the freddie &fannie

8/14/2019 The Freddie &Fannie

1/3

THE FREDDIE &

FANNIE ROPE TRICK

Ritesh Bhusari8/4/2008
http://www.abbyy.com/buyhttp://www.abbyy.com/buy


2/3

2 | P a g e

THE FREDDIE & FANNIE ROPE TRICK

Freddie Mac or the Federal Home Loan Mortgage Corporation and Fannie Mae or the Federal

National Mortgage Association are US government sponsored enterprises (GSEs) and are two of

the largest financial institutions in the United States. These two entities together guarantee or

own roughly half of the $12 trillion US mortgage market. While they do not directly lend tohomeowners, their role is to facilitate the availability of mortgage finance to homebuyers at

affordable interest rates.

They do this by buying investment quality mortgages from approved lenders and then packaging

and selling these mortgages to investors. Mortgage lenders like commercial banks, savings

institutions and credit unions use the proceeds from selling loans to Freddie Mac and Fannie Mae

to replenish the pool of funds available for further lending to homebuyers. In effect, these

institutions function as secondary market conduits between mortgage lenders and investors, thus

expanding the scope of affordable housing in the US.

Despite the fact that Freddie and Fannie are government sponsored enterprises, they are privately

owned and enjoy special privileges like not having to register their securities with the

government, not being liable to pay state and local income taxes, being conferred special

treatment for investment purposes by bank regulators, etc. Being government sponsored

enterprises, despite their private ownership, securities issued by Freddie and Fannie have the

aura of a government guarantee and are priced as low-risk investments in the credit markets. As

a result, they are able to place their securities at lower yields in the global financial markets than

would have been otherwise possible, which in turn benefits US homeowners both in terms of

access to credit and its affordability.

This appears to be a neat and elegant capitalistic solution to the issue of augmenting home

ownership where homeowners get easy access to affordable mortgages, lenders profit from

originating mortgages without having to hold these mortgages in their books, investors earn a

good return on their safe investment in securities backed by a pool of mortgage receivables

guaranteed by government sponsored enterprises and Freddie and Fannie profit from their access

to cheap credit.

How then did the music in this never ending party stop? The fortunes of Freddie and Fannie were

affected by the tremors of the subprime crisis though they were not packaging and sellingsubprime loans themselves. The mortgages Freddie and Fannie were buying were of investment

quality with substantial down payments and meeting well-documented income criteria. However,

with widespread repossession and distress sale of homes representing subprime mortgages, there

has been a general decline in home prices leading to negative equity and delinquency in respect

of several mortgages that met Freddie-Fannie investment criteria at the time of origination.


3/3

3 | P a g e

Given the ease with which they could raise money from the financial markets because of their

government sponsored enterprise status, Freddie and Fannie were terribly overleveraged with

their owned funds backing an astronomical 65 times of debt and guarantees. At this level of

leverage, it does not take much delinquency by the ultimate homeowners or adverse interest rate

movements to bring the edifice crashing down and this was exactly the situation Freddie and

Fannie were inexorably heading towards. The market called the bluff on the financial health of

the GSE duo and business as usual became untenable for them. At the end of July 2008, the

US government had to make the guarantees explicit by enacting a law that prevents Freddie and

Fannie from collapsing and given the size of their obligations this warranted a substantial

increase in the government debt ceiling to $10.6 trillion.

The lessons to be learnt from this saga are many. For starters, there is a basic contradiction in

terms in a privately owned entity that is also a government sponsored enterprise. A privately

owned entity is subject to the discipline of the market place where lenders will carefully consider

the financial health of the company and will limit exposure to prudent levels while doingbusiness with the entity. It is the status of a GSE that helped create the aura of an implicit

government guarantee more so because this was not explicitly denied by the government, till

recently that allowed the GSE duo to go on a leveraging spree. Among the investors were

several governments investing their foreign exchange reserves and this was certainly an

additional factor forcing the US governments hand in the bailing out of Freddie and Fannie.

While the activities of Freddie and Fannie greatly helped the mortgage market and served a

useful social purpose, the US government was in effect, keeping the enormous liabilities of the

GSE duo out of its balance sheet. However, this did not make the US governments liability any

less or any less real. The private shareholders of Freddie and Fannie have been raking in

supernormal profits over the years because of the special privileges granted by the government.There have been some attempts to break this cosy duopoly in the past but the powerful GSE duo

had, like in many democracies, managed the political process very well through some deft

lobbying.

In the ultimate analysis, the strange animal that the GSE duo had evolved into represented the

very pinnacle of misdirected incentives and rent seeking where private stockholders reap the

benefits of special government dispensations but when the going gets tough, the tax payer is

forced to pick the tab under the maxims too big to fail and preserving the integrity of the

financial system. Of course, if there was ever a case for applying the too big to fail maxim

this was indeed it, because the debt and guarantee obligations of the GSE duo was gigantic,

nearing half the GDP of the US economy.

What is surprising is that this level of indulgence to two shareholder-owned listed entities has not

happened in a third-world banana republic but at the avowed temple of free market capitalism. In

comparison, the dalliance of the Indian government with bailing out the infamous US-64 a

decade ago appears to be kindergarten stuff!

the freddie &fannie

Documents