Fannie and Freddie were government sponsored entities (GSE's). This meant that they had to be competitive, like a private company, and maintain their stock price. On the other hand, the value of the mortgages that they sold was guaranteed by the government. This caused them to hold less capital to support their mortgages in case of loss. As a result, they had pressure to take on risk to be profitable but knew they wouldn't suffer the consequences if things turned south.
The government set them up this way to allow them to buy qualified mortgages, insure them and resell them to Wall Street, thus freeing up funds for banks to make new mortgages. In this way, they are involved in at least half of all new mortgages made each year. By December 2007, when banks began to constricting their lending, they were really the only lender still operating, responsible for 90% of all mortgages.
Government regulations preclude Fannie and Freddie from buying mortgages that don't meet down payment and credit requirements. However, as the mortgage market changed, so did their business. Between 2005-2007, few of the mortgages acquired were conventional fixed-interest loans with 20% down. Fannie Mae's loan acquisitions were:
- 62% negative amortization
- 84% interest only
- 58% subprime
- 62% required less than 10% downpayment.
- 72% negative amortization
- 97% interest only
- 67% subprime
- 68% required less than 10% downpayment.
In 2005, the Senate sponsored a bill that sought to forbid them from holding mortgage-backed securities in their portfolio because it wanted to reduce the risk to the government. In total, the two GSE's own or guarantee a total of whopping $5.5 trillion of the $11.2 trillion mortgage market.
After the Senate bill failed, the two actually increased their holdings of risky loans. That's because they could make more money from the loans' high interest rates than from the fees they got from selling the loans. Again, they were seeking to maintain high stock prices during a very competitive housing market. Even so, by 2007 only 17% of their total portfolio was either either subprime or Alt-A loans. Due to regulations, their percentage of these loans are actually better than many banks. (Source: Barron's, Is Fannie Mae the Next Government Bailout?, March 10, 2008; IHT, Fannie and Freddie's blame game, August 24, 2008)
As GSE's, Fannie and Freddie weren't required to offset the size of their loan portfolio with enough capital from stock sales to cover it. This was a result of both their lobbying efforts and the fact that their loans were insured, so they felt they didn't need to. Instead, they used derivatives to hedge the interest-rate risk of their portfolios. When the value of the derivatives fell, so did their ability to insure loans. (Source: NYT, Fannie, Freddie and You, July 14, 2008)
However, this exposure proved their downfall, as it did for most banks. As housing prices fell, even qualified borrowers ended up owing more than the home was worth. If they needed to sell the house for any reason, there would lose less money by allowing the bank to foreclose. Borrowers in negative amortization and interest-only loans were in even worse shape. For Fannie and Freddie, the 17% of subprime and Alt-A loans loans made up over half of the losses in 2007.
Many predict that Fannie and Freddie will eventually be eliminated, and the U.S. will copy Europe in using "covered bonds" to finance most home mortgages. In this case, banks retain the credit risk on home mortgages they have made, but sell bonds backed by those mortgages to outside investors, thus off-loading interest-rate risk. However, elimination of Fannie and Freddie will reduce the availability of mortgages and increase the cost. Interest rates could go as high as 9-10%. Although this will reduce the likelihood of another housing bubble, it also means it will take longer for housing prices to return to 2005 levels. (Source: Barron's, Life After the Old Fannie and Freddie, September 15, 2008)
