There are two colossal institutions in the United States mortgage industry: Fannie Mae and Freddie Mac. Most people have heard of them, but few understand what they do or the important role they play in financing American homeownership. Nor do most people understand the potential systematic risk they pose to our entire financial system. In this article we'll discuss what they do, their government-sponsored enterprise (GSE) status, their public missions and how they profit. We'll then explore the danger these behemoths could pose to the U.S. mortgage market if they failed to manage their risk effectively. Remember, when giants fall, it's the peasants who get squished.
What They Do
Fannie Mae and Freddie Mac purchase and guarantee mortgages through the secondary mortgage market. They do not originate or service mortgages.
Mortgage originators sell mortgages directly to Fannie Mae and Freddie Mac, or exchange mortgage pools with them in return for a mortgage-backed securities (MBSs) backed by those same mortgages but which carry the added guarantee of the timely payment of principal and interest to the security holder. When mortgage originators sell mortgages to Fannie Mae or Freddie Mac, or sell the MBSs that have been issued back to them, it in turn frees up the funds used to originate those mortgages so that the originators can then create even more mortgages. Fannie Mae and Freddie Mac also invest heavily in their own MBSs in what is known as their retained portfolios.
Fannie Mae and Freddie Mac are GSEs. Both were created by acts of Congress; Fannie Mae in 1938, and Freddie Mac in 1970. Both are publicly traded companies chartered to serve a public mission. Their shares trade on the NYSE under the symbols FNM and FRE, respectively. While they are publicly traded companies, because of their charters, they have the following ties to the Federal Government:
- Both companies have a board of directors made up of 18 members, five of which are appointed by the president of the United States.
- To support their liquidity, the secretary of the Treasury is authorized, but not required, to purchase up to $2.25 billion of securities from each company.
- Both companies are exempt from state and local taxes.
Because of these ties, the market tends to believe that the securities issued by Fannie Mae and Freddie Mac carry the implied guarantee of the U.S. government. In other words, the market believes that if anything were to go wrong at Fannie Mae or Freddie Mac, the U.S. government would step in to bail them out. This implicit guarantee is reflected by how cheaply they are able to access funding. Fannie Mae and Freddie Mac are able to issue corporate debt, known as "agency debentures", at yields lower than other institutions.
Fannie Mae's and Freddie Mac's Public Purpose and Mission
According to their charters, Fannie Mae's and Freddie Mac's public purpose is to facilitate the steady flow of low-cost mortgage funds.
Their charters include the following:
- Their singular focus is the residential mortgage market. They may not enter into unrelated lines of business or discontinue support for the residential mortgage market.
- The mortgages that they purchase and guarantee must be below an amount specified by the Office of Federal Housing Enterprise Oversight (OFHEO).
- They are barred from entering the business of other housing finance companies - mortgage origination, for example.
- They must meet annual goals established by the Department of Housing and Urban Development (HUD). These goals center around low and moderate income housing and housing for minorities.
- They are subject to risk-based and minimum capital requirements and annual examinations by OFHEO.
Freddie Mac's website states that its mission is to provide liquidity, stability, and affordability to the housing market. Fannie Mae's website states that its mission is to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market. (To keep reading about real estate, see Investing In Real Estate, Smart Real Estate Transactions and our Exploring Real Estate Investments tutorial.)
Profit-Driven Companies with a Public Mission
Make no mistake - Fannie Mae and Freddie Mac are driven by profits, as their shareholders demand. While fulfilling their public mission, they make their profit in two primary ways: guarantee fee income and retained portfolios.
- First, let's cover guarantee fee income, or "g-fees". Fannie Mae and Freddie Mac retain a certain percentage of each mortgage payment for each mortgage they have guaranteed a timely payment of principal and interest to a MBS holder (investor). For example, every monthly mortgage payment can be broken down into principal and interest.
Principal and interest, as collected by a mortgage servicer, is passed onto one of the two companies, let's say Fannie Mae. Fannie Mae then passes the principal and interest along to the holder of the mortgage-backed security; however, it keeps a certain percentage of the interest as the guarantee fee - usually between 0.12% and 0.50% annually. Think of it as an insurance policy. Hopefully Fannie Mae collects more in guarantee fee income than it pays out to its mortgage-backed securities holders because of borrower defaults. It's a very big insurance policy. At 2006 year end, the two companies had credit guarantees on $2.9 trillion of MBSs, according to the Treasury's Secretary Robert K. Steel (March 15, 2007 Testimony before the U.S. House Financial Services Committee on GSE Reform).
- Second, Fannie Mae and Freddie Mac have huge retained portfolios of mortgages and MBSs. They invest heavily in their own - and each other's - securities. Because of their implied Federal guarantee, as discussed earlier, they are able to issue debt at yields lower than other corporations to fund their retained portfolios. In other words, they are able to earn spreads on their portfolios which are potentially greater than other institutions because of this funding advantage. To say the size of their portfolios is huge is an understatement. At their 2006, the combined mortgage portfolios of the two companies were $1.4 trillion, again according to Steel (March 15, 2007).
Oversight Over Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac are regulated by the OFHEO and the HUD. OFHEO regulates the financial safety and soundness of Fannie Mae and Freddie Mac, including implementing, enforcing and monitoring their capital standards and limiting the size of their retained portfolios. OFHEO also sets the annual conforming loan limits. HUD has responsibility for the housing mission of Fannie Mae and Freddie Mac. All new loan programs that they may participate in (purchase and/or guarantee) must be approved by HUD. In addition, HUD sets annual goals for Fannie Mae and Freddie Mac to carry out their housing mission. These goals center on low and moderate income housing and housing for minorities.
Too Much Risk Concentrated in Two Companies with Federal Ties?
There is no doubt that Fannie Mae and Freddie Mac play critical roles in our housing finance system. However, there is danger in having so much risk concentrated in only two companies. They manage an immense amount of credit and interest rate risk. If something went wrong with their risk management and/or portfolio management practices, there is no doubt that pain and stress would be felt throughout financial markets worldwide. Many critics feel that, due to their size and the complexity of managing mortgage risk, they pose too large of a systematic risk to our economy. Furthermore, some believe Fannie Mae and Freddie Mac have an unfair advantage because of their implicit federal guarantee which allows them to issue debt at interest rates unavailable to other corporations - specifically, that it is this implicit guarantee that has allowed Fannie Mae and Freddie Mac to grow so large.
Put simply, there is a danger that the two companies have been allowed to take on too much risk at the potential expense of the American tax payer. To put things in perspective, according to Treasury Secretary Steel, at the end of 2006, Fannie Mae and Freddie Mac had about $4.3 trillion of mortgage credit exposure, which was about 40% of total outstanding mortgage debt in the U.S. (March 15, 2007). Or viewed differently, the two companies have $5.2 trillion of debt and MBS obligations outstanding, exceeding the $4.9 trillion of publicly held debt of the U.S. government, according to the Federal Reserve's board of director's Chairman Ben Bernanke (April 2007).
Furthermore, no one ever claimed that either the credit risk or the interest rate risk of a mortgage is easily managed or mitigated through the use of derivatives.
In the summer of 2007, the market for all mortgages except those guaranteed by Fannie Mae and Freddie Mac came to a complete standstill, emphasizing the importance of the roles played by the two companies. In the fall of 2007, Freddie Mac shocked the market by announcing large credit-related loses, fueling the fire for the argument that the two companies pose a tremendous risk to the entire financial system. Will the benefits Fannie Mae and Freddie Mac create for the American homeowner outweigh the risks they pose to our entire financial system and the American taxpayer? Only time will tell.
To read more about these two institutions, check out Profit From Mortgage Debt With MBS.