What Does the Future Hold For Fannie & Freddie?

The functions of Fannie Mae and Freddie Mac -- liquidity, stability, and access -- remain important for the housing economy. Indeed, the two companies today are providing more than 70 percent of all the financing for housing even while under conservatorship. But their collapse into the federal government's arms is causing a wholesale reevaluation of how best to provide those functions in the future.

In September 2008, on the precipice of the economic crisis finally catching up with Wall Street, Treasury Secretary Henry Paulsen, Federal Housing Finance Agency Director James Lockhart and Federal Reserve Chairman Ben Bernanke converged on Fannie Mae’s and Freddie Mac’s boardrooms — and they were not in a good mood. The world credit markets were in free fall, and Fannie Mae and Freddie Mac, together holding more than half of all the mortgage debt outstanding in the US market, were reeling from unprecedented losses from plunging real-estate values, rapidly escalating delinquencies in their single-family portfolios, and a sudden lack of interest in their debt securities around the world.

The G-men told the two boards that they could either make it hard or make it easy, but before the meetings were over, both would turn over the reins of their companies to Director Lockhart.

And just like that, institutions born during the last great mortgage crisis of the 1930’s to ensure that lenders and consumers always had access to capital for mortgages were out of business. The privately owned, high-flying companies that once were Wall Street darlings and charmed investors from Peking, Illinois to Beijing, China were finished, turning over majority ownership to the US Government in return for more than $80 billion in funding to keep the two companies solvent.

How did this happen, and why does it matter? What, if anything, will be built to replace the two companies whose investments fueled the biggest homeownership growth in history? And why should advocates and activists who fight for working families and their communities care?

The Federal National Mortgage Association was chartered in 1938 to issue US government debt and to use it to buy mortgages insured by the FHA, which four years earlier had launched the first long-term, fixed-rate, self-amortizing mortgages through its insurance authority. Before this, homebuyers had only two basic choices in financing their homes: pay cash or get a short term, interest only loan that had to be rolled over through a refinancing, usually every five years. FHA insurance placed the government’s guarantee behind 20 year, fixed-rate, self-amortizing mortgages, establishing for the first time the financing model of choice for housing consumers for the next 75 years.

But without some effective secondary market, lenders would quickly reach the limit of their ability to hold such long-term paper. The new agency’s job was to buy up these mortgages from the lenders, and resell them where possible to private investors, to provide new capital and use the federal government’s own balance sheet to absorb the risks if necessary.

This new model worked, and worked well. Especially after World War II, when the US economy boomed and millions of demobilized servicemen returned to resume their lives and start families, mortgage lending through FHA and later VA mortgages boomed, too.

In 1954 Congress adopted a mixed ownership model for the company. The US Treasury retained nonvoting preferred stock in the company and lenders selling loans to Fannie Mae were required to buy nonvoting common.

In 1968 Fannie Mae was fully privatized with the sale of the Treasury’s preferred stock and its transition to private shareholder ownership with a national charter, was complete. The newly-formed Department of Housing and Urban Development (HUD) retained a new entity, the Government National Mortgage Association (Ginnie Mae) to provide liquidity for government guaranteed home loans, primarily those backed by FHA and VA and provide liquidity for special government-sponsored mortgage programs. Fannie Mae in its new, private form developed into the dominant secondary market actor for the conventional market, although it could and did purchase government guaranteed loans in some amounts.

In 1970, the secondary market was expanded with the addition of the Federal Home Loan Mortgage Corporation (Freddie Mac). Freddie Mac was capitalized through the sale of $100 million in stock to the 12 Federal Home Loan Banks. Freddie Mac was designed, and operated for more than a decade, as the secondary market arm for the Home Loan Bank system, and was housed within the Federal Home Loan Bank Board, which was the Federal Home Loan Bank system’s overseer. When the Board was reorganized after the collapse of the S&L industry in 1989, Freddie was privatized, too, with the same charter as Fannie Mae.

Give and Take

The companies’ peculiar status as government sponsored enterprises (GSEs) stems from their unique congressional charters. Other institutions, like national banks, also have national charters that trade certain benefits for specified obligations and have long been used to encourage private participation in meeting public ends.

The Fannie and Freddie charters provide a clutch of valuable terms: exemption from state and local income taxes; exemption from registering their debt and equity securities with the SEC (although both agreed voluntarily to register their equities with the SEC in 2002); special treatment of their securities held by regulated banks; access to the Fed window; and a Treasury line of credit for $2.25 billion in case of a liquidity crisis. An additional benefit that arose from their charters was the ability to borrow money only slightly more expensively than the US Treasury, based on the “implicit guarantee” provided through their charter relationship to the US Government.

In return for these benefits, the companies have limitations and obligations: business is restricted to the secondary market in residential mortgages; they cannot operate outside the United States; they are expected to operate in all markets, at all times; and they were given specific percent of business goals to lend to low- and moderate-income borrowers and underserved communities. In 1992 and again in 2008 Congress adopted oversight provisions and terms that govern their capital and safety and soundness, assigning “mission” oversight to HUD and safety and soundness oversight to a new agency, OFHEO. In 2008 these functions were consolidated into the new FHFA.

Despite their special status, until the September 2008 takeover neither company had ever received any direct federal funding after their privatization. But under 2008 revisions to their charters, both could be placed in conservatorship by their regulator to protect their safety and soundness. It was this authority that was invoked at the September meetings with both companies’ boards.

The development of this system served a number of basic and vital functions in the mortgage market. One is liquidity. Fannie and Freddie insured a reliable source of financing for mortgages that did not depend on a lender’s access to deposits. A closely linked function is stability, achieved both through ready liquidity and a growing standardization of mortgage terms. Third is access, for communities and borrowers across the country and in all times. Fannie’s and Freddie’s ability to attract investments across the yield curve and manage the extensive duration risks of holding long term assets enabled them to make 30 year, fixed rate mortgages available to any buyer.

What’s My Line?

Fannie and Freddie carried out a number of distinct but related businesses. Financed through the issuance of debt, the companies’ portfolio businesses originally were used to purchase whole loans directly from lenders. But over time as securitization became more and more important, the portfolios also purchased mortgage-backed securities, both their own and those issued by others, like Wall Street banks.

The far larger business of guarantee fees accelerated with the growth of the market for mortgage-backed securities in the 1990s. In return for providing a guarantee of the timely payment of principal and interest to the investors who buy Fannie Mae and Freddie Mac mortgage bonds, the companies charge lenders a fee, which is passed on to borrowers. These assets are not held on the companies’ balance sheets, although they must hold reserves against loan losses, and these fees continue throughout the life of the loan and are collected through the borrower’s monthly payment.

While both companies also developed other fee generating business, notably in technology as they developed automated underwriting systems, their principal businesses are the portfolio and the guarantee businesses.

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