10 September 2008

Fannie Mae and Freddie Mac

The Federal National Mortgage Association (FNMA) was created in 1938 by Act of Congress. The purpose was to purchase loans from conventional lending institutions, such as thrifts, thereby reducing the risk to the firm originating the loan. In order to ensure the loan was worth something, the new Federal Housing Authority (FHA) investigated the terms and the property before permitting the FNMA to buy the loan. In a very short time, the FNMA became a de facto monopoly for home loans, even though it did not originate any; all of the nation's lending institutions simply deferred to its FHA guidelines on making loans, and then passed them on to "Fannie Mae." In 1944, VA loans were added to the FNMA portfolio.

This is credited with stimulating a postwar boom in new housing; loans were now virtually risk-free to the originator, and easy to obtain.

In 1968, Fannie Mae was privatized; at the same time, a large segment was spun off as the Government National Mortgage Association (GNMA), which remains a division of Housing and Urban Development (HUD). GNMA specialized in special government development programs and higher risk loans; by 1997, it (rather than Fannie Mae or Freddie Mac) handled 95% of FHA loans, and 13% of residential loans.1 Ginnie Mae does not buy or sell loans or issue mortgage-backed securities (MBS); instead, it guarantees loans for fourth party issuers such as Countrywide or Wells Fargo.2

Two years after the split/privatization of Fannie Mae, the Federal Home Loan Mortgage Company (FHLMC, or "Freddie Mac") was created by Congress explicitly for the savings association system (thrifts).3 Freddie Mac usually buys loans with higher credit ratings than Fannie Mae does, and it favors special savings association loans; according to Wikipedia entries, the 2007 assets of Fannie Mae were $882 billion, and those for Freddie Mac were $794 billion.

Freddie Mac and Fannie Mae are both known as government-sponsored entities (GSE's); in addition to the $1.68 trillion in assets that they hold in their portfolios, they sell an immense number of MBS's. Ginnie Mae, as mentioned above, contracts out the mortgages to fourth parties; assets held by it are not available.

A Brief Description of Mortgage-Backed Securities

When a mortgage is purchased by the GSE's, it becomes part of an immense pool of assets. This pool is divided into numerous subdivisions based on comparative risk; tiny pieces of the total are sold off as securities. The risk of default on any loan is distributed therefore evenly across all of the loans in the pool. MBS are commonly referred to as "pass-through" certificates because the principal and interest of the underlying loans is "passed through" to investors. The interest rate of the security is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. Ginnie Mae MBS's are guaranteed by the full faith and credit of the federal government. Whether or not the mortgage payment is made, an investor in a Ginnie Mae MBS will receive payment of interest as well as principal. In the case of Fannie Mae/Freddie Mac, there is considerable variation in available instruments.

In 1983, Freddie Mac introduced a variation on the MBS called a "collateralized mortgage obligation" (CMO). The CMO segments the cash flows from the underlying block of mortgage loans into four basic classes of bonds with differing maturities. Prior to the CMO, FNMA and FHLMC issued plain vanilla MBS's like the ones described above. The CMO prioritized payments received; high priority meant low risk (and therefore, low—but reliable—ROI), while low priority meant high risk (and therefore, potentially high ROI).

The GSE's: Public or Private?

Ginnie Mae is a division of the Department of HUD; it's obviously a public sector entity. It carries no MBS's on its balance sheet. Fannie Mae and Freddie Mac became private sector entities when they issued public offerings of stock (1968 and 1970, respectively). Incidentally, I've noticed some confusion between "private sector" (which means, "non-governmental, for profit") and "privately held" (which means, there is no publicly issued stock in the firm). A publicly-held corporation usually is run for a profit, but has traded shares; a privately-held corporation is also run for a profit, but it's not possible to buy shares in that company. The GSE's were publicly traded until the recent melt-down wiped out 99.4% of their value.

However, as private-sector entities, there were some peculiarities about the GSE's:
  • Five members of the board of directors (a minority) were appointed by the White Houst e;
  • The Secretary of the Treasury could invest up to $2.25 billion in GSE securities;
  • They were exempt from corporate income taxes;
  • Their debt securities were eligible as collateral for federal government deposits of tax revenues in private banks;
  • Risk-weighting of their securities was only 20% for banking capital, as opposed to 100% for private-sector companies (under the terms of the Basel 2 Accords—PDF)
The last point is somewhat arcane, but the Basel Accords (1 & 2) were agreements to regulate the capital requirements of banking institutions worldwide; the purpose was to ensure that banks based in countries with lax standards would not have a competitive advantage vis-à-vis banks based in countries with sound standards. Banks based in the USA were allowed to use GSE shares to meet capital adequacy standards, with the understanding that GSE shares were effectively gold-plated.

Not surprisingly, the GSE's were regarded with hostility by the rest of the financial sector since they competed on a very uneven playing field. While lobbyists for the GSE's argue that the above features ensured that their funds cost the government nothing (and Fannie Mae/Freddy Mac were required to warn investors that their issues were not backed by the federal government), the Congressional Budget Office estimated that the opportunity cost to the federal government amounted to $6.5 billion annually (1996), of which $4.4 billion was passed through to customers. A 2001 survey revised the estimate slightly downward, to $5.4 billion in '95 and $10.6 billion in '00. Projections in the same report suggested this would reach $13-16 billion by '08.

There's some controversy over the cost of this. The CBO's estimates include a few hundred million in lost tax revenues, combined with several billions in opportunity costs. In other words, either the GSE's ought to have done something more with the off-book assets they enjoyed (e.g., used their fiduciary role to require better urban design, and subsidized the marginal cost) or else given the federal government the money. The money was "captured" from the financial services industry and its customers by the peculiar financial advantages the GSE's enjoyed.


Fourth party issuers: the first party is the home buyer; the second is the firm that originates the loan. GNMA (third party) guarantees the loan, and the approved issuer (say, Countrywide or Wells Fargo Home Mortgage) issues the actual GNMA MBS. Countrywide was the largest approved issuer in '07, writing $20.6 billion in MBS. The fifth party is anyone who buys the MBS.

ROI: return on investment; the payoff of an investment.

1 John W. Reilly, The Language of Real Estate, Dearborn Real Estate Education (2000), p.181

2 GNMA home page

3 "Savings and Loan Associations," US History Encyclopedia; captured from Answers.com


NYT: Fannie Mae, & Freddie Mac; see also Eric Dash, "Federal Mortgage Success Stories" (9 Sep 2008) on "Ginnie Mae" & "Farmer Mac"

Reuters: "FACTBOX: Government bailout tally tops $900 billion" (16 Sept 2008)

John W. Reilly, The Language of Real Estate, Dearborn Real Estate Education (2000)

Congressional Budget Office, "Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac" (May 1996)

Freddie Mac, "Information Statement" (PDF), includes general reference on firm (26 March 2001)



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