The role of Fannie and Freddie

“Fannie” and “Freddie” are household names synonymous with housing and the U.S. mortgage market, but the specifics of the role they play are not common knowledge. Lending is more nuanced than “Bank A writes a mortgage for Borrower B, with the expectation that Borrower B will repay the loan over time with interest.”

As all businesses do, banks ultimately seek to increase revenue. In the mortgage industry, that translates to issuing more loans. But if banks were simply lending their own money, their coffers would soon run dry, as the cash flow from monthly mortgage premiums would be insufficient to support the writing of many more loans. So, they sell the loans.

“Banks want to sell mortgages to get more money quicker, so they can write more mortgages,” Cowan explains.

That is where Fannie and Freddie come in.

Banks cannot sell their loans to investors, because they cannot guarantee payment (there is too much risk). So they sell their mortgages to a mortgage insurer: an institution like Fannie Mae or Freddie Mac. As of this year, Fannie and Freddie either own or insure three out of every five residential mortgages in the U.S., representing $4.6 trillion in loans; that is roughly $700 billion more than are owned or insured in the private sector.

But Fannie and Freddie do not want to hold on to those loans, either. Instead, they want to sell those loans to investors, but there is one hitch – it is not so easy to sell individual mortgages to investors, because most investors are not interested in the few hundred dollars a month that mortgage payments provide. So Fannie and Freddie, therefore, assess the risk of each individual loan, stamp them with a guarantee, bundle them into what is known as a “mortgage-backed security,” and then sell the whole lot of mortgages.

Because Fannie and Freddie asess the risks of the mortgages when securitizing them, that standard filters down to the lenders themselves, explains Guaranteed Rate Executive Vice President Lizzie Garner. “Fannie and Freddie help us decide what is the right amount of risk,” she says.

The conservatorship

That arrangement proved problematic, though, when the housing bubble burst in 2008. Because lenders had sold risky mortgages to Fannie and Freddie – who then bundled those risky mortgages into securities for investors – the GSEs sustained heavy losses that mounted into the tens of billions of dollars. To save the nation’s housing market from a complete collapse, the government took over Fannie and Freddie, and they were placed into conservatorship.

When that happened in late 2008, the FHFA was bright, shiny and new, having recently been formed to serve as master banking regulator in the wake of America’s mortgage crisis. The arrangement was described by then-Treasury Secretary Henry Paulson as a three-pronged effort to provide stability to financial markets, support the availability of mortgage finance and protect taxpayers – which meant minimizing near-term costs to taxpayers and setting policymakers on a course to resolve “the systemic risk created by the inherent conflict in the GSE structure.” Paulson said that Fannie Mae and Freddie Mac were “critical” to ensuring a successful housing market correction – which, he added, posed “the biggest risk to our economy.” In many ways, it still does.

When the conservatorship took effect in late 2008, the market was rife with delinquencies, foreclosures and risk. The situation today is not so bleak, as Frank Nothaft, chief economist for CoreLogic, noted in a statement accompanying the group’s recently released third quarter Housing Credit Index report.

“As the U.S. entered the eighth year of economic recovery this past summer,” he wrote, “we continued to see mortgage originations with relatively low credit risk, and this pattern will likely continue in 2017.”

Mel Watt, who heads the FHFA, echoed Nothaft’s sentiment in a statement of his own, referencing positive changes in the market. Since 2008, he said, Fannie and Freddie have lowered the number of delinquencies and foreclosures in their respective legacy books of business, “significantly” decreased the number of REO property holdings, and taken 3.6 million-plus actions to prevent foreclosures (in addition to the 3.3 million-plus refinances authorized through HARP). In addition, they have increased diversity and inclusion in their respective business operations, consistent with legal standards and with projections that the future composition of homeowners, renters and the country as a whole will be more diverse.

By all accounts, Fannie and Freddie – and by association, the housing market – have thrived under the conservatorship arrangement. In 2016’s third quarter, the two GSEs reported comprehensive incomes of $3.0 billion and $2.3 billion, respectiely. And therein lies the quandary that lenders, economists, policymakers and all other variety of mortgage market experts are trying to reconcile: have Fannie Mae and Freddie Mac exhausted the benefit of the conservatorship? And if so, should they return to their previous, quasi-private status?