Fannie and Freddie, part 1: Understanding their role in the housing market

Amanda Maher
Get the latest industry insights.

Published on October 4, 2016

Some people might think that Fannie Mae and Freddie Mac are our long-lost aunt and uncle. If that were the case, maybe it would be easier to understand their role in the family.

But no, Fannie and Freddie are two critical players in the housing finance market. The ins-and-outs of Fannie and Freddie can be difficult to understand. We’re here to break things down for property owners and managers—you shouldn’t have to be a finance guru to understand the basics of Fannie and Freddie. Part I will focus on Fannie and Freddie’s history and their role in the 2007-2008 housing crash. Part II (next week!) will take a look at recent efforts to reform the agencies, and why reform is necessary.

A Brief History

For the majority of the 20th century, most home loans originated at banks that would hold the loan until the mortgage amortized. Everything changed in 1968, when the U.S. Congress chartered Fannie Mae as a government-sponsored enterprise (GSE), and two years later, chartered Freddie Mac as the same in order to increase competition. In doing so, Fannie and Freddie created a liquid secondary mortgage market.

This meant that banks no longer had to hold onto the mortgages they originated. As long as the mortgages conformed to certain standards, the mortgages could be sold onto the secondary market shortly after their origination. The GSEs would then buy these mortgages and either hold them, or more commonly, bundle them into mortgage-backed securities that could then be sold in bulk to investors. Today, these securities amount to more than $4 trillion and play a central role in the bond market.

These bulk securities are attractive to investors because they come with an implicit guarantee that if the loans default, the GSEs will make investors whole again. Under the GSEs’ congressional charters, the U.S. Treasury is authorized (but not required) to purchase up to $2.25 billion worth of securities from each company in order to support their liquidity. The GSEs charge lenders a fee for that guarantee, which is typically passed down to borrowers in the form of a higher interest rate.

Contrary to popular belief, Fannie and Freddie do not issue loans directly. Nonetheless, their guarantees are what make today’s standard, 30-year fixed rate mortgage possible. This has opened the door to homeownership for millions of Americans who would otherwise be unable to afford it.

The GSEs have been called a “shining example” of public-private partnerships: each entity is privately owned by shareholders, and the federal government harnesses their private capital to advance the social goal of expanding homeownership (and specifically, homeownership among underserved demographics). In exchange, the private entities are backed by the federal government and regulated by the U.S. Department of Housing and Urban Development (HUD).

7 Habits of Highly Successful Property Managers Guide

You will discover creative ways to identify and eliminate routines that are no longer benefiting your business.

Download

The GSEs’ implicit guarantee created a perception in the marketplace that if either firm ever ran into financial trouble, the federal government would step in and bail it out. The fact that the market believed in this guarantee allowed Fannie and Freddie to borrow money in the bond market at lower rates than other financial institutions. Yields on Fannie and Freddie’s agency debt were historically 35 basis points (0.35%) higher than U.S. Treasury bonds—which doesn’t seem like much, until applied to the trillions of dollars that the GSEs borrowed to purchase loans in the primary mortgage market. This allowed Fannie and Freddie to have a GSE monopoly on a large part of the secondary mortgage market. This monopoly, combined with the government’s implicit guarantee to keep these firms afloat, would later contribute to the housing market crash.

The GSEs Role in the Financial Crisis

In the early 2000s, a new crop of adjustable-rate mortgages began to pop up. They often had “exotic” characteristics, such as interest-only or even negative-amortization features. Underwriting guidelines for these loans were lax, and a lack of oversight allowed many borrowers to misrepresent their true income and/or assets. Many borrowers who could not conservatively afford mortgages received them anyway. Pension funds, insurance companies and other institutional investors began to buy up these sophisticated “subprime” loans with fury, and Fannie and Freddie saw their market shares drop.

Facing shareholder pressure, the GSEs also lowered their underwriting standards in an effort to compete with private lenders’ highly aggressive terms. Fannie and Freddie began purchasing and guaranteeing more loans and securities of low-credit quality.

It was only a matter of time before borrowers began to default on their mortgages. In 2007, the housing market bubble burst and home prices plummeted. The GSEs collectively owned or guaranteed more than half of the $10 million U.S. mortgage market. Because the GSEs’ assets are all tied to mortgages, the two firms sustained major losses in the wake of the crash. By September 2008, Fannie Mae’s outstanding debt stood at $843 billion and Freddie Mac’s at $815 billion.

Without intervention, these “shining examples” of public-private partnerships seemed doomed, putting the dream of homeownership at risk for millions of Americans in the process.

Next week, we’ll take a deeper dive into the reforms that were initiated in response to the housing crash. Some have been successful, others not so much. Learn more about why policymakers feel further reform is still desperately needed.

Read more on Property Management Trends
Amanda Maher

Amanda Maher is a self-proclaimed policy wonk who dabbles in real estate law. She holds a B.S. in Political Science and Sociology from Boston University, as well as a master's in Urban and Regional Policy from Northeastern.

Trending Stories For You
Property Management Trends What does Buildium’s Open API mean for property management companies?
Take a second and think about how much information you collect from your residents, owners, and their properties each day. From your books to your…
Tony Maiella
| 6 min. read
Resident Management Property managers can master the new student housing market with technology. Here’s how
It’s been a long two years for property managers, particularly in college towns, where vacancies skyrocketed after colleges and universities closed their doors. As students…
Laurie Mega
| 6 min. read
Scaling How to create a data-driven culture: 7 steps for your property management business
You may have heard the buzzword data-driven culture bounced around for decades. But implementing a company culture based on data is more than just a…
Laurie Mega
| 10 min. read

Be a more productive
property manager