interest rates ¾ to a point higher than the government backed loans. However with the government artificially holding rates down it is hard to say how much rates would go up and when. But rates and down payment will be more.

Thirty year mortgages and low down payments in all likelihood would go away without government backing. Shorter terms and higher down payments would become the norm. The belief is that people would still buy, it just would require a larger down payment. This is a large stumbling block for most. Over the last fifty years, the US consumer has shown a dramatic change in their savings habits; going from 30% of income being saved by our grandparents 50+ years ago, to currently less than 3% of our total income. The US is very much a consumer economy, showing a reluctance to save. Whether it is a home, car or college education, most are looking for the ability to put as little cash down up front as possible. Look at the financial predicament the nation has had on housing, the car industry, and student debt if you don’t agree.

One of the beliefs of most economists is that construction (housing being a large portion of that) is a major pillar of economic recovery. If consumers can’t qualify, then construction slows, in turn slowing down industry and ultimately the recovery.

The slow recovery has allowed housing affordability to stay around longer than most thought. Because of lack of supply today and in the near future, prices are going to rise. Presently FNMA /FMAC mortgage backing allows lower down payments and rates. They have to go up!

The conclusion is that there has never been a more affordable time to buy.

The federal government must continue to play a key role in the housing market, whether it is through the current system or a new agency. The previous system worked for years, because of safe basic underwriting. It was when pressured by the legislative arm to be more aggressive in their lending that they got in trouble. Allow the agency to be run separate from any government pressure. Only then will private industry have comfort in getting back in the game. Again all this leads to higher lending rates, down payments, and stricter guidelines.

We will say it again, there has never been a more affordable time to buy.