Fannie Mae and Freddie Mac are the two major companies in the mortgage industry of the United States. Whilst almost everyone will have heard of them, there are not that many that understand what they do and what a vital role they play in financing American homeownership. There are few that understand the potential risk that these two companies pose to the entire financial system of America. In this article what they do, their government sponsored enterprise (GSE), their public missions and how they make a profit.
What They Do
Fannie Mae and Freddie Mac purchase and guarantee mortgages through the secondary mortgage market, but they do not provide mortgages.
Those that originally obtain the mortgage for the average home owner then sell these mortgages to Fannie Mae and Freddie Mac, or they exchange mortgage pools for mortgage backed securities which are backed by those same mortgages but that carry the guarantee of timely payment of the principal plus interest to the security holder. When mortgages are sold to Fannie Mae or Freddie Mac, or the MBSs are sold back to them, this frees up the funds that have been used to obtain the mortgage in the first place and means that the originators can then create further mortgages. Fannie Mae and Freddie Mac also heavily invests in their own MBSs which is known as their retained portfolios.
Fannie Mae and Freddie Mac are government sponsored enterprises, and both were created by Congress, Fannie Mae in 1938 and Freddie Mac in 1970. . Both were created by acts of Congress; Fannie Mae in 1938, and Freddie Mac in 1970. Both have the following ties to the Federal Government:
- Fannie Mae and Freddie Mac are both companies that are made up of 18 members on the board of directors, five of which are appointed by the president of the United States.
- The secretary of the Treasury is authorized to support their liquidity, and can purchase up to $2.25 billion of securities from each company.
- Both companies are exempt from state and local taxes.
Due to these ties the market assumes that the securities issued by Fannie Mae and Freddie Mac carry some guarantee of the U.S. government and if anything were to go wrong that the U.S government would step in to bail them out. This is also reflected by how cheaply they can access funding and they are both able to issue corporate debt at far lower yields than any other institution.
Fannie Mae’s and Freddie Mac’s Public Purpose and Mission
In accordance with their policies, Fannie Mae and Freddie Mac have a purpose to provide a steady stream of low-cost funds for mortgages.
The mission as shown on Freddie Mac’s website states that they will provide liquidity, stability, and affordability to the housing market. The mission on Fannie Mae’s website is to expand affordable housing and bring global capital to local communities to serve the U.S. housing market.
Profit-Driven Companies with a Public Mission
There is no doubt that Fannie Mae and Freddie Mac are driven by profits, and this is something that their shareholders demand. They make their profit in two ways: guarantee fee income and retained portfolios.
The guarantee fee income for both Fannie Mae and Freddie Mac means that they keep a certain amount of each mortgage payment that they have guaranteed the investor a timely payment, for example every mortgage can be divided into principal and interest.
Principal and interest, when collected by a mortgage servicer, is then passed onto one of the two companies, such as Fannie Mae. Fannie Mae will then passes the principal and interest along to the holder of the mortgage-backed security; but it will keep a certain percentage of the interest as the guarantee fee in the similar way of an insurance policy. Fannie Mae should be collecting more in guarantee fee income than it is paying to the mortgage backed securities holders.
Fannie Mae and Freddie Mac also holds huge retained portfolios of mortgages and MBSs. This is because they invest heavily in their own -and each other’s securities. Due to the implied Federal guarantee, they are also able to issue debt at yields lower than other corporations to fund their retained portfolios.
Too Much Risk Concentrated in Two Companies with Federal Ties?
Fannie Mae and Freddie Mac plays major roles in the financing of housing. There is a danger in having so much risk concentrated in only two companies as they manage an immense amount of credit and interest rate risk. Many people feel that they pose too large a risk to the economy, and some believe that Fannie Mae and Freddie Mac have an unfair advantage as they can offer rates that are unavailable to other corporations.
In the summer of 2007, the mortgage market with the exception of those guaranteed by Fannie Mae and Freddie Mac halted and this emphasized the importance of the roles played by these two companies. Freddie Mac shocked the market when they announced large credit related loses. However it is yet to be shown whether the benefits Fannie Mae and Freddie Mac create for Americans will outweigh the risks they pose to our entire financial system.