Fannie Mae, Freddie Mac and You

Fannie Mae and Freddie Mac are the oddballs of American finance. These government-sponsored enterprises (GSEs) were once federal agencies -- then they became private corporations with many privileges (such as exemption from state income taxes) and a virtual monopoly on mortgage lending in the U.S.

What do they do, exactly, and how does it affect your home loan?

Mortgages in the Depression Era

Fannie and Freddie are the products of an earlier and larger mortgage meltdown. During the Great Depression, 50% of borrowers were late or in default on their mortgages (sound familiar?) and banks became dangerously strapped for cash. So President Franklin D. Roosevelt and Congress created the Federal National Mortgage Association (Fannie Mae) in 1938. The agency's mission was to buy mortgages from lenders, providing liquidity that could be used to make more loans.

Fannie Mae's creation allowed lenders to loan money to low- and middle-income buyers who otherwise might not have been considered creditworthy. According to the St. Louis Federal Reserve, mortgage lending before Fannie Mae was very different from the way it is done today. Lenders typically required 50% down payments. Moreover, they usually structured their home loans with short terms -- terms as brief as five years, after which the borrower had to come up with a "balloon payment" for the remaining balance. As a result, homeownership was out of reach for most American households.

Fannie Mae and Freddie Mac's charters specify roles that they should take in promoting homeownership affordability. If your parents own their homes, chances are it's because of Fannie Mae that they were able to finance their purchases.

Freddie Mac: Fannie Mae's Younger Brother

Fannie Mae grew so large over the years that in 1968, with the pressures of the Vietnam War straining the national budget, President Lyndon Johnson took Fannie Mae's debt portfolio off the government's balance sheet. Fannie Mae was converted into a publicly traded company owned by investors. Two years later, the Federal Home Loan Mortgage Corporation (Freddie Mac) was launched, mainly to keep Fannie Mae from functioning as a monopoly. Freddie went public in 1989. Freddie Mac's guidelines and pricing structure are almost identical to Fannie Mae's.

The Conforming Mortgage

Fannie's purchasing power allows it to pretty much dictate underwriting and pricing terms to mortgage lenders: As long as a mortgage is underwritten in accordance with Fannie Mae's guidelines, the lender can sell the loan to Fannie. This is why loans destined for Fannie Mae (and Freddie Mac) are referred to as "conforming" mortgages -- they conform to the guidelines established by these mortgage giants.

If your application package doesn't conform to their guidelines, chances are you'll have to pay considerably more to get mortgage financing.

2008: The Government Takes Back Fannie and Freddie

Fannie Mae and Freddie Mac's influence in the U.S. and world economies is so pervasive -- they get trillions of dollars in investments from mutual funds, pension funds and foreign governments -- that the Federal Reserve and the U.S. Treasury felt they had little choice but to take over and prop up the companies when they got into financial trouble in the wake of the subprime debacle.

The U.S. government's placement of Fannie and Freddie into conservatorship caused mortgage rates to drop half a percentage point, as investors were assured that the federal government would stand behind the companies' mortgage-backed securities.

While you may not agree with the government's decision to bail out the mortgage giants, the modern home loan market has been built around them. Without the federal support, mortgage lending would have largely come to a halt. With federal support, these markets for financing and refinancing remained open, and if you refinanced a mortgage or bought a home in the early years after the housing market crisis happened, you probably paid substantially less each month than you would have had the bailout not taken place.

Had the GSEs actually failed outright, millions of troubled homeowners would not have been able to work out their mortgages and retain their homes, nor would millions of non-troubled homeowners been able to refinance underwater mortgages. Without the standards and structures for mortgages the GSEs impart, and their sheer size and influence, the HAMP and HARP programs could not have existed.

What's Ahead for Fannie and Freddie?

Fannie and Freddie got into trouble largely because they differed from other market makers in one key respect -- the GSEs are supposed to promote affordable housing (a government mandate) while making money for their shareholders (a corporate mandate). It's partly that split mission that pushed the firms deeper into subprime and Alt-A lending, and most of their losses came from those loans. Since they are government-backed they could not simply shut down their operations to protect themselves from losses as so many Wall Street firms did.

During conservatorship, Fannie and Freddie were required to essentially eradicate their "retained portfolios" of investments in mortgages and mortgage-backed securities. When conservatorship began, Freddie Mac was holding $867 billion on its books; Fannie Mae, $784 billion. At the end of 2018, those holdings had been divested down to $218 billion (Freddie) and $179 billion (Fannie). As well, for the first several years of government control, some profits from the GSEs were used to repay the money they drew from the Treasury to keep them afloat; in 2012, the Treasury modified its agreement and began sweeping all profits from the GSEs. By mid-2019, Freddie has paid about $120 billion to the Treasury, far in excess of the $48 billion it borrowed; Fannie has turned in about $181 billion, about $60 billion more than it utilized.

With divestiture of holdings happening and all profits being swept, it began to look at times that the GSEs, although profitable and stable by this point, would find themselves short on cash and would need to borrow the same funds from Treasury that they were regularly turning in. As such, FHFA in 2017 allowed Fannie and Freddie to again hold $3 billion each in capital to smooth out the ebb and flow of their businesses.

The fact that Fannie Mae and Freddie Mac need to be reformed (in some manner) is pretty much the consensus in Washington, and has been for years. But what reforms should be undertaken is still up for debate, and we may never see comprehensive housing finance market reform... but we are likely to change.

2019: "Recap and Release" begins

After ten years of studies, regulator reviews, think-tank and trade group recommendations and more, Fannie and Freddie remain wards of the state. With Congress failing to make substantive housing finance reform a reality, so-called "administrative solutions" are being implemented to allow Fannie and Freddie to rebuild capital buffers ("recapitalize") in preparation for again becoming a public company at some point ("release"). That could be years away... and the process of moving them again in that direction could be derailed or changed if a new administration comes into power at any point in the future and chooses to take up housing finance reform.

It's not clear at this point how all that will work; among many other things, the Treasury Housing Reform Plan calls for Fannie and Freddie to eventually buy and fully pay for the credit backing they receive from the taxpayers and also looks to open up that availability to other competitors. Only time will tell how this will all unfold.

On September 30, 2019, Treasury and the Federal Housing Finance Agency (FHFA) announced that they had agreed to modifications of terms of the conservatorship agreement that would allow Fannie Mae and Freddie Mac to retain additional earnings in excess of the $3 billion capital reserves currently permitted by their Preferred Stock Purchasing Agreements (PSPA). Under the modifications, Fannie Mae and Freddie Mac will be permitted to maintain capital reserves of $25 billion and $20 billion, respectively. It is the initial step toward "recap and release".

Ultimately, Fannie Mae and Freddie Mac will likely need tens or even hundreds of billions of dollars of recapitalization. This would likely mean reforming new companies and issuing new stock, but there are any number of legal questions and issues yet ahead in that regard, not the least of which is what to do about investors holding existing shares of Fannie and Freddie stock.

We'll continue to track and follow what's happening with Fannie Mae and Freddie Mac as things evolve, most likely as part of the MarketTrends newsletter, much as we did here.

Keith Gumbinger updated this article.