Fannie Mae and Freddie Mac were two government-sponsored enterrises (GSEs) that created, and remain highly involved in, the secondary market for mortgage-backed securities. Before the subprime mortgage crisis, they owned or guaranteed $1.4 trillion, or 40%, of all U.S. mortgages. They only held $168 billion in subprime mortgages -- but it was enough to capsize the two. Find out how the two GSEs supported the secondary market, which helped American families realize the dream of homeownership, and how that turned into the nightmare of the subprime mortgage crisis.
What was the subprime mortgage crisis? Read this primer first to find out what the definition of subprime mortgages and how they helped cause the real estate downturn in 2006. Understand the relationship between interest rates, real estate and the rest of the economy. See how banks and mortgage companies packaged these risky loans into mortgage-backed securities. They resold them on the secondary market that was enabled by the legislation that created Fannie Mae and Freddie Mac. This legislation was supposed to help homeownership become more affordable. Understand how derivatives then spread the risk into mutual funds, pension funds and corporations. Follow the chronology of events in 2006 and 2007 that turned a good idea turned into a bad situation.
The first warning that there was a problem with subprime mortgages came in August 2007. That's when Fannie Mae announced it would skip a benchmark debt offering for the first time since May 2006. This meant that even the highly-rated mortgage-backed securities offered by the government-sponsored entities were being rejected by the secondary market. At that time it was thought that Fannie had enough cash to enable it to wait until the market improved. However, by November 2007. Fannie declared a $1.4 billion quarterly loss and announced it would seek $500 million in new funds. Freddie then disclosed a $2 billion loss, sending its stock price down 23%. (Source: Fannie Mae Web Site, "Fannie Mae Will Not Issue Benchmark Notes in August," 8/20/07; The Economist, The cracks are spreading, 11/21/07)
On March 23, 2008, Federal regulators agreed to let Fannie Mae and Freddie Mac take on another $200 billion in subprime mortgage debt. This was despite the fact that the the two GSEs were already up to their armpits in alligators trying to raise enough cash to keep themselves solvent. It also points out how everyone at the time thought the subprime crisis was restricted to real estate, and it would correct itself soon. Perhaps they didn't realize how derivatives had exported the subprime mortgage defaults throughout the entire financial world. As it turned out, this was another $200 billion the government had to bail out later that year.
March 25, 2008 - The Federal Housing Finance Board agreed to let the regional Federal Home Loan Banks take an extra $100 billion in mortgage-backed securities for the next two years. These loans were also guaranteed by Fannie and Freddie. In just a week, the two GSEs had $300 billion in bad loans added to their already-shaky balance sheet. This was also after the Federal Reserve agreed to take on <a href="http://useconomy.about.com/b/2008/03/12/fed-200-billion-loan-probably-wont-help.htm">$200 billion in bad loans</a> from dealers (actually, hedge funds and investment banks) in exchange for Treasury notes. Last, but certainly not least, the Fed had already pumped $200 billion into banks through its Term Auction Facility. In other words, the Federal government had guaranteed $730 billion in subprime mortgages, and the bank bailouts were just getting started.
On July 22, 2008, U.S. Treasury Secretary Henry Paulson asked Congress to approve a bill allowing the Treasury Department to guarantee as much as $25 billion in subprime mortgages held by Fannie and Freddie. The two GSEs held or guaranteed more than $5 trillion, or half, of the nation's mortgages. However, the $25 billion guarantee was more to reassure investors -- and it didn't work for long.Wall Street investors continued to pummel the GSEs stock prices, to the point that they couldn't raise the cash needed to pay off the loan guarantees they held. Wall Street was savvy enough to realize that a $25 billion infusion by the Federal government wasn't going to be enough. Stockholders wanted out -- before Fannie and Freddie were nationalized and their investments equaled zero.
April 17, 2008 - Fannie Mae and Freddie Mac made further commitments to help subprime mortgage holders keep their home. Fannie Mae developed a new effort called “HomeStay”, while Freddie modified its program called "HomePossible". That program gives borrowers ways to get out from under adjustable-rate loans before interest rates reset at a higher level and make monthly payments unaffordable. Unfortunately, it was too little and too late.