Fannie Mae and Freddie What?

9 Sep

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With the subprime crisis in full effect, you must have come across words like ‘Fannie Mae’ and ‘Freddie Mac’ a lot. They may appear to be names of cartoon characters, but trust me, they are not. Fannie and Freddie are the two most important players in the US secondary mortgage market.

A secondary mortgage market is a market for the sale of securities or bonds collateralized by the value of mortgage loans. In simple terms, when a bank issues a home loan, the loan is broken down into bits and pieces of securities called mortgage backed securities (this process is called securitization) and sold by the bank in the market. The payment of interest and the principal on such securities depend on the monthly installments by the borrower of the home loan from the bank. Thus if the borrower of the home loan from the bank defaults, the liability no longer lies with the bank but with the investor who holds the mortgage backed securities issued in lieu of that home loan.

The above process of securitization and issuing of mortgage backed securities has had the effect of widening the market for home loans and also providing liquidity to entities providing home loans. The presence of the secondary mortgage market has thus helped the American borrowers. However, in recent times, it is becoming evident that such a market has a dark side to it also, and that which is capable of drowning the entire global financial system.

Fannie Mae is short for Federal National Mortgage Association, Freddie Mac short for Federal Home Loan Mortgage Corporation. Fannie Mae was founded in the depression era of 1938, at a time when millions of families could not become homeowners, or faced losing their homes, because of a lack of mortgage funds. It was a government agency until 1968. Freddie Mac was created in 1970 to provide competition to Fannie Mae. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, have operated since 1968 as government sponsored enterprises (GSEs). This means that, although the two companies are privately owned and operated by shareholders, they are protected financially by the support of the Federal Government.

The two firms do not lend directly to homebuyers, instead buying mortgages from approved lenders and then selling them on to investors, i,e, participating in the secondary mortgage market. They buy house loans from banks and other approved lenders, break them down into pieces, and issue securities backed by such loans to investors, or invest directly in mortgage backed securities issued by others.

One part of Fannie and Freddie’s income is generated through the positive interest rate spread between the rate paid to buy home loans from the banks and the return it earns on securities that were issued backed by these loans. They also earns a significant portion of its income from guaranty fees it receives as compensation for assuming the credit risk on the mortgage backed securities issued by it. (Remember, that when Fannie or Freddie issue mortgage backed securities or invest directly into them, they assume any credit risk that might originate on account of default by a borrower on a home loan.) Investors, or purchasers of mortgage backed securities, are willing to let Fannie and Freddie keep this fee in exchange for assuming the credit risk; that is, Fannie and Freddie’s guarantee that the scheduled principal and interest on the underlying loan will be paid even if the borrower defaults.

The recent prominence of Fannie and Freddie is on account of the fear that both might collapse as a fallout of the subprime crisis. Following the crisis, billions of dollars worth of investment grade mortgage backed securities have been reduced to junk on account of large scale default by American borrowers on their home loans. Since a substantial part of such mortgage backed securities have the Fannie and Freddie guaranty, it now appears that their capital base is too insignificant to absorb such guarantees. Thus the entire hoopla about the State taking control of the two bodies.

A perfect case of “privatised profits (remember, both Freddi and Fannie are listed companies with private shareholders) with socialized losses.”

Published by Ravi Saraogi

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2 Responses to “Fannie Mae and Freddie What?”

  1. Richard Morris September 29, 2008 at 9:32 am #

    It was suggested in an NY Times opinion blog this morning that Congress should appove a plan to purchace actual “whole” mortgages rather than the mortgage backed securities and related derivatives that the Paulson Plan targets in the bailout bill. If these “whole” mortgages are already broken into pieces and spread around in the secondary market, how could they so to speak be re-aggregated? In other words, how could all the little pieces be put back together again?

  2. Ravi Saraogi September 29, 2008 at 9:36 am #

    Hello Richard

    On the face of it, it appears that purchasing “actual whole mortgages” might refer to government itself purchasing the real estate properties on which the mortgage backed securities has been drawn (we need to be clear about the terminology here- is it government purchasing “actual whole mortgages” or government purchasing “actual whole mortgage backed securities?”) . Since the value of the mortgage backed securities depends on the capacity of the home loan borrower to pay back his loan, the government purchasing “actual whole mortgages” will shore up the value of such securities which will save many financial firms which hold such securities.

    If the plan refers to purchasing “whole” mortgage backed securities, I fail to see how the govt. would go about doing that, since like you said, mortgages are already broken into securities, mixed with securities on other mortgages and circulated in the secondary market. Moreover, how would purchasing “whole” securities be better than purchasing disaggregated securities?

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